The 2017 Tax Cuts and Jobs Act (the “TCJA”), signed into law by President Trump on December 22, 2017, introduces sweeping changes in U.S. tax law, affecting businesses of all kinds. This Practice Note focuses on a few key provisions of the TCJA particularly relevant to non-U.S. manufacturing corporations with U.S. distribution subsidiaries. These changes in U.S. tax law may impact these companies operate now, as well as future plans for entering the U.S. market.
Federal Corporate Income Tax Rate
- Change: Most significantly, the US federal corporate tax rate has permanently been reduced from 35% to 21%. In addition, the corporate alternative minimum tax (which applied when higher than the regular corporate tax) has been repealed.
- Comment: The reduction of the headline U.S. federal corporate tax rate to 21%, which is a lower rate than in many of the home countries of non-U.S. corporations, will obviously benefit non-U.S. manufacturers with existing U.S. subsidiaries, and may influence those who sell directly into the U.S. (g., through independent distributors) to consider forming US subsidiaries and expanding their U.S. presence.
- Change: Under the TCJA, net business interest deductions are generally limited to 30% of “adjusted taxable income,” which is essentially EBITDA (taxable income plus depreciation and amortization deductions) for years 2018-2021 and EBIT (taxable income without adding back depreciation/amortization). Disallowed interest expense is carried forward indefinitely. Before the TCJA, interest was generally deductible when paid or accrued, subject to numerous limitations, including debt/equity ratios and taxable income. U.S. corporations – other than small businesses (average annual gross receipts under $25 million, on an affiliated group basis) – are subject to these limitations.
- Comment: The TCJA’s limitation on interest deductions are designed to protect the U.S. tax base. As a result, non-U.S. manufacturers with existing U.S. subsidiaries, and those planning to establish U.S. subsidiaries, may decide to reduce or limit the amount of debt in their U.S. subsidiaries.
Base Erosion and Anti-Abuse Tax (BEAT)
- Change: Under the TCJA, large U.S. corporations that are part of multinational groups are potentially subject to a new BEAT tax, which is essentially a minimum tax applicable to corporations that seek to reduce their US taxes by claiming large deductions for “base erosion payments” to non-US affiliates. The targeted deductions include royalties, interest and depreciation. However, and of particular significance to non-U.S. manufacturers, the version of the BEAT as finally enacted does not treat inventory costs (cost of goods sold) as base erosion payments. The BEAT generally applies to U.S. corporations that are part of multinational groups with average annual gross receipts of $500 million over the prior three-year period. The tax rate is five percent in 2018, 10% through 2025, and 12.5% thereafter.
- Comment: U.S. corporations with foreign headquarters that may be subject to BEAT may wish to revisit current practices as to purchase and sale of product, license arrangements and the provisions of back-office and other services between foreign parent and U.S. subsidiary.
Net Operating Losses
Net operating losses (NOL) from prior years generally can no longer be carried back to claim refunds. A U.S. company may use NOL carryforwards to offset only up to 80% of its taxable income (with unused NOLs carried forward into future years). Note that NOLs arising in tax years that began on or before December 31, 2017, will remain subject to the prior two-year carryback and twenty-year carryforward rule until their expiration and will also continue to be available to offset 100% of taxable income. As a result, a corporation with pre-TCJA NOLs may be viewed as more valuable than corporations with newer NOLs.
Foreign-derived Intangible Income (FDII)
- Change: The TCJA implements a new tax regime that provides a lower 13.125% U.S. federal income tax rate (rather than the new standard 21% rate) on “foreign-derived intangible income” for U.S. corporations. The special tax rate is effected by granting a 37.5% deduction for a C corporation’s foreign-derived intangible income. Foreign-derived intangible income is, generally, a portion of a C corporation’s income in excess of a threshold return derived from services performed for persons not located in the United States and from sales or licensure of property to non-U.S. persons for consumption outside the United States. The 37.5% deduction is temporary, and for tax years beginning after December 31, 2025, drops to 21.875%, resulting in a U.S. federal income tax rate of 16.406% (rather than the standard 21% rate) on foreign-derived intangible income for those years.
- Comment: FDII should encourage non-U.S. manufacturers to hold intellectual property (IP) in the U.S. and exporting from the U.S, rather than, for example, through a tax-haven entity that licenses the IP to a U.S. subsidiary. This may be particularly of interest to non-U.S. technology-based companies that seek to migrate to the U.S., as their principal market (whether for talent, sales or financing).
Of course, this Practice Note only provides a broad summary of certain highly technical provisions of the TCJA that we think are particularly relevant to non-U.S. manufacturing companies with U.S. distribution subsidiaries. Because they are new (and unclear in certain respects), many open questions remain on which we await further guidance. Please contact me in case you have any questions regarding these matters.