This article is the second half of the discussion of the sweeping ramifications of The Tax Cuts and Jobs Act of 2017 (“Tax Act”). Part one discussed the transition tax on deemed repatriation of foreign earnings, the reduction in the corporate tax rate from 35 percent to 21 percent, the changes in the taxation of the international operations of U.S. companies, and changes to interest and depreciation deductions.
In this article, we address provisions of the Tax Act that potentially accelerate tax liabilities, repeal the performance-based exception to the limits on compensation deductions for certain corporations, change the treatment of net operating losses, and cut back the favorable tax treatment of research and development expenses.
David C. Cole
1. Potential Acceleration of Tax Liabilities. Before the Tax Act became law, the requirements for the recognition of taxable income were independent from those for financial reporting—or so-called “book” purposes. In fact, certain types of income could be recognized for tax purposes later than the period in which they were recognized as revenue for book purposes. The Tax Act narrows these taxable income deferral opportunities by accelerating the recognition of certain taxable income to more closely match financial reporting.
This new rule is of particular concern in light of the new accounting rules under the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) Topic 606. Under those accounting rules, expected revenue must generally be recognized as goods or services are provided to customers. Thus, unbilled receivables for partially performed services might be recognized for book purposes—and now for tax purposes, too—ratably as the services are performed, rather than when the services are complete or when the taxpayer has the right to demand payment from the customer. Similarly, items such as performance bonuses might be recognized for book purposes—and now for tax purposes—over the life of the contract, rather than when the standards for receiving the bonus have actually been met.
David C. D’Alessandro
The new tax rules may also affect taxpayers whose contracts with customers contain multiple-element deliverables (e.g., software sales agreements that include a license, updates, and support services, or sales of goods that include a warranty), because the rules now require that the allocation of payments among these deliverables be the same for tax and financial reporting purposes.
What Directors Should Do. This potential acceleration of the recognition of taxable income could have significant cash flow consequences for certain businesses. Directors, and in particular audit committee members, should ensure that the company’s treasury and tax departments have coordinated and evaluated the potential acceleration of tax liabilities as a result of the combined effect of the Tax Act changes and ASC 606. Depending on the extent of any accelerated tax liabilities, it may be necessary for a company to consider potential liquidity sources to meet its 2018 tax obligations.
2. Repeal of Performance-Based Exception to Limits on Compensation Deductions. Public companies may not deduct compensation paid to certain executives in excess of $1 million. Previously, there was an exception to this rule for performance-based compensation that met certain requirements. However, the Tax Act removed the performance-based exception effective for tax years beginning after December 31, 2017. As a result, a public company will generally not be able to deduct compensation in excess of $1 million paid to its chief executive officer, chief financial officer, or its three other most highly-compensated officers. The Tax Act provides some relief through a transition rule, which preserves the deduction for performance-based compensation that is paid pursuant to a written binding contract that was in effect on and not materially modified after November 2, 2017 (the “Transition Rule”).
What Directors Should Do. In light of the removal of the tax incentives for granting performance-based compensation to certain executives, companies may be interested in revising their performance-based compensation programs by, for example, shifting a greater percentage of a covered executive’s compensation to guaranteed salary. However, the terms of some equity and cash incentive plans nevertheless require performance-based compensation to comply with the now-repealed requirements for deductibility, which would limit the changes that could be made to programs without amending the plans. As such, before changes are made to a company’s compensation programs, directors should ensure that the terms of the applicable plans are reviewed to determine if amendments to the plans are necessary to accommodate such changes to the compensation programs.
Additionally, some large institutional investors and proxy solicitation firms have indicated that they expect companies to continue with their existing compensation programs that condition awards on the achievement of rigorous, transparent, pre-established performance goals. Directors should also consider how changes to a company’s performance-based compensation programs will be viewed by the company’s shareholders.
Finally, it will be important for companies with outstanding long-term, performance-based awards to preserve the deductibility of those awards pursuant to the Transition Rule. As such, companies should determine whether performance-based compensation arrangements that were in effect on November 2, 2017 qualify as grandfathered under the Transition Rule and, if so, consider the implications of any potential modifications to such plans.
3. Changes to the Treatment of Net Operating Losses. The Tax Act makes significant changes to the utilization of net operating losses (“NOLs”). Previously, NOLs could generally be carried back to a taxpayer’s prior two tax years and carried forward for 20 years. Extended carryback periods applied to certain product liability-type losses and casualty and disaster losses. Also, under prior law, the corporate alternate minimum tax precluded corporations from completely eliminating their tax liability through NOL deductions. Instead, the alternative minimum tax (AMT) imposed an effective 2 percent tax rate on a corporation that otherwise would owe no tax because of NOLs.
Under the Tax Act, corporations (other than certain farmers and property and casualty insurers) cannot carry back NOLs arising in tax years beginning on or after January 1, 2018. Those losses are no longer a means to generate cash refunds of previously paid taxes. Also, a corporation may not eliminate more than 80 percent of its taxable income (determined without regard to the NOL deduction) for a given year. Thus, although the corporate AMT was repealed under the Tax Act, this limitation effectively results in a minimum tax of 4.2 percent on a corporation suffering losses (more than doubling the previous effective rate). On the positive side, NOLs now can be carried forward indefinitely instead of only 20 years.
What Directors Should Do. The changes to NOLs are particularly troublesome for early stage companies, corporations in cyclical businesses, and companies that suffer product liability-type and substantial casualty or disaster losses. Losing the ability to carry back NOLs to generate tax refunds and the ability eliminate all taxable income with NOL deductions will negatively affect cash flow. Because of these changes, corporations should attempt to better match their income and deductions annually to reduce the extent of the NOLs they generate.
Directors of companies that incur NOLs should ensure that their tax departments are sensitive to this issue and are considering ways to better match income and deductions. For example, in years that appear likely to generate a net operating loss, opportunities to trigger or accelerate taxable income should be considered. Also, the new 100 percent deduction for the acquisition of tangible assets (discussed in Part I of this article) is not mandatory. Accordingly, consideration should be given to electing out of that “immediate expensing” if doing so avoids creating NOLs.
4. Cutbacks to the Favorable Treatment of Research and Development (R&D) Expenses. The tax laws have long provided favorable treatment for certain R&D expenses in order to encourage U.S. companies to invest in research. These include a current deduction for such expenses and a tax credit based on specified increases in the level of certain R&D spending. Under the Tax Act, however, the favorable treatment of R&D expenses is scheduled to be reduced in future years.
First, beginning in 2022, corporations may no longer currently deduct R&D expenses. Instead, those expenses must be capitalized and amortized over 5 years (in the case of U.S. research) and 15 years (in the case of non-U.S. research). Also, the Tax Act created a new Base Erosion and Anti-Abuse Tax (BEAT) that applies to larger U.S. corporations that make certain payments to non-U.S. affiliates. Beginning in 2026, the amount of tax a U.S. corporation would owe under the BEAT will no longer reduced by its R&D credit—potentially resulting in a significant decrease in the value of such credit.
What Directors Should Do. Given the future effective date of the R&D changes, companies may wish to consider lobbying Congress to repeal the Tax Act changes before they become effective. In addition, the numerous changes to the taxation of international operations discussed in Part I of this article should be considered as part of any restructuring or expansion decisions. In the case of locating or expanding R&D centers, the pending changes reducing the tax benefits of U.S. R&D expenses should be included in that analysis.
George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits (ECB) department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. David C. D’Alessandro is an executive compensation and benefits partner at Vinson & Elkins and advises employers and executives in the structuring of employment agreements and executive compensation arrangements.
The Tax Cuts and Jobs Act of 2017 (“Tax Act”) has sweeping ramifications. These range from mechanical compliance issues (e.g., revised withholding rates for employees) to strategic concerns that must ultimately be decided in the boardroom. For domestic corporations and foreign corporations with U.S. operations, one strategic imperative is a wholesale re-evaluation of the structure of a company’s operations. In this first of two articles, we identify four significant aspects of the Tax Act with which corporate directors should become familiar.
1. Mandatory “Transition Tax” on Deemed Repatriations of Deferred Foreign Earnings. Many corporations have deferred foreign earnings under Accounting Principles Board Opinion No. 23, recording no associated financial statement U.S. income tax liability based on the position that such earnings are indefinitely reinvested in foreign operations. The Tax Act terminates the deferral and imposes a tax liability on deferred earnings regardless of whether they are actually repatriated. The Transition Tax on this “deemed repatriation” is 15.5 percent on the portion of the earnings represented by cash and cash equivalents and 8 percent on the portion invested in non-cash assets. Although most of the provisions of the Tax Act take effect in 2018, the Transition Tax is due on a corporation’s 2017 tax return and will likely cause a charge to 2017 earnings. There is an election to pay the tax in installments over an eight-year period.
What Directors Should Do. Computing the Transition Tax can be extremely complex and requires data the corporation may not have collected in the ordinary course of its business. This is particularly the case where the corporation has acquired companies that earned foreign profits after 1986. The U.S. Securities and Exchange Commission (SEC) has issued guidance, including Staff Accounting Bulletin 118, to assist corporations in applying generally accepted accounting principles (GAAP) to reflect the impact of the Tax Act where necessary information is not yet available. Directors, and in particular audit committee members, should ensure that the corporation devotes adequate resources to preparing a reasonably accurate computation of the Transition Tax in time to make their disclosures for the fiscal quarter or year ended December 31, 2017. Given the many open issues regarding the Transition Tax that may not be clarified by the filing date of the corporation’s tax return, corporations should enlist expert assistance to interpret the law and refine the company’s computation of the Transition Tax.
The deemed repatriation affords many corporations greater flexibility to utilize previously “trapped” cash (i.e., cash that was held by non-U.S. entities that could not be repatriated without being subject to U.S. tax). This cash might be used to fund acquisitions, capital expenditures, debt repayments, stock buybacks or dividends. Directors should ask management to focus on the corporation’s optimal capital allocation and to report to the board concerning available options.
2. Reduction in Corporate Tax Rate from 35 Percent to 21 Percent. The default rate on corporate taxable income drops from 35 to 21 percent, although there are special lower rates for certain types of foreign earnings discussed below. This 40-percent reduction in the corporate tax rate will affect the value of a corporation’s deferred tax assets and liabilities. For example, all things being equal the value of a net operating loss carry-forward may drop by 40 percent. At the same time, however, the lower tax rate may increase after-tax earnings going forward for many corporations. There are many less obvious implications of the rate reduction, particularly in conjunction with other changes in the Tax Act.
What Directors Should Do. Directors should commission a study by the corporation’s tax department of potential changes in the corporation’s legal entity and operational structures to take full advantage of the rate reductions in combination with other relevant provisions of the Tax Act. Such a study will also be useful in completing the corporation’s tax accounting analysis of the impact of the Tax Act under GAAP and related disclosures in the corporation’s SEC filings.
3. Reform of Taxation of International Operations. The Tax Act radically changes the taxation of profits earned outside the United States.
First, it eliminates the deferral of U.S. tax on foreign earnings. Thus, U.S. income tax now will be imposed on most current earnings of foreign subsidiaries rather than being postponed until earnings are repatriated.
Second, as a limited exception, foreign profits amounting to a 10 percent return on certain investments in tangible assets are permanently exempt from U.S. tax.
Third, profits from intangible assets earned outside the U.S. can be taxed at a special rate of 10.5 percent to the extent those profits result from certain types of revenues. Profits earned by domestic corporations from certain foreign sales of property or services are eligible for a special tax rate of 13.125 percent. Both of these special rates are scheduled to increase after 2025, but to levels well below the general 21 percent corporate rate.
What Directors Should Do. Directors should request a thorough review of the corporation’s international footprint as part of the study described above. This review should consider the optimal location not only of the corporation’s operations, but its personnel, tangible assets and intangible assets. Unlike GAAP consolidation, tax reporting must generally be made on an entity-by-entity basis (although consolidation of affiliates within a single country is often allowed). As a result, the corporation’s legal entity structure and inter-company contracts must be carefully aligned with its commercial arrangements. Given evolving changes in the tax laws of other member countries in the Organization for Economic Co-operation and Development (OECD), and particularly under the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, structuring operations to accommodate both foreign tax laws and the new U.S. tax regime may be challenging. Finally, in evaluating any structure, directors should consider the prospects for future tax changes in reaction to the Tax Act in jurisdictions where the corporation operates.
4. Changes to Interest and Depreciation Deductions. The Tax Act gives with one proverbial hand—allowing immediate deduction of 100 percent of the acquisition cost for certain depreciable assets—and takes away with the other by limiting deductibility of net interest expense for many corporations. The “immediate expensing” provision applies only to tangible assets like plant and equipment and is phased down beginning in 2023. This new provision is more generous than prior “bonus depreciation” rules because it also applies to used assets, as well as new assets.
The interest expense rule limits certain corporations’ ability to currently deduct net business interest expense amounts exceeding 30 percent of certain thresholds. These thresholds are based on Earnings Before Income and Tax (EBIT) in years through 2021 and—less favorably—on Earnings Before Income, Tax, and Depreciation (EBITDA) after 2021. Disallowed interest deductions generally may be carried forward indefinitely. Interest expense on existing indebtedness is not grandfathered. Regulated public utilities are automatically exempt from these rules. Corporations in a broad spectrum of real property related businesses, farming businesses, and certain other agricultural businesses may elect to have these rules not apply.
What Directors Should Do. Directors should evaluate the impact of these two provisions on their corporation’s capital structure and its investment decisions. They should understand the implications of immediate deductibility of depreciable assets on acquisition structures. For example, acquiring stock may result in a lower internal rate of return than acquiring assets. Regarding the business interest limitations, directors should encourage management to determine whether the corporation is eligible to elect out of these rules and, if not, to explore alternatives to debt repayment, such as preferred equity instruments or other structures, that might mitigate the impact of these limitations.
Visit the NACD Board Leaders’ Blog again for the second installment in this series.
George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. Thoughts expressed here are their own.
A few weeks into the Trump presidency, it is tempting to obsess about the political rhetoric and soundbites coming out of Washington, DC. While the first month of this new administration is certainly unprecedented in style, method, and message, the real cumulative impact on business remains unclear.
The combination of the chaotic start, the many political appointee vacancies across key departments and agencies, conflicting policy views between a Republican White House and Republican-controlled Congress on key issues, and ongoing investigations makes it challenging for businesses to respond and separate signal from noise.
Nevertheless, a recent pulse survey conducted by the National Association of Corporate Directors (NACD) offers some early insight into how companies and their boards are starting to navigate this new political environment.
1. A small majority of respondents (51%) is positive or very positive about the possible impact of the new administration on the growth prospects for their companies in the next 2 years. Almost 29 percent of respondents rated the possible “Trump effect” on business as either negative or very negative.
The differences in outlook are likely influenced by the relative dependence of individual companies on the benefits of international trade, the expected industry benefits of deregulation and infrastructure spending, and perceptions about the impact of a changing US leadership role in the global economy and security architecture.
2. Corporate tax reform, deregulation, and trade protectionism are the most highly ranked “policy” topics that respondents plan to discuss at their next board meeting. That’s not surprising since the (gradual) effect of policy changes in these three areas can significantly alter cost and revenue projections for business. The big question for many boards and executive teams will be whether the potential
fallout from trade protectionism (actions by the United States and possible retaliation by its trading partners) would offset any gains from a reduced tax and regulatory burden.
Trump’s unorthodox approach of injecting himself in the daily business of individual companies and their decisions seems to concern fewer respondents. Only 13 percent plan to discuss reputational exposure and management at their next board meeting.
3. Fifty-one percent of companies are now reassessing core assumptions about the impact of new and proposed policies on their strategic growth plans, which is an important exercise when so many key variables are moving or likely to move in the near future (for example, corporate tax rates, inflation, value of the dollar, interest rates, and import/export barriers).
Also, in response to the speed and ferocity with which consumers in this very polarized environment now react to corporate actions, many business leaders are beginning to proactively communicate the authenticity of their brand and their company’s contributions to society. More than 44 percent of respondents report that their companies are now reaffirming their core values and commitments to key stakeholder groups.
4. Only 25 percent of respondents decided to introduce scenario planning exercises to adapt to changes in the operating environment. Of that group, 85 percent are considering discontinuous scenarios based on major swings in key economic indicators, while 76 percent are scenario planning different outcomes from the planned overhaul of the US corporate tax system. Other macro-issues, for which boards will use scenario-planning in the coming months, include the possible repeal of the Affordable Care Act, the commercial fallout of trade protectionism, and the impact of significant geopolitical crises.
If used effectively, these scenario exercises can help open the minds of decision-makers—corporate directors included—to different signals, and prepare for surprises that directly affect the business strategy. Leading companies actively monitor for such signposts that would trigger course corrections in their strategic pathway.
To help corporate directors sense and respond to changes in this operating environment, NACD continuously assesses and interprets the impact of emerging issues. Every week we post our most recent analyses in our Emerging Issues Resource Center. Stories are accessible to all members.