How is the recent US tax reform expected to impact Cyprus?

Article by Stelios Violaris, Tax Advisory Partner at PwC Cyprus, Board member of the American Chamber of Commerce in Cyprus

 

Introduction 

On 22 December 2017, President Donald Trump signed the US tax reform bill and essentially set in motion the largest overhaul of the US tax code since 1986 which happened under President Ronald Reagan.

A number of the provisions contained within the US tax reform have a significant bearing on US international tax rules including moving the US from a worldwide to a territorial system of taxation (see below). These provisions will invariably have an impact on US multinationals conducting business within and outside the US as well as non-US multinationals with US sourced incomes, physical presence and any other form of vested interest.

To that extent, the impact that the US tax reform will have on such multinationals with presence in Cyprus needs to be closely examined.

A brief summary of the key domestic and international tax provisions of the US tax reform is set out further below including a discussion on how Cyprus stands to be affected. 

 

Notable general business tax provisions

Federal corporate tax rate

Reduction of the Federal corporate rate from 35% to 21% for tax years beginning 2018.

 

As a result, combined US corporate rate (i.e. 21% Federal rate plus State average) now stands at 25.75%, only two percentage points higher than the 23.75% average rate for all OECD nations and second lower out of all G7 countries.

 

Pillars of international business tax provisions

Territorial tax system

International tax regime

‘Territorial’ system, i.e. 100% exemption from Federal corporate tax of foreign dividends received by US corporate shareholders (subject to conditions).

‘Toll charge’

Imposes a one-off tax on a US shareholder’s pro rata share of certain foreign subsidiaries’ previously untaxed foreign profits post-1986 as follows:

- 15.5% on cash and cash-equivalents, and,

- 8% on non-cash assets

This is payable over a period of 8 years in increasing instalments. Foreign tax credits for the portion of earnings subject to the toll charge would be available to offset the tax.

Base Erosion Protections

Limitation on deductibility of net interest expense

Limitation on deduction for net interest expense to a measure that is roughly similar to 30% of EBITDA (tax years beginning before 1 January 2022) and 30% of EBIT thereafter.

Base Erosion and Anti-Avoidance Tax (“BEAT”)

BEAT is designed to discourage US companies from shifting revenues from the US to low-taxed foreign jurisdictions.

 

This is a minimum tax equal to the excess of 5% of the 2018 taxable income determined without regards to base erosion payments (i.e. deductible payments to a related foreign persons) over the regular tax liability. Rate is increased to 10% for tax years 2019 to 2025 and 12.5% for tax years beginning after 31 December 2025.

Minimum Tax

Global Intangible Low-Taxed Income (“GILTI”)

The idea of the GILTI provision is to subject a US shareholder to tax on half of its combined net foreign income above a routine return of 10% on foreign tangible assets.

‘Hybrid’ situations

Anti-hybrid measures now apply to:

- Deny tax deductions for expenses where the corresponding income is not subject to tax in the counterparty jurisdiction, and,

- Deny a dividend exemption where the non US payer has received a tax deduction for the dividend payment.

Incentives to onshore

Foreign-Derived Intangible Income (“FDII”)

A 37.5% deemed tax deduction is allowed for FDII produced in the US thus making the US effective corporate tax rate on such FDII to be as low as 13,125% at least for the tax years up to 2025.

 

What does the US tax reform mean for Cyprus?

Cyprus’ headline corporate tax rate of 12.5% (effective tax rate often being much lower due to a number of exemptions and deductions) remains very competitive compared to the combined US corporate rate of 25.75% and is at par with Ireland as the second lowest amongst OECD countries.

Repatriation ‘toll tax’ might be a reason for increased activity observed in the case of Cyprus subsidiaries of US MNCs, particularly if they have been cash-rich over the years.

Hybridity is an area that is not expected to affect negatively the US business of Cyprus as the use of hybrid entities / instruments is very limited through Cyprus. Further, the introduction of relevant anti-hybrid tax legislation by Cyprus as adopted from the latest EU Parent-Subsidiary Directive amendment and the soon to be implemented EU ATAD I & II Directives is proof that Cyprus, as a full EU Member State, and the EU itself are tackling the issue themselves.

Areas that warrant a closer look are the GILTI and FDII provisions. The former is relevant for US-parented groups holding all or part of their IP offshore (e.g. in a Cyprus subsidiary). Any returns from holding and exploiting such IP abroad may be taxed at an effective rate of around 10.5% in the US before consideration of foreign taxes.

On the contrary if the same group held such IP in the US, FDII would become relevant whereby a 37,5% deduction for sales and services income provided to unrelated persons provides for an effective tax rate of around 13,125% on returns from this same IP.

US MNCs should thus weigh the pros and cons of keeping these IPs offshore versus onshoring to the US. Of particular note here is that a proposed provision under the Senate bill to enable tax efficient repatriation of IP back to the US was excluded from the signed Act hence the higher US tax rate where the IP is repatriated. Further, there are concerns that FDII may violate the US’s World Trade Organization (WTO) obligations as it could be treated as an export subsidy.  Nevertheless, through the tax reform, the US seem to have found the ways to tax the worldwide IP profits of their own MNCs at very competitive tax rates.  If Cyprus wants to attract the research and development and/or the exploitation of US owned IP, it will have to find its own ways to remain competitive besides tax.

Finally, Cyprus based businesses operating in the US one way or the other should consider closely the impact on their financing set-ups and arrangements as well as the supply chain for their US based operations given the interest expense limitation and BEAT provisions should both be relevant for US inbound business.

 

Conclusion

The US tax reform will undoubtedly reshape the global tax landscape which will in turn have an impact on how multinationals, especially the US ones who are the ones directly affected, model their global business operations going forward.

Cyprus is positioned well enough in terms of competitiveness of its tax regime vis a vis its EU peers and can therefore win its fair share on that count.  Taxation however is only one of the factors considered by the global players in deciding where to establish, conduct their business from and commit their assets to.  We have our own EU driven challenges and yet again are invited to assess the ever changing rules and soon will have to take the right decisions to protect our tax attractiveness.  However, there is a lot more than that; we need not forget the great significance of the ‘ease of doing business’, providing certainty, continuous investment in infrastructure, improving and maintaining the regulatory and legal environment of ours and other ‘softer’ factors such as connectivity.

These many and varied challenges are in fact not US specific.  They need to be co-ordinated and developed through a master-plan with one central owner if we truly want to succeed as an international financial centre in the new and varied demands and challenges unfolding rapidly in front of us.

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