The political leadership behind the Tax Cuts and Jobs Act was focused on using tax reform to bolster economic growth. But in enacting measures meant to make profitable companies even more profitable in the interest of increasing jobs, productivity, and investment, lawmakers may have weakened tax policy tools that help mitigate the effects of economic downturns. For one, by increasing the federal deficit, the TCJA limited the government’s fiscal policy levers. More broadly, in betting the bank on growth, the law may have made bankruptcy and losses more costly.
As the social and economic disruption caused by the coronavirus promises to become more widespread, the pressure to help manage the challenges faced by loss-making companies will likely increase. A review of legislative and administrative actions during and since the 2008 financial crisis can provide timely insight into the use of tax policy tools to manage a downturn’s larger economic effects. But the TCJA’s changes mean that some of those tools may be more difficult to use now — a timely warning as global organizations consider changes to international tax rules.
2008 Responses
Early on, the 2008 financial crisis was characterized by a seizing up of credit markets. Treasury tried to alleviate pressure on the credit markets and the cash crunches companies faced.
Relaxing Section 956
In Notice 2008-91, 2008-43 IRB 1001, Treasury narrowed the section 956 definition of the word “obligation” for determining when a controlled foreign corporation’s investment in U.S. property (which can include an obligation of a U.S. person) might result in an inclusion in a shareholder’s U.S. taxable income. It said circumstances affecting liquidity had made it difficult for taxpayers to fund their operations, and that it would issue regulations to facilitate liquidity in the near term. Under the notice, taxpayers could choose to exclude from the definition obligations held by a CFC that would otherwise constitute an investment in U.S. property if those obligations were collected within 60 days of the date incurred.
Notice 2008-91 expanded rules that taxpayers had relied on for 20 years to manage borrowings within the technical constraints of section 956. Under Notice 88-108, 1988-2 C.B. 445, an obligation that would otherwise constitute an investment in U.S. property if held at the end of a CFC’s tax year wouldn’t be considered U.S. property under section 956 if collected within 30 days of the date incurred. A taxpayer would flunk the requirement if, for at least 60 days in a tax year, the CFC held obligations that (without regard to the 30-day rule) would otherwise constitute an investment in U.S. property.
Treasury extended the relief granted by the 2008 notice in Notice 2009-10, 2009-5 IRB 419, and Notice 2010-12, 2010-4 IRB 326. All three notices were intended to provide relief for companies that historically relied on short-term access to credit markets to refinance intercompany loans but now faced difficulty accessing those markets. Loosening the section’s definition also gave companies more flexibility to access cash from anywhere in the group.
Also in 2008, Treasury issued Rev. Proc. 2008-26, 2008-21 IRB 1014, saying it wouldn’t challenge whether a security was a section 956(c)(2)(J) readily marketable security for three years before the revenue procedure’s May 12, 2008, effective date. In general, the definition of an obligation under section 956 excludes an obligation whose principal amount doesn’t exceed the fair market value of readily marketable securities sold or purchased under a sale and repurchase agreement or otherwise posted or received as collateral for the obligation in the ordinary course of business by securities or commodities dealers.
Treasury said market conditions and liquidity constraints were creating uncertainty about whether a security could be considered readily marketable for section 956 purposes, noting that the market for some securities that had been readily marketable had become severely curtailed. Rev. Proc. 2008-26 was intended to give taxpayers greater certainty by describing circumstances in which the IRS wouldn’t challenge a security that would be readily marketable under ordinary market conditions.
In late 2009, Treasury extended the application of Rev. Proc. 2008-26 to any day in calendar year 2010 for which the definition of readily marketable may have been relevant.
NOL Restrictions
In Notice 2008-83, 2008-42 IRB 905, Treasury granted a one-time exception to the rules of section 382, which generally limit the tax benefits available to an acquiring company from losses generated by a target company. The notice said that for section 382(h) purposes, deductions allowed after an ownership change to a bank for losses on loans or bad debts wouldn’t be treated as built-in losses or deductions attributable to periods before the change date. Specifically issued to allow merging banks to benefit from losses incurred in connection with the financial crisis, the notice was attacked by members of Congress who argued that it was an improper exertion of Treasury authority. The notice was widely viewed as an incentive for Wells Fargo’s acquisition of Wachovia, a move said to be worth $20 billion for the acquiring bank.
In the American Recovery and Reinvestment Act of 2009, Congress revoked the notice. It also provided transition relief that allowed taxpayers to continue to rely on the notice for any ownership change that occurred under a written agreement that had been entered into and publicly announced before the effective date of revocation.
Notice 2008-100, 2008-44 IRB 1081, addressed Treasury’s acquisition of equity interests from qualifying financial institutions under the capital purchase program established by the Emergency Economic Stabilization Act of 2008 (EESA). It specified that when held by Treasury, the owned shares wouldn’t be treated as a Treasury ownership interest in the company for some section 382 purposes.
Notice 2009-14, 2009-7 IRB 516, amplified and superseded Notice 2008-100 to address the capital purchase program for publicly traded issuers, private issuers, and S corporations; the targeted investment program; and the automotive industry financing program. It included rules for the treatment of indebtedness, preferred stock, and warrants to purchase stock acquired by Treasury under those five listed EESA programs. It stated that under the programs, any instrument issued to Treasury would be treated as debt if so denominated, and as section 1504(a)(4) stock if denominated as preferred stock (providing for a more favorable result under section 382). Also, any amount received by an issuer would be treated as received in its entirety as consideration for the instruments issued (again minimizing concerns that section 382 would apply to limit tax benefits from losses generated before the Treasury investment). The notice said that in general, no instrument like that would be treated as stock under section 382 while held by Treasury or by others. It also maintained the government’s position that any capital contribution made by Treasury to a loss corporation under a covered program wouldn’t be considered made as part of a plan whose principal purpose was to avoid or increase any section 382 limitation.
Congressional Action
In the American Recovery and Reinvestment Act, Congress temporarily extended the section 172 carryback period for net operating losses from two years to five years for small businesses. The act also reduced estimated 2009 tax payments for some small businesses and allowed taxpayers to elect accelerated depreciation for investment property acquired in 2009.
Other provisions that helped loss companies included extending a taxpayer’s ability to elect to accelerate alternative minimum tax and research credits in lieu of bonus depreciation and a special exception to the general requirement that discharge of indebtedness income is taxable income. The amendment to section 108 allowed for deferral and ratable inclusion of income arising from business indebtedness discharged by the 2009 or 2010 reacquisition of a debt instrument.
TCJA Changes
The TCJA’s modifications to the code have made the type of temporary measures introduced in response to the 2008 financial crisis less viable. In many cases, they seem likely to exacerbate the effects of any financial downturn.
Inclusion of Foreign Income
It’s harder for Treasury to modify requirements for including foreign earnings in U.S. taxable income (as it did in Notice 2008-91) now that section 951A has been enacted, which requires U.S. shareholders to include in income each year the net positive foreign earnings of CFCs (minus some specifically excluded amounts). As a result, if a U.S. small business with foreign operations or a U.S. multinational loses money in the United States but makes money overseas, it will pay U.S. tax. There’s little ability to finesse Treasury definitions to change that outcome, although a wholesale rewrite of foreign tax credit regulations to relax expense allocation rules could help.
That result is made worse by several other aspects of the new global intangible low-taxed income regime. For one, the section 250 deduction that reduces the U.S. rate on GILTI is reduced if the U.S. shareholder doesn’t have U.S. taxable income aside from GILTI and foreign-derived intangible income. As a result, a taxpayer with U.S. losses but foreign profits is doubly penalized: Not only will it face a U.S. tax liability, but the foreign earnings will be taxed at the full statutory U.S. rate, rather than at the 10.5 percent rate available to companies with positive taxable income.
Further, companies with foreign sales that qualify for the FDII deduction but with no positive U.S. taxable income will also be penalized because the deduction is available only for companies with positive income (defined to exclude GILTI and FDII).
In the past, companies that may have had a mandated inclusion of foreign earnings under subpart F but had no U.S. taxable income still could have used FTCs associated with the foreign-earned income through a carryback or carryforward. But taxpayers with a GILTI inclusion are limited in their ability to claim any credits associated with a GILTI inclusion not just currently, but ever, under a modification to section 904(c).
Finally, the section 951A netting of positive-tested-income companies against tested loss CFCs is generally supposed to smooth the bumps associated with having some pockets of positive foreign earnings and others of negative foreign earnings. However, because of the way Treasury interprets the FTC rules in connection with section 951A, it’s also likely that in a downturn taxpayers will suffer additional economic losses associated with the inability to claim FTCs when there’s been a lowered inclusion resulting from the netting. That’s partly because taxes associated with tested loss companies are simply uncreditable. And if a tested loss company’s losses offset the positive earnings of a tested income company for calculating the section 951A inclusion, a proportionate share of the tested income foreign taxes becomes uncreditable — lost in current, prior, and subsequent years.
How the new foreign inclusion regime is calculated can magnify the economic losses of businesses that during a downturn make money only overseas, or that lose money in hard-hit countries while generating income elsewhere.
Loss Limitation Rules
Section 172 reduces a company’s ability to claim NOLs to 80, rather than 100, percent of taxable income. Thus, losses incurred in a down year won’t be fully recoverable against profits in a subsequent year, essentially increasing the tax rate in later years and making it harder to pay off debt. The TCJA did remove the limitation on the ability to carry losses forward for 10 years, which could help relieve pressure on companies’ financial statements but won’t help their cash positions during a downturn.
The law also changed section 172 so that losses can only be carried forward. The restriction on carrybacks means that without a legislative change, companies won’t be able to claim refunds in an especially bad year by carrying back losses to a prior, profitable year.
Interest Expense Limitation
The TCJA expanded the section 163(j) limitation on the ability to deduct interest expense by lowering the thresholds at which the limitation kicks in and widening the group of taxpayers the limitation applies to. That means the interest expense limitation could become much more widely felt in a downturn.
Accelerated Depreciation
The TCJA increased a business’s ability to depreciate investment property to allow for immediate expensing, a rule set to expire at the end of 2026. But allowing immediate expensing during economic growth removes a tool that can be used to alleviate downturn effects. Even more troubling, the sunset likely increased incentives for upfront spending.
BEAT
The TCJA generally repealed the corporate alternative minimum tax but adopted another type of minimum tax: the base erosion and antiabuse tax. The BEAT operates by effectively denying a deduction for related-party payments when the taxpayer is over a specific size and the payments exceed a threshold amount.
Because multinationals’ related-party structures may be governed by transfer pricing arrangements whose pricing terms may continue regardless of overall corporate profit, or because they depend on complex supply chain arrangements that might not be easily unraveled, the BEAT could increase companies’ tax liabilities in a downturn.
That result is potentially exacerbated by some decisions Treasury made in the reg-writing process, such as putting restrictions on a taxpayer’s ability to use the recomputation method for calculating modified taxable income under section 59A(c), which limits the ability to offset income with NOL carryforwards. Meanwhile, companies that deferred payments or deductions from 2019 to 2020 in anticipation of a profitable 2020 may have increased a 2020 NOL that can’t be carried back.
OECD Changes
Changes introduced by other countries in response to the OECD’s base erosion and profit-shifting project, including those recommended by actions 2-4 and possibly action 5, also have the potential to magnify downturn effects for U.S. multinationals.
Interest Expense Limitation
The TCJA changes to section 163(j) parallel the OECD recommendation in action item 4 that countries adopt a rule limiting an entity’s net deductions for interest and payments economically equivalent to interest to a percentage of its earnings before interest, taxes, depreciation, and amortization, at a ratio of 10 percent to 30 percent. (Alternatively, the OECD suggested a worldwide group ratio rule that could allow an entity to exceed that limit if it had net interest expense above a country’s fixed ratio. The worldwide group ratio would allow a deduction for interest up to the group’s net interest-EBITDA ratio.)
The worldwide group ratio could give companies greater flexibility to manage borrowing and associated interest expenses in a downturn, but more countries, including the United States, have chosen the fixed interest rule. (South Africa is the latest to propose adopting a fixed ratio interest expense limitation rule in line with the OECD’s recommendations.)
If the section 163(j) limitation restricts a company’s ability to borrow effectively to meet business needs during a time of unexpected losses in customer activities, the BEPS-induced changes multiply those constraints.
Hybrids
The anti-hybrid rules proposed by BEPS action 2 similarly restrict companies’ ability to claim deductions for interest expense — in this case when income from the underlying instrument isn’t taxed the same way in the recipient jurisdiction (the TCJA enacted a similar anti-hybrid rule). This rule — adopted as an antiabuse rule to prevent multinational tax avoidance — also limits a company’s capacity to manage profits, losses, and economic downturns in different countries.
CFC Rules
The BEPS action 3 report outlines ways countries could enact rules to ensure a minimum or increased level of taxation of CFC earnings in the headquarters jurisdiction. In a downturn, that kind of rule creates the same problems as GILTI. While the action 3 report originally had little traction, it’s taken on new life as part of the OECD’s recent work on addressing the tax challenges of digitalization.
What Can Be Done?
Most TCJA changes can’t be undone without congressional action. While Treasury retains some flexibility to issue guidance to help loss companies, as it did in 2008, Congress has sharply rebuked it for doing so. Thus, the department — which is under congressional investigation for allegedly superseding its authority in the reg-writing process — might hesitate to undertake those kinds of measures. It did have discretion to allow taxpayers more capability to benefit from FTCs linked to the GILTI inclusion, but in issuing regs that make it harder for taxpayers to claim those credits, Treasury also made it harder to reverse its position.
In short, antiabuse tax rules written in times of global profit and economic growth can come back to bite in times of crisis. That’s an important lesson as the OECD seeks to adopt a global minimum tax rule and reallocate profits based on sales in a way that wouldn’t necessarily reflect current-year losses.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker Chtd., and a contributor to Tax Notes International.