The legislative package is the most comprehensive tax reform since Ronald Reagan's 1986 Tax Reform Act. One of the Trump administration's goals for the US tax reform legislation was to incentivise corporations to invest in the US.
Several provisions, including the lower federal corporate tax rate, 100% depreciation on qualifying tangible property purchases and a reduced tax rate on certain 'export' income (foreign derived intangible income (FDII)), aim to attract investments in and to encourage companies to allocate income to the US.
In addition to the above-mentioned tax benefits, there are certain provisions that intend to protect the US tax base and discourage base-eroding payments. Two provisions for which this is particularly true are the base erosion anti-abuse tax (BEAT), which may limit the tax deductibility of certain payments made by US companies to related foreign entities, and the rules for global intangible low-taxed income (GILTI), which effectively results in US taxation of non-US subsidiaries' income in excess of a 10% return on tangible assets held by non-US subsidiaries.
Against this background, the TCJA has the potential to increase global tax competition. It is expected that further jurisdictions such as France, Belgium and UK will take the opportunity to reduce tax burdens for companies, resulting in additional pressure on the German government. With effective taxation of 28% to 30%, Germany may 'fall behind' and remain the highest-taxing jurisdiction among OECD countries.
The new provisions may also directly or indirectly affect German multinationals with investments in the US. The following article summarises the main changes relevant for business, with a particular focus on implications for German-based investors.
General changes in US the corporate tax system
Reduced corporate tax rate
The first and most prominent pillar of the TCJA is the reduction of the corporate tax rate from 35% to 21% at the federal level (Internal Revenue Code Section 11b). Under the consideration of the state and local taxes, the combined tax burden in the US will in future be between 21% and approximately 30.5%, depending on the state. This is substantially lower than in the past. The application of the FDII rules may further reduce the US's effective tax rate.
Depreciation on qualifying tangible property purchases
Under the US tax reform legislation, qualified property acquired after September 27 2017 and placed into service on or before December 31 2022 is generally eligible for 100% immediate expensing (IRC Section 168k). Qualified property generally includes new (including newly acquired from a third party) tangible, depreciable property (excluding land and buildings) with a useful life of up to 20 years as well as software.
The new rules also apply if the assets are acquired second-hand, for example in 'asset deal' business acquisitions. If certain elections are made, this provision can provide significant benefits to corporate acquirers when a business acquisition is structured as an asset deal (in contrary to the acquisition of shares), with an incentive to allocate as much of the purchase price as possible to property that is eligible for 100% immediate expensing.
Amended tax credits
Numerous special deductions and tax credits will no longer be available in future. Although the tax incentives for R&D will remain, corresponding expenses will have to be capitalised and depreciated over five years (or 15 years for R&D projects carried out abroad) from the year 2022 onwards (IRC Section 174).
Loss carry forwards
In addition, the mechanism for the utilisation of tax loss carry forwards is amended comprehensively. As per IRC Section 172, a loss carry back will not be possible in future, while losses recognised in years from 2018 onwards can be forward for an indefinite period of time. However, for the losses arising from 2018 onwards, the utilisation of the loss carry forward amount will be limited. Losses will only be deductible to the extent of 80% of the taxable income generated (IRC Section 174a in combination with Section 13302a). Due to the time restriction for carrying forward tax losses incurred before 2018, multinationals may consider whether a conversion of 'legacy losses' into 'new losses' is an appropriate strategy.
The TCJA's impact on US funding structures
In the light of the high US tax rates in the past, multinationals used debt financing to the extent permitted by the former law to reduce their tax burden in the US.
Multinationals should take a closer look at the impact of the TCJA on their financing structure. Previous existing regulations for classifying financial instruments as debt or equity (IRC Section 385) are still applicable and were not triggered by the introduction of the new interest barrier rules (IRC Section 163j). Multinationals that convert debt into equity post-TCJA will have to consider the risk of an unintended generation of taxable income. In individual cases, companies could consider increasing interest income in the US, if the interest barrier would otherwise not be triggered.
The new IRC 163j rules on the restriction of the deductibility of interest payments for tax purposes are very similar to the German interest barrier: Net interest expenses (paid to third parties or other group members) are deductible immediately only up to a level of 30% of earnings before interest, tax, depreciation and amortisation (EBITDA). From 2022 onwards, the 30% limit will be based on EBIT, instead of EBITDA.
The TCJA's impact on transfer pricing and operating models
There are new international provisions intended to attract investments in US ('the carrot') and to dis-incentivise US companies to keep certain operations outside the US ('the stick').
Combined with the reduction of the federal corporate income tax rate from 35% to 21% and the commercial and operational business opportunities the US market offers, multinationals may consider shifting to, or establishing, entrepreneurial functions and activities in the US.
For innovative companies, the TCJA introduces preferential treatments that provide additional incentives to develop technology and IP in the US and market the products worldwide. The preferential treatment rules (IRC Section 250) stipulate that FDII is subject to a lower effective tax rate of 13.125%. The term (FDII) applies to service, licence or sales revenues and thus, the FDII benefit is granted regardless of whether the US entity generates IP income or holds intangible assets in the US. The Trump administration aims to incentivise the establishment of R&D hubs in the US.
|US tax reform employs both the carrot and the stick methods|
On the other hand, the TCJA enacts a minimum taxation for US group entities (above a $500 million per annum US revenue threshold) that receive services from affiliates from abroad. The BEAT aims to prevent the domestic tax base from shrinking by making certain payments for services to foreign (affiliated) companies. Consequently, US companies making inter-company payments for licences, services or interests to foreign affiliated companies may not be able to deduct these as expenses for tax purposes, while in the country of origin, the payments are treated as taxable income. In those cases, multinationals face the risk of double taxation.
Effects on German taxation
German CFC rules
After reducing its federal corporate income tax rate, the US may be classified as a low tax country under German CFC rules (Section 7-14 of the German Foreign Tax Act), which may lead to taxation of US income in Germany.
German CFC rules limit the shift of 'mobile' income in low-tax jurisdictions. Technically, this happens by attributing passive income of foreign subsidiaries as taxable dividends to the German shareholder, if the foreign effective tax rate is below 25%. By lowering the US federal tax rate to 21%, a state tax rate of less than 4% would result into an effective tax rate that is lower than 25% and thus, the income would be treated as low-taxed from a German CFC perspective.
Although the German financial administration is considering reducing the 25% threshold, it is unclear whether and when that change of law will come. In cases where US subsidiaries of German multinationals are entitled to FDII benefits, the combined effective tax rate may, independent from the state tax rate, be below the 25% threshold, due to the preferential tax rates applicable on this income (effective tax rate of 13.125%). Thus, FDII income may be subject to the German CFC rules. Accordingly, multinationals should very carefully analyse if additional state taxes increase the effective tax rate to more than 25% (See Section 8, paragraph 3 of the German Foreign Tax Act) and whether passive income is generated by the US-subsidiary (e.g. interests, licence income derived from acquired IP). Should that be the case, it would be crucial that the US activities are deemed as "active" within the meaning of the German Foreign Tax Act in order to avoid additional taxation in Germany and jeopardise US tax benefits.
Deductibility of licence payments
Since the beginning of 2018, a new rule in German tax law (Section 4j of the Income Tax Act) has applied. This so-called 'licence barrier' limits the tax deductibility of licence payments to foreign affiliates.
According to the licence barrier, licence payments to foreign affiliates are non-deductible for tax purposes in Germany if a foreign affiliate's licence income is subject to a non-OECD-compliant preferential taxation. One such example would be if special tax rates apply for the foreign affiliate's income from intangible assets and the preferential tax regime does not consider the nexus approach as defined by the OECD standards.
In cases that an US affiliate benefits from the new FDII rules and receives licence payments from the German company, it has to be analysed whether the tax deductibility of the licence payments in Germany may be denied.
According to the latest discussion in German academia, it is questionable whether the FDII rules are in accordance with the modified nexus approach. However, it is argued that the FDII rules cannot be classified as a preferential regime, since the FDII benefits are not directly related to the IP income but pertain to a calculated fictitious excess return. Against this background, the FDII rules are considered by some commentators as not being harmful to the chances of attaining a tax deduction of licence payments paid by companies in Germany. Nevertheless, since the German tax authorities will likely use a broad interpretation of the concept of preferential regimes, there is still uncertainty for German taxpayers, and no official guidance is available as yet.
Multinationals that intend to amend their supply chain and shift income to the US have to consider German regulations regarding the transfer of functions. These strict rules for the transfer of functions may result in taxable income in Germany and should prevent multinationals from relocating intangibles to foreign jurisdictions without taxing the profit potentials of the respective intangible.
Accordingly, companies should use caution when planning adjustments to corporate functions and responsibilities, in response to the increased fiscal attractiveness of the US as a business location, to avoid exit tax in Germany.
The dramatic reduction of the US corporate tax rate has accelerated international tax competition. Although broadening the tax assessment basis results in an additional tax burden, many multinationals will benefit from the TCJA.
If multinationals have confidence in the consistency of the new legislation, they need to take a closer look at the impact of US tax reform on their operating models. It is not only necessary to understand the new tax rules, but also the interdependencies and trade-offs with other business factors like labour costs, customs, import duties and logistics.
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Oliver Wehnert is an international tax partner in EY's Düsseldorf office and heads the international tax services practice in Germany, Switzerland and Austria. He joined EY in 1998 after working for PwC for six years.
Oliver has vast experience in client services on inter-company pricing, international tax planning and transfer pricing controversy services.
Oliver's experience includes: global transfer pricing documentation projects, transfer pricing audit defence and operating model effectiveness projects. Oliver has significant experience in TP controversy including supporting clients with their applications to tax authorities of various countries in Europe, the Americas and Asia with mutual agreement procedures and advance pricing agreements.
Oliver has numerous years of experience in providing transfer pricing services to a wide variety of industry sectors, particularly the pharmaceutical, automotive and retail and consumer products sectors.
Partner, international tax services and head of tax Bavaria
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Christian Ehlermann has practical tax advisory experience since 1990 in the areas of international taxation, M&A and restructuring transactions, mostly in a cross-border context. He has advised on some of the largest M&A transactions involving German companies. In recent years, he has also focused on tax policy matters, such as the BEPS-related developments.
His clients include German and foreign multinationals from a broad range of industries, as well as financial investors. Before joining EY in 2013, Christian worked for another Big 4 firm, but also as an in-house international tax specialist for a German DAX-30 company.
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