Tax planning at a crucial juncture in manufacturing

Three major changes in tax law over the last two years have broadly affected the tax treatment of capital and research spending and the debt used to finance it:

1. Section 174: For tax years beginning in 2022 and later, domestic research and experimental (R&E) costs under Section 174 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.
2. Section 163(j): The deduction for net interest expense is generally limited to 30% of adjusted taxable income under Section 163(j). Previously, adjusted taxable income was similar to 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 is particularly acute for manufacturers making large capital investments that create sizeable depreciation deductions. As high interest rates persist, more manufacturers than ever are being hit with this limit. Although taxpayers can carry forward their unused interest deductions, the 30% limit will continue to apply and the disallowance can be effectively permanent for some companies. 

3. Bonus depreciation: Property placed in service this year can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the rest of the cost recoverable over the normal depreciable period. This treatment is scheduled to diminish 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.  

Many taxpayers hesitated to address these changes, hoping Congress would reverse them legislatively. Most taxpayers were finally forced into implementation when filing 2022 returns, so manufacturers should have completed the significant work of identifying R&E costs under Section 174 and applying the new interest limit. With compliance out of the way, it’s time to go from defense to offense.

These provisions together can push manufacturers out of losses and into a taxable position.

Planning alternatives that may not have made sense when generating net operating losses should get a fresh look. All companies should assess the impact to investment and financing plans, and evaluate planning opportunities that can soften the impact of the tax changes. There may be one last chance for lawmakers to provide retroactive relief before the end of this year, so manufacturers should watch out for potential legislation. Assuming those efforts fail, there are a variety of planning strategies that can provide benefits.

Manufacturers that will exceed the cap on their interest deduction may have opportunities to instead allocate interest expense 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. For a more detailed discussion, see Strategic considerations for the newly restrictive 163(j).

“How interest is allocated can affect how quickly the cost is recovered,” Sites said. “Shifting deductions can also affect international provisions such as FDII and GILTI. It’s important to model out the interactions to see what levers can be pulled to achieve the best tax result.”

Manufacturers with international operations should consider the impact to foreign tax credit (FTC) limitations and global intangible low-taxed income (GILTI). Companies that are newly coming out of losses can consider elections to group controlled foreign corporations (CFCs) under Section 163(j), which can create additional group income to use carryforwards and lower the GILTI inclusion. There may also be opportunities to carry excess income to the U.S. entity, raising the cap on the interest deduction domestically.

Section 174 presents its own set of planning challenges and opportunities. The IRS released important guidance on how to apply these rules just weeks before returns were due for many calendar-year corporations. The guidance clarifies key areas, like the scope of software development, which must generally be capitalized under Section 174. Taxpayers should analyze the new rules, which are proposed to be applicable for tax years beginning after Sep. 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.

With bonus depreciation shrinking to 80% this year and 60% next, it’s worth looking at opportunities to accelerate deductions for fixed assets. An analysis to identify costs that can be considered repairs has always been 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. Manufacturers can 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.

“Manufacturers producing long-production period property have an additional opportunity,” Murphy said. “This property is still eligible for 100% bonus when placed in service in 2023 and the interest related to the property must generally be capitalized and recovered with it.”

Foreign tax credits

Late last year, the IRS finalized regulations to rewrite 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. The good news for manufacturers is that in July the IRS 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. Manufacturers 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.

“Manufacturers can generally continue to apply the rules in place before the new regulations, which provides much more favorable results,” Sites said. “In addition, we expect the IRS to significantly alter the suspended rules before they are scheduled to take affect again.”

Pillar 2 global minimum tax

Multinational manufacturers with €750 million or more in consolidated financial statement revenue in at least two of the previous four years can’t afford to ignore Pillar 2 any longer. 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 allow parent countries to impose “top-up” tax on earnings of foreign subsidiaries with effective rates below 15%.
• Under-taxed profits rule (UTPR): The UTPR denies deductions and using other mechanisms to effectively impose additional tax on earnings 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 potentially be double taxed in future years when relief for the U.S. GILTI 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.

“Your preparation needs to start with an assessment,” Sites said. “It’s 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 to financial statements and cash flow, and allows companies to evaluate potential changes to structure or operating model to mitigate bad results.”

The complex computations will require covered companies to spend substantial time gathering and analyzing data points on an annual basis, some of which may not be readily available. Manufacturers should consider automation and software solutions to increase efficiency. 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, due to shifting supply chains, sweeping international tax law changes and increased global 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. Manufacturers 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 it is to resolve transfer pricing issues. 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 make for a complicated and expensive resolution process,” Sites said. “Manufacturers can consider alternative dispute resolution programs, like administrative appeals, mutual agreement procedures, and advance pricing agreement programs.”

Public stock buyback tax

Public manufacturing companies face a new 1% excise tax on the fair market value (FMV) of stock repurchases beginning in 2023. The IRS is still working on guidance, but has said 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. Manufacturers 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 a 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 of a tax base if they are recharacterized as a repurchase, so the tax should be considered as a 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.

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Manufacturers should expect elevated 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 corporations have seen their audit rates fall significantly in the last few years, and should expect them to rebound in the next few years.

Manufacturers commonly have issues that the draw significant IRS attention. In addition to analyzing transfer pricing issues, the IRS has also opened a compliance campaign targeting taxpayers who overstate the cost of goods sold through inventory manipulation or valuation, overstatement of costs or improper deduction of nondeductible items. Finally, the R&D credit has long been one of the largest sources of IRS controversy, and the IRS is actively litigating many R&D credit issues in court.

R&D credit

Despite the audit activity, the R&D credit remains one of the most valuable incentives available to manufacturers. According to IRS data, manufacturers claim more R&D credits than every other industry combined. The credit is even more valuable with the new requirement to amortize research costs under Section 174, since 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(c) long required taxpayers to reduce their deductions under Section 174 by the amount of any R&D credit, or to reduce the R&D credit by the tax effect. The Tax Cuts and Jobs Act amended Section 280C(c), so taxpayers only need to reduce their capital account for future Section 174 expenditures to the extent that any R&D credit exceeds the deduction for those costs. For many manufacturers, the deduction will exceed the R&D credit, meaning they can claim the full R&D 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 any 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 the development activities constituted elements of the process of experimentation or that there was not sufficient uncertainty from the outset.

“Taxpayers should consider a full R&D credit study that not only maintains detailed records but explores whether there are missed opportunities in areas identified by the need to capitalize Section 174 expenditures,” Murphy said. “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 found did not qualify as a whole.” 

Export incentives

The FDII deduction was created specifically to benefit export manufacturers. The provision is generally designed to create a reduced rate on income from applying intangibles abroad, but it’s a very mechanical calculation that applies a benefit more broadly than many taxpayers realize.

The deduction is potentially available for any domestic manufacturer that sells, licenses or leases any products to any foreign entity, for use outside the U.S. There are planning opportunities that can further leverage the deduction. A detailed review of sales contracts, transfer pricing, fixed assets and accounting methods can often uncover ways to improve the benefit. Manufacturers that use foreign branches of foreign disregarded entities may have opportunities to use transfer pricing and the disregarded payment rules to reclassify non-qualifying income.

Energy tax credits

The IRA’s transformative new energy tax package can benefit manufacturers in several different ways. The available credits vary depending on a company’s manufacturing sector and energy needs:

• Emissions-heavy processes: Manufacturers with processes that create significant carbon emissions, including chemical companies, distillers, steel manufacturers, cement producers and paper companies, can apply under Section 48C for a 30% credit against the costs of investments to reduce emissions by at least 20%. There is also a credit available under Section 45Q for capturing and permanently sequestering carbon oxide.

• Energy supply chain: Section 45X offers a powerful new credit for manufacturers that make wind, solar and battery components in the U.S. Even better, Section 48C offers a credit for a much broader range of manufacturing activities that goes well beyond renewables, including manufacturing products or components of energy and fuel storage systems, carbon capture equipment, clean vehicle parts and charging infrastructure, grid modernization property, energy and thermal storage systems, critical minerals and other conservation technologies.

Energy sources: All manufacturers with energy needs should assess the potential benefits of using sources that qualify for the new broader and more lucrative investment tax credit under Section 48. It applies to traditional renewable energy sources like wind, solar, and geothermal property, but has also been expanded to cover stand-alone energy storage, microgrid controllers and electrodynamic glass. The credit starts at 30% for taxpayers meeting or exempt from prevailing wage requirements, and can increase 10% for domestic content and another 10% for certain projects in energy communities. Manufacturers that generate a combination of thermal energy and either electric or mechanical energy in their manufacturing processes should evaluate the potential for a credit on combined heat and power systems. 

“Taxpayers do not need to actually pay tax to benefit from these credits,” Sites said. “The IRA made several of them refundable, while the rest can generally be sold to unrelated taxpayers for cash. Manufacturers should reevaluate their energy needs given the new landscape, especially if they have ESG goals to meet.”