U.S. Tax Reform: Long Overdue Opportunity for Growth
The business world in the U.S. and abroad has universally celebrated the U.S. Tax Reform which became law on December 22, 2017. Much has been written about how those new provisions will encourage capital investment and attract more foreign direct investment to the U.S. Among these measures are the immediate reduction in the corporate tax rate from 35% to 21% and the full write-off of the purchase of certain capital assets. On the international side, the so-called deemed repatriation of foreign earnings of U.S. multinationals has received the most attention. It automatically treats an estimated $2 to 3 trillion of accumulated foreign earnings of U.S. multinationals that are currently held abroad as though they had already been distributed to U.S. shareholders and taxes them at a preferential U.S. tax rate of 15.5%. From a policy perspective, this one-time measure was considered necessary for the U.S. to transition from a worldwide taxation system to a „territorial“ system. Under the territorial system, the earnings of a U.S. group’s foreign subsidiaries generally are exempt from U.S. tax, both when the earnings are made by the foreign subsidiary and then when distributed to their U.S. shareholders as a dividend. The influx of cash into the U.S. as a result of the deemed repatriation will be a further boost to the U.S. economy directly and indirectly. The hope is that companies benefitting from this transitional rule will invest this cash into the U.S. economy in the form of capital, increases in employee compensation and benefits, stock buy backs or via enhanced dividends to public shareholders.
The EU Commission and many of the EU Finance Ministers reacted much less enthusiastically to the U.S. Tax Reform. They expressed concerns regarding two features of the international provisions that they think unfair and possibly illegal: the foreign derived intangible income (FDII) and the base erosion anti-avoidance tax (BEAT). FDII seeks to create an incentive for companies to conduct their international operations from the U.S. Income that a U.S. company can categorize as FDII is subject to a favorable rate of U.S. tax of 13% (compared to the new standard rate of 21%). Included in the FDII tax base is generally income a U.S. company earns from the use of its intangible property (including services) by foreign affiliates and third parties outside of the U.S. The EU’s concern is that the favorable FDII rate is an illegal export subsidy for U.S. companies. Similarly, BEAT has been criticized as being an unfair if not illegal tax on certain intercompany payments made from U.S. companies to their foreign affiliates. After an initial rate of 5% the BEAT rate goes to 10% in 2019. The tax base is determined through a complex calculation that seeks to isolate by formula what the U.S. considers to be an excessive return (also referred to as base erosion) on intercompany charges to U.S. companies by foreign affiliates. The BEAT rate may seem relatively small, but the Europeans will argue there should be no BEAT at all.
The risk that FDII and BEAT will be formally challenged before an authority like the World Trade Organization should not have a chilling effect on the decision to increase investment in the U.S. The tax drivers mentioned at the outset of this comment are by themselves compelling for foreign investors to act on their U.S. investment plans now. The common policy underlying many of the new international provisions, including BEAT and FDII, is an attempt to combat what the global tax community and the G-20 refer to as tax base erosion. And it was the Europeans who have championed since 2012 the now globally-endorsed OECD base erosion profit shifting (BEPS) project to clamp down – if not eliminate – tax structures and intercompany transactions once considered creative but legal. The above measures in the U.S. Tax Reform which the EU is now criticizing were inspired by a U.S. version of the anti-base erosion policy endorsed by the G-20.
The U.S. Tax Reform also creates opportunities for business investment at the U.S. state level. The dramatic decrease in the statutory tax rate at the Federal level will place an increased focus on the state corporate tax liability for U.S. operations. The state corporate tax rate is now a relatively larger component of a company´s overall tax liability for doing business in the U.S. Today, the state corporate tax rates vary from 0% (Wyoming) to 12% (Iowa). Minimizing the combined Federal and state tax burden on U.S. investment will become a greater factor for foreign groups to decide in which states to place their direct investment. This factor is also likely to prompt some states to lower their corporate tax rate to remain competitive with other states for new foreign direct investment.
In a matter of weeks, if not days, it will be America’s turn to criticize the tax policy of the EU Commission. It is rumored that the EU Commission will propose in its forthcoming paper that a gross revenue tax (in addition to current VAT liability) be levied on large multinationals in the digital sector. The targeted sector happens to be dominated by U.S. multinationals, so the bulk of the revenue from such a tax will come from U.S. businesses. The EU Commission’s proposal is expected March 21, 2018, if not before. As with U.S. tax reform, businesses in the U.S. and in Europe are on the same side regarding a gross revenue tax: they generally oppose it. More on that once the EU Commission paper is published.
Rick Minor is a U.S. tax lawyer. He can be found on LinkedIn: https://www.linkedin.com/in/rick-minor/ .