President Trump’s rhetoric around tax reform is heating up. So are technology companies’ worries about it.
The plural majority (25 percent) of tech CFOs view tax changes as the biggest challenge to their organization in the year ahead, according to the 2017 BDO Technology Outlook Survey. Tax changes outweigh other worries around healthcare policy (21 percent), slowing emerging market growth (20 percent), lack of a qualified workforce (14 percent), trade and immigration policies (10 percent), and interest rate changes (9 percent).
Perhaps more telling are tech CFOs’ concerns related to corporate tax reform specifically. Fifty-three percent of tech CFOs rank corporate tax rates as most concerning when it comes to corporate tax reform, up from 49 percent in 2016 and showing a consistent increase over the past six years. Other concerns relating to corporate tax reform included aggressive state tax laws (20 percent), concerns around US taxation of overseas activities (19 percent), and tax reform for Base Erosion and Profit Shifting, or BEPS (8 percent).
What are tech CFOs gunning for when it comes to tax reform? Unsurprisingly, most (61 percent) say lowering corporate tax rates is their top tax priority, echoing 2016 campaign rhetoric. Incentives for research and innovation came next (19 percent), followed by incentives to repatriate foreign earnings (11 percent) and overhauling tax rules for international activities (9 percent).
Lowering the US corporate tax rate has long been on the wish list for US-based entities, as the combined federal and state statutory tax rate is the highest among Organization for Economic Cooperation and Development (OECD) nations, according to the Congressional Budget Office’s March 2017 report comparing international corporate income tax rates. Many of those countries continue to reduce their corporate income tax rates, while others offer even lower rates for income derived from intellectual property. When combined with increasing domestic political pressure to bring back cash and jobs to the United States, it is no wonder that this issue is top of mind.
Trump’s campaign promises to both lower the corporate tax rate to 15 percent and to implement a one-time “tax holiday,” allowing companies to repatriate profits earned abroad at a one-time 10 percent rate, have belied hopes for reform once considered a pipe dream.
As the Technology Outlook Survey indicates, while corporate tax changes do gain the most fanfare, they also draw the most concern from executives, and for good reason – the details, or rather, lack thereof.
While the Trump administration has repeatedly expressed a desire to reform the corporate tax rate, a consensus has yet to emerge on how exactly others reforms will take shape. Although a reduced corporate tax rate enjoys bilateral support, in the face of rising deficits, there will certainly need to be revenue-raisers, as well, in the absence of dramatic dynamic economic growth expectations spurred on by any proposed tax legislation.
One of the main blueprints for tax reform is a controversial plan promoted by House Speaker Paul Ryan (R-WI), which includes a border-adjustment tax proposal that would create a consumption tax utilizing a 20 percent rate.
Based on the outline provided in the House Republicans’ tax policy plan, A Better Way, the border-adjustment tax conceptually would tax companies on their sales to US customers while excluding export sales from the tax entirely. This would generally be considered positive for companies with global customer bases, like many tech companies. However, the costs of goods, services, and intangibles purchased from foreign parties and sold to US customers would not be deductible from taxable income, as they currently are under US income tax principles. This could be a game-changer for an industry that frequently relies on foreign contract manufacturers as a major part of their supply chain.
The below graphic illustrates the border-adjustment concept.
Without something dramatic like the border-adjustment tax, tax legislation featuring a reduced corporate tax rate may have a hard time getting off the ground. At present, there are few alternatives to provide positive offsets.
Nevertheless, reports indicate that such proposals are getting lukewarm support at best. “Revenue-raising alternatives to border adjustment, such as a carbon or consumption tax, are getting nowhere in internal discussions,” reported the Wall Street Journal on April 5.
Concerns Transcend US Borders
And while lower corporate tax rates indeed gain the most fanfare, for an industry with an effective corporate tax rate often well below the official 35 percent rate, other international tax developments could also have a profound impact.
In late 2015, the OECD issued its BEPS guidelines. A set of 15 actions concerning global tax rules related to transfer pricing, permanent establishments, and aggressive tax planning, including the use of intellectual property holding structures, the actions are designed to combat aggressive international tax planning and to promote greater transparency around transfer pricing and the use of certain tax-driven structures.
Many countries have already begun implementing BEPS-compliant tax laws. The United States recently implemented BEPS guidance related to country-by-country reporting, which will require the disclosure of certain critical information that can be accessed by the taxing authorities of all member states. Additionally, the European Union (EU) has been pushing to eliminate certain tax benefits in its member countries that, under EU state aid law, are considered anti-competitive and unfair.
Tech companies also have a new Financial Accounting Standards Board (FASB) standard, Accounting Standards Update (ASU) No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory, to consider. In 2016, the FASB removed the exception for intercompany transfers. The new rule, which goes into effect in 2018, will require full recognition of current and deferred income taxes from intercompany transfers of all property – except inventory – when the transfers occur, even though the intercompany pretax profit would still be eliminated and recognized in future periods.
The impact will be significant.
For example, an outbound transfer of intellectual property from a US parent to a foreign subsidiary in Ireland would trigger recognition of US and Irish income tax effects (using tax rates of 35 percent and 12.5 percent, respectively). Assuming the fair market value of the intellectual property on the transfer date is $10 million, a taxable transfer would result in a $3.5 million US tax expense (assuming zero tax basis for internally-developed intellectual property) and a $1.25 million tax basis step-up in Ireland (net tax effect of $2.25 million).
Prior to ASU 2016-16, this net tax effect would be deferred and recognized over several years (typically between five to 10 years for tech intellectual property). Under ASU 2016-16, the net tax effect is recognized when the asset is transferred. This will mean no more spreading (over multiple periods) the tax consequence from intercompany transfers of intellectual property and other assets.
The significance of this change should be considered in the context of the new international tax landscape. For example, a multinational entity that currently owns the non-US rights in a “zero” tax jurisdiction might have to restructure and transfer such rights to another foreign country where the tax rate is more than zero but is sustainable under BEPS-compliant rules requiring operational substance. Or, emerging tax legislation could make existing intellectual property structures obsolete – and even conceivably result in the repatriation of intellectual property or related rights.
Tech executives’ worries around US tax changes – especially the way they would be enacted – are warranted. And while they need to keep abreast of developments around US tax reform, they are also challenged with the prospects of global tax law and accounting changes, and potential re-evaluation of conventional intellectual property structures.
Financial reporting disclosures of material-enacted changes are important to keep users of financial statements informed about current and expected tax burdens. The accounting standard change required by ASU 2016-16 will cause tax rate volatility when intellectual property (or other property, except inventory) is transferred via intercompany transfers, which will give greater prominence to material intercompany transfers and force greater transparency of intellectual property holding structures and tax planning.
However, uncertainties about potential US tax reform might necessitate a “wait-and-see” approach before current intellectual property holding structures are significantly modified.
About David Yasukochi and Yosef Barbut
David Yasukochi is a managing partner in BDO USA’s Tax Office. Yosef Barbut is a national Assurance partner and the ASC 740 subject-matter technical leader for BDO USA.