MANUFACTURING INSIDER

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1 MANUFACTURING INSIDER VOLUME 9 :: ISSUE 1 In This Issue: IRS Issues Final Regulations On Internal Use Software For R&D Credit Qualification North American Automotive Production Forecast Summary - Q Captive Insurance Company: Reduce Risk, Insurance Premiums, And Taxes Current State Of The Manufacturing Industry of non-ius software development costs eligible for the credit. This is good news for businesses and especially those who develop software to run their business and at the same time provide services to customers (i.e. web sales). IRS ISSUES FINAL REGULATIONS ON INTERNAL USE SOFTWARE FOR R&D CREDIT QUALIFICATION On Oct. 3, 2016, the Internal Revenue Service issued final regulations clarifying the definition of Internal Use Software for purposes of the Section 41 Credit for Increasing Research Activities. The regulations also address the treatment of dual function software. Section 41(d)(4)(E) provides that, except to the extent provided by An independent member of UHY International the regulations, research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer is excluded from the definition of qualified research under Section 41(d). In general, Internal Use Software (IUS) is software that is not sold, leased or licensed to a third party. The final regulations narrow the definition of IUS and at the same time broaden the range THE R&D CREDIT The R&D credit requires development efforts to meet four basic criteria to be eligible for the credit. In short, the work must involve developing a new or improved product by eliminating uncertainties through a process of experimentation that is technological in nature. Historically, in addition to the normal four-part test that other types of research must meet, IUS costs and related work eligible for the R&D tax credit had to satisfy a high threshold in innovation (HTI) standard. The HTI standard requires that internal use software (1) be innovative the software results in a reduction in cost or improvement in speed or other measurable improvement that would be economically significant, (2) involve significant economic risk the taxpayer is uncertain as to recovery of project dollars within a reasonable period and (3) not be commercially available for use by the taxpayer. Continued on Page 2... The next level of service

2 2 UHY LLP MANUFACTURING INSIDER Continued from Page 1... over 15 examples addressing use of the new rules that will potentially allow developers of many of the applications that have become part of our everyday lives to now qualify for the research credit in the same way as traditional product developers. Taxpayers who develop software should review their development efforts to determine if software that was treated as Internal Use Software under the old rules would still be categorized the same under the final regulations. The final regulations are prospective and apply to tax years beginning on or after Oct. 4, Further, the proposed regulations state the IRS will not challenge return positions consistent with the regulations for taxable years ending on or after Jan. 20, Tracey Powell, Senior Manager (Columbia, MD) INTERNAL USE SOFTWARE Under the new regulations, internal use software (IUS) is defined as software developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer s trade or business. General and administrative functions are intended to include back office functions such as financial management, human resources and support services. The regulations further clarify that software developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer s system is not considered IUS. The determination of whether software is developed for internal use or to enable a taxpayer to interact with third parties depends on the intent of the taxpayer and the facts and circumstances at the beginning of the software development effort. DUAL FUNCTION SOFTWARE The regulations also provide guidance with respect to dual function software. Dual function software is software developed for both internal use and by third parties. Dual function software is presumed to be for internal use and therefore, subject to the high threshold of innovation standard. However, if the taxpayer is able to identify subsets of elements that that enable interaction with third parties or allows third parties to initiate functions or review data, the subsets will not be considered internal use software making them eligible for the research credit using the four-part test. The regulations include a safe harbor that allows taxpayers to treat 25 percent of the project research expenses of the remaining subsets as qualified research expenses if they can establish that at least 10 percent of the software s use is reasonably anticipated to relate to third party interaction. How software is used has changed dramatically since the R&D credit was introduced in the Tax Reform Act of The final regulations are a welcome breath of fresh air and contain How software is used has changed dramatically since the R&D credit was introduced in the Tax Reform Act of 1986.

3 UHY LLP MANUFACTURING INSIDER 3 NORTH AMERICAN AUTOMOTIVE PRODUCTION FORECAST SUMMARY - Q Summary includes economic outlook, light vehicle sales outlook, current production drivers, production capacity and long-term trend, model launches and investments. NORTH AMERICA ECONOMIC OUTLOOK US GDP growth in the US is expected to average 2.2% pa in and then slowing to 1.6%. The output gap, currently around 1.5% of GDP, is expected to close gradually supported by strong fundamentals. Canada Curtailed investment in the energy sector is expected to drag on the Canadian economy limiting overall growth. Capital stock is expected to expand by about 1% pa over the next decade (weaker than 2.3% pa in ). Mexico Long-term growth was lowered amid a less optimistic outlook for the US and the global economy due to the risk of secular stagnation from some advanced economies. GDP GROWTH Source: Oxford Economics, LMC Automotive

4 4 UHY LLP MANUFACTURING INSIDER NORTH AMERICA LIGHT VEHICLE SALES OUTLOOK CURRENT NA PRODUCTION DRIVERS Source: LMC Automotive

5 UHY LLP MANUFACTURING INSIDER 5 NORTH AMERICA PRODUCTION AND CAPACITY LONG-TERM TREND Demand level adds stability layer through horizon Localization and exports drive production expansion. Some relief in the mid- to long-term, but utilization holds in the 85% to 90% range. NORTH AMERICA PRODUCTION MODEL LAUNCHES Source: LMC Automotive

6 6 UHY LLP MANUFACTURING INSIDER INVESTMENT POURS INTO NORTH AMERICA Investment in Mexico: BMW San Luis Potosi Daimler Aguascalientes (COMPAS) w/ Renault-Nissan FCA Toluca Ford Cuautitlan GM San Luis Potosi Hyundai Monterrey Mazda Salamanca Renault-Nissan Aguascalientes 2 & COMPAS Toyota Guanajuato, Baja Volkswagen San Jose Chiapa Investment in the USA: BMW Spartanburg Daimler North Charleston (DG) 2 Faraday Future North Las Vegas FCA Belvidere, Toledo North Ford Flat Rock Assembly Fuji Heavy Lafayette Geely Ridgeville GM GM Van, Hamtramck, Lansing Grand River, Spring Hill Honda Greensburg Hyundai Montgomery Tesla Fremont (Tesla) Toyota Georgetown 3, Tupelo Volkswagen Chattanooga Source: LMC Automotive

7 UHY LLP MANUFACTURING INSIDER 7 CAPTIVE INSURANCE COMPANY: REDUCE RISK, INSURANCE PREMIUMS, AND TAXES High insurance costs are a concern for most businesses. The majority of Fortune 500 companies utilize captive insurance companies ( captives ) to help manage their overall risk profile and reduce insurance costs. Captives can be used to supplement existing commercial policies, provide insurance for risks that are not otherwise insurable, and insure against risks that are cost prohibitive to obtain commercial insurance for. There is a wide variety of risks that can be covered by a captive; including, but certainly not limited to, general liability, workers compensation, employee benefits, product liability, property, intellectual property, and cyber risk. WHAT IS A CAPTIVE? A captive insurance company is an operating insurance company owned by a business or, in some cases, the owners of a business. The captive may be formed as a separate entity or as a subsidiary. Alternatively, an existing group captive can be joined. Captives collect premiums, process claims, make payments to the insured, and invest capital. Similar to traditional insurance companies, captives are subject to regulation by the state in which they are domiciled. A captive exists to provide risk management tools, helping the parent company meet their business goals. RISK MANAGEMENT A captive can insure the same risks insured by a commercial insurance company. One benefit of utilizing a captive is that you may insure risks that are not covered by commercially available insurance. A captive also has the ability to insure risks that may be too costly to justify obtaining commercial insurance for. Captives also assist in managing risk due to their ability to offer highly customizable insurance policies. These factors lead to greater control over claims, flexibility in underwriting, pricing stability, stronger incentives for loss control, increased coverage, and better claims processing. PREMIUM REDUCTIONS A captive can be used to reduce the amount of premiums being paid to commercial insurers. This can be accomplished by increasing the deductible on the commercial policy, causing a reduction of the premiums paid, followed by purchasing a policy from the captive to cover the higher deductible. These premium reductions provide additional cash flow for the operating business. REDUCED TAXES Taxes are an important consideration in the decision to form a captive. If the captive qualifies as an insurance Continued on Page 8...

8 8 UHY LLP MANUFACTURING INSIDER Continued from Page 7... company for U.S. income tax purposes, premiums paid to the captive are tax deductible to the insured and the captive enjoys favorable tax treatment on its receipt of the premiums. A traditional captive is taxed on the net premium income it receives, less a deduction for an actuarially determined reserve. If the captive writes premiums of less than $2.2 million (for 2016 and prior years = $1.2 million) and they meet diversification requirements, it could qualify to make an election under Section 831(b) of the Internal Revenue Code ( micro-captive ) not to be taxed on the premium income it receives. The micro-captive is only taxed on its investment income. In both cases, the operating entity is entitled to a deduction for the premium paid. If a captive accumulates excess capital, a dividend can be made to the owner(s) that can qualify for the preferential qualified dividend tax rates. LIKELY CANDIDATE Businesses with $30 million+ in annual gross revenue, $200,000+ in annual property and casualty expense, or $100,000+ in annual self-insured losses make good candidates for benefitting from a captive insurance company. The manufacturing, construction, and healthcare industries have a strong potential to benefit from the use of a captive. Ideal candidates also include businesses that have substantial uninsured or commercially uninsurable risks. SETUP AND OPERATION To determine whether a captive can provide benefit to your business, the process starts with a high-level analysis of your business and potential risks. If the analysis identifies enough potential for benefit using a captive insurance company structure, the next step is a feasibility study. This study is a detailed analysis of your business, determination of insurable risks, and a projection of the benefits a captive structure will provide. After the study is complete, the decision of whether or not to form or join a captive is made. Once the captive is formed or joined, insurance policies are drafted for underwriting. Premiums are paid by the operating entity and claims are processed by the captive. A captive management company may be engaged to manage the underwriting, claims processing, payments, and general maintenance of the captive insurance company. Annual tax returns and financial statements are also required. RECENT DEVELOPMENTS Starting in 2017, the maximum amount of premiums a captive is allowed to write and still qualify as a micro-captive increased to $2.2 million from the previous $1.2 million cap. At the same time, the rules have changed in terms of ownership limitations under the micro-captive treatment. In 2017, the ownership of a captive, if not owned directly by the business, must closely resemble the ownership of the operating company. Prior to this rule change, ownership was not restricted (had more estate planning incentives). Unfortunately for captives formed in prior years, they must now conform to the new law. Due to the large incentive for abuse and tax sheltering with the microcaptive structure, the IRS has looked at these transactions with increased scrutiny. On Nov. 1, 2016, the IRS released Notice This notice designates certain captive insurance companies that have made the Section 831(b) election (micro-captives) as a Transaction of Interest. This label by the IRS requires that a Form 8886, Reportable Transaction Disclosure Statement, be filed by participants in the transaction. This designation is typically used to help curb the use of an abusive transaction due to the required reporting. Most sources believe the IRS is focusing on premiums that far exceed their commercially available counterpart, insuring false risks (hurricane insurance in Kansas), and duplicative insurance coverage.

9 UHY LLP MANUFACTURING INSIDER 9 Example A one owner S-corporation forms a Sec. 831(b) captive (micro-captive) and writes a $1 million policy. Claims of $200,000 are processed in years 2 & 4 and a $1.2 million claim is processed in year 3. (in thousands) Year Cash Flow of Operating Entity: Premiums Paid (1,000) (1,000) (1,000) (1,000) (1,000) Captive Formation Fees (65) Claim Reimbursement , Pre-tax Cost to Operating entity (1,065) (800) 200 (800) (1,000) Tax Benefit (44.6%) (89) After Tax Cost to Operating Entity (590) (443) 111 (443) (554) Cash Flow of Captive: Premium Income 1,000 1,000 1,000 1,000 1,000 Investment Income (2% return) Organizational Costs (15) Operating Expenses (50) (50) (50) (50) (50) Claims Paid - (200) (1,200) (200) - Reinsurance Recovery (50%) Tax on Investment Income (35%) - (7) (13) (15) (21) Underwriting Profit Liquidation Value of Captive: Cumulative Cash in Captive 935 1,797 2,170 3,048 4,038 Tax on liquidation (25%) (234) (449) (543) (762) (1,010) Cumulative Net Liquidation Value 701 1,348 1,627 2,286 3,028 After Tax Benefit to Shareholder: Cumulative cost to operating entity (590) (1,033) (922) (1,365) (1,919) Cumulative Net Liquidation Value of Captive 701 1,348 1,627 2,286 3,028 Cumulative after tax profit to shareholder ,109 Assumptions: Individual tax rate = 44.6% [39.6% federal + 5% state] Capital Gain Rate = 25% [20% max capital gain rate + 5% state] In only a 5 year span, this structure produces $1.1 million of after-tax benefit to the shareholder. Greg Pearson, Tax Manager (St. Louis, MO)

10 10 UHY LLP MANUFACTURING INSIDER CURRENT STATE OF THE MANUFACTURING INDUSTRY

11 UHY LLP MANUFACTURING INSIDER 11 According to a new Standard & Poor s report there are two key indicators that will tell you what kind of shape the manufacturing industry is in. The first is the Institute for Supply Management s manufacturing purchasing manager s index and the second is the Federal Reserve s Capacity Utilization Index for motor vehicles and parts. A reading above 50 percent for the ISM index indicates that manufacturing is expanding in the US, and below 50 means that it is contracting. History shows that each time since 1983 that the index fell below 43 percent speculative grade automotive companies began to panic. Similarly any time the Fed s utilization rate dropped below 72 percent during that period, it caused stress to automotive companies. Let s take a look at where we stand as of December ISM Purchasing Managers Index: 54.7% Fed.Capacity Utilization Rate: 74.8%

12 MANUFACTURING INDUSTRY INSIGHT UHY LLP recognizes that manufacturing companies require their auditors, tax specialists and business advisors to add value to financial reporting activities. That is why we combine the strength of business and financial expertise with a hands-on, shop floor approach to solving complex business decisions in these key segments: Aerospace & Defense Distribution Automotive Suppliers Industrial Manufacturing Consumer Products Our professionals are leaders in the industry and take the steps necessary to ensure our client s future success by identifying and addressing new trends, accounting requirements and regulations. OUR LOCATIONS CA Orange County CT Norwalk CT West Hartford GA Atlanta MD Columbia MD Frederick MI Detroit MI Farmington Hills MI Sterling Heights MO St. Louis NY Albany NY New York NY Rye Brook ADDITIONAL UHY ADVISORS LOCATIONS IL Chicago Our firm provides the information in this newsletter as tax information and general business or economic information or analysis for educational purposes, and none of the information contained herein is intended to serve as a solicitation of any service or product. This information does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided as is, with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose. UHY LLP is a licensed independent CPA firm that performs attest services in an alternative practice structure with UHY Advisors, Inc. and its subsidiary entities. UHY Advisors, Inc. provides tax and business consulting services through wholly owned subsidiary entities that operate under the name of UHY Advisors. UHY Advisors, Inc. and its subsidiary entities are not licensed CPA firms. UHY LLP and UHY Advisors, Inc. are U.S. members of Urbach Hacker Young International Limited, a UK company, and form part of the international UHY network of legally independent accounting and consulting firms. UHY is the brand name for the UHY international network. Any services described herein are provided by UHY LLP and/or UHY Advisors (as the case may be) and not by UHY or any other member firm of UHY. Neither UHY nor any member of UHY has any liability for services provided by other members UHY LLP. All rights reserved. [0117]