The legislation contains $1.5trillion of cuts and represents the biggest overhaul of the US tax system since 1986. Crucially, the reform will challenge current thinking on the most effective tax structure for UK businesses and worldwide groups operating in the US. What will it mean for your business?
Headline reforms impacting UK businesses
Drop in corporate tax rate
Perhaps the biggest headline in the bill is the reduction in the US corporate tax rate from 35% to 21%. UK businesses with US affiliates will benefit from this rate drop.
This will create a large disparity in effective tax rates between C corporations and pass-through entities such as an LLC. Pass-through entities have always been a popular choice of vehicle for UK businesses operating in the US and the US tax reform measures may prompt a rethink on the preferred operating model, particularly given the changes to taxation on conversion discussed below.
Pass-through taxation has been one of the most contentious and complex elements of the debate surrounding the Republican tax bill. These businesses include partnerships, limited liability companies (LLCs) and S corporations. They are not subject to federal taxation the way traditional US corporations are. Instead, taxable income is passed through to the owner. Under the tax reform provisions, a deduction for qualifying business income of 20% will become available but with other reform measures also having an impact, this still results in an effective top tax rate of 29.5%. Coupled with the drop in corporate rates, this change may make pass-through entities less attractive vehicles going forward.
The bill also provides relief from the previously unfavourable tax consequences of a conversion from an S corporation to a C corporation by expanding the ability of former S corporations to make tax-free distributions on conversion. This could make a conversion favourable given the corporate tax rate drop. However, S corporations with international operations would have to weigh this relief against the loss of the special provision allowing them to defer indefinitely the one-time tax on repatriated earnings.
Limitation on interest deductions for tax purposes
The bill limits the deduction for net interest to 30% of adjusted taxable income for tax years beginning after 31 December 2017.
Other international provisions
The current worldwide system of taxing US corporations on the foreign earnings of their foreign subsidiaries is being replaced with a partial territorial system. This will provide a 100% dividends received deduction (DRD) to domestic corporations for foreign source dividends received from 10% or more owned foreign corporations, similar to our own participation exemption.
The bill also includes measure to discourage base erosion and profit shifting (BEPS) behaviour by imposing a tax based on deductible payments to related foreign parties. Referred to as the “Base Erosion Anti-Abuse Tax” (BEAT) the tax will be phased in at a rate of 5% for tax years beginning in 2018 rising to 12.5% for tax years beginning after 31 December 2025. These provisions could be particularly troubling for inbound companies with large deductible payments to foreign-related parties.
There are also new rules to deny a deduction for interest and royalties paid to related parties in connection with a hybrid transaction. Interest or royalties will not be deductible under these rules to the extent there is no corresponding income to the related party under the tax law of the country of which the related party is resident. The adoption of these rules is consistent with certain recommendations made by the OECD to combat BEPS. These provisions are likely to be significant for US based multinationals. Taxpayers should begin assessing the impact of these provisions immediately in order to mitigate the effects of these rules on their income.
Will the reform just affect tax? Quite simply no. We believe the reach will be much broader than that. For instance, tax reform will affect treasury considerations such as financial statement reporting and hedging transactions. Businesses may be more likely to move operations to the US and so may their customers. This could have far-reaching operational consequences beyond tax. It is crucial to plan and think about how this affects your supply chain and logistics operations. With change comes opportunity, speak to our people to fully understand how the US tax reform measures will impact your business – it could be a great time to re-evaluate your operating structure based on what you want to achieve.
For more information, please contact Nicola Pardy, Associate Director.