U.S. tax reforms – Overview and impact

In December last year, U.S. President Donald J. Trump signed into immediate effect the largest overhaul of the American federal income tax system in the past three decades—the Tax Cut and Jobs Act, 2017. The reform lowers tax rates on corporations, pass-through entities and individuals and moves the U.S. toward a participation exemption-style system for taxing foreign-source income of domestic multinational corporations. Some of the cost of the lower tax rate has been offset by a tax on offshoring of services, taxation of deemed intangibles located abroad, provisions that scale back or eliminate many long-standing deductions, credits, and incentives for businesses and individuals. The current administration hopes to recover some of the tax loss through the above measures, which will stimulate domestic economic activity and, thus, generate tax revenue.

Various proposals are interlinked and could move in opposite directions. So, it is important to consider an impact analysis of all changes holistically and plan accordingly.

Reduction in corporate tax rates

The reduction in federal corporate tax to a flat rate of 21% does away with the graduated corporate tax rate structure, and is perhaps the most significant change in the U.S. tax system, as it tries to compete with its European peers in attracting domestic business.

A reduced corporate tax rate in the U.S. is likely to result in a lower U.S. effective tax rate for Indian MNCs having U.S. subsidiaries. Such impact is likely to prompt Indian MNCs to reconsider their U.S. structures, such as converting a U.S. low-risk distributor to a full-risk distributor, or reconsidering the role and authority of a U.S. agent subsidiary, etc.

One-time transition tax on accumulated foreign subsidiaries’ income

The reforms have also addressed another important issue that has been a concern for long—non-repatriation of accumulated profits of U.S. corporations’ foreign subsidiaries to the U.S. Corporations in the U.S. preferred parking such profits outside the country, than have such profits be subject to almost 35-40% tax in the U.S. To promote repatriation of such profits to the U.S., the reform introduces a one-time transition tax on untaxed foreign accumulated earnings (from 1987 to 2017). The U.S. taxpayer will have an option to pay such tax in lump sum or over a period of eight years, and would be entitled to foreign tax credit on the same, if repatriated in the same year.

The reform also provides for a 100% dividends received deduction (DRD) for foreign-source portion of dividends, which makes the U.S. an attractive investment regime where dividends from foreign investments would be tax exempt.

Base erosion proposals

One of the most-talked about provision in the new law is the Base Erosion and Anti-Abuse Tax (BEAT).

Under this new provision, most corporations with excess base erosion payments for the taxable year must pay a tax equal to 10% (5% for 2018) of its adjusted taxable income (after disallowing base erosion payments) if such tax exceeds regular tax liability. Interestingly, BEAT does not apply to payment for purchase of goods since such payments fall within the scope of “cost of goods sold”; so China has an advantage over India on this.

BEAT could have a significant impact for U.S. companies which have set up back offices in India depending on their structure. This could also result in an overall increase in the group tax costs and dilute some of the cost benefits which these U.S. companies obtain by setting up India back offices. BEAT could also hit Indian MNCs with U.S. businesses, which pay back most of the income to India in the form of royalties/fees. According to certain reports, Indian IT giants’ U.S. subsidiary earnings could be impacted by 4-5% in light of the BEAT law. Some of the IT companies have already restructured their business operations to mitigate the risk of BEAT.

Some of the other interesting proposals include the GILTI which seeks to deem income earned by foreign corporations beyond the deemed rate of return, as intangible income which is then taxed in the U.S. in the hands of the shareholder. This could again impact Indian back offices and other businesses of U.S. multinationals. Then there is the FDII which encourages U.S. persons to export goods and services from the U.S. by seeking to tax such export income at a lower rate, resulting in potential planning opportunities.

Overall, the tax reform law is likely to make the U.S. more competitive in terms of trade and business in the global markets. Tax outflow and attributes of U.S. multinationals are set to undergo a change, which could now prompt them to re-think their entity compositions, captive arrangements, business and commercial agreements, financing models, etc. Not everyone will jump at the idea of shifting their base to the U.S. because there will be multiple considerations, such as Brexit, incentives in other jurisdictions, primarily in Europe, possibility of further changes to the U.S. tax system, including any political impact, etc.

From an India perspective, one would expect to see activity around re-evaluation of business models for both, U.S. investments into India and India investments into the U.S. With today’s evolving and transformational business models, these reforms, along with BEPS, are an important consideration from a business perspective.

Vipul Jhaveri is, managing partner–tax, Deloitte India; Rajesh Gandhi is partner–tax, Deloitte India. Views are personal.