The proposals, arguments and questions have been bandied about for months. General agreement is that tax reform in the US has an excellent chance of being enacted in some form in the next six months. Even if the final outcome isn’t completely clear, the time to get prepared is now.
A recent webcast, 'Preparing for tax reform: What you should be doing now?' sponsored by Grant Thornton in partnership with Bloomberg BNA, addressed looming tax reform proposals and steps businesses can take now to prepare. The discussion centered on the significant provisions likely to be enacted including:
- a corporate tax rate cut;
- transition to a territorial system;
- repatriation of foreign earnings;
- full expensing and loss of interest deduction.
This article summarises the webcast discussions and some of the planning strategies that companies should be considering before and after tax reform is effective.
What do the US tax reform proposals mean?
Corporate rate cut
A corporate tax rate cut is sure to be included in any tax reform bill that passes, and House Republicans have proposed a 20% rate while the administration has proposed 15%.
“Tax reform is a lot about competition,” said David Sites, international tax services partner in Grant Thornton’s Washington National Tax Office. The purpose of the corporate rate cut, he said, is to level the playing field with other jurisdictions and countries so that companies don’t feel pressured to locate outside of the United States solely for tax benefits. Looking at major trading partners, the Canadian rate is close to 25%, UK rate is below 20% and many other jurisdictions are in these ranges. David sees the 20% rate as a globally competitive number that could yet be tweaked, depending on whether the decision is for a permanent cut — taking a revenue-neutral stance — or a temporary cut that isn’t revenue neutral.
With the current starting point of 35%, a move to either President Trump’s original 15% proposal or the more talked-about 20% would be welcome, according to Senate Finance Committee Tax Counsel Tony Coughlan. He said the committee is pondering corporate integration — specifically, a dividends paid deduction (DPD) method. A DPD would let corporations deduct dividends paid out to shareholders against their corporate tax.
The territorial system
Interest in international tax reform could signal a move to a territorial system, rather than border adjustments, said Tony Coughlan. In a territorial system, the dividend a US shareholder receives from a controlled foreign corporation or a US corporation’s foreign subsidiary would be exempt from corporate tax. To address concerns about loss of US income production to lower-tax jurisdictions, Congress will probably consider a base erosion provision such as minimum rates on certain global income. Deemed repatriation, Tony said, should be expected in a transition.
Repatriation of foreign earnings
“Reform will almost certainly impose a one-time tax on existing offshore earnings if enacted”, David Sites said. The rate is up for debate; the House’s is 8.75% for offshore cash and 3.5% on earnings from property investments. Companies with earnings they plan to leave offshore generally haven’t needed to care about the calculations. But a territorial system would be of great concern to a company that has a substantial foreign tax credit carried forward. The foreign tax credits might not be worth as much as they once were or anything at all in a post-tax-reform world. Calculations of the earnings could suddenly become very important.
Full expensing and loss of interest deduction
David Sites said, “the ‘on the fence’ category, is the immediate expensing of capital investments coupled with the disallowance of net interest deduction.” Under this proposal, a company’s net interest expense wouldn’t be deductible currently but would carry forward to offset only interest income. The flip side is that companies could fully expense their capital investments. This proposal is controversial because of uncertainty about effects outside the revenue window.
Tax reform action steps
With the prospect of a rate cut and the loss of incentives, companies should consider accelerating deductions and credit and deferring income. Companies might find they can accelerate R&D and other credits. Simple language tweaks to benefit plans and bonus pools could allow acceleration of deductions.
This is the time to review fixed assets and accounting methods, as the potential for a rate cut can turn these timing benefits into permanent benefits. In fact, said Ellen Fitzpatrick Martin, partner in Grant Thornton’s Washington National Tax Office, “a scrub of accounting methods overall can spotlight undiscovered deduction opportunities. Most changes are automatic, and don’t require IRS consent or a user fee”.
Common accounting method changes that can accelerate deductions include software development, self-insured expenses, property and payroll taxes, prepaid expenses and rebates. Looking at depreciation can turn up misclassified assets and provide a bump in current year deductions.
Method changes for foreign subsidiaries can also be pivotal in preparation for a transition to a territorial system and repatriation of foreign earnings. Offshore earnings that have been subject to little or no foreign tax and a 35% US tax might, going forward, be subject to no tax at all. Deferring earnings to post-tax-reform through accounting methods or utilising existing attributes to repatriate those earnings could be greatly beneficial.
“From both a strategic and financial perspective”, said David, “companies considering mergers and acquisitions need to look at baking into valuations the effects tax reform will have on cash flow.” An example is the House blueprint full expensing provision. If acquisition of a business may lead to full expensing of a significant portion of the assets upon acquisition rather than a drawn-out amortisation or depreciation period, the result could be a net operating loss, which would carry forward and affect the cash flow.
Conversely, sectors such as private equity will be concerned about deals if interest is not deductible. They’ll need to decide if using leverage is the way to effect an acquisition or if it would be better to shift to a different equity instrument or other methodologies. M&A activity will turn on whether a company believes the capital gains rate is going down. In that case, the choice may be to defer selling; just a 5% decrease in capital gains rate could be significant. If the company determines that tax reform will make business difficult, it may accelerate divestiture.
Preparation can’t cover all scenarios, but the wise route is basing it on the provisions most likely to come to life, watching and learning, and keeping an open mind about different directions for your business. If you would like to discuss US tax reform in more detail please speak to one of our International corporate tax advisors.