Monthly Tax Roundup (Volume 3, Issue 1)
Tax Alert
Introduction
Taxpayers are still swimming back to the surface after a deluge of year-end guidance. In the final month of 2023, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released notices addressing PTEP basis in certain inbound transactions, potential double counting of CFC income under the corporate alternative minimum tax, the interaction of U.S. tax rules with Pillar Two top-up taxes, and the scope of research expenditures under section 174. Alongside the torrent of notices, Treasury and the IRS published proposed regulations for the Advanced Manufacturing Production Tax Credit (section 45X) and issued an advice memorandum asserting that implicit support affects the pricing of intercompany debt. In our first Monthly Tax Roundup of 2024, we identify the key takeaways from December's developments.
Tax Fact: The IRS Large Business and International Division (LB&I) received only 20 Pre-Filing Agreement (PFA) program applications from 2019-2022, with less than half accepted.
"Well, there certainly is realization here by the corporation, if not the taxpayers, right? It isn't a case like appreciation of property where nothing has happened." –Chief Justice John Roberts, Supreme Court oral arguments in Moore v. United States
IRS Releases Informal Guidance on the Effect of Implicit Support Under Section 482
Rocco Femia, Kevin Kenworthy, Layla Asali, and Lisandra Ortiz
Right before the end of 2023, the IRS released an advice memorandum issued by the Office of Chief Counsel on the pricing of intercompany debt under section 482. Specifically, the memo addresses the extent to which the IRS may consider group membership in evaluating the pricing of intercompany debt. This issue is the subject of a regulatory project per the IRS's Priority Guidance Plan. The effect of group membership when pricing intercompany guarantees and loans is also the subject of litigation in Eaton Corp. & Subsidiaries v. Commissioner, No. 2608-23 (T.C. filed Mar. 3, 2023), which is pending in the U.S. Tax Court.
Under the facts analyzed in the memo, a foreign parent (FP) wholly owns a U.S. subsidiary (U.S. Sub), which "operates businesses essential to the group's financial performance." The memo assumes that if U.S. Sub's financial condition were to deteriorate, FP was "expected to likely provide financial support" to prevent U.S. Sub from defaulting on its obligations. Notably, the memo further assumes that both FP and U.S. Sub are rated by independent rating agencies, and that FP has a credit rating of A and U.S. Sub has a rating of BBB (one notch below FP's rating and two notches above U.S. Sub's standalone credit rating). U.S. Sub's rating of BBB reflects implicit support — that is, the possibility that FP (or another affiliate) would provide financial support to U.S. Sub if it faced financial distress even without an explicit guarantee or legally enforceable commitment to do so. U.S. Sub issued debt to FP, which is not supported by an explicit guarantee and which the memo assumes is bona fide debt under debt-equity principles.
Assuming these facts, the memo addresses the legal issue of whether the IRS may consider group membership in determining an arm's length interest rate for intercompany debt under section 482. The IRS answers this question in the affirmative. In the memo, the IRS leans heavily on the realistic alternatives principle, positing that if an unrelated lender would consider group membership, then the IRS may adjust the interest rate in a controlled lending transaction to reflect group membership. The memo reasons that a "commercial lender" would charge interest based on the borrower's credit rating, and therefore that factors that inform the borrower's rating would inform the arm's length rate of interest. The memo concludes that the IRS may adjust the interest rate on the intercompany loan to a rate corresponding to U.S. Sub's BBB rating, which was determined by an independent rating agency and reflects a two-notch uplift based on the expectation of implicit support.
This conclusion is at tension with the arm's length standard as it permits an uncompensated transfer of value from FP to U.S. Sub. The memo requires FP to bear without compensation some of the credit risk assumed on the loan (represented by the two-notch differential between U.S. Sub's standalone credit rating and its rating with implicit support). The memo acknowledges this tension without fully addressing it, instead articulating the view that the under compensation of FP is somehow required by the arm's length standard. The memo also addresses the related question of whether a borrower needs to compensate its parent or other affiliate for the value of implicit support. The IRS invokes the passive association rule from the section 482 regulations applicable to controlled services transactions to conclude that implicit support is not separately compensable, thereby permitting an uncompensated transfer of value from FP to U.S. Sub.
The memo leaves open questions regarding the pricing of intercompany financial transactions under section 482. For one, the memo relies on certain notable factual assumptions in reaching its conclusions. In addition, the memo does not engage fully with the application of the arm's length counterfactual, under which the borrower and its affiliates are treated as unrelated to each other. Stay tuned for further developments in this area, including the potential for regulatory guidance under section 482 or further updates in ongoing litigation.
IRS and Treasury Provide Welcome Guidance on Treatment of PTEP Basis in Inbound Transactions
Layla Asali, Rocco Femia, and Jeffrey Tebbs
On December 28, 2023, the IRS and Treasury issued Notice 2024-16, announcing that forthcoming proposed regulations will provide that, in certain cases, the tax basis of a U.S. shareholder in a controlled foreign corporation (CFC) that has been transferred to it by another CFC in an inbound liquidation or asset reorganization will reflect the transferor CFC's section 961(c) basis in the acquired CFC. The Notice is timely and important guidance that resolves uncertainty for companies seeking to simplify corporate structures and remove unnecessary holding companies to facilitate cash movement and manage reporting requirements.
In order for a transferor CFC's section 961(c) basis to be taken into account under the Notice, the section 961(c) basis must have resulted from previously taxed earnings and profits (PTEP) included under section 951 or 951A by the same domestic corporation that owned the transferor CFC immediately before the transaction (or was inherited by that domestic corporation under section 961(c)'s successor rules).
The rules announced in the Notice apply to "covered inbound transactions," which include section 332 liquidations and upstream asset reorganizations in which the domestic acquiring corporation acquires all the stock of the acquired CFC from a transferor CFC, and inbound F reorganizations of the transferor CFC in which the same domestic corporation that owned the transferor CFC owns all of the stock of the domestic acquiring corporation after the transaction. For this purpose, de minimis stock ownership of one percent or less is disregarded.
The Notice provides several limitations on the scope of a covered inbound transaction. The receipt of money or other property in a reorganization is generally disqualifying, unless the boot is one percent or less of the fair market value of the stock of the transferor CFC. A transaction is not a covered inbound transaction if there is a loss in the stock of the acquired CFC. Subsequent drop downs of the stock of the acquired CFC to a corporation (other than within the same consolidated group) or partnership prevent a transaction from being a covered inbound transaction. And the rules do not apply to regulated investment companies (RICs), real estate investment trusts (REITs), or S corporations. If an inbound transaction involves the acquisition of multiple acquired CFCs, these limitations are applied separately with respect to each acquired CFC.
The result in the Notice is appropriate and welcome because it ensures that a U.S. shareholder that has already been taxed on an acquired CFC's PTEP will not be taxed a second time when that PTEP is repatriated or when the acquired CFC is sold. The IRS and Treasury have decided to provide guidance now to address basis in the relatively simple fact patterns covered by the Notice as they continue to consider more challenging questions involving PTEP and basis. To the extent a transaction falls outside the limited scope of the Notice, "[n]o inference is intended" on the treatment of section 961(c) basis.
Through this Notice, Treasury and the IRS continue recent efforts to reduce technical uncertainty that might inhibit the repatriation of assets, including a December 2023 notice addressing CFC dividends under the corporate alternative minimum tax (CAMT), as well as May 2023 proposed regulations addressing the consequences under section 367(d) of repatriating intangible property.
Taxpayers may rely on the rules in the Notice for transactions completed on or before the date proposed regulations governing these transactions are published. Treasury and IRS request comments on the Notice, including whether the rules should address transactions other than covered inbound transactions and whether additional limitations should apply in those cases. Comments are due February 26, 2024.
Treasury and the IRS Clarify and Modify Prior Section 174 Guidance
A recent Internal Revenue Bulletin Notice and Revenue Procedure from Treasury and the IRS clarify and modify prior sub-regulatory guidance on specified research or experimental (SRE) expenditures subject to section 174. Notice 2024-12 (the 2024 Notice) clarifies and modifies prior substantive guidance and is particularly relevant for contract-research providers. Rev. Proc. 2024-9 (the 2024 Revenue Procedure) modifies and clarifies existing automatic method change rules and adds a new automatic method change for SRE expenditures relating to long-term contracts subject to the section 460 percentage of completion method (PCM). The 2024 Notice and the 2024 Revenue Procedure also address important issues for taxpayers seeking to rely on prior substantive guidance before Treasury and the IRS publish section 174 proposed regulations in the Federal Register.
Substantive Guidance in the 2024 Notice
Treasury and the IRS issued Notice 2023-63 in fall 2023, announcing their intention to issue proposed regulations addressing (1) the capitalization and amortization of SRE expenditures under section 174, (2) the treatment of SRE expenditures under section 460, and (3) the way in which section 482 applies to cost sharing arrangements involving SRE expenditures. See our prior coverage here. The 2024 Notice clarifies and modifies Notice 2023 63 in three ways.
- First, the 2024 Notice changes the rules Treasury and the IRS intend to apply to contract-research arrangements. Notice 2023-63 proposed a broad rule that would have treated a research provider as incurring SRE expenditures subject to capitalization and amortization if the research provider either (1) bears financial risk under the contract with the research recipient or (2) has the right to use any resulting "SRE product" or otherwise exploit any such SRE product in the research provider's business without having to obtain prior approval from an unrelated counterparty. The 2024 Notice revises these rules to propose that a research provider does not incur SRE expenditures if, under the contract with the research recipient, the research provider (1) does not bear financial risk and (2) obtains only "excluded SRE product rights." For this purpose, an excluded SRE product right is an SRE product right that is separately bargained for (i.e., arose from consideration other than the cost paid or incurred by the research provider to perform SRE activities under the contract) or was acquired for the limited purpose of performing SRE activities under the contract or another contract with the research recipient.
- Second, the 2024 Notice changes the requirements for a taxpayer to rely on Notice 2023-63 before Treasury and the IRS publish section 174 proposed regulations in the Federal Register. In general, Notice 2023-63 allowed taxpayer reliance "provided the taxpayer relies on all the rules [in Notice 2023-63] . . . and applies them in a consistent manner." The 2024 Notice removes the requirement that a taxpayer must rely on all the rules in Notice 2023-63 to be entitled to rely on any of them.
- Third, while Notice 2023-63 stated that section 5 of Rev. Proc. 2000-50 — relating to costs of developing computer software — is obsolete, the 2024 Notice clarifies that section 5 of Rev. Proc. 2000-50 is obsolete only for expenditures paid or incurred in taxable years beginning after December 31, 2021, and not for expenditures paid or incurred in taxable years beginning on or before December 31, 2021.
Method Change Guidance in the 2024 Revenue Procedure
Treasury and the IRS issued Rev. Proc. 2023-11 in early 2023 to allow taxpayers to use the automatic accounting method change procedures to change their accounting method for SRE expenditures to comply with section 174. See our prior coverage here. Treasury and the IRS included this procedural guidance, with some revisions, in Rev. Proc. 2023-24 (the List of Automatic Changes). The 2024 Revenue Procedure clarifies and modifies the List of Automatic Changes in three ways.
- First, the 2024 Revenue Procedure expands the existing automatic method change for SRE expenditures so that it also applies to a change to an accounting method that follows the substantive guidance in Notice 2023-63. In doing so, the 2024 Revenue Procedure adds a new elective provision that applies to certain method changes that occur after a taxpayer's first taxable year beginning after December 31, 2021 (a post-Year-1 change). These post-Year-1 changes generally must occur with a modified section 481(a) adjustment calculated by reference only to amounts paid or incurred in taxable years beginning after December 31, 2021, and before the year of change. But if the modified section 481(a) adjustment is negative, then the new elective provision allows a taxpayer to choose to make the post-Year-1 change on a cut-off basis rather than with a modified section 481(a) adjustment.
- Second, the 2024 Revenue Procedure adds a new automatic method change for a taxpayer that wants to change its method of accounting for SRE expenditures relating to long-term contracts subject to the section 460 PCM to a method that follows the guidance in Notice 2023-63. For SRE expenditures that a taxpayer pays or incurs in taxable years beginning after December 31, 2021, the new method allows a taxpayer to treat only the current amortization with respect to such SRE expenditures (rather than the full amount of the SRE expenditures) as an incurred and allocable contract cost for purposes of calculating the section 460 completion percentage. This means the numerator of the completion percentage includes only section 174 amortization as such amortization arises. With respect to the completion percentage's denominator, the new method allows a taxpayer to choose whether to include (1) 100 percent of the amortization that will ultimately result from the SRE expenditures (even if this amortization arises after the contract term) or (2) only the amortization that is expected to arise during the contract term.
- Third, consistent with the 2024 Notice, the 2024 Revenue Procedure clarifies the List of Automatic Changes to make clear that section 5 of Rev. Proc. 2000-50 is obsolete only for expenditures paid or incurred in taxable years beginning after December 31, 2021, and not for expenditures paid or incurred in taxable years beginning on or before December 31, 2021.
Miller & Chevalier Reactions
The 2024 Notice makes welcome changes for contract-research providers. Although the specific facts and circumstances of any given contract-research arrangement will control, we expect these changes will allow many contract-research providers to avoid capitalization and amortization for their contract-research expenditures. Removing the requirement that a taxpayer follow all aspects of Notice 2023-63 to rely on any aspect thereof is also taxpayer favorable and, according to the 2024 Notice, is intended "[t]o facilitate reliance on the rules described in Notice 2023-63 in a more administrable manner." The 2024 Notice explains further that removing the requirement obviates the need for taxpayers to file amended returns in situations where an accounting method change is not available to bring an already-filed return into full compliance with Notice 2023-63.
The 2024 Revenue Procedure also makes welcome revisions to the List of Automatic Changes Although expected based on Notice 2023-63, taxpayers will take comfort in knowing that a change to a Notice 2023-63 method is eligible for the automatic change procedures. The flexibility to elect to forego a negative modified section 481(a) adjustment is also a taxpayer-favorable addition, particularly for taxpayers facing potential exposure to the corporate alternative minimum tax. Finally, the new automatic method change for PCM contracts is notable for several reasons. Historically, method changes for long-term contracts had to follow the nonautomatic change procedures. Taxpayers are sure to cheer the ability to rely on the less onerous automatic change procedures. Allowing taxpayers flexibility to choose between approaches for including SRE expenditures in the denominator of the section 460 completion percentage is also refreshing. Notice 2023-63 explicitly requested comments on which approach was correct, suggesting that Treasury and the IRS expected to allow one approach and prohibit the other. The 2024 Revenue Procedure suggests Treasury and the IRS have decided that both approaches are permissible, perhaps in recognition of the fact that the difference between the two is merely timing.
The 2024 Notice and the 2024 Revenue Procedure are silent on many of the hot-button issues that Notice 2023-63 did not address. Examples include how section 280C applies when a taxpayer claims a section 41 research credit and the way in which the disposition rules in section 174(d) apply to partnership transactions. For these and many other reasons, taxpayers are sure to eagerly await section 174 proposed regulations later this year.
Notice Provides Relief from Potential Double Counting of CFC Income under CAMT
Loren Ponds, Jeffrey Tebbs, Caroline Reaves, and Candice James
On December 15, 2023, Treasury and the IRS issued Notice 2024-10, which provides interim guidance to prevent the potential "double counting" of CFC earnings under the CAMT. In a welcome approach, taxpayers are instructed to disregard income items reported on their financial statements and instead follow the regular tax treatment for certain CFC distributions. The Notice also offers additional guidance on determining the appropriate applicable financial statement (AFS) for members of a tax consolidated group or foreign-parented multinational group.
Under section 56A, the taxpayer's adjusted financial statement income (AFSI) includes both dividends from corporations not included on the taxpayer's consolidated return and the taxpayer's pro rata share of each CFC's net income or loss. Double counting of a CFC's earnings could thus occur if the taxpayer includes both its pro rata share of CFC income in the calculation of its AFSI and includes some or all those earnings again in AFSI when they are later distributed from a lower-tier to upper-tier CFC or from the CFC to the U.S. shareholder. The statute directs Treasury to issue guidance preventing the omission or duplication of any item.
The Notice describes forthcoming proposed regulations addressing the CAMT treatment of a "Covered CFC Distribution." The Notice defines a "Covered CFC Distribution" as a distribution from a CFC "to the extent it is a dividend (within the meaning of § 316), determined without taking into account § 959(d)." By turning off section 959(d), a Covered CFC Distribution thus includes not only a distribution of section 959(c)(3) untaxed earnings and profits, but also a PTEP distribution. Covered CFC Distributions specifically exclude deemed dividends arising from the disposition of stock under section 1248.
For a Covered CFC Distribution from a CFC to a U.S. shareholder, the Notice would determine AFSI by disregarding any items reported on the U.S. shareholder's financial statement arising from the distribution and instead, including the U.S. shareholder's items of income and deduction under the regular tax system that result from receipt of the distribution. In general, to the extent a distribution would be eligible for the section 245A dividends received deduction or would be excluded from gross income as PTEP under section 959, the distribution would not increase the U.S. shareholder's AFSI.
Similar rules are provided for Covered CFC Distributions between CFCs. To determine the adjusted net income or loss of a recipient CFC with respect to a Covered CFC Distribution, the income item on the recipient CFC's financial statement is disregarded. Instead, the recipient CFC includes items of income, as determined under the regular tax system, resulting from the receipt of the Covered CFC Distribution, without regard to any exclusions (for example, the subpart F high-tax exception under section 954(b)(4)). That CFC item of income is then reduced to the extent the Covered CFC Distribution is excluded from:
- Both
- The recipient CFC's foreign personal holding company income under section 954(c)(3) or section 954(c)(6); and
- The recipient CFC's gross tested income under Treas. Reg. § 1.951A-2(c)(1)(iv);
or
- The recipient CFC's gross income under section 959(b).
In short, the Notice conforms the CAMT AFSI calculation mechanisms to the regular U.S. tax treatment, given that a U.S. shareholder is generally able to exclude distributions between CFCs of PTEP, high-taxed CFC income items, related party dividends, and same-country dividends from its subpart F income and global intangible low-taxed income (GILTI) inclusions.
Taxpayers are permitted to rely on the interim guidance with respect to Covered CFC Distributions that are received on or before the date the forthcoming proposed regulations are published in the Federal Register. Comments on the Notice are due by January 15, 2024, though comments submitted after that date will be considered as long as they do not delay the issuance of the forthcoming proposed regulations.
Guidance Addresses Creditability of Pillar Two Taxes, Interaction of DCL Rules with Pillar Two, and Indefinite Suspension of 2022 Foreign Tax Credit Regulations
Loren Ponds, Jeffrey Tebbs, Caroline Reaves, and Candice James
On December 11, 2023, Treasury and the IRS issued Notice 2023-80 addressing the creditability of certain top-up taxes consistent with the Pillar Two Global Anti-Base Erosion (GloBE) Model Rules and whether the calculation of a Pillar Two tax would trigger the recapture of "legacy" dual consolidated losses (DCLs). Generally, creditability of Pillar Two top-up taxes under the Notice depends on whether the foreign tax takes into account any amount of that taxpayer's U.S. tax liability. For DCL purposes, taxpayers subject to Pillar Two should not be deemed to have foreign use with respect to DCLs incurred prior to the GloBE transitional period even if all or a portion of the legacy DCL is taken into account for purposes of determining net GloBE income for a particular jurisdiction. The Notice also indefinitely extends the suspension of the controversial January 2022 modifications to longstanding foreign tax credit (FTC) regulations.
Comments on the Pillar Two portion of the Notice are due February 9, 2024.
FTC Availability for Pillar Two QDMTTs and IIRs
On January 1, 2024, top-up taxes pursuant to the Organisation for Economic Cooperation and Development's (OECD) Pillar Two work became effective in more than two dozen countries. These taxes include qualified domestic minimum top-up taxes (QDMTTs) and those imposed pursuant to income inclusion rules (IIRs) consistent with the GloBE Model Rules. Under the GloBE Model Rules, QDMTTs are not computed by reference to any shareholder taxes. For the computation of top-up tax that may be due under an IIR, shareholder taxes may be pushed down to the tested company if the shareholder and the tested company are part of the same multinational enterprise (MNE) group.
The Notice describes forthcoming proposed regulations on the interaction of the U.S. tax system with Pillar Two top-up taxes. The Notice assumes, but does not provide or confirm, that QDMTTs and IIRs are foreign income taxes. For U.S. FTC purposes, creditability for each U.S. taxpayer would hinge on whether the foreign tax is a "final top-up tax" that takes into account any amount of that taxpayer's U.S. tax liability. A QDMTT that conforms to the GloBE Model Rules would not be considered a final top-up tax and a U.S. shareholder would generally be allowed an FTC. In contrast, an IIR tax would be considered a final top-up tax for which an FTC would be prohibited in many cases. Whether a U.S. FTC is permitted for an IIR tax would depend on whether the tax is computed by accounting for U.S. taxes imposed on the direct and indirect owners of the tested company, with such taxes allocated to the tested company when calculating its effective tax rate. This would typically be the case for a U.S.-headed multinational corporation where the U.S. corporate shareholder and the tested foreign company are part of the same MNE group. The Notice does not provide guidance on top-up taxes imposed by third countries under so-called undertaxed profits rules, which are not expected to come online until 2025 at the earliest.
Read more about the creditability of Pillar Two top-up taxes under Notice 2023-80 here.
Limited Relief Provided on Interaction of Pillar Two Rules and Existing DCLs
In addition, the Notice addresses the interaction of the Pillar Two rules and the U.S. DCL rules and provides limited relief with respect to certain "legacy DCLs." Under the general DCL rules, a taxpayer is precluded from the domestic use of a DCL if a "foreign use" of that DCL may occur. If a taxpayer elects domestic use of the loss and a subsequent "foreign use" occurs, the total amount of the DCL is recaptured as ordinary income plus an interest charge. A "foreign use" may occur if any portion of a deduction or loss taken into account in computing the DCL is "made available" under foreign tax law to offset items of income or gain.
The GloBE Model Rules require a jurisdictional blending approach where the income and loss of "Constituent Entities" in the same jurisdiction are aggregated for the purposes of ascertaining GloBE net income and jurisdictional top-up tax liability. Taxpayers are unable to opt out of the aggregate approach, even if making the loss available would not reduce the amount of top-up tax due in the jurisdiction. The Notice highlights, but ultimately leaves unaddressed, whether a DCL that is aggregated with other entities' income or loss in the same jurisdiction (i.e., in the calculation of the net GloBE income) for purposes of calculating a Pillar Two top-up tax constitutes a "foreign use" for DCL purposes. Similar questions exist on whether the computations of a Pillar Two top-up tax can result in a deduction or loss subject to section 267A or section 245A(e).
The Notice provides that, subject to an anti-abuse rule, a taxpayer will not have a foreign use of a "legacy DCL" solely because a portion of the deductions or losses that comprise the legacy DCL are taken into account in determining the net GloBE income for a particular jurisdiction. "Legacy DCLs" are DCLs that are incurred in (1) taxable years ending on or before December 31, 2023, or (2) taxable years beginning before January 1, 2024, provided the taxpayer's taxable year begins and ends on the same dates as its MNE group. While this relief is welcome, the interaction of the GloBE and DCL rules going forward urgently needs to be addressed, given that calendar year taxpayers will begin provisioning for the U.S. treatment of current (non-legacy) DCLs as early as the first quarter of 2024. Unfortunately, the Notice provides little indication of how Treasury and the IRS will address this issue in the future.
Taxpayers should be aware that the OECD has published additional Pillar Two administrative guidance on adjacent issues affecting the transitional "Country-by-Country Report" (CbCR) safe harbor determination, which generally allows MNE groups to use their CbCRs to determine effective tax rates on a country-by-country basis during a transitional period. Published on December 18, 2023, the administrative guidance would exclude income or expense from pre-tax book income if it arises from certain "hybrid arbitrage arrangements." A hybrid arbitrage arrangement is described as any deduction/non-inclusion (DNI) arrangement, duplicate loss arrangement, or duplicate tax recognition arrangement entered into as of December 15, 2022. A duplicate loss arrangement includes arrangements in which an expense or loss reflected on an entity's financial statement is also included as an expense or loss on another entity's financial statement or the arrangement gives rise to a deductible amount for purposes of determining the taxable income of another entity in another jurisdiction. The guidance provides that the transitional CbCR safe harbor is not available to an MNE group to the extent a hybrid arbitrage arrangement would result in a jurisdiction qualifying for the safe harbor. As with all aspects of the Pillar Two administrative guidance issued by the OECD, the extent to which this guidance is implemented into the law or administrative practice of countries imposing top-up taxes remains to be seen.
Extension of the Temporary Relief on Final FTC Regulations
The Notice also indefinitely extends the temporary relief offered in Notice 2023-55 that suspended the application of controversial January 2022 modifications to longstanding FTC regulations. Taxpayers may now generally apply certain key aspects of prior regulations governing the creditability of foreign taxes, which were in effect before the January 2022 modifications, until the date that guidance withdrawing or modifying the temporary relief is issued. Taxpayers may choose to apply the prior regulations or the January 2022 regulations on a year-by-year basis. The Notice also clarifies that with respect to foreign taxes paid by a partnership, in general, the partnership determines whether to apply the temporary relief.
Fifth Circuit Expands on Key Concepts for R&D Credit
George Hani, Rob Kovacev, and Samuel Lapin
On November 13, 2023, the U.S. Court of Appeals for the Fifth Circuit upheld disallowance of a claimed refund for research and development (R&D) credits because the taxpayer could not point to a viable business component on which to base its claims and because its claims related to funded research. In United States v. Grigsby, 86 F.4th 602 (5th Cir. 2023), the court emphasized the importance of timely and specifically raising bases for a refund and expanded on the application of the "funded research" exception.
Eligibility for the R&D credit in section 41 depends, in part, on the taxpayer's performance of qualified research. Qualified research must, among other things, be "undertaken for the purpose of discovering information . . . the application of which is intended to be useful in the development of a new or improved business component of the taxpayer." Section 41(d)(1)(B)(ii). A business component means any product, process, computer software, technique, formula, or invention" that is (1) held for sale, lease, or license, or (2) used by the taxpayer in a trade or business of the taxpayer. Id. at (d)(2)(B). In addition, qualified research does not include funded research within the meaning of section 41(d)(4)(H). Research is funded if (1) the researcher retains no substantial rights in their research or (2) payment is not contingent on the success of the research. Treas. Reg. § 1.41-4A(d)(2).
The taxpayer is the majority owner of a construction company, Cajun Industries, LLC (Cajun), an S corporation. Cajun filed an amended Form 1120S claiming approximately $1.3 million in additional R&D credits for its 2013 tax year. On the basis of Cajun's amended return, the taxpayer claimed his pro rata share of Cajun's additional credits. In 2017, the IRS paid the taxpayer the claimed return, but in 2019 notified the taxpayer that it was issued erroneously. The government sued to recover the contested refund. For purposes of this case, the taxpayer and the government agreed that four projects — two in which Cajun built petrochemical refineries and two in which it built flood protection systems — would serve as representative of the dozens of construction projects in which Cajun engaged during its 2013 tax year. The taxpayer took the position during discovery that Cajun's work on the four representative projects led to the development of four new products that constituted business components. When the government moved for summary judgment, the taxpayer argued for the first time that Cajun also developed processes in connection with the projects that constituted business components.
The district court granted the government's motion for summary judgment on two grounds:
- First, the district court found that Cajun did not perform qualified research because taxpayer could not point to a business component developed as a result of Cajun's work. The district court found that the taxpayer offered no evidence that Cajun's work on the four projects led to new products. It also rejected the taxpayer's argument that Cajun's work resulted in the development of new processes because not timely raised. Second, the district court held that all four projects were funded research.
The Fifth Circuit affirmed the district court on both points. First, it held that Cajun could not support any business component in connection with the four projects. To the extent Cajun offered any evidence of business components, the Fifth Circuit found that the evidence was in support of new processes, not products. The Fifth Circuit held that Cajun failed to timely raise new processes as business components, so they could not serve as a basis for the credit. It also held that, even if Cajun did timely raise new processes, Cajun failed to provide any information about those processes beyond vague and conclusory statements. - Second, the Fifth Circuit held that even if Cajun had identified viable business components, none of its work on the representative projects constituted qualified research because it was all fully funded research. Cajun's work on three of the projects were funded because Cajun transferred all rights developed in connection with those projects to its counterparty and, accordingly, failed the substantial rights prong. The fourth project was funded research because the payment to Cajun was not contingent on the success of its research. The Fifth Circuit rejected the taxpayer's arguments that a payment contingent on the delivery of a product or result is equivalent to a payment contingent on the success of research, and that Cajun was entitled to the credit merely because the counterparty, a government entity, could not claim it. In addition, the Fifth Circuit rejected the argument that research cannot be funded if it was performed pursuant to a fixed price contract and was inherently risky. Finally, the Fifth Circuit held that the project was funded under the language of the statute— that Cajun was compensated for all expenditures that formed the basis of its claim for the R&D credit and was therefore within the plain meaning of "funded."
This case should serve as a reminder to taxpayers of the importance of introducing all bases for your claim clearly and timely to avoid risking any waiver. In addition, taxpayers should describe in some level of detail some or all the business components that form the basis for their claim. In addition, this case provides a useful demonstration of both prongs of the "funded research" exception. Interestingly, the court held that one project was funded research based solely on the plain language of the statute. Construction of the statute could be important in the future in the event of challenges to the validity of the regulatory "funded research" prongs.
Treasury and IRS Releases Long Awaited Proposed Regulations Under Section 45X
On December 15, 2023, Treasury and the IRS published in the Federal Register proposed regulations under section 45X, the Advanced Manufacturing Production Tax Credit. These long-awaited regulations provide critical guidance as calendar-year taxpayers begin claiming these credits on their income tax returns for the first time. A detailed write-up of the regulations, published last month, is available here.
The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.
This, and related communications, are protected by copyright laws and treaties. You may make a single copy for personal use. You may make copies for others, but not for commercial purposes. If you give a copy to anyone else, it must be in its original, unmodified form, and must include all attributions of authorship, copyright notices, and republication notices. Except as described above, it is unlawful to copy, republish, redistribute, and/or alter this presentation without prior written consent of the copyright holder.