Sound hospitality tax planning strategies can serve savings

Section 174 R&E cost amortization

While research and development (R&D) might not immediately come to mind as a big spend for the hospitality industry, the new requirement to capitalize software development expenditures under Section 174 warrants a deeper look into both the research credit and the treatment of research expenses.

For tax years beginning in 2022 and later, domestic research and experimentation (R&E) costs under Section 174, which included all software development costs, must now be amortized over five years instead of being expensed. Since a midyear convention must be used, this effectively reduced the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years.

Many businesses hesitated to address this provision change in hopes that Congress would reverse it legislatively. Most taxpayers were ultimately compelled to implement the new Section 174 rules when filing 2022 returns, so hospitality companies should have completed the significant work of identifying R&E costs under Section 174 already. Now is the time to look at more proactive planning. There might be one last chance for lawmakers to provide retroactive relief before the end of this year, so watch out for potential legislation.

The IRS released expansive guidance on how to apply these rules just weeks before returns were due for many calendar-year taxpayers. Taxpayers should analyze the new rules, proposed to be applicable for tax years beginning after Sept. 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.

R&D tax credit

“Hospitality and restaurant companies shouldn’t overlook the R&D tax credit,” said, Grant Thornton R&D Tax Credit Partner Rob Levin. “While industries like pharmaceuticals, technology, and manufacturing, typically take advantage of R&D tax credits; over the last few years, as the hospitality industry has started to rely more heavily on technological advancements to improve efficiency and meet evolving consumer demands, we have seen the sector taking advantage of the R&D tax credit more and more.”

Hospitality organizations could be eligible for R&D tax credits in areas such as on-line portal advancements, digital transformation projects, application design and other lesser-known operational areas such as point-of-sale/online transaction improvements. A list of other potentially qualifying activities includes:

• Functional product improvements such as culinary innovation; new cooking techniques; or new sourcing methods
• Loyalty programs that integrate with mobile payment applications
• Improving mobile commerce capabilities
• New design/build projects of the hospitality establishment
• Robotics to improve the customer experience
• Advanced fraud detection and prevention technologies
• Value engineering to the storefront
• Lighting system design for energy efficiency

The R&D credit is actually more valuable with the new requirement to amortize R&E costs under Section 174 because many companies discovered they had qualified activities for which they had never taken the credit previously because they had not identified the research activities. Additionally, some taxpayers may no longer need to reduce either their R&D credit or the amount recovered under Section 174.

Section 280C has long required taxpayers to reduce their deductions under Section 174 by the amount of any R&D tax credit, or to reduce the R&D tax credit by an equivalent amount.

The Tax Cuts and Jobs Act amended Section 280C, so taxpayers now only need to reduce their capital account for future Section 174 amortization if any R&D tax credit exceeds the deduction for those costs. For many hospitality companies, that deduction will exceed the R&D tax credit, allowing them to claim the gross R&D tax credit without any reduction in the ability to recover Section 174 costs. Taxpayers should monitor this issue, however, as the IRS has not yet issued guidance on interpreting the new statutory language.

The IRS scrutiny of the R&D credit underscores the need for taxpayers to properly document and substantiate their R&D credit claims The IRS has won several recent cases based on the failure of taxpayers to establish that “substantially all” of all the development activities constituted elements of the process of experimentation or that there was not sufficient uncertainty from the outset. Hospitality businesses should consider an R&D credit study. Some of the taxpayers who lost recent cases could potentially have preserved partial credits under the “‘shrink-back rule’” if they had provided the documentation to apply their analysis to subcomponents of a project that the court’s found did not qualify as a whole. Hospitality companies should consider a full R&D credit study that not only maintains detailed records to the extent available, but explores whether there are missed opportunities in areas identified by the need to capitalize Section 174 expenditures.

Debt planning

The era of cheap money is over. High interest rates have proven frustratingly resilient, so companies need to re-evaluate their investment plans and financing strategies. Tax rules will only make it harder.

The deduction for net interest expense is generally limited to 30% of adjusted taxable income under Section 163(j). Previously, adjusted taxable income resembled earnings before interest, taxes, depreciation and amortization (EBITDA). For tax years beginning in 2022 or later, depreciation and amortization must be included, lowering adjusted taxable income to an amount similar to EBIT. The change can be particularly relevant for hospitality businesses, which frequently make significant capital investments. Although taxpayers can carry forward their unused interest deductions, the 30% limit will continue to apply, so projections could show a near-perpetual disallowance.

“There are planning opportunities to mitigate the impact, but it’s important to model out the scenarios,” Olivardia said.  “Changes in the deduction for interest can also affect other items on the return so it is important to consider that as well.”

Like Section 174, there is some bipartisan interest in reversing the new Section 163(j) rules legislatively, so pay attention to Congress this winter. Assuming those efforts fail, there are a variety of planning strategies. Companies may be able to reduce the amount interest limited under Section 163(j) by allocating that interest to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to another asset, the interest becomes part of the cost of that asset and is recovered using the accounting method applicable to that item. For example, if interest is recharacterized to a fixed asset, it would be recovered through depreciation deductions. Refer to our previous article for a more detailed discussion.

Fixed assets

Hospitality businesses grew accustomed to fully deducting the cost of most buildouts. Almost any improvement to the interior of real property already in use qualified for 100% bonus depreciation as qualified improvement property (QIP). Unfortunately, bonus depreciation itself is diminishing.

Property placed in service in the year 2023 can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the remaining cost recoverable over the normal depreciable period. This treatment is scheduled to decrease over time, with the bonus rate dropping to 60% for property placed in service in 2024, 40% in 2025, and 20% in 2026. Bonus depreciation is scheduled to disappear entirely in 2027.

“For lodging and other hospitality businesses, losing 40% of the previously immediate deduction can be painful,” Olivardia said. “These organizations were used to fully deducting improvements to buildings interiors and other investments in tangible property,” said Olivardia. “That benefit is decreasing each year just as the new unfavorable limit on interest deductions kicks in. Hospitality businesses should model out the interaction between these and other provisions and evaluate planning opportunities to mitigate the impact. The good news is there are planning opportunities that may have been ignored when bonus depreciation was still 100%.”

An analysis to identify costs that can be considered repairs has always been and remains valuable when looking at structural property that doesn’t qualify for bonus depreciation. With bonus depreciation at 60% next year, this repairs analysis could also now significantly accelerate the cost recovery of other types of property, including costs that would otherwise be Qualified Improvement Property (QIP) and recoverable over 15 years. Businesses should also consider a broader cost segregation analysis, which identifies costs eligible for recovery as property with a shorter depreciable period. This effort can be paired with Section 163(j) planning to accelerate the recovery of any related interest expense.

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State and local taxes

State taxes considerations are paramount for an industry with a physical footprint as large as the hospitality industry. Sales tax has become increasingly complex as delivery models change and restaurants and hotels increasingly partner with other parties to provide services. Consider performing a sales and use tax “reverse audit” to review purchase records over the past several years to identify potential missed exemptions, misapplied rates and overpayments. The reviews often yield significant refunds, as well as identify areas of exposure.

Property taxes are also often a very large cost for restaurant, hotel, and other hospitality businesses. These taxes, which are generally based on formulas that take the value of property into account, can be notoriously sensitive to inflation. Commercial property values took a big hit at the outset of the pandemic, but with people returning to cities to work at least part of the time, and a reimagination of what work could look like post-pandemic, these values are again increasing.

“Assessors are looking to recapture some of the revenue lost when restaurant valuations plummeted during the heart of the pandemic,” said Rhodes. “Some of the increases may not be supportable. Business have the right to challenge valuations, and a property tax assessment can uncover significant savings.”

Also, several states have enacted food delivery service taxes, creating new tax obligations not only for third-party providers like Grubhub and Uber Eats, but also for restaurants with their own delivery service. Difficulties in interpreting such laws often hinge on the definition of a “marketplace facilitator” which is difficult to determine, for instance, in a hybrid situation where a third-party service takes orders from a restaurant website and coordinates the delivery independently of the restaurant.

Taxes affecting hospitality businesses have also been part of major state taxation overhauls, such as in Minnesota where tax legislation reducing the dividend received deduction and the net operating loss deduction will be important considerations. New Jersey recently made major changes to its Corporation Business Tax on combine group filing.

Pillar 2 global minimum tax

Multinational hospitality businesses with 750 million euros or more in financial statement revenue can no longer afford to ignore Pillar 2. While implementation is stalled here in the U.S., it is moving forward abroad, with initial rules taking effect as early as 2024.

Pillar 2 is an initiative from the Organisation for Economic Co-operation and Development (OECD) designed to ensure large multinationals pay a minimum level of tax on income arising in every jurisdiction where they operate. The framework generally consists of three interlocking rules:

• Income inclusion rule (IIR): The IIR will allows parent countries to impose a “top-up” tax on earnings of foreign subsidiaries with effective rates below 15%
• Under-taxed profits rule (UTPR): The UTPR denies deductions and use other mechanisms to effectively impose an additional tax on certain other types of income with effective rates under 15% that aren’t covered by an IIR
• Qualified domestic minimum top-up tax (QDMTT): The QDMTT “tops-up” tax on domestic entities to 15% before another country’s UTPR or IIR applies

Global adoption will affect U.S. multinationals in significant ways. The foreign income of U.S. multinationals could be hit by QDMTTs and UTPRs in foreign jurisdictions, and could be double-taxed in future years when relief for the U.S.’s global intangible low-taxed income regime expires. Domestic subsidiaries of foreign parents with domestic income taxed at an effective rate below 15% could also be taxed under the IIR of the parent’s jurisdiction. When transition relief expires in 2025 or 2026, any domestic income taxed at an effective rate below 15% could be taxed by the UTPR of even a subsidiary jurisdiction. In addition, there may be financial statement implications, and affected companies will be required to perform detailed calculations and extensive reporting on a jurisdiction-by-jurisdiction basis.

An assessment is critical to determine the potential applicability based on the revenue threshold, the entities in scope, and eligibility for any safe harbors. Modeling can also help determine the impact on financial statements and cash flow, and allows companies to evaluate potential changes to their structure or operating model to mitigate bad results. The complex computations will also require covered companies to spend substantial time gathering, analyzing, and mapping data points on an annual basis, some of which may not be readily available.

“Hospitality businesses should consider tax automation and software solutions to increase efficiency,” Olivardia said. “Most covered companies will also need a global network to assist with the preparation and review of returns in each jurisdiction.”

Transfer pricing

Transfer pricing has rarely been more difficult thanks to rising interest rates, shifting supply chains, sweeping international tax law changes, and increased global tax reporting requirements. Transfer pricing has also never been more important.

The growing exposure involved with transfer pricing issues is matched only by how pervasive it is. Taxpayers are required to determine an arm’s-length transfer price for any cross-border transaction or agreement between related parties, including for goods, services, intangible property, rents and loans. This represents a staggering amount of activity. According to the U.S. Census Bureau, imports and exports between related parties surpassed $2 trillion last year, representing more than 40% of all import and export activity. And this doesn’t even include intercompany services, loans, or payments for intangibles.

The amount of tax at stake can be substantial. The largest tax disputes in Tax Court history involve transfer pricing, with judgments reaching billions of dollars in taxes and penalties. The IRS has seen some success in its recent litigation and is stepping up enforcement. These efforts will be aided both by $60 billion in new IRS funding and legislative changes driven by Pillar 2. With the IRS winning cases, taxpayers need to look more closely at whether their transfer pricing positions represent uncertain tax positions that must be reflected on financial statements.

The costs of a transfer pricing dispute can go beyond the adjustments in tax, or even the potential 20% or 40% penalties for valuation misstatements. Sizeable costs in professional fees and in-house resources are common due to how notoriously complex and difficult to resolve transfer pricing issues are. Given the cross-border nature of the issue, all transfer pricing disputes involve at least three parties affected by the outcome: the taxpayer and both countries affected by a change in transfer price.

The size, complexity and ambiguity of transfer pricing issues makes for a complicated and expensive resolution process. Hospitality companies can consider alternative dispute resolution programs like administrative appeals, mutual agreement procedures, and advance pricing agreement programs.

Foreign tax credits

Finally, some good news. The IRS finalized regulations late last year that rewrote the foreign tax credit (FTC) rules and significantly restricted the ability of taxpayers to credit foreign taxes, including digital service taxes, withholding taxes on fees for technical services, and certain royalties. So, what’s the good news? After widespread complaints, the IRS in July 2023 effectively delayed the implementation of the final rules and will generally allow taxpayers to use a modified version of the rules in place as of April 1, 2021. The relief does not apply to digital services taxes. Taxpayers can generally continue to apply the rules in place before the new regulations, which provides much more favorable results. In addition, the IRS is expected to significantly alter the suspended rules before they are scheduled to take effect again.

“Hospitality groups that filed 2022 returns before the relief was available should analyze their FTC positions to see if there are opportunities to file for refund claims on an amended return,” Olivardia said.

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Public stock buyback tax

Public hospitality groups are now facing a new 1% excise tax on the fair market value (FMV) of stock repurchases beginning in 2023. While the IRS is still working on guidance, it has indicated the tax will be remitted and reported annually with Form 720 for the first quarter after the end of the tax year. This means the 2023 tax and form will likely be due for calendar year taxpayers by April 30, 2024. Hospitality companies that will be affected need to move quickly to understand the impact.

The tax applies to corporations with stock traded on an established securities market, which includes corporations with stock that is traded on a national securities exchange. The tax may also apply to certain acquisitions of a foreign corporation’s stock. A repurchase is defined for this purpose as a redemption under Section 317(b), plus “economically similar” transactions. The tax could increase costs on many kinds of common stock redemption activity, including redemptions related to M&A and stock compensation plans. The new excise tax is not deductible for income tax purposes.

Under initial guidance from the IRS, the tax will cover a variety of corporate transactions, including acquisitive reorganizations, certain E and F reorganizations, and exchanges in some split-off transactions. The tax can also apply to redemptions of non-publicly traded stock, such as preferred stock, if the corporation has other stock traded on an established securities market.

There are important exceptions and exclusions. Stock issued effectively reduces the amount considered repurchased for purposes of calculating the tax. There are specific rules for determining the FMV of stock issued and repurchased. In addition, the following repurchases are excluded:

• Reorganizations within the meaning of Section 368(a) where no gain or loss is recognized
• Repurchases to the extent that stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan
• If the aggregate FMV of stock repurchased in a year does not exceed $1 million
• Repurchases by a dealer in securities in the ordinary course of business
• Repurchases by a regulated investment company (RIC) or a real estate investment trust (REIT)
• To the extent that a repurchase is treated as a dividend

Planning for the tax is important. Different types of transactions can be treated differently under the current guidance. Some M&A transactions can give rise to a large increase in a tax base if they are recharacterized as a repurchase, so the tax should be considered as part of transaction planning and structuring. Because stock issued by a corporation may offset stock repurchases during the year, companies should consider the timing of repurchases related to their stock issuances. Any excess of stock issuances cannot be carried forward and used against stock repurchases in future years.

IRS enforcement

Taxpayers should expect increased scrutiny from the IRS over the next few years. The Inflation Reduction Act provided the IRS with $80 billion in new funding, and over 50% is earmarked for enforcement. The debt limit deal included a handshake agreement to reallocate $20 billion of that money to other spending priorities, but $60 billion is still a staggering sum compared to normal IRS funding. It represents more than four years of annual appropriations based on recent IRS funding levels, and it comes on top of regular annual funding with no restrictions on when it can be spent.

The increased enforcement may come more quickly than some taxpayers expect. The IRS has already significantly expanded its workforce in the last two years and is actively recruiting 3,700 new auditors. Much of the activity will be focused on partnerships and high-net-worth individuals, but no population of taxpayers will be unaffected. Even the largest public corporations have seen their audit rates fall significantly in the last few years and should expect them to rebound in the next few years.

Next steps

Hospitality companies face numerous and multi-faceted tax issues that are best addressed with foresight. A thorough analysis and models of future obligations can reduce or eliminate unanticipated tax consequences. The return of a sense of normalcy to business can’t mask that the hospitality industry has been changed permanently by the effects of the last decade. Concurrent tax law changes have added new obligations, and some favorable opportunities, to hospitality companies trying to adjust to these industry threats.

Heading into and during early 2024, hospitality companies find themselves in an ideal time to consider the tax implications of their planning options for various growth strategies and investments. Given the complexities, companies can usually benefit from the input of third-party advisers familiar with taxation issues and their application to the industry.