Outlook for the US tax reform (VII) The spillover effect after the final enactment of US s new tax legislation

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1 News Flash China Tax and Business Advisory Outlook for the US tax reform (VII) The spillover effect after the final enactment of US s new tax legislation December 2017 Issue 36 In brief It has been over 30 years since the last significant US tax reform, i.e. the Tax Reform Act of Up to this day, there has been widespread consensus that the current US business tax system has become increasingly out of step to boost the US s economy, with a number of loopholes which could be used for tax avoidance. Against this backdrop, the new US Administrations seizes the opportunity to conduct the overhaul of the current US tax law, with the aim to rebuilt attractiveness and competitiveness of the US in the global market. On 15 December 2017, the House and Senate Conference Committee reached an agreement on differences in the House and Senate tax reform bills, and released an updated version for voting purpose (the Conference Agreement). On 20 December 2017, the Senate and House respectively passed the final version of the Conference Agreement. Only 2 days later, on 22 December 2017, the US president signed the legislation into law (the signing), which will take effect from 1 January The signing indicates that this high-profile US tax reform has officially set off from now. Considering its international influence, the spillover effect of the US tax reform this time is notable and will have a significant impact on domestic economy of the US, and even the economy of the world including China. In detail Overall principle of the US tax reform The four key principles laid out for the tax reform include: 1) simplifying the current burdensome tax regime to make it fair and easy to understand; 2) giving US workers a pay rise by allowing them to keep more of their hard-earned paychecks; 3) making US the job magnet of the world by creating a fair competition environment for US businesses and workers; and 4) facilitating the repatriation of huge amount of overseas profits to boost US economic growth. The highlights of the Conference Agreement and our observation Compared with the current tax law, the Conference Agreement introduces key reform measures in both domestic and crossborder taxation. For the details of the Conference Agreement, intention of the legislation and our observations, please refer to the Appendix. The domestic and global impacts of the Conference Agreement The Conference Agreement is named Tax Cuts and Jobs Act 1. According to the estimation of the Joint Committee on Taxation (JCT), the net revenue effect of the Conference Agreement will increase the on-budget federal deficit by $1.456 trillion over 10 years, which is obviously a powerful tax cut plan to reduce federal tax revenue. However, it should be noted that, when calculating the aforesaid deficit amount, the dynamic effect (i.e. the tax revenue will increase as the tax reform should also boost the economy) has not been taken into account. Considering the complexity of the US economy, it is difficult to accurately predict the whole impact of the US tax reform under the dynamic effect, e.g. when the outcome of tax cut will localise and then further promote the growth of the economy and create more jobs in the US? However, it could be certain that the reduction of income tax rate and the increase of the on-budget federal deficit would immediately impact the public psychological expectation, which have already been reflected in the stock market rapidly in the past few months.

2 There is another reason why the impact of the US tax reform is unpredictable, i.e. although the Corporate Income Tax (CIT) rate and the Individual Income Tax (IIT) rate are respectively reduced to ease the tax burden, part of existing tax incentives (such as deduction for domestic production, research and development (R&D) credit, etc.) and normal deduction items (e.g., business interest expense, net operating losses (NOL), and anti-base erosion regime) have been abolished or adjusted to keep the federal deficit under control. It will have different effects on different groups, classes and industries, which may not result in tax cut effect or significant effect to everyone. In addition, the reduction of IIT rate is relatively mild. In this regards, the US tax reform this time in fact is a structural tax reform with not only contain provisions to reduce the tax burden of individuals, families and businesses, but also provisions to enlarge the tax base and increase the tax burden. It is important to note that, as shown in the Appendix, while some provisions are permanent measures, others are temporary measures whose future expiration will weaken the tax cut effects. For government of other countries and multinational corporations (MNCs), they may be more concerned with the new international tax rules in the US tax reform: Repatriation toll tax : it will impact short-term capital flows and exchange rates; Foreign derived intangible income (FDII): the preferential tax rate in this rule provides tax cut for US corporations involved in export business, which could be challenged as an illegal export subsidy; Base erosion and anti-avoidance tax (BEAT): it in fact increases taxes on import services, intangible assets, etc., which could have harmful distortions in the global trades and have already caused significant concerns from a EU perspective; 2 Global intangible low-taxed income (GILTI): the purpose of the GILTI provisions is similar to the BEPS Action Plan s, however certain one-side anti-tax avoidance provisions may be too aggressive and not in line with the existing internationally agreed tax rules. Moreover, one of the main objectives of the US tax reform is to simplifying current tax regime, however the complicated amendments in this area have instead increased the complexity of the US international tax rules. All of above rules will impact the US normal international investments and trades, and will cause a disturbance globally to a certain extent. The takeaway As the second biggest economy globally behind the US, China s business trading with the US are getting more and more frequent. Both Chinese enterprises going abroad and the Chinese government need to cautiously consider how this US tax reform could affect the businesses and investments between the two countries and fully prepared themselves accordingly. For Chinese enterprises going abroad, as mentioned in the Appendix, although the federal income tax rate is significantly reduced, the overall tax burden of enterprises in the US is comparable to that of enterprises in China after taking state tax and local tax into account. It is inappropriate to jump to the conclusion that the US tax rate is more attractive. Furthermore, the tax regime is not the only factor to be considered by an enterprise when choosing investment location. Chinese enterprises going abroad should comprehensively consider all relevant factors based on their own long-term development strategies to explore the global market. It should also be noted that the Conference Agreement has included a number of anti-tax avoidance rules, such as anti-abuse rules for passthrough entities, limitation on the deduction of business interest expense, limitation on the carryforward of NOL, etc. Enterprises should pay close attention to meeting the US tax compliance requirement. However, the signing is just the beginning of the enactment of US new tax regime. Relevant US departments need to write and release more detailed implementation provisions, and the impact brought by the US tax reform would then be easier to be identified. We will pay close attention to the relevant development and share our observations in due course. Endnote 1. Regarding the full text of Tax Cuts and Jobs Act, please refer to the link: /CRPT-115HRPT-466.pdf 2. EU Finance Ministers Fire Warning Shot on U.S. Tax Reform /eu-finance-ministers-fire-warningshot-us-tax-reform 2 PwC

3 Appendix Comparision between current Tax Law and the Conference Agreement together with the Intention of the Legislation and our Domestic corporate taxation Corporation tax rate Passthrough entities Corporate Alternative Minimum Tax (AMT) Progressive tax rates with a top rate of 35% Taxed at individual rates, max of 39.6% AMT imposed on tentative minimum tax liability in excess of regular tax liability AMT on corporations is 20% 21% effective from % deduction for qualified domestic service income (from 1 Jan 2018 to 31 Dec 2025) For individual filing, annual income from pass-through entities over $157, 500 ($315,000 for joint filing) could choose: 1) 20% deduction for qualified domestic service income, or 2) the greater of 50% of the wages paid for qualified trade and business, or the sum of 25% of the W-2 wages paid for qualified trade and business plus 2.5% of the unadjusted basis of qualified properties The deduction does not apply to income from specified service business in the fields of health, law, consulting, athletics, financial services, and brokerage services, etc., with annual income over $157, 500 for individual filing ($315,000 for joint filing); specified investment income; specified payment and security deposit from investee to investor Repeals corporate AMT since 2018 The federal corporate tax rate is reduced. After combining with the average state and local tax rates, the overall tax rate is in line with the average rate of 25% for OECD members One of the main goals is to attract more foreign investment The purpose is to encourage the repatriation of the accumulated foreign earnings of US MNCs, stimulate investment, and create more local job opportunities However, how state and local tax rates change needs further observations, which may directly impact the outcome of lowering the federal corporate tax rate There is a large number of pass-through entities paying IIT in the US. Under the current tax law, the overall tax rate of passthrough entities (top rate of 39.6%) is lower than that of C corporations (income is taxed at both corporate and individual level, combined tax rate is around 45%). Lowering corporate tax rate will eliminate the tax advantage of passthrough entities. Therefore, to continue to encourage individual investment, the US increases deductions for passthrough entities Meanwhile anti-avoidance provision is designed to prevent large amount of personal services income from being converted to pass-through income AMT is separately calculated, and paralleled to regular tax liability. The original intention of AMT is to ensure that taxpayers still fulfill their tax obligation even though they have excessive tax incentives and deductions. Repealing corporate AMT simplifies the tax regime, and 3 PwC

4 reduces filing burdens and tax uncertainty for taxpayers Cost recovery Business interest expense Domestic production R&D Credit Depreciation with Modified Accelerated Cost Recovery System (MACRS) or Alternative Depreciation System (ADS) Deductible as incurred 9% exclusion for domestic manufacturing, production, cultivation and mining 6% exclusion for oil and natural gas Regular credit-20% Permits the immediate deduction for research expenses under Sec % full expensing for property placed in service after 27 Sep 2017 and before 1 Jan 2023 Phases down full expensing by 20% a year in the case of property placed in service after 31 Dec 2022 and before1 Jan 2028 Limited to 30% of the adjusted taxable income (defined similar to EBIT) Adds back depreciation and amortization(i.e. EBITDA) to calculate limitation after 1 Jan 2018 and before 31 Dec 2021 Disallowed interest is permitted to be carried forward indefinitely Repeals Section 199 for taxable years beginning after 31 Dec 2018 Maintains R&D credit Specified research and experimentation expenditures under Section 174 must be capitalised and amortised over a 5-year period for expenditures paid or incurred after 2022 (15 years for foreign expenditures) The overall goal is to encourage entrepreneurship, update infrastructure and outdated equipment and facilitate fixed assets investment, with the aim to enhance productivity It is a temporary measure as the 100% full expensing policy is only valid for 5 years and the phasing-out policy will start at the beginning of the next 5 years Amortization/depreciation is replaced by a one-time write-off, which defers taxes to future periods(timing difference) Full expensing is allowed for property placed in service in current year. The increased cash flow could be used to expand investment, support real economy, increase salaries, and distribute dividends The goal is to attract more investment into the US in the form of capital instead of debt Limitation on interest expense deduction could raise the cost of financing, decrease leveraged acquisitions, or reduce margins of leveraged investments. The provision appears to take into account the suggestions under BEPS Action Plan 4, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, in order to enhance anti-avoidance regulation on interest expense. The goal of repealing deductions for specified industries is to broaden the tax base and reduce tax cut impact on fiscal deficit It may negatively affect industries that are enjoying tax preferential treatment under the current tax law Retaining R&D credit indicates the US government highly values R&D and encourages US corporations to engage in R&D activities. It may negatively affect relevant corporations after repealing specified R&D deduction 4 PwC

5 Net operating losses (NOL) Carryback up to 2 years and carryforward up to 20 years Limited to 80% of income, with indefinite carryforward No carryback The goal of limiting NOL carryover is to broaden the tax base and reduce tax cut impact on fiscal deficit Domestic individual taxation Individual tax rate Individual AMT Seven rate brackets (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%) AMT is the minimum tax payable with separate calculation method. Taxpayers pay AMT when minimum tax exceed regular income tax Top rate of 28% for individuals, properties, and trusts Seven rate brackets (10%, 12%, 22%, 24%, 32%, 35%, 37%) with adjustments to middle and high class of income level Sunsets after 2025 Maintains individual AMT Increases individual AMT exemption amounts to $109,400 (joint filing) and $70,300(individual filing) Increases phase-out thresholds to $1,000,000 (joint filing) and $500,000 (individual filing) Overall tax burden on individuals is reduced as promised by current Republican government. According to statistics provided by US government, a middle-income class household of four members (with annual income of $73,000) may reduce individual income tax in the amount of $2,059. High-income class taxpayers may receive a greater tax cut, since the income levels are adjusted in higher tax rate brackets (i.e. 35% and 37%) Top rate is decreased to 37%, mainly considering that highincome class taxpayers in the states with high tax burden (such as California, New York and New Jersey) may be limited in state and local tax deduction. Although, unlike corporate AMT, individual AMT is retained, taxpayers who need to pay AMT (especially middle-income class taxpayers) will only be partially affected since exemptions and relevant income thresholds are raised, certain itemised deductions are repealed, and state and local tax deductions are limited. Individual standard deduction Personal exemption $6,500 for single filers/$13,000 for joint filers (2018, adjusted for inflation) $4,150 for each person, spouse, and dependents (2018) Increases to $12,000 for single filers/ $24,000 for joint filers (adjusted for inflation based on chained CPI) Repeals deduction for personal exemptions Individual standard deduction is nearly doubled, which means no tax liabilities for single filers with annual income of less than $12,000 (and joint filers below $24,000), aiming at reducing tax burden of low-income taxpayers. Under current tax law, personal exemption is $4,150 for each taxpayer, including the taxpayer s wife and other family members. Repealing personal exemptions may adversely affect households with large family members as their tax exemption amount is reduced. The overall impact to those households should be comprehensively evaluated with the increase in standard deductions and child 5 PwC

6 tax credits Crossborder taxation Child tax credit Individual itemised deduction State and local tax deduction Mortgage interest deduction Estate/gift tax Carried interest General income tax regime $1,050 per child Itemised deduction phase out begins at $320,000 for joint filers and $ 266,700 for single filers Allows State and local tax deduction Mortgage interest on a principal or second home is deductible Limited to acquisition debt of $100 million and home equity debt of $100,000 Maximum 40% rate for taxable estates exceeding $5.6 million (2018) Short-term capital gains are taxed as normal income at IIT rates Long-term capital gains (holding period over 1 year) are taxed at longterm capital gains rates (top of 20%) Worldwide tax system with foreign tax credits to mitigate double taxation Increases to $2,000 per child ($1,400 refundable) Applicable to single filer with annual income lower than $200,000 and joint filer with annual income lower than $400,000 $500 credit for non-child dependents Repeals multiple deductions Maintains medical expense, mortgage interest deduction, and charitable donation deduction No overall limitation on itemised deductions Only state and local property taxes, income taxes, and general sales taxes are deductible Limited to $10,000 Retains current law limitation for existing acquisition debt Limited to acquisition debt of $750,000 for newly purchased homes since 2018 Repeals interest deduction on home equity loan Available for a first or second home Retains estate tax Doubles exemption amounts from 2018 to 2025 Imposes a three-year holding period requirement for qualification as long-term capital gain (taxed at top of 20%) with respect to certain partnership interests received in connection with the performance of services Carried interest that failed to meet the three-year requirement should be taxed as normal income at IIT rates (top of 37%) Territorial system - 100% foreign dividend exemption since 2018 (except for hybrid dividend) Increasing child tax credit helps middle-income households with many children and who provide support to non-child dependents. Retains those itemised deductions which are most common and have wide impact. The individual tax regime is simplified and could benefit more taxpayers The taxpayers resided in the states with high-tax burden such as California, New York and New Jersey will be adversely affected by increased tax burden Mitigates local differences between mortgage interest and state and local tax deductions, but may still greatly affect taxpayers in the states with high-tax burden The goal of estate/gift tax reform is to reduce tax uncertainty and costs for the inheritance of private farms and private firms, and to enhance the liquidity of wealth The US government plans to gradually repeal estate tax by doubling exemption amounts and further narrowing applicable population of estate/gift tax Long-term investment activities is encouraged instead of shortterm speculation The characters of territorial system are neutrality in capital inflow, simple, and convenient for collection and administration. Following the global trend of converting to a 6 PwC

7 Repatriation toll tax Foreignderived intangible income (FDII) Currently no provision. Previously untaxed foreign earnings subject to 35% corporate rate when repatriated Currently no provision. Subject to normal corporate income tax at top rate of 35% Previously untaxed foreign earnings: 15.5% cash and cashequivalents 8% non-cash assets Payable over 8 years (8% each year for 5 years, then 15%, 20%, and 25% for next 3 years) Overseas untaxed foreign earnings should be taxed and collected regardless of actual status of repatriation. Deduction of 37.5% FDII is allowed (21.875% since 2026) FDII is the sales income of US companies in excess of a tangible asset capital return rate of 10% derived from foreign markets territorial system, the US has decided to partly adopt a territorial system, i.e. only dividend could be exempted from tax. In order to attract repatriation of foreign earnings, increase domestic investment, and enhance competitiveness of US corporations, the tax reform has simplified the foreign income tax system and removed tariffs of overseas profits repatriation. It also aims at increasing tax advantages of using US corporations as holding companies. A new concept of a hybrid dividend is introduced to limit the benefit arising from the arbitrage of US and foreign tax laws with respect to payments that are treated differently under US and foreign tax laws. In details, if the foreign-sourced dividend paid to the US shareholder is already deducted when calculating foreign tax payable of foreign subsidiaries, then the US shareholder shall not enjoy the dividend exemption. This provision is consistent with suggestions in BEPS Action Plan 2, Neutralising the Effects of Hybrid Mismatch Arrangements. Current tax law requires foreign earnings repatriated to be subject to corporate income tax at a top rate of 35%. Under the Conference Agreement, foreign earnings is free of tax. As a transitional policy, the one-off repatriation tax on earnings accumulated overseas must be taxed regardless of actual status of repatriation It is expected to result in a short-term fluctuation in global capital flow, i.e. capital may flow out of foreign subsidiaries into the US, which would impact the exchange rates of USD and other foreign currencies (depending on the amounts and currencies) Based on the corporate tax rate of 21% in the Conference Agreement, the effective tax rate of FDII is % and will be % after Dec 31, The reason why it is called intangible income is that FDII refers to deemed intangible income which in excess of a tangible asset capital return 7 PwC

8 Sourcing of income from the sale of inventory CFC rules for anti-base erosion and anti-deferral tax (Subpart F) Gain from sale of inventory produced by taxpayer is sourced in part based on where inventory is produced and in part based on location of title passage Subpart F antideferral regime includes CFC s insurance income, foreign base company income, etc. Foreign tax credit is allowed Gain from sale of inventory property produced by the taxpayer is sourced based on the location at which the inventory is produced Generally retains Subpart F Expands the definitions of CFC and US shareholders Foreign subsidiary could be deemed as a US CFC, if its parent company has both domestic and foreign subsidiaries rate of 10% FDII would encourage US corporations to manufacture domestically and sell to foreign markets, and encourage them to move the manufacturing back to the US FDII provides tax advantage to sales of domestically manufactured goods to foreign markets (i.e. 21% corporate tax for income with capital return rate of below 10%, and a lower tax rate for FDII) Income derived from sales of goods produced overseas to domestic markets is free of tax in the US Income derived from sales of goods produced domestically to foreign markets is taxed at full amount Enhances information collection on MNCs Strengthens CFC rules to improve anti-avoidance regulation Complementing the territorial system for dividend 8 PwC

9 Global Intangible Low-taxed Income (GILTI) Base erosion and antiabuse tax (BEAT) Currently no provision. Currently no provision. A US shareholder should include its GILTI in income of its CFCs in a manner similar to subpart F income inclusions GILTI means the excess of the shareholder s net CFC tested income over the shareholder s net deemed tangible income return. In details, a US shareholder s GILTI is calculated as: GILTI=net CFC tested income-(10% x qualified business asset investment (QBAI)) Net CFC tested income means the CFC s net income excluding the income which has already paid tax in the US, relevant expense and loss QBAI refers to with respect to any CFC for a taxable year, the average of the aggregate of the adjusted basis in specified tangible properties GILTI is subject to 21% tax rate and US corporations could deduct 50% of the GILTI included in gross income (37.5% since 2026), which means effectively tax would be 10.5% (13.125% since 2026) A 80% foreign tax credit (FTC) is permitted From 2018, if a US corporation meets both of two requirements: 1). its average annual income reaches $500 million or above for recent three years; 2) the proportion of deductible payments to overseas related parties to its total deductible payments reaches 3% or above, it should be subject to BEAT, which should be calculated as: BEAT=(taxable income + deductible related-party payments) x BEAT rate normal income tax payable BEAT rate is 5% for 2018; 10% for the period from 2019 to 2025; 12.5% since 2026 BEAT is applicable to all deductible related party payments (include interests) except the cost of sales of inventories In the past, GILTI was not the target of CFC rules. The intangible income of a US shareholder in now included in the taxable scope of CFCs as an anti-tax avoidance measure. The reason why it is called intangible is that GILTI refers to deemed intangible income which is excess of a QBAI return rate of 10% The reason why GILTI is so called low-taxed is that, taking FTC regime into consideration, US shareholders in CFCs do not need to pay tax in the US as long as such income is subject to high tax overseas. Therefore, GILTI is designed to impose tax only on foreign low-taxed income. It is an anti-tax avoidance provision to enhance the administration on cross-border related-party payments 9 PwC

10 Let s talk For a deeper discussion of how this issue might affect your business, please contact a member of PwC s US Tax Consulting Team: Wendy Ng wendy.wy.ng@hk.pwc.com Albert Chou +86 (21) albert.sc.chou@cn.pwc.com Peter Kao +86 (10) peter.c.kao@cn.pwc.com Our US Tax Consulting Team offers a wide range of US tax consulting and compliance services in Hong Kong and China, with a significant portion of clients which are private equity funds, real estate funds, hedge funds, as well as multinational corporations. We provide solutions to help our clients improve tax efficiency and meet their US tax obligations. We are the largest team of US tax consulting professionals in Asia, with over 80 members in Hong Kong, Shanghai and Beijing serving local and offshore clients. Members of our team are proficient in Cantonese and/or Mandarin. In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 26 December 2017 and were based on the law enforceable and information available at that time. This China Tax and Business News Flash is issued by the PwC s National Tax Policy Services in China and Hong Kong, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Consultants (Shenzhen) Ltd. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Consultants (Shenzhen) Ltd. which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.