When America squeezes – implications of US tax reform for China
The passage of the US tax reform law ushered in big changes to the global tax landscape. Governments and businesses globally have since expended considerable efforts to understand and assess the wide-ranging impacts of these critical changes. Wade Wagatsuma, Xiaoyue Wang, David Ling, Shirley Shen, Koko Tang and Jennifer Weng, discuss the key changes and their impact on China.
On December 22 2017, US President Donald Trump signed into law the most significant US tax reform legislation in more than 40 years. In the months since, governments and businesses globally have expended considerable efforts to understand and assess the wide-ranging impacts of such critical changes in US tax policy.
By and large the US tax reform law amounted to a business tax reform. Its overarching framework clearly reflects the partisan nature of the bill (no Democrat in either the US House of Representatives or Senate voted in favour). It is also premised upon the fairly standard conservative tax view that in reducing the corporate tax burden, investors and businesses alike will take up the incentive to actively reinvest and undertake development initiatives that will grow the domestic market. On the flip side, such measures only serve to enhance the US's competitiveness in the global markets.
While boosting growth was a fundamental driver behind the US tax reform, equally paramount in concern was the closing of what had come to be been seen as gaps in policy that favoured the stockpiling of cash and division of labour outside the US. The end result is a law that implemented a sizeable reduction to the overall headline corporate tax rate, tempered with new measures that focus heavily on reducing profit shifting away from the US through a variety of new limitations and a major expansion of the rules applicable to foreign affiliates of US corporations.
The reaction in China was to establish a special task force to study the impacts of US tax reform, while at the same time moving forward with tax policy developments that had been planned long before the passing of the US tax reform. In particular, less than a week after the US tax reform was signed into law, China released Caishui (2017) 88 (Circular 88) and relevant interpretations, introducing a withholding tax deferral incentive for profit reinvestments in China. This circular, and its successor, Circular 102, are discussed in the chapter, Not-so-old wine, in a not-so-new bottle – perennial tax challenges for M&A with new twists.
Remaining focused on preserving China's competitiveness in the global market, in April 2018, at the Bo'ao Forum, President Xi Jinping announced plans for further substantial reforms to liberalise the investment environment for foreign investors, and encourage inbound investment. This included plans to create a free trade zone on the southernmost island of Hainan by 2020, and a free trade port by 2025. It is anticipated that Hainan might be used as a pilot zone for new fiscal policies to be potentially rolled out nationwide at a later stage. Other initiatives to maintain and enhance China's investment attractiveness, outlined further in the chapter, Coming of age – China's leveraging of BEPS, include:
A reduction, from 63 to 48, in the number of economic sectors restricted for foreign investors under the 'negative list';
Plans to abolish the requirements for foreign investors to have Chinese joint venture (JV) partners across a whole host of sectors, allowing 100% foreign ownership. These include transport and logistics, ship and aircraft building and repair, wholesale activity, professional services, energy and transport infrastructure, and, on a phased basis in the period to 2022, auto manufacturing and financial services;
Plans to open further sectors to 100% foreign ownership in the foreign trade zones (FTZs), including a range of telecoms and internet services; and
Recent enhancements to the tax incentives for advanced equipment investment (i.e. expensing of items less than RMB 5 million ($720,000)), the raised ceiling for staff education expense deductions (2.5% to 8%), the special individual income tax (IIT) treatment for 'breakthrough bonuses' to scientists, enhanced venture capital (VC) tax incentives, and increased research and development (R&D) super deductions; see the chapter, R&D 2.0: taking tax incentives to the next level in China.
It might be observed that discussion on the medium- to long-term impact of US tax reform on business activity and investment, cross-border into and out of China, is now frequently combined with discussion on the impact of the China-US trade issues, which increasingly look like they may continue for some time. In determining whether there is a need to restructure operations with China, foreign and Chinese MNEs will clearly have to consider the combined effect of these key business environment changes on their strategic options. The China-US trade issues are dealt with in the chapter, In the eye of the storm – how does China act and react in times of trade tension?
Reduced headline tax rate
The centrepiece of the law is the permanent reduction in the US corporate income tax rate (CIT) from a maximum 35% to a flat 21%. No distinction between investment income and business income earned by corporations is made for purposes of applying the 21% tax rate. When taking into account US state taxes, the US weighted average CIT rate is now 25.7%, down from 38.9% pre-tax reform. For reference, the standard China CIT rate is 25%, with lower rates for high-tech and small enterprises.
Over the past 30 years, the US had become an outlier in not reducing corporate tax rates. Combined with the complexity of the US worldwide system of taxation, the US corporate tax regime was often seen as a considerable barrier to foreign investment.
The corporate rate reduction under US tax reform is intended to make the US corporate tax rate more competitive with the rates imposed by other countries, putting the US statutory corporate rate more in the middle of the 'pack' of statutory corporate rates levied by central governments of major OECD nations. To what extent the change in law will increase the attractiveness of the US as a place of investment will factor on whether other countries will respond by further rate reductions on their part.
While the reduced tax rate is expected to be a considerable tax benefit for US corporations going forward, an immediate and notable side-effect of the rate reduction is a corresponding write-off of the deferred tax assets, due to the tax differential between the prior maximum 35% and new 21% corporate income tax rates. This has been estimated to trim at least $18 billion from the book values of leading US companies.
The result of the new law is a US corporate tax rate that now sits substantially below the top individual tax rate of 37%. Where prior law often favoured the conduct of business through pass-through entities for many US taxpayers, the corporate rate reduction effected by the new law will and has already been shown to affect the choice-of-entity decisions for some business entities, as the flat 21% corporate tax rate differs from the effective rate for domestic business income of individuals earned through pass-through entities, for which certain income is still taxed at individual rates (i.e. up to 37%).
Private equity firm KKR is a prominent example of a tax restructuring following US tax reform. KKR, which has long operated under a flow-through structure, announced in May 2018 that it would convert from a partnership to a corporation in July 2018. This means that KKR will now subject its revenue, including all performance-related revenue, to the 21% corporate tax rate, rather than pass such amounts up to be taxed solely at its ownership level as would be the case under a partnership structure.
Ultimately, choice-of-entity decisions will continue to depend on individual facts and circumstances. However, it is hard to argue that US tax reform has not swayed considerations in favour of business via the corporate form.
Of notable mention, the law provides for a further boost to the reduced corporate tax rate, albeit temporary, by implementing provisional measures that allow for the immediate and full expensing of certain business assets acquired and placed in service after September 27 2017, and before 2023. Technology and energy companies have already been noted as making use of this incentive and driving a rebound in US capital expenditure spending. This expensing regime goes beyond pre-enactment law by applying to both new and used eligible property, provided such property is new in the hands of the taxpayer. Such benefit applies through 2022, and then ratably phases down over the succeeding five years.
Shift in approach to taxing MNEs
The law makes fundamental changes to the taxation of multinational entities. In general, the law steps the US away from its historic system of imposing worldwide taxation with income deferral, to a partial participation exemption regime with a more comprehensive taxation of foreign income. To accomplish this, the law includes several features, including:
A 100% deduction for dividends received from 10%-owned foreign corporations;
A one-time transitional tax on the deemed repatriation of previously untaxed 'old earnings' of non-US affiliates; and
A permanent minimum tax under the global intangible low-taxed income (GILTI) regime.
Furthermore, the US tax reform law includes substantial anti-base erosion measures targeted at cross-border transactions. Notably, the law includes provisions revising the tax treatment of hybrids, as well as a base erosion anti-abuse tax (BEAT) that imposes a minimum tax on certain deductible payments made to foreign affiliates.
A territorial tax regime (in part)
Under prior law, the operating earnings of a foreign subsidiary of a US corporation were generally subject to US corporate income tax when repatriated to its US parent corporation. To the extent a foreign subsidiary generated certain subpart F income (generally passive income streams, e.g. dividends, interest, or royalties), its earnings could potentially be taxed under the historic anti-tax deferral regimes. Nevertheless, the operating income of the foreign subsidiary would remain largely untaxed in the US until repatriated. The prospect of being hit by this additional tax burden upon repatriation had long been seen as a major factor dissuading businesses from repatriating income to the US, resulting in substantial offshore earnings remaining offshore.
The US tax reform law introduces a 100% participation exemption system for dividends received by US corporations owning 10% (by voting power or value, determined under complex rules) or more of the foreign corporation making the dividend distribution, which moves the US away from a worldwide tax system and closer to a territorial tax system for earnings of foreign corporations. While a truly territorial system cedes the taxation of foreign generated income to the foreign country in which such income is generated, the new law adopts a limited approach in shifting to territoriality, benefitting solely qualifying domestic corporations rather than cross-border investors on the whole.
Generally, a participation exemption regime effects a tax exemption by virtue of share ownership, and aims to reduce the double taxation generally applicable to corporate profits (i.e. at both the corporate and shareholder levels). Under the new law, a participation exemption has generally been adopted on foreign earnings, but only to the extent earnings are neither subpart F income nor subject to the new GILTI minimum tax. In practice, these exclusions mean that US companies can no longer avoid paying tax on non-US profits by keeping the money outside the US.
As under prior law, subpart F income generated by a US controlled foreign corporation (CFC) remains subject to tax on a current year basis to the US parent corporation, even when it is not repatriated to the US. Generally, a CFC is a non-US corporation with more than 50% of its stock in aggregate, directly or indirectly, owned by US persons owning at least 10% of such stock. While fundamentally the same rule as before, the scope of entities potentially classified as CFCs has been substantially widened, due to the expansion of applicable attribution rules and the inclusion of owners of non-voting stock (prior law defined ownership with reference to voting power only).
Expanding the potential income pool subject to current year taxation, the US tax reform law also imposes a new minimum tax on a CFC's GILTI. By application of deductions, the effective tax rate on GILTI is 10.5% for tax years 2018 to 2025, and 13.125% for 2026 and beyond. However, to the extent GILTI income is already subject to foreign taxes of at least 13.125% (16.4% for post-2025 years), foreign tax credits (FTCs) are generally available to offset the minimum tax in full.
In general, GILTI is described as the excess of a US shareholder's 'net CFC tested income' over its 'net deemed tangible income return', which is defined as 10% of its CFC's 'qualified business asset investment' (QBAI), reduced by certain interest expense taken into account in determining net CFC tested income. For many corporations in practice, GILTI generally amounts to a CFC's non-subpart F income in excess of the 10% QBAI threshold (adjusted by interest expenses taken). Although by name GILTI singles out 'intangible' income, the GILTI rules have a much broader application, not necessarily being limited to income from intangible assets, and looks to most of the CFC's non-subpart F income when applying the new minimum tax.
Under the new participation exemption system, a US corporation (other than a real estate investment trust and regulated investment company) that owns at least 10% of the vote or value of a foreign corporation is generally entitled to a 100% dividends received deduction (DRD) on dividends received from such foreign corporation. To qualify for the 100% DRD, the dividend paying stock must be held for at least 365 days within the 731-day period preceding the dividend payment, and the US corporate shareholder must likewise satisfy the 10% ownership requirement at all times during such period. Additionally, any hybrid dividend (generally defined as an amount for which the foreign corporation received a deduction or other tax benefit related to taxes imposed by a foreign country) will not be eligible for the 100% DRD. For any dividend allowed a 100% DRD, the US corporate shareholder will not be eligible to claim a FTC or deduction for any foreign taxes paid or accrued with respect to such dividend.
To facilitate the transition to the participation exemption regime, the new law imposes an additional tax burden for a US corporation's 2017 tax year on the accumulated, historically untaxed earnings of any 10% owned foreign corporation. This transition rule itself includes a participation exemption, the net effect of which is to tax a US shareholder's mandatory inclusion at a 15.5% rate to the extent it is attributable to the shareholder's aggregate foreign cash position and at an 8% rate otherwise. In effect, this one-time tax serves to reset the tax base and parameters by which the US worldwide tax rules will apply for US corporations. Existing net operating losses and FTCs of the US taxpayer may potentially be used to offset the resulting tax liability in 2017. China withholding taxes paid or accrued on the future distribution of such historic earnings to the US are expected to result in a FTC available in future years, but only in part (i.e. subject to a haircut).
Anti-base erosion measures under the BEAT
In drafting the law, the Republican lawmakers involved expressed the intention to incorporate new rules thought to level the playing field between US-headquartered parent companies and foreign-headquartered parent companies. The US tax reform law implements this principle by effectively creating a base-erosion-focused 10% minimum tax (the base erosion and anti-abuse tax, or BEAT) on large multinationals by clawing back the US tax benefit of deductions on cross-border related-party payments that are otherwise permitted, potentially resulting in an additional tax liability. From 2026, the effective minimum tax rate is increased to 12.5%.
The BEAT applies to US corporations (other than S Corporations, RICs, or REITs) that are part of a group with at least $500 million of annual US (including effectively connected amounts earned by foreign affiliates) gross receipts (over a three-year averaging period), and which have a 'base erosion percentage' (discussed below) of 3% or higher for the tax year (or 2% for certain banks and securities dealers). The BEAT also applies to non-US corporations engaged in a US trade or business for purposes of determining their effectively connected income tax liability.
Base erosion payments are subject to the provision when they give rise to a 'base erosion tax benefit', meaning that it can have an impact in the tax year in which a deduction for the payment is allowed. The targeted base erosion payments generally are amounts paid or incurred by the corporation to foreign-related parties for which a deduction is allowable, and also include amounts paid in connection with the acquisition of depreciable or amortisable property from the foreign related party. Generally, the definition of a foreign-related party includes any 25% foreign shareholder of the taxpayer, related persons thereto, and any other person related to the taxpayer under general US transfer pricing principles. In practice, many taxpayers may find it difficult to identify related parties because shareholder ownership may not be readily accessible.
The BEAT includes within its scope almost every outbound payment made by corporations subject to the rule, except for payments treated as cost of goods sold or otherwise as reductions to gross receipts. However, this exclusion in determining gross receipts is unavailable for taxpayer groups that 'invert' after November 9 2017. Other than for such inverted groups, the BEAT therefore does not apply, for example, to payments for inventory manufactured outside the US.
There are two main exceptions to the provision's scope for otherwise deductible payments. The first is for any amount paid or incurred for services that qualify 'for use of the services cost method' under US transfer pricing rules and that reflects the total cost of the services without markup. The second is for 'qualified derivative payments' for taxpayers that annually recognise ordinary gain or loss (e.g. mark to market) on such instruments, and is subject to several exceptions.
The base erosion percentage used for the 3% (or 2%) threshold requirement is generally determined by dividing the aggregate amount of base erosion tax benefits of the taxpayer for the tax year by the aggregate amount of the deductions allowable to the taxpayer for the year with certain exclusions.
Where applicable, BEAT effectively imposes a tax liability increase (i.e. a minimum tax) by disallowance of the tax benefit for in-scope related party payments. A complex multi-step formula is used to derive the BEAT minimum tax amount.
China considerations going forward
The reaction among Chinese tax policymakers has generally been that the US tax reform amounted to a fairly standard CIT rate reduction to bring the US more in line with the OECD average, an update to core CIT provisions (e.g. dividend exemption) to align closer to principles adopted by other OECD countries, and the implementation of a range of BEPS-focused measures (e.g. CFCs, hybrids, and interest deductions).
As such, policymakers have not made calls for any immediate dramatic overhaul of China CIT rules. Instead, China's policymaking in the period since the passage of the US tax reform law has focused on further enhancing China's innovation tax incentives and improving its VAT rules. China's institution of the dividend reinvestment incentive had already been in planning well before the US tax reform.
US MNEs with Chinese affiliates are undertaking organisational reviews to understand how the new US tax law impacts them, and what organisational changes can be made (e.g. reorganising their cross-border payments), if any, to mitigate any adverse tax impact of the BEAT. However, the precise impact of the US tax reform on the China operations of foreign MNEs and on Chinese enterprises, in both the cross-border context and in the context of their wider global value chains, will only become clear after detailed US tax guidance/regulations have been released and digested by the greater market (e.g. in relation to GILTI and the BEAT).
The final shape of these rules, together with the emergence of greater clarity on the medium term effects of developments in China-US trade relations, will likely feed into MNE supply and value chain (re)structuring. Once the state of play becomes more apparent, there may be further thought given by China tax policymakers on the way forward.
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Wade Wagatsuma is a partner and the head of US corporate tax for KPMG China. Previously, Wade was based in London, UK and served as partner-in-charge of the US tax practice of KPMG (UK), and prior to that, a principal with the Washington national tax practice, KPMG (US). Prior to joining KPMG, Wade was a partner with the global law firm Jones Day.
Wade earned his bachelor's degree from the University of Hawaii at Manoa, where he graduated with distinction and was a member of Phi Beta Kappa. Wade holds a Juris Doctor from Case Western Reserve University where he was an editor of the Case Western Reserve Law Review, and was elected to the Order of the Coif. He also holds a Masters of Law in Taxation from New York University. Lastly, Wade served as attorney-advisor to Judge Arthur Nims, III of the US Tax Court.
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Xiaoyue Wang joined KPMG China in November 2016 and is the transfer pricing national leader as of December 1 2018.
Prior to joining KPMG, Wang had a long and distinguished career at the State Administration of Taxation (SAT) of China, rising to the position of deputy director general of the international taxation department. Wang was the top transfer pricing official at the SAT for many years. She represented the Chinese government in international negotiations on tax policy and administration. She led the development, drafting and implementation of all major transfer pricing, advance pricing arrangement (APA), and anti-avoidance initiatives, both in terms of legislation and tax administration, and developed a highly effective national structure for transfer pricing and anti-avoidance administration within the SAT.
Since joining KPMG, Wang has led many projects involving the resolution of bilateral and multilateral transfer pricing disputes, including APAs and mutual agreement procedure (MAP) resolutions. Her work has involved companies all over the globe and in a wide range of industries including the electronics, automobile, consumer goods, telecommunication, real estate, pharmaceutical, and luxury fashion industries.
Wang has a PhD in economics from the Renmin University of China and an LLM in taxation from Golden Gate University in the US.
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David Ling is a tax partner and has been the head of the China tax centre in the US since October 2017. From 2011 to 2017, he was the head of tax in the northern region of KPMG China and also led the tax dispute and controversy resolution team nationwide.
David joined an international accounting firm in the US in 1992 after obtaining his master's degree in US taxation. He was transferred to China in 1993 and has worked in the offices located in Hong Kong, Shenzhen, Shanghai and in Beijing where he spent most of his time. He was promoted to tax partner in 2002 and joined the KPMG Beijing office in the same year.
David has extensive experience in Chinese tax planning, tax advice and tax dispute resolution. When delivering corporate tax and transfer pricing services, David regularly assists multinational businesses in achieving their business goals in China in a tax-efficient manner, including tax planning for cross-border structuring to ensure tax efficiency, and the assessment of merger and acquisition risk from the Chinese tax perspective.
With in-depth understanding of the tax and regulatory system and the local practice in China, David is renowned for his expertise in helping enterprises overcome the tax complexities and challenges associated with business operation in China.
With 25 years in professional practice, David also has well-established relationships with various Chinese authorities at both central and local levels and assisted many foreign companies to secure favourable tax and other rulings.
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Shirley Shen started her career with professional accounting firms in Australia in 2004 and has experience in various disciplines including tax and accounting. Before joining KPMG in 2007, she worked in the tax department of another Big Four Firm for two years. Shirley is now a leader of the China tax centre in the US.
Shirley has rich experience in advising multinational companies. She has been providing tax health checks, tax provision reviews, tax due diligence, and structuring and planning advice.
She has also been actively involved in the VAT reforms in China, having assisted the legislative affairs office of the Budgetary Affairs Commission of the National People's Congress and the Ministry of Finance (MOF) since 2009. She has been involved in many VAT reform projects for multinational companies and state-owned enterprises and provides a full range of services relating to VAT implementation.
She has been instrumental in influencing policymakers on behalf of industries such as the transportation industry, finance leasing industry and financial services sector to achieve improved policy outcomes under the VAT reforms.
Shirley is a noted speaker on tax issues and has presented at numerous seminars for various regulators, professional associations and industry groups on tax topics in China.
Shirley is a member of Certified Practising Accountants of Australia (CPA Australia). She is also a certified tax agent of China and a Hong Kong certificated tax advisor.
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Koko Tang is a tax partner based in Shenzhen with KPMG China. She has more than 20 years' tax experience in China, US and Canada. She has extensive experience in providing tax consulting services to Chinese domestic clients and multinational enterprises in a wide range of industries, including TMT, life sciences and healthcare, clean technology, automobiles and manufacturing.
She specialises in structuring of cross-border transactions, mergers and acquisitions (M&A), global tax planning and business model optimisation for multinational corporations, M&A-related tax matters (e.g. tax due diligence, deal structuring, post-deal integration, etc.), and accounting for income taxes under US and China generally accepted accounting principles (GAAP). She also assists Chinese domestic companies in restructuring their businesses for supply chain efficiency and initia public operating (IPO) purposes.
In addition, she provided tax advice to Chinese high-net-worth families on their estate tax planning, family trust, immigration, common reporting standard (CRS), stock incentive plans and partnership programmes.
Koko is a frequent speaker at tax seminars for clients and the public on high-net-worth family tax matters, privately-owned enterprises tax matters, and CRS. Koko has a master's degree in taxation from the University of Waterloo and a bachelor's degree in accounting from Fudan University. She is a member of the American Institute of Certified Public Accountants (AICPA) and the Chinese Institute of Certified Public Accountants (CICPA) as well as a certified tax agent in China.
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Jennifer Weng is a partner based in Shanghai. She has more than 20 years' experience in advising multinational clients across a wide range of sectors such as the consumer, industrial and manufacturing, real estate, logistics and financial industries in relation to appropriate corporate holding and funding structures to conduct their proposed business activities in China. She has helped multinationals identify and address tax and foreign exchange controls issues arising from their operations, and provided advice on tax efficient expansion and restructuring planning and repatriation of funds from China.
Jennifer is a member of the Chinese Institute of Certified Public Accountants (CICPA) and a Certified Tax Agent in China.