Tax opportunities and challenges for manufacturers in 2017
INSIGHT ARTICLE |
Based on proposals put forward by the new administration—as well as by the House and the Senate—there may be some major tax law changes on the horizon for 2017 and beyond. Although these proposed reforms are focused on reducing tax rates, certain tax incentives might be repealed or restricted. Many of the proposed changes will affect not only federal and international tax positions, but also state and local taxes as many states struggle with shrinking budgets and impose various decoupling positions.
Prior to filing their 2016 company tax returns, manufacturers should consider tax planning to take advantage of techniques that can help them defer income, accelerate tax deductions and leverage tax incentives.
There are actions that manufacturers can take now to prepare their companies for what is to come. Following are highlights of anticipated tax law changes and what manufacturers should consider prior to filing their 2016 tax returns and tax planning for 2017.
Federal tax: 2017 planning tips
There are a number of policies, regulatory issues and initiatives that are worth tracking in the coming months that could help manufacturers remain competitive.
The border adjustment tax, for example, which House representatives are proposing to ensure import and export taxes are applied fairly for U.S. companies. There also is a call for creating a more reasonable regulatory environment, particularly for middle market manufacturers, who make up approximately 40 percent of the GDP. Many rules and regulations are aimed at benefitting large organizations or small businesses; midsize companies do not see as many policies directed towards them, making it that much more expensive to grow.
That competitive edge could be achieved by continuing to incentivize research and development, leveraging technology and employing top talent. Government could help make this happen, along with stimulating growth and enhancing productivity, by reforming trade, energy and environmental policies and improving infrastructure. It will also be important to invest in education and reform health care in order to ensure manufacturers can employ the best, brightest and healthiest workforce.
Proposed business tax reform
Comprehensive tax reform is at the top of the list of priorities for both the administration and Congress. But to simplify the tax code, incentives such as the domestic production activities deduction may be taken away, while those incentives for R&D are likely to remain.
Investments in capital—both tangible and intangible—are in proposals for reform by both the Trump administration and Congress. The administration wants to end inversions and tax foreign earnings as earned, eliminating deferrals; House Republicans, who hold the majority, want to restructure taxation of foreign earnings. Trump and the House need to come to some agreement on these issues.
From a tax perspective, manufacturers will want to start planning now to take advantage of the anticipated new proposals.
The current Protecting Americans from Tax Hikes (PATH) Act for 2016 contains deductions that are very advantageous to manufacturers:
- R&D credits: For years, the R&D credit was not permanent but that changed at the end of 2015. Innovation and improvement of existing products and processes are key elements to remaining competitive and this credit is an effective mechanism for capturing the costs of these efforts and obtaining a credit on taxes for doing so. There are some special rules for small businesses, including being able to use the R&D credit against the alternative minimum tax.
- Work opportunity tax credit (WOTC): This provision reduces the employer’s tax liability up to $9,600 per each newly hired employee from a qualified group. It has been extended through 2019. Many companies may be hesitant to take advantage of this credit, as it can seem intrusive to ask employees if they qualify. Employers may not realize that they have employees who fall into the qualifying groups (which include veterans, those receiving Supplemental Nutrition Assistance Program benefits, those in empowerment zones and others). The process can also seem cumbersome but in most cases the information needed can be easily obtained over the phone or online, the privacy of the employee can be maintained and the company can receive the credit. Flow-through entities can qualify for the credit as well.
- S corporations: Still in effect for 2016 taxes is the stock basis adjustment for charitable contributions of property as well as the exemption from corporate tax on built-in gains assets.
- Capital expenditures: Small business expensing is still available. In addition, some 39-year property still qualifies for 15-year recovery under the PATH Act and bonus depreciation. When companies are considering their capital expenditures, these can help increase that competitive advantage.
Tax accounting methods
Generally, when companies are preparing their financial statements, these are done on a generally accepted accounting principles basis or by a similar method. The IRS scrutinizes tax accounting methods on exam but, in a changing tax rate environment, a company can defer income to a low tax year and accelerate expenses to a high tax year under what may be called a “tax rate arbitrage.”
For example, a manufacturer has a pre-paid expense in insurance. Generally, that pre-paid expense is going to be capitalized until the company starts using its insurance policy. However, for tax purposes, the company can accelerate recognition of that item until the date it was paid. Potentially, the company could get a deduction on its tax return in 2016 at a 35 percent rate. Assuming corporate tax rates change to a 15 percent rate in 2017, when the book tax difference flips and the company has to pay it back, the company can generate a 20 percent permanent tax savings.
Benefits of reviewing tax accounting methods
Taxpayers must get consent from the IRS in order to change a method of accounting. Some accounting method changes are subject to a streamlined filing process where the request is attached to a timely filed tax return. A change in accounting method avoids amending prior returns, provides IRS exam protection, and often allows for a historic adjustment that could potentially reduce taxable income in the current year.
For manufacturers, two commonly used strategies may prove useful in tax planning:
- Income deferral involving advanced payments, deposits and deferred revenue; long-term contracts; installment sales; and like-kind exchanges
- Expense acceleration involving prepaid expenses, software development costs, fixed assets and other opportunities
Manufacturers are encouraged to examine for tax purposes how they are accounting their income and expenses.
State tax: Important changes with state taxing regimes
State and local tax compliance can be complicated. It's important to understand the rules, risks and opportunities, especially if you have a growing business.
State tax nexus
Nexus is one of the core issues of multistate taxation, and is the subject of substantial amounts of legislation, regulatory action and litigation. Nexus is the level of activity a business has to have with a state before that state can impose a tax liability and compliance responsibility on the business. It is an evolving concept, and every state applies nexus principles differently. It's important to not only know what your business is doing, but how your business is doing it in every state.
Nexus standards are in a constant state of change as a result of court decisions, developments in state tax department policy and fiscal pressure on states. There have been significant expansion movements regarding factor presence and economic nexus standards. Additionally, the traditional and generally applicable nexus standards are not consistent between states or even among tax types. You can potentially create nexus in any state by simply selling to customers there.
The question of whether and where a company has to file only scratches the surface of the importance of nexus. Other nexus issues―such as whether the company has the right to apportion or has to throw back or throw out sales from its sales factor―may have more bearing on the amount of total state income and franchise tax liability actually due.
Additionally, it is important to understand whether or not a company has any opportunities to restructure legal entities or business operations to generate tax benefits from either increasing or reducing its nexus footprint. For example, a company in a loss year with an expectation of generating income in future years may be well-advised to establish nexus now in states it has targeted for expansion in order to protect a net operating loss. In some cases, this can be as easy as hiring or moving an employee a little bit earlier than originally planned; however, regardless of the necessary steps, any nexus-establishing activities must be done by year-end.
Other state tax planning opportunities include:
Apportionment rules for manufacturers: A reform effort has led to reconsideration of whether manufacturers should be subject to a state’s standard apportionment formula. Historically, states tax corporations based on a ratio of the company’s sales, property and payroll. Incentives to promote in-state activities can lower the tax burden on companies.
Tax credits and economic incentives: Transaction-driven activities such as acquisitions may qualify manufacturers for tax credits. Company-driven actions such as creating new business operations and expanding facilities or maintenance on existing facilities may also qualify. Hiring and training employees, purchasing new equipment and improving infrastructure can provide opportunities for various tax credits to be claimed on an income tax return. Other tax credits and most economic incentives must be negotiated with the state economic developers before they can be claimed.
State tax reform possibilities to watch
States generally align with reforms at the federal level, so there may be a cascading effect on various tax issues in the months to come. However, some states decouple from favorable federal income tax rules due to different fiscal considerations and balanced budget requirements. This includes bonus depreciation and some manufacturing deductions.
Some states are broadening what services, goods and software qualify for sales and use tax, including repair, maintenance and installation services. States could migrate away from a traditional income tax in favor of a gross receipt or hybrid tax system, such as Ohio’s commercial activity tax, the Texas margin tax or the Nevada commerce tax.
In addition, real and tangible personal property tax reforms are proposed among the states on an annual basis. Manufacturing industries, which often hold a large amount of personal and real property, may feel the impact if those proposals are enacted.
International tax: Considerations for the multinational manufacturer
There were a number of developments in 2016 that affect manufacturers with offshore operations.
Base erosion and profit shifting (BEPS)
Governments around the world are seeking to adapt their tax systems to stem falling revenues in the face of the changing global economy. The goal is simple: ensure that companies are paying taxes on their revenue in the countries where that revenue is created. It will be up to each nation to decide whether to implement the BEPS solutions, but it is clear that many will. It’s estimated that when the multilateral instrument is signed into law in mid-2017, it will update some 2,000 treaties simultaneously. It will also change commissionaire structures, which many manufacturers are using.
Country by country reporting (CbCR)
The IRS issued final regulations requiring annual CbCR by some U.S. taxpayers that are the ultimate parent of a multinational enterprise group. These regulations are based on model legislation from the Organisation for Economic Co-operation and Development and are part of the project addressing BEPS. This new tax filing requirement applies to companies with $850 million or more in global group revenues. Simply capturing the information needed can be difficult.
Section 987 regulations finalized
For multinationals with disregarded or flow through entities in their structures and that use a currency other than the U.S. dollar, these regulations govern the recognition of exchange gain and loss when a company has remittances back to the United States. These regulations are quite complex, and must be adopted by 2018; manufacturers should begin to prepare now.
Possible 2017 International tax reform
The tax reform debate in Washington is centering around different systems of taxation: worldwide transactional (which is the current system where domestically headquartered companies are taxed on all worldwide income when the money is repatriated to the United States) and a territorial system (where companies are taxed only on the income earned within a country’s borders and income earned abroad is not taxed).
The new administration wants to retain the worldwide system and eliminate deferral of tax on foreign earnings; House Republicans advocate a territorial system, with border adjustments that would impose a tax on imports and a rebate tax on exports. Both approaches have their supporters and detractors. There may also be proposals to allow tax favored repatriation of accumulated foreign earnings as a way of funding a potential infrastructure bill.
Questions to ask
Despite the uncertainty, there is a general consensus that the tightening of treaty benefits, lower corporate tax rates and one-time tax on foreign earnings will ultimately go through.
Manufacturers should ask themselves a few questions about their company tax structure:
- Do you have aggressive treaty positions or rely on commissionaire structures?
- What’s your overall global tax strategy and how does this align with the general direction that the U.S. tax system is headed?
- How will the one-time deferred earnings tax affect you?
- Do you have low-taxed earnings that this could “free up” to bring back?
- Is there a reason to consider bringing highly taxed earnings back before the new regime?
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