President Donald Trump signed a landmark tax reform on Christmas Eve to replace a 30-year-old, complex U.S. tax system. The 429-page law, Tax Cuts and Jobs Act 2017, reflects his resolve to fulfil an election promise, impacting citizens as well as domestic and international businesses.
Here we discuss the changes impacting the cross-border tax regime and the U.S. multinational corporations in India. Besides a 20 per cent reduction in corporate tax rate, there are four key changes:
- A move to the territorial tax system, as opposed to the resident taxation system
- Imposition of transition tax for U.S. multinationals repatriating earnings kept in foreign jurisdictions
- Limitation of interest deductions in line with the G-20-led and OECD-led base erosion and profit sharing (BEPS) initiative.
- Excise tax on imports to boost domestic manufacturing
Territorial tax system: Under the new system, U.S. corporations will no longer be taxed on foreign earnings of their subsidiaries and dividends distributed from such foreign subsidiaries will enjoy an exemption, provided the U.S. corporation owns 10 per cent in its foreign subsidiary.
Logically, no foreign credit will be allowed for taxes paid in foreign jurisdictions. It will replace a complex U.S. tax system to tax global income with complex foreign tax credit mechanism and in line with the European participation exemption. Given that India levies dividend distribution tax, which is not creditable under the U.S. foreign tax credit rules, the move could encourage U.S. subsidiaries to repatriate earnings more efficiently unless they have sent dividends to the regional subsidiaries outside the US.
Repatriation tax on accumulative foreign earnings: U.S. corporations, in pursuance of the change in the territorial tax system, will now be encouraged to repatriate foreign earning representing post-1986 profits, which have not been subjected to U.S. tax. A one-time tax of 12 per cent will be levied on such accumulated foreign earnings representing cash, cash equivalent or short-term assets (5 per cent tax on assets such as property, plant and machinery). Most U.S. MNCs used creative ways such as buyback of shares to repatriate earnings from India until India levied an additional tax to bring buyback on par with dividend declaration and I see the limited impact of this.
Limitation of interest expense deduction: All net interest expense that exceeds 30 per cent of taxable income will now be subjected to a limitation capped at 110 per cent of the corporation's shares of the group's net interest expense. The interest disallowed can be carried forward for a period up to five years based on FIFO. It is in line with the OECD-led BEPS action points, and a similar provision was legislated by India in its 2017/18 budget (section 94B).
New excise tax: All deductible payments made by U.S. companies to their related foreign companies will be subjected to a 20 per cent excise tax. Deductible payments include the cost of goods sold and cost that forms the basis of amortisation of assets, royalties and services. It is the most debatable and burdensome part of the law. Although the Bill has not used the term border adjustment tax, which is much talked about and debated since the new Presidency, the features are somewhat similar. The EU leaders have reacted negatively, and most analysts predict that such tax will have to pass the WTO scrutiny. Imports from related parties located in high-tax jurisdictions such as India could be spared from an additional U.S. tax burden as the risk of shifting profits to India would remain low given India's tough transfer pricing regime.
Even though the tax reform suggests a drastic corporate tax cut, the fine print indicates an additional tax burden on U.S. multinationals, reaching upwards of $60 billion over a 10-year period.
While the best minds in the US have worked to design the tax reforms, international business heads and political heads have expressed their views on policies that could potentially harm their businesses and national interests, respectively. A few EU countries have also reacted negatively, but reactions from emerging markets are yet to come in. The tax fraternity feels that the changes in the U.S. territorial system are welcome although it could lead to aggressive transfer pricing audits and questions about reported offshore earnings.
Column by Mukesh Butani, Managing Partner, BMR Legal