Global tax reform has dramatically changed the tax planning landscape. Driven by the Organisation for Economic Co-operation and Development's (OECD's) base-erosion and profit-shifting (BEPS) initiatives and the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, global tax law is in a state of flux. The complexity of recent changes and the possibility of future changes make it challenging for multinational corporations to marry the effects of tax law changes with an efficient global operational structure. The changes directly impact the after-tax economic return on a company's supply chain, internal financing, and intangible property deployment (referred to in this article as a company's "value chain"). With this changing landscape, U.S. C corporation multinationals should consider reevaluating their value chain.
US tax reform post-TCJA
The TCJA was signed into law on Dec. 22, 2017. While the corporate tax rate reduction from 35% to 21% (effective Jan. 1, 2018) made headlines, the new international tax provisions affecting U.S. companies with foreign operations may be more important. They are complex and have been layered onto the existing U.S. international tax regime.
The TCJA has now moved the United States away from a worldwide system with deferral to a quasi-territorial tax system. C corporations that meet ownership and holding period requirements enjoy a 100% dividends-received deduction (DRD) (Sec. 245A) on dividends from their foreign subsidiaries. The DRD could provide a significant benefit for certain taxpayers but is limited by both preexisting and new anti-base-erosion provisions.
Existing Subpart F rules (Secs. 951-964) related to foreign personal holding company income, foreign base company income, and other provisions remain unchanged. In addition, the TCJA expanded its anti-deferral provisions by adding the new global intangible low-taxed income (GILTI) regime. Taken together, it is possible that most of the income of controlled foreign corporations (CFCs) will be taxed under Subpart F and GILTI.
Two of the most prominent international tax provisions of the TCJA are the GILTI and foreign-derived intangible income (FDII) regimes. These provisions were enacted to discourage the shifting of income outside the United States under the old rules. Prior to the TCJA, tax deferral was achieved by offshoring high-value intangibles and operations in foreign low-tax (or no-tax) jurisdictions.
The GILTI regime (Sec. 951A) taxes most of the income of CFCs (net tested income) in excess of a 10% return on tangible assets (referred to in Sec. 951A as qualified business asset investment, or QBAI) similar to Subpart F income. Tested income includes most CFCs' taxable income with some exclusions, such as Subpart F income and income that would be Subpart F income but for the high-tax exception. The GILTI inclusion may be reduced by a 50% deduction (37.5% after 2025), generally resulting in a pre-foreign tax credit tax rate of 10.5% (which is only available to domestic C corporations).
The GILTI eligible for a deduction is limited by the U.S. corporation's taxable income. The post-deduction GILTI may then be further offset by an indirect foreign tax credit that is contained in a separate foreign tax credit limitation basket but limited to 80% of the foreign tax credit in the GILTI basket. Assuming no losses for the domestic corporation and no foreign tax credit expense allocations (Regs. Sec. 1.861-8) against the separate foreign tax credit limitation basket, a foreign tax rate on GILTI in excess of 13.125% results in no U.S. tax on GILTI. However, in recently issued proposed regulations, expense allocations are applied against the GILTI foreign tax credit, thereby raising the 13.125% breakeven point. For low-tax foreign subsidiaries this represents a potential for significant tax increases but at the 10.5% tax rate.
GILTI is balanced by the FDII regime (Sec. 250) in a carrot-and-stick type of approach. The FDII regime provides an incentive to maintain intellectual property and operations in the United States by allowing a 37.5% deduction on a U.S. corporation's foreign-derived income in excess of a 10% return on domestic QBAI. This results in a 13.125% tax rate. The deduction is calculated on the foreign income generated by the provision of services, sale of goods, and licensing/rental of property to unrelated foreign persons and, in certain cases, to related foreign persons. Since FDII is calculated on the excess over a specified QBAI return, the benefits drawn by asset-intensive businesses versus those with very few assets can be significantly different.
Lastly, the TCJA introduced the base-erosion and anti-abuse tax (BEAT), which discourages U.S. base-erosion payments made to a foreign related party (including foreign subsidiaries of a U.S. corporation). BEAT acts as a minimum tax on U.S. corporations with average annual gross receipts over $500 million over the previous three years. BEAT is based on modified taxable income, which is computed excluding certain payments to related parties and taxed at a 10% tax rate (5% for 2018 and 12.5% after 2025). Base-erosion payments specifically exclude cost of goods sold (COGS) (and other specific exceptions). Accordingly, intercompany COGS deductions would not be added back to modified taxable income when calculating such income. Identifying intercompany expense that can become part of COGS or structuring the supply chain such that the related-party payment is for COGS deductions could yield significant BEAT savings.
In 2015, the OECD issued a series of action plans with the goal of limiting certain global tax-minimization strategies. These minimization strategies included income sourced to jurisdictions with no substance, artificial avoidance of the creation of permanent establishments, use of hybrid mismatch arrangements (transactions that generate multiple deductions for a single expense or deductions without corresponding taxation of the same payment), and treaty shopping. The action plans address these abuses, while providing countries with a framework for aligning economic activity with the right to tax. Acting on BEPS Action Plan 2, the European Union adopted Anti-Tax Avoidance Directives (ATAD) 1 and 2, which prescribe rules against anti-avoidance practices directly affecting the functionality of the EU's internal market and specifically address hybrid mismatches
Transfer pricing has also been a key focus of the BEPS initiatives. Actions 8-10 were developed to ensure that the transfer-pricing results align with value creation. Coupled with a broader definition of intangibles by the TCJA, the allocation of premium returns to the United States and other jurisdictions will inevitably be affected, creating tension between countries. This also results in a reduced emphasis on strategies that use companies with little substance (or without appropriate employees) for intangibles, financing, and supply chain operations. Under BEPS, these entities will either no longer produce the desired return, or the deductions in the use countries will be disallowed via anti-abuse rules.
The changes in global tax laws from BEPS and the TCJA, among others, have caused businesses to rethink how they operate. Without planning, both the foreign and U.S. tax could increase. Balancing the value-chain efficiencies with those of tax is becoming a much more critical measure of economic performance and post-tax income, and the time for this exercise is now.
Global tax reform and the value chain
As a company's value-chain footprint grows, it opens itself up to an ever-increasing variety of cost and operational challenges that have significant impacts on customer service performance, product pricing, asset location, and supply chain governance, which, ultimately, play a significant role in margin growth.
Organizations continue to face cost-efficiency challenges in the jurisdictional selection and the location of their manufacturing, procurement, and distribution operations. As part of ongoing business efficiency decisions, operations and other nontax considerations are being evaluated for cost savings and efficiency. Beyond establishing a hub for local product supply, the choice of a manufacturing venue requires a multi-matrixed decision model where local wage rates, customs duties and tariffs, country-of-operation value-added tax compliance (potentially across multiple stages of the production process), and transfer pricing all combine to influence the taxable presence and business decision. Local incentives and grants, including state credits and incentives, and the new opportunity zones created by the TCJA could also have an impact.
While local manufacturing operations represent a logical investment to dramatically lower customer service lead times and transportation costs, the creation of a new taxable presence can result in new taxes that potentially offset cost-efficiency gains captured elsewhere.
As the decision to relocate manufacturing carries with it significant local tax risks, those risks are often multiplied by the extended supply chain required to feed the operation. Viewed holistically, the choice of a supply partner now moves far afield from pure delivered cost and must consider the physical location of the supply partner's manufacturing locations and key distribution mechanics, including warehousing and distribution center locations. The operational considerations must be evaluated against the tax costs (and in some cases benefits) resulting from global tax reform in order to arrive at the optimal value-chain structure.
While manufacturing locations and choice-of-supplier decisions are complex in their own right, intellectual property (IP) generation and patent protection considerations have surged to the forefront in global supply chain footprint design. As with the manufacturing presence and choice of supply partner decisions, IP taxation provides an added dimension that, ultimately, influences in-country pricing strategies, asset footprint investments, and even the desired location for innovative thought and patent development.
The new world: What it all means
Tax reform has changed the landscape of risks and opportunities and its impact on the value chain. Pre-TCJA and BEPS planning may not be optimal in the post-reform world. It becomes imperative to perform quantitative analysis and to pay special consideration to each jurisdiction's tax rates and regimes to arrive at a structure that provides both operational and global tax advantages.
From a U.S. perspective, Subpart F income has historically been considered something to avoid. Post-TCJA, it may now be preferable to GILTI under certain scenarios (i.e., when a GILTI deduction cannot be claimed due to U.S. losses, or if GILTI foreign tax credits cannot be used in the year of a GILTI inclusion). This entails comparing the 10.5% tax rate with foreign tax credits that are available with Subpart F inclusions. Alternatively, companies may choose to sidestep the Subpart F and GILTI debate by pivoting to a branch structure to allow for a foreign tax credit carryforward for income not subject to Subpart F. These new considerations clearly have an impact on value-chain decisions and structures.
The new DRD regime has also introduced the need for planning. Although the DRD now brings the opportunity to exempt some CFC earnings from U.S. corporate tax, no foreign tax credits are permitted with DRD-eligible distributions. Therefore, it may be preferable to avoid dividends if the taxpayer wants to credit taxes paid by a CFC in a high-tax jurisdiction and the taxpayer has other foreign-source income streams from low-tax jurisdictions so it can take advantage of foreign tax credits. Conversely, it may be beneficial to structure into the DRD regime, through proactive planning and supply chain changes, to reduce GILTI.
Finally, the TCJA and BEPS are causing companies to revisit whether it is preferable to onshore or offshore certain operations and IP. Onshoring certain value-chain activities to the United States could be more attractive as a result of FDII's 13.125% effective tax rate. It is important to weigh the cost of U.S. income net of an FDII deduction against the tax cost in foreign jurisdictions and the impact of GILTI and Subpart F. This should be evaluated in conjunction with the BEPS requirements, including the importance of careful consideration when determining the location of assets, functions, and workforce.
Tax reform has changed the way U.S. multinational corporations do business. They should reconsider their value chain to compete in the global market. Even at the new, lower tax rates, further tax savings can be achieved through tax-effective value-chain planning. Because of the U.S. changes and the clear move globally to an enactment of BEPS in the near future, it would be important to commence this value-chain evaluation before tax laws completely change or business decisions are finalized.
Tax, however, is only one part of the broader value-chain equation. Therefore, tax planning in response to global tax reform should be considered in concert with other business value-chain efficiency efforts.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.