On December 22, 2017, U.S. President Donald Trump signed into law the Tax Cuts and Jobs Act (TCJA), which many have hailed as the biggest tax reform in the United States since 1986. Of the many provisions in the 1,097-page TCJA, a few stand out in respect of their potential implications to non-U.S. companies, such as those from Hong Kong and Mainland China, doing business in the U.S. (U.S. Inbound) and Hong Kong or Mainland Chinese companies owned by U.S. shareholders (U.S. Outbound).
The most headline grabbing element of the TCJA is likely the dramatic reduction in the U.S. corporate income tax rate from 35% to 21%, which should be a boon to many foreign groups with U.S.
subsidiaries. However, the sharp reduction in tax rates and other tax incentives would invariably lead to a significant decline in revenue collection by the government. To pay for this anticipated shortfall, the TCJA included a number of revenue raising measures such as:
- The net operating loss (NOL) carryback period is eliminated (i.e., no more tax refund can be claimed from the prior profitable years). Although the NOL carryforward period is to become indefinite, NOL carryforward deduction in any year is limited to 80% of the taxable income in that year, i.e., some tax will be payable regardless of how big the NOL carryforward is.
- Interest incurred by a business is no longer deductible in its entirety, but is limited to the business’ interest income plus 30% of its “adjusted taxable income” (as defined). This new rule would likely diminish the desirability and value of debt leverage for business purposes.
- If foreign groups have relied on foreign related-party debt to finance their U.S. operations, they would need to be aware of the potential negative impact of another provision in the Act. TCJA introduces the Base Erosion and Anti-Avoidance Tax (BEAT), which is intended to preclude U.S. companies from reducing their U.S. tax liability by making deductible payments to related foreign persons – for example, interest on intercompany loans. However, BEAT’s coverage is much wider than interest payments; it applies to other deductible payments such as royalties and most service fees. BEAT is the shorthand of an additional tax based on a recalculated taxable income (by disallowing the otherwise deductible payments to related foreign persons). As a result of BEAT, it is anticipated that large U.S. companies would turn more to domestic financing, IP licensing and service providers, rather than going abroad.
For U.S-owned foreign companies, what seems like the most welcome news – that profits earned by these companies, when repatriated back to the U.S. corporate parent (but not applicable to U.S. individual shareholders), would no longer be subject to U.S. tax, the so-called “Participation Exemption” – is offset by a number of complex revenue raising provisions that could hit the U.S. parent companies (and individual shareholders) hard:
- A one-time repatriation tax (the “Transition Tax”) will be imposed on prior years corporate earnings held overseas (the greater as of 2 November or 31 December, 2017). The tax would be imposed on these earnings at 15.5% (to the extent represented by the company’s liquid assets) and 8% (to the extent represented by the company’s illiquid assets), respectively. The tax, payable over eight years in back-loaded installments, will take effect for taxable years beginning before 1 January 2018. This means it would affect the 2017 tax returns (due April 15, 2018) for calendar year taxpayers. It should be noted that the tax is applicable to both U.S. corporate and individual shareholders.
- A new category of income earned by U.S.-owned foreign companies has been created, the Global Intangible Low Tax Income (GILTI). The main purpose of GILTI is to discourage the creation and maintenance of intangible property, and income arising from such property, in foreign companies owned by U.S. shareholders. The GILTI regime is targeted at low-taxed (in the foreign locations) IP income generated without the help of significant tangible assets. Unfortunately, the potential reach of GILTI is much wider than what was originally targeted. The idea is relatively straightforward: any U.S. foreign owned company that earns income over a “prescribed” return (now set at 10%) on tangible assets would be treated as GILTI, which would be subject to tax in the U.S. shareholders’ hands at the usual applicable tax rates on a current basis (i.e, the Participation Exemption would not be of relevance or help).
Consider a one-man consulting firm, a Hong Kong company owned by a U.S. individual shareholder, that operates a consulting business in Hong Kong with little or no tangible assets. In the past, the Hong Kong company would pay Hong Kong tax at 16.5% and there would be no U.S. tax payable until the company makes a dividend distribution to the U.S. shareholder. With GILTI, almost all of the Hong Kong company’s income would be GILTI, which would be taxable to the U.S. shareholder on a current basis. Worse still, the individual U.S. shareholder may not even claim a foreign tax credit with respect to the 16.5% Hong Kong tax that his company paid without going through some complex U.S. tax-planning gymnastics that would generate other problems of its own.
On the IP front, GILTI is often contrasted with the newly created Foreign-Derived Intangible Income (FDII) provision. If GILTI is the stick, FDII is often characterized as the carrot. FDII is aimed at encouraging U.S. companies with foreign operations to create and maintain IP in the U.S. and leverage this IP to earn income from foreign markets. U.S. companies that are taxed at 21% can enjoy a lower tax rate of 13.25% in deriving FDII, i.e., income, licensing, leasing property or providing services for use outside the U.S.
Trump’s signature on the TCJA represents a major step in his crusade to “Make America Great Again”. The TCJA gives U.S. companies a competitive edge, by way of the participation exemption, in operating in overseas markets. It encourages U.S. companies to move their “movable” assets or businesses, primarily relating to intellectual property and R&D businesses, back to the U.S. where they can enjoy a much lower tax rate and potentially benefit from FDII treatment and at the same time, avoid GILTI punishment. Unfortunately, U.S. individual taxpayers who do business overseas through their foreign companies may be caught in the crossfire of GILTI and the Transaction Tax that could lead to a higher tax burden. It is expected that many of these U.S. individual-owned foreign companies would have to be restructured to minimize the otherwise heightened tax exposure. From this perspective, TCJA may not be seen as so “great” for these U.S. individual taxpayers.