Issues & Opportunities for Business Taxpayers Related to the CARES Act
The COVID-19 crisis has created serious liquidity issues for many businesses, and the recently enacted Coronavirus Aid, Relief, and Economic Security Act (CARES Act) should provide some welcome assistance to taxpayers by temporarily reversing or modifying certain changes that were enacted by the Tax Cuts & Jobs Act (TCJA) in 2017. These measures will give businesses the flexibility to use NOLs and interest deductions to offset their taxable income, providing them with liquidity and a reduced cost of capital as they work through the economic impact of the COVID-19 crisis.
Taxpayers should consider carefully whether they are able to take advantage of the business tax relief provisions in the CARES Act, but they should also consider the interaction of the various rules in order to maximize the benefits and mitigate any negative tax consequences.
Net Operating Loss (NOL) Issues
The CARES Act effectively repealed two changes from the TCJA that limited the deductibility of net operating losses (NOLs) arising in tax years beginning after December 31, 2017 and before January 1, 2021 (Affected NOLs). First, the CARES Act includes provisions that allow taxpayers to carry back NOLs arising in tax years beginning after December 31, 2017 and before January 1, 2021 to the five prior tax years (Carryback Window), whereas the TCJA eliminated the ability to carryback these NOLs. Second, the CARES Act permits taxpayers to fully offset prior-year taxable income when carrying back Affected NOLs, repealing the TCJA’s limitation which stipulated that these losses could only offset up to 80 percent of taxable income.
Furthermore, the CARES Act fixed a drafting error from TCJA and clarified that corporations with NOLs in a fiscal tax year that began before and ended after December 31, 2017 may carry back those NOL’s for 2 taxable years under the pre-TCJA rules. The CARES Act also stipulated that taxpayers carrying back Affected NOLs may not use those losses to offset income taxed under the § 965 transition tax and provides for an election to exclude taxable years to which § 965 applied from the carryback.
Observation: These changes were enacted to allow corporations with NOLs in 2018 and 2019 (or who expect to have NOLs in 2020) to access a quick source of liquidity by obtaining refunds of prior year Federal taxes paid. The benefit is amplified when compared to carrying the losses forward, since the losses will be carried back to taxable years when the maximum corporate tax rate was 35% compared to the current corporate rate of 21%. However, before deciding to carry back a loss, taxpayers should consider a number of items including:
- Short tax years, each of which are treated as a full tax year to which the loss may be carried back
- The full effect on taxable income computations in the carry back year and subsequent tax years, including deductions with taxable income limitations (e.g. charitable donations or former § 199 deductions)
- Changes to tax attributes (e.g., general business credits or foreign tax credits)
- Changes to the group composition during the Carryback Window and separate return loss years
- Who is entitled to the refund if there was an M&A transaction during the Carryback Window
The CARES Act also granted taxpayers the ability to file carryback claims for the 2018 tax year, as well as certain fiscal and short tax years, within 120 days of the Act’s enactment. Please see our True Alert at the following link for more details about recent IRS guidance for NOL Carryback Claims and other tax compliance matters: IRS Guidance on NOL Carrybacks and Related Compliance Issues.
Interest deductibility under Section 163(j)
The TCJA generally limited the deduction for business interest expense to business interest income plus a threshold amount of 30 percent of “adjusted taxable income” (ATI). The CARES Act increases the 30% ATI limitation to 50% for tax years beginning in 2019 and 2020 for all businesses (except see below for a special rule that applies to partnerships in 2019). The CARES Act also allows all taxpayers (including partnerships) to elect to use their 2019 ATI for the 2020 limitation.
A special rule excludes partnerships from the increased limitation based on 50% of ATI in tax year 2019. Instead, in 2020 partners may deduct 50% of their distributive share of the partnership’s excess business interest carried forward from 2019 without regard to the Section 163(j) limitation.
Observation: The combined benefits from the new temporary 50% threshold and the ability to use 2019 ATI to compute the limitation in 2020 should increase interest deductions in 2019 and 2020 for taxpayers otherwise limited by § 163(j). These deductions may create or increase NOLs in 2019 or 2020 that now may be carried back to the previous 5 tax years.
Refundability of previously generated AMT credits:
The TCJA repealed the corporate alternative minimum tax (AMT) but included a new Section 53(e) allowing corporations to apply previously generated AMT credits against regular tax or refund 50 percent of the excess in tax years after 2017 and before 2022. The CARES Act generally would allow corporations to apply for a tentative refund of all excess credits remaining after 2018.
Observation: This effectively means that all corporate AMT tax credit carryovers remaining after 2018 are immediately available for refund.
TCJA technical correction for qualified improvement property
The CARES Act includes a technical correction to the TCJA that would treat qualified improvement property (QIP) as 15-year property under MACRS and eligible for 100 percent bonus depreciation. This corrects an unintended mistake in the TCJA that classified QIP as 39-year property. The correction is effective retroactively as of the date the TCJA was passed.
Observation: This is an issue that Republicans have wanted to fix since enactment of the TCJA, but Democrats were unwilling to address it without the ability to address issues of importance to them. The timing for this change, however, is good as it will benefit industries that have been particularly hard hit by the COVID-19 crisis – restaurants, retail stores and hotels. By including QIP as 15-year property that is eligible for bonus depreciation, the CARES Act will allow these businesses to immediately expense the costs associated with improving their facilities. In addition, it allows taxpayers to recover previously incurred QIP costs through bonus depreciation. The IRS and Treasury are expected to issue guidance addressing this new provision for QIP, including procedures for claiming retroactive relief (i.e., through amended returns, accounting method changes or both).
Issues for Private Equity Businesses & Government Loan Programs
Private equity funds and their portfolio companies have felt the stress of the economic shutdown, but in addition to tax provisions that could provide sources of liquidity, these companies may also benefit from government loan programs such as the Paycheck Protection Program (PPP), the Economic Injury Disaster Loan Program (EIDLP) or the Federal Reserves’ new Main Street Lending Program. For more details about the PPP and EIDLP, please see our True Alert at the following link: The COVID-19 Pandemic: IRS Guidance & Loan Assistance to Businesses.
However, private equity funds and their portfolio companies should consider whether the Small Business Association’s (SBA’s) affiliation rules impact their eligibility by aggregating the employees of multiple businesses when determining the headcount restriction of 500 employees (or greater in certain industries). The private equity industry has been lobbying the SBA, Treasury, and the Congress asking for an exception from the SBA affiliation rules to make it clear that they can apply for the loan programs.
Payroll Tax Deferral and Relief: The CARES Act allows employers to defer payment of the employer portion of Social Security payroll taxes (i.e., FICA taxes but not Medicare taxes) attributable to wages paid during 2020 after the enactment of the CARES Act. 50% of the deferred tax payments are due at the end of December 2021, and the remaining 50% are due at the end of December 2022.
The CARES Act also creates the “employee retention credit,” which allows employers a credit against their employment tax liability equal to 50% of the first $10,000 in wages per employee (including the value of health plan benefits). To qualify for the credit, the employer must have had their business fully or partially suspended due to a government order, or the employer must have experienced a greater than 50% reduction in its gross receipts for a calendar quarter when compared to the same quarter in the prior calendar year. The credit applies to wages paid after March 12th and before January 1, 2021.
Prior to utilizing these payroll tax benefits, companies should note that there are restrictions on claiming certain CARES Act tax benefits when also taking advantage of the SBA’s loan programs.
Opportunity Zones – Impact of COVID-19 Pandemic
Qualified opportunity zone investors may face challenges in meeting project deadlines due to the COVID-19 crisis, which could result in losing tax benefits or being forced to terminate projects if deadlines are not extended. Although the IRS has postponed several tax filing and payment deadlines from April 15th to July 15th, to date there has been no specific relief given for opportunity zones, although Notice 2020-23 may provide some relief (explained below). The final regulations released in December of 2019 include some relief provisions that taxpayers may be able to use, e.g., with respect to an opportunity zone located within a federal declared disaster area. Every state is now under a federal disaster declaration due to action by the President.
The Opportunity Zone program allows investors to reinvest capital gains within a 180-day window into designated low-income areas in exchange for certain tax benefits that increase the longer the money is invested in a qualified opportunity fund (QOF) until December 31, 2026. If investments in the QOF are held for five years, then 10% of capital gains on the prior investment will be forgiven, while 15% of capital gains will be forgiven if the investments are held for seven years. Thus, an investor had until December 31, 2019, to receive the 15% tax benefit.
Under the final regulations issued in December of 2019, there are two methods of investing in the program. Under a one-tiered structure, a QOF directly holds qualified zone property. In a two-tiered structure, a QOF invests its money into one or more opportunity zone businesses whose tangible property is substantially located in a zone and at least 50% of whose gross income comes from the active conduct of the business.
An investor in a one-tiered structure must invest gains into a QOF within 180 days of the sale or exchange that gave rise to that gain. Some investors made sales or exchanges of capital gains at the end of 2019 in order to take advantage of the maximum 15% tax relief, so their window will close at the end of June. The ability to invest the funds into a qualifying QOF may not be possible now within the 180 days due to the impact of COVID-19 on the economy.
The IRS issued Notice 2020-23, which provides guidance to taxpayers in a number of areas with respect to extensions of tax deadlines, and that Notice is being interpreted by some, including the National Association of Realtors, to cover the case of an investor who sold a capital asset and needs to rollover the gain into an opportunity fund within 180 days. The investor may be able to extend the previous 180-day deadline if it fell between April 1 and July 15th until July 15th, but taxpayers should be aware that the Notice does not specifically refer to Opportunity Zones.
Investors who have already invested in a QOF may have problems meeting the requirement that 90% of the assets of the fund be in qualified property, due to the fact that physical construction and government approvals for projects may be delayed, which could result in penalties. There is a “reasonable cause” exception to the penalties, but there is no detailed list of cases that qualify for this exception. Guidance from Treasury and the IRS on these issues would be helpful but has not yet been issued.
State Tax Issues
Nexus Issues: One issue facing employers is whether individual states will assert nexus on businesses whose employees are working from home. It remains to be seen whether states will issue guidance that clarifies this issue for companies, although the New Jersey Division of Taxation has led the way by announcing on March 30th that it will not treat the presence of employees working from home in New Jersey as creating nexus for out-of-state corporations, if those employees otherwise work from offices located in other states and are working from home solely due to the coronavirus outbreak and/or social distancing policies. For more information on the NJ announcement, please see our True Alert at the following link: New Jersey Temporarily Waives Certain Corporate Nexus Thresholds.
Mississippi, Pennsylvania, and the District of Columbia have also all indicated that they will not exert nexus because an employee is working remotely due to COVID-19. The Multistate Tax Commission and the Federation of Tax Administrators are aware of these concerns and have shared comments with tax administrators, but the support of each state’s legislatures will be needed to fully address the situation.
Decrease in State Tax Revenues: State budgets will be affected by lost and delayed tax revenues from both individuals and businesses. This includes decreased sales and excise taxes collected from businesses being shut down and consumers buying less, and reduced travel and tourism. With many individuals unemployed, the collection of personal income tax will be lower in 2020. At some point when the economy restarts, state governments will look for ways to replace the lost tax revenue, which could result in changes to both the individual and business income tax systems, including the loss of deductions, and increases in or the addition of new excise taxes. States may also decide to ramp up audit activity and offer amnesty and voluntary disclosure programs.
International Tax Issues
Many governments have taken unprecedented actions to address the COVID-19 pandemic including restricting travel and implementing quarantine requirements while approving stimulus packages to support employment, which has resulted in some cross-border employees being unable to physically perform their work duties in their country of employment. This has created cross-border tax issues covering situations that include employees being stranded in a country where they are not tax residents and has raised questions about the application of bilateral tax treaties.
The presence of employees working from a fixed location in a country will generally cause the employer to have a taxable presence under local law or a permanent establishment (PE) under an applicable income tax treaty. Also, many countries use a central management and control test to determine whether a company is resident in that country.
An employee working in another country through an employer’s fixed place of business may create a PE in that country for the employer if the employee has and regularly exercises the authority to conclude contracts. Also, where an employee working remotely is acting in a management capacity or exercising authority as a member of the company’s board of directors, that activity may create a risk that the company could be viewed as having its central management and control in that country and, therefore, some countries may consider them a resident for tax purposes.
Observation: If a company has employees who could potentially be creating a PE in countries where they are telecommuting, it may be advisable to issue internal guidelines for remote workers affected by the COVID-19 crisis to prevent them from binding the company to a contract and to provide proper oversight to the employee’s decision-making authority. This will assist the company in making their case to the tax authorities that no PE was established should that become necessary. A number of issues could arise if the employee does create a PE, including withholding tax obligations, social security contributions, and the need to set up a payroll. Because the PE rules and obligations are determined based on a tax treaty between the home country and the jurisdiction in question, the company will need to look at each case separately.
Stranded employees may also become subject to tax if their stay in the jurisdiction exceeds the number of days allowed under the relevant local law or income tax treaty.
Observation: Individuals who are nonresidents of the US may find themselves subject to US Federal tax on their worldwide income if they are deemed “substantially present in the US” by being in the US for at least 183 days during any calendar year, or an average of at least 122 days over a 3-year period. There are limited exceptions to this rule, including if a nonresident individual is unable to leave the US because of a medical condition that arose while the individual was present in the US. To date, the IRS has not expanded this medical condition exception to cover the case of COVID-19.
Similarly, a US resident employee may be unable to travel home from a foreign country because of COVID-19, in which case they must consider whether they became an income tax resident of the foreign country or whether they can claim an income tax treaty tiebreaker position.
Additional Issues for Companies: There are other issues that companies may face from the fallout of COVID-19 on the cross-border movement and activities of their employees, including the rules for sourcing income from the performance of personal services and the determination of whether a company is engaged in a US trade or business. Please contact us for additional information on how to address these issues.
Country Guidance: Some countries, including the UK, Australia, France (in coordination with Belgium and Switzerland), and Germany (in coordination with the Netherlands) have started to issue guidance on how the COVID-19 crisis will impact the tax residency status of individuals who have been forced to relocate. The US Council for International Business has recommended that the US Treasury issue such guidance and stated in a letter to Treasury that the relocation of employees is one of the group’s high-level concerns related to the COVID-19 crisis.
OECD Secretariat Guidance on the PE and Residency Issues
In response to requests from some member countries, the Organization for Economic Cooperation and Development (OECD) issued guidance on April 3, 2020, on issues related to international tax treaty rules and tax issues that have arisen due to the COVID-19 pandemic. Specifically, the guidance addresses whether a permanent establishment (PE) could be created by an employee who is stranded in a country where they don’t normally work due to travel restrictions and whether a new individual tax residence could be created by employees who are working in a country different from their normal work situation.
Some businesses have told the OECD they are concerned that their employees may be dislocated to countries other than where they regularly work which may create PE in those countries and may trigger new filing requirements and tax obligations. The OECD has commented that they believe a PE should not be established in these cases, stating: “The exceptional and temporary change of the location where employees exercise their employment because of the COVID-19 crisis, such as working from home, should not create new PEs for the employer. Similarly, the temporary conclusion of contracts in the home of employees or agents because of the COVID-19 crisis should not create PEs for the businesses.”
The guidance suggests that the COVID-19 crisis may also raise concerns about a potential change in the “place of effective management” of a company as a result of a relocation, or inability to travel, of chief executive officers or other senior executives, and thereby may affect the country where a company is regarded as a resident for tax treaty purposes (this rule applies in some countries but it does not create tax residency in the US). The OECD states: “It is unlikely that the COVID-19 situation will create any changes to an entity’s residence status under a tax treaty. A temporary change in location of the chief executive officers and other senior executives is an extraordinary and temporary situation due to the COVID-19 crisis and such change of location should not trigger a change in residency, especially once the tie breaker rule contained in tax treaties is applied.”