The Tax Cuts and Jobs Act (TCJA) was signed into law just days before the 2017 year-end holidays, after months of starts and stops and speculation as to what the tax package would eventually include. With the unexpected enactment, corporate treasurers spent their year-end weeding through the provisions, trying to make sense of what it would mean for their organisations, and how best to respond.
In early 2017, HSBC held a series of webinars for corporates to provide a top-level overview of the potential impact the changes might have on valuation, corporate finance strategy, and funding and risk management decisions. Here are five takeaways, which are key considerations for companies when evaluating the impact of the new law.
Change in the Corporate Tax Rate
The headline of US tax reform is the corporate tax rate, which dropped from 35 per cent to 21 per cent, for tax years beginning after 31 December 2017. This impacts any US corporation, whether domestic or foreign owned. Companies whose fiscal year does not correspond to the calendar year will have a blended rate for the taxable year that includes 1 January 2018.
Among the chief considerations tied directly to this change in the tax rate is how it impacts corporate valuation and the weighted average cost of capital (WACC), including both debt and equity. For most businesses, the lower tax rate is good news because it will result in higher after-tax cash flows. For companies who were well-optimised under the previous tax regime and those highly indebted, however, the boost in after-tax cash flows could be minimal. The lower tax rate will also likely increase the after-tax cost of debt, which could mean WACC will also go up.
Limit on Net Interest Expense Deductibility
The TCJA introduces a limitation on the deductibility of interest expense to 30 per cent of adjusted taxable income (ATI). For the tax years 2018-2021, ATI approximates earnings before interest, taxes, depreciation and amortisation (EBITDA), and then EBIT (earnings before interest and tax). Highly leveraged companies, or those that generate a majority of their earnings overseas but have financed the business out of the US, are most likely to be impacted by this limit in the near term. More companies will probably be affected when the measure changes to EBIT. The new taxable income classifications, global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII), provide some additional capacity under the calculation. To be within this constraint, companies will want to evaluate the use of domestic or foreign entities as borrowers, and opportunities to reconfigure interest expense and optimise interest income.
New Territorial Tax System
The new tax law is moving from worldwide taxation towards a territorial model. The highlight of this change is that foreign dividends received by certain US corporate shareholders will be excluded from US tax. As a result, we may not see the same level of overseas cash accumulation as we have in the past. This may also have implications for international treasury centers set up by US corporates. International companies will also need to think about how cash coming back into the US will impact the way they fund local subsidiaries.
Deemed Repatriation Provisions
Under the new tax law, accumulated foreign earnings from 1987 to 2017 are “deemed” to have been repatriated to the US. These funds are subject to a tax rate of 15.5 per cent on cash and cash equivalents and 8 per cent on illiquid investments regardless of whether they are distributed to the US or not. Taxes can be paid all at once in 2018, or companies can opt to make payments free of interest over the next eight years in increasingly stepped-up percentages.
Companies may want to use repatriated funds to return funds to shareholders, repay debt or make pension contributions, as well as for capital investment and acquisitions. Depending on the use of repatriated funds, there may be resulting risk management and debt profile adjustments to consider.
Going forward, with the move to a territorial tax system where foreign dividends received by a US company will be 100 per cent tax exempt, some corporates may reevaluate how they approach FX risk management as it relates to foreign earnings and subsidiary funding strategies.
Base Erosion Anti-Abuse Tax
The TCJA also introduces a Base Erosion Anti-Abuse Tax (BEAT), an alternate tax that companies may be liable for depending on whether their deductible payments to foreign affiliates exceed certain thresholds. Companies are currently awaiting clarifications from the IRS on a number of points regarding the calculation of BEAT. The new tax is a significant consideration for many multi-national companies because the interest on intercompany loans is included in the calculation of “BEAT-able payments.” As a result, non-US parent companies are exploring alternatives to raise external debt at the US subsidiary level rather than using intercompany loans, as many companies do currently.
Overall, many companies anticipate benefiting from the lower corporate tax rate. However, the introduction of a number of new provisions also makes the final impact less clear for many at this stage. In addition to consulting with your tax experts as to how the change in law impacts your funding and cash management strategies, you may learn more by watching our webinars – US Tax Reform: Potential Corporate Finance and Risk Management Implications, An International Perspective and US Tax Reform: Corporate Finance and Risk Management Implications.
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Nothing on these materials is intended by HSBC to be construed as tax advice. These materials are not intended to be used and cannot be used to avoid tax penalties under the US Internal Revenue Code. For all purposes you should obtain your own independent advice regarding the tax effects of the proposals outlined in these materials based on your particular circumstances. HSBC does not warrant or guarantee the tax results of these proposals.