06 February 2018

The US tax reform's impacts on Sino-US cross-border investment

This article was written by Tony Dong(Partner),Duan Tao (Daisy)(Partner),Cao Linlin(Managing Associate) and Yang Yingjie(Legal Assistant).

The US Senate and House of Representatives eventually voted to clear  the Tax Cuts and Jobs Act on December 20, 2017, after several rounds of back and  forth between the Houses. Two days later, the US President Donald Trump  officially signed this Act into effective law, as the culmination of the US tax  reform that had galvanized worldwide attention. This legislation is the biggest  and most compressive overhaul of the US tax system since the Reagan  administration in 1986.

Undoubtedly, this tax reform will have a profound  impact on the economic landscape of America and the world at large. A historic  tax overhaul program introduced by the world’s largest economy will inevitably  produce spillover effects, likely to intensify the competitive tax cut  situations among countries seeking to maintain their own competitiveness and  also have potential indirect influences on both the direction of current  G20/OECD-led tax reform and tax policies of other countries.

In view of  the massive scale of cross-border investment between China and the US, this  article will discuss what influences the US tax reform will bring to companies  that pursue cross-border investment between the two countries, vis-à-vis the  major highlights of the US tax reform.

Impacts on Chinese Companies Making Investment in the US

Highlight I: Lower Corporate Tax Rates

As one of the major highlights of this tax reform, a flat 20-percent tax rate, effective from January 1, 2018, replaces the previous progressive federal corporate tax rates of up to 35 percent.

The reduction in corporate tax rate will help enhance returns on investment, with its most direct effects on US domestic companies and Chinese companies with investment in the US. These is no doubt that a lower tax rate will stimulate investment in the US, making America a more appealing destination for foreign capital (including Chinese companies), and may even result directly some multinational groups to relocate their headquarters or certain business units to America. With all that said, tax is only one important but not decisive factor affecting corporate investment. Chinese companies, before making a final decision to invest in the US, need to take into account diverse factors, such as economic stability and growth potentials, labor costs and quality, exchange rate stability, distance to markets, business environment and infrastructure. Even in cross-border acquisition deals proposed by Chinese investors to buy American companies, commercial considerations are often a  fore and foremost factor, and tax plays an important role in the design of the entire deal structure but it alone almost never dictates whether or not a major transaction could go through or not.

Moreover, most US states levy a parallel state corporate tax with the top rate ranging from 3 percent to 12 percent. In California where the tax is relatively higher, for example, the federal and state corporate tax rates together add up to 28 percent approximately. Hence, Chinese companies that plan to make investment in the US should also consider the applicable tax rate of the target US state, when assessing the overall tax burden.

It is noteworthy that for Chinese companies with investment in America to repatriate their investment profits to China, the overall tax burden on the investment depends on not only the local tax rates in America, but also the Chinese tax credit system applicable to foreign-source income obtained by Chinese companies. Tax credits refer to the amount of income tax paid overseas that can be used to offset the enterprise income tax  (EIT) payable in China when a Chinese company remits its income obtained overseas back to China, though up to a ceiling that is equal to the tax payable calculated for the overseas income under China’s applicable tax rules. According to the Circular on Issues concerning Improvement of the Tax Credit Policy for Enterprises' Overseas Income (Cai Shui [2017] No.84) issued by the Chinese Ministry of Finance and State Administration of Taxation on December 28, 2017, an enterprise may calculate aggregately its taxable foreign-source income amount either by a “country (region) specific and non-item specific” approach or by a “non-country (region) and non-item specific” approach; and for foreign-source dividend income, the EIT-creditable limit is to be calculated on the basis of the dividend income from qualified shareholdings in the top five layers of foreign companies in the corporate shareholding structure. Given the Chinese rules on tax credits, reduction in the US corporate tax will possibly have a negative impact on the repatriation of profits to China. Under the previous tax system, the US federal corporate tax rates could go up to 35 percent, which could make the income tax paid in America higher than the tax credit ceiling granted in China, meaning that a Chinese company would not need to pay the Chinese EIT on its profits repatriated to China. However, if the total corporate tax to be paid at the current lower tax rate in the US is less than the EIT calculated under China’s flat 25-percent tax rate, Chinese companies will have to fill the tax gap in China when they transfer their profits realized in the US back to China, which is likely to make them less motivated to repatriate profits. Nevertheless, Chinese companies may choose to calculate taxable foreign-source income by the “non-country (region) and non-item specific” approach, thereby grouping together profits sourced from countries with low tax rates to neutralize overseas income tax liability and make maximum use of tax credits back in China.

Highlight  II: Stricter Limit on the Before-tax Deduction of Business Interest

Beginning in 2018, the business interest expense of a loan, either from a related party or a non-related party, deductible for an American company every year, will be up to 30 percent of the adjusted taxable income, plus the business interest income in the current year; the non-deductible part in excess of the deductible limit can be carried forward to succeeding years over an indefinite period of time. Although interest deduction was subject to restrictions in the US under its previous tax system, those were only applicable to loans from related parties and the deduction reached up to 50 percent of the adjusted taxable income. This change may be aimed at encouraging investors to invest in the US in the form of equity not debt, and Chinese investors may need to reduce their debt-to-equity investment ratio. Compared with equity investment, debt investment is more flexible in terms of investment period, exit method, and investment amount, and as interest is deductible before tax while dividend is distributed after tax (meaning not deducted before tax), the cost of the debt investment is generally lower. For Chinese investors, this change is likely to result in higher costs for borrowing for investment in the US, and they will need to rethink of proper ways to raise funds.

Highlights III: Preferential Treatment of the Before-Tax Deduction of Property  Cost

After the tax reform, US allows taxpayers to immediately expense and itemize 100 percent of the cost of qualified business assets acquired and placed in service after September 27, 2017 and before January 1, 2023. From 2023 until 2027, the percentage of such cost that can be expensed will decrease by 20 percent year by year. Although this temporary preferential policy only results in a time difference to pay tax and does not actually reduce tax burdens, it allows corporations to pay lower tax for the current period by filing a bigger before-tax deductible amount, which is helpful for corporations to increase investment in property and accelerate updating invested property and to have more cash flow in the short term for expanding business and investment, thus stimulating the economy. In addition, if certain conditions are met, this preferential policy also applies to used property purchased by corporations, implying that corporations may enjoy this preferential policy through property acquisition than through equity acquisition. Therefore, there might be significant influences on M&A deals.  

Highlight  IV: Introduction of Anti-Tax Avoidance Measures

Beginning in 2018, a US corporation with annual gross receipts of at least $500  million (averaged over the latest three taxable years) has to pay the base  erosion and anti-abuse tax (“BEAT”) if the payments (including interest) made by  the corporation to related parties located in China or other places outside the  US territory, deductible before tax in the US, exceed a certain threshold. The  BEAT rate is 5 percent in 2018 and is to increase to 10 percent from 2019 to  2025 and further grow to 12.5 percent as of 2026. The formula to calculate the  tax reads as: (taxable income + deductible payments made to foreign related  parties) x applicable BEAT rate – tax payable regularly by the  corporation.

The imposition of BEAT introduced by the US tax reform is  aimed to curb unjustified transfer of profits between related-party corporations  by taxing expense deduction from cross-border payments, so that profits made in  the US will be kept in the US to the greatest extent. However, under this new  provision, all targeted deals, despite their prices being reasonable or not,  will be subject to tax. Although this sweeping approach makes the levy feasible  in practice, whether the levy is reasonable and fair remains to be discussed.  Starting levying BEAT will potentially make American corporations less motivated  to contract services to their related-party companies at  abroad.

Impacts on American Companies Making Investment in China

Highlight I: Introduction of the “Participation Exemption” System with Territorial Nature

For American companies with investment in China, the most significant change brought by this tax reform is the introduction of the so-called “participation exemption” system. In other words, from 2018, 100 percent of the foreign-source portion of dividends and bonuses paid by a foreign corporation (excluding a passive foreign investment company) to a US corporate shareholder can be deducted before tax and thus exempt from US taxation, provided that the US corporate shareholder has owned 10 percent or more of the foreign corporation’s shares or equities for over 365 days within a given period. 

For many years, the US tax system has been a model on capital export neutrality and worldwide tax liability, pursuing the expansion of American capital in the globe and insisting on, from the perspective of American investors, equal tax burdens on US domestic investment and outbound investment. Accordingly, the previous US tax system provided that foreign-source dividend income remitted back to the US shall be taxed in the US, with any tax paid overseas taken as creditable to avoid double taxation. The “participation exemption” system on the other hand, is a typical territorial tax system traditionally adopted by European countries that remain neutral on capital import, such as the Netherlands, Luxembourg and Switzerland. The “participation exemption” system is introduced to encourage more US corporations to repatriate their overseas profits to the US to drive domestic investment and economic growth in the US. Moreover, the launch of this system may lead US multinational groups to set up their holding companies domestically or to relocate their holding companies from foreign countries (e.g., Luxembourg, Singapore and other traditional jurisdictions for holding companies) back to the US, which will undoubtedly generate profound impacts on global capital flows and industrial layouts. Furthermore, proposals made in the BEPS action plan were taken into consideration when this system was designed, to exclude “hybrid dividends” from the scope of tax exemption. This means, if dividends paid by a foreign corporation are locally deemed deductible before tax, these dividends will not be eligible for tax exemption treatment when they are remitted to the US, for the purpose of avoiding double non-taxation and cracking down on tax avoidance arrangements.

Highlight II: Introduction of a Transitional Policy of Mandatory Tax on Foreign-Source  Profits

A transitional policy is also launched accompanying the above-said “participation exemption” system, stating that if a foreign corporation is controlled by a US corporate shareholder or 10 percent or above of its voting rights or values are held by a US corporate shareholder, the historically accumulated profits that the US corporate shareholder has obtained after 1986 and has not been previously subject to US corporate tax, determined as of November 2, 2017 or December 31, 2017, despite whether these profits have been actually remitted back to the US, will be deemed as having remitted to the US and shall be subject to tax at the 15.5 percent rate (applicable to cash or cash equivalent) or the 8 percent rate (applicable to other property), which is payable over a period of up to eight years in installments. This transitional policy will undoubtedly have a negative impact on the short-term capital flows and current profits of those US corporations investing in China.

It is reported that Apple, Microsoft, Cisco, Oracle, and Alphabet, Google’s parent company, are the top five US corporations by the amount of foreign-source income they have kept overseas, including $252.3 billion by Apple, $127.9 billion by Microsoft, $67.5 billion by Cisco, $54.4 billion by Oracle and $52.2 billion by Alphabet. The latest policy to tax all profits kept by US corporations overseas all at one time will result in the repatriation of tremendous amounts of overseas capital to the US. As one of the leading American multinational corporations, Apple has responded quickly to the new provision, announcing on January 17, 2018 that it will pay $38 billion tax for its overseas profits in a lump sum. It is speculated by US financial media that Apply is likely to remit all of its $250 billion cash profits kept overseas back to the US.

Highlight III: Introduction of the “Global Intangible Low-Taxed Income”  Provision

If a US corporate shareholder owns over half of a China-based US corporation’s  shares, this China-based corporation may be recognized as the US corporate  shareholder’s controlled foreign company (“CFC”). A new provision introduced by  the US tax reform requires a US corporate shareholder to pay US corporate tax at  the rate of 10.5 percent (from 2018 to 2025) or 13.125 percent (from 2026  onwards) for its CFC’s global intangible low-taxed income (“GILTI”), i.e. the  portion of the CFC’s net tested income that is in excess of 10 percent of  qualified business asset investment, adjusted downward for interest expense.  Under the previous tax system, this portion of income earned by a US corporate  shareholder’s CFC was not subject to tax in the US. By taxing income in excess  of a deemed return from tangible business property, this policy with an anti-tax  avoidance nature is designed to discourage US corporations from keeping massive  amounts of profits abroad for the purpose of being exempted from tax or paying  less tax.

The intent of these tax reform measures discussed above is  obviously to encourage US corporations to redirect capital back to the US. And  it happened on December 21, 2017, four government authorities in China issued  the Circular on Issues concerning the Policy of Temporary Suspension of   Withholding Tax on Distributed Profits Used by Overseas Investors for Direct  Investment (Cai Shui [2017] No.88), providing that the  profit income obtained by a foreign investor from its subsidiary located in  China on or from January 1, 2017 which is used to re-invest directly in China is  eligible for deferred taxation, provided that certain conditions are met. This  means that such investor will be temporarily not subject to withholding tax in  China (which is usually levied at a 10 percent rate, unless a preferential rate  granted by an applicable tax treaty applies). This   circular, expressly stating that it is aimed to “further proactively  utilize foreign capital” and to “encourage foreign investors to continue to  expand their investment in China”, is undoubtedly good news for foreign  multinational corporations that have invested and intend to make more  investments in China.

Impacts on High Net Worth Individuals

Highlight I: Changes to Individual Income Tax Rates and Deductions, but Same Capital Gains Tax

The previous progressive seven-bracket system of individual income tax rates remains under the recent tax reform, but the tax rates for five income brackets are made slightly lower and the tax base of each income bracket is broadened, narrowed or kept unchanged in difference cases. To the benefit of high net worth individual (HNWI) taxpayers, the tax rate applicable to the highest income bracket, now starting from $500,000 instead of the previous $426,700, is adjusted from 39.6 percent downward to 37 percent. Meanwhile, although the deduction of personal exemptions is repealed in the reform, annual standard deductions are significantly enhanced (e.g. an increase from the previous $6,500 to $12,000 for individual taxpayers), and itemized deductions, including mortgage interest, charitable contributions and miscellaneous expenses, are all adjusted as well. However HNWI taxpayers, whose capital gains, dividends and bonuses may account for a certain proportion of their property and income, are still subject to capital gains tax up to 20 percent and tax on net capital gains and qualified dividends under the existing systems which remain unchanged in this tax reform. But an overall analysis of all factors reveals that the changes introduced by the tax reform are as a whole helpful for HNWI taxpayers to reduce tax burdens.

Highlight II: 20% Deduction for Income Distributed by Pass-through Businesses to Individuals  

Another great news to HNWI taxpayers is that 20 percent of their qualified business income (excluding investment income, such as dividends, capital gains, and non-business interest) obtained from partnerships, S corporations and sole proprietorships can be deducted before tax, meaning that the tax rate will actually come down to only 29.6 percent if the highest 37-percent individual income tax rate applies to such income.

Highlight III: Doubled Exemption Amount for Estate Tax to the Benefit of High Net Worth  Families

Under the previous US tax system, there was a basic estate and gift tax exemption amount of $5 million on a per-donee basis, and the portion in excess of this exemption amount would be subject to a potential top estate/gift tax rate of up to 40 percent. For HNWIs with accumulated wealth higher than this exemption amount, it meant that almost half of their property in excess of the exemption amount would be used to pay tax. As a result, HNWIs tend to make use of trust funds, insurance or other financial instruments or legal tools to maximize the amount of estate passed down in the family. After this tax reform, this basic exemption amount is doubled for estate tax purpose, a dramatic increase to $10 million, which will doubtlessly reduce the tax burden on HNWIs when they allocate wealth among family members or pass down family wealth and thus increase the appeal of America to HNWIs seeking investment immigration. But from an objective perspective, this preferential policy will be valid only till the end of 2025, leaving the tax policy in this regard from that point on uncertain at this moment. On the other hand, although the federal exemption amount is significantly increased, considering that some US states also levy a parallel state estate and/or gift tax at a different tax rate with a different exemption amount, the practical effects of this favorable measure may vary and need to be analyzed on a case-by-case basis.

Prospects

As an all-round structural overhaul, the US tax reform has obvious  intents to ease tax burden, impel the repatriation of capital to the US and  drive the economic growth, in order to “Make America Great Again”. It will  produce prominent stimulating effects on the US economy and stir up big changes  in the global economic landscape. Although the profit-oriented nature of capital  will turn America into a popular investment destination for tax purpose, its tax  reform should not be considered as the trigger point for a new round of  “competition” or “battle” in the economic and capital fields. Effects of changes  to the tax system, as one of tools to regulate the economy, are not always  immediate, after all economic development has its own rules to follow  too.

In a rapidly evolving and changing age, we will see potential chain  effects caused by the US tax reform on other major players’ tax policies, though  the reform was most originally aimed at reforming the tax rules in US. We are  convinced that the US tax reform will mean both opportunities and challenges for  Chinese companies that are interested in making investment in the US as well as  US corporations seeking investment in China, and that reasonable and positive  responses to this tax reform will help achieve win-win results for both Chinese  and US companies.

Note: This article was firstly published on Lexis Practical Guidance-Asia Portal. 

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