Before the details of the GOP’s tax plan emerged, talk was rampant that the White House and Congressional leaders had wimped out. Supporters of a sweeping overhaul feared that the blueprint would lower the excessive U.S. corporate tax rate in baby steps, and that instead of putting multinational companies on an equal footing with overseas rivals, the tax plan would impose a steep, punitive “minimum tax” on offshore profits.
Fortunately, the final version of the GOP tax plan is surprisingly strong and straightforward. The most significant provisions by far apply to businesses, and especially the provisions for overhauling taxation of foreign income. Lightening the tax burden on America’s corporations is the best lever for boosting growth.
Here are the three provisions under the GOP tax plan that are most crucial to rewriting the code for business. The list unveils plenty of surprises, most of them highly favorable to corporate America.
Domestic Taxes: Lower rates, less shelter for interest
The law, entitled the “Tax Cuts and Jobs Act,” would lower the corporate rate from 35% to 20%. That’s no surprise: The 20% target was the centerpiece of the “Big Six” framework released by the Republicans in late September.
What’s highly encouraging is that first, the 20% would apply immediately (for the 2018 tax year) and second, it would be permanent. Those were girders that many conservative critics forecast would fall. “There was a lot of talk about phasing in the reductions,” says Nicole Kaeding of the free-market-leaning Tax Foundation. “It’s great news that didn’t happen.”
The original GOP House blueprint for tax reform proposed eliminating the corporate interest deduction in exchange for allowing companies to expense capital expenditures right away, instead of the current requirement of writing down investments in plants and equipment over a number of years. The new tax plan would keep the 100%, immediate capex deduction. But the restrictions on interest are a lot milder.
Businesses would be able to deduct interest expense up to a limit of 30% of their earnings before interest, taxes, depreciation, and amortization (EBITDA). Capping the deduction would help pay for sharply lowering the overall rate. Limiting the interest writeoff, rather than eliminating it, is a tonic for profits but less favorable to the federal budget: It substantially dilutes one of the biggest “pay-fors” in the House proposal.
Foreign Profits: A “minimum tax” that’s truly minimal
The Tax Cuts and Jobs Act would move the U.S. to a territorial tax system, the regime employed by most big industrialized nations. Today, the U.S. imposes its super-high 35% rate on all earnings, generated anywhere in the world, while competing nations require their multinationals to pay only the levies in the nation where they make the products, with no extra tax due at home. The system has encouraged our multinationals to defer and avoid punitive U.S. taxes by leaving earnings in foreign subsidiaries for decades instead of returning the cash to the U.S., where it could be more profitably used for building new plants or making acquisitions.
Going forward, all profits from U.S. subsidiaries abroad would pay only the local tax—that’s how a territorial system operates. But the GOP tax plan proposal comes with a major caveat. It also protects the U.S. tax base by providing a potentially stiff penalty for some companies that shift income to jurisdictions with extremely low tax rates—Ireland, Hungary, and the Bahamas come to mind.
The original GOP tax plan contained a brief reference to a minimum U.S. surtax on profits earned in offshore tax shelters. No proposal was less welcome to America’s corporate chiefs. The fear was that the GOP would advocate something like a base levy in the mid-to-high teens, greatly weakening the benefits of a territorial system.
The new legislations does contain a minimum tax—but CEOs and CFOs should relax. It’s mostly “minimum lite.” The concept is an “excess profits” levy. The goal, and it’s a good one, is to discourage multinationals from moving IP, patents and other assets that are highly mobile and represent relatively small investments, to foreign tax shelters. Here’s how it works, according to an example provided by Gavin Ekins of the Tax Foundation.
The idea is to tax foreign profits above a certain threshold in the U.S., based on return on assets. The key is that only “tangible” assets such as buildings, plants and inventories count in the investment base. Such intangibles as patents and goodwill do not. Say a U.S. multinational generates $10 million in pre-tax income in Ireland on investment, hard assets only, of $100 million. That’s a return of 10%. The proposal stipulates that the bogey for “excess profits” is 7% plus inflation, now running at 1% annually. In this case, that would mean 8%, or $8 million. So our company is garnering pre-tax profit that’s $2 million over the bogey, or in the excess profits zone.
The multinational would be required to pay our 20% domestic rate—not on all the excess profits, but half. It would also get a credit for 80% of the tax already paid in Ireland; let’s say that’s its maximum Irish rate of 12.5%. The credit would be 80% of 12.5%, so 10%. The company would pay an excess profits tax of 20% on $1 million (half the total excess profits of $2 million) or $200,000, less a deduction of $100,000 (credit for a portion of the Irish rate already paid on that $100,000), for a total bill of $100,000. So all told, the additional tax would be 5% of the $2 million in pre-tax profit.
That’s not nearly as high as CEOs and CFOs dreaded, given the language in the framework. But the law gets punitive for multinationals that send IP to tax shelters. “It’s possible that a company with patents and a few lawyers in a foreign sub might have $100,000 in tangible assets, and generate $100 million income,” notes Ekins. In that scenario, a tech titan would face a big surtax on around $50 million (one half of the $100 million). If the local levy in an exotic island nation is 5%, the company would owe an extra $7.5 million to the Treasury. The GOP reckons that these provisions will accomplish two goals: Putting U.S. multinationals on equal terms with foreign rivals in most nations, but at the same time, discouraging them from blatant avoidance by parking IT where the sole lure is super-low taxes.
Repatriation: A trickle, not a flood
It’s well known that U.S. multinationals are sitting on nearly $3 trillion in foreign profits they’ve left abroad, often in the subsidiaries in Ireland, Germany, or Japan that generated the profits. Republicans have long advocated a “deemed repatriation,” in which the Treasury would tax those overseas earnings at a super-low rate. “Deemed” means that multinationals would have no choice but to pay the “repatriation” levy. Once they’d complied, the money could flow back to the U.S. with no additional penalties. And since all future foreign earnings would be subject to the minimum tax in the current year, no deferrals or exclusions allowed, multinationals would no longer have any incentive to leave mountains of profits accumulating, tax free, in foreign subs.
The Tax Cut and Jobs Act does indeed propose a deemed repatriation. But once again, it’s full of surprises. The two-tiers of rates are somewhat predictable. Multinationals would pay 12% on such liquid assets as cash and securities, and 5% on profits that are reinvested abroad in such hard assets as plants and inventories.
Here are the stunners. First, the new GOP tax plan doesn’t require that businesses pay right away. In fact, they have eight years to cover the bill on both profits that are reinvested, or those sitting in cash. They do, however, need to make minimum installments of 12.5% a year. Second, the categories of cash and reinvested profits are fixed as of the day of proposed legislation was released, November 2, 2017. Scurrying to move money from the 12% to 5% buckets today is therefore fruitless. “If companies had been given a few weeks or more to comply they would have moved lots of cash into investments to save 7 points in taxes,” says Ekins.
So the cash will return in a relative trickle rather than a flood. Companies can still shelter a portion of their foreign profits for an additional eight years. But if the law is enacted, it will encourage what really matters, freeing capital so that it moves not to where taxes are lowest, but where opportunities and growth are most promising. America, the natural magnet for that capital, should benefit more slowly than expected, but richly nevertheless.