Understanding the Impacts of the Tax Cuts and Jobs Act on Private Equity and M&A
April 2, 2018
I’ll do a little bit of background on some of the clients that we serve. We tend to focus on clients that are in the middle market. We have a good contingency of high net worth individuals and small businesses. We provide some specialty services to public companies. We also help individuals, and the client base that I serve primarily is private equity and corporate development departments of corporate clients.
A little bit of background on myself. I’ve been serving in tax here for a little over 15 years. I started my career off at PWC, and had stops at Deloitte, and Alvarez and Marsal. I joined Aprio about four years ago, specifically to focus on the M&A Tax, where I focus primarily on tax structuring, tax due diligence, and also assisting some of our clients on the sell side services that we provide.
Here in the room with me, I also have Robert Verzi. Robert is a partner in our international tax services, but I’ll let Robert to do his own introduction, because he can do a little more service to it than I can.
Robert Verzi: I’ve been with Aprio for 10 years now. I spent a lot of my career with a Big Four firm practicing primarily in international tax, transfer pricing, structuring, some M&A in the international space. I’m glad to be here with Cardell.
Cardell M: Alright, With that said, let’s set the agenda for today’s webinar. The first thing we’re going to do is set the stage and talk about our U.S. tax system as a whole, give you some background and data that we thought would be interesting and helpful to provide a little bit of a background on the tax reform.
Then we’ll transition to more so the tax reform highlights from a very high level, to talk about the areas where this tax reform is increasing revenue and some of the areas where you’ll see a reduction in taxes.
We’ll then walk through some of the impact of the reform and specific examples that we’ve laid out as a part of this presentation. Then in our summary and closing, we’ll provide some very high-level highlights and also do a Q&A session.
We will note that you do, as a participant, have the ability to offer or submit questions during this presentation, so that you don’t have to wait to the end in order to submit a question and we’ll do our best to respond and be as fluid as we can to the questions that are submitted during the course of the presentation.
With that said, what we’re going to do is really in a live session, we kind of did a pop quiz with respect to some information around really our current situation, but as of right now, what we’ll do is really just kind of walk through some of the slides. You’ll see the slide that kind of shows that the gap between the revenue and the spending that is currently occurring.
We have kind of a structural mismatch of revenues and expenses here with respect to the government. Tax policies is really driving that blue line and in terms of the revenue, we just wanted to provide a little bit of information around our background with respect to revenues, and tax revenues in particular.
Really, the real driving factor behind a lot of the tax policy around the Act was the fact that in the U.S., our corporate combined income tax rate is 39%, as you can see, and that level is much higher than the other members of the G7. That was really one of the areas where everyone felt for the U.S. to be more competitive, we have to lower that rate.
The other side of that equation, however, is there’s the statutory rate and then there’s effective tax rate. Our effective tax rate in the U.S. was really on par with the other countries, particularly from a corporate perspective. We just wanted to provide a little bit of contrast between what is the top tax rate versus what is the effective tax rate.
The key in terms of the business activity in the U.S. that you’ll see is there’s been a significant decline since 1982 in the number of corporations that are filing, and a steady rise in the number of pass-through entities that you see that are filing, because of the popularity of limited liability companies.
A lot of small businesses are being set up as flow-through entities. When you see that, that is driving the fact that the individuals pay income taxes, or account for a large percentage of the income taxes that’s collected. Here what we’ve attempted to do is just really provide a snap shot of the fact that a significant amount of individual income tax resonates and resides with the top levels of income. Keep in mind that everyone is really responsible for payroll taxes, because you can’t escape that and excise tax and a state tax, which is more so geared towards the top individuals in the top 1%.
Here on this slide, we’re just trying to show that really the top 1%, they account for 40% of all the individual income tax that is collected in the U.S. In terms of lowering the income tax rate, the one thing that we hear a lot is, “Who are the winners in this particular scenario in terms of individuals?”
It’s really the fact that the top individual rate was lowered from 39% to 37% and the gradual reductions amongst the other classes, so that a large percentage of that individual benefit resides in this group, but this group accounts for 38% of the individual income tax revenue that’s collected.
The question that we typically get is in terms of tax expenditures or in terms of the taxes that we see is, “What is this compared to some of the other programs, more popular programs that you see in terms of government spending?” As you’ll see for defense, Medicare and Social Security, the tax expenditures are in excess of each of those individual programs, and so we’re talking about a significant amount of dollars here in terms of tax expenditures.
To get a better glimpse of the tax expenditures by individuals or corporate, here’s this breakdown for the individual income tax expenditures or exclusions, and what those particular items are. Really, you’ll see a lion’s share is the exclusion for the employer sponsored health insurance, exclusion for contributions to retirement savings, some of the capital gains, the state and local tax deduction and kind of working your way down through the analysis there.
The share of these tax expenditures, as you’ll see by this slide, is really the highest quintile of individual taxpayers or really for the individuals receiving about half of that benefit. The large part of that benefit being capital gains, treatment, charitable deductions and state and local tax deductions, which is going to be changed by this law, because those state and local taxes, on an individual level, are going to be reduced to 10%. Here on this slide, we just lay out the six most popular individual tax expenditures, which is really consistent with the graph that we previously covered.
In terms of tax reform, it was more an opportunity to do away with some of the tax breaks to lower the marginal tax rates. The idea is in turn it would reduce the deficit, because if we are a more competitive country, there would be more GDP and economic activity that was here in the U.S. In turn, this would fuel economic growth and reduce the complexity and the burden of our tax compliance process. That was the goal, but I don’t know if that’s the result. That was really just kind of some of the ideas that were contemplated.
With that said, understanding some of the tax expenditures, how much they cost and where they’re really focused is important. What we wanted to do is on a high level, talk about the Tax Cuts and Jobs Act. The purpose of this slide is to, as best we can, explain how quickly this Bill was introduced and signed into law.
From the day of introduction to the House to the actual President signing, it’s roughly 57 days. As you can tell by this chart, it went through a significant number of steps in a very short period of time, which has led to a lot of areas that need further explanation, to say the least. This is because Congress, while they were able to, in a very advanced way, pass this legislation, the IRS has not had the ability to keep up with the questions and the filing obligations, and even just explaining some of the provisions, which need a much better explanation.
On the next slide, basically we’re just going to talk about the highlights in terms of the Tax Reform Act. We’re going to talk about the individuals, the corporations, internationals and pass-through. The thing this slide does an excellent job of showing from a very high level on the left hand side, the areas in which the government plans to increase taxes over the next 10 years, and how much that is going to cost, or the amount of revenue that is expected to bring in, and contrasting that with the reduction in taxes, which are on the right hand side and some of the provisions there.
Just starting from the top left hand side of the column, you’ll see that limiting the interest deduction and basically the provision that now limits interest deductions to 30% of EBITDA. That is going to increase the taxes collected by $253 Billion over the next 10 years.
There’s an expectation that the limitation on the use of NOLs (net operating losses) is going to increase the amount of taxes collected, $200 Billion over the next 10 years. There’s a new provision that disallows losses in excess of half a million dollars. That’s expected to really increase tax revenue by $150 Billion over the next 10 years.
Contrast that with some of the newer provisions. The more popular one is the corporate income tax rates falling from 39% to highest, from 39% to 29%. Instituting that provision is going to reduce taxes, corporate taxes by roughly $1.3 Trillion over the next 10 years.
Incorporating a 20% partnership deduction that’s going to reduce taxes over $400 Billion over the next 10 years, and incorporating the expensing provisions, that’s going to cost $86 Billion. We just wanted to provide this slide as a chart in terms of the amount that were provided by the Joint Committee of Taxation, and an estimate of how much these corporate business tax provisions would cost, and some of the savings that would be garnered by taxpayers.
Moving on to the higher level, explaining what some of these actual visions are. Again, top left corner, you’ll see the corporate tax rates go from 35% to 21%. In terms of net operating losses, for tax years beginning after 2007, companies are going to be limited in terms of their NOLs to offset only a maximum of 28% of its company taxable income, as opposed to 100%, which was the prior rule.
Businesses that are really capital-intensive, and any businesses that have capital expenditures, are going to be able to expense those in the year of acquisition until 2022, and then there’s going to be a phasing out after that period. We also briefly covered the fact that for EBITDA, the interest deduction is going to be limited to an adjusted taxable income. That’s really EBITDA and after 2022, that’s more EBIT.
One of the things that we wanted to throw out in terms of the private equity: There’s now a carried interest requirement that there must be a three-year minimum of terms of holding an asset for service providers to qualify for long-term capital gains treatment. I just wanted to throw that out there to this audience. The Joint Committee of Taxation is projecting that this provision is going to raise about $1 Billion over a 10-year period. We mentioned the disallow pass-through losses in excess of half a million for a year on the individual side.
One of the casualties of this tax law was the Domestic Product Activity Deduction. Some of you might have known this as DPAD. DPAD has basically been repealed as a part of this new tax law, and then there is a reduction for 20% on the deduction of a pass-through income. There’s a Definition Qualified Business Income from a pass-through perspective. This effectively reduces the rate on pass-through income for eligible taxpayers to roughly 29.6%. Those are really just some of the high level business provisions that were applied.
We also wanted to briefly touch on the individual tax. On the individual side, you’ll see that in terms of increases in taxation, there was a repeal of the personal exemptions. There’s a repeal on the itemized deductions. In terms of some of the areas where the benefits to certain taxpayers where there’s going to be tax cuts, or the restructuring and the lowering of the tax brackets, there’s an increase in the standard tax deduction. The increase to the alternative minimum tax phase out, and some of the other areas in that individual should benefit.
Last, like I said, is the mortgage interest deduction for mortgage debt. It’s now a cap of $750,000 for that deduction on the principal. The other cap that was instituted was $10,000 deduction on state and local taxes. That is going to hit people, particularly if you are in high tax states.
On the international side, I probably would rather just walk through some of the high level summary of this side just to touch upon this before taking a deeper dive into some of these provisions.
Robert Verzi: The main increases are the one-time repatriation tax for companies that have, or individuals that have CFCs, Controlled Foreign Corporations offshore. There’s a mandatory repatriation of all those deferred earnings. There’s a BEAT, or Base Erosion Activity Tax, which basically is the disallowance, or the effective disallowance of certain expenditures made to offshore related parties.
GILTI, or the Global Intangible Low Tax Income, is probably the most controversial provision. It’s basically ending deferral of foreign earnings of U.S. controlled foreign corporations. There are a few other reductions and tax on the CFC level and certain sourcing rules that have been changed.
Participation exemption means simply that if you’re a U.S. corporation going forward in 2018 and later, if you pay dividends from your foreign subsidiaries, those dividends are no longer taxable in the U.S. and I’ll caveat that. It’s only if you’re a U.S. corporation. If you’re an individual partnership, that’s for the extent that you receive dividends from your foreign controlled companies. You would basically still pay individual income tax on those dividends.
FDII, Foreign Derived Intangible Income: this is the carrot in the provision that was designed to encourage people to leave the intangible intellectual property they developed in the U.S. and leave it on shore. As a result of leaving it on shore, you get a reduced tax rate on those earnings.
Oil-related taxes, I don’t do much work in that area, but there’s some additional taxes cuts related to that. Domestic Loss Recapture, if you’re in a foreign tax credit position going forward, then you’ll be able to benefit from this provision.
Cardell M: With that said, we’ll transition now to some of the areas where the impact of the tax cuts and jobs is being evaluated. The reason that we put this slide out is as a result of the corporate tax rate falling to 21%, the main question we start receiving as tax advisors is, “Should we convert our pass-through entity to a corporation? If the affected tax rate for individuals is going to be as high as 37% and the corporate tax rate is only 21%, wouldn’t it be more advantageous for someone to convert a pass-through entity to a corporate entity?”
What we’ve done is we’ve attempted to highlight on the left side, showing the prior law. Starting with a business income of $100, noting that if you were a corporation, with the corporation being at a 35% tax rate, that essentially the effective tax rate for that individual would come out to be about 48%. Under the new Tax Act, doing the same analysis using the 21% as the tax effective rate, or as the tax rate, that effective tax rate for the individual on the corporate side is now 36.8%. Well, even though that is the case, it isn’t lower.
We’ll show you on the right-hand side where it says, as of The Act, Pass-Throughs have a tax rate with the implementation of this law of 29.6%, assuming that you qualify for the 20% pass-through deduction.
Just on a side-by-side analysis, there might be situations when it may be advantageous to convert to a C Corp, but outside of those special situations, I don’t think we’ve come across a general consensus that everyone needs to convert from a pass-through to a corporation because of this reduction in corporate tax rate.
With that said, we wanted to highlight some of the business provisions in a little more detail. On the left hand side, we talk about the fact that there’s a reduction in the corporate tax rate. I think that’s probably the biggest impact that people are seeing.
In terms of private equity, I wanted to note that, to the extent that you have a net operating loss and you anticipate utilizing that net operating loss in the tax years of 2018 and going forward, you’re just going to have to keep in mind that there may be situations whereby you have tax linkage, and you’re paying taxes even though you have NOLs, but those NOLs could be limited.
The other aspect that we wanted to mention is in this area is, regarding the limitations on NOLs, they only apply to NOLs that are 2018 and going forward. If you have a portfolio company that is currently using prior NOLs, this limitation of the 80% should not apply to that bucket of NOLs, but it should only apply to the bucket of NOLs going forward. We highlight that to say that , one, you need to bifurcate your NOLs between pre-2018, post-2018 going forward, but also understand which NOLs you’re utilizing and understand how that will impact any analysis that you’re doing.
In terms of the Capital Expenditures on the left lower corner, the Capital Expenditures is definitely something that you want to take advantage of. The good thing about this particular provision is it’s one of those provisions that starts in September of 2017. It applies for all assets that were acquired after September 22 of 2017 — it seems very arbitrary — but the good part of that is for those acquisitions in the later part of the year, you’ll be able to deduct those 100% on your 2017 tax returns.
The other provision that we wanted to make sure we mention to this group, and that’s going to have a lot of interest, particularly in private equity companies, is the fact that in this business, there’s going to be an Interest Expense limitation. We tend to want to talk about this on a level where you have a company that is acquired and the acquisition is done on a multiple that is not EBITDA.
The one entity that really comes, or the sector that comes to mind a lot of times is technology. We’ve seen it to where some of our technology targets are acquired as a function of revenue, not necessarily as a function of earnings. If that is the case, you’re going to have to be very mindful in the fact that for some of these companies, the interest expense associated with acquiring those companies may be limited because they are not producing a significant EBITDA and they’re in a growth mode.
That interest expense is something that you want to keep in mind as you’re doing your modeling, because that could potentially impact the value of the company, and also have an impact on the cashflow of that company as well. The next question that we often get is, “If there is a limit to the interest expense, what happens when the company is acquired?”
Assuming that there had been an interest expense that has been limited for a particular entity and now you’re selling that company, and this is one of those areas where the IRS is really going to have to speak to providing some guidance. That interest expense is indicated that that’s going to be considered a cash attribute. Unfortunately, whenever you have a tax attribute in the context of a company that is being acquired, it could be limited under Section 382. The IRS is going to have to issue regulations on exactly what the limited interest expense implications are going to be in the context of a subsequent acquisition.
The next item that we often get in terms of private equity is in terms of this interest expense limitation, is it on a per company basis, or does it expand the entire portfolio that we’re looking at? Most companies are doing an acquisition, and then each company represents a legal entity, and so until we get more clarity on that. Right now we’re applying these at each individual taxpayer level, but there could be rules where this particular limitation is applied on an affiliated basis, but the IRS is really going to have to come out with some regulations around that.
Here on this slide, slide 35, we are taking a look in comparison for the C Corporation, the graduated rate versus the new 21% flat tax that’s going to be applicable for years going forward. Here, what we’re doing is we’re walking through a net operating loss example.
In this example, we have a corporation that has a $2 Million accumulative NOLs prior to 2007. It generates $15 Million in 2018. 2018 taxable income is forecasted to be $15 million, and so for this particular entity, they can utilize the entire $2 Million to offset the 2018 taxable income.
In that example, we’re just trying to compare the fact that you have NOLs that are post 2018 and then the ones that are pre. The thing that you want to keep in mind is you can carry NOLs back. You can utilize those up to your limitations, but you can carry them back for two years and then forward for 20.
Again, in the interest of time and making sure that we cover both the domestic and the foreign, I’m going to skip through some of these examples in order to make sure that we have the opportunity to talk about the federal tax and the international provisions as well. Here on slide 48 is we’re simply comparing the new tax rates for individuals.
Same with the married filing jointly, head of household, so you can see side by side the old rates versus the new, and where some of the limitations are kicking in. We’ll make sure that we have this presentation and the slides available after the webinar so you can have it as a record. The area that I wanted to make sure to get to on the international, and so I’ll turn it over to Robert to go through some of the international provisions.
Robert Verzi: The international provisions probably were the most thought-provoking provisions in the Tax Reform Act, primarily on the left side. We have the GILTI, which basically are going to end deferral of much of the income that’s earned by foreign corporations offshore. Basically what that is, it’s another type of Subpart F income, which is basically anti-deferral rules, which will, like I said, allow or require foreign companies that are owned by U.S. persons or U.S. corporations to repatriate that income back to the U.S. There’s some planning ideas that we’ve come up with where pass-through entities that we’ll discuss a little bit later, which may mitigate some of the negative aspects of the GILTI provision.
If you look at what Congress is trying to accomplish with the GILTI provisions, is for many years there were concerns that U.S. multinational companies were stock piling large amounts of cash offshore in an effort not to bring the cash back and pay tax at the 35% corporate tax rate. What these provisions are designed to combat, is if companies in the U.S. are still attempting to keep earnings offshore, then this GILTI provision will require those earnings to be deemed repatriated to the U.S. regardless of whether the cash is actually brought back.
You’ve heard that the international aspects of the law are generating what’s called the territorial system. I don’t really view it as a true territorial system. The main reason is that it’s a territorial system if you’re a U.S. corporation, but if you’re not a U.S. corporation, then maybe not so much.
One of the provisions that is linked up with the territorial system is this transition tax. Again, what the territorial system is basically saying is that if you are a U.S. corporation and after 2017, you earn profits offshore, you can bring those profits back in the form of a dividend without any additional U.S. tax. That only applies of you’re a corporation.
If you’re an individual, this territorial tax doesn’t really help you because when you pay dividends from your controlled foreign corporation offshore, those dividends are still going to be taxed to the individual. That would include partnerships and S Corps. Those dividends would pass through those entities and the individual shareholders would be subject to tax. More to get all the former earnings earned by these controlled foreign corporations taxed, again, I’ll pick on Apple again.
Apple had billions of dollars offshore, and so in order to get this territorial system in place whereby future dividends would no longer be subject to tax, Congress wanted to clear out all the previous deferred income of U.S. based multinationals. What’s known as the transition tax requires that U.S. shareholders of certain controlled foreign corporation have to include in income the deferred earnings of those foreign companies. We’ll go through an example a little bit later about how that’s going to work. There is a rate reduction on that transition taxable income, which is somewhat beneficial. It still requires individuals and corporations to include all those deferred earnings that we’ve been piling offshore trying to defer U.S. tax.
Their BEAT provisions are basically an anti-avoidance rule whereby if you make a lot of payments to offshore related parties, you’re a U.S. company. Those amounts may not be giving you any tax benefit in the future. A foreign source dividend, as I mentioned, is basically an exclusion of certain dividends in the future for earnings that have been generated post 2017.
Getting a little bit further into detail about the international provisions. In some aspects, the Tax Act has caused simplification. A lot of individuals will no longer be required to file a Schedule A showing itemized deductions, or even standard deduction, and there’s a few other provisions. From an international perspective, there was really not much simplification. There’s a few things that have changed that will make tracking your international business a little bit easier going forward, but as far as simplification, I really don’t view this as a simplifying Tax Act.
With the movement to the territorial system whereby dividends received by U.S. corporations would be excluded from tax starting in 2018, and again, to get to the point where future earnings are not subject to tax, we had to clean out all of the previously deferred and un-repatriated earnings, and that’s this one-time transition tax, which will require those earnings to be included in income. I talked a little about the GILTI provisions, we have a little example later on that, and the BEAT, or Base Erosion Anti-Abuse provision.
There are some positive things in the Tax Act. One is there’s an incentive for U.S. persons to keep their intangible income onshore, instead of trying to migrate it, as a lot of U.S. multinationals did. In the future, moving certain intangible assets offshore, and deferring U.S. tax — the FDII provisions — were designed to reward U.S. persons for leaving intangible income onshore, and as a reward, again, if you’re a corporation, not an individual, then you could basically be taxed at a significantly lower rate on your foreign income.
Talk about the end of deferral. This is basically the transition tax, whereby if you have un-repatriated earnings as of December 31, 2017, those earnings are going to be coming back in the form of a deemed dividend under section 965. The transition tax is going to apply to controlled foreign corporations, which basically are defined as foreign entities that are controlled by 10% or more U.S. shareholders. For example, if you have three U.S. shareholders at around 25% each and the remaining interest in the foreign company is owned 25% by a foreign person, 75% is controlled by 10% or more U.S. shareholders. In that case, you would have a controlled foreign corporation.
The distribution, or deemed distribution, back to the U.S. shareholders of that controlled foreign corporation will be taxed at a preferential rate. Basically, if the earnings relate to cash or cash equivalence, which includes receivables, it would be taxed at a 15.5% rate if you’re a corporation.
For non-cash earnings that were left offshore through 2017, you would be taxed at an 8% rate. If you look down on the slide, if you’re an individual, then the rates are slightly different, because we’re basically taxing this deemed dividend at the corporate rate less a deduction and for the individual rates. The individual rate is 39.6%. They come out to a higher effective rate of 17.5%, or 9.05% on the non-cash.
On the basis of advantage, or at least the benefit (if you want to call it that), is that you don’t have to pay all of tax on all these earnings in one year. You can elect to pay those over an eight-year period and the payments on the tax are actually backloaded. Years one through five, you pay 8% of the tax. In year six, you pay 15%, year seven you pay 20% and year eight you pay 25%. You’re not going to have to come up with the whole amount of tax and pay it under your 2017 return.
By the way, this does apply to your calendar year, your 2017 return. We’re having some issues now with partnerships that have investments in a foreign corporation that are widely held by several shareholders, maybe a pension fund, maybe private equity firms. This transition income that’s going to have to be subject to tax, taxes through all the way to either a corporation or individual. We have different rules for corporations and individuals. Lo and behold, today is the day before the partnership filing due date.
IRS issued an information release, finally telling us how we should report this transition tax income on the Schedule K-1 for partnerships and other past due entities. We’re scrambling a bit to make sure those reporting requirements are met correctly, so if any of you are having to file a partnership return tomorrow, then there’s a set of rules that you have to familiarize yourself with to make sure your K-1s are reported properly.
The one-time tax, again, is due by the due date of final return without extension, so if you’re a corporation or an individual, the two persons that are required to ultimately pay this tax, you’re going to have to make the payment by April 15 this year. I think there might be a lot of work to do if you’ve invested in yourselves or if your portfolio companies have invested in offshore companies.
As far as how you compute the one-time tax, it’s a multi-step process, which you basically have to go back to 1987 if your controlled foreign corporation has been in existence that long, and compute earnings and profits. What are earnings and profits? It’s a terminology and tax vernacular, which is basically a proxy for retained earnings. In order to compute earnings and profits, you first look at the local gap financial statements of your foreign CFC, and you convert that to U.S. gap.
We’re not done yet. We have to convert that to U.S. tax, and then once we figure out what the U.S. tax income would be, if you restate that foreign company’s earnings, then we have one further adjustment, and there’s certain adjustments to get from tax to earnings and profits. Basically, those deal with certain depreciation adjustments and amounts of taxes that are accrued and not paid, etc.
Once we have our earnings and profits, probably the more difficult part of this is determining what your foreign tax credit might be, related to this income. Under the transition tax, individuals and corporations may be able to claim a credit against the transition tax where foreign taxes paid can buy their controlled foreign corporations on the E&P that was computed in step one.
In order to claim a credit, the IRS has pretty strict rules in determining what you have to document. You have to be able to prove that this tax was actually paid to the foreign government. Going back maybe two or three years, that might not be such a hard thing to do, but going back 20 years could be a fairly significant endeavor. I’ll give you a notice that that could be a potential problem.
Aggregation: If you have a CFC that has income and you have one that has an aggregate loss, then you’d be able to offset the losses with the income, so you basically net all of your profitable and your unprofitable foreign subs to get to a net inclusion amount. Once we determine what the net amount is, we have to determine how much of the net earnings relate to cash and noncash. What we do is we look at the balance sheet of all of our CFCs, determine how much cash was on the balance sheet (and again, cash includes receivables net of payable), and once we do that, we determine how much of the retained earnings or the E&P relates to cash. That’s taxed at the higher 15.5% rate. Everything else is considered to be noncash, which will be taxed at the 8% rate.
We’re not done yet. We’ve have to make certain elections. For example, if you have a lot of these foreign tax credits, which are in step two, and if your corporation has not been operating well since, you may want to elect not to use your net operating loss to offset this transition taxable income. You may be able to use credit subs at the tax, instead of using your NOLs, and you’d want your NOLs to carry forward, but you have to make an election to do that.
If you don’t make the election, then the Net Operating Losses are used first, and then if you later on realize that you could have sheltered most of this transition taxable income with credit and you didn’t make the election, guess what? You’ve lost the benefit of these credits, which will probably never be good to use in the future. That’s a very important election.
Finally, the tax computation and documentation. Again, we just found out the form that the IRS wants us to submit the calculation of the transition tax, and there’s a specific form. I was a little bit surprised at this. They want a specific form attached to the return, and they want a separate tax payment made for this transition tax.
You’re going to have to write two checks this year if you’re a corporation or individual: one for your normal tax liability, and one for the transition tax liability. Keep that in mind when you are filing your return. Also keep in mind that on April 15, when individual returns are due and corporate returns are due prior to the availability of the extension, this transition tax has to be paid at that point, so we have about a month for everyone to compute what their transition tax is and get those gets those checks to the IRS.
This is a very simplified example of what the transition tax is. Again, in this example, we have accumulative earnings in our foreign CFC of $1,000. We’re assuming all of this is cash and we get to the 55.71% deduction of the income, and that’s how you get to your 15.5% rate. You don’t actually get taxed at 15.5%. You’re still paying tax at your normal rate, whether you’re a corporation or individual, but you get this deduction that’s allowed in the statute to reduce the income, so you will get to an effective rate of 15.5%. Like I said, if you’re an individual, that rate where it says tax at 35%, if you’re an individual, that would be taxed at 39.6%, assuming you’re in the top marginal bracket.
The GILTI is probably the most controversial provision in the law. There’s a carrot and a stick in the new law. The carrot I alluded to earlier, which was the Foreign Derived Intangible Income, is a benefit for leaving your IP onshore and getting a lower tax rate.
GILTI is the stick. The IRS basically says if you still leave your intangible profits offshore, we’re going to deem those to be taxed in the U.S. whether you repatriate the cash or not. For the GILTI provisions, I’ll take a simple example. Say you have a U.K. subsidiary that made $1 Million in 2018. By the way, these provisions are effective 2018, so they did have an impact on your quarterly estimates if you’re a corporation or individual, so keep that in mind.
To go back to my example. $1 Million profit. U.K. tax rate’s about 20%, so you’re left with $800,000 of profit. Guess what? If you’re a corporation, that $800,000 plus the $200,000 you paid in taxes, the whole million dollars gets included in your taxable income on your federal return, whether you repatriate or not. There’s a foreign tax credit that’s allowed against that GILTI income, but guess what? It’s a haircut. You can only get 80% of the $200,000 to claim as an offset against your U.S. tax on that GILTI income.
As you can see, under the GILTI rules, for periods going through 2018 to 2025, you’re going to get an effective rate of 10.5% on your GILTI income and after that, the deduction for GILTI income goes down, so your effective rate is 13.125.
If you’re an individual, the news is even worse: The GILTI deduction, because you’re getting a deduction against your GILTI income for 37.5% in the transition year, and 50% in 2018 through 2025. If you’re an individual, you don’t get those GILTI deductions. In my example, you would have, from an individual perspective, full taxation on the $800,000 of income at your normal rate, unless you make an election under Section 962, which allows and individual to be treated as a corporation for purposes of determining its U.S. income on Subpart F income, which GILTI is.
That’s something another possible election that individuals would have to make in order to claim foreign tax credit against its GILTI income. Yet another decision that we’d have to make for our individual clients to see whether it makes sense to make this election or not.
The reason why you may not want to make this election, is because basically you’re going to get taxed again when you pull the money out from your CFC. For example, if you pay GILTI income tax and you make this election, when you pay the cash out, you’re going to actually have to pay tax at 23.8% on the cash. It’ll be double taxation if you make this election, so we have to keep that in mind.
If you pay a high enough effective rate in the foreign country, you probably want to make this election if you’re not going to be pulling the cash out any time soon. If you pay a low effective rate in the foreign country, you may not want to make this election. You might want to just pay the tax once and not have to pay it again when you pull the cash out.
I neglected to mention that, when I went over the last slide, you get to reduce your GILTI income by 10% of the adjusted tax basis of your tangible assets that are offshore in that company. There’s sort of a threshold that you have to go over in order to have GILTI income.
Say you’re a technology company and you don’t have a significant amount of fixed assets. In that case, probably most of your income’s going to be GILTI. Say you’re a contract manufacturer, then as a CFC, you’d have a lot of physical equipment, a lot of PP&E and you don’t have a whole lot of profit, because you’re a contract manufacturer and getting like a cost plus income from your parents. In that case, maybe you don’t have as high amount of GILTI, because you get this 10% times your tax basis as a reduction of your GILTI income. That’s something else, another calculation we’re going to have to do. Again, GILTI starts in 2018. If you have subsidiaries that have significant earnings, this may impact your first quarter estimate that’s due April 15, so please keep that in mind.
As far as your intangibles are offshore currently, or intangibles that are still onshore and you’re thinking about migrating those to be offshore and at a lower tax jurisdiction, the foreign derived intangible income provision (the carrot I was alluding to) comes into effect. If you’re a good taxpayer and you leave your intangible property, intellectual property and income onshore, Congress is going to let that income be subject to a much lower tax rate at 13.125%, versus the 21% of the normal corporate tax rate. That rate goes through 2025 and starting in 2016, that rate would go up to 16.406%.
That’s something to keep in mind: if you’re thinking about migrating intangible profit offshore, that income probably will come back as GILTI income and be subject to taxed at the 10.5% rate with only the 80% credit. Whereas if you leave it onshore, you don’t go through the hassle and the cost of trying to get your IP outside the U.S., which is a very time consuming and sometimes not a very tax friendly endeavor. If you leave it onshore, then you’re going to get a significantly lower rate.
As far as the foreign derived intangible income, how that is derived we’re not exactly sure yet. We have no guidance about how that is derived, but it basically comes from the sales of property, or for example, licenses of software or services provided for foreign use to a non-U.S. person. If you’re an export-heavy company, then this could have a significant impact on your ultimate tax rate. Again, individuals were not allowed to participate in this, because the deduction that allows you to achieve this reduced corporate rate doesn’t apply to individual taxpayers.
Now, I mentioned the BEAT, or the Base Erosion and Anti-Abuse Tax. That was really designed to punish companies that had gone through inversions to move their headquarters and their tax residence offshore. A lot of times when inversions were accomplished, and they have sort of slowed down because there are new rules that really put a kibosh on doing inversions. The companies that did do it typically leveraged up their U.S. subsidiary that was left behind and tried to reduce the tax base in the U.S. by putting a lot of debt in that company and a lot of interest expense.
If you think about the U.S. company, the U.S. Congress just lowered rates to 21%, but they really don’t want their base being eroded by a lot of deductible payments that are being made to non-U.S. related persons.
These BEAT provisions are basically designed to make companies who are creating a lot of these deductible amounts to pay at least a minimum tax. The good news is, this only applies if your U.S. businesses that are foreign owned have gross receipts for the three preceding years of more than $500 Million and your base erosion percentage is 3%.
Base erosion percentage basically is, if you look at your deductible payments to foreign persons, for example interests and royalties, and those are 3% or more of your total deductions on your return, and if you have the $500 Million gross EBITDA hold in it, then you would be under these provisions.
If you’re under these provisions, basically what happens is you look at your taxable income before the deduction of these base erosion payments, and you’re in 2018 it’s a 5% rate, and going forward after 2018 it’s a 10% rate. You would re-compute your tax without these deductible amounts, compare that to your normal tax rate and if your BEAT rate is higher than your effective normal rate, then you pay the higher of the two.
It’s sort of like another alternative minimum tax that has been introduced. Corporate Alternative Minimum Tax was repealed, but now we have two different alternative minimum taxes. We have the NOL disallowance, and now we have these base erosion payment disallowance, so there’s a few more tax calculations other than the normal corporate tax calculation you’re going to have to go through.
I mentioned the interest deduction limitation. Cardell’s already covered that, and there’s one kind of sleeper provision out there. If you’re a U.S. company that has a 25% or more foreign owner, then generally you have to disclose transactions with that foreign owner on a Form 5462.
Before the passage of the Act, it was a $10,000 penalty for not properly disclosing your related party payments. That now has been increased to $25,000 per year, so it’s gone up significantly. If you have situations where you’re a U.S. company that’s controlled by a foreign person, or even just have a 25% shareholder, make sure you get this filing on the 1120 of the U.S. Corporations to avoid these penalties.
That’s all I have today, and I’m going to turn it back over to Cardell.
Cardell M: Well, we encourage anyone who might have any questions right now to submit those questions. We’ll give a moment to see if any questions come through. If not, we’ll wrap up here and we appreciate everyone’s time in joining us today. Hopefully, you’ve been able to garner some information from this presentation that’ll be beneficial to you. Make sure you go to our website to download the presentation and have access to the webinar at a future date.
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