By Matthias Amberg, Tax Advisor, Certified Public Accountant, Rödl & Partner Chicago and Elisa Fay, Partner in Charge, Rödl National Tax – U.S. Rödl & Partner Atlanta
The reform offers good opportunities for growth for German companies with US subsidiaries. They will benefit from having to pay less tax themselves and from the fact that the purchase and production costs of many commodities in the USA can be immediately offset against profit over the next five years. The reform may also have advantages for German companies which currently only export to the USA, as American companies now have more money to spend. Demand for investment goods will grow, benefiting German mechanical engineers in particular. German machinery has an outstanding reputation in the USA, but it can be expensive. Now more American companies will be able to afford German products.
The lower tax rates are of course an incentive to invest in the USA now, however companies should not make strategic decisions based on tax issues. Economic prospects are the main factor here, and the prospects in the USA remain excellent. In order for foreign companies to enjoy success on the American market, it is vital that they have production sites and after-sales services in the country. German companies which have hitherto only exported to the USA should take the reduced corporation tax rates as an opportunity to consider setting up an American subsidiary. Experience has shown that customers and companies have completely different views of foreign companies which also produce in America. Those which not only export, but also contribute to the growth of the American economy enjoy a much more favorable reception and thus a better chance of prevailing over the American competition in the market.
The core point of this reform is the BEAT tax which companies should keep an eye on. It is due, for example, on licensing or management fees paid to the German parent company by the US subsidiary. German companies run the risk of having to pay tax for these licenses twice: once in Germany and once in the USA. It remains to be seen whether other states will accept this somewhat protectionist instrument, or if they will take the matter to the World Trade Organization (WTO). The majority of medium-sized companies will not be affected at all, as the tax generally does not apply to US subsidiaries until they reach a turnover of more than 500 million US dollars and BEAT-relevant payments of more than three per cent of operating costs (see below for more detail). This will mainly affect DAX companies, however the tax could be a huge problem for them.
By returning profits, earned in the past but not yet taxed, from foreign subsidiaries to the USA, American companies now have cheap access to their foreign assets. This presents a risk. The switch to the territorial principle, which is also used in Germany, means that profit accumulated abroad is subject to a one-off federal tax of just 15.5 percent (maximum), instead of the previous 35 percent. Future profits from foreign subsidiaries can then be distributed in the USA essentially with no further taxation. This is expected to flush large sums of money into American companies, which then have plenty of cash to spend - potentially damaging the position of German companies.
The key lesson is that the reform has made the USA a much more attractive location for business, and that German politicians need to think about their reaction. The federal government should now take steps to bolster Germany as a business location. German tax policy has remained stagnant for too long and in the business world, stagnation is equivalent to moving backwards. The new federal government needs to be brave enough to fundamentally overhaul corporation tax, for example by reexamining local business tax, which does not exist to anything like the same extent in any other country in the European Union.
The list below describes the key changes to tax law regarding their significance for business activities in the USA or for the export of goods to the USA and makes recommendations for German companies with business interests in the USA.
Reduction in corporate tax rate
For corporations, the former top rate of tax of 35 percent is being replaced by a flat rate of 21 percent. This is a huge reduction in the tax burden on American companies, even taking into account the changes to federal corporate tax rates, unaffected by the reform, which add another six percent to the bill on average. By increasing companies' liquidity, the cut will enhance companies' willingness to invest and innovate. This is especially important for German mechanical engineering and opens up completely new prospects.
Change to the taxation of partnerships
Natural persons who own shares in an American partnership are generally granted a deduction of 20 percent of their permissible US commercial income. However, the deduction amount may not exceed 50 percent of the wage bill or 25 percent of the wage bill plus 2.5 percent of the purchasing or production costs of the permissible assets of the commercial enterprise. Natural persons should note that these changes, and many of the others, only apply until 2025.
100 percent immediate amortization for commodities
The purchasing and production costs of many commodities commissioned between September 27, 2017 and January 1, 2023 can be claimed as operating expenses. From 2018 to 2022, 100 percent of the investments can be tax deducted immediately. The rate then falls by 20 percent per year from 2023 to 2026, finally expiring in 2027. This provision excludes investments from supply companies such as electricity providers. It does, however, include the purchase of machinery and will therefore, like the reduction of corporation tax rates, have an enormous impact on companies' plans with regards to investment. The result is new prospects and business opportunities for the German engineering industry.
Base Erosion and Anti-Abuse Tax (BEAT) provisions
Fortunately, the feared import duty has not been introduced. The taxation of capital exports, also suggested later, has also been dropped. Instead, the Base Erosion and Anti-Abuse Tax (BEAT) provisions are now law. This tax applies where a US company with turnover of at least 500 million US dollars makes payments to an associated foreign company (25 percent threshold) and the payments subject to BEAT account for at least three percent of the total operating expenditure. For most companies, the BEAT tax rate will be five percent in 2018, ten percent from 2019 to 2025, and 12.5 percent from 2026. Tax is payable where the BEAT tax, which is determined based on the tax result adjusted for BEAT payments, is higher than the regular federal corporation tax. German companies should be aware of this tax and check and adapt their structures in the US accordingly if required.
Changes to the deductibility of interest
The amount of deductible interest is being changed and must not exceed 30 percent of the adjustable taxable income. The adjustable taxable income is determined in an auxiliary calculation and is similar to the definition of EBITDA (2018-2021) or EBIT (from 2022). Companies should examine their strategies for loans to US subsidiaries.
Interest deduction is denied for hybrid companies or for transactions in which the corresponding interest earned is not taxed abroad or in which the interest expense is deducted twice. The rule also applies to licensing expenses.
Changes to the use of tax losses
Tax loss carry-back has been abolished except in few sectors, such as agriculture. Instead, tax losses accrued from 2018 can be carried forward for an unlimited period. However, loss exploitation is effectively limited to 80 percent of taxable income.
The domestic production deduction has been abolished, but the research and development credits remain.
Effects on balance sheets
The tax reductions mean that both active and passive deferred tax liabilities on the balance sheet will need to be reassessed. This will have a sometimes huge impact on companies' earnings after tax and effective tax rates, however initially with no additional money.
This overview clearly shows that the German mechanical engineering sector believes there is a need for action, regardless of whether companies are merely exporters or already have US subsidiaries. The following effects are key:
- Modeling of the impact of the tax reform regarding effects on the business model and investments or acquisitions.
- Analysis of the impact on consolidated financial statements (deferred taxes, consolidated tax rate).
- Identification of adjustments required to finance and capital structures, given the limited deductibility of interest.
- Planning considerations on the use of the deliberate tax incentives and on avoiding double taxation from a German and American point of view.