11 minute read 16 May 2018

Why US tax reform could be a game changer for your business

Businesses across the globe should take the opportunity to plan now for their future.

After many years of discussions, alternative plans and varying proposals, the long-desired wish for a sweeping tax reform has finally been realized. Now everyone needs to shift their thinking from “what if?” to “what now?”

The US Government predicts its tax system overhaul will lead to greater economic growth. The top US corporate tax rate is now 21% compared to 35% previously, which makes it lower than the average G20 corporate income tax rate for the first time in more than two decades.

A new EY analysis estimates the US economy will grow 1.2% faster per year as a result of the tax measure through 2022 before settling down to “modest” increase in annual growth as some provisions in the new law expire and the economy fully adjusts to the changes.

But while these new tax policies will boost cash flow and profit in the short term for many enterprises, it remains to be seen whether the changes themselves will make businesses more competitive or successful in the long term. Companies will need to take the initiative to determine the best business strategy to fully leverage the economic benefits of the US Tax Cuts and Jobs Act (TCJA).

These reforms will have a far wider impact beyond tax departments, touching every part of the business: capital spending, the supply chain operations, mergers and acquisitions, debt/equity structures, financial reporting and employee benefits and executive compensation. Business leaders who understand this broad impact can adopt a new perspective, shift strategies and better navigate the business landscape.

“This is a landmark moment for US businesses,” says EY Global Chairman and Chief Executive Officer Mark A. Weinberger. “CEOs are going to have to evaluate what the new tax law means for their company, how to put it into effect and where the best opportunities are.”

Territorial taxation

With the TCJA, signed into law by President Donald Trump on 22 December 2017, the US has moved from a worldwide taxation system for businesses to a territorial system — a policy that the other G7 member countries already have in place.

Under the prior system, the US Government could tax the worldwide income of US-based multinational enterprises. However, US businesses could postpone those taxes indefinitely as long as those earnings were held overseas and weren’t repatriated.

Many US companies opted to do so, keeping almost US$2.5 trillion in cash overseas in 2015, according to a 2016 research report from Capital Economics.

In a 2017 summary of its tax proposal, the US House of Representatives’ Ways and Means Committee acknowledged that the old policy had drawbacks for US businesses and the overall economy. Firstly, US-based multinational enterprises had to pay an additional level of tax than their competitors in other jurisdictions which distorted the playing field. Secondly, it created a “lock-out effect” through which US companies kept the earnings from their foreign subsidiaries abroad.

The US Government believes the new territorial tax system for businesses will eliminate these disadvantages. A provision in the TCJA allows 100% of the foreign source portion of dividends paid by certain foreign businesses to a US corporate shareholder to be exempt from US taxation. This provision means US-based multinational enterprises will no longer have to pay additional US taxes on future foreign profits and can repatriate that cash and invest it at home.

As for post-1986 tax-deferred foreign earnings, US businesses must pay a one-time transition tax of 15.5% for liquid assets (cash and cash equivalents) and 8% for illiquid assets (property, plants and equipment). But these are much more favorable terms compared with the 35% tax rate that US businesses previously faced when repatriating cash from abroad.

Taking the long view

Much attention has been placed so far on what many businesses are doing with the extra cash generated by US tax reform, such as raising dividends or paying one-time bonuses to employees.

While this is an important short-term consideration, the focus on this one area is too narrow. The C-suite should be looking more widely across the business in order to understand the wider and long-term implications of US tax reform.

The new law will act as a catalyst that will compel companies to reappraise their business model, strategy and operating model so that they can deliver on their plans for growth.

The shift in US policy — from a worldwide to a territorial system for corporate taxation — could have sweeping implications for an organization’s business and operating models. Organization leaders should be undertaking a strategic reappraisal now of their company’s location, supply chain structure and investments, as well as the overall operating environment.

“Businesses need a broader strategic view of how US tax reform will impact their business,” says Washington-based Yvonne Metcalfe, a member of the International Tax Services group in the Ernst & Young LLP National Tax Department. “The new law will act as a catalyst that will compel companies to reappraise their business model, strategy and operating model so that they can deliver on their plans for growth.”

For example, an industrial products business that is already in the process of introducing a new operating model in order to boost profit should consider how this initiative could be impacted by the new US tax law.

Or take a business that has structured its supply chain in such a way that a large amount of cash is accumulated and invested overseas. US tax reform presents an opportunity for that organization to take another look at its supply chain since the new territorial tax regime could make US investments more compelling.

“Digital disruption and the evolving global marketplace are already forcing many companies to reconsider their business and operating models,” says Jerry Gootee, EY Americas Advisory Sector Leader, Industrial Products and Automotive and Transportation.

“US tax reform can provide important additional financial incentives for such a transformation,” Gootee says. “But businesses should take their time and make sure they are well informed. Only then will they be able to avoid pitfalls and take advantage of all the opportunities it brings.”

Home advantage

The US Government is optimistic the new tax law will encourage businesses to invest more in the US, for example, by hiring more workers, raising wages and building new factories and offices.

Businesses suddenly have a lot more cash and they are making strategic investments on how and where to spend it right now. A recent EY survey of 500 US C-level executives from businesses with more than US$500 million in annual revenue found that 47% of respondents plan to boost spending on research and development, 46% plan to return capital to shareholders and 42% want to invest tax savings in M&A activity.

“There are a lot of new sources of capital, which is a fortunate situation for businesses to be in,” says Kate Barton, EY Americas Vice Chair — Tax. “Businesses are going to customize how they invest that cash. There is no single solution.”

Some companies are passing the tax benefits on to their employees. Financial services firm Wells Fargo & Company, for example, announced plans in December 2017 to raise the minimum wage for its employees to US$15 an hour. Telecom company AT&T plans to pay a US$1,000 bonus to more than 200,000 US employees.

The US Government has welcomed such actions; stagnant pay remains an ongoing issue, with annual real wage growth of just under 0.2% in the US, according to a 2017 report from The Brookings Institution, a Washington, DC-based public policy organization.

Other businesses are already rolling out new capex plans. Under the TCJA, the US Government provided new incentives to invest in the US. Thanks to a temporary tax break, businesses will be able to immediately expense 100% of certain capital expenditures.

Encouraged by US tax reform, logistics company UPS has unveiled plans to invest an additional US$7 billion over a three-year period to construct and renovate facilities, purchase new aircraft and ground fleet vehicles and upgrade its information technology platforms to enable new customer solutions. AT&T has said it would invest an extra US$1 billion in capital spending in the US in 2018.

Other businesses are rewarding investors, using their extra cash to launch large stock buyback programs, including tech company Cisco (US$25 billion) and soft-drinks company PepsiCo (US$15 billion).

Building value

While US tax reform offers incentives for investment — be it spending on new equipment or strategic acquisitions — businesses should take a deliberate and formalized approach when assessing future capital allocation and investment projects.

New York cityscape

Many companies may seek to alter their business structures by divesting certain business units or expanding through acquisitions. For example, businesses will need to reassess their optimal level of debt in light of US tax reform. The restriction on the amount of tax deductions for interest expense on debt, combined with a lower tax effect with the decline in the corporate US tax rate will make high leverage levels less appealing going forward. An EY report, Making capital allocation decisions in light of US tax reform, predicts the amount of debt held by public companies could decline by up to 25%.

Businesses will also have to adjust the way they evaluate potential acquisition targets as the tax rate cuts will affect income, cash flow and the discount rate. The benefits stemming from these rate cuts will differ from business to business and sector to sector.

“Companies should aim to deploy their capital in a way that creates sustainable value across the business,” says Torsdon Poon, EY Americas Transaction Tax Leader. “Those who simply increase spending across the board could be left with value-destructive projects.”

Poon notes that businesses may face conflicting spending agendas as shareholders push for dividend increases and share buybacks, while leadership pursues plans to expand the business through capex investments or acquisitions. The key here is communication, he says.

“Companies need to demonstrate to shareholders that they have examined all the tax-related nuances and that their decision will deliver value creation in the end,” says Poon.

Companies should aim to deploy their capital in a way that creates sustainable value across the business. Those who simply increase spending across the board could be left with value-destructive projects.

Down to the details

The new US tax law ushers in numerous changes that will affect financial reporting — each with its own effective date, transition and phase-in rules. Companies should not underestimate the complexity of this task. Businesses and their advisors will need to implement these modifications and technical details in an environment where many points remain unclear.

Additional guidance from the Internal Revenue Service (IRS), the US tax administration, should help provide clarity, both in terms of preparing financial statements and understanding the broader tax implications that will affect the business in the future.

“The company’s finance, treasury and tax departments need to work together to execute a plan that responds to the different items,” says Frank Mahoney, EY Americas Vice Chair – Assurance. “This could include the new corporate tax rate, the one-time transition tax, a write-off of certain assets, or any adjustments to existing tax attributes or internal controls that may be necessary.”

For example, businesses may need more time to evaluate the new tax law’s provisions and account for these effects. If a business has not yet finished this analysis, it should make robust disclosures about where its accounting is not yet complete and therefore subject to change.

The tax law, for instance, contains new provisions targeting both US- and foreign-based multinational enterprises. These provisions create a new minimum tax on global intangible low-taxed income (GILTI) and a new base erosion anti-abuse tax (BEAT) through which certain payments made by a US company to a foreign-related business will be subject to an alternative tax computation.

Businesses subject to the new GILTI and BEAT provisions will need to evaluate how they may affect a company’s future tax obligations, effective tax rates and financial reporting.

For public companies, the law places new limits on deductions for compensation paid to certain covered employees. The tax law increases the number of employees’ subject to these provisions and eliminates the exemption for performance-based compensation. Businesses will need to pay close attention to these provisions to understand whether existing compensation plans can be grandfathered under the new law or if they need to be reevaluated.

There are also critical issues to address regarding the financial statement implications of the one-time repatriation tax. The complexities of understanding the amount subject to tax and the application of different tax rates will require additional effort and analysis.

Prepare for more change ahead

The US won’t be the last jurisdiction to cut corporate tax rates; the trend toward lower corporate income tax rates and a broader tax base will continue in 2018, according to EY’s Global tax policy outlook for 2018. Tax reform in another large economy could again be a game changer, forcing businesses once again to rethink their strategy.

But it will be important to look beyond a jurisdiction’s headline tax rate. As competition for investment and job creation continues, businesses will have to continuously evaluate tax as part of the overall landscape for business decisions. This includes understanding and managing an increasingly contradictory world of tax.

On one hand, many jurisdictions are competing for investment by reducing corporate income tax rates and revamping incentives to attract businesses and grow the economy. At the same time, we are seeing tax administrations increasing resources to drive up tax collections through digitalization and transparency initiatives while proposing sweeping changes to the taxation of the digital economy.

The world of tax and the impact of tax reform is about much more than taxes. Make sure you understand what it means for your business as a whole.

Summary

Tax reform in the US is forcing businesses once again to rethink their tax strategy, and re-evaluate tax as part of the overall landscape for business decisions.

About this article

By

Jay Nibbe

EY Global Vice Chair – Markets

Innovative and forward-thinking go-to-market leader helping EY clients worldwide achieve their goals. Technology enthusiast and part-time wine producer.