By Abi Joshi, CPA
Tax Director, PricewaterhouseCoopers, McLean
There is no doubt that the United States is by far the largest economy in the world. With GDP of $19.36 trillion, the U.S. has the world’s seventh-highest per capita GDP, and the U.S. dollar is the currency most used in international transactions and is the world’s foremost reserve currency.
Not surprisingly, up until 2017, the United States also had the highest corporate tax rate of 35 percent among the Organization for Economic Co-operation and Development (OECD) countries. With the Trump administration in the White House and the Republicans having control in both Senate and House, the party was able to pass the biggest tax reform in the U.S. history since 1986. The last major tax overhaul known as “Tax Reform of 1986” was introduced under late President Ronald Reagan’s tenure back in 1986.
After 30 years, this new tax law (Public Law 115-97), also known as the Tax Cuts and Jobs Act, has marked a significant legislative victory for President Trump. It is estimated that this new law enacted on Dec. 22, 2017, will approximately create $1.5 trillion of U.S. deficit over the course of 10 years. Republicans say that this tax reform overhaul will create economic growth, and encourage businesses to create more jobs and bring investments in the U.S. economy. The major piece of this legislation is to bring corporate tax rate down from 35 percent to 21 percent, and change its worldwide taxation model to territorial tax regime. Some of the other important provisions of this legislation include; i) acceleration of cost recovery , ii) interest limitation deduction, iii) repatriation toll charge and anti-hybrid rules, iv) 20 percent deduction on certain pass-through business income, etc.
Not only does this new bill have a far-reaching impact on the U.S. economy but also it creates a major impact on overall global economy. Out of many aspects of the tax provision, the one with the most direct impact will be on the international tax arena in terms of taxation of U.S. corporations’ foreign subsidiaries.
Up until Dec. 22, 2017, the United States had a worldwide tax regime where income earned by any U.S. multinationals was taxed on a worldwide basis including other five nations such as Japan, South Korea, Mexico to name a few. On the other hand, majority of other developed nations use territorial tax regime where the income is taxed only to that jurisdiction where the company is based at. To give an example of worldwide tax regime, let’s say a U.S. multinational company doing business in Ireland (with corporate tax rate of 12 percent) earns income of $1 million in Ireland. After that U.S. subsidiary pays Irish corporate tax rate of 12 percent, it usually re-invests the after tax profits of $880,000 ($1 million minus $120,000 Irish tax) in Ireland. If the U.S. parent of the foreign multinational wants to bring back the after-tax proceeds to the United States, it would have to pay the current corporate tax of 35 percent on that $1 million income again with a potential foreign tax credit of 12 percent for taxes paid in Ireland. This extra layer of 23 percent tax (35 percent minus 12 percent) imposed on U.S. companies for repatriation of foreign profits encourages U.S. multinationals to not bring cash home at all.
Instead, they will re-invest their after-tax income in foreign countries, which have been key source of investment in those foreign jurisdictions. According to Moody’s Investor service, U.S. companies had about $1.8 trillion in cash held in overseas accounts at the end of 2016. Some of the largest U.S. multinational companies that have cash stacked abroad are Apple Inc. ($230 billion), Microsoft ($113 billion), Cisco Systems ($62 billion), Google parent Alphabet Inc. ($49 billion) and Oracle Inc. ($52 billion). Retaining such profits offshore may be regarded as a tax strategy and many corporations have accumulated substantial untaxed profits offshore, especially in countries with low corporate tax rates.
With this new tax bill, not only is U.S. corporate tax rate be 21 percent effective Jan. 1, 2018, but also motivates Companies to bring offshore cash back to the United States by paying one time deemed-repatriation tax between 8 percent to 15.5 percent on its foreign earnings (depending on cash or non-cash items on their books), with additional option to be paid over the course of 8 years. In exchange for this new one-time tax liability, U.S. companies could repatriate accumulated profits whenever it wanted to do so going forward without facing double taxation. This can be a huge incentive for companies to bring foreign earnings back to the United States creating a possibility of further job growth and investment in various sectors such as health and technology, road and bridges etc. In addition, the excess cash the U.S. multinationals will have can be used for various corporate purposes such as share buybacks to increase the value of earnings per share, increase merger and acquisitions to strengthen their balance sheet and attract talented pool of individuals with higher salary and bonuses.
According to a recent article published by CNN, as part of the new tax bill, corporations like Apple will enjoy a repatriation tax of 15.5 percent for returning money to the United States from their overseas cash files and Apple’s top priority will likely be “accelerated” share buybacks. Apple has already committed to a $300 billion capital return program that includes buybacks and dividends for shareholders. In addition to this, it will not be surprising to find out that various multinational companies are re-thinking their business strategy/consideration in terms of their change in treasury function and evolution of supply chain such as transformation of their current capital structure, relocation of intellectual property (IP) and other business assets, profit alignment, etc. While this can create a huge boost on the U.S. GDP, this can potentially reduce investment in Asia and Europe.
Although the shift from worldwide tax regime to territorial tax regime under this law will have most obvious impact on the U.S. economy, the reduction in corporate tax rate to 21 percent may have even larger indirect effect on the global economy. With reduced tax rate, U.S.-based companies will no longer have to shift their operations or their Intellectual Property (IP rights) to foreign jurisdictions to avoid 35 percent tax rate, which is currently the highest statutory tax rate on corporate profits amongst OECD countries. Currently, the OECD countries have an average tax rate of 24.7 percent as of 2016. Because of the high U.S. tax rate, a majority of the IPs of U.S. companies are currently housed in European nations such as Ireland, the Netherlands, Belgium and Luxembourg. For example, Apple and Google currently oversees their foreign operations through their European headquarters in Ireland. Not only Apple Inc. has created thousands of jobs in Irish economy, it also gets various incentives from the Irish government for doing business in the Ireland. These types of profit shifting and tax strategy has recently created sparks and outrage in international tax community.
To curb sweet deals like these, various developed European nations including the United States and Japan have enacted OECD Action Plan on Base Erosion Profit Shifting (BEPS), introduced in 2013. The goal is to prevent companies shifting their profits from high tax rate jurisdictions to low tax rate jurisdictions and also to end tax incentives such as State Aid which is a pattern where one country gives special tax preference to any unique company at the detriment of the other nation. For example, based on recent article published by Bloomberg News, the European Commission has announced that it was taking Ireland to court for failing to collect higher taxes from Apple, after Ireland ignored a ruling from European Union to collect its tax from Apple . If the EC wins the battle, Apple could owe $15 billion and this pattern has been prevalent for other U.S. companies such as Amazon and Google. The reduction of the U.S. tax rate will create a huge paradigm shift in the global economy as foreign multinationals will further be motivated to do business in the United States further bringing additional competition and growth. Furthermore, various ongoing legal tax battles between U.S. multinationals in European Court can also demotivate U.S. companies to shift their operations to other European countries in light of the U.S. tax rate cut. After all, the high U.S. tax rate was the main reason for U.S. companies to shift their operations to European nations to begin with, which will be solved by this potential reduced U.S. tax rate. There is also a possibility that reduction of the U.S. tax rate may cause other developed nations to reduce their corporate tax rates to improve their attractiveness in a global scale.
In light of this, many foreign developed nations are already modeling the potential impacts of U.S. tax reform and assessing how they might shape their tax policies in response. Likewise, many multinational companies and their boards are also performing similar due diligence as this major shift in U.S. tax policy is going to make a seismic shift in the business world. In this global economy, there is no denying that the United States plays a vital role in international transactions as it has abundant capital resources, and this tax reform is going to make the United States even further attractive place to do business.
Disclaimer: These comments are my own, not those of my employer.