12 Jan 2018
US Tax Reform and Its Likely Impacts on HK-US Trade and Investment
On 22 December 2017, America’s President Trump signed into law the biggest overhaul of the US tax system in more than 30 years. Widely regarded as the President’s first major legislative triumph, the newly-enacted Tax Cuts and Jobs Act of 2017 will give about 80% of US households a tax cut over the next decade. Furthermore, most US corporations will enjoy a lower after-tax cost of capital thanks to the new law. However, it is being criticised for widening the US government’s fiscal deficit by adding a projected US$1.5tn (HK$11.7tn) to America’s current national debt of US$20tn in the coming 10-year budget window.
The negative effect on the US government’s finances is likely to be somewhat offset, however, by an expected boost to the economy from the tax reforms. According to the US Congress’s Joint Committee on Taxation, the reduction in effective marginal tax rates on wages will lead to an increase in labour supply, while the reduction in the after-tax cost of capital will potentially cause an increase in the after-tax rate of return on business investment, and thus an increase in investment. These two factors are projected to boost US GDP by 0.7 percent annually on average, even though many of the personal tax cut provisions expire or are phased out towards the end of the budget window.
Another feature of the tax bill concerns foreign and domestically-controlled multinational entities receiving foreign-source earnings from subsidiaries in which they own or control at least 10 percent of the stock for a minimum of one year. The bill makes significant changes to the taxation of these multinational entities, allowing them to receive these earnings without incurring US tax on the income, effectively turning the US corporate tax regime from a worldwide system, which often results in double taxation, to a territorial one.
The new tax law also makes it easier for American businesses to bring home their eligible foreign earnings and assets by creating one-time, ultra-low repatriation tax rates. The relevant earnings may be accounted for over an 8-year period in back-loaded increments, while all future eligible earnings can be held overseas or repatriated to the US free of tax.
A more comprehensive view of how US tax reform is likely to impact on HK-US trade and investment will only be available when the Internal Revenue Service (IRS) begins to issue regulations for the new law in late February/March 2018. However, the cocktail of a substantial permanent corporate tax reduction, the switch to a territorial tax system and low repatriate tax rates for foreign earnings and assets is likely to create an incentive for US corporations to bring home their current and future earnings and/or assets from overseas for domestic investment.
It could also encourage some foreign companies to relocate their headquarters to the US to take advantage of the friendlier tax regime, potentially reducing overall US investment in Asia, including Hong Kong and mainland China, as well as in other regions. Foreign tax jurisdictions, including those of Hong Kong and mainland China, may also come under pressure to provide more favourable tax conditions so as to be able to retain and attract investment from American and multinational companies.
Major Changes Brought Forward by the US Tax Reform
The Tax Cuts and Jobs Act of 2017 has made substantial changes to the taxation of individual income. It lowers the effective marginal tax rates on most of the seven tax brackets; doubles the standard deduction; abolishes the penalty payments for failure to obtain qualified health insurance coverage required as part of the Affordable Care Act (ACA); and increases the coverage and the maximum amount of the child tax credit. The new law also changes the way individuals are taxed on business income, with a 20% deduction on the first US$315,000 of joint income earned from qualifying pass-through businesses  such as sole proprietorships, partnerships, S-corporations  and limited liability companies (LLCs).
Major Provisions in the Tax Cuts and Jobs Act of 2017
|Individual tax rates||Seven brackets: 10%, 15%, 25%, 28%, 33%, 35% and 39.6%||Seven brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%|
|Standard deduction||Single: US$6,350|
|Child tax credit||US$1,000 credit for each child||US$2,000 credit, US$500 credit for non-child dependents|
|“Pass-through” tax treatment||“Pass-through” income taxed at personal income-tax rates||Deduction allowed for 20% of qualifying “pass-through” income; denied to service industry over US$315,000 |
|The Patient Protection and Affordable Care Act (ACA Obamacare or Obamacare) taxes||3.8% net investment income tax; individual mandate tax penalty; 0.9% Medicare payroll tax||Repeals individual mandate |
|Corporate tax rate||Federal corporate tax rate of 35%||Permanent and immediate tax-rate reduction to 21% |
|Expensing||Complicated rules for deducting business expenses over many years ||Five years of expensing for new equipment; phased out after year five |
|International tax rules||Taxes worldwide corporate profits which can be deferred minus taxes paid elsewhere||Moves towards a territorial system; adds new anti-base erosion taxes |
|Repatriation tax||–||15.5% on cash and liquid assets; 8% on physical assets |
|Source: Heritage Foundation |
As far as business is concerned, there is a drastic and permanent cut of the US corporate income tax rate from 35% to 21%, bringing it down from near the top of the global corporate tax spectrum to the lower end. The new law also extends and expands the scope of the bonus depreciation at 100% until the end of 2022, allowing companies to immediately write off the expense of many kinds of property, before phasing it out by the end of 2026.
As mentioned earlier, domestic corporations will also be able to receive earnings from their foreign subsidiaries without incurring US tax on the income, effectively switching the US corporate tax regime from a worldwide system to a territorial one. American businesses will also be allowed to bring home their eligible foreign earnings by paying a one-time, ultra-low repatriation tax of 15.5% on cash and other liquid assets and 8% on non-cash assets. The relevant taxes due may be accounted for over an 8-year period in back-loaded increments of 8% in years 1 through 5, 15% in year six, 20% in year seven and 25% in year 8.
Although this provision only applies to earnings from foreign corporations where the US corporate entity holds at least a 10% voting interest for a minimum of one year, it also allows all eligible, future earnings to be held overseas or repatriated to the US free of tax. This measure, designed to limit the erosion of the US corporate tax base, will not only reduce the incentive for US corporations to attribute their profits to low-tax countries and their costs to the US, but also has far-reaching implications for US investment flows. It’s estimated that US$2.6tn of earnings were stashed abroad to defer or avoid US taxes as of end-2016 by Russell 1000  companies, a figure equivalent to about 14% of US GDP that year.
Aside from using lower tax rates to encourage American companies to repatriate or keep their profits onshore, the new tax law puts into place a number of sticks, and one carrot, to discourage them from locating their profits overseas. First, it creates the requirement that Global Intangible Low-Tax Income (GILTI) be included in a US corporation’s taxable income. GILTI essentially involves “excess” offshore returns generated by intangible assets such as intellectual property (IP). The taxable “excess” is considered any amount above a standard 10% return on intangible income. US corporate shareholders – C corporations  only – can be eligible for a 50% deduction on the GILTI-related tax. This would yield an effective tax rate on GILTI of 10.5% (half of the new corporate rate of 21%) before rising to 13.125% after 2025.
Alongside the GILTI stick is the new foreign-derived intangible income (FDII) carrot. FDII acts as a “patent box” whereby US taxpayers can receive a deduction on overseas earnings based on intangible assets located in the US. In other words, it creates an incentive to locate intangible assets such as IP in the US even if the earnings remain overseas and are not taxed by the US. US corporations will be eligible for a deduction of 37.5% on FDII, lowering their effective tax rate on those earnings from 21% to 13.125%. This rate would continue through 2025 and then rise to 15.625% thereafter. As with the GILTI deduction, the FDII is only available to US C corporations.
In addition to these provisions, the new law also creates a new tax – sometimes referred to as a global minimum tax or the base erosion anti-abuse tax (BEAT). This minimum tax applies only to large US corporations with annual gross receipts of US$500m or more registered each year for the three years prior to the new law, and is only applicable to corporations with a 3% “base erosion percentage” calculated by dividing the foreign-related deductible payments for the year by the total allowable deductions. For corporations exceeding the 3% threshold, the payable BEAT is the difference between 10% of their total taxable income without the foreign-related deductions and 21% of their total taxable income including those deductions. Essentially, the BEAT functions as an alternative minimum tax on outsourced functions to prevent excessive “offshoring” of intellectual property or services imported into the US.
Likely Impacts on HK-US Trade and Investment
With the bulk of US households expecting to see a tax cut of varying degrees for most of the coming decade, the new law should provide at least a short-term stimulus to US consumption, even though many of the personal tax cut provisions expire towards the end of the 10-year budget window. With consumer spending comprising 70% of US GDP, and with the US being Hong Kong’s second-largest export market accounting for about 9% of the city’s total exports, the tax reform is likely to create a substantial boost for Hong Kong’s exports.
However, the combination of the lower US corporate rate, the lower rate for repatriated foreign earnings and the anti-abuse provisions, could create an incentive for American companies to keep current and future earnings in the US. With fewer incentives to avoid or defer US tax, US corporations will have fewer incentives to locate in low-tax jurisdictions such as Hong Kong.
That said, US corporations could also benefit from the incentives created by GILTI and FDII, whereby companies could reduce their risk of tax liability by onshoring intangible assets such as IP and at the same time offshoring tangible assets such as overseas brick-and-mortar operations in Hong Kong.
The introduction of GILTI and FDII also creates incentives to return or keep intangible assets in the US instead of locating them in low-tax jurisdictions. Some have expressed fears that the main thrust of US offshoring will shift from IP to manufacturing. The combination of an exemption for foreign-source earnings and the linking of GILTI to an earnings base could incentivise companies to move or increase manufacturing operations overseas while keeping intangible assets such as IP in the US to take advantage of tax savings.
The adoption of a territorial tax system – even a modified version like this one – brings the US into closer alignment with the tax systems of other developed countries. Consequently, this will make the US more competitive as a home for business and investment, encouraging foreign companies to relocate their headquarters to the US to take advantage of the friendlier tax regime and therefore potentially reducing overall US investment in Asia, including Hong Kong and mainland China. This could change the dynamics of international business decision-making and put pressure on other tax jurisdictions such as Hong Kong’s to lower their own tax rates and further optimise their tax systems to stay competitive in the eyes of US-based businesses.
As this does not represent a shift from a citizen-based income tax system to a residence-based system, this tax exemption on foreign earnings will not extend to individual taxpayers, leaving the US as one of the few countries that levies personal income tax on all of its citizens regardless of their domicile. As a consequence, the earnings of most – if not all – of the 8.7 million Americans  living and working outside the US will continue to be subject to US taxes.
Given there is no comprehensive double taxation avoidance agreement (CDTA) in place between Hong Kong and the US, the unavailability of favourable repatriation tax rates (i.e. 15.5% on cash or cash equivalents and 8% on illiquid assets for foreign corporations where the US corporate entity holds at least a 10% voting interest for a minimum of one year) and the lower personal tax rates facilitated by the new US tax legislation could potentially act as disincentives for US citizens when considering Hong Kong as a career move, inevitably making it more difficult for Hong Kong companies to recruit and retain US professionals.
It is worth noting that when the initial House and Senate tax reform bills began to circulate, many expressed concerns about potential violations of WTO rules or bilateral tax treaties. For example, FDII may prove to be in contravention of WTO rules on differential taxation and export subsidies, while GILTI may run afoul of internationally-accepted standards on taxation, as it represents an unprecedented extension of US tax authority to cover foreign earnings by a foreign company simply on the basis of US ownership of stock.
The ultimate impact of the tax law on foreign or US corporations will not be known until more details are made clear by the Internal Revenue Service (IRS) when it begins to issue regulations for the new law in late February/March 2018. But as more tax experts analyse the law, more potential loopholes and problems – such as potential violation of WTO rules or bilateral tax treaties like CDTAs – are expected to be discovered. It may be that fresh amendments will need to be made to the law, although the likelihood of any such amendments being passed is slim as any changes would require 60-vote majority support in the Senate. In light of this, the new tax regime could well be in place – drawbacks and all – for many years to come.
Details of future developments relating to US tax legislation will be featured in the HKTDC’s Regulatory Alert-US newsletter.
 A pass-through business refers to a business structure where corporate income is not taxed at the corporate level, but levied at the individual owners' level.
 An S corporation files a federal form 1120-S which passes most items of income or loss to shareholders who are responsible for reporting that information on their individual tax returns.
 The Russell 1000 Index represents the top companies by market capitalisation, typically comprising approximately 90% of the total market capitalisation of all listed US stocks.
 A C corporation files a federal form 1120 when its shareholders pay tax at their individual income tax rates for dividends or other distributions from the company.
 Source: Association of Americans Resident Overseas