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Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II will explore the first of several significant topics, coupled with an analysis of the implications for Swiss financial institutions and investors.
Competitive Corporate Tax Rates
Prior to the Tax Cuts and Jobs Act, the US imposed one of the developed world’s steeper corporate tax rates at 35% (coupled with a further tax of up to 39.6% on the shareholder for dividends received). The new bill slashes that rate to 21% (and repeals the alternative minimum tax for corporations). The business- and investor-friendliness of this rate reduction is indisputable. In a flash, it will enhance the post-tax return on investment for US corporations, which ought to make the US operations of Swiss companies more profitable and the investment holdings of non-US investors more valuable. As noted in Part I of this series of blogs, numerous non-tax factors may mitigate the intended impact, but the tax wind clearly gusts in the direction of higher corporate post-tax profits and thus presumably a more attractive investment destination (for further illustration of this attractiveness, please see ECI section below).
One quirk of the rules for tax accounting, however, will result in an immediate harm to the balance sheets of US corporations (both US-headquartered companies or the subsidiaries of non-US parents) due to the reduction of the corporate tax rate. This harm is superficial, but may lead to some holes on the asset side of the balance sheets for US corporations with significant accumulated losses (called “net operating losses” in tax parlance or NOLs, for short). The US tax code permits US corporations to carry forward NOLs from one year for use against positive earnings in future years (subject to multiple limitations). As such, NOLs are valuable for reducing future tax costs and thus may be treated as an asset in the financial reports of the corporation. For accounting purposes, the amount of future deductible losses is known as a deferred tax asset (DTA) and boosts the asset side of a balance sheet so long as the corporation has a reasonable expectation that it will earn enough income to offset it in future years before it expires.
Well, in 2008 a lot of banks lost a lot of money. A LOT. Since then, they have been carrying DTAs of up to USD 20B, inflating their balance sheets correspondingly. However, the amount of a DTA is a product of the total NOL multiplied by the corporate tax rate. For example, if you have an NOL of USD 100, it still can only offset USD 100 of future income. Going forward though, the value to the corporation on taxes saved will be 100 x 0.21 or a DTA of USD 21, whereas previously it would have been 100 x 0.35 or a DTA of USD 35. Fortunately, the financial markets tend to discount such tax elements of a balance sheet as they do not signal the overall health and future prospects of the corporation (arguably, a large DTA signals the opposite). Nonetheless, there may be some secondary effects in response to this tax accounting adjustment.
Lower Rates on ECI, an Incoming Withholding Regime and More
Effectively Connected Income or ECI is income earned through a direct investment in an active trade or business (mainly). At its most straightforward, the US branch or other permanent establishment-type operations of non-US corporations generate ECI. Non-US investors can also earn ECI through investments in private equity, venture capital or other investment funds that acquire ownership stakes in start up companies, which tend to operate as LLCs or in other flow through forms. In the absence of a “blocker” corporation, the earnings of the portfolio companies pass through to the investment fund and then on to the non-US fund investors as if such non-US fund investor had earned the active operating income directly. Accordingly, income earned through such investments is taxed at the rate applicable to US corporations, not the standard dividend or capital gains rates that typically avail for non-US investors in US securities.
The new tax bill contains several provisions that will affect ECI calculations for non-US investors. It also institutes a new withholding requirement that will impose a further operations burden on QIs and other withholding agents. The core changes are as follows:
Part III of this blog series dissecting the new US tax code provisions will be published in a few days’ time. If you wish to be automatically notified when it’s posted, please send an email to firstname.lastname@example.org and you will be added to our subscriber list.