Has US Tax Reform delivered all it promised, or could businesses be in for a dose of reality?
From the point it first landed on desks in early November the timetable for US Tax Reform was bold and aggressive leading to a seven week run-up to Christmas which was a roller-coaster of a ride that kept many on the edge of their seats. But from the start there seemed to be an inevitability to the entire process. I sensed an expectation amongst my US colleagues that reform would happen, the question was one of degree – how much would actually make it over the finish line?
Now reform has been signed into law and it is time to work out whether the ‘Tax Cuts and Jobs Act' was the gift to business that was promised, all wrapped up in a $1.5tn tax cut, or whether the reality is biting.
For a Few Dollars More?
From a US perspective, tax reform aligns closely with President Trumps ‘Make America Great Again’ agenda and his drive to encourage US investment and jobs. My overall impression from business is that it has been received positively. Yes there are wrinkles, and yes there will be some measures that act negatively in any particular business scenario. But the drop in the headline corporate tax rate from 35% to 21% alone moves the US to one of the most competitive rates internationally (the UK remains lower at 19% reducing to 17%). Coupled with an expectation of deregulation there is a real hope that reform delivers a platform on which to build the US as a location for foreign investment. Most economists are predicting a boost for the US economy although those growth estimates may not be as bullish or enduring as President Trump may have hoped.
There is, however, a degree of uncertainty as to how quickly business will respond behaviourally to the new tax landscape in the US. Admittedly it is early days, but the political environment in the US may well result in business and investors being cautious. The 2018 midterms mean that all of the House of Representatives and a third of the Senate seats are at stake. There may be a shift in the balance of power within the US political machinery and there are questions over what impact that might have on tax reform.
In addition, whilst US reform has been generally well received by business it has not landed particularly well with voters. There is a perception that it has rewarded big tax cuts to big business – never a popular move as voters struggle to see the intended connection between tax cuts and job creation. And the reforms on personal taxes are perceived to deliver benefits to the well-off. These perceptions are causing some commentators to question the longevity of US Tax Reform and whether it will survive in part or in whole.
And we should not forget disrupters in the broader global context. Brexit still looms large with uncertainties over what trading arrangements will ultimately be agreed between the UK and Europe.
It will be interesting to see how countries respond to US tax reform. The finance ministers of several countries have already written to the US to express concern over some of the measures in the reform package. A sceptic may view that as indicative of more fundamental worries about the potential impact of US reform on their economies. We may see responses with countries introducing new tax policies to maintain their relative tax competitiveness. The UK, for example, may see this coupled with Brexit, as an opportunity.
Ultimately however, decisions that fundamentally affect business operations and value chains can be disruptive and will not be entered into in a rush. Businesses and investors may want to see the dust settle politically before committing to a major operational reorganisation.
The devil is in the detail
Whether US tax reform ultimately drives a migration of jobs and activity to the US it is still imperative on all organisations with US touch points to understand the impact of tax reform on their particular fact pattern.
Even here there are a number of challenges. Due to the fast pace of the reform process some consequences are still unclear. The IRS is in the process of issuing guidance but this will understandably take some time and in the meantime business will have to make assumptions to support their operational planning when it comes to tax.
A question I frequently get asked is what impact reform will have on different sectors of the economy. The reality is that I do not think there are clear sector winners and losers for the simple reason that there are too many moving parts in the reform package. Inevitably each group must undertake an impact assessment to understand how their business operations look under US Tax reform. And, in these situations, I would start by focussing on the big ticket headlines.
Reduction in rate
The first big ticket change is the reduction in the corporate tax rate to 21%. This will have a major impact on companies’ brought forward tax positions and financial statements. Deferred tax assets and liabilities will need to be revalued and we are already seeing a number of announcements in the market from affected businesses. Whether you are a winner or a loser will likely depend on whether you are in a net deferred tax asset or liability position. A go-forward effective tax rate will need to be forecast. Clearly the rate change would be expected to drive a reduction in the effective tax rate. But wider implications may arise. With a high historic US tax rate there has also been an easy assumption that foreign owners would not pay any additional tax on US earnings due to expected Foreign Tax Credits. That may need to be revisited.
Secondly, there are significant new rules limiting the deductibility of interest expense and most companies will now need to look at the capital structure of their US operations. If affected, this will dilute the benefit from the rate reduction. Specifically, the new rule generally limits net business interest expense to 30% of EBITDA for taxable years before 1 January 2022 and thereafter applied on 30% of EBIT.
With a high historic tax rate in the US and a comparatively generous limitation on interest expense deductibility under prior law, there had been a tendency to lend into the US and benefit from a tax rate arbitrage between the US and the lending jurisdiction. The rate cut already changes, and possibly reverses, that picture and the interest limitation will deepen the impact. Those that are highly leveraged into the US, such as infrastructure or other capital intensive businesses will be most impacted.
Further, US tax reform introduced a measure that generally denies interest and royalty deductions for certain hybrid transactions and involving hybrid entities in certain circumstances, including the payments of royalties or interest (under US tax principles) to hybrids in situations where there is effectively no inclusion in the hands of the recipient.
Base Erosion Anti-Abuse Tax (BEAT)
After these big ticket items, the taxpayer needs to consider some of the clawback or anti-base erosion provisions. The one that is attracting a lot of interest is the Base Erosion Anti-Abuse Tax (BEAT) which effectively applies a 10% minimum tax for taxable income adjusted for base erosion payments. The tax only affects businesses where US gross receipts are in excess of US$500m (aggregated on a global group basis) and so has limited application for multinational groups without a significant US presence. In addition, costs of goods sold (“COGS”) are generally excluded from the definition of base erosion payments, and so for example a US business that imports product for manufacturing and/or resale is likely to be less effected by a company that pays for services.
Where the UK company’s US subgroup owns interests in non-US companies (i.e., a ‘sandwich structure’) there are more considerations. An effective participation exemption has been introduced for dividends from foreign corporations (subject to certain criteria). This will be largely beneficial but most of the attention has been focussed on the mandatory repatriation tax which effectively applies a tax on Earnings and Profits accumulated overseas since 1986. The one-off tax charge amounts to 15.5% in relation to cash reserves and cash equivalent assets and 8% to other reserves. The tax may be paid in instalments over an 8 year period.
Going forward this deemed repat tax will incentivise US corporations to bring back cash to the US. As these pools of often untaxed or low taxed offshore cash have caused public ire in the ongoing debate around the taxation of multinationals, this move may represent the US laying claim to those amounts. If US corporations repatriate cash the hope will be that this will boost the economy domestically. In the wider international debate it may also prevent other jurisdictions seeing them as a source of untapped tax revenues.
Global Intangible Low-Taxed Income
The final big ticket item which may apply if there is a US sub-group is the Global Intangible Low-Taxed Income or GILTI. This is another anti-base erosion measure that is causing a lot of interest. The measure targets US corporations that own Controlled Foreign Companies for US tax purposes, and operates a current income inclusion regime similar to the pre-existing Subpart F regime (which still lives on). The US shareholder will have to include its share of the CFCs GILTI in its income. For these purposes the non-Subpart F net income of the CFC in excess of a 10% return on depreciable tangible assets is deemed to be GILTI. A deduction of up to 50% is generally allowed (until 2026) which may reduce the effective US tax rate on GILTI to 10.5%. Foreign tax credits are allowed equal to 80% of the foreign tax paid. Effectively, therefore, CFCs whose income is subject to tax at an effective rate of 13.125% may be ‘exempt’ from GILTI.
The flip-side of GILTI is a measure that allows a deduction for foreign-derived income attributable to intangibles (FDII). Again it only applies to taxable income in excess of a 10% return (amounts under 10% are once again deemed to be attributable to tangible assets). The rules apply a deduction of 37.5% from income (until 2026) meaning that the end result is an effective US tax rate of 13.125%. It therefore offers a beneficial tax system in situations where US IP generates foreign income.
It’s not over ‘til it’s over
Those are the big ticket items but obviously there are numerous other provisions not highlighted here.
The net effect of it all, however, is that it is difficult to draw broad conclusions about what businesses or sectors will be winners and losers from tax reform. It really is a question of working through the rules on a fact specific basis and understanding the implications. Assessing the impact will involve making a number of assumptions and these may be critical as calculations could move substantially as the rules become clearer and assumptions are refined.
Companies grappling with reform should first focus on the short term impacts to ETR guidance, deferred tax assets, interest deductibility and any implications of the mandatory repatriation tax if there are US sub-groups.
Longer term, there may be ways to simplify or change the supply chain and operating model if the consequences are severe, but such changes may be disruptive in the short term and so need to be approached with care.
Businesses that embrace the changes early put themselves in an excellent position to capitalise on the opportunities US reform may offer to support their business growth ambitions.