When the US president signed the Tax Cuts and Job Act (TCJA) (PL 115-97) into law on December 22 2017 it represented the most substantial overhaul of the US tax code since 1986 (US tax reform). This legislation was the result of a lengthy pursuit of business tax reform and, among other things, included several provisions targeting cross-border transactions. These changes will require multinational enterprises (MNEs) to actively consider and manage several business decisions such as location of people and assets, supply chain management, existing contractual arrangements, financing, investments, and so on. Some of the key features of the US tax reform include:
- A permanent substantial reduction in the statutory corporation tax rate to 21% (from 35%) with effect from January 1 2018 and repeal of the corporate alternative minimum tax;
- A limitation on the deduction of net business interest expenses to 30% of adjustable taxable income;
- A 'temporary' expensing provision that allows taxpayers to immediately write off 100% of the cost of purchase of new or used qualifying property;
- A shift from a system of worldwide taxation with deferral to a worldwide system with favourable treatment of offshore income; and
- The limitation of carry-forward of net operating losses (NOLs) to 80% of taxable income, and elimination of the carry-back of these losses.
The US tax reforms are likely to have a fundamental and far-reaching impact on MNEs. This article, however, focuses on certain key provisions of the US tax reform that are expected to impact MNEs with operations in the Asia Pacific region (and specifically, Australia, China, Japan, Korea, Sri Lanka, and Taiwan) as they impact on their related party arrangements, and it explores what considerations may be relevant for the ASPAC companies.
This article discusses the potential impact of key provisions involved.
Base erosion and anti-abuse tax
A new anti-base erosion measure has been introduced that applies to both US and foreign-based multinationals called the 'base erosion anti-abuse tax', commonly referred to as the BEAT. It is a minimum tax that applies to large corporations that reduce their US tax liabilities below a certain threshold by making deductible payments (e.g. interest, royalties and many services payments) to related foreign entities.
The BEAT generally applies to corporations that are not S corporations, regulated investment companies or real estate investment trusts, with group revenue of at least $500 million of annual domestic gross receipts (over a three-year averaging period) and have a 'base erosion percentage' of 3% or higher (2% for certain banks and securities dealers). The base erosion percentage generally is determined by dividing overseas related party payments that are deductible (subject to certain exclusions) by the total amount of the corporation's deductions for the year. It is relevant to note that costs included in the total cost of goods sold are not considered as deductions because they are a reduction to gross receipts in computing gross income rather than a deduction from gross income. Hence, the cost of goods sold is neither included in the numerator nor the denominator for calculating the BEAT liability. The BEAT rate generally is 5% for 2018, and will be 10% for 2019-2025, and 12.5% after 2025. The BEAT rate is 1% higher for banks and registered securities dealers.
Corporations that meet the base erosion percentage are required to run a separate set of calculations to determine whether they are subject to a BEAT liability. The BEAT provision generally requires a taxpayer to recompute its taxable income as if it had not made any base erosion payments and then multiply that 'modified taxable income' amount by the applicable BEAT rate. If the resultant amount exceeds the taxpayer's post-credit regular tax liability (the BEAT rules provide preferential treatment for four types of tax credits), the taxpayer will generally have a BEAT liability.
Limitation on the deduction of net business interest expense
The new law generally disallows a deduction for net business interest expenses of any taxpayer exceeding 30% of a business's adjusted taxable income (generally earnings before interest, tax, deductions, amortisation – or EBITDA – for the years before 2022, and earnings before interest and taxes – or EBIT – thereafter). In general, business interest expense and business interest income is interest allocable to a trade or business and does not include investment interest expense or income. The law does not grandfather existing debt, meaning that the new limitation also applies to interest on debt incurred before enactment – a key issue for highly leveraged companies. The new interest limitation also can be expected to have a disproportionate impact on corporations that employ a higher degree of leverage, operate in an economic downturn, or experience financial difficulty.
The limitation does not apply to certain small businesses with average gross receipts under $25 million and to certain other classes of entities. Subject to this exception, the provision applies to all businesses, regardless of form, and any disallowance is generally determined at the tax filer or entity level (e.g. at the partnership level instead of the partner level). For a group of affiliated corporations filing a consolidated return, the provision applies at the consolidated tax return filing level.
Subject to special rules for partnerships, any business interest disallowed would be carried forward indefinitely, but would be subject to the tax code's loss limitations in the event a corporation underwent an ownership change. Special rules allow partnerships' or S corporations' unused interest capacity to be used by their partners and shareholders.
Foreign-derived intangible income
The new law creates a new category of 'foreign-derived intangible income' (FDII). The new law provides a 13.125% effective tax rate (increasing to 16.406% in 2026) on FDII earned directly by a US corporation from foreign sales, leases, licences and services. The reduced effective tax rates are achieved through a special deduction by the US corporation. At a high level, a US corporation's FDII is its net income from export activities reduced by a fixed 10% return on its depreciable assets used to generate the export income. Presumably, the goal of this provision is to provide an incentive for US companies to locate productive assets in the US, rather than offshore.
A special rule applicable to related-party transactions provides that if a US taxpayer renders services to a related party outside the US, its services will not qualify as FDII. This is the case even if the related foreign person might ultimately use the US services to complete its service obligations to unrelated persons outside the US, unless the US taxpayer can demonstrate that its services are not substantially similar to services the related foreign person provides to persons in the US.
Impact of the US tax reform on the Asia-Pacific region
Many US MNEs have set up operations in Australia in the form of local service entities supporting the US parent. Often, these local Australian subsidiaries are structured as sales and marketing service entities supporting the offshore principal in making Australian sales. These service entities are generally compensated on a cost-plus basis with payments flowing from the US to Australia. These payments will often come under the purview of BEAT, potentially resulting in additional tax liability for the US parent.
These structures are also on the Australian Tax Office's (ATO) radar under the new anti-avoidance rules (Multinational Anti-Avoidance Law and Diverted Profits Tax) and they are likely to be reviewed by the ATO at some point.
In order to manage the risk, both from a US and Australian perspective, we have observed companies transitioning the Australian operations from a service provider to a buy-sell model. By creating a foreign-based income (i.e. non-US revenue), the inter-company payments associated with this transaction would not be subject to the BEAT provision. This business model change (subject to appropriate transfer pricing [TP] considerations) may also address the anti-avoidance measures and permanent establishment risks in Australia.
A reduced US corporate tax rate for exports (i.e. FDII) should encourage Australian companies to expand into new business by way of the following:
- New business expansion and business/company acquisitions in the US; and
- Evaluation of transferring existing assets and functions into the US, such as intellectual property; and principal and other supply chain functions (for both US and non-US sales).
However, care should be taken when deciding how to finance future acquisitions and operational cash needs of the US business in light of the new interest expense limitation rules. These rules do not grandfather existing debt. Hence, highly leveraged companies will need to consider the impact in the context of existing capital funding structure and evaluate ways to mitigate the consequences.
Less than a week after the US tax reform was signed into law, China released the Caishui (2017) 88 (Circular 88) and relevant interpretations, introducing a withholding tax (WHT) deferral incentive for profit reinvestments in China. In accordance with Circular 88, profits derived by a foreign investor from resident companies in China will be entitled to a tax deferral incentive and temporally will not trigger withholding tax so long as such profits are reinvested (e.g. through capital increase, capital injection or share purchase) in 'encouraged projects', if certain conditions are met. The benefit is applicable for profits distributed on or after January 1 2017, and signals the country's drive to continuously attract and retain foreign direct investment.
In April 2018, President Xi Jinping announced 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 for new fiscal policies to be potentially rolled-out nationwide at a later stage. Reforms like the Hainan free trade zone are expected to create a favourable investment climate as voices within the Ministry of Finance have expressed concerns about the 14% reduction in the headline corporate income tax rate passed with the US tax reform.
It is our understanding that a special task force was formed by the State Administration of Tax to study the impact of the US tax reform on China and more measures and actions are anticipated as a result of this effort.
For Japanese companies, US tax reform may have an important impact on both business and tax strategy. We understand that the major discussion points from Japanese companies' and the National Tax Agency's (NTA's) perspectives are as follows:
- The impact of the reduction in US corporate tax rate: Despite the recent gradual reduction of the corporate tax rate in Japan, the change to the US corporate tax rate may result in the movement of functions to the US. Specifically, the NTA is concerned that Japanese companies may shift value-creating functions such as manufacturing and research and development functions to the US. Such a shift may result in increased audit activity and a review of possible exit tax implications.
- The impact of BEAT: Several Japanese companies engage in transactions with related entities in the US which will be impacted by the BEAT provisions (such as commission or royalty payments). Further, given that there are several advance pricing arrangements (APAs) and mutual agreement procedure (MAPs) cases in place between Japanese and US companies, it will be important that taxpayers clearly define transaction types and cost items in APA applications with the BEAT in mind. It is unclear whether taxation of the BEAT can be treated in the APA or MAP processes between the Internal Revenue Service (IRS) and the NTA and this point will need to be clarified.
Historically, Korean companies have diligently transferred intangibles acquired and/or developed in the US to Korea due to the low effective tax rate in Korea and their existing transfer pricing policies. With the introduction of the new US tax exemption for exports (i.e. FDII), Korean companies may evaluate the effective tax rate benefit of retaining any intangibles in the US. However, in practice, our observations suggest that it is unlikely that Korean companies will actively restructure the ownership of any intangibles simply because of the lower tax rate given. There are several other relevant considerations.
Sri Lanka's two main foreign exchange earning sectors engaged in trade with the US are the garment and information technology (IT) sectors.
Numerous incentives are granted to these sectors via Sri Lankan income tax law to promote and enhance foreign exchange earnings, and these sectors are taxed at a concessionary rate of 14% with the introduction of the new income tax law effective from April 1 2018. The IT sector has been granted further incentives through an additional 35% deduction on staff costs. Although these developments were not in response to the US tax reform, operations in Sri Lanka continue to be tax beneficial, due to the aforesaid incentives.
Moreover, due to advantages of labour arbitrage and trade and customs incentives through first sale for export arrangements, enterprises still consider it advantageous to invest and continue operations/trade relations with Sri Lanka. Accordingly, Sri Lanka could be viewed as being less impacted than other jurisdictions in the region by the US tax reform.
Due to the unavailability of tax treaties between the Taiwan and the US, the repatriation of profit from the US to Taiwan headquartered companies is subject to 30% withholding tax. As a result, Taiwan corporations may not be prompted to invest in the US despite the reduction in the US corporate tax rate to 21% (from 35%).
The introduction of the BEAT and the limitation of interest deductions is likely to cause Taiwan corporations to closely review existing TP policies, value chain arrangements and financing structures and to reconsider some modifications in relevant related-party transactions to minimise the potential tax implications. As a result, Taiwan companies may re-evaluate the effect of restructures and assess related-party transactions to be in accordance with the US tax reform; however, the full importance of the US tax reform is still to be observed.
US tax reform presents both opportunities and challenges (risks). Multinational enterprises will need to identify the concrete steps required to capitalise on opportunities and build pragmatic plans to manage and mitigate substantial risks.
KPMG is working to understand the important changes discussed in this article and over time intends to work with our clients to plan actions, including substantially restructuring the way that they conduct business in the US, in order to fully take advantage of the benefits of the new law while actively managing the risks.
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Tony Gorgas is a senior partner in KPMG Australia's transfer pricing practice and KPMG's Asia Pacific leader, with 20 years of experience advising multinational groups on complex transfer pricing issues. With prior commercial experience negotiating arm's-length pricing arrangements, Tony provides a practical interpretation of the complex technical rule book. Tony's abilities to influence and negotiate on behalf of clients are the cornerstone of his reputation. Tony has significant experience across the Asia Pacific region and leads transfer pricing projects for his clients regionally and globally. Tony has extensive contacts within the Australian Taxation Office (ATO), and strong working relationship within the ATO at all levels including the Competent Authority. Tony is well experienced in negotiating favourable outcomes for clients, and has successfully concluded advanced pricing arrangements with key jurisdictions including the US, UK, Japan and Korea. He also has valuable experience in the resolution of mutual agreement proceedings between competent authorities. Tony assists clients across all industries in setting and reviewing global transfer pricing policies, ensuring optimal tax outcomes and successfully defending such policies with revenue authorities.
Tower 3, 300 Barangaroo Ave, Sydney NSW 2000
Jay Mankad has 10 years of experience focusing on transfer pricing compliance, advisory, advance pricing arrangements, global structure planning and transfer pricing dispute resolution.
Jay has worked in Australia and India providing global assistance across a broad range of industries and sectors, including technology, retail and consumer, manufacturing, specialty chemicals, financial services and industrial products.
Jay has assisted many global multinationals in planning, documenting and defending their global transfer pricing positions. This includes preparing transfer pricing documentation, negotiating successful risk review and audit outcomes, and bilateral/unilateral advance pricing arrangements.
More recently, Jay has assisted clients on the evolving BEPS landscape, anti-avoidance engagements, helping global clients manage the introduction of the country–by-country rules regionally as well as managing regional documentation projects.
Tower 3, 300 Barangaroo Ave, Sydney NSW 2000
Jennifer Goldkopf has five years of experience in KPMG'S global transfer pricing practice, including roles in the US and Australia, assisting multinational companies with compliance, planning, and controversy support services. Jennifer's clients operate across a broad range of industries including life sciences, consumables, medical device, asset management, and consumer markets.
Jennifer has assisted clients in a variety of engagements including documentation/filings prepared in compliance with US, Australian and OECD transfer pricing legislation, transfer pricing planning/restructuring, operational transfer pricing, ATO audit reviews, and BEPS compliance (country-by-country reporting, master file and local file).
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Cheng Chi is the head of KPMG global transfer pricing services for China and Hong Kong SAR. Cheng has led many transfer pricing and tax efficient supply chain projects in Asia and Europe, involving advance pricing arrangement negotiations, cost contribution arrangements, pan-Asian documentation, controversy resolution, global procurement structuring, and headquarters services recharges for clients in the industrial market including the automobile, chemical, and machinery industries, as well as the consumer market, logistic, communication, electronics and financial services industries.
In addition to lecturing at many national and local training events organised by the Chinese tax authorities, Cheng has provided technical advice on a number of recent transfer pricing legislative initiatives in China. A frequent speaker on transfer pricing and other matters, his analyses are regularly featured in tax and transfer pricing publications around the world. Cheng has been recommended as a leading transfer pricing adviser in China by the Legal Media Group.
Cheng started his transfer pricing career in Europe with another leading accounting organisation, covering many of Europe's major jurisdictions while based in Amsterdam before returning to China in 2004.
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Yosuke Suzaki is a partner in KPMG in Tokyo's global transfer pricing service practice who has more than 16 years of experience in transfer pricing, valuation, and economic analysis services. Out of 16 years, he had worked for KPMG in the US's transfer pricing practice in New York for two years until September 2014 to support Japanese based companies as well as other multinational companies.
He has advised clients on matters in the areas of transfer pricing planning study, TP documentation, APAs), Competent Authority, cost sharing, IGS cost allocation, and examination issues. Also, he is a specialist of valuation and economic analysis such as intangible and businesses valuation and business planning.
101 TOWER, No.7, Sec.5, Xinyi Rd., Taipei, 11049, Taiwan, R.O.C.
Anita Lin is a director in KPMG's global transfer pricing service practice in Taiwan. Prior to joining transfer pricing practice in KPMG in Taiwan in 2006, Lin worked for assurance and corporate tax practice for three years in KPMG in Taiwan.
Lin has a wide range of transfer pricing experience, having been involved in advising transfer pricing planning, preparing contemporaneous documentation and assisting in tax audits for multinational corporations operating in information, communication and financial service. In addition, Lin was seconded to KPMG in Singapore's transfer pricing practice and engaged in a variety of international transfer pricing projects.
Lin is a US certified public accountant and holds a MSc degree in international business and management from the UK, and has a bachelor's degree in accounting administration from Taiwan.
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Shamila Jayasekara is the head of the tax division at KPMG in Sri Lanka. She also serves as the alternate chairperson of the faculty of taxation of the Institute of Chartered Accountants of Sri Lanka and is a member of the tax sub-committee of the Chamber of Commerce.
Shamila counts experience in direct and indirect tax across a number of sectors and has been closely involved in advising on inbound investments into Sri Lanka.
Shamila leads the transfer pricing unit of KPMG in Sri Lanka. KPMG in Sri Lanka is a market leader in transfer pricing and has won engagements in fast-moving consumer goods, apparel, IT service and industrial sectors. Shamila also works very closely with the Department of Inland Revenue and has assisted them in implementing transfer pricing in Sri Lanka. She has also been assisting the Institute of Chartered Accountants in preparing a framework for practitioners and has been an active speaker at public forums on the subject.
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Jee-Won Shin is a director at KPMG Korea transfer pricing and the leader of Latin America business in Korea. Before joining KPMG Korea TP team, Jee-Won had almost six years of experience in KPMG Brazil assisting Korean companies in Brazil with their TP issues as a Korea desk, and almost four years of industry experience in the textile and healthcare devices sectors in the US.
Jee-Won has been heavily involved with foreign invested companies in Korea assisting their TP issues such as BEPS compliance, TP planning, and audit review.