Q1 2022 Tax Law Changes
March 31, 2022
By Murray J. Solomon and Adam Firestone
As we close out the first quarter of 2022, executives responsible for the tax provision should be aware of numerous tax changes which are effective for the first time beginning in Q1. Companies should consider the impact these changes will have on their income tax provision, and whether they should be accounted for discretely or through the annual estimated effective tax rate. Here are a few of the most impactful developments:
1. IRC Sec. 174 – Capitalization of Research and Experimental Costs
Prior to 2022, research and experimental costs were currently deductible unless an election was made to capitalize such costs. Pursuant to the Tax Cuts and Jobs Act of 2017 (“TCJA”), taxpayers will now be required to capitalize all research and experimental (“R&E”) costs for tax years beginning on or after January 1, 2022. R&E costs generally refer to costs incurred to discover information which would eliminate uncertainty in the creation or improvement of a product. This could be in the form of wages, salaries or supplies, and also indirect costs, such as overhead and deprecation. Capitalized costs could even go beyond the costs that qualify for the R&E tax credit and include software development expenses.
Domestic costs incurred related to research and experimentation will be subject to a five-year recovery period, while foreign costs will be subject to amortization over a fifteen-year period. The mandatory capitalization of these costs can affect estimated tax payments, tax expense and other tax matters. More specifically, from a financial reporting and tax provision perspective, a new temporary difference will be recorded that will increase current period taxable income, while providing for a new deferred tax asset on the balance sheet.
While there have been several bipartisan efforts to delay the implementation of mandatory R&E capitalization, there has been no success thus far in repealing this provision.
2. IRC Sec. 163(j) Limitation of Interest Expense – Base Limited to EBIT
As was planned since the TCJA first imposed a limitation on interest expense in 2018, beginning in 2022, the IRC Sec. 163(j) interest limitation will no longer include the benefit of an addback of depreciation and amortization expense. Interest expense will essentially be limited to 30% of taxable income before interest and taxes (or taxable EBIT). There is, however, a small consolation, which is that the gross receipts test, which exempts taxpayers from IRC Sec. 163(j), has been raised to $27M for 2022.
Interest expense that is suspended due to the IRC Sec. 163(j) limitation creates a deferred tax asset which has an indefinite carryforward. Companies will need to evaluate whether this deferred tax asset is realizable or if a valuation allowance is necessary. In addition, companies with indefinite-lived intangible assets and so called “naked credits” may find that the additional interest expense disallowance significantly impacts such naked credits.
3. Bonus Depreciation Phase-down
One of the most taxpayer-friendly provisions of the TCJA was an increase in bonus deprecation from 50% to 100% for qualifying assets. 2022 is the final year in which taxpayers can immediately deduct their qualifying assets entirely. Beginning January 1, 2023, the rate for bonus depreciation will be reduced to 80%, followed by a reduction in 2024 to 60%, a reduction in 2025 to 40% and finally reduced to 20% in 2026, at which the bonus amount would remain unless the law is amended. Generally, property eligible for bonus depreciation is property with a MACRS recovery period of less than 20 years, such as machinery, equipment, and furniture.
The 100% rate at which bonus depreciation can be taken is another provision which appears to have widespread support in Congress for an extension but has not yet come to fruition. On the face, companies should consider accelerating capital expenditures into 2022 to reap the benefits of the full expensing; however, it is also important to consider the impact the additional depreciation would have on the IRC Sec. 163(j) interest limitation and other limitations. While the temporary nature of the depreciation adjustment means the effective tax rate will not be impacted, there are cash tax implications which should be considered with regard to estimated payments. In addition, taxpayers will need to consider the state conformation to the federal bonus rates annually.
4. ASC 842: Leases
In February of 2016, FASB issued ASU 2016-12 which requires that all leases be recorded on the balance sheet. Following a pandemic delay, the adoption is mandatory for all private companies in fiscal years beginning after December 15, 2021. Public companies have been complying with the standard since Dec. 15, 2018.
ASC 842 retains the two-model approach to classifying leases as either operating or finance leases, but regardless of classification type, the leases are generally recorded on the balance sheet. When the lease is initially recorded on the balance sheet, a lease liability is recognized based on the present value of the future payments. Accordingly, an offsetting right-of-use (ROU) asset is established. A discount rate is applied to determine the present value based on the rate implicit in the lease.
The rules governing tax accounting for leases have not changed. Because the ROU asset comprises different components, each with unique tax implications, the traditional change-in-balance approach to tracking book-tax differences may no longer apply. Companies will likely need to establish deferred tax assets based on the lease adoption entries and track the varying components, the ROU amortization and interest expense, which is not deductible, and the cash rent paid, which is deductible under the all events test. Companies should also consider the presentation of the corresponding deferred tax asset created by the lease liability and deferred tax liability created by the ROU asset and whether separate presentation on the footnote is appropriate. A method change could also be required in certain circumstances.
- Net operating loss (NOL) limitations: The TCJA and CARES act have added layers of complexity to the net operating loss carryforward rules. For losses generated in tax year 2022, net operating losses cannot be carried back, but can be carried forward indefinitely and can only offset up to 80% of taxable income.
- Charitable contribution limitations: In 2021, the CAA extended the benefit of corporations being subject to an increased charitable contribution limitation of 25% of taxable income, which returns to 10% for tax year 2022.
- Meals deduction at 100%: Under the CAA, for tax years 2021 and 2022 there is a full deduction for the cost of food or beverages provided by a restaurant. In general, any of the meals that would have previously fallen under the 50% deduction are now fully deductible if they were paid or incurred after December 31, 2020 and before January 1, 2023.
With the end of the first quarter behind us, time is running out to ensure your Q1 tax provision is current with the tax law changes above to avoid surprises, cash flow problems and check that the increased data required by the above changes can be met by the accounting software. Further, the implications of these changes will have reach far beyond the income tax provision. With interest rates rising and increased limitations on deductibility, raising capital through debt will become very costly. It is crucial executives plan for these changes today.