Tech Firms: Consider New Tax Law Before Pursuing Strategic Investments
posted Oct 9, 2018 by Paul Oliveira, CPA in the Global Tax Blog
Successful tech ventures reinvest profits to keep up with the pace of technological change. Doing so allows them to grow, innovate and stay on the cutting edge of technology.
In general, technology companies welcome the lower tax rates and expanded depreciation breaks under the new tax law. These provisions are designed to encourage strategic investments and growth. But the Tax Cuts and Jobs Act (TCJA) also contains some lesser-known provisions that could adversely affect your company’s capital spending plans. Here’s a reminder.
Limits on Interest Expense Deductions
Companies with limited cash on hand to invest in growth opportunities may need to borrow money. The loan proceeds may be used to fund equipment purchases, new product launches, facilities build-outs and research projects.
Under prior law, interest expense on capital investments was 100% deductible as a business expense. Unfortunately, starting in 2018, the TCJA generally limits interest expense deductions to 30% of adjusted taxable income (ATI). But there’s an exception to this restriction for small tech firms: It applies only to businesses with more than $25 million in average annual gross receipts.
Through 2021, ATI is computed without regard to deductions for depreciation, amortization or depletion. Beginning in 2022, ATI will be decreased by those items, further limiting the interest expense deduction for companies with significant depreciation deductions.
The negative effects of interest expensing limits will become more apparent as interest rates rise, thereby increasing the after-tax cost of capital. The Federal Reserve increased rates by a quarter point three times in 2017. The Fed is expected to continue to gradually increase rates in 2018 to counter the effects of inflation.
New Requirement to Capitalize Certain Research Costs
Tech companies tend to invest heavily on researching new products and processes. Under prior law, companies could generally expense 100% of research costs in the year they were paid or incurred. Some firms also qualified for a research tax credit generally equal to 20% of the excess of qualified research expenses for the year over a base amount.
Although the new law retains the research tax credit, the TCJA requires companies to capitalize specified research and experimental expenditures and amortize them over five years, for tax years starting in 2022. (The amortization period is 15 years for research conducted outside of the United States.)
The requirement to capitalize these costs means that companies will be allowed to deduct only a portion of the research costs they pay or incur in the first year. The remaining deductions will be spread over the amortization period. Delays in deducting these costs for tax purposes could adversely affect the financial feasibility of certain research projects by increasing the accounting payback period and reducing the return on investment, key metrics used to evaluate strategic decisions.
Moreover, if your company abandons a research project, any remaining basis in the research property must be deducted over the remaining amortization period, rather than written off in the year of abandonment.
Net Limits on NOLs
Innovative products often take time to develop and drum up customer demand. So, operating losses — where deductible costs exceed taxable income — are common when tech companies are in the start-up phase or working on a major long-term research project.
Under prior law, net operating losses (NOLs) could be carried back for two years and carried forward for up to 20 years. NOLs could be used to offset up to 100% of the tax obligations from a company’s profitable product lines and segments.
The new tax law restricts NOL deductions to 80% of taxable income (determined without regard to the deduction) for losses in tax years beginning after December 31, 2017. It also repeals the two-year carryback provision (except for certain farming businesses). However, NOLs generated in tax years beginning after December 31, 2017, can now generally be carried forward indefinitely.
In addition, NOLs can no longer be used to offset a company’s entire tax liability. So, high growth firms that invest significant amounts in research projects may need to set aside some cash to pay taxes on profitable business units.
The new tax law contained several high-profile provisions that encourage research and investment projects. But there are some hidden pitfalls that growth-driven tech firms need to watch out for. Our tax professionals can help you understand the full impact of the new tax law on your capital spending plans and minimize surprises when you file federal tax returns for 2018 and beyond.
For more tax reform updates, be sure to visit our Tax Reform Center- your “one stop shop” for all things Tax Cuts and Jobs Act (TCJA) related.