2024 industry tax planning guide
The technology industry is navigating global shifts in laws and regulations, including to tax policy. As many tech companies focus on cutting costs and balancing workforces, it becomes even more important for them to make smart decisions about business investments and financing. To make those decisions effectively, companies need to account for recent tax changes.
Tech companies must contend with a new, stricter limit on the ability to deduct interest expense, at the same time that interest rates are reaching highs not seen in years. Also, tech companies must now capitalize and amortize their substantial investments in research, and they are poised to lose their ability to fully deduct investments in new equipment.
Taken together, these changes can have a significant impact on financial statements and tax returns, even pushing companies from loss positions into taxable income.
“Tech companies may need a new set of strategies to address all of the recent tax changes, especially if they’ll be pushed out of losses.”
“Tech companies may need a new set of strategies to address all of the recent tax changes, especially if they’ll be pushed out of losses,” said Grant Thornton Technology Industry National Managing Partner Andrea Schulz. “The provisions can affect many other items on the return, so modeling is a must. Tax considerations should be part of all financing and investment decisions.”
The technology industry is uniquely global, which can raise another set of issues. The IRS gave taxpayers a temporary reprieve from harsh new foreign tax credit rules, but key pieces of the Pillar 2 global minimum tax regime are scheduled to take effect in January. The global tax rules will create complex new computational and compliance responsibilities and can affect everything from financial statements to transfer pricing. Large tech companies are also facing aggressive efforts to impose taxes on digital services.
“Just because implementation of Pillar 1 and Pillar 2 isn’t going anywhere fast in the U.S. doesn’t mean they won’t impact U.S. companies,” said Grant Thornton International Tax Services Partner Christopher H. Summer. “Other countries are moving forward, and their rules should be part of any long-term decision making on intercompany financing, the location of intangible assets, and supply chain and research investments.”
With all of the challenges ahead, tech companies should make sure they’re leveraging all of the incentives the tax codes still offer, including the deduction for foreign-derived intangible income (FDII) and the research and development (R&D) credit. Now is an excellent time for tech companies to assess their business plans and identify key tax planning considerations.
Cost of borrowing
The era of cheap money is over. Although inflation has eased, debt is still significantly more expensive than many companies became accustomed to over the last decade. Interest rates are changing how companies think about funding investments with borrowed money, and the tax implications should be part of that assessment.
The rising interest rates and a change in tax law are also making it harder for tech companies to get a deduction for their interest expense. The deduction for net interest expense was generally limited to 30% of adjusted taxable income under Section 163(j) under the Tax Cuts and Jobs Act. Previously, adjusted taxable income was similar to earnings before interest, taxes, depreciation and amortization (EBITDA). For tax years beginning in 2022 or later, depreciation and amortization must be included, lowering adjusted taxable income to an amount similar to EBIT. The change can be particularly relevant for tech companies that manufacture hardware and are considering substantial investments in equipment. Although taxpayers can carry forward their unused interest deductions, the 30% limit will continue to apply, so the disallowance can be effectively permanent for some companies.
“The interest limit affects many other items on the return, including international provisions,” Summer said. “There are planning opportunities to mitigate the impact, but modeling is important.”
There is some bipartisan interest in reversing the new tax rules legislatively, so watch for potential changes. If the rules remain, there might be planning alternatives. Taxpayers may have opportunities to reduce the amount of interest expense subject to Section 163(j) by allocating interest expense to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to another asset, the interest becomes part of the cost of that asset and is recovered using the accounting method applicable to that item. For example, if interest is recharacterized to inventory, it would be recovered through the costs of goods sold.
How interest is allocated can affect how quickly the cost is recovered. It’s important to model out interactions to see what levers can be pulled to achieve the best tax result. For more details, see Strategic considerations for the newly restrictive 163(j).
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Domestic tax issues
Research and equipment recovery
The changes to deductions for research and tangible property might present the biggest new challenge for tech company tax planning.
For tax years beginning in 2022 and later, domestic R&E costs under Section 174 must be amortized over five years instead of expensed. Since a midyear convention must be used, this effectively reduced the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years.
Many taxpayers hesitated to address the change in hopes that Congress would reverse it legislatively. Congress may make another attempt at legislation before year-end, but most taxpayers were finally forced to implement the change when filing 2022 returns. So, tech companies should already have completed the significant work of identifying R&E costs under Section 174. With compliance out of the way, and assuming there are no further law changes, it’s time to go from defense to offense and look for planning opportunities.
For tech companies, that means looking at software development, which now must generally be amortized under Section 174. The IRS released important guidance on how to apply these rules just weeks before returns were due for many calendar-year corporations. The guidance offered important insight into how the IRS views the scope of what’s included in software development, but some uncertainty remains for how to identify and segregate software costs that are still deductible as maintenance rather than an upgrade or enhancement.
For now, taxpayers should analyze the new rules, which are proposed to be applicable for tax years beginning after Sep. 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.
For investments in tangible property, bonus depreciation is also shrinking. Property placed in service this year can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the rest of the cost recoverable over the normal depreciable period. This treatment is scheduled to diminish over time, with the bonus rate dropping to 60% for property placed in service in 2024, 40% in 2025, and 20% in 2026. Bonus depreciation is scheduled to disappear entirely in 2027.
“For tech companies making sizeable investments in hardware, losing 40% of an immediate deduction can be painful. It will be crucial to look for planning opportunities that may have been ignored when bonus depreciation was 100%.”
“For tech companies making sizeable investments in hardware, losing 40% of an immediate deduction can be painful,” Summer said. “It will be crucial to look for planning opportunities that may have been ignored when bonus depreciation was 100%.”
Tech companies have always benefited from analyses of property that doesn’t qualify for bonus depreciation, to identify costs that can be deducted as repairs. With bonus depreciation at 60% next year, this repairs analysis could also now significantly accelerate the cost recovery of other bonus depreciation property. Plus, tech companies can consider a broader cost segregation analysis that identifies costs eligible for recovery as property with a shorter depreciable period. This effort can be paired with Section 163(j) planning, to accelerate the recovery of any related interest expenses.
R&D credit
The R&D credit remains one of the most valuable incentives available to the technology industry. According to IRS data, tech companies claim more R&D credits than every other industry except manufacturing. The credit is even more valuable with the new requirement to amortize R&E costs under Section 174, because many companies discovered they had qualified activities for which they had never taken the credit previously because they had not identified the research activities. Additionally, some taxpayers may no longer need to reduce either their R&D credit or the amount recovered under Section 174.
Section 280C(c) traditionally required taxpayers to reduce their deductions under Section 174 by the amount of any R&D credit, or to reduce the R&D credit by the tax effect. The Tax Cuts and Job Act amended Section 280C(c), so taxpayers only need to reduce their capital account for future Section 174 expenditures to the extent that any R&D credit exceeds the deduction for those costs. For many tech companies, the deduction will exceed the R&D credit, meaning they can claim the full R&D credit without any reduction in the ability to recover Section 174 costs. Taxpayers should monitor this issue, however, as the IRS has not yet issued any guidance on interpreting the new statutory language.
“Unfortunately, the R&D credit is one of the most heavily audited issues by the IRS,” Summer said.
The IRS scrutiny of the R&D credit underscores the need for taxpayers to properly document and substantiate their R&D credit claims. The IRS has won several recent cases based on the failure of taxpayers to establish that “substantially all” of the development activities constituted elements of the process of experimentation or that there was not sufficient uncertainty from the outset.
That’s why many companies in the tech industry should consider an R&D credit study. Some of the taxpayers who lost recent cases could potentially have preserved partial credits under the “shrink-back rule,” if they had provided the documentation to apply their analysis to subcomponents of a project that did not qualify as a whole. Tech companies might want a full R&D credit study that not only maintains detailed records to the extent available, but also explores whether there are missed opportunities in areas identified by the need to capitalize Section 174 expenditures.
Public stock buyback tax
Public tech companies face a new 1% excise tax on the fair market value (FMV) of stock repurchases beginning in 2023. The IRS is still working on guidance, but has said the tax will be remitted and reported annually with the Form 720 for the first quarter after the end of the tax year. This means the 2023 tax and form will likely be due for calendar year taxpayers by April 30, 2024. Tech companies that will be affected need to move quickly to understand the impact.
The tax applies to corporations with stock traded on an established securities market, which includes corporations with stock that is traded on a national securities exchange. The tax may also apply to certain acquisitions of a foreign corporation’s stock. A repurchase is defined for this purpose as a redemption under Section 317(b), plus “economically similar” transactions. The tax could increase costs on many kinds of common stock redemption activity, including redemptions related to M&A and stock compensation plans common to the tech industry. The new excise tax is not deductible for income tax purposes.
Under initial guidance from the IRS, the tax will cover a variety of corporate transactions, including acquisitive reorganizations, certain E and F reorganizations, and exchanges in some split-off transactions. The tax can also apply to redemptions of non-publicly traded stock, such as preferred stock, if the corporation has other stock traded on an established securities market.
There are important exceptions and exclusions. Stock issued effectively reduces the amount considered repurchased for purposes of calculating the tax. There are specific rules for determining the FMV of stock issued and repurchased. In addition, the following repurchases are excluded:
- Reorganizations within the meaning of Section 368(a) where no gain or loss is recognized
- Repurchases to the extent that stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan
- If the aggregate FMV of stock repurchased in a year does not exceed $1 million
- Repurchases by a dealer in securities in the ordinary course of business
- Repurchases by a regulated investment company (RIC) or a real estate investment trust (REIT)
- To the extent that a repurchase is treated as a dividendw
Planning for the tax is important. Different types of transactions can be treated differently under the current guidance. Some M&A transactions can give rise to a large increase of a tax base if they are recharacterized as a repurchase, so the tax should be considered as a part of transaction planning and structuring. Because stock issued by a corporation may offset stock repurchases during the year, companies should consider the timing of repurchases related to their stock issuances. Any excess of stock issuances cannot be carried forward and used against stock repurchases in future years.
State and local taxes
For many tech companies, state and local taxes can be as important as federal taxes. States looking for new revenue sources are aggressively targeting digital goods and marketplace facilitators.
As we move farther and farther from the 2018 decision in South Dakota v. Wayfair, states continue to push the envelope with economic nexus provisions requiring remote sellers and marketplace facilitators to collect and remit sales tax. Several states are targeting the tangential presence of inventory relocations to an intermediate state to facilitate transport, sometimes without the seller’s knowledge, which can create a reporting and collection responsibility on the seller. The adoption of marketplace facilitator legislation, in which an operator of a marketplace is required to report and collect sales tax in place of sellers on the platform, has been challenging in part because states have differing concepts of the types of entities that can be classified as a “marketplace facilitator.”
The evolution in sales and use taxes on digital goods has an even more direct impact on tech companies.
Maryland is one of the first states to impose a digital services tax. While there is litigation challenging it, the tax is currently in effect and other states are considering similar efforts. Many states are also looking at economic nexus for income and gross receipts taxes on revenue for digital goods and services, including toward a cost-of-performance method for sourcing sales. Such laws could require tech companies to recognize revenue based on where the production costs for the services take place. This is a particularly relevant issue as hybrid and remote work arrangements become a permanent part of the workforce relationship, which also creates significant withholding and reporting issues on employee income.
Global tax issues
Taxing digital services and cloud computing
Worldwide taxing authorities are seeing an increasing share of economic activity flow through digital sources and are aggressively targeting tech companies to mine for new revenue. This is happening both through existing indirect consumer tax regimes like value added taxes (VATs) and coordinated efforts to directly tax digital services.
Pillar 1 is a sweeping global initiative from the Organisation for Economic Co-operation and Development (OECD) designed to allow countries to tax a share of profits from digital goods and services consumed in a jurisdiction even when the taxpayer has no physical presence there. It is meant to replace the patchwork of unilateral digital service taxes (DSTs) from participating countries. For now, Pillar 1 is targeting the largest tech companies — multinationals with €20 billion in global revenue and a pre-tax profit margin of more than 10%. But the implications could be broader. There is no guarantee that the thresholds will not change in future years. More importantly, implementation of Pillar 1 is stalling, so countries are increasingly looking to impose their own DSTs in its place — and those DSTs can apply at much lower thresholds.
Nearly all of the countries that signed onto the Pillar 1 framework agreed to extend a moratorium on DSTs through the end of 2024. That extension, however, is contingent on at least 30 jurisdictions accounting for at least 60% of the parent companies of affected taxpayers signing the multilateral convention before the end of 2023. A draft of the multilateral agreement was recently released to muted enthusiasm, and the U.S. indicated it may not be ready to sign, meaning the moratorium could end in 2023.
Even if it is signed, it faces an uphill battle domestically. Such treaty instruments generally require two-thirds support in the Senate, a near nonstarter given Republican opposition. The Treasury Department is reportedly exploring whether the administration can use any unilateral mechanisms to achieve implementation, but without a clear road, U.S. multinationals could be facing DSTs all over the map by 2025 or even 2024, and many of these taxes might not be creditable against U.S. tax, discussed more below. Some countries are already moving aggressively.
Canada’s 3% digital services tax is scheduled to take effect as early as 2024 and would apply retroactively to 2022. It would be imposed on multinationals with global revenue of at least €750 million and digital services revenue in Canada of more than $20 million CAD. Digital services would include:
- Online marketplace services
- Online targeted advertising services
- Social media services
- The sale or licensing of data gathered from users of an online marketplace, a social media platform or an online search engine
U.S. lawmakers are pledging to retaliate against Canada with trade measures if the DST moves forward, and have made similar threats to other countries with DSTs. But it’s an open question whether these moves will be effective in curbing the DSTs, and there are downsides. Trade sanctions could have other negative economic consequences.
Many counties are also looking to target digital goods and services with the expansion of VATs, or even with withholding taxes on digital transactions or cloud-based software. There are significant compliance and planning challenges related to VATs in the evolving landscape. The treatment of sales may be complicated when a single inclusive price is charged for separate identifiable services, and apportionment is needed if they’re taxed at different rates. On the plus side, a business may have opportunities to reclaim VAT on services supplied to it.
Cloud-based software or software as a service deserves special consideration. In addition to potential targeting through VATs or other indirect taxes, there are open questions about how such software is treated and sourced under existing international tax rules. Current regulations under Section 861 governing transactions for computer programs don’t address modern cloud computing arrangements. Proposed regulations issued in 2019 would create new rules for determining whether a cloud transaction should be considered a provision of service or a lease of property. While the IRS is looking to finalize these rules, tech companies should be assessing the treatment of their platforms or services for potential risk or opportunity under the existing framework.
Pillar 2 global minimum tax
Pillar 2 is a separate but related initiative from the OECD that will affect tech companies with €750 million or more in revenue in the consolidated financial statements in at least two of the previous four years. While implementation is stalled here in the U.S., it is moving forward abroad, and initial rules are taking effect as early as 2024. Tech companies with low-taxed earnings in jurisdictions like Ireland may be particularly affected.
Pillar 2 is designed to ensure large multinationals pay a minimum level of tax on income arising in every jurisdiction where they operate. The framework generally consists of three interlocking rules:
- Income inclusion rule (IIR): The IIR will allow parent countries to impose a “top-up” tax on earnings of foreign subsidiaries with effective rates below 15%
- Under-taxed profits rule (UTPR): The UTPR denies deductions and uses other mechanisms to effectively impose additional tax on earnings with effective rates under 15% that aren’t covered by an IIR
- Qualified domestic minimum top-up tax (QDMTT): The QDMTT “tops-up” tax on domestic entities to 15% before another country’s UTPR or IIR applies.
Global adoption will affect U.S. multinational tech companies in significant ways. The foreign income of U.S. multinationals could be hit by QDMTTs and UTPRs in foreign jurisdictions, and could potentially be double-taxed in future years when relief for the U.S.’s global intangible low-taxed income regime expires. Domestic subsidiaries of foreign parents with domestic income taxed at an effective rate below 15% could also be taxed under the IIR of the parent’s jurisdiction. When transition relief expires in 2025 or 2026, any domestic income taxed at an effective rate below 15% could be taxed by the UTPR of even a subsidiary jurisdiction. In addition, there may be financial statement implications, and affected companies will be required to perform detailed calculations and extensive reporting on a jurisdiction-by-jurisdiction basis.
“The first step is determining the potential applicability based on the revenue threshold, the entities in scope, and eligibility for any safe harbors,” Summer said. “Companies should also model the impact and evaluate potential changes to their structure or operating model, to mitigate bad results.”
The complex computations will require covered companies to spend substantial time gathering and analyzing data points on an annual basis, some of which may not be readily available. Tech companies should consider automation and software solutions to increase efficiency, and most covered companies will also need a global network to assist with the preparation and review of returns in each jurisdiction.
“Unfortunately, the relief does not apply to digital service taxes. Tech companies are still subject to the more restrictive standard for determining if DSTs are creditable.”
Foreign tax credits
Late last year, the IRS finalized regulations that rewrote the foreign tax credit (FTC) rules and significantly restricted the ability of taxpayers to credit foreign taxes, including digital service taxes, withholding taxes on fees for technical services and certain royalties. This July, the IRS effectively delayed the implementation of the final rules and will generally allow taxpayers to use a modified version of the rules in place as of April 1, 2021. Tech companies that filed 2022 returns before the relief was available should analyze their FTC positions to see if there are opportunities to file for refund claims on an amended return.
“Unfortunately, the relief does not apply to digital service taxes,” Summer said. “Tech companies are still subject to the more restrictive standard for determining if DSTs are creditable.”
Transfer pricing
Transfer pricing has rarely been more difficult thanks to shifting supply chains, sweeping international tax law changes, and increased global reporting requirements. Transfer pricing has also never been more important.
The growing exposure involved with transfer pricing issues is matched only by how pervasive it is. Technology companies are required to determine an arm’s-length transfer price for any cross-border transaction or agreement between related parties, including for goods, services, intangible property, rents and loans. This represents a staggering amount of activity, and the amount of tax at stake can be substantial.
Some of the largest tax disputes in Tax Court history involve transfer pricing for technology companies. There are pending transfer pricing cases against both Microsoft and Meta, with billions of dollars at stake. The IRS has been successful in some of its recent litigation and is stepping up enforcement. These efforts will be aided both by $60 billion in new IRS funding and legislative changes driven by Pillar 2. With the IRS winning cases, taxpayers need to look more closely at whether their transfer pricing positions represent uncertain tax positions that must be reflected on financial statements.
Source: IRS Budget and Workforce webpage, retrieved Oct. 8: https://www.irs.gov/statistics/irs-budget-and-workforce
“The costs of a transfer pricing dispute can go beyond the adjustments in tax, or even the potential 20% or 40% penalties for valuation misstatements,” Summer said. “Sizeable costs in professional fees and in-house resources are common, due to the complexity and difficulty of resolving transfer pricing issues.”
Given the cross-border nature of the issue, all transfer pricing disputes involve at least three parties affected by the outcome: the taxpayer and both countries affected by a change in the transfer price. The size, complexity and ambiguity of transfer pricing issues make for a complicated and expensive resolution process. Tech companies can consider alternative dispute resolution programs like administrative appeals, mutual agreement procedures and advance pricing agreement programs.
Export incentives
The FDII deduction was created specifically to benefit tech companies that choose to exploit their intellectual property from the U.S. The provision is generally designed to create a reduced rate on income from applying intangibles abroad, but it’s a very mechanical calculation that offers a benefit more broadly than many taxpayers realize.
The deduction is potentially available for selling, licensing or leasing any products to any foreign entity for use outside the U.S. There are planning opportunities that can further leverage the deduction. A detailed review of sales contracts, transfer pricing, fixed assets and accounting methods can often uncover ways to improve the benefit. Tech companies that use foreign branches of foreign disregarded entities may have opportunities to use transfer pricing and the disregarded payment rules to reclassify non-qualifying income.
Next steps
Tech companies need to make sure they’re addressing all the new challenges and seizing any planning opportunities.
It’s time to reassess upcoming investment and M&A plans while considering the tax implications and planning options. To efficiently manage expenditures in the competitive tech industry, companies need a well-informed and proactive tailored tax strategy.
Contacts:
Christopher H. Summer
Principal, International Tax Services
Grant Thornton Advisors LLC
Chris is the leader of Grant Thornton’s International Tax Analytics initiative as well as the Carolinas international tax practice leader.
Charlotte, NC
Industries
- Technology, media & telecommunications
- Manufacturing, Transportation & Distribution
- Life sciences
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- Tax
- International Tax
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