US tax reform is not a sure thing but with Republicans controlling the White House and Congress, the likelihood of a tax reform is as high as it has been in the past 30 years. The timetable is anyone’s guess. Regardless of what may happen, not only US groups, but also foreign groups with US operations should be prepared for some possible major changes, not only affecting their bottom lines but also the manner in which they may do business.
In a speech to a joint session of Congress earlier this week, Trump declared that he remained committed to his campaign pledge to cut corporate tax rates and provide “massive tax relief” to the middle class. Although the details remain slim, the best place to start at this stage is the House Republican “blueprint” that has been unveiled in June 2016, notwithstanding the slight differences this may bear to Trump’s original plan. The basis of the plan is provided by three principles: simplification, growth, and IRS reform, meaning that it basically calls for the following:
- Reduction of tax rates on business and individuals: Most widely held corporations could see their income tax rate cut from 35percent to 20 (or even 15 percent if the Original Trump “plan” from his campaign were to come to fruition).
- End of many deductions: Interest deductions could be denied, except the extent offset by interest income.
- Move from a worldwide taxation system to a territorial regime with a consumption-based focus (commonly referred to in the press as a “Border Adjusted Tax”).
The plan is designed to be revenue-neutral. Should the plan be enacted, there would of course be losers and winners amongst tax payers.
As mentioned above, the timing of enactment is anyone’s guess. Based on President’s Trump statements and the fact that the tax reform is very high on the priorities list of the Republican Party, things may move forward rapidly. A draft bill could be released by The House of Representatives within the next month or two. The biggest hurdle is expected to be passing the bill by Senate due to the Republicans having an only slight majority of 52 out of 100.
It typically takes 60 votes in the Senate to pass such legislation. As a result, the Republicans plan to invoke special “budget reconciliation” procedures to try and bypass the Democrats in the Senate. Thus, although it could be difficult to pass a tax reform bill in 2017, this budget reconciliation procedure might make it possible. Nevertheless, some speculate that the tax reform taking place sometime in 2018 presents a more realistic scenario.
“Border Adjusted Tax” (BAT) as the main and most controversial measure
Key to the House of Representatives’ Republican’s tax proposal, is a move towards a destination-based tax. Such a move may sound alarming, however, it does not mean that the US would adopt a value added tax or national sales tax. Instead, the corporate tax system would focus on where goods and services are consumed, rather than on their production location. This would entail a radical departure from the current worldwide taxation system, where business and people are taxed on their total income, regardless of where it is made from. It has to be noted that its compatibility with current US tax treaties and trade agreements is controversial. For example, the World Trade Organization (WTO) may reject to BAT on the grounds of it being incompatible with its rules.
The specific parameters of such BAT concept are far from clear at this stage. Conceptually, the idea behind BAT is that imported goods and services into the US would not be deductible to the US buyer (hence when one hears about a “border tax” it is the denial of the tax deduction that is triggering “the tax revenue”). Exported goods and services would on the other hand be exempt from US tax. Thus, in terms of deductible expenses, a taxpayer may deduct his/ her domestic cost of goods sold (COGS) but not his/ her foreign COGS.
The following scenarios aim to illustrate the practical impact of these measures depending on the establishment and activities of the Swiss groups or IHQ in the US:
Scenario 1: Company produces goods in the US for sale in the US. In such a scenario, the company would pay corporate tax at the US corporate rate.
Scenario 2: Company produces goods in the US for export purposes. In this scenario, no US corporate tax would be due.
Scenario 3: Company produces goods outside the US and imports them to the US. In such a case, the Company would pay taxes at the US corporate rate on US based sales with no deduction for costs of import.
Scenario 4: Company produces goods outside the US for sale outside the US. No US taxes should be due.
What should Swiss groups and IHQ expect and do?
Based on the scenarios briefly highlighted above, Swiss groups with US operations might be affected as follows:
- Swiss groups manufacturing goods outside of the US (be it in Switzerland but also Asia or Mexico) and importing them into the US might be affected by the border adjustability of the new proposed corporate tax. Although they may benefit from a rate reduction for US based activities, the non-deductibility of foreign expenses would impact them significantly (whether imported to their own US subsidiary or to a third party that loses the deduction for such imports). This might especially be relevant for the watch making industry (relying on the Swiss made label) but also precision or pharma industry;
- Swiss groups with existing manufacturing activities in the US for their US sales should in principle benefit from such measures, as they would significantly profit from a reduced rate applied to the same tax base as under current rules.
- Swiss groups with highly leveraged US operations or relying on specific tax incentives in the US may also be significantly hit given the proposal to end interest rate deductibility and certain tax incentives designed to encourage particular activities.
- Swiss regional headquarters of US groups might be adversely impacted if they sell goods or services in the US. This is typically the case when the Swiss entity owns IP rights and is accordingly remunerated by the US, or if the Swiss entity sells goods in the US market. Should the Swiss entity buy and sell goods or services outside of the US only, the impact should be minimal and would only be affected by getting rid of the requirements currently set by the US CFC rules (which should go away as the US would move to a territorial regime).
The expected tax reform might well end up being a tax revolution. No matter how long the process takes, businesses should not wait to take action. As described above, several Swiss groups might actually end up being left worse off than under the current tax rules, if they rely on non US suppliers and use debt heavily to finance their US operations. As an immediate measure, they should study the House’s blueprint carefully, and follow the developments over the next weeks/months. With the help of modeling tools, they should in parallel start estimating the impact on their structure and operations, as well as think of ways to restructure their supply chain in order to mitigate or reduce the impact of possible new measures.