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Guidance & FAQs On Information Needed For Valid Research Credit Refund Claims Released By IRS

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The IRS has released two pieces of interim guidance on its revised administrative policy for valid research credit refund claims. On January 3, 2022, the IRS issued procedural guidance for applying the revised administrative policy. On January 5, the IRS published a corresponding set of frequently asked questions (FAQs) on the policy. Both the guidance and the FAQs are effective for all research credit claims filed on or after January 10, 2022.

Background

On October 15, 2021, the Office of Chief Counsel released Chief Counsel Advice Memorandum 20214101F releases its revised policy regarding research credit claims. The CCA mandates that taxpayers include certain information along with a research credit refund claim filed under Internal Revenue Code (IRC) Section 41 on or after January 10, 2022, or risk having such claims deemed “deficient” and, thus, rejected without further IRS inquiry. The IRS stated that the CCA is intended to improve tax administration by:

  • Providing clear instructions for eligible taxpayers to claim the Section 41 credit; and
  • Reducing the number of disputes over such claims.

The interim guidance regarding the application of the CCA sets out specific procedures. These procedures must be followed to determine if a claim is “valid,” including requiring a taxpayer to provide detailed information to the IRS on the grounds and facts upon which a research credit refund claim is based. The IRS will assess the validity of each claim filed after January 10, 2022. However, the interim guidance reflects other procedural exceptions the IRS may apply during its evaluation of the validity of a claim. The IRS has committed to make determinations on such claims within six months of receipt.

Determining the Validity of Refund Claims that Include a Claim for Credit for Increasing Research Activities

Existing Treas. Reg. § 301.6402-2(b)(1) requires taxpayers that are filing a tax refund claim to apprise the IRS of the basis for the claim. According to the CCA and the January 5 FAQs, taxpayers filing an amended research credit refund claim will also be required to provide, at a minimum, five essential pieces of information:

  1. All business components that form the factual basis of the Section 41 research credit claim for the claim year;
  2. A description of all research activities performed, by business component;
  3. The first and last names or title/positions of all individuals who engaged in the research activity, by business component;
  4. The information each individual sought to discover, by business component; and
  5. The total qualified employee wage expenses, supply expenses and contract research expenses.

The above list is the minimum criteria that must be submitted. In addition, each taxpayer submitting an amended research credit refund claim must submit a declaration. This declaration must be signed under penalty of perjury verifying that the facts provided are accurate. For most taxpayers, the signature on Forms 1040X or 1120X serves this function.

The interim guidance also clarifies that taxpayers submitting a research credit claim begin explaining the information that each individual sought to discover by business component. Specifically, this information, included under criterion 4, may be submitted as a list, table or narrative. This is beneficial for taxpayers that may have anticipated challenges in reporting this information.

Transition Period and Time to Perfect

For amended research credit refund claims filed during the period January 10, 2022 through January 9, 2023 (“transition period”), taxpayers will be given 45 days to perfect a timely filed claim that is deemed deficient because it failed to provide the five minimum criteria listed above. Notably, this is an extension of the period previously mandated under the CCA, which originally granted only 30 days to perfect such a claim. 

Taxpayers that fail to provide the required five minimum criteria will be notified via Letter 6428, Claim for Credit for Increasing Research Credit Activities – Additional Information Required. The 45-day perfection period will begin on the date Letter 6428 is issued. If a taxpayer does not submit sufficient information to perfect the claim pursuant to the process set forth in the letter, the claim will be considered deficient, and the taxpayer will be issued Letter 6430, No Consideration, Section 41 Claim. If the IRS does not receive a taxpayer’s information or the missing information is insufficient following the 45-day perfection period, the IRS will reject the research credit claim without further consideration.

Claims Filed After the Transition Period Ends

Taxpayers that file a research credit claim after the transition period will be subject to general rules of Section 6511(a). Then, will not have the opportunity to perfect a claim that is deemed deficient. The IRS will evaluate each research credit claim based on the same five minimum criteria outlined above and verify that each claim was signed under penalty of perjury. If a claim is determined to be deficient, examiners will issue Letter 6430, No Consideration, Section 41 Claim, to the taxpayer, and reject the research credit claim without further consideration.

Next Steps for Companies

The IRS’s revised administrative policy impacts many U.S. taxpayers that engage in research and development (R&D) activities. As a result, the American Institute of Certified Public Accountants (AICPA), American Bar Association (ABA), National Association of Manufacturers (NAM) and many others have commented on the need for the IRS to delay implementation and resolve potential uncertainty for taxpayers. However, taxpayers submitting amended research credit refund claims must be prepared to set forth the following in detail:

  • Each ground upon which a credit or refund is claimed; and
  • Facts sufficient to support the basis for the claim in accordance with the IRS’s new five minimum criteria.
  • A written declaration verifying such facts under the penalty of perjury.

While it is expected that taxpayers will continue to be able to uphold the validity of research credit claims that have previously been filed, taxpayers should consider the IRS’s five minimum criteria for future research credit claims and the potential need to perfect claims the IRS may deem as deficient for failure to meet these criteria.

We Can Help

We understand the challenges that companies face. Whether you’re a startup or an established company, we offer a breadth of integrated services tailored to your individual needs. We also have extensive experience assisting taxpayers of all industries and sizes. We help with evaluating their qualified R&D expenses, calculating their credit claim amount for filing and, when necessary, defending the position with the IRS. To ensure companies continue to efficiently and effectively file claims, we can provide comprehensive support in assisting companies with planning and complying with the IRS’s new administrative policy.

Michigan Enacts PTE Tax Election As Workaround To $10K SALT CAP

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Michigan Governor Whitmer signed H.B. 5376 into law on December 20, making Michigan the latest state to allow pass-through entities (PTEs) the option to be taxed at the entity level. The new PTE regime creates a workaround for owners of PTEs doing business in Michigan to the $10,000 federal cap on state and local tax (SALT) deductions that was enacted in the 2017 Tax Cuts and Jobs Act. The election is effective for tax years beginning on and after January 1, 2021.
 
Entities treated as partnerships or S corporations for federal income tax purposes can elect to be taxed at the entity level. Publicly traded partnerships, disregarded entities and financial institutions cannot make the election in Michigan. Multi-tiered partnerships and PTEs with non-individual owners are not precluded from making the election.
 
The election must be made by the 15th day of the 3rd month of the first tax year to which the election is to apply. For tax years beginning in 2021 only, the election must be made by April 15, 2022, regardless of tax year end. Unlike many other states that have created elective PTE tax regimes, Michigan’s election is irrevocable and is binding for the year of the election and the subsequent two tax years.
 
Electing PTEs calculate tax on their positive income tax base, subject to adjustments specified in the bill, after applying Michigan’s individual income tax allocation and apportionment rules. When calculating the elective PTE’s tax, the electing PTE includes only the business income tax base allocable to those members who are individuals, PTEs, estates or trusts. The electing PTE excludes the business income tax base allocable to those members that are corporations, insurance companies or financial institutions. The elective PTE tax rate is tied to Michigan’s individual tax rate, which is currently 4.25%.
 
Individual owners of electing PTEs may claim a refundable credit for their allocated share of the tax as reported to the member by the electing PTE. Likewise, corporate owners of electing PTEs may also claim a refundable credit for their allocated share of the tax.

Insights 

  • Stay tuned for a more detailed analysis of Michigan’s new elective PTE tax law, along with the guidance expected to be released by the Department of Treasury.
  • Based on informal discussions with Treasury, a notice is in progress and expected to be released by December 27, 2021 that will provide guidance as to how to make Michigan’s election for 2021 before year end. For at least the 2021 tax year, it appears that a form will not be available to make the election by December 31, 2021. Rather, Treasury indicated that payment of the tax for 2021 will constitute making the election. Payments must be made electronically through Michigan Treasury Online, which is expected to be open for payments the week of December 27.
  • Because the election is binding for the year of election and two subsequent tax years, it should not be entered into lightly. Taxpayers contemplating making the PTE election should perform a detailed analysis and modeling to determine whether the election is beneficial to the entity, its resident owners and – most importantly – its nonresident owners.

OECD Releases Pillar Two Model Rules To Bring Global Minimum Tax Into Domestic Legislation

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The OECD on December 20 released model rules to assist the 137 jurisdictions that agreed to the Inclusive Framework/G-2- Pillar Two framework to implement into domestic legislation a 15% minimum tax on those multinational enterprises (MNEs) that fall within its scope.

The model rules fill in the details regarding Pillar Two of the agreement announced on October 8 to address the tax challenges of the digitalization of the economy. Pillar Two set out in broad strokes the parameters of the Global Anti-Base Erosion (GloBE) rules, which establish a “top-up tax” to be applied to profits in any jurisdiction if the effective tax rate is below the minimum 15% rate in that jurisdiction.

The rules, originally expected to be release in late November, represent the next step in a process that ultimately would reform the global tax system.

The Details

The 70-page model rules are organized into 10 chapters that deal with the scope of the rules, the computation of GloBE income or loss and the top-up tax, corporate restructurings and holding structures, administration and transition rules. The OECD explained that the model rules have been designed to accommodate a broad range of tax systems and business structures, and therefore many of the specific provisions may not apply to all jurisdictions or in-scope MNEs.

Chapter 1 of the model rules delineates the scope of the GloBE rules, which will apply to constituent entities that are members of an MNE group with annual revenue of EUR 750 million or more in at least two of the four fiscal years immediately preceding the tested fiscal year.

Specific types of entities are excluded from application of the rules, in addition to those that fall below the monetary threshold of EUR 750 million. These include government entities, international organizations and nonprofit organizations, as well as entities that meet the definition of a pension, investment or real estate fund.

Chapters 2 to 5 comprise the heart of the model rules. Chapter 2 sets out the charging provisions whereby the amount of top-up tax payable is determined, Chapter 3 provides rules for calculating the income (or loss) on a jurisdictional basis, Chapter 4 for determining the tax attributable to that income, and under Chapter 5 the top-up tax of each low-taxed constituent entity is determined.

In essence, the model rules establish a five-step process to determine an MNE’s top-up tax liability:

  1. As a first step, MNEs must determine whether they fall within the scope of the GloBE rules and must identify all constituent entities in the group and their locations.
  2. Step 2 is to determine the income of each of the MNE’s constituent entities.
  3. Under Step 3, the MNE would determine the pre-GloBE tax attributable to each constituent entity’s income.
  4. The results of steps 2 and 3 would allow the MNE to determine the effective tax rate of each of its constituent entities; if the effective tax rate of all constituent entities located in the same jurisdiction is below 15%, then the top-up tax would be applied to income in that jurisdiction.
  5. Finally, Step 5 would impose the top-up tax on the member of the MNE group that is determined to be liable for the tax in accordance with an agreed-upon rule order.

The determination of an MNE’s income or loss relies on financial accounts, after some adjustments to align those accounts with tax purposes. For example, dividends and equity gains are removed, as are expenses disallowed for tax purposes. For MNE groups that have international shipping income, the model rules exclude that income from the computation of GloBE income.

To determine the income taxes attributable to an MNE’s constituent entities, the rules provide that the calculation includes income taxes but does not include non-income-based taxes such as indirect taxes, payroll and property taxes. The rules also allocate income taxes charged as a withholding tax or following the application of a controlled foreign corporation (CFC) regime.

The model rules recognize that temporary differences that arise when income or loss is recognized in different years for accounting and tax purposes must be addressed. The rules adopt deferred tax accounting as the primary mechanism for addressing these timing differences; as a result, timing differences generally will not result in top-up tax. However, this is subject to a recapture mechanism in respect of certain deferred tax liabilities that do not unwind within five years. Therefore, even businesses that operate only in “high tax” jurisdictions will need to carefully follow how the model rules are translated into local legislation in the jurisdictions in which they operate to determine if top-up tax may be likely to arise in those jurisdictions.

Once the effective tax rate is calculated — the calculated tax divided by the income and aggregated on a per jurisdiction basis, the rate of tax owed is the difference between the 15% minimum rate and the effective tax rate in that jurisdiction. That top-up tax percentage is then applied to the GloBE income in the jurisdiction, after deducting a substance-based income exclusion. This substance-based carveout has two components: the payroll carveout and the tangible asset carveout, and serves to exclude income equal to 5% of the carrying value of tangible assets and payroll. For purposes of the carveout, tangible assets include property, equipment and natural resources located in the jurisdiction, as well as a lease on rights to use tangible assets.

The final step of the process to determine an MNE’s top-up tax liability is to pinpoint which entity in the group is liable for the tax. The rules provide that the top-up tax is first imposed under the “Income Inclusion Rules” or IIR on a parent entity with an ownership interest in the lowtaxed constituent entity. If any residual amount of top-up tax remains unallocated after the IIR applies, the undertaxed payments rule (UTPR) allocation mechanism comes into play, so that liability for residual top-up tax will land in the UTPR jurisdictions through a UTPR adjustment.

The model rules also address the administrative aspects of Pillar Two implementation and impose an obligation on MNEs to file a standardized information return in each jurisdiction that has introduced the GloBE rules to provide information on the MNE’s tax calculations.

Next Steps

The OECD expects to release a Commentary on the model rules in early 2022, and will address the issue of the rules’ coexistence with the U.S. global intangible low-taxed income (GILTI) rules at that time. The OECD then plans to issue an implementation framework dedicated to administrative, compliance and coordination issues regarding Pillar Two. Although the OECD did not specify a date for the expected release of the implementation framework, it did state that it intends to hold a public consultation on the framework in February 2022.

The OECD is also working on model rules for the “Subject to Tax” rule, the second prong of Pillar Two, as well as on a multilateral instrument for its implementation. Another public consultation event on the Subject to Tax model rules and multilateral instrument will be held in March 2022.