Tax Implications of Recent Federal Legislation for Technology Companies, Douglas Sayuk, Practical Tax Strategies January 2023 Issue. Copyright 2023 Thomson Reuters/Tax & Accounting

The tax landscape for technology companies has shifted dramatically over the past five years. Beginning with the 2017 Tax Cuts and Jobs Act ("TCJA"), U.S. tax policy has taken a notable shift toward incentivizing domestic commercial activity. This was accomplished in part through a dramatic reduction in the U.S. corporate tax rate to 21%, establishing an effective global minimum tax via the global intangible low-taxed income (GILTI) regime, eliminating some tax deductions on outbound transfer pricing payments via the base erosion and anti-abuse tax (BEAT), and incentivizing export sales through taxing foreign derived intangible income (FDII) at an effective reduced rate.

While U.S.-centric companies largely benefitted, the TCJA increased taxes overall for many technology companies whose footprint tends to be more global than other industries. In addition, the TCJA significantly increased reporting requirements for foreign operations resulting in substantial new compliance costs. Now, although largely overlooked at enactment due to a delay in its implementation, technology companies are facing the real prospect of no longer being able to immediately deduct R&D expenditures.

The technology industry landscape has dramatically shifted since TCJA. Many companies thrived during the pandemic as everything went virtual and easy monetary policies resulted in an influx of substantial outside investment dollars. Now tech companies find themselves struggling as monetary policy tightens and inflation takes a large bite out of discretionary consumer spending.

While not as far-reaching as TCJA, technology companies may find themselves impacted by the recently enacted Inflation Reduction Act of 2022 (IRA) 1 and CHIPS and Science Act of 2022 (CHIPS Act). 2 The tax provisions of these new laws are a mixed bag for tech companies.

On the one hand, the legislation creates valuable targeted incentives related to domestic semiconductor investment, research by start-up companies, and clean energy. Conversely, larger technology companies will be disproportionately impacted by the new corporate minimum tax provisions and excise tax on share buybacks which have long been favored by technology companies. Companies may find themselves subject to increased audit scrutiny from a significant expansion of IRS enforcement resources, but at the same time may benefit from increased IRS technology spending. Perhaps most important is what was not included - a deferral or repeal of the TCJA requirement to begin capitalizing R&D costs starting in 2022.

This article examines the impact of these tax provisions, specifically as it relates to technology companies.

Corporate minimum tax

The largest revenue generator in the recent tax legislation (raising an estimated $222 billion over 10 years) 3, and the one garnering the most attention, is the corporate minimum tax on global book income (CMT). Nonetheless, the number of companies impacted by the CMT will be extraordinarily narrow, estimated to target only around the largest 150 companies, 4 so the vast majority of technology companies will go unscathed.

In essence, starting in tax years beginning after 12/31/2022, companies earning over $1 billion in average annual profit over the prior three years will pay the higher of: (1) their tax liability as computed under the Internal Revenue Code, and (2) 15% of adjusted financial statement income (AFSI). In effect, for the tax to be applicable, the AFSI would need to be 40% higher than taxable income for the minimum tax to apply (the 6% difference between the 21% corporate rate and the 15% minimum rate).

Approximately two-thirds of the estimated 470 companies who meet the AFSI thresholds already pay tax in excess of the minimum rate. For example, the Washington Post found many of the largest technology companies, including Apple, Meta, and Microsoft, paid cash taxes in excess of 15% last year. 5 Nonetheless, the Joint Committee on Taxation (JCT) found that technology companies, along with manufacturing, will be most impacted by the CMT. This may in part be due to unfavorable impacts of certain items which disproportionately affect technology companies, such as those from stock awards and foreign derived intangible income.

However, the legislation contains a number of provisions which should serve to reduce the impact of the CMT on technology companies. Most notably are benefits around R&D expenditures. While companies are now required to capitalize and amortize R&D over five years in computing taxable income (more on this below), R&D is expensed for AFSI (book) purposes and thus allowable in full to offset the 15% minimum tax liability. Furthermore, general business credits, including research credits, may offset 75%
of the minimum tax liability. Green and foreign tax credits can also offset the CMT, as are book loss carryovers incurred since 2020.

At first glance, this seemingly aligns U.S. tax policy with the OECD's Pillar Two 15% minimum tax, but upon closer examination, the new CMT contains more differences than similarities. The broad applicability of tax credits, along with accelerated depreciation and other carve-outs, causes the CMT to diverge from the OECD Pillar 2 provisions, which significantly limits these benefits. The OECD minimum tax also applies to a significantly broader base of companies, those with €750 million in revenues versus $1 billion in book income.

If the OECD minimum tax rules are ultimately adopted by the over 130 countries that agreed to the provisions in 2021, global companies who escape the CMT may find themselves subject to the OECD rules in foreign countries. Or worse, large corporations may find both provisions applicable. The end result may be companies finding themselves subject to more layers of tax computations (in addition to those already added for GILTI and BEAT in TCJA), or at a minimum face significant new reporting
burdens.

Stock repurchase excise tax

The IRA added new IRC Section 4501, which imposes a 1% non-deductible excise tax on the value of repurchased stock after 12/31/2022. Added late to the legislation to counteract revenues lost by the removal of carried interest provisions, Section 4501 is expected to raise $74 billion over 10 years, presumably through a combination of excise tax and a shift in behavior from buybacks to taxable dividends.

Technology companies historically have been heavy purchasers of their own stock, and so appear to be disproportionally impacted by this excise tax. Within the industry, share buybacks are generally seen as a preferred (and more tax-efficient) mechanism for returning excess cash to investors than dividends. Notably, the four companies spending the most on share buybacks are all technology companies. 6

The extent to which the excise tax ultimately impacts companies is dependent on two factors. First, is whether it results in a reallocation of excess cash from share buybacks to dividends. Research has indicated that a 1% excise tax would increase dividend payments by an estimated 1.5%. 7 In addition, given that S&P 500 companies alone spent $280 billion in repurchases in the most recent quarter 8 (implying on a static basis an excise tax collected of more than double Congressional Budget Office (CBO) revenue estimates from the S&P 500 alone), a dynamic model would suggest companies will react by significantly reducing share buybacks.

Less obvious to some practitioners will be a provision which applies the excise tax to transactions "economically similar" to a redemption. To the extent the IRS interprets this provision broadly, commentators have noted that new Section 4501 could capture a broad range of corporate transactions including split-offs, leveraged buy-outs, and tax-free reorganizations with boot. 9

IRS enforcement funding

The IRA includes additional IRS funding of $80 billion, which is expected to raise $180 billion over the next decade, resulting in $100 billion in net revenue. Of the $80 billion in new spending, over half ($46 billion) is allocated to enforcement, including enhanced investigative technologies. The new enforcement spending represents a 69% increase relative to previous projections. Operations support receives $25 billion, a 53% increase, with smaller amounts of budget ascribed to business system modernization ($5 billion, a 153% increase) and taxpayer services.

Enforcement can be a popular mechanism to raise revenues as it does not require changes in policy such as rate increases or broadening the tax base. Simply closing the tax gap is viewed by some as a "free lunch" as it just collects taxes which are otherwise due. Based on current spending levels, it has been estimated by the CBO that an additional dollar in enforcement spending can yield $5 to $9 in additional revenue, although it appears diminishing returns are anticipated based on CBO collections estimates.

The impact of the additional IRS funding on technology companies is unclear and depends on where the enforcement dollars are spent. On the one hand, technology companies have historically already seen substantial scrutiny of their transfer pricing, international, and research credit positions; as such, the IRS may determine a greater return can be achieved by focusing efforts elsewhere, such as high net worth individuals or the earned income credit. In addition, increased IRS technology and systems spending would not only benefit technology companies' top line, but enhanced IRS system automation could ultimately result in lower compliance costs. On the other hand, to the extent additional IRS enforcement efforts focus on the tech companies, there will be net costs both in terms of taxes paid and compliance costs (even for those already paying their full liability).

Excise tax on drug manufacturers

Biotech companies may be indirectly, but adversely, impacted by a punitive excise tax on drug manufacturers in the IRA. This provision does not appear to be intended to raise money through the excise tax, but rather to force pharmaceutical companies to lower drug prices, resulting in a $102 billion reduction in federal spending over ten years.

The United States has been the biotechnology leader during the 21st century, with U.S.-based companies producing almost double as many drugs as their European counterparts and receiving 70-80% of global funding. 10 Many industry analysts attribute this success to the relatively laissez faire approach to drug pricing in the United States relative to Europe and other parts of the world which more aggressively implement price controls. While the impact of this excise tax on the biotech section is
unclear, empirical evidence indicates the excise tax on drug manufacturers could have a chilling effect on the U.S. biotech industry.

Green energy tax credits

With an estimated $400 billion in green energy tax credits and incentives, 11 clean tech companies are a clear industry winner in the recent tax legislation. Key tax provisions include a critical extension and modification of the IRC Section 45 production tax credit and IRC Section 48 investment tax credit as well as the creation of a new clean energy investment (IRC Section 48D) and production tax credits (IRC Section 45Y). Also included is the new IRC Section 45X advanced manufacturing production credit, which anticipates $30 billion to support the manufacture of solar, wind, and battery equipment.

The IRA is not nearly as extensive as what was proposed in the Build Back Better Act. However, given recent technological and market challenges facing the industry, these provisions look to reinvigorate earlier optimism in a more rapid shift away from carbon fuels by subsidizing domestic investment in both more established clean energy (i.e., solar, wind, nuclear) and nascent technologies such as clean hydrogen. Although the impact of these credits and incentives on inflation is far from certain, they offer a
critical lifeline to the struggling clean tech industry during a time of energy transition.

Advanced manufacturing incentive credit

Aside from clean tech companies, semiconductor companies received the most targeted support in the recent legislation via the CHIPS Act. In addition to other non-tax incentives, the Act provides $24 billion via an expansion of IRC Section 48D in the form of a new investment tax credit equal to 25% of qualified investment in a U.S. facility whose primary purpose is manufacturing semiconductors or semiconductor equipment. Importantly, the law provides for a direct pay mechanism, effectively making the credit
refundable so a company does not need to be a taxpayer to benefit from the advanced manufacturing incentive credit. The CHIPS Act also interestingly contains provisions disqualifying the credit for companies that expand manufacturing facilities specifically in China within a 10-year period after claiming the credit.

If the legislation is successful in expanding domestic semiconductor manufacturing, the improvement to the supply chain could arguably do more to reduce inflation than the curiously named Inflation Reduction Act. However, given the significant cost of constructing semiconductor manufacturing facilities in the United States, at issue is whether the CHIPS Act incentives will be sufficient to offset the cost and other competitive advantages of manufacturing overseas, primarily in Asia. The fact that currently only 12% of semiconductors are manufactured in the United States underlies the challenges of manufacturing domestically.

The extraordinary cost of building semiconductor fabrication facilities limits the number of companies that can benefit from this credit, although smaller equipment manufacturers may benefit. However, to the extent the legislation increases domestic production of semiconductors, numerous supporting suppliers may indirectly benefit from the expansion.

Start-up company R&D credit payroll tax offset

In a nod to the start-up community, the IRA expands the amount of research credits a qualified small business (QSB) can offset against its payroll taxes from $250,000 to $500,000.

While a refundable credit mechanism is welcome as many companies engaged in R&D do not generate taxable income, the number of companies this benefit applies to is quite limited. A QSB is defined as a business with gross receipts of less than $5 million in the current year and no gross receipts (including non-business income such as interest) before the prior five-year period. As a result, only small start-up companies qualify and those that do must generate enough R&D credit and pay sufficient payroll tax to fully benefit from these provisions.

In addition, the legislation does not address the computational challenges inherent in claiming the R&D credit. While legislative steps have been taken to simplify the R&D credit computation since it was introduced in 1981, rules for determining which expenditures qualify under the IRC Section 41 four-part test are overly complex, especially for smaller companies. In addition, those companies who do not qualify under the narrow definition of a QSB cannot monetize their R&D credits until they generate
taxable income after net operating losses; as such, it can take many years to utilize the credits, if ever. For these reasons, it has been estimated that up to 30% of the U.S. R&D credit value goes unclaimed and less than 3% of the value went to small businesses. 12

While the IRA is another step in the right direction in assisting companies monetizing R&D credits, further simplifying the computation (for example, by more fully aligning tax with the ASC 730 book definition) and substantially broadening the refundable credit, as is seen in many other countries, would greatly benefit companies making investments in U.S. research.

Retention of capitalized R&D

Notably absent from the IRA and CHIPS Act was a repeal or deferral of the TCJA provision requiring capitalization and amortization of R&D expenditures over five years. Accordingly, starting in 2022, and for the first time since 1954, companies are no longer able to immediately expense their R&D costs in the U.S. Due to heavy R&D investment in the industry, technology companies are expected to be disproportionately impacted.

When this provision was included in the TCJA with a five-year delay, it was perceived by many practitioners as a budgetary gimmick, never intended to be implemented. As a matter of policy, the capitalization of R&D runs counter to the general objective of TCJA, which was to bring investment back to the United States. It also adds compliance cost since capitalization runs counter to expensing of R&D for book purposes.

While deferral or outright repeal of this rule seems to enjoy bipartisan support, it could be that addressing this did not fit squarely into either bill. The CHIPS Act was targeted specifically toward the semiconductor industry, while R&D is incurred broadly throughout many sectors. A key part of winning support for the IRA was achieving deficit reduction, and the $153 billion cost of a permanent repeal would have offset most of the $238 billion in projected net revenue.

For now, technology companies' best hope seems to be a deferral in implementation of these provisions in a year-end extender package. Temporary patches are not generally considered good tax policy, as the uncertainty impacts taxpayers' ability to plan investments. However, for those impacted by an immediate 2022 tax bill, even a temporary reprieve would be very welcome.

Conclusion

As with all changes in tax laws, the IRA and CHIPS Act create opportunities and challenges. There will be winners and losers. How the laws are ultimately implemented, as well as resulting behavioral changes in reaction to the new provisions, will determine the ultimate impact on technology companies.

Footnotes

1. P.L. 117-169 (8/16/2022)

2. P.L. 117-167 (8/9/2022)

3. "How the Senate-Approved Corporate Minimum Tax Works" (Tax Policy Center, 8/9/2022)

4. "The corporate minimum tax could hit these ultra-profitable companies," Washington Post, 8/11/2022

5. "The corporate minimum tax could hit these ultra-profitable companies," Washington Post, 8/11/2022

6. "Stock Buyback Tax: the 10 Biggest Spenders on Their Own Shares" (businessinsider.com, 8/6/2022)

7. "Poterba, Taxation and Corporate Payout Policy" (National Bureau of Economic Research Working Paper Series, 2004), www.nber.org/system/files/working_papers/w10321/w10321.pdf

8. "Stock Buyback Tax: the 10 Biggest Spenders on Their Own Shares," (businessinsider.com, 8/6/2022)

9. "US Inflation Reduction Act - Corporate Minimum Tax and Stock Repurchase Excise Tax," Mayer Brown Perspectives & Events (8/30/2022)

10. "Ensuring U.S. Biopharmaceutical Competitiveness" (itif.org,, 7/16/2020)

11. "CBO Scores IRA with $238 Billion of Deficit Reduction," Committee for a Responsible Federal Budget (crfb.org,, 9/7/2022)

12. https://www.silo.tips/download/the-ripple-effect-of-an-rd-tax-credit-study-s-real-costs
https://www.novoco.com/sites/default/files/atoms/files/measuring_tax_expenditures_111113.pdf

Originally Published by Thomson Reuters Practical Tax Strategies January 2023 issue

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