The Inflation Reduction Act of 2022 (“IRA”) introduced a corporate alternative minimum tax (“CAMT”) on an “applicable corporation’s” (“Applicable Corporation”) financial statement income. The CAMT is applicable for taxable years beginning after December 31, 2022 and imposes a 15% minimum tax on a corporation’s “applicable financial statement income” (“AFSI”). To be an Applicable Corporation, the corporation, together with every person treated as a single employer with that corporation, must have aggregate average annual AFSI for the prior three-taxable years in excess of $1 billion. If the corporation is part of a foreign parented multi-national group, then, for the corporation to be an Applicable Corporation, the overall group must meet the $1 billion test and the corporation must have average AFSI for the prior three-taxable years in excess of $100 million. The starting point for determining AFSI is the net income or loss on the “applicable financial statement” (“AFS”), as defined in Section 451(b)(3) of the Internal Revenue Code of 1986, as amended (the “Code”), of the corporation or in the case of a group of entities (the “AFS Group”) the group’s AFS. The net income or loss is then subject to a number of adjustments found in Section 56A of the Code to determine AFSI.
On December 27, 2022, the Treasury Department and Internal Revenue Service published Notice 2023-7 (the “Notice”) announcing that they intend to issue proposed regulations, consistent with the guidance in the Notice, addressing the application of the CAMT. In the interim, the Notice provides guidance on certain “time-sensitive issues” that taxpayers may rely upon. Specifically, the Notice provides guidance addressing the treatment of certain nonrecognition transactions, tax consolidated groups, cancellation of debt (“COD”), depreciation of property subject to Section 168 of the Code and certain tax credits. The Notice also provides a simplified “safe harbor” method for determining if a corporation is subject to the CAMT and clarifies how an interest in a partnership is treated for determining whether a taxpayer is subject to the CAMT.
Treatment of Taxable and Non-Taxable Transactions for Calculating AFSI
The Notice provides rules governing the effect on AFSI (and corresponding adjustments) arising from “Covered Nonrecognition Transactions” and “Covered Recognition Transactions”. Covered Nonrecognition Transactions are transactions that are subject to various nonrecognition provisions in the Code, and Covered Recognition Transactions are any sale, contribution, distribution or other disposition of property treated as resulting in gain or loss for U.S. federal income tax purposes. Together Covered Nonrecognition Transactions and Covered Recognition Transactions are defined as “Covered Transactions.”
The Notice requires that, for CAMT purposes, financial accounting treatment conform to the U.S. federal income tax treatment of a Covered Nonrecognition Transaction. Accordingly, any financial accounting gain or loss resulting from the application of the accounting standards is not taken into account for purposes of calculating AFSI. This means that the acquirer in a Covered Nonrecognition Transaction will receive a transferred financial accounting basis in the assets received for purposes of future AFSI calculations and will need to track these differences for future taxable years. The Notice provides a number of examples illustrating the CAMT treatment of nonrecognition transactions, including an important example respecting the nonrecognition treatment of a split-off that qualifies under Section 355 of the Code.
Weil Observation. The differing treatment between financial accounting and CAMT accounting of taxable and non-taxable transactions gives a glimpse of the future compliance burden that corporations subject to (and close to being subject to) the CAMT will need to undertake. These corporations will now have to maintain multiple sets of books and records, including those for financial statement accounting, ordinary tax accounting, and CAMT accounting.
Within the definitions for Covered Nonrecognition Transaction and Covered Recognition Transaction, the Notice provides that each component transaction of a larger transaction is examined separately for qualification as a nonrecognition or recognition transaction, and the AFSI treatment of a transaction as taxable or nontaxable will generally follow the U.S. federal income tax treatment of the transaction. However, it also goes on to caution that a component transaction may be affected by any other component transaction of the larger transaction taking into account all relevant provisions of the Code and general tax principles (e.g., the step transaction doctrine). Accordingly, the analysis of the treatment of a transaction for CAMT purposes appears to generally follow the analysis for non-CAMT tax purposes. For instance, Example 5 in Section 3.03 of the Notice provides that Partner A contributes property to an existing partnership in a transaction purporting to qualify for nonrecognition under Section 721 of the Code, and then subsequently Partner A receives a distribution of cash purporting to qualify for nonrecognition under Section 731 of the Code. Together these component transactions are treated in part as taxable and in part as a nontaxable contribution under the disguised sale rules resulting in the contribution and distribution being treated as a Covered Recognition Transaction for CAMT purposes. The Notice seeks comments on how partially taxable and partially nontaxable transactions should be treated for purposes of calculating AFSI.
Weil Observation: The Notice treats the transaction in Example 5 as a Covered Recognition Transaction. While the Notice does ask for comments on the proper way to calculate AFSI in a partially taxable and partially nontaxable transaction, the example seemingly (although not entirely clear) focuses only on the portion of the contribution that is matched by the distribution and is, therefore, treated as a taxable disguised sale. Accordingly, it is not entirely clear whether the example is also meant to show that the portion of the contribution that is not taxable is not tainted for purposes of calculating AFSI.
Consequences of Covered Transactions for Determining Applicable Corporation Status
As discussed above, whether a corporation is an Applicable Corporation generally depends on whether its average AFSI (taking into account the AFSI of certain related parties) meets the $1 billion test and, in the case of a foreign parented multi-national group, the additional $100 million test. Importantly, under the guidance provided in the Notice, the acquisition of a corporation or group of corporations, can affect this calculation and cause an acquirer to become an Applicable Corporation.
Under the Notice, if an acquirer acquires a corporation (or the assets of a corporation) or group of corporations (or the assets of the group), the acquirer will generally include the AFSI of such target corporation or group of corporations in its AFSI for applying the average AFSI tests. For purposes of determining who is the acquirer and who is the target is in the transaction, the Notice applies financial accounting standards and not tax rules. If an acquirer acquires a corporation (or the assets of a corporation) or group of corporations (or the assets of a group of corporations) from another testing group, then the AFSI of the target group is allocated to the acquired corporation or corporation(s) (or the assets of such corporation or corporations) based on any reasonable allocation method selected by the target group. This AFSI is then combined with the acquirer’s AFSI for purposes of applying the three-taxable-year period test. However, such allocation does not reduce the AFSI of the target group for purposes of the target group’s test. Thus, the AFSI of the acquired corporation or group of corporations (or the assets of such corporation or corporations) is taken into account by both the acquiring and target groups for determining whether a taxpayer is an Applicable Corporation. Similar allocation rules apply when a corporation is distributed out of a testing group.
The Notice indicates that the future proposed regulations will provide an allocation methodology to be used for allocating AFSI but, until then, any reasonable allocation method will be respected.
Weil Observation. In this context, the allocation methodology chosen can have a significant financial impact on a transaction. As such, acquirers should undertake additional due diligence to determine the amount of AFSI a potential target will bring with it in the acquisition, and taxpayers will want to consider addressing the allocation through the purchase agreement, including language requiring cooperation and access to information.
Treatment of Tax Consolidated Groups
The Notice provides that a consolidated group is treated as a single entity for purposes of computing AFSI for the group’s status as an Applicable Corporation and for purposes of calculating AFSI for CAMT liability.
Consequences of COD and Emergence From Bankruptcy
Under the Notice, if cancellation of debt results in income on the AFS of an AFS group, but the COD income is excluded for U.S. federal income tax purposes, then financial accounting gain equal to the amount of excluded COD income is not taken into account for purposes of calculating the AFSI of the AFS Group for the taxable year in which the discharge of indebtedness occurs. Similar to the federal tax rules, the AFS Group’s CAMT attributes must be reduced to the extent tax attributes are reduced under the U.S. federal income tax rules taking into account the ordering rules provided in Section 108(b) of the Code and Section 1017 of the Code.
If emergence from bankruptcy results in gain or loss on the applicable financial statement of the AFS Group, such gain or loss is not taken into account for purposes of calculating AFSI of the group for the taxable year of the emergence from bankruptcy. In addition, any increase or decrease in the financial accounting basis of property (other than as a result of attribute reduction from excluded COD income as discussed above) is not taken into account for purposes of computing AFSI for any taxable year.
Section 56A(c)(13) of the Code provides that AFSI shall be reduced for depreciation deductions allowed under Section 167 of the Code for property to which Section 168 of the Code applies with corresponding adjustments to the AFSI for deductions taken for such property on the taxpayer’s AFS. The Notice provides that tax depreciation, including depreciation capitalized into inventory and recovered as costs of goods sold, in computing taxable income for the year shall reduce AFSI, and AFSI shall be adjusted to disregard any book depreciation, expenses, and cost of goods sold taken into account for financial accounting purposes. The Notice also provides a catchall for other adjustments provided in future published guidance.
However, the Notice clarifies that only the portion of the cost of property depreciated under Section 167 of the Code and Section 168 of the Code are subject to this adjustment and any portion deducted under another Section of the Code is not Section 168 property. Further, if a property is not property to which Section 168 of the Code applies (for example by virtue of a taxpayer electing out of additional first year depreciation deductions under Section 168(k) of the Code), then the adjustments to AFSI do not apply.
The Notice also requires that corresponding adjustments be made to AFSI to take into account any Section 168 property placed in service prior to January 1, 2023. As a result of these adjustments, depreciation taken on the AFS of a taxpayer is likely to be reduced and any gain on the disposition of such property is likely to be greater for AFSI purposes than it is for financial accounting purposes.
Weil Observation. Taxpayers will need to work with their tax advisors to determine the effect of prior Section 168 adjustments on their AFSI and consider the impact on their AFSI calculations of electing out of Section 168 of the Code for property placed in service in the future.
Safe Harbor Method for Determining Applicable Corporation Status
As discussed above, Section 59(k) of the Code provides the test(s) for determining whether a corporation is an Applicable Corporation. The safe harbor method in the Notice attempts to simplify these tests by allowing taxpayers to make the determination without the need to make many of the adjustments to net income or loss on the taxpayer’s AFS set forth in Section 56(A)(c) and (d) of the Code for calculating AFSI. However, the trade-off for these simplifications is a reduction to the threshold average AFSI amounts from $1 billion to $500 million, and from $100 million to $50 million. Also, the Notice provides additional simplification for taxpayers that have an AFS year different than their taxable year by allowing these taxpayers to use their AFS year to calculate whether the average AFSI thresholds are met. If a taxpayer fails the safe harbor test, then the corporation will be an Applicable Corporation only if it is determined to be an Applicable Corporation under Section 59(k)(1) of the Code without the modifications provided by the safe harbor.
Adjustments to AFSI for Certain Credits
The Notice provides that advanced manufacturing credits and certain clean energy credits that a taxpayer elects to be applied as a payment against its tax liability are to be disregarded in calculating AFSI. Further any transfer of certain clean energy credits that are not includible in income and the receipt of certain advanced manufacturing credits or certain clean energy credits that are treated as tax exempt income will also not be taken into account in calculating AFSI.
Applicability of Section 56A(c)(2)(D)(i) for Purposes of Determining Applicable Corporation Status
The calculation of AFSI for purposes of determining whether a corporation is an Applicable Corporation and for purposes of calculating the tax liability of an Applicable Corporation are different. For example Section 56A(c)(2)(D)(i) of the Code provides that if a taxpayer is a partner in a partnership, AFSI shall be adjusted to take into account only the taxpayer’s “distributive share”. Section 59(k)(1)(D) of the Code provides that, solely for purposes of determining whether a corporation is an Applicable Corporation, Section 56A(c)(2)(D)(i) of the Code is disregarded. There was apparently some uncertainty whether the adjustment to AFSI in Section 56A(c)(2)(D)(i) applied for purposes of determining whether a corporation that is a partner in a partnership is an Applicable Corporation if such corporation and such partnership are not aggregated as a single employer under Section 52(a) or (b). The Notice reiterates the rule in Section 59(k)(1)(D) of the Code, and makes clear that AFSI disregards the adjustment in Section 56A(c)(2(D)(i) for determining Applicable Corporation status.
The Notice announced that additional interim guidance will be issued prior to the issuance of the proposed regulations. In this future guidance, Treasury and the IRS expect to address issues related to the treatment of items marked-to-market for financial statement purposes (such as life insurance company separate account assets and certain financial products), the treatment of certain items reported in other comprehensive income for financial accounting purposes, and the treatment of embedded derivatives arising from certain reinsurance contracts. The Notice also seeks comments on a litany of other questions, including matters addressed by the guidance above.