In this second quarter update, we cover some of the most important tax issues for companies in the technology, clean technology, life sciences, and communications and media industries and touch on what your organization can do to stay ahead of them.
Trump Administration Unveils New Tax Reform Plan to Lower Business Taxes and Simplify the Tax Code
The White House administration proposed a new tax law reform plan on April 26, 2017, that would reduce corporate tax rates to 15 percent, streamline the number of individual tax rate brackets from seven to three, and change the way foreign activities are taxed by replacing the worldwide tax system with a territorial system and imposing a one-time tax on repatriated profit overseas. Read more about how these potential tax law changes could affect you and your business in our Insight.
Section 956 Tax Trap for Foreign Subsidiaries
Many US technology companies have foreign subsidiaries that perform product development or sales and support functions on their behalf. The intercompany transactions between these related entities can create intercompany payables and receivables that are unpaid because of cash flow or other reasons—but those unpaid intercompany accounts can create taxable income for the US parent company in some circumstances.
US taxpayers are generally able to defer the foreign earnings of their subsidiaries from US taxation until those earnings are repatriated to the United States. Overriding this treatment is a set of anti-abuse rules that require current taxation of certain income, such as Section 956 income, which results from a foreign entity owning an asset based in the United States.
How Section 956 Works
If a foreign subsidiary loans money to its US parent company, the loan receivable is a US asset. Intercompany transactions that result in a payable from the US parent company to the foreign subsidiary—where the payable remains outstanding beyond normal terms—may also be considered a loan from the foreign subsidiary to the US parent company. This situation often occurs when a US parent company doesn’t transfer the full amount of the intercompany service fees, but instead only transfers enough cash to its foreign subsidiary to meet its operating needs, leaving the foreign subsidiary with an intercompany receivable.
Consider a US parent company that reimburses its foreign subsidiary on a cost-plus basis for software development services performed on its behalf. If the parent company simply provides enough cash to meet the subsidiary’s operating needs—only the “cost” portion of the cost-plus payment—and doesn’t pay the subsidiary the full amount that’s due, an intercompany balance that is a net receivable from the US parent company will accumulate, triggering a possible Section 956 income event.
Section 956 income is taxed in the United States on a current basis, unless an exception applies. The regulations provide an explicit 60-day safe harbor for debt obligations that arise from the provision of services by a foreign subsidiary to a US parent company. This means Section 956 income can be avoided by US parent companies if their intercompany payables and receivables are fully paid within a 60-day period.
Other Rules That May Apply
The US tax code requires certain intercompany transactions to be accounted for on a cash basis. This means that if the payment is made within the 60-day safe harbor period, but after the tax year ends, the deduction for that payment may not be available until the subsequent year when the cash is actually paid to the foreign subsidiary.
Positive earnings and profits of the foreign subsidiary are also required for Section 956 income to impact the parent company. It can also be generated by transactions other than intercompany payables and receivables, such as using assets of the foreign subsidiary to guarantee the parent company debt or the parent company pledging the stock of the foreign subsidiary.
What You Can Do
Consult with your tax advisors regarding cross-border intercompany transactions and use of foreign assets to secure US borrowings to avoid adverse tax results.
R&D Credits Payroll Tax Offset Update
The Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) featured some enhancements starting in 2016, including offsets to payroll tax for eligible businesses. The credit is still based on credit-eligible R&D expenses, but offsets apply to only costs incurred beginning in 2016. Read more about navigating the uncertainty surrounding the new R&D credit payroll offset in our Insight.
The IRS provided an update on the certification process for Professional Employer Organizations (PEOs), stating that 84 applicants were certified on June 1, 2017. This is important news for clients that use a PEO for payroll services and seek to claim the R&D payroll credit this year. However, it’s important to note that this announcement doesn’t apply if the client uses a non-PEO payroll provider.
The R&D payroll credit rules refer to certified PEOs that can process the credit claims for their clients. Prior to this announcement, a number of PEOs had pointed to the lack of IRS certification as one reason for being unable to process R&D payroll credit claims for their clients. However, this logic is no longer applicable following the IRS announcement, and those certified should have no further administrative hurdles to prevent processing a credit claim. The question now becomes one for each individual certified PEO, and whether they have the technical capacity to process the client’s credit claim.
IRS Proposes Guidance for Changing Tax Methods Related to Adoption of New Revenue Recognition Standards
On May 28, 2014, the Financial Accounting Standards Board (FASB) announced a new financial accounting standard for recognizing revenue, titled Revenue from Contracts with Customers (ASC 606). The new standards are effective for annual reporting periods beginning after December 15, 2017, for publicly-traded entities and after December 15, 2018, for all other entities. Early adoption is allowed for all entities for reporting periods beginning after December 31, 2016.
The new standards represent a significant shift from current financial accounting guidance and are expected to affect each company in some way. Importantly, the new standards will likely also have significant tax consequences, even though the income tax principles for revenue recognition under Internal Revenue Code (IRC) 451 and related guidance haven’t changed. Possible tax consequences include accelerated taxable income where tax looks to financial statement recognition, new or changed book-tax differences, the need or desire to change tax accounting methods, and changes to deferred taxes. The new standard may also affect state income taxes, sales and use taxes, indirect taxes, and international tax reporting.
On March 28, 2017, the IRS issued Notice 2017-17, outlining a proposed revenue procedure for taxpayers to obtain automatic consent to change their tax accounting method for the same year the taxpayer adopts the standard for financial statement purposes. Specifically, the proposed procedure would apply to method changes that are made as a result of, or directly related to, the adoption of the new revenue recognition standards. The IRS requested comments on this proposed procedure as well as renewing their request for comments from taxpayers to help identify the issues the new financial standards create for taxpayers.
As companies evaluate the financial reporting implications of the new standards, it’s critical that they work with their tax advisors to help identify and address the potential tax impacts. Additionally, companies may modify their customer contracts or underlying information systems as part of their implementation process, which would also require analysis from a tax perspective. Addressing the tax issues upfront during the assessment process can help minimize unpleasant tax surprises down the road.
State Tax Developments
California Guidance on Application of Sections 382, 383, and 384
On April 6, 2017, the Franchise Tax Board (FTB) of California issued Technical Advice Memorandum (TAM) 2017-03 providing guidance on the application of Internal Revenue Code (IRC) Sections 382, 383, and 384 to the availability of California net operating losses (NOLs) and tax credits following an ownership change and whether the determined limitations must be apportioned for California tax purposes. Prior to this TAM, California tax law and the FTB didn’t provided guidance as to whether any of the limitations of IRC Sections 382–384 should be applied on a pre-apportionment or post-apportionment basis.
The FTB concluded that:
- The California apportionment factor percentage doesn’t apply to a loss corporation’s Section 382 and 383 limitations.
- The apportionment factor percentage that exists as of the date of the ownership change should be applied to recognized built-in gains (RBIGs) or losses (RBILs) and net unrealized built-in gains (NUBIGs) or losses (NUBILs) for purposes of Section 382, 383, and 384.
- The California tax rate should be used for purposes of determining the Section 383 limitations to California tax credits.
The FTB also reasoned that the calculation of the Section 382 and 383 limitations didn’t involve items related to net income, so apportionment wouldn’t apply. For California tax purposes, apportionment only relates to net income, which is comprised of items such as income, deductions, gains, or losses. Unlike other states, there’s no statutory or case law authority in California to apply apportionment provisions to items that don’t directly relate to net income. On the other hand, the determination of RBIGs, RBILs, NUBIGs, and NUBILs relates to gains and losses and, so the FTB concluded the California apportionment factor should be applied. The FTB also determined that the California tax rate should be substituted for the federal tax rate when determining the Section 383 limitation to California tax credits by noting that it’s an obvious difference when applying the relevant federal treasury regulations for California tax purposes.
How This Might Affect You
To the extent a company has been assuming the federal and California limitations for an ownership change are the same, the company will need to take a closer look at any calculations of RBIG or RBIL and NUBIG or NUBIL for California purposes. Apportionment won’t apply to the base limitation, so this amount is the same for federal and California purposes. Any additional limitation available because of an RBIG—or deemed RBIG in connection with Notice 2003-65—will need to be apportioned for California purposes.
Tennessee Expands Nexus
Beginning with tax years on or after January 1, 2016, Tennessee has adopted the Revenue Modernization Act, which creates new economic nexus standards and market-based sourcing and increases the number of companies that are subject to the Tennessee business tax (TBT). If you have customers in Tennessee you may now be subject to tax there. Learn more about how these changes to Tennessee tax law may affect your business in our Alert.
Now more than ever, as you look to expand internationally, it’s important to fully understand and factor in domestic and foreign tax implications. Here’s why:
- The White House administration’s proposed tax reform may impact traditional international tax structuring. Learn more about how the proposed changes could potentially affect your business in our Alert.
- Base Erosion and Profit Shifting (BEPS) regulations are changing globally. Find out more about how these regulations could affect your organization in our Insight.
- There continues to be regular changes to local tax laws that may impact your company, such as the recent policy updates to the UK Value-Added Tax (VAT) that are discussed below.
United Kingdom Value-Added Tax
There has been an unannounced change in tax policy made by the British taxation authority, Her Majesty’s Revenue and Customs (HMRC), regarding how HMRC treats VAT on imports of goods into the UK. The changes remove the ability of the third-party service or manufacturing vendors commonly used by US pharmaceutical companies to deduct the import VAT. This means that the VAT, which is charged at a 20 percent rate in the United Kingdom, becomes an added cost to the company. As a result, we’re seeing significant charges being billed back to US companies by service providers based in the United Kingdom.
Many companies that ship drug products for trials or active pharmaceutical ingredients (APIs) for manufacturing to the United Kingdom are now considering changing physical supply chain routes or exploring alternative tax options to reduce the VAT risks and costs.
Significantly, this change in policy appears to be retrospective as far back as 2014, which may create exposure.
Other International Developments
Taiwan VAT Changes
As of May 1, 2017, Taiwan began requiring foreign suppliers of electronically delivered services to consumers to register for Taiwanese VAT. The threshold is around $16,000 USD annually. Foreign suppliers are now assigned an ID number and are required to file periodic VAT returns. The VAT applies to services provided through the internet or other electronic methods, with or without download to or storage on computers or mobile devices. Taiwan’s VAT is assessed at 5 percent.
Malaysia Withholding Tax Changes
Effective January 17, 2017, Malaysia began charging a withholding tax under newly expanded technical services and royalties withholding laws. Software as a service (SaaS) providers, software vendors, and digital downloads can expect to incur a 10 percent withholding tax.
We’re Here to Help
Moss Adams continuously reviews the regulatory and tax landscape for technology, clean technology, life sciences, and communications and media companies. For more information about any of the issues discussed above or for insight on how they may impact your business, contact your Moss Adams professional.