The new US tax reform is highly complex and has far-reaching impacts for multinationals, specifically those that operate vital business functions outside of the country.
Along with the widely publicized reduced rate of 21%, the tax reform has been designed to incentivize US companies to move functions back to home soil, rather than capitalizing on the benefits of offshore locations.
“The reform includes provisions for the use of intangibles outside the US that are producing income,” said Anthony Bellew, Director at Deloitte Chicago, during a recent public webinar. “It is designed to keep functions, assets, and risks, and the management of those, within the US in order to drive up the tax take, which the administration hopes will help pay for the reduction in the general rate,”
Snapshot of Main Changes
Alongside a reduced regular federal tax rate of 21% down from 35%, the US tax reform introduced three international tax provisions:
- Foreign Derived Intangible Income (FDII): This gives a preferential tax rate of 13.125% for companies that manage their foreign operations from inside the US, rather than having the foreign HQ retain that profit. If companies retain that management and control within the US, this preferential rate will apply until 2025, when it goes up to 16.4%.
- Global Intangible Low Tax Income (GILTI): Essentially, this is a new general minimum tax of 10.5% on foreign earnings. Unless your foreign corporation tax is greater than 13.125%, you will have to pay this right away, before making any distributions or dividends.
- Base Erosion Anti Abuse Tax (BEAT): Before this came into play, companies got a deduction for all payments related to the costs of doing business. This change reduces the deduction on payments that are made outside the US, but does not apply to third-party payments, just related-party payments (i.e. companies in the same group). The idea is to incentivize companies not to shift functions outside of the US, such as shared services.
What Does This Mean for Operations Outside the US?
“With the introduction of these provisions, companies need to look more closely at how an outsourcing model will fit within the overall group structure, and what it means for the effective tax rate for the group,” said Bellew.
Looking at BEAT, specifically, the most important aspect is that the provision only applies to related-party payments, NOT third-parties. For example, if a U.S. corporation is paying another company within the same group to perform certain functions, then the tax on those payments will now be higher. On the other hand, if this is outsourced to a third-party provider, BEAT has no impact.
“To avoid the additional costs of BEAT, a company might seek to outsource services rather than insource services, because the tax deduction may be lower,” said Bellew. “Even so, it’s hard to know if this will prompt companies to return shared services to US soil, because the laws are still being bedded down.”
There are many ripple effects between the BEAT provision, the FDII, and the GILTI provision that didn’t exist before. For this reason, the outsourcing and provision of services can no longer be left as isolated projects, as was possible before to some extent – re-enforcing the government’s goal to bring back functions to the US.
The changes actually position the U.S. as a location that can reasonably be considered for operations, and creates an opportunity to re-centralize functions on home soil at a potentially lower cost.
“It can offer the potential to create a structure whereby the resulting savings don’t just fall to the individual entities in different countries, but where some of those savings are centralized into a lower-tax jurisdiction and can fall to the bottom line,” said Bellew. “Of course, if companies already have something set up then there is the cost of dismantling it to consider, but if they were subject to BEAT on those operations, then there may be other ways to limit the impact on the overall US tax return.”
The complexities of the US tax reform are clear, even in this brief explanation, so here’s what you should know as a US company with foreign operations.
- To qualify for the preferential tax rate under the FDII provision, the governance and management of contracts – which includes operating procedures, employee roles, paper trail, and overall decision-making – should be moved away from the foreign operation and into the US HQ. The main challenge here is being able to demonstrate to authorities that this is in fact being done, but the potential savings are worth investigating.
- There are ripple effects between the provisions, so companies should be more cognizant of the impacts that one operational change might have on its overall taxation.
- The reform positions the US as a good location for the principal company or headquarters, which makes it attractive to have a centralized outsourcing management division on US soil.
- BEAT does not apply to third-party payments, so outsourcing to services vendors may become preferable to insourcing functions.
Subject to Change
While these changes have some short-term and immediate impacts that should be considered, not everything is set in stone, according to Bellew.
“There is still a lot of “mist” out there regarding some of the more detailed regulations, as many interpretations still have to be published by the IRS,” he said. “Provisions like the FDII may well get challenged by the World Trade Organization as an export subsidy, but that may take years to go through. There is also political uncertainty over a potential administration change at the end of this term.”
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