As the promise of tax reform sputters into the fourth quarter, companies have some big decisions to make about where to make and hedge their bets when it comes to tax planning.
Based on the latest tax reform framework—the likely basis for legislation—the top federal income tax rate for corporate taxpayers could drop from 35 percent to 20 percent, which is lower than the average for other industrialized countries. Capital investments could be subject to immediate expensing. The deductibility of interest expense could be limited, and many other common deductions could be wiped out entirely.
The framework also takes aim at foreign earnings, seeking to “end the perverse incentive” to keep foreign earnings offshore by taxing them only when they are brought into the United States. It would replace the current system with a worldwide tax system, treating foreign earnings currently held abroad as repatriated. Earnings held as illiquid assets would be taxed at a lower rate than those held as cash or cash equivalents, and the tax liability would be spread out over several years.
But how much of that framework will become reality? And when? And if it won’t happen until 2018, will any of it be retroactive? Companies can only guess the certainty, timing, and magnitude of any of it. That makes year-end 2017 tax planning particularly challenging.
“A lot of companies are in a bit of a wait-and-see situation,” says Raimundo Diaz, head of the Americas at international consulting firm TMF Group. “Directionally, it means a reduction of taxes and a simplification of taxes.” Some believe a reduction in rates coupled with the removal of many common deductions and exceptions will produce no meaningful change in the actual tax corporations pay, he says. “We’re already seeing that reduction thanks to loopholes and deductions.”
That’s fueling the wait-and-see approach, Diaz says. “Most companies today are planning based on what they know, which is the current situation,” he says.
On top of the uncertainty of tax reform, companies have also followed closely reports emerging from the U.S. Treasury regarding the potential regulatory reforms that wouldn’t require legislation. These are measures the executive branch of the federal government could pursue under its own authority.
“The only certainty this year is uncertainty. Companies should be planning and modeling for the impact of some of the potential changes. Look at the financial statement impacts of a rate reduction and some of the deductions that might get limited and tossed out.”
William Andreozzi, Partner, CohnReznick
“It’s unclear where that would lead us,” says Todd Simmens, national managing partner of tax risk management at audit firm BDO USA. “Like every other practitioner, we’re watching very, very closely to see what’s happening. It’s hard to advise clients to rely on them.”
In one small measure of relief, for example, Treasury has already delayed by one year the effective date for Obama-era reporting requirements regarding the treatment of certain cross-border transactions as debt or equity for tax purposes. Uncertainty runs deep around other provisions that have been raised as possible points of relief. Some regulations are required by underlying legislation, and some are just necessary because they provide guidance for statutory provisions that otherwise couldn’t be applied or enforced, says Simmens.
“The only certainty this year is uncertainty,” says William Andreozzi, a partner with audit firm CohnReznick. He doesn’t necessarily see that as a reason to paralyze tax planning, however. “Companies should be planning and modeling for the impact of some of the potential changes. Look at the financial statement impacts of a rate reduction and some of the deductions that might get limited and tossed out.”
A reduction in the corporate rate would have a significant effect on deferred tax assets and deferred tax liabilities companies carry on their balance sheets, says Andreozzi. These are accounts that companies use to reflect timing differences between tax and accounting rules for various taxable events. A 20-percent rate applied to a deferred tax liability will produce a much different ultimate tax expense than a 35-percent rate. The same principle applies to a deferred tax asset, or a tax benefit a company will realize at some point in the future.
If you have a company in a deferred net tax asset position, a rate reduction would be a hit to earnings,” says Andreozzi. “It would be a one-time adjustment that would negatively affect earnings.” Likewise, a rate reduction on a net deferred tax liability would have a positive effect on earnings, he says. “So you are likely to see not only a balance sheet impact but also a profit and loss impact.”
That equation suggests companies can start to do some calculations now to determine how their earnings and balance sheet would be affected by a rate reduction, says Andreozzi. It won’t be a perfect number, he says, given the potential for changes in various deductions, but it gives companies some sense of the potential direction and magnitude of change.
Five Ways to Prepare for Tax Reform
1. Assess the impact – The framework for tax reform released by Republicans would dramatically alter how businesses are taxed. Understand how it affects your business to enable smart decisions and identify planning opportunities.
2. Accelerate deductions – With the prospect of a rate cut creates, accelerate deductions against today’s higher rates. Businesses can often control the timing of many types of expenses, including compensation, bonus pools and benefit payments.
3. Review accounting methods – Most businesses employ dozens of separate accounting methods on everything from inventory to software development. Identify better methods to achieve favorable adjustment taken fully in the year of change. Potential may be greatest in deferring recognition on advanced payments or disputed income and accelerating deductions for computer software, self-insured medical expenses, property taxes, payroll taxes, prepaid expenses and rebates.
4. Plan for one-time tax – The Republican framework would impose a one-time tax on all unrepatriated foreign earnings as part of a transition to a territorial tax system. Develop and implement plans to reduce the impact of this one-time tax.
5. Discuss risk on the financial statement – The impact of legislative changes aren’t recorded in the financial statement until enacted, but shareholders of public companies expect management to understand, plan for, and disclose risks. Consider whether to include a discussion of the potential impact of tax reform in the MD&A.
—Dustin Stamper, Grant Thornton
Dustin Stamper, a director in the Washington national tax office at Grant Thornton, is even more bullish on tax planning in the current environment. “There’s a big opportunity this year because of the prospects of tax reform,” he says. “The potential for a significant corporate rate cut makes the traditional deferral strategies all that more powerful.”
Public companies in particular are sometimes reluctant to pursue various revenue or expense deferrals to achieve tax timing differences, says Stamper, rationalizing they don’t show up on the balance sheet. In the event of a meaningful rate reduction, however, the rate cut would produce a permanent benefit, not just a timing difference, he says. “You can accelerate deductions into this year when the rates are higher, and defer income to next year when the rates are lower,” he says.
Stamper says companies can take a look at capital expenditures and their recovery periods for fixed assets, looking to determine if certain components can be segregated and depreciated along a faster timeline. They can also can review accounting methods to determine where changes in those methods may be turning deferrals into permanent tax savings, he says.
Compensation and benefit plans may also provide some year-end tax planning opportunities in the current environment, says Stamper. Employee bonuses, for example, if paid within the first two and a half months of 2018, may be deductible in 2017. Companies might want to consider how they are paying bonuses in the early part of 2018 and take measures to assure they will be deductible in 2017, he says. Early payments into pension funds might also be deductible in 2017.
“We’re definitely already seeing big companies doing some of this now,” says Stamper.
With respect to earnings held in foreign-controlled corporations, companies would be wise to study their positions and give some thought to how they would be affected by the trajectory of international tax reform, says Stephen Henley, senior managing director and national tax practice leader at CBIZ MHM. If a change in those tax rules would subject companies’ foreign-held earnings to U.S. tax, companies should be looking at where and how those earnings are held to get a sense of how they might be affected.
While it’s considered likely companies will experience some kind of one-time tax hit to transition from the current U.S. position on foreign earnings to a new worldwide tax system, there may be a silver lining down the line. “It would bring an ability to bring earnings back to the U.S.,” says Henley. “It would help companies from a cash management standpoint.”