The Inflation Reduction Act (IRA) of 2022 significantly changed the U.S. Federal income tax code, including introducing the new Corporate Alternative Minimum Tax (CAMT). The CAMT is a parallel tax system that applies to applicable corporations based on their Adjusted Financial Statement Income (AFSI) for tax years beginning after December 31, 2022. The CAMT is designed to ensure that certain large corporations who show large financial statement profits pay a minimum level of tax, regardless of the amount of tax deductions and credits they claim.
While companies have historically used tax accounting methods for effective tax planning, companies are now considering available financial accounting policies and elections as well.
One such financial accounting election relevant to the energy industry is hedge accounting. The CAMT is complex, and there is limited guidance at this point, but below are some of the basics and a discussion regarding the interaction with financial statement elections.
The Tax Cuts and Jobs Act (TCJA) eliminated a prior version of alternative minimum tax on corporations in late 2017. This change resulted in many corporations paying little to no income tax despite showing significant profits for financial statement purposes. The IRA introduced the CAMT, intending to change this discrepancy.
CAMT is a 15% tax on a company’s AFSI, which is defined as its net income or loss on the company’s Applicable Financial Statements (AFS) for a tax year with certain adjustments. The AFS is a financial statement prepared following GAAP or IFRS, reported to the SEC, or otherwise used for reporting to shareholders or for credit purposes. It applies to regular corporations with a 3-year average AFSI (starting with the 2020 taxable year) of over $1 billion. For a foreign-parented corporation, the U.S. average annual AFSI must also exceed $100 million over three taxable years. In recent notices, the IRS has provided safe harbors to reduce the complexities for determining whether a corporation is an applicable corporation subject to the CAMT.
AFSI differs from financial statement income due to several adjustments. One of the most relevant adjustments for capital-intensive industries, including most energy companies, is the substitution of tax depreciation for book depreciation due to accelerated depreciation methods for tax purposes. Additionally, similar adjustments for intangible drilling costs and depletion were considered for oil and gas companies but ultimately rejected.
The effects of specific accounting policies and elections have historically not been relevant for most tax planning. However, the direct impact of particular accounting policies and elections on AFSI allows companies that could be subject to CAMT to reevaluate. Companies looking to mitigate CAMT should consider Hedge Accounting and its impacts on financial statement income and AFSI.
What is Hedge Accounting?
Hedge Accounting is a special accounting election used on derivative instruments. By default, a company must record a derivative instrument at fair value, with the changes in fair value going through net income. This can create significant fluctuations in net income as the fair value of the instrument changes over time. Many concerned about the associated earning volatility will elect hedge accounting and designate the derivative as a cash flow hedge.
Considerations for Electing Hedge Accounting
Companies should consider the following before electing hedge accounting:
- The complexity of hedge accounting designations and the need for hedge accounting advisors
- The cost of implementing and maintaining a hedge accounting designation
- The potential impact on the company’s financial statements.