Business Tax Reform – An International Perspective
For U.S.-based multinational corporations, the framework of the President’s tax plan presents questions, challenges and opportunities thus far. While the framework does not provide detail or a specific timeline, there is ostensibly enough between the lines to gauge an overall theme for reform and for tax practitioners to formulate “intelligent speculation.” While we cannot predict the ultimate manifestation of tax reform that may be enacted this year or next, we believe there are certain areas that merit proactive discussion and thought now, rather than reaction post-reform.
The key facets of the framework are reduction of the corporate income tax rate, taxation of foreign earnings, and transition to a territorial system. If these proposed changes are enacted, the consequential ripple effects will impact corporate leadership behavior, business decisions, the economy and provisions of the Internal Revenue Code (the “Code”) at minimum.
The ratification of any comprehensive tax reform will be dependent on the complexities of Washington politics. Regardless of political affiliation, legislators involved are aware of the fact that the U.S. corporate income tax rate ranks as amongst the highest for advanced economies. Lowering the corporate income tax rate to 20% will make the U.S. further competitive globally and will surely impact current operations and future planning of U.S. multinational and foreign-based corporations. As a standalone (i.e., ignoring all other aspects of the proposal), the mere reduction in the corporate income tax rate from 35% to 20% should, at minimum, require corporate taxpayers to either revisit their proposed plans or reconsider the state of current operations. For example, consider a U.S.-based corporation that had been considering moving its headquarters to the U.K. or comparable jurisdiction as part of a “five-year plan” to achieve tax and operating efficiencies. With a 20% corporate income tax rate in the U.S., should the company reconsider the impacts of the relocation? Another common scenario is the migration by U.S. companies of intellectual property to a jurisdiction outside of the U.S. that provides tax advantages. Will U.S. companies now decide to keep their intellectual property in the U.S. if the tax rate is reduced to 20%?
Alternatively, we should consider behavior of foreign corporations after tax reform. Will foreign-based corporations consider moving their headquarters or other facets of their operations to the U.S. to take advantage of the U.S infrastructure and an overall favorable location to do business? The dialogue in this area frequently centers on levelling the playing field for U.S.-based corporations, but we should also consider if we will have an influx of businesses, intellectual property, capital, and personnel from abroad. In addition, there are certain domestic provisions such as Section 199 (domestic production activities deduction) and Section 41 (research and development credit) that would make the U.S. attractive for foreign corporations to relocate – however, there has been speculation that they may be reduced by tax reform. Notably, this does not even consider state and local incentives available to further attract relocation of foreign businesses. In any case, it is likely that foreign governments will respond with their own incentives to remain competitive globally. While the mere reduction of a corporate income tax rate from 35% is 20% is arguably very basic conceptually, the impact on global behavior may be nuanced and complex.
We note that there are no other specifics regarding this proposed reduction in the corporate income tax rate. For example, we are not certain if there would be graduated corporate income tax rates for different levels of taxable income. Further, we do not know if the 20% corporate income tax rate (25% proposed tax rate for business income of small and family-owned businesses which are typically partnerships and S corporations) will be gradually phased in over a number of years or retroactively applied. The implementation of the new rate could have a significant impact on corporate behavior and, consequently, the economy. For example, if the rate reduction were gradually implemented over the course of five years (e.g., each year there is a reduction of 3% in the corporate income tax rate), it may influence business decision makers to accelerate deductions or defer income.
Moving from a worldwide system of taxation in the U.S. to a territorial system of taxation will be extremely impactful, perhaps more so than the aforementioned proposed reduction in the U.S. corporate income tax rate in terms of global repercussion. In tandem with this shift, the framework proposes a deemed repatriation tax whereby all un-repatriated accumulated foreign profits would be subject to a one-time tax that would be paid over a number of years. U.S. corporations would now have the ability to repatriate these earnings at their own volition. However, the framework was unclear if this would apply to both illiquid and liquid assets alike, and it was similarly unclear regarding the specific number of years over which the tax would be paid. Notably, the actual repatriation of funds from overseas will likely be subject to a foreign withholding tax. As such, the existing U.S. foreign tax credit rules would need to be reviewed to ensure U.S. companies are not forgoing foreign tax credits.
The Treasury Department estimates that U.S. corporations currently have approximately $2.6 trillion of profits accumulated offshore.1 With a territorial system of taxation in place later this year or next, U.S. corporations would then be able to repatriate future foreign profits with little or no U.S. taxation. The influx of cash into the U.S. economy may potentially be enormous if these U.S. corporations decide to use these funds domestically for investments, such as expansion of operations, increased research and development, new plants, etc. However, if the cash is not invested back in the economy, the positive impacts will be lessened. Further, the rate of such of influx might not be predictable. If those overseas profits are invested in illiquid assets, repatriation might be difficult for some U.S. corporations. There will be a number of questions that need to be addressed specifically in regards to repatriation. For example, what would be the exact measurement date of foreign earnings and profits for purposes of a deemed repatriation?
Transition to a territorial system, coupled with a 20% corporate income tax, will likely have an impact on tax modelling and forecasting. The anticipated tax corollaries of a business opportunity may be the deciding factor for corporate leadership decisions. We therefore recommend that even in the absence of finalized detailed tax law changes, companies should consider evaluating potential tax impacts before year-end by modelling the likely tax law change scenarios that may impact their businesses and existing planning. Modelling in this case can be challenging because international tax models will require consideration of U.S. and foreign tax laws currently in effect and also consider multiple scenarios that incorporate iterations of the President’s proposals. Nonetheless, proactive modelling helps position companies to quickly and accurately assess opportunities and determine if any corrective actions should be taken before year-end; and given the uncertain timing of the legislative process, being nimble is likely to be an advantage.
Certain provisions of the Code may be revised or completely eliminated with a transition to a territorial system of taxation. Consider foreign tax credits as an example. Foreign tax credits currently alleviate double taxation when U.S. taxpayers are taxed on the same item of income domestically and abroad. With a territorial system of taxation, the U.S. would only tax income arising within its borders. There would be no double taxation. However, what would happen to foreign tax credit carryforwards currently in existence? Unused foreign tax credits may be carried forward for ten years. If a U.S. corporation generates significant foreign tax credits in 2017 and a territorial system of taxation is implemented in 2018, there is an obvious discrepancy. We assume (or hope) future legislation will address this and similar issues.
The Subpart F provisions of the Code will likely be impacted under a territorial system. We envision that certain aspects, such as foreign base company sales and service income, will be eliminated. By contrast, we surmise that Subpart F provisions targeting passive income and foreign personal holding company income will remain in some form under a territorial regime. In short, we predict a significant impact to the Subpart F provisions, but we cannot predict with certainty the exact changes that will take place.
U.S. multinationals must also consider the impact to deferred tax assets and deferred tax liabilities for ASC 740 purposes, which will need to be revalued if the corporate income tax rate is lowered to 20%. Simply stated, the future benefits of deferred tax assets under the new corporate income tax rate would be reduced and a corresponding charge to the financial statements would be required. The same should be considered for deferred tax liabilities. For example, the proposed reduction in the corporate income tax rate would lower the future cost of a deferred tax liability (e.g., accelerated depreciation on property and equipment), and a benefit would be recognized in the financial statements.
Further, the impact of any reform will be analyzed industry-by-industry. For example, the impact of a territorial system of taxation will differ for a U.S. financial services company versus a U.S. exporter of auto parts. In addition, there are likely many other tax considerations that will be raised and require new legislation.
The remaining months of 2017 and beginning of 2018 will be eventful in terms of tax reform. The omission of meaningful details in the framework provided by the current administration spawns more questions than answers. These questions will need to be addressed by actual legislative proposals by the House Ways and Means Committee. Taxpayers along with their tax advisers should monitor the flurry of developments we envision during the next few months to determine how tax reform will impact their operations, both current and planned.
1 Fortune 500 Companies Hold a Record $2.6 Trillion Offshore, Institute on Taxation and Economic Policy, dated March 28, 2017, https://itep.org/fortune-500-companies-hold-a-record-26-trillion-offshore/ (accessed October 5, 2017)