After many proposals that have been the subject of high-level discussion for several months (read previous blog articles), The Ways and Means Committee of the US House of Representatives released a legislative text last week. This text represents the most significant step towards tax reform in over 30 years; it starts off the first official phase of the tax reform process and provides a first glimpse of the details of many proposals that have been discussed at a high level so far. It also reveals the other proposals being considered by the tax writers, including proposals for raising revenue to pay for some of the policy modifications.
It is important to bear in mind that last week’s developments only represent the first step on the long road to a potential tax reform. There are numerous other steps which must be completed for tax reform to become law, and many changes may be made to the bill unveiled last week.
In line with previous proposals, the key component of the proposal is to reduce the US federal corporate tax rate from 35% to 20%.
The relevant measures that would affect Swiss parented groups with operations in the US include:
- A new ‘Excise Tax’ of 20% on payments (excluding interest) to related non-US parties, which effectively results in such payments becoming non-deductible. The Excise Tax applies to payments for services, cost of goods sold and capital assets. The Excise Tax will not apply if the taxpayer elects to treat the income from the payment as ‘Effectively Connected Income’ and subjects the net profit to US corporate income tax at a rate of 20%. The proposed scope of application of this regime targets groups where the annual amount of deductible payments to related parties exceeds $100m. It is unclear if an Excise Tax (or the substitute corporate income tax) would be creditable in the country of the recipient of the payment.
- A new regime for the tax deductibility of interest. The proposed regime limits the available tax deduction for net interest expense to 30% of relevant adjusted taxable income of a business. A further limitation may apply where the US corporation’s share of the group’s net interest expense exceeds 110% of the US corporation’s share of the group’s EBITDA.
- Anti-treaty shopping measures on US source payments including interest and royalties, through the taxation at either a US withholding tax rate of 30% or the withholding tax rate provided for in the US tax treaty with the country of the foreign parent.
- Limits on the use of net operating losses
- Immediate expensing of investment in capital assets (excluding assets used in a real estate property trade), so that the costs of equipment acquisition can be written off.
The combined effects of these measures, if enacted, could be significant for the supply chains of goods and services to the US market.
Additional measures of relevance to US parented multinational groups with operations in Switzerland include:
- A move to a territorial regime whereby an exemption from US tax on dividends from foreign subsidiaries would apply where the US parent owns at least 10%. As a transition to this new system, under the bill previously deferred foreign earnings would be deemed to be repatriated. A tax on the deemed repatriation of overseas profits would apply at a rate of 12% for earnings held in cash or cash equivalents and 5% for non-cash earnings. The tax can be paid in equal instalments over 8 years.
- A new measure to introduce what is essentially a 10% minimum tax on ‘High Return Profits’ from foreign subsidiaries.
- The controlled foreign corporation (Subpart F) regime continues to apply, such that passive income of foreign subsidiaries remains subject to immediate US tax.
Excise Tax on payments to foreign affiliates: is “BAT” back?
One of the more novel proposals in the text is a proposed 20% Excise Tax on all “specified amounts” paid by a US person to a related foreign person. Specified amounts are any payments that create deductions, COGS, or depreciable/amortizable bases except (1) interest, (2) acquisitions of commodities, (3) FDAP (Fixed, Determinable, Annual or Periodic income) subject to 30% withholding and (4) services provided at cost. By imposing a 20% tax on these items, they become effectively non-deductible. The new 20% Excise Tax regime effectively inflicts a destination-based tax on the income of a foreign- or US-parented multinational group that imports into the United States through a taxable presence. To some extent, this can be viewed as carrying on the spirit of the “BAT” (border adjustment tax) proposal that was abandoned earlier in the year (see my blog article). It does, however, differ significantly in that it applies only to transactions with related parties, and even there it provides for an option which allows a formulaic deduction for costs incurred with unrelated parties.
Such proposal obviously targets transfer pricing abuse regarding cross-border transfers of goods, services and intellectual property rights.
What could it mean for Swiss groups having a US presence?
Swiss and foreign groups that sell foreign-made products to the US market through local distribution units could be among those affected most by this new Excise Tax. Such companies may end up paying tax on the transfers twice – first by paying the Excise Tax in the United States and then in Switzerland (or in the countries the sales are made from) where they are taxed now and where the new Excise Tax would not be accounted for without changes to bilateral tax treaties. Under such circumstances, Swiss and foreign multinationals may think of opting to avoid the Excise Tax by electing to pay US corporate tax on all the profits related to products sold in the United States. These include profits on activities conducted overseas, like manufacturing or research, which are also subject to foreign income taxes.
There is a lot of uncertainty and many questions regarding how the new rules would work in practice. What is certain though is that this measure will trigger lots of discussions and debates in the coming weeks. Another certainty is that Swiss and foreign groups with a US presence would be significantly affected by a reform such as that drafted in this text. They should thus continue to follow the developments over the next weeks. 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.
For tax reform to become law, the House and ultimately, the Senate, will have to pass identical legislation and send it to the President. Thus, a conference committee might be convened to work out the differences between the two bills. The more significant the differences between the two bills, the longer it may take to negotiate a conference agreement, and reaching an agreement could be challenging. For tax reform to become law, the conference agreement would need to be approved by both the House and the Senate and signed by the President.
The stated goal of Republican congressional leadership is to present President Trump with a bill that he could sign prior to the end of 2017. The aggressive schedule outlined by the House and Senate leaders is aimed at meeting this deadline. If actions move forward and stay on track, this deadline might be met. Any significant hiccups at any of the many stages along the path to enactment could however compromise this tight timeline and delay the process to 2018, or even lead to the demise of the bill.
These measures are only a portion of the US tax reform package, which also proposes fundamental reform for the taxation of individuals and US domestic businesses. There are many variables which will continue to be debated by US tax writers before the final shape of the US tax reform is determined. It is therefore still very important for Swiss groups to continue to monitor and assess the implications of what is ultimately agreed, as the proposals continue to develop.