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US tax changes

Leaders call for preparation as rules shift

Three Deloitte managing partners, Tim Brandt, Jeff Cotton, and Ed Heys, recently sat down to talk about tax legislation.

Our leaders' insights into new tax legislation

It’s been about seven months since the 2017 Tax Act was signed into law, and tax departments are still grappling with its nuances and implications. There’s good reason why: It not only lowered tax rates, but accelerated some deductions while limiting and removing others altogether. The implications for not just C-corporations, but also pass-through companies and individuals, are manifold.

For businesses, the act replaces the former graduated rate structure with a flat 21 percent corporate rate, but also allows a deduction for up to 20 percent of pass-through income for certain types of payers.

Three Deloitte managing partners recently discussed how the legislation is shaping the structure, strategy, and future of companies in their markets.

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Considering the complexity around the tax changes, what are the biggest challenges among companies in your regions?

Jeff Cotton, Deloitte’s Minneapolis managing partner (JC): When I talk to executives, they are focused on putting themselves in the best possible position to respond to the act. We’ve all seen the reports of companies adjusting compensation and bonuses to pass some of the savings to workers. However, one of the biggest challenges, which is a universal issue arising out of the act, is centered around supercharging growth.

For example, companies across all industries are faced with the question of how the new tax law can free up capital and incentivize investment to build and grow their business. That’s just one example of something companies need to figure out to remain at a competitive advantage.

Ed Heys, Deloitte’s Atlanta managing partner (EH): I also hear about the challenges around remaining competitive. With a brand-new law, companies are working to make sure they have the right data for new types of calculations. Organizations have had some time to examine the new provisions, but it is critical that chief financial officers (CFOs) proactively work with colleagues, the board, and their audit committee to ensure everyone knows the type of data that is needed and how long it will take to assemble and analyze that information.

Tim Brandt, Deloitte’s Orange County, California managing partner (TB): CFOs definitely can play a big role in identifying and acquiring that data and this new law is coming into effect as companies adjust to an increasingly digital environment. One challenge that has come up in tax discussion is how to decide which technology approach makes sense. Should you automate key calculations? Where do analytics help?

As tax teams prepare companies for the future, there are many things to consider beyond just changes in the operating environment and the technology solutions to support companies along the way.

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Deciding on the appropriate corporate structure is one of those key considerations. What are you hearing from companies around conversions from pass-through to C-corporations, for instance?

EH: This will all depend on knowing how the business and the owners are taxed and whether the company has an exit strategy. As an example from the banking industry, there are many financial institutions that are closely held companies, Subchapter S-corporations, that pass tax liability to shareholders. The dividends typically have the funds added in to cover the tax liability. The act includes special rules to allow S-corporations to convert to C-corporation status.

Now, the Tax Act makes it possible for pass-throughs and sole proprietorships to deduct 20 percent of qualifying income. There’s that provision, along with the reduction in the overall lower corporate tax rate, which businesses will need to assess to determine the appropriateness of a pass-through or a C-corporation structure.

JC: It’s a matter of doing that assessment and looking at how the act treats a specific type of business. We’re even seeing it begin in private equity. Recently, a global investment management company switched its status from a partnership to a corporation in an effort to broaden its investor base. The private equity firm will now pay the 21 percent rate on all revenue, though this is still lower than the top rate on certain pass-through income. But, as a publicly-traded entity, the firm could now be eligible for stock index listings, which is a positive for shareholders, as is the ease of owning shares rather than partnership units.

It really is an individual business consideration—tax departments have to do a patient and thorough analysis of these changes to see what makes the most sense for their organization and also must consider the consequences of shifting to C-Corp status if they decide later they would, in fact, have been better off remaining a pass-through.

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What about cross-border deals? What are you observing now that some domestic firms have lower tax profiles and might be more attractive targets for overseas buyers?

JC: The picture is pretty complex. If you talk about Canadian firms looking at US targets, for example, they’re saying that valuations and cash flow projections are now going to be easier to determine thanks to the passage of the Tax Act. You have some investment experts even calling it a big advantage for these firms looking at US companies. But, in the first quarter of this year, inbound deal volume from Canada to the United States was only about two-thirds of what it was in 2017, so whether these predictions end up holding true will remain to be seen.

EH: I’d say there’s a global appetite for US targets. Shortly before the Tax Act passed, Deloitte surveyed global executives from private companies which expressed an expectation of increased cross-border activity.

Now, a lot more of these firms seem to realize that they are potential targets for foreign buyers. There are other provisions that may incentivize increased inbound deal flow, such as lower rates of tax on US income tax paid on foreign-derived royalty income. Buyers can also write off certain asset acquired through 2022, which makes potential deals that much more attractive.

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In our recent CFO survey, 46 percent of respondents said they anticipate higher investment in US operations, and 77 percent said they expect to steer repatriated foreign earnings to their investment in R&D and innovation. To what extent is tax reform fueling an innovation boom?

TB: At the very least, we’re seeing a mergers and acquisitions (M&A) boom. True to prediction, pharmaceutical companies, for example, that had cash overseas have started to bring it back onshore as a result of changes in the tax code. There were nearly $47 billion in biotech M&A deals announced in the first quarter of 2018, as well as several more deals announced of late.

Innovation is definitely part of the mix, however. In some of the other deals, for example, we’re seeing companies looking to get a jump on testing or looking to boost their position in the treatment of certain diseases.

JC: I see it too. M&A activity is strong, and like our survey showed, a lot of CFOs are taking a close look at how they can reduce some of the risks that might weaken growth. Investing in research and development (R&D), emerging technologies and innovation can help set the stage for strong performance over the long-haul. Those are the types of decisions that can help hedge against some of the uncertainty we are hearing about the long-term impacts of the Tax Act.

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Innovations in tax technology have come a long way in recent years. What are some useful tools that could be helpful for companies in this new environment?

JC: First and foremost, it’s important for companies to figure out where their tax function is in analytics. Do you know where all of the data you need for the new tax reform provisions will come from? That data has to then help you create models that represent where you are and where you need to go as tax changes take effect.

TB: Companies also have to know how their existing software will take the new provisions into account. There are technology solutions that can help tax departments conduct detailed compliance and planning. As Jeff said, it’s important to have and be able to use your data. Some of the newer tools can take recent tax returns and analyze the potential tax reform implications over several years, so companies can get a handle on these changes.

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What about scenario modeling for the long term? What guidance would you offer to plan for growth, a potential exit, or even succession?

EH: I’d use the example of Georgia, where the government has opened ports, roads, and infrastructure to the world to stay competitive. An approach to long-term scenarios for tax planning has to be considered in a similar way. Some of your data and technical aspects that apply today might be irrelevant in the near future, so design a system where you can easily make changes such that tax colleagues down the road aren’t having to overhaul the enterprise when new people step in, which is inevitable over time.

JC: There are some common pain points in tax scenario planning—the amount of time required for reviewing data, the same sets of data coming up on a recurring basis and potential misunderstandings. A good approach for the long term is to use tools to streamline how you review, investigate and monitor those results in real-time. Knowing where you stand and what your company is worth can lead to stronger outcomes.

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Visit Deloitte’s tax reform page to read more perspectives, learn about upcoming events, and connect with our leaders.

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