Tax Reform Drafting Errors Hurt Restaurants & Retailers
The retail and restaurant industries have generally been supportive of the recent Tax Reform (Tax Cuts and Jobs Act, H.R. 1, signed into law by President Trump on December 22, 2017), which reduced the corporate tax rate from a 35 percent maximum rate (under a graduated rate structure) to a flat 21 percent rate. However, two Congressional drafting errors stand to severely affect retailers and restaurants with respect to the depreciation of improvement property and the utilization of net operating losses.
In a letter sent to the Senate’s Committee on Finance and the House of Representatives’ Committee on Ways & Means on June 5, 2018, more than 100 major national retailers and restaurants, along with the National Retail Federation, the National Council of Chain Restaurants, and the Retail Industry Leaders Association, urged Congress to take swift legislative action to correct the errors. The letter points to the economic impact of a likely significant decline in store and restaurant remodeling projects and leases of locations requiring improvements, as well as a negative impact on businesses that are already facing liquidity issues.
The Drafting Errors
Generally, the cost of commercial real estate improvements is recovered over 39 years via straight-line depreciation. Prior to Tax Reform, Section 168(e) of the Internal Revenue Code carved out three exceptions to this rule: qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property were eligible for a 15-year recovery period. Moreover, such property was eligible for 50 percent bonus depreciation under pre-Tax Reform Section 168(k).
The Tax Reform Bill intended to simplify the existing law by consolidating the three types of improvement property into one “qualified improvement property” category with a 15-year recovery period. However, in what appears to be an unintentional oversight, lawmakers failed to assign “qualified improvement property” (QIP) a 15-year life, nor did they make QIP one of the enumerated asset classes eligible for bonus depreciation. As a result, under the law as currently written, QIP should be depreciated over 39 years with no bonus depreciation.
Consequently, retail and restaurant improvement property is now ineligible for one of the biggest benefits of the new tax law: 100 percent first-year bonus depreciation under the new Section 168(k), which provides an immediate tax write-off for both new and used property with a recovery period of 20 years or less, applicable to property acquired and placed in service after September 27, 2017, and before January 1, 2023. As a result, costs for improvements to stores or restaurants cannot be fully depreciated in the first year the improvements are made, but must be depreciated over 39 years.
The second technical error relates to the effective date of a provision that prohibits carrying back net operating losses (NOLs) to prior years. While lawmakers intended this provision to take effect for taxable years STARTING AFTER December 31, 2017, the law instead states that it applies for taxable years ENDING AFTER December 31, 2017. The erroneous effective date concerning carryback eligibility negatively impacts businesses in loss positions that were relying on an NOL carryback to finance continuing operations, inventory and needed investments. For the many retailers and restaurants that use a fiscal year ending January 31, the applicability of the prohibition on NOL carrybacks from their fiscal years ending January 31, 2018, effectively means a retroactive tax increase.
Since these errors in the statutory language clearly contradict the Congressional intent outlined in the conference agreement, taxpayers and practitioners had hoped for a “workaround” in the form of interpretive guidance by the Internal Revenue Service (IRS).
The IRS has quashed hopes of a “workaround,” taking the position that the statute will need to be applied as written until a corrections bill is passed.
However, concerning depreciation, the IRS takes a taxpayer-favorable approach to an existing discrepancy between effective dates: While the 100 percent bonus depreciation became effective for property that was placed in service after September 27, 2017, the new definition of “qualified improvement property” did not take effect until January 1, 2018. The IRS confirmed that it treats this discrepancy in effective dates such that retail and restaurant improvement property placed into service after September 27, 2017, is eligible for three months of full expensing (September 28, 2017 through December 31, 2017).
It is unclear how soon technical corrections can be made. Unlike the original Tax Reform bill, which passed Congress via a reconciliation process that enabled Republicans to pass it along party lines in both chambers, a corrections bill will require at least nine votes from Democrats in the Senate. This assumes all Republicans would vote for the correction, given that 60 total votes are required in the Senate, where Republicans hold 51 seats. Democrats in the Senate’s Committee on Finance have expressed reluctance to fix drafting errors unless substantive changes are made to the tax law.
If the legislative errors remain uncorrected, this could have far reaching repercussions for the retail and restaurant industry. In addition to creating financial pressure for businesses in loss positions, the current statute could discourage investments in communities where retailers and restaurants are doing business and affect private equity-backed mergers and acquisitions in the retail and restaurant sector.
Material discussed in this blog post is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances.