A high-wire act: Walking the regulatory and tax tightrope in US manufacturing

Rethinking risk for a connected worldMention regulations in a room full of U.S. manufacturers and you’d better be ready to hear a collective groan. “If you try to talk about red meat, taxes or regulations, you’re going to get people fired up,” says Chad Moutray, chief economist at the National Association of Manufacturers (NAM).

Government rules are often provided as a reason why developed nations like the U.S. are seen as attractive manufacturing destinations — because of the maturity and stability of their tax, legal and regulatory environments. The U.S.’ strong intellectual property protection policies, for example, contribute positively to technology development and adoption.

But in the eyes of manufacturing business owners, the volume and pace of regulation are significant issues. An increasing regulatory burden adds time, cost and bottlenecks to their business — with little measurable value to the bottom line. That can be deeply frustrating, especially for midmarket firms that already face tight budgets and limited resources that they need to grow their operations.

“The flood of regulations coming out of our nation’s capital is scary,” says Keith Van Scotter, president and CEO of Lincoln Paper in Lincoln, Maine. He says his company must contend with labor regulations, energy regulations, transportation regulations, health and safety issues dictated by OSHA, and environmental issues related to the way the company’s raw materials are harvested. “It’s always been scary — it’s only more scary now,” he says. (Lincoln Paper and Tissue is no longer operating and in bankruptcy, due in part to regulations and health care costs, Van Scotter says.)

The U.S. also has the highest corporate tax rate of any of its major trading partners and all Organization for Economic Cooperation and Development countries. It is also the only country in the G-7 that taxes the active foreign earnings of its companies worldwide.

Jeff French, leader of Grant Thornton LLP’s Manufacturing practice, believes that manufacturers that cannot invest in the high-level lobbying tactics employed by the multinationals need to take a smart approach to the tax and regulatory environment. This involves both smart tactics from their industry associations, and a smart approach to compliance and tax and regulation planning. “In the past, trade associations would fight tooth and nail to defeat an unfavorable regulatory policy,” he says. “I think they’re now taking a more strategic approach, where if a regulation’s going to go in, they look to limit the damage it does. This means they focus specifically on areas that they can get better control of. In addition, manufacturers need to stay on the forefront of these issues, minimizing the impact and actively managing future tax and regulatory risk,” French advises.

The regulatory burden in manufacturing While some countries have pursued a path of deregulation, U.S. manufacturers are traveling a very different road.

Compared to the average domestic business, U.S. manufacturers spend about twice as much per employee on compliance with federal regulations — or roughly $20,000 — according to the NAM annual outlook survey. And the smaller they are, the more expensive they get, with the smallest manufacturers spending nearly $35,000 per employee on compliance due to issues of scale.

“The Obama administration is very aggressive when it comes to environmental, labor and a lot of other regulations,” Moutray says. “The National Association of Manufacturers — and the business community generally — continue to push back against much of that.”

Kurt Bauer, president and CEO of Wisconsin Manufacturers & Commerce, believes that the tax and regulatory regime puts the brakes on American manufacturing’s global competitiveness. “It is beyond ridiculous what we are doing to hobble manufacturing. Manufacturing is very important in this country in terms of national GDP [gross domestic product], and here in Wisconsin it’s over 20% of the state version of GDP. Washington seems to be doing everything it can to debilitate manufacturing when we should be engaged in a renaissance, particularly with [the] energy advantage we have,” Bauer says.

Here, we take a look at two of the key policies that will have a particularly significant impact on the regulatory landscape for U.S. manufacturers.

Ozone regulation
One of the most recent examples is the ozone regulation, which is designed to lower the current threshold for ozone pollution to a range of 65 – 70 parts per billion from 75 parts per billion. The effort is designed to reduce soaring rates of asthma among children, which is caused in part by pollution. But the cost will be astronomical: The Environmental Protection Agency estimates it will cost U.S. industries roughly $3.9 billion by 2025 to install the necessary technology to clean the pollutants from smokestacks in order to meet requirements.  

“This regulation could be the most expensive that has ever come out of Washington,” Moutray says. And it is just one in a series of regulatory controls put in place in recent years.

Affordable care
The other regulation that has manufacturers fired up is the Patient Protection and Affordable Care Act. This health insurance initiative requires employers with 50 or more full-time equivalent employees to offer health insurance to at least 95% of full-time employees and their dependents up to age 26, beginning in 2016. Those who do not comply will have to pay a fee per employee.

Not only is this an expensive proposition, but the documentation required to prove compliance is complicated and time-consuming. Companies have to electronically file forms for every full-time employee, and be able to prove to the IRS that coverage was offered to every eligible employee — within 90 days of their start date — whether they accepted it or not. “Obamacare is a disaster for us,” says Lincoln Paper’s Van Scotter. “Health care costs are escalating — double digits or greater — and the regulations in terms of what we have to cover, what we have to pay for and how we have to cover it are unbelievable.”

This heavy regulatory burden is forcing many midmarket manufacturers into a constant balancing act, making sure they set aside enough resources to meet regulatory guidelines while still investing in innovation and growth initiatives. Unfortunately, the scales tend to tip in the regulators’ favor.

However, while many are opposed to overzealous and burdensome regulations, not everyone is opposed to all rules and frameworks. Lance Reinhard of Big Tex Trailers argues that certain regulations can drive safety, quality and competitiveness by forcing manufacturers to align with standards or face stiff penalties. “Regulations play an important role in our industry, whether it’s ensuring that you have annual inspections on the trailers or meet OSHA requirements,” he says. “As this industry matures, the regulations are going to force [those who can’t comply] out of business.”

Soaring taxes flatten manufacturers Taxes are one of the most significant issues facing U.S. manufacturers. When asked about the regulatory issues that have the biggest impact on how businesses operate, respondents ranked income and indirect tax rates as a top priority (see Chart 1). “America needs tax reform for business,” declares Martin Richenhagen, president and CEO of AGCO, an agricultural equipment manufacturer in Duluth, Ga. “We are one of the few countries where profits that have been generated outside the U.S. and taxed locally are taxed again as soon as you repatriate the money and bring it back to America.”

Tax and regulations chart 1
Many industry leaders feel the U.S.’ high corporate tax environment and growing regulatory scrutiny and uncertainty are stifling manufacturers’ growth ambitions, and forcing some companies, like Littelfuse, to move their operations overseas. Chart 2 illustrates the regulatory and tax areas that have the most impact on investment decisions about where to locate facilities. John Quille, vice president and chief accounting officer of Littelfuse, which manufactures circuit protection products, cites the incredibly low tax rate in the Philippines — roughly 8% compared to 35% in the U.S. — as one of the reasons his company has moved much of its operation overseas in recent years. “There is very little incentive for us to bring it back,” he says. “We tend to look for acquisitions and opportunities overseas because we’re not about to take a 20% haircut just because of taxes here.”

Tax and regulations chart 2

However, some companies, like chemical manufacturer Prayon, are taking advantage of tax benefits and expanding locally. Beth Allen, Prayon’s vice president of finance and procurement, notes that the city of Augusta offered the company several incentives to build a plant in Georgia, including leasing agreements to avoid property tax, and incentives to avoid paying sales tax on natural gas and electricity.

The R&D tax credit: It applies more often than you think The R&D tax credit is an incredibly valuable incentive that is often overlooked. It allows companies to deduct dollar-for-dollar expenses incurred for a wide range of R&D projects. It was designed to boost economic growth, encourage domestic investment and spur innovation, and it can be a strategic way for manufacturers to mitigate some of the risk of new investments.

Many companies fail to take advantage of this credit because they assume it is only applicable in the development of game-changing products. In reality, as long as your project delivers improved functionality, quality, reliability or performance, and it has an element of risk and experimentation, it can be considered R&D. That includes things like the purchase of new equipment to achieve efficiencies, computers to develop software systems, or facilities that use environmentally friendly materials.

And don’t worry if you feel like you’ve missed out: The credit has an amendment feature that allows companies to do an analysis of all past expenditures and file an amended return using the alternative simplified research credit (ASC) method.

However, filing for this credit can be complicated. You have a choice: You can calculate using increased gross revenues related to R&D investments over several years to receive a 20% credit (startups can claim the credit prospectively), or you can also go with the easier ASC method, but that only allows companies to calculate a 14% credit based on the prior three years of R&D expenses incurred.

Either way, you should not try to do it alone. Get advice from a tax professional to help you identify all of the investments that qualify, and to make sure you have the data in place to verify the relevancy of these expenditures. It can take a little time, but the cost benefits can be significant and worth the effort.

Taxes and regulations: Midsized vs. big players When it comes to taxes and regulations, size matters. Large firms are better positioned to absorb the impact of income and other taxes, given their ability to park money in non-U.S. jurisdictions. Companies like Tyco Electronics, Stratasys and Ingersoll-Rand have moved billions of dollars to countries like Bermuda and the Cayman Islands to avoid U.S. taxes. Midsized firms do not have that kind of flexibility; they are typically too small to have the capability to move liabilities offshore, and too big to attract any major government exemptions. “We need to become more globally competitive if we’re going to continue to attract some of that new or reshored investment,” Moutray says.

According to our survey, larger firms are also more likely to see income tax rates as a possible source of competitive advantage compared to midsized firms (33% vs. 9%, respectively). This is likely due to the fact that the high price of doing business in the U.S. can make it impossible for smaller firms to thrive.

The news is not all bad. Midsized companies hold an advantage on the labor front, with smaller and less-costly workforces in comparison to their larger rivals: 43% of large manufacturers in our survey said they will need to change in relation to labor compensation regulations, whereas just 21% of midsized firms said the same.

Large companies also face greater worries about labor issues than their midsized counterparts (30% vs. 19%, respectively), whereas midsized companies have a tougher time keeping pace with product safety regulations than large companies (29% vs. 13%, respectively), given they are unlikely to have this expertise on tap internally.

Andrew Wilson, Manufacturing Tax practice leader at Grant Thornton, believes that midmarket companies need to design their tax strategy around their business model. “Tax has to fit into the business model,” he explains. “That means looking at the different ways that you’re innovating, such as R&D credits. It also involves where the work is done, where the product is going to be sold, and whether you should own the intellectual property or split it. You look at how the work will get funded and put together a good set of incentives. Whether it’s the R&D credit or incentives offered to manufacturers to locate in a region, the eventual solution is going to be different based on the specific company’s business model,” Wilson says.

Regardless of whether you are big or small, dealing with taxes and regulations is literally the price of doing business in this field. Organizations like NAM will continue to push back against rules they feel are overly burdensome, but even with powerful advocates on your side, the pressure is not likely to subside any time soon.

Key takeaways There are few things in life that are more dependable than taxes and regulations. You cannot avoid them, but you can manage them effectively:

  • Manage your tax risks. At least once a year, work with your advisers to do a thorough review of the taxes that affect your business to be sure you understand where the biggest risks lie. Pay attention to shifting regulations and how they might affect your budget.
  • Develop a strong tax governance framework. Agree on a tax strategy that is in line with wider business objectives.
  • Be proactive about regulatory compliance. Use data analytics to build risk awareness and a compliance culture within the organization, including ensuring employees and business partners are trained regarding regulatory compliance policies.
  • Use regulations as a competitive advantage. Love or hate them, they are an integral part of your business, so turn them into an asset. Exceeding OSHA requirements for safety, meeting environmental requirements, and adopting innovative technologies to be more energy-efficient can build the quality of your brand while enabling you to stay ahead of government regulations.
  • Look for incentives. If you have plans to build a new plant or hire new workers, use it as leverage to secure local tax incentives.
  • Take advantage of the R&D tax credit. Many new projects and investments are considered eligible for this incentive, which can reduce your costs and risk over time. Talk to your adviser to determine if investments like new equipment, new facilities or production improvements qualify.