This is the second installment in a two-part series on what smart businesses can do to prepare for tax reform. See our previous coverage here.
Although the road thus far has been bumpy, with a few twists and turns along the way, the United States is positioned for the first significant tax reform in decades. With the healthcare debate seemingly behind us for the time being, all eyes have shifted to tax reform. Republican lawmakers control both chambers of Congress, the Trump administration is in control of the White House, and nearly everyone agrees – both Republicans and Democrats – that tax reform is long overdue.
Republican leadership have presented various proposals and expressed numerous opinions on how best to accomplish tax reform. Though these plans vary, and in some cases quite dramatically, one common ground seems to be a complete overhaul of international tax laws – specifically, how foreign earnings are taxed in the United States. Amid the uncertainty, one thing does seem certain, if tax reform is achieved, cross-border taxation will see a significant transformation.
Despite tax reform’s historic momentum, many multinational businesses remain unprepared. The legislative process can seems like a black box. Many frustrated observers believe that no matter what goes in, there’s no way of knowing what will come out. Although this may be true to an extent, engaging in strategic international tax planning now can make multinational businesses agile in the face of the next tax reform.
Agility allows multinational businesses to adapt to whatever comes out of the legislative black box, and also opens the door for valuable planning opportunities, both before and after reform.
The best tax reform planning is often that which will result in a tax efficient outcome under existing law, but also provides agility for the future. Agility allows multinational businesses to adapt to whatever comes out of the legislative black box, and also opens the door for valuable planning opportunities, both before and after reform. Tax reform also brings with it significant risk, so it’s imperative that multinational businesses act decisively to keep pace with the competition.
So, how can a multinational business become agile when facing a sea of change in international taxation, all while remaining poised to be in the best position under the current system?
Below are five things smart multinational businesses are doing right now to prepare for tax reform:
- Modeling –The first step to planning for international tax reform is to understand how it affects the business. This holds true not only for domestic tax reform, but also for international tax reform.
Republican leadership have released various proposals for tax reform that could dramatically alter how businesses are taxed. The proposals call for significant changes to international taxation, including a shift to a territorial system for international taxation in addition to significant corporate rate reductions. Smart multinationals are already modeling the impact of the various proposals so that they can make effective business decisions and identify international planning opportunities.
The Now – It’s imperative that multinational businesses understand what impact the various proposals will have on their bottom line before taking action. Modeling for tax reform not only helps plan for the future, but also provides an opportunity to take a fresh look at the present. Modeling also allows multinational businesses to run various scenarios, not just under tax reform, but also under current law. Once the scenarios are understood, only then can multinational businesses confidently look to accelerate deductions, defer income, and employ other strategies in response to tax reform.
The Next – Modeling is the cornerstone of tax planning agility. Preparing for the unknown is always a daunting challenge, but with informed, methodical planning, one can have confidence in any decision. Modeling tools need to be deployed in a fashion that will allow companies to see how critical business decisions would play out under the major tax reform proposals. Not only will the model demonstrate to stakeholders that the multinational business is tackling tax reform head on, but it will also provide invaluable insight into what the future may hold. The model allows multinational businesses to simulate potential international tax planning outcomes even in the face of uncertainty.
- Managing International Tax Attributes – Multinational businesses must fully understand their global footprint before they can understand how international tax reform will affect their business. All major proposals contain some form of one-time tax on all unrepatriated foreign earnings. Although the mechanics and rates may differ, one thing is certain under the leading reform plans – multinational businesses will see their attributes impacted.
The Now – Foreign earnings and profits are not only a key input when planning for tax reform, they are also necessary for understanding tax and financial statement implications of existing foreign operations. Understanding this, and other attributes, can provide significant benefits irrespective of tax reform planning. Such benefits include improved repatriation planning, reduced financial statement risk, cash tax savings, among others.
Computing and maintaining international tax attributes may seem simple, but in reality it is often complex with a wide range of pitfalls for the unprepared. Managing a foreign corporation’s earnings and profits and other tax attributes presents a never-ending challenge: complex tax laws, the ever expanding global business environment, and compressed timeframes stretch resources and challenge accuracy. Even so, potentially broad, adverse tax implications can result if international tax attributes are not computed properly. Therefore, it’s vital to proactively monitor international tax attributes, and be aware of the many complicated issues that arise in the cross border context.
The Next – The top tax reform plans all propose a one-time tax on unrepatriated foreign earnings as part of a transition to a territorial tax system. The plans propose rates for this one-time tax ranging from 10 percent on all earnings to 8.75 percent on cash and cash equivalent and 3.5 percent on reinvested earnings.
However, many uncertainties surround the computation of unrepatriated foreign earnings under these plans. For example, when will the measurement date be? Will it be effective when the legislation is introduced, or some later date in the future? How will foreign deficits be considered in the computation?
Despite the many open questions, the most nimble multinationals are already assessing their international tax attributes. This not only enables multinational businesses to act quickly when necessary, but also enables other planning opportunities. For example, many domestic planning opportunities – such as accelerating deductions, deferring income and strategically utilizing deficits – may also be used to manage foreign earnings in the face of impending tax reform. But, only after the international tax attributes are understood and quantified.
- "Multinational businesses can no longer rely on last generation’s tax planning involving overly complex holding companies, hybrid entities, and sometimes limited economic substance." (David Sites, Partner, Washington National Tax Office)Tax Efficient Structuring – Even the best tax planning can be rendered inefficient by poorly structured operating entities.
The United States is on the precipice of tax reform, but so too is the world. With the Organisation for Economic Co-operation and Development’s Base Erosion and Profit Sifting (BEPS) initiative, the Europeans Union’s Anti-Tax Avoidance Directive, the UK’s Brexit and diverted profits tax, and other reforms occurring across the globe, multinational businesses must remain agile or risk losing a competitive advantage.
The Now and the Next – Now is the time to take a fresh look at the businesses global structure. Even with the uncertainty of U.S. tax reform, the next has already arrived around the globe. Multinational businesses can no longer rely on last generation’s tax planning involving overly complex holding companies, hybrid entities, and sometimes limited economic substance. This type of planning is a thing of the past, and companies must act now to prepare for the next in global taxation. An agile structure will allow any tax reform outcome, here or abroad, to be managed in a tax efficient manner.
- Foreign Tax Credit Utilization – When computing foreign tax credit limitations, multinational businesses must allocate and apportion deductions. The allocation and apportionment of deductions for purposes of determining a taxpayer's taxable income from a particular source or activity is often undervalued by multinational businesses.
The Now – Determining the proper allocation and apportionment of deductions is no small task for most multinational businesses, and often requires a complex annual functional analysis. Still, getting it right can result in significant tax savings for many taxpayers and allows for cash tax refunds in the right circumstances. Updating methods used for allocated and apportioned deductions can be done on amended returns; providing taxpayers with economies of scale by covering both current and prior years during a study.
- Inbound Financing – Many multinational businesses are financed, or capitalized, through a mixture of debt and equity. An investor’s return, particularly for inbound investors, may be significantly impacted by this mixture.
Most major tax reform proposals contain some form of interest limitation or thin capitalization rules. These rules look to limit a multinational businesses’ ability to benefit from interest deductions. Some tax reform plans even go as far as to entirely eliminate interest deductions in excess of interest income. Such limitations are likely to have substantial impacts on multinationals’ bottom lines.
The Now – Multinational businesses have become increasingly focused on cash management, related-party lending and other treasury functions. These functions are key to the operational success of the business, but have significant tax implications and considerations. The successful multinational businesses have found a balance between operational need and tax efficiency.
However, the window for this type of planning may be short lived. Leverage may be a key target of tax reform – we have already seen this occur during tax reform around the world. The United States is no exception – with a focus on base broadening and budget neutral tax reform, inbound investors’ interest deductions are nearly certain to be in the crosshairs.
A fresh look at the treasury/finance function may reinvigorate operations by inserting necessary capital, while concurrently providing cash tax savings. Acting now may provide benefits before the window closes, but may also allow multinational businesses to benefit from “grandfather” provisions (i.e., exempting existing instruments from the requirements of future legislation) that are commonly afforded as part of this type of legislation.
The Next – Beyond the potential benefit that may be afforded “grandfathered” arrangements under tax reform, revisiting inbound financing may provide other benefits when planning for the next in tax reform. Cash infused may be used to fund other tax reform planning strategies. For example, multinational businesses may want to accelerate deductions when today’s tax rates are high, rather than in the future when rates might be lower. Businesses can often control the timing of many types of expenses, including compensation, bonus pools and benefit payments. But, accelerating deductions often requires outlays of cash in the short term – something that inbound financing could help achieve.
Partner, Washington National Tax Office
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