The proposals, arguments and questions have been bandied about for months. General agreement is that tax reform has an excellent chance of being enacted in some form in the next six months. Even if the final outcome isn’t completely clear, it’s time to plan for those likely to survive.
A recent webcast, “Preparing for Tax Reform: What You Should Be Doing Now?” sponsored by Grant Thornton in partnership with Bloomberg BNA as part of the Future Ready Business: Washington Impact series, addressed looming tax reform proposals and steps businesses can take now to prepare. The discussion centered on the significant provisions likely to be enacted including a corporate tax rate cut, transition to a territorial system and repatriation of foreign earnings, and the planning strategies in response that companies should be considering before and after tax reform is effective.
Modeling is key to gauging tax reform impacts
A really good billiard player knows where every ball is on the table and sets those balls up so that three shots from now, he or she deploys the plan, depending on the opponent’s strategy. The same is true for today’s business leaders as they approach tax reform, said Grant Thornton International Tax Services Partner David Sites. It’s critical to lay out information so that when change happens, the company is in the best position to capitalize on opportunities.
The decision to not yet act has serious consequences. It’s crucial to consider possible impacts of proposals that are likely to become law, and be willing to make changes. “Sometimes the instinct of companies is to see how things shake out and then take action,” said Dustin Stamper, director of Grant Thornton’s Washington National Tax Office. “I think that’s a mistake. You can’t take a wait-and-see approach and put your company on hold.”
The first step, Stamper said, is running models to see how various tax reform proposals might affect their business. “This is the absolute necessary first step. We don’t have a ton of details on these proposals. But we do have enough for you to dust off last year’s tax return and see how it would be affected by the changes.”
A modeling tool illustrates potential outcomes for individual companies, and planning opportunities that can be implemented before tax reform is effective. The tool utilized by Grant Thornton professionals focuses on the major tax proposals that were in the House blueprint. In the example below, Sites explained that the client would face a significant impact associated with a border adjustment tax but that the proposed full expensing provision would have little effect on the company when taking the interest provision into account.
Sites cautioned, “It’s important to point out that some proposals are more ‘plannable’ than others.” He explained that in the example of this client, “while the loss of the foreign tax credit and the move to a territorial system might have a small impact, they might offer significant opportunities to utilize existing attributes such as in the area of foreign tax credits.”
He further explained, “Let’s assume you have a company that has a significant foreign tax credit carried forward and that a territorial system might be included in tax reform. That means those foreign tax credits might not be worth much at all in a post-tax reform world.”
Sites suggested that companies should be evaluating that attribute today and asking “What should I be doing with foreign tax credits in a pre-tax reform world in order to get the most bang for the buck? Do want to repatriate foreign earnings and do I have the markers in place to effectuate that idea once I learn more about tax reform?”
With tax reform now a top priority for the GOP, companies are faced with the challenge of understanding the possible ramifications of various proposals and their impact on their business.
What the proposals mean
Corporate rate cut
A corporate tax rate cut is sure to be included in any tax reform bill that passes, and House Republicans have proposed a 20% rate while the administration has proposed 15%.
“Tax reform is a lot about competition,” said David Sites
, International Tax Services partner in Grant Thornton’s Washington National Tax Office. The purpose of the corporate rate cut, he said, is to level the playing field with other jurisdictions and countries so that companies don’t feel pressured to locate outside of the United States solely for tax benefits. Looking at major trading partners, the Canadian rate is close to 25%, UK rate is below 20% and many other jurisdictions are in these ranges. Sites sees the 20% rate as a globally competitive number that could yet be tweaked, depending on whether the decision is for a permanent cut — taking a revenue-neutral stance — or a temporary cut that isn’t revenue neutral.
With the current starting point of 35%, a move to either President Trump’s original 15% proposal or the more talked-about 20% would be welcome, according to Senate Finance Committee Tax Counsel Tony Coughlan. He said the committee is pondering corporate integration — specifically, a dividends paid deduction (DPD) method. A DPD would let corporations deduct dividends paid out to shareholders against their corporate tax.
The territorial system
Interest in international tax reform could signal a move to a territorial system, rather than border adjustments, said Coughlan. In a territorial system, the dividend a U.S. shareholder receives from a controlled foreign corporation or a U.S. corporation’s foreign subsidiary would be exempt from corporate tax. To address concerns about loss of U.S. income production to lower-tax jurisdictions, Congress will probably consider a base erosion provision such as minimum rates on certain global income. Deemed repatriation, Coughlan said, should be expected in a transition.
Repatriation of foreign earnings
Reform will almost certainly impose a one-time tax on existing offshore earnings if enacted, Sites said. The rate is up for debate; the House’s is 8.75% for offshore cash and 3.5% on earnings from property investments. Companies with earnings they plan to leave offshore generally haven’t needed to care about the calculations. But a territorial system would be of great concern to a company that has a substantial foreign tax credit carried forward. The foreign tax credits might not be worth as much as they once were or anything at all in a post-tax-reform world. Calculations of the earnings could suddenly become very important.
Full expensing and loss of interest deduction
In the “on the fence” category, Sites said, is the immediate expensing of capital investments coupled with the disallowance of net interest deduction. Under this proposal, a company’s net interest expense wouldn’t be deductible currently but would carry forward to offset only interest income. The flip side is that companies could fully expense their capital investments. This proposal is controversial because of uncertainty about effects outside the revenue window.
Take decisive tax reform action steps
With the prospect of a rate cut and the loss of incentives, companies should consider accelerating deductions and credit and deferring income. Companies might find they can accelerate R&D and other credits. Simple language tweaks to benefit plans and bonus pools could allow acceleration of deductions.
This is the time to review fixed assets and accounting methods, as the potential for a rate cut can turn these timing benefits into permanent benefits. In fact, said Ellen Fitzpatrick Martin, partner in Grant Thornton’s Washington National Tax Office, a scrub of accounting methods overall can spotlight undiscovered deduction opportunities. Most changes are automatic, and don’t require IRS consent or a user fee.
Common accounting method changes that can accelerate deductions include software development, self-insured expenses, property and payroll taxes, prepaid expenses and rebates. Looking at depreciation can turn up misclassified assets and provide a bump in current year deductions.
Method changes for foreign subsidiaries can also be pivotal in preparation for a transition to a territorial system and repatriation of foreign earnings. Offshore earnings that have been subject to little or no foreign tax and a 35% U.S. tax might, going forward, be subject to no tax at all. Deferring earnings to post-tax-reform through accounting methods or utilizing existing attributes to repatriate those earnings could be greatly beneficial.
Implications for M&A
From both a strategic and financial perspective, said Sites, companies considering mergers and acquisitions need to look at baking into valuations the effects tax reform will have on cash flow. An example is the House blueprint full expensing provision. If acquisition of a business may lead to full expensing of a significant portion of the assets upon acquisition rather than a drawn-out amortization or depreciation period, the result could be a net operating loss, which would carry forward and affect the cash flow.
Conversely, sectors such as private equity will be concerned about deals if interest is not deductible. They’ll need to decide if using leverage is the way to effect an acquisition or if it would be better to shift to a different equity instrument or other methodologies. M&A activity will turn on whether a company believes the capital gains rate is going down. In that case, the choice may be to defer selling; just a 5% decrease in capital gains rate could be significant. If the company determines that tax reform will make business difficult, it may accelerate divestiture.
Preparation can’t cover all scenarios, but the wise route is basing it on the provisions most likely to come to life, watching and learning, and keeping an open mind about different directions for your business.
Director, Washington National Tax Office
T +1 202 861 4111
Ellen Fitzpatrick Martin
Partner, Washington National Tax Office
T +1 202 521 1558
Partner, International Tax Services
Washington National Tax Office
T +1 202 861 4104