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.”
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.