Manufacturers have spent the first months of this year crunching the numbers and evaluating the true impact of the Tax Cuts and Jobs Act to their industry. The new legislation greatly reduces corporate rates, sets new limits on the deductibility of interest, offers full expensing on qualifying new and used equipment purchases, and has a number of international taxation implications. Manufacturing companies need to rethink everything about their business and tax planning strategies, including domestic and international structuring, financing investments, global supply chains, how M&A transactions are best structured.
These complex changes require detailed analysis and provide ample tax-planning opportunities. Many tax decisions made during 2018 will have long-term ramifications, making it essential for companies to understand the nuances of tax reform and how each provision will affect their business. In addition, there are immediate time-sensitive opportunities that must be completed before 2017 returns are filed.
New rates will drive arbitrage opportunities
The biggest impact for C corporations is the federal tax rate reduction to 21%. Profitable companies currently paying tax will realize significant tax savings from this lower rate and will have the opportunity to reinvest in their business, both in terms of infrastructure and personnel, pursue merger and acquisition activity and/or increase shareholder returns. For manufacturers structured as pass-through entities (i.e., S Corporations, partnerships and limited liability companies) taxed at individual rates, the news isn’t as promising. The top individual rate is reduced to just 37%, though a 20% pass-through deduction can lower the effective rate to 29.6%. Still, regardless of how companies are organized, it is not too late to leverage the rate cuts with arbitrage planning. Businesses should accelerate deductions into 2017 against the higher rates and defer income into 2018 when rates are lower. Many deferral strategies are available until the 2017 return is filed.
There are dozens of automatic accounting method changes, allowing for deduction acceleration or providing for revenue deferral, which can be made on the return itself. For a capital intensive sector like manufacturing, fixed assets and cost segregation may be particular opportunities to be explored.
Rate divide prompts structuring considerations Tom Rudibaugh
, Grant Thornton Strategic Federal Tax Services partner in Cleveland notes, “My manufacturing clients are wrestling with the difficult considerations around converting from pass-through entity status to C Corporation status and understanding the multiple domestic and international implications associated with federal tax reform.”
The stark difference between corporate and individual rates may tempt many pass-through entities to consider converting to a C corporation. Pass-through businesses will want to model operating as a C-corporation to compare the benefits compared to pass-through status. The analysis is complex, and will depend on earnings distributions, accounting methods, exit plans, generational wealth transfer plans, state taxes, international operations, and the potential cost of conversion itself. Some pass-through entities may very well find it beneficial to convert to C corporation status.
New opportunities with fixed assets
There are significant changes to the tax treatment surrounding fixed assets. Most notably, the new tax law provides 100% bonus depreciation for qualifying property placed in service after September 27, 2017 and before January 1, 2023. The bonus depreciation rate will then phase out by 20% each year over the five succeeding years until it is no longer permitted starting in the 2027 tax year. For the first time, used property will also be eligible for bonus depreciation, providing significant savings opportunities for manufacturing companies making asset acquisitions. It should be noted that this change may favor asset purchases over stock acquisitions. The favorable depreciation rules provide an enormous opportunity to minimize taxable income over the next five years.
International changes are complex
The U.S. will now function primarily as a territorial system, but with strings attached. For manufacturers with global supply chains and foreign income and/or operations, tax reform ushers in a number of important changes:
- As the U.S. transitions from a worldwide system of taxation to a semi-territorial system, foreign earnings not yet subject to U.S. tax may be subject to a one-time “toll tax.” For calendar-year taxpayers, this tax is due with 2017 tax returns. For many companies, determining this tax is proving to be a challenge. A full and accurate accounting of accumulated untaxed foreign earnings and profits is required. Until now, there may not have been compelling reasons to spend time on such detailed calculations.
- Introduction of a dividends received deduction for certain foreign earnings of controlled foreign corporate subsidiaries. This positive change is somewhat offset by new U.S. global minimum tax rules:
“Collectively, these new rules are complex and make most manufacturers’ international structures obsolete,”
- GILTI – The new tax Global Intangible Low-Taxed Income (GILTI) is meant to impose a minimum tax on foreign income from intangibles (broadly defined) exceeding a 10% rate of return on the tax basis of depreciable assets (reduced by certain interest expense)
- BEAT – The Base Erosion Anti-Abuse Tax is a minimum tax generally targeted at deductible intercompany payments. It will only apply to manufacturers with $500 million in average gross receipts over three years.
Andrew J. Wilson, partner, Corporate and International Tax.
“Collectively, these new rules are complex and make most manufacturers’ international structures obsolete,” explained Andrew J. Wilson
, partner, Corporate and International Tax. “Current supply chains, cost sharing agreements, and intercompany arrangements may no longer be tax efficient. But companies that plan for the new rules as part of the company’s strategic review can benefit from lower effective U.S. tax rates coupled with taking advantage of international incentives and overall international compliance. Fully realizing these benefits will require consultation with an advisor that has international tax and industry expertise.”
To fully understand tax reform implications and support tax planning, businesses must model 2018 and future year using estimates and what-if scenarios including the following complexities:
- Limitations on losses
- Limitation on net interest compared to EBITDA
- Loss of Section 199 and other changes
- Whether to fully expense or depreciate
- Financing options
- Cash flow needs
- International growth plans
The moving parts within tax reform will initially create some challenges and will require new data gathering and analytics for tax departments. It should come as no surprise when tax departments request more support.
Tax reform has the potential to not only affect business plans for individual companies, but to impact the U.S. economy.
“In the first quarter, businesses were focused on evaluating and reporting the financial impact of tax reform and the one-time repatriation,” explained Brian Murphy, national tax leader, Industry-Administration. “Now, businesses are beginning to model tax reform’s 2018 provisions. What we are finding is that each situation is unique and a detailed model is the only way to get your arms around the moving parts. With a working model, we can then begin to evaluate each provision and mitigate the problem areas.”
Grant Thornton has heard from a number of clients and companies in manufacturing. They have described a variety of plans and options for how they will look to take full advantage of the improved profitability from this historic tax reform. Among these are plans to:
- Convert from pass-through entity status to C Corporation status to enhance investible cash flow
- Invest in operations to improve margins
- Accelerate R&D and product development
- Evaluate acquisitions with the understanding that asset transactions may be more advantageous than stock purchases due to the new expensing rules
- Analyze business financing and capitalization. For highly leveraged businesses this will probably require additional planning and creativity due to the net interest limitation. Businesses may need to restructure debt, pay down debt more aggressively or look for alternative financing opportunities, such as leasing.
- Review global structure and supply chains net of tax. The lower U.S. tax rate and new international provisions present opportunities and challenges. To avoid the traps, businesses may need to restructure operations and transactions to avoid or minimize BEAT and GILTI taxes.
Manufacturers stand to benefit from many favorable aspects of tax reform, but it could also present traps to those that do not fully consider its short- and long-term effects. To balance the risks and rewards, companies should undertake careful analysis and planning for the impact of the new law on both current and future cash flow.
Gain more insights:
Should pass-through owners switch to C-corp status?
Tax reform law transforming business and tax planning
M&A impact of pass-through conversions
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