In order to boost job opportunities in the US, to increase US tax revenue, and capital and profits, support the growth of the US economy, and to prevent companies from shifting their revenue to foreign countries, the US Tax Cuts and Jobs Act entered in force on 1 January 2018.
It represents a major change to the US tax system, holding high significance particularly to multinational companies and the US economy as a whole.
In the long term, the reform is predicted to raise the US GDP and wages, assuming that the tax cuts will provide increased stimulus for investment and activities, thereby increasing labor demand. These new incentives and deterrents have consequences on the foreign investments of US companies, including in the GCC region.
The US Tax Cuts and Jobs Act entered into force on 1 January 2018 is meant to significantly positively impact businesses.
Through this reform, along with an important reduction of the corporate income tax rate, another major change in the US taxation system appeared: the worldwide US taxation system has been switched to one that is very close in nature to a territorial system. This shift is accompanied by a “transition tax” and implies that corporations doing business abroad will no longer be taxed by the US on the profits they generate overseas.
While the reform brings restrictions on interest and loss deductions, related party payments and movements of intangible property (IP), it also introduces favorable dividend exemptions, capital investmentand exportincentives. This will ideally provide the necessary push to repatriate reserves of cash held overseas.
The reform also introduces new anti-avoidance and incentive tax measures, namely the Base Erosion and Anti-Abuse Tax (BEAT), the Global Intangible Low Taxed Income (GILTI) and the Foreign Direct Intangible Income (FDII).
IMPACT ON US BUSINESSES
1. Corporate Income Tax Rate Reduction
The main feature of the US tax reform is definitely the reduction of the Federal Corporate Income Tax (CIT) from 35% to 21%, starting from tax years beginning after 1 January 2018, with an average drop from 39% to 26%, including state income taxes.
This 26% CIT rate will be in line with the average among Organization for Economic Co-operation and Development (OECD) member nations.
2. Interest Expense Deduction Limitation
This new provision provides for a limitation of the interest deduction for all business interest expenses paid by the taxpayer, namely interest paid or accrued on debt which can be traced back to a trade or business.
This new restriction applies to all businesses, regardless of entity type, at the legal entity level. This includes “C corporations” which are taxed separately from their owners and subject to corporate income taxation, and “S corporations” which’ shareholders are directly subject to tax on their pro-rata shares of income based on their shareholdings (e.g. sole proprietorship).
However, this restriction does not affect small businesses since it applies only if the taxpayer’s average annual gross receipts for the three tax year period ending with the prior tax period do not exceed $25 million. Certain regulated public utilities, real estate and farming businesses that use the alternative (generally straight line) depreciation system for particular properties are allowed to elect for an exemption of this limitation.
This new measure, subject to some exceptions, limits the deductibility of interest to 30% of the “adjusted taxable income”. This “adjusted taxable income” can be largely compared to earnings before interest, depreciation, depletion, interest income, interest expense and amortization (EBITDA) for the first four years till 2022. From 2022 onwards, the limitation will be applied on an amount closer to the EBIT of the company. Any disallowed business interest deduction can be carried forward indefinitely.
This restriction on interest expense deduction was designed to deter companies from shifting debt financing to foreign subsidiaries, thereby discouraging cross company loans and borrowing for tax avoidance.
3. Loss restriction
The treatment of the Net Operating Losses (NOLs), the carry back and carry forward provisions were notably modified by the reform. The NOLs deduction is now limited to 80% of the taxable income of the year.
Previously, the NOLs offset was not limited and could be carried forward up to 20 years and carried back up to two years for corporate income tax purposes. With the reform, the carry back is eliminated while the carry forward is allowed indefinitely.
The reform only applies to NOLs generated in taxable years ending after 31 December 2017. Subject to limitations, NOLs generated earlier will be subject to the former rules. Therefore, taxpayers have to track NOLs depending on the year of their generation.
This reform aims at dissuading companies from bringing losses to the US to artificially reduce their profit and shift costs including interest to foreign affiliates to make better use of loss deductions.
4. Foreign Participation Exemption:
US parent companies who own at least 10% of a foreign group or affiliates are exempt from tax on dividends received from these companies. The ownership criterion can alternatively be the number of voting shares or their value.
The objective is to encourage US multinationals to shift their foreign profits onshore, since they can now bring cash back without heavy tax liabilities.
This exemption will not apply to any “hybrid dividend”, defined as any dividend for which the foreign affiliate received a deduction for local income tax purposes. This might notably happen when the capital provided to the foreign affiliate is deemed as a loan and grants the right to interest deduction to the foreign company, while the return on the same capital would classify as dividends in the US and be exempt. This would result in a double tax deduction on these amounts.
5. Transition Tax:
The inclusion of a transition tax is a strong signal that the US tax reform will confer many benefits from the territorial tax system but comes with compensation.
Current overseas untaxed earnings still accumulated and held abroad since 1986 will be subject to a one-time transitional tax payable over 8 years. This applies to controlled foreign corporations (CFC) or any other foreign companies with a 10% US corporate shareholder. The law refers to them as “Specified Foreign Corporations” (SFC).
The untaxed earnings would be charged at a lower rate of 15.5% for earnings held in cash or specified asset. Such items include:
– net accounts receivable,
– actively traded personal property, and
– obligations with a term of less than a year.
Any remainder will be taxable at 8%.
US shareholders are allowed to opt to pay the transition tax over eight years:
– 8% each year during the first five years,
– 15% the 6th year,
– 20% the 7th year,
– 25% the 8th year.
In case the US corporation does not pay this tax within 10 years of the Act’s enactment, a safety net ensures that the full amount of untaxed earnings is subject to the transitional tax to a 35% tax rate.
This is directed at increasing the amount of corporate cash available for M&A transactions and overall increasing the liquidity levels in the US.
This computation may present extreme complexity as there is a need to determine post-1986 earning pools and historic tax payments to substantiate any foreign tax credit attributable to post-1986 earnings. This would potentially require companies to arrange significant cashflow needed to pay tax.
6. Capital investment:
The previous bonus depreciation percentage which qualified property could benefit from has been increased, following the reform, from 50% to 100%, from September 2017 up to the end of 2022.
Accordingly, a company that acquires assets may be able to immediately deduct a significant portion of the purchase price as compared to the acquisition of the equity interests.
Beginning 2023, this bonus depreciation will be phased-out till 2026 (i.e. 80% for qualified property placed in service before 1 January 2024, 60% before 1 January 2025; 40% before 1 January 2026; and 20% before 1 January 2027).
The bonus depreciation is also applicable to non-original first use property as long as it is the tax payer’s first use.
This provision encourages structuring investments in new ways to take advantage of the deductions in the US along with the reduced effective tax rate as compared to other regions like Europe, Asia and Latin America.
7. Base erosion and anti-avoidance tax (BEAT):
The BEAT is introduced amid a global crackdown against companies which have used the world’s tax regimes and deprived governments of a large chunk of corporate revenue, estimated at USD 100-240 billion.
According to the BEAT, if a large multinational, operating in the US makes related-party payments that are potentially part of aggressive profit shifting, they will be subject to a new minimum tax.
BEAT only applies to companies:
– with average annual gross receipts of at least $500 million for the most-recent three year period, and
– with related-party deductible payments of 3% (2% for banks) or more of their total deductions for the year (the “base erosion percentage”).
These related party disallowed payments include royalties, interest, rent, high-margin service payments to a foreign related party for the purposes of avoiding tax but exclude most cost of goods sold, payment for services at cost and certain qualified derivative payments.
Computation is done by using a minimum rate of tax a company should be paying on income without disallowed payments (Modified Taxable income or MTI), comparing this to the regular tax liability of the taxpayer arising at the federal corporate tax rate. If the regular tax liability is lower than the minimum computation, the excess is the BEAT amount to be paid as an additional tax.
The minimum rate of tax to be used for this calculation is 5% of the MTI for year one, 10% thereafter and increasing to 12.5% from 2025 (additional 1% for banks and broker-dealers).
The BEAT is of major concern to foreign subsidiaries and could lead to a significant increase in US tax liability. Companies may find it beneficial to establish contracts in such manner that cost-sharing contracts between parents and subsidiaries are used instead of transactional payments in order to avoid the profit shifting arrangement.
8. Global intangible low tax income (GILTI):
This regime taxes the intangible low taxed income received from CFCs in the hands of the US shareholders.
This tax is charged on an accrual system where the US parent includes in their income the GILTI value to be fully taxed regardless of whether it is remitted back to the US or not. This decreases the benefit for US companies to shift their IP in foreign low tax jurisdictions.
The GILTI amount is calculated on a net deemed tangible return based on the CFC’s tangible assets, which equal 10% of the shareholder’s aggregate pro rata share of the CFC’s qualified business asset investment (QBAI). The QBAI can be defined as the CFC’s quarterly average tax basis in depreciable tangible property used in the CFC’s trade or business to produce tested income or loss.
The GILTI requires also to determine the US shareholder’s aggregate pro rata shares of its CFCs’ “net tested income”, which corresponds to the difference between the “tested income” (Gross income of a CFC excluding several listed incomes) and the specific “tested losses”.
The portion of the CFC’s net tested income that exceeds the deemed tangible return on tangible assets is then included in the U.S. shareholder’s GILTI amount.
For C corporations only, a deemed deduction of 50% will be applied to the GILTI amount but subject to a taxable income limitation. 80% of certain foreign income taxes paid by the CFCs will be deductible from the GILTI tax amount.
If the foreign effective tax rate on GILTI is at least 13.125% the US residual tax on the GILTI can be eliminated. If no foreign tax applies on the GILTI, US will tax this amount at a default rate of 10.5%.
9. Deduction for foreign derived intangible income (FDII):
While the tax reform uses GILTI to penalize taxpayers that have migrated IP offshore, it simultaneously incentives companies that leave their valuable IP in the U.S. using the FDII.
This provision grants a preferential effective tax rate of 13.125% to eligible income of C companies. This is relevant to US headquartered companies and non-US companies doing business in the US.
FDII can be defined as the net domestic income earned thanks to operations in the US but only related to export (sales, services, lease…).
Similarly to GILTI, the FDII is the part of the income of the US company that exceeds the deemed tangible return amount calculated with reference to the QBAI.
IMPACT ON BUSINESSES IN THE GCC
In the aftermath of the US reform, companies around the world will look to alter their policies to maintain their corporate revenue and tax advantages.
Some GCC countries have almost no corporate tax (i.e. UAE, Bahrain) and are, similar to other jurisdictions, being affected by the aforementioned measures. It would prove beneficial for US subsidiaries in the GCC to assess the extent to which costs have been shifted to them from the US. It is also expected that lower budgets will now be allocated to these subsidiaries, to hold cash within the US, impacting the available cash in the GCC.
Adversely, GCC headquarters with US affiliates will be impacted by the BEAT, as a transfer pricing inter-company loan component. Any major cash remittances back to the GCC parent will be under scrutiny for anti-tax avoidance purposes.