Top tax considerations for manufacturers in 2019
Breaking down the key tax issues affecting manufacturers today
INSIGHT ARTICLE |
Following are highlights of a webcast that took place in January 2019.
For U.S. manufacturers, 2018 was a very strong year. Tax reform provided businesses with many opportunities for growth, including lower tax rates, flexibility to repatriate cash and generous depreciation expensing provisions, among others. The reforms were not without their own set of challenges, including new interest limitations, state deduction limitations and decoupling provisions, and recent global tariff increases. Combined with labor shortages, rising wages and the emphasis on digital transformation, tax planning is more important than ever.
Following are key tax issues and new rules manufacturers should consider in wrapping up 2018 and looking ahead to 2019.
State and local tax considerations
State and local tax compliance can be complicated. It's important to understand the rules, risks and opportunities, especially as the rules keep changing.
Federal tax reform impact on states
Federal tax reform is having a significant impact on state budgets and political processes. State conformity to federal tax reform varies greatly among the states. There are differences of conformity within specific states depending on whether the taxpayer is a corporation, pass through or individual. Thus, there continues to be a cascading effect on various tax issues that will require detailed work papers be maintained specifically for state income tax purposes.
South Dakota v. Wayfair
Last year’s South Dakota v. Wayfair decision didn’t just affect retailers, it affected manufacturers as well. More than 35 states have already adopted an economic nexus standard for sales tax, and that number will continue to grow. The management and maintenance of exemption certificates have grown in importance for manufacturers. Additionally, the registration for sales and use tax purposes may have collateral implications resulting in increased income, franchise or gross receipt tax filings. Look for a growing number of states to adopt economic (or factor presence) nexus over the next few years.
Business incentives opportunities
Capturing the value of state and local credits and incentives is more important than ever. As manufacturers increase domestic capital investments, there is a host of credits and incentives of which companies can take advantage, including cash grants, tax credits, abatements and deferrals, low-interest financing, below-market property acquisitions, expedited permitting and more. Triggers for taking advantage of these incentives may include:
- Company-driven events such as creating new business operations, expanding, realigning or relocating facilities, or maintaining existing facilities
- Construction, purchase, lease of new or expanded facilities
- Purchase of new machinery or equipment
- Infrastructure improvements
- Training of new or existing employees
There are four main areas of federal tax that manufacturers should be aware of when making their tax plans:
1. Proposed section 163(j) regulations
The proposed regulations under section 163(j) limit deductible interest expense. The general limitation is calculated on adjusted taxable income before interest, taxes, depreciation and amortization for tax years before 2022.
The proposed regulation states that to the extent that deprecation is capitalized to inventory under section 263A, it is not allowed to be added back to adjusted taxable income. This can have a substantial impact on manufacturers considering the depreciation of product equipment or facilities that may be disallowed. The proposal essentially puts manufacturers on an EBITDA standard for purposes of 163(j) immediately.
2. Capital expenditures and bonus depreciation
A marquee feature of tax reform was a 100 percent expensing provision until 2022, with a phase out for 2023 and beyond. One of the more notable features of the new rules is that it includes both used and new assets, if acquired as part of a business combination. This may affect mergers and acquisitions activity, as it makes an asset structure more attractive. But there are caveats to consider regarding bonus depreciation:
- An acquired and placed-in service date (Sept. 28, 2017) should be considered when transitioning from the old rules to the new.
- Certain like-kind exchanges of tangible personal property are no longer permitted.
- Certain elections related to section 163(j) interest limitations require depreciation using the MACRS alternative depreciation system, which does not qualify for bonus depreciation.
- The taxpayer or predecessor must not have used the property at any time before acquiring it.
- The taxpayer must acquire the property by purchase.
- Many states have decoupled from the federal rules when it comes to bonus depreciation; companies may have to resort to the historic depreciation rules for their state.
3. New UNICAP regulations
The new rules effective for tax years beginning on or after November 2018 (generally 2019) primarily affect producers, while minimally affecting resellers. But the new modified simplified production method uses the term “direct material costs” rather than “raw material costs.” Taxpayers using the MSPM are not required to track the direct material component of work-in-process and finished goods.
4. Revenue recognition
Companies implementing ASC 606 to account for deferred revenue need to consider whether a method change is necessary for tax purposes. The new rules under sections 451(b) and 451(c) further complicate the timing of revenue recognition.
There were a number of developments in 2018 that affected manufacturers with global operations:
Global intangible low-taxed income
One goal of the 2017 tax reform act was to discourage certain perceived profit shifting strategies where companies were trying to move (or defer) profits to lower tax jurisdictions and away from the U.S. tax net. Starting in the 2018 tax year, new section 951A imposes a tax on 10 percent U.S. shareholders of controlled foreign corporations to the extent of such CFCs’ global intangible low-tax income. While many people assume that the tax regime only affects entities with valuable intangible property in low tax jurisdictions, many manufacturers are surprised to learn that their operations in relatively high tax-rate jurisdictions (and with little to no intangible assets) are affected. While most taxpayers are finding that they have some GILTI income, the ultimate tax impact can differ greatly depending on taxpayer type (e.g., C corporation, individual or pass through). This is because many perceived tax benefits were granted to C corporations as opposed to individuals and pass-through entities. These benefits include:
- A deduction of 50 percent of the GILTI inclusion: The deduction is 50 percent of the GILTI amount (subject to TI limits) for taxable years beginning before Dec. 31, 2025. Thus, coupled with a 21 percent tax rate for C corporations, the deduction results in an effective rate of 10.5 percent on GILTI income for tax years before 2026.
- A possible foreign tax credit against the GILTI tax for underlying taxes paid at the CFC level: For C corporations only, foreign tax credits are allowed to offset some or all of the U.S. tax. In theory, no residual U.S. tax is owed on GILTI inclusions provided the foreign effective tax rate is 13.125 percent or higher. This ignores possible expense allocations that may affect this credit.
There are a few observations that manufacturers should keep in mind related to GILTI:
- The section 250 deduction is not allowable in calculating net operating losses and may result in existing net operating losses being absorbed more quickly.
- GILTI may apply even if a taxpayer has no low taxed foreign earnings.
- State and local taxation of GILTI inclusions will vary greatly among jurisdictions.
- GILTI rules (coupled with the newly expanded Form 5471) will place a substantially larger reporting and compliance burden on all taxpayers.
Foreign-derived intangible income
Another goal of the 2017 tax reform act was to encourage more domestic manufacturing activity. As part of tax reform, a new regime referred to as the foreign derived intangible income regime was established to incentivize U.S. production for export. This regime under new section 250 allows for a special tax deduction from income of a U.S. C corporation that earns FDII. For tax years 2018 through 2025, taxpayers may deduct 37.5 percent of their FDII, which can result in this income being taxed at an effective rate of 13.125 percent. Generally, FDII is any income derived from property or services sold to non-U.S. persons for use, consumption or disposition outside the United States.
Foreign sourcing of inventory sales
In the past, income from sales of inventory manufactured in the United States and sold for export (with title passing outside of the country) was treated as being 50 percent U.S. income and 50 percent foreign income for purposes of taking a foreign tax credit. Under newly enacted tax reform, these rules were changed: This type of income now is sourced solely based on where the inventory is produced. As such, manufacturers could see a reduction in their ability to utilize foreign tax credits and especially those generated from the sale of inventory through disregarded entities. For example, assume a U.S. partnership manufactures and sells inventory to its U.K.-disregarded entity, and the United Kingdom sells this inventory to its customers. Under the new rule, all of the income from this transaction would be considered U.S.-sourced income, and the ability to utilize the foreign taxes paid in the United Kingdom would be limited.
VAT isn’t new, but it continues to affect many manufacturers. There are a few noteworthy trends that manufacturers should consider:
- VAT continues to expand around the world. Recent implementers include Saudi Arabia and the United Arab Emirates in 2018, with Bahrain, Oman and Kuwait soon to follow.
- There appears to be a move away from traditional compliance processes toward real-time reporting. Historically, reporting was done on a monthly basis but there are some countries that are moving toward reporting on a weekly basis or even in real time, making the compliance burden heavy for manufacturers.
- VAT rates are on the rise, and this is increasing taxpayers’ exposure and creating strains on cash flow. The average rate in the European Union is over 21 percent and globally, it averages about 15 percent.
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