A much anticipated tax reform framework was released last week. The Framework was formulated by the “Big Six” representatives from the House, the Senate, and the Administration and is, as anticipated, very high level. It serves now as a template for the tax-writing committees of the House and Senate, whereby the details need to be elaborated by these committees. The Framework can thus be viewed as an important but small step on a long, uncertain journey that doesn’t necessarily end in 2017.
The Framework is generally consistent with President Trump’s following “four principles” of tax reform discussed so far. First, make the tax code simple, fair and easy to understand. Second, give American workers a pay raise by allowing them to keep more of their hard-earned paychecks. Third, make America the jobs magnet of the world by leveling the playing field for American businesses and workers. Finally, bring back trillions of dollars that are currently kept offshore to reinvest in the American economy.
Rate reduction to 20% and move to a territorial regime
On the business side, the content of the Framework does not include any major surprise compared to the previous releases (read article). The main elements are the following:
- Reduction of the corporate tax rate to 20 percent and elimination of the corporate “AMT” (alternative minimum tax). The Framework also proposes to allow businesses to immediately write off the cost of depreciable assets “other than structures” acquired after 27 September 2017, for at least a period of five years.
- Repeal or restriction of “special exclusions and deductions”, and specifically comments that the current-law domestic production (“section 199”) deduction would be eliminated. However, tax incentives for research and development and low-income housing would remain.
- Partial limitation of the deduction of net interest expense by corporations. The tax-writing committees have been tasked with considering the appropriate treatment of interest paid by non-corporate taxpayers.
- Adoption of a “territorial system,” whereby U.S. multinationals would have “a 100% exemption for dividends from foreign subsidiaries (in which the U.S. parent owns at least a 10% stake).” Base erosion rules will be included to protect the U.S. tax base by taxing at a reduced rate, and on a global basis, the foreign profits of U.S. multinational corporations.
- The very last sentence of the Framework states that “the committees will incorporate rules to level the playing field between U.S.-headquartered parent companies and foreign-headquartered parent companies”. It is unclear what this sentence means. The best guess at this stage is a proposal based on transfer pricing and earnings stripping. There will be for sure lots of discussions about this specific sentence in the coming weeks.
- A one-time tax on accumulated offshore profits to encourage U.S. multinationals to bring such profits onshore immediately. The applicable rate is not disclosed, but it will be higher for income held in cash/equivalents than for income held in illiquid assets. The one-time tax would be payable over several years.
What does that mean for foreign and Swiss groups?
The good news is: the BAT (“Border Adjustment Tax”) seems to be definitely off the table. The elimination of the AMT would also be a welcome relief. Furthermore, the articulation of a clear figure in terms of rate reduction makes it a bit more tangible and that is another good news.
A lot of uncertainty still remains around the topics of interest expense limitation and industry-specific tax regimes. Given the lack of technical details, it is not clear how the partial limitation of net interest deduction incurred by corporations may look like and what changes the tax-writers might contemplate with respect to industry-specific tax regimes. In addition, the impact of potential rules mentioned in the very last sentence of the document is unclear at this stage.
As to regional headquarters of US multinationals, a move to a territorial taxation system along with a mandatory repatriation process and base erosion rules would have significant implications. Such base erosion rules will be included to protect the U.S. tax base by taxing at a reduced rate, and on a global basis, the foreign profits of U.S. multinational corporations. The references to “a reduced rate” and “on a global basis” appear to contemplate a U.S. “top off” tax to ensure that combined U.S. and foreign tax rates imposed on foreign income equal a specified rate. The mechanics of the rules are left to the tax-writing committees. The chosen language may indicate that any foreign tax rate thresholds are to be applied across all foreign subsidiaries on an aggregate basis.
At this stage, it appears very likely that the Republicans will have to undertake the so-called “budget reconciliation” process to pass the tax reform. Consequently, for the proposed tax cuts to be permanent, such cuts will have to be offset by additional revenue. With the border-adjusted tax off the table, it remains unclear how the proposed tax cuts are to be financed. Although the Framework does propose some revenue raisers, additional measures such as the elimination of deductions or exemptions or immediate taxation on accumulated offshore profit will be required. The Framework does not include any specific details in this regard.
That said elements of the Framework can be expected to be modified, as details will be formulated in the course of the legislative process. While the Framework shows us there is a path to tax reform, there are still many hurdles to be overcome – both politically and procedurally – before it could become law.
What to expect and do?
No matter how long the process takes and what the final content is, businesses should stay tuned. Foreign and Swiss groups might be affected by a reform if they use debt heavily to finance their US operations and rely on specific incentives/credit in the US. They should thus continue to follow the developments over the next weeks/months. In parallel and with the help of modeling tools, they should estimate the potential impact on their structure and operations, as well as thinking of ways of restructuring their supply chain in order to mitigate or reduce the impact of possible new measures.