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USA: Big Companies Seeing Tax Benefits From Law Change Some of Them Fought

March 8, 2023

Provision requires spreading research-expense deductions over at least five years

Some large technology and pharmaceutical companies are telling investors that a new tax-law change is reducing their tax rates. It’s the same tax-law change corporate executives at many companies have been urging Congress to reverse.

The provision requires companies to spread their deductions for research expenses over at least five years instead of writing them off immediately. As a result, many companies, particularly manufacturers and defense contractors, are facing higher tax bills now.

But there is a counterintuitive benefit for some companies—including Qualcomm Inc., Alphabet Inc., Pfizer Inc., Moderna Inc. and Meta Platforms Inc.—that derive domestic profit from overseas sales, according to securities filings. Those companies now qualify for a bigger tax break for exports because of the way the research-deduction change alters their tax calculations. That bigger export break reduces the effective tax rates they report to investors and thus improves their bottom-line profit.

“It still would be a net negative, but it’s a little bit less negative,” said Dave Zion, a research analyst at Zion Research Group.

Moderna saw that tax break jump to a 7.4 percentage-point benefit on its tax rate from 4.8 points in 2021, even as its cash tax payments rose. However, said CFO Jamey Mock, having capital for research is important.

“The recent change in research and development capitalization rules will require a greater use of short-term cash and could place some pressure on the amount that innovative, research-based companies can invest over time,” he said.

Some corporate tax advisers see opportunities for companies to take advantage of the law. A Deloitte LLP tax-tips document posted online suggests recharacterizing certain expenses and analyzing and potentially altering supply-chain structures so companies are hurt less by the research-deduction change and take a bigger export tax break.

“The analysis is an investment that may reveal the potential to reduce cash taxes,” the document says. Deloitte declined to comment.

The change requiring companies to spread out research deductions was part of the 2017 tax law, and it was designed to partly offset the revenue loss from cutting corporate tax rates. Lawmakers from both parties have said they want to go back to letting companies write off research expenses right away, though talks have stalled.

Currently, because companies must spread research deductions over time, they have higher taxable income and must pay more in taxes, starting in 2022. Lockheed Martin Corp. said the provision caused its cash tax payments to climb by roughly $660 million last year, and Northrop Grumman Corp. said its cash flow was reduced by approximately $900 million.

In annual reports, however, companies can count the research deductions they will get to take in future years as deferred tax assets usable against future earnings. That means their net income, as measured under accounting standards, is unchanged.

At the same time, the smaller research deduction means many companies can get a bigger advantage from the export tax break.

Here’s how that works: In 2017, Congress created a tax break for what’s known as foreign-derived intangible income, or FDII. That is domestic profit generated from sales in foreign markets, often due to exports.

The size of the FDII tax break is based in part on how much income a company has. When research deductions go down, income goes up and so does the FDII deduction. That is what lowers the tax rates companies report to investors.

Alphabet’s benefit from FDII climbed to 5.4 percentage points on the tax rate, more than double its 2021 level. Meta’s rose to 7 percentage points, from 3.5 in 2021. Alphabet declined to comment. Meta didn’t respond to a request for comment.

Scott Dyreng, an accounting professor at Duke University, said the law change overall is negative for companies. “But if I were a manager whose bonus was tied to net income, I might be like, ‘Oh, this is good,’” he said. “It’s a very strange interplay of accounting and tax.”

Companies generally would rather have smaller cash tax bills in the short term, said Pat Brown, co-leader of the national tax office at accounting firm PwC LLP. For many companies, that would outweigh any gain from the FDII deduction.

“One thing we’ve learned over the course of the past year is that cash taxes really matter to companies that do a lot of R&D, because they’re all going up to Capitol Hill saying, ‘You have to fix this,’” he said.

There is bipartisan support in Congress for reversing the research-deduction change and allowing companies to deduct research expenses immediately. Lawmakers in both parties say returning to pre-2022 law would encourage high-paid research jobs in the U.S.

Talks stalled late last year and remain deadlocked. Democrats insisted on pairing business-tax breaks with an expansion of the child tax credit. Republicans resisted, arguing providing that credit to families without earned income would undermine work incentives.

Raytheon Technologies Corp. said it saw a $93 million increase in its FDII benefit, primarily because of the new rules. But the research-deduction changes led it to pay $1.6 billion in additional cash taxes in 2022, and the company borrowed money to make those payments.

Gregory Hayes, chairman and CEO of Raytheon, told analysts Jan. 24 that the research provision would prevent the company from hitting its 2025 goal of $10 billion in free cash flow.

“We hope that people in Washington will understand that they’re making a very, very bad tactical decision here in not allowing us to deduct R&D,” he said, “but it is the reality that we face today.”

[CFO Journal]

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