ARTICLE
28 February 2024

House Passes Tax Relief Bill, Contemplates Path For SALT Deduction Cap

On January 31, 2024, the U.S. House of Representatives overwhelmingly passed The Tax Relief for American Families and Workers Act of 2024 (H.R. 7024) by a vote of 357 to 70...
United States Tax
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On January 31, 2024, the U.S. House of Representatives overwhelmingly passed The Tax Relief for American Families and Workers Act of 2024 (H.R. 7024) by a vote of 357 to 70, concluding yearslong negotiations over the expansion of the child tax credit and the relief from a trio of business tax provisions enacted by the TCJA (the capitalization of research or experimental (R&E) expenses, the business interest deduction limit, and the phase-out of 100% bonus depreciation for certain property). To muster support for the new bill from House Republicans in high-tax states, Republican leaders committed to separately advance legislation that would increase the state and local tax (SALT) deduction cap (the current proposal is doubling the $10,000 limit for joint return filers with adjusted gross income of less than $500,000, for 2023).

The $78 billion estimated cost — which also includes expanding the low-income housing tax credit (LIHTC), enhancing disaster relief, and providing double taxation relief on U.S.-Taiwan cross border investments — would largely be offset by retroactively setting the deadline for filing an employee retention credit (ERC) claim to January 31, 2024, and increasing ERC enforcement provisions.

In this alert, we highlight the bill's proposed changes to (1) the treatment of domestic R&E expenses; (2) the business interest deduction limit; and (3) the 100% bonus depreciation for certain property, as well as some considerations taxpayers should be mindful of, and certain areas in which further guidance from the IRS is needed.

Treatment of Domestic R&E Expenses

Under the TCJA, for taxable years beginning after December 31, 2021:

  • Taxpayers must capitalize R&E expenses, including software development costs, and amortize them over a five-year period for domestic research activities (fifteen-year period for foreign research) with no deduction allowed for unamortized expenses on the disposition, retirement, or abandonment of property with respect to which R&E expenses had been incurred. Instead, the taxpayer must continue to amortize the expenses over the relevant period.
  • If a taxpayer's research credit exceeds the allowable R&E deductions for the taxable year, the taxpayer must either reduce the capitalized amount for the taxable year (and reduce the subsequent amortization) or reduce its research credit by 21% (the current maximum corporate tax rate).

Under H.R. 7024:

  • Taxpayers can choose whether to deduct or capitalize domestic R&E expenses for taxable years that begin after December 31, 2021, but not after December 31, 2025. If a taxpayer chooses to capitalize domestic R&E expenses, the taxpayer can either retain the expenses in a capital account or amortize them over at least five years (beginning with the month the taxpayer first realizes benefits from the expenses).
  • Under a modified rule for taxable years beginning after December 31, 2022, if a taxpayer's research credit exceeds the allowable R&E deductions for the taxable year, the taxpayer must either reduce the amount of domestic R&E expenses for the taxable year by the allowable research credit or reduce its research credit by 21% (the current maximum corporate tax rate).

A&M Insight: Because H.R. 7024 only applies to domestic R&E expenses, taxpayers must continue to differentiate between "domestic" R&E expenses and "foreign" R&E expenses, which is a costly endeavor (e.g., allocation of indirect expenses). Additionally, taxpayers will continue to clamor for Treasury and IRS guidance on how to apply the TCJA rules as they will still apply to foreign R&E expenses (and domestic R&E expenses if taxpayers elect to capitalize and amortize them). The existing Treasury and IRS guidance (Notice 2023-63, Notice 2024-12, and Rev. Proc. 2024-9) has left many unanswered questions and government officials have acknowledged that they are rethinking some aspects of the guidance.

This uncertainty further complicates M&A transactions as the parties may take different approaches to the treatment of domestic R&E expenses upon passage of H.R. 7024. The parties must consider, for example, who has control over pre-transaction tax returns and potential refunds for pre-transaction periods, as well as the consequences of divergent treatments of domestic R&E expenses on a going forward basis.

Additionally, if taxpayers have the option to either deduct or capitalize domestic R&E expenses, they should carefully model different scenarios to determine which approach is most beneficial. This analysis, however, is complicated by the effects that R&E expenses can have on tax provisions that depend on taxable income. For example, the decision to expense or capitalize R&E expenses could have significant consequences on taxable income under the following provisions:

  • Foreign Derived Intangible Income (FDII) Deduction: For domestic corporations, the FDII deduction — currently a 37.5% deduction on applicable foreign income that is set to decrease to 21.875% for taxable years beginning after December 31, 2025 — relies partly on how R&E expenses are allocated to foreign income. Certain taxpayers may prefer to capitalize R&E domestic expenses to benefit from a greater FDII deduction instead of deducting the full amount of R&E expenses in the taxable year.
  • Net Operating Loss (NOL) Deduction: The allowable NOL deduction for a taxable year is capped at 80% of taxable income. As such, taxpayers would benefit from taking a deduction for domestic R&E expenses up to the point it eliminates current year taxable income, without creating an NOL deduction, and delaying the deduction of any remaining R&E expenses into a subsequent year when it would not be limited. This may be easier within a consolidated group where each member is generally entitled to use its own method of accounting. This means one member could deduct their domestic R&E expenses, while another could choose to capitalize and amortize them.

Lastly, taxpayers should be aware of the transition rules in the bill, which may warrant additional guidance from the IRS.

Business Interest Deduction Limit

Under the TCJA as modified by the Coronavirus Aid, Relief, and Economic Security (CARES) Act:

  • For taxable years beginning in 2018 and beginning in 2021 and beyond, the deduction for business interest expense was generally capped at 30% of a taxpayer's adjusted taxable income (ATI). For taxable years beginning in 2019 and 2020, the deduction was capped at 50% of a taxpayer's ATI.
  • Prior to taxable years beginning in 2022, ATI was effectively earnings before interest, taxes, depreciation, and amortization (EBITDA). Beginning in 2022, ATI was adjusted to effectively be earnings before interest and taxes (EBIT).
  • Any disallowed business interest expense deduction generally may be carried forward indefinitely subject to limitations in the year it is applied.

Under H.R. 7024:

  • For taxable years beginning in 2022 and 2023, taxpayers may elect to apply the EBITDA-based calculation retroactively.
  • For taxable years beginning in 2024 and 2025, ATI will be based on EBITDA.

A&M Insight: Since the enactment of TCJA, there has been a notable increase in interest rates, which when coupled with the conversion of ATI from the EBITDA-based calculation to the EBIT-based calculation, may have resulted in a taxpayer having a significant portion of its business interest expense being disallowed. The automatic relief in 2024 and 2025 will be welcome news for most taxpayers, however, like the choice regarding R&E expensing, taxpayers should model and analyze the effects of potential increases in their interest expense deductions in 2022 and 2023.

100% Bonus Depreciation

Under the TCJA:

  • Taxpayers were allowed a 100% bonus depreciation allowance for certain newly acquired and used property (qualified property) placed in service after September 27, 2017, and before January 1, 2023.
  • In 2023, the phase out of the 100% bonus depreciation allowance begins with an annual 20 percentage point reduction (e.g., 80% for 2023 and 60% for 2024), resulting in no bonus deduction allowed after 2026.

Under H.R. 2074:

  • The 100% bonus depreciation allowance would apply to qualified property placed in service in 2023, 2024, and 2025.
  • Beginning in 2026, the TCJA rules would apply such that qualified property placed in service in 2026 would be eligible for a 20% bonus depreciation allowance and no bonus deduction allowed after 2026.

A&M Insight: Like the changes to the deductibility of interest expense, the change to bonus depreciation will be welcome news for most taxpayers, especially coupled with the calculation of ATI based on EBITDA. However, under the TCJA, the business interest expense limitation did not apply to taxpayers who elected to be an excepted trade of business, which among other things, required that certain assets not be eligible for bonus depreciation, but instead must be depreciated using the alternative depreciation system. With the increased business interest expense limitation and the extended 100% bonus depreciation period, taxpayers who elected to be an excepted trade or business may want to revisit such elections (assuming subsequent Treasury and IRS guidance allows them to do so).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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