As discussed in our prior Legal Update “US Inflation Reduction Act – Corporate Minimum Tax and Stock Repurchase Excise Tax,” the Inflation Reduction Act introduced a new corporate alternative minimum tax (“CAMT”) applicable to large corporations (so-called “applicable corporations”) for tax years beginning after December 31, 2022. The CAMT is a 15% tax on the adjusted financial statement income (“AFSI”) of applicable corporations.
On December 27, 2022, the Treasury Department and the Internal Revenue Service (“IRS”) issued Notice 2023-7 (the “Notice”) describing proposed regulations Treasury intends to issue to address certain aspects relating to the application of the CAMT. Even though several important questions remain unanswered, the Notice provides welcome guidance on many critical issues as taxpayers evaluate the impact of the CAMT on their financial reporting and estimated tax payments for the first quarter of 2023. Taxpayers are allowed to rely on the Notice until proposed regulations are issued.
On that same day, Treasury and the IRS published Notice 2023-2 providing interim guidance on the stock buyback excise tax, another new tax introduced by the Inflation Reduction Act. (Please see our Legal Update on Notice 2023-2, “1% Stock Buyback Tax: US Treasury, IRS Release Interim Guidance.”)
Simplified Safe Harbor Method for Determination of “Applicable Corporation” Status in 2023
The Notice incorporates a simplified safe harbor method taxpayers may apply to determine “applicable corporation” status for the first tax year beginning after December 31, 2022.
Under the statute, a corporation is subject to the CAMT if, together with its controlled group of corporations, it has over $1 billion in average annual AFSI over a three-year testing period. If it is a foreign-parented multinational group, the AFSI of the US members of the group and the “effectively connected” AFSI of its foreign members must be at least $100 million to come within the scope of the CAMT.
The simplified safe harbor method looks to spare certain taxpayers that are well below these thresholds from having to convert their book income into AFSI for 2023. Under the safe harbor, a corporation can simply look to the income or loss reflected on its applicable financial statement, apply the group aggregation rules and adjust to eliminate the effect of income tax expenses rather than perform all the adjustments required to arrive at AFSI. The corporation will not be an “applicable corporation” if its average annual “unadjusted” financial statement income does not exceed $500 million over the three-year testing period or, if the corporation is a member of a foreign-parented multinational group, if the average annual “unadjusted” financial statement income of the domestic members and “effectively connected” “unadjusted” financial statement income of the foreign members is less than $50 million.
Of course, a corporation that fails the Notice’s simplified safe harbor may still establish that it is not an “applicable corporation” for 2023 under the tests set forth in the statute.
Calculation of AFSI and Determination of “Applicable Corporation” Status Following Acquisitions and Divisions
The Notice provides guidance for determining AFSI and testing for “applicable corporation” status after certain tax-free and taxable acquisitions or divisions.
In the case of an acquisition of a standalone group, the target group will no longer be considered an “applicable corporation” (assuming it was one pre-acquisition), and the acquirer group will take into account the AFSI of the target group for the three-year period ending with the tax year of the acquisition.
If an acquirer purchases a target company or certain assets from a larger group (i.e., a carve-out acquisition), the acquirer group will add to its AFSI the portion of the seller group’s AFSI attributable to the target or to the purchased assets based on any reasonable allocation method for the three-year testing period. The seller group’s AFSI will also include the target’s allocated AFSI for purposes of determining the seller group’s “applicable corporation” status.
Similarly, in the case of a spin-off or split-off, the controlled corporation that is being distributed will be allocated a portion of the distributing group’s AFSI based on any reasonable allocation method for the three-year testing period, but such allocated AFSI will also be included in the distributing group’s AFSI.
Treatment of Partnership Income and Consolidated Groups
The Notice clarifies that a corporation that is a partner in a partnership does not take into account its distributive share of the partnership’s financial statement income or loss in determining whether such corporation is an “applicable corporation.”
The Notice treats a consolidated group as a single entity for purposes of calculating AFSI, both for determining “applicable corporation” status and for calculating the CAMT liability.
Tax-Free Transactions under the CAMT
The Notice provides relief under the CAMT for tax-free transactions that qualify for one of the so-called non-recognition provisions of the Internal Revenue Code of 1986, as amended (the “Code”), such as liquidations of subsidiary corporations into their corporate parent, asset or stock corporate reorganizations, transfers of property to controlled corporations, tax-free spin-offs and split-offs, and contributions and distributions to and from partnerships. Any financial statement gain or loss that results directly from any such non-recognition transaction will be excluded from AFSI, while any step-up or step-down to the financial accounting carrying value of assets that results from the transaction is disregarded for future years’ AFSI calculations (i.e., the pre-transaction carrying value will be used to measure any AFSI results from future dispositions of such assets). These asset basis adjustments for CAMT purposes are likely to represent an additional compliance burden for CAMT taxpayers that engage in tax-free transactions.
The treatment of transactions that are only partially tax-free (e.g., reorganizations with “boot”) is still uncertain, and the Notice requests comments on this issue.
Relief for Financially Distressed Companies
Section 108 Codecontemplates that cancellation of indebtedness income is excluded from taxable income under certain circumstances, including when the debt discharge occurs in a bankruptcy proceeding or to the extent the debtor is insolvent. According to the Notice, any financial statement income recognized by a corporation in a debt discharge transaction will be excluded from AFSI in an amount equal to the amount excluded from taxable income under the Code. Also, mirroring the treatment under Section 108 of the Code, the financial statement attributes of the corporation (e.g., loss carryforwards, asset basis) will be reduced for CAMT purposes to the extent of the amount of such reduction for regular income tax purposes. Further guidance will be needed to specify the methodology of this attribute reduction under the CAMT.
In addition, the Notice excludes from AFSI any financial statement gain or loss that results from the emergence of bankruptcy of an applicable financial statement group, subject to adjustments to the financial statement basis of the taxpayer’s assets to preserve the pre-emergence basis of these assets.
Treatment of Tax Depreciation
Under the CAMT statute, tax depreciation, rather than financial accounting depreciation, is taken into account for CAMT purposes with respect to certain depreciable property. The Notice clarifies that taxpayers may only use tax depreciation with respect to tangible depreciable property that is actually depreciated under Section 168 of the Code and that adjustments must be made to the financial statement basis of these assets to reflect the use of tax depreciation rather than the financial statement depreciation. The Notice also provides that depreciation deductions that are capitalized into inventory under Section 263A of the Code will reduce AFSI for CAMT purposes to the extent of the amount recovered as part of cost of goods sold for regular income tax purposes. Importantly, these rules also apply to calculate the depreciation, and resulting adjusted basis, for CAMT purposes of assets placed in service prior to 2023.
Additional Interim Guidance to Come and Request for Comments
As noted above, taxpayers may rely on the interim guidance laid out in the Notice until the issuance of the corresponding proposed regulations. The Notice announces that Treasury and the IRS intend to issue additional interim guidance to address other corporate minimum tax issues prior to the issuance of proposed regulations, including, notably, issues relevant to the insurance industry (e.g., treatment of marked-to-market items, treatment of embedded derivatives arising from certain reinsurance contracts). Finally, the Notice requests comments on a wide array of issues under the CAMT (e.g., calculation of corporate partner’s distributive share of partnership income for CAMT purposes, circumstances required to establish that an “applicable corporation” should no longer be treated as one, application for CAMT purposes of anti-loss trafficking rules of Sections 382 and 383 of the Code).