With Republican control of both the White House and Congress in 2017, tax reform is widely anticipated, and the impacts from several proposed provisions — from those addressing cross-border activities to the loss of certain deductions — could have important implications for the media and entertainment (M&E) industry. While effects will vary within the diverse M&E subsectors (including film and television, publishing, cable operators, advertising, music and sports), this Alert highlights some of the proposals with the broadest reach within the industry, as well as tax planning considerations.

International trade and the digital economy

The proposals

American trade competitiveness was an important issue during the 2016 presidential election. During the campaign and since his inauguration, President Donald Trump has called for taxes or tariffs on imports, aimed in large part at discouraging US investment in overseas production facilities.

The House Republican tax reform "Blueprint", a framework released in June 2016 and around which legislation may take shape, echoes this theme. It would transform the US corporate income tax into a destination-based tax on domestic consumption and includes a proposal that aims to encourage exports and discourage imports. Under the Blueprint's 20% border adjusted cash flow tax (BACFT) proposal, revenue from export sales would not be taxable, and the cost of imported goods and services would be included in the tax base (or taxed separately). This approach is commonly known as a "border adjustment." The BACFT would apply to all domestic consumption and would exclude any goods and services that are produced domestically, but are consumed outside of the United States. Companies that import more and have less flexibility in what they import could expect to see their federal tax bills increase, while exporters could see tax benefits, although both negative and positive tax impacts could be offset over time by the effects of resulting currency adjustments on prices, according to economists.

Effects on M&E

The ease of moving content across a border can make the impact of border adjustments quite significant for some M&E companies. For example, cash flow received from licensing a film or other content across borders, or the streaming of sports and live events overseas, would be tax-exempt. Conversely, paying for content originating overseas would not be deductible. It is expected that the Blueprint's BACFT would treat the export of intangibles as tax-exempt, and this could be particularly valuable to US media companies that monetize their intellectual property offshore or license their content outside the United States. Longer term, however, if the dollar rises in value as economists suggest, the sales price for foreign content would decrease, possibly offsetting the tax benefit. It is hard to predict how long it would take for such currency corrections to occur and how large they would be.

While the M&E industry is not unique in its cross-border licensing and digital monetization of content, its revenue streams from foreign sources make this an area of particular interest.

Transition to territorial tax: repatriation and intellectual property (IP) implications

The proposal

The Blueprint would replace the existing worldwide tax system, which allows US tax on foreign active business income to be deferred until that income is repatriated, with a territorial system allowing a 100% exemption for dividends from foreign subsidiaries. As part of the transition to a territorial system, the Blueprint would impose a mandatory 8.75% tax rate on previously untaxed accumulated foreign earnings held in cash or cash equivalents, and a 3.5% tax rate on all other accumulated earnings. Taxpayers could elect to pay the tax liability in installments over a period of up to eight years.

Effects on M&E

The US tax rate reduction, transition to a territorial system, and potential for favorable treatment of US-based licensing all could have substantial tax ramifications for M&E companies. In particular, the proposed changes would significantly affect multinationals in the M&E industry with substantial untaxed accumulated foreign earnings, due to the implications for repatriation of those earnings as outlined in the proposal. Location of business operations and IP investments should be considered in light of these proposals and the company's overall business model. As discussed later, planning (including analysis of accounting methods for purposes of earnings and profits, or E&P) may be an effective tool in helping to mitigate the impact of these anticipated changes.

The M&E industry may be particularly interested in the implications for IP. As part of an IP-intensive industry, M&E companies — particularly those that have or are considering offshore IP investments — will want to consider the potential benefits of US-based IP under a transition to a territorial tax system.

Elimination of deductions: Section 199 activities and net interest expense

The proposals

The Blueprint also proposes eliminating specific business deductions in favor of a lower overall tax rate. One deduction the Blueprint would eliminate is the Section 199 deduction, which allows, in some cases, a several-point tax rate reduction for certain domestic production activities, including qualified film production activities.

Another deduction that would be eliminated is net interest expense. Under the Blueprint, taxpayers could deduct interest expense against interest income (and any net interest expense could be carried forward indefinitely as a deduction against interest income in future years), but net interest expense could not be taken as a current deduction.

Effects on M&E

If the Section 199 deduction is eliminated, the more favorable rate for such activities will no longer apply. As this is generally a significant rate benefit within the industry, the impact on costs would be felt across much of the M&E sector. While the loss of the deduction could be offset by lower overall rates, companies should consider the relative benefit of incurring costs that are eligible for the deduction while it still exists.

The Blueprint portrays the loss of the net interest expense deduction as a fair trade-off in light of its additional proposal to allow the immediate expensing of business investments. For many in the M&E industry, however, the trade-off might not be favorable. Many M&E companies are already able to accelerate the expensing of many of their assets, yet they are still highly leveraged and currently make use of the net interest expense deduction. This may, however, provide an added benefit regarding film assets deducted over the life of the film. Still, such companies could lose the value of a significant deduction, while gaining little from the expanded immediate expensing of business deductions relative to more capital-intensive industries.

Accounting methods planning

There are certain tax-planning actions M&E taxpayers may consider taking now regarding the timing of deductions and income recognition. Such planning would cause minimal disruption to the business, but could create permanent tax savings given the possibility of a future drop in tax rates.

M&E-specific examples

Expense acceleration/methods analysis:

— Analyze the application of the income forecast method and other cost recovery methodologies for eligible intangible property to ensure optimal methods (e.g., application of Section 181 for film, television and theatrical production costs)

— Change to an optimal method for recovering creative property costs, as applicable. Revenue Procedure 2004-36, for example, provides a 15-year safe harbor amortization period for eligible creative property costs

— Analyze accrual of various expenditures, such as circulation expenses, agent commission expenses, and publisher rebates under Section 461, also to ensure optimal methods

Revenue deferral/methods analysis:

— Analyze accrual of subscription revenue under Section 451 to ensure optimal methods

— Analyze accrual of revenue in other specific industry contexts (e.g., licensing and royalties) to ensure optimal methods

— Analyze disputed revenue to ensure amounts are not accrued prematurely (e.g., cable company revenue and associated billing procedures)

Other method considerations

Expense acceleration/methods analysis:

— Deduct eligible repair expenditures that presently may be capitalized (e.g., repair expenditures that have not been analyzed fully and eligible repair deductions exist)

— Accelerate depreciation deductions through a fixed asset or cost segregation study to identify assets eligible for shorter recovery periods and/or recovery of missed bonus depreciation (a similar recovery period analysis can be undertaken for intangibles (e.g., software))

— Deduct prepaid assets using the 12-month rule, if applicable, as opposed to ratably (e.g., over the term of coverage or contract)

— Deduct expenditures in accordance with the "all events" test, including economic performance and favorable recurring item exception, as applicable

— Analyze Section 263A uniform capitalization rules to identify optimal methodologies

Revenue deferral/methods analysis:

— Defer eligible advance payment income

— Defer income that is not fixed (e.g., subject to milestone events or other conditions precedent)

Changing the timing of deductions or income typically would necessitate an application for change in accounting method (i.e., Form 3115). Non-automatic accounting method changes must be filed on or before December 31, 2017, to be effective for the 2017 tax year for calendar-year taxpayers. Automatic accounting method changes must be filed on or before the extended due date of the tax return (e.g., to be effective for the 2016 calendar tax year).

E&P planning, including accounting methods

As noted previously, policymakers are looking at the repatriation of undistributed foreign earnings as a new potential source of revenue under tax reform. Both plans currently being considered call for a "deemed repatriation," with President Trump's plan (as outlined during his campaign) proposing a 10% rate on all undistributed foreign earnings and the Blueprint proposing rates from 3.5% to 8.75%.

The deemed repatriation amounts of undistributed foreign earnings in controlled foreign corporations (CFCs) likely will be treated as a taxable Subpart F dividend. Thus, the taxable amount of the dividend from the CFC will be directly determined by the CFC's E&P. Foreign tax attributes, such as foreign tax credits, can also be affected by E&P. For this reason, E&P tax planning and analysis should be completed as soon as possible, so that companies have an understanding of their total amount of E&P and are able to evaluate alternatives to manage the proposed deemed repatriation tax and better utilize their foreign tax attributes. Accounting method changes (i.e., to accelerate expenses and defer revenue) can be used as an effective tool to manage E&P in this context.

Absent any adjustments required to compute E&P, a CFC's tax accounting methods are used to determine E&P, and a Form 3115 is required to change existing methods. Accounting method opportunities similar to those discussed earlier apply in this context as well. Procedural method change rules, as applicable, should be carefully assessed. As is the case with methods of accounting in general, most E&P method changes require a Section 481(a) adjustment, which potentially can have a significant impact on a CFC's E&P.

State and local tax implications

Yet to be fully considered in the tax reform debate are the state and local tax implications to M&E companies. Nearly all states in some way, shape or form tie their business tax system to determinations of federal taxable income. Depending upon how the states conform to the federal tax base, federal tax law changes could be felt at the state level as well. More importantly, while most states tie to the federal tax base, they do not automatically tie to federal tax rate reductions. Thus, as the federal tax base expands under tax reform, unless states that conform to that expanded federal tax base respond with reductions to their tax rates, taxpayers could experience increased tax burdens without those states taking any legislative action.

As each state's taxing system varies in its approach and conformity to federal tax law changes, M&E companies should address the impact the proposed federal tax law changes will have not only on their federal tax liabilities but also on their state business tax liabilities. Doing so will put such businesses in the best position to identify and execute planning strategies to minimize the state and local tax impact of the proposals while enabling them to utilize relevant attributes efficiently. In addition, such businesses will be in a better position to engage state and local lawmakers as they too begin to prepare to respond to forthcoming federal tax reform measures.

Conclusions

The first step in preparing for any changes likely to stem from any tax reform proposal is modeling the impact the changes would have on a business's federal and state tax liabilities. A clearer idea of the effects on a particular M&E company's sub-sector and individual business will inform planning discussions around particular issues.

The potential increased costs of importing goods, tangible or digital, under some new form of a destination-based system is an important issue to keep in mind as reform debates proceed. Additionally, the creation of a new category of tax-exempt revenues — those received from the "export" of US content — may provide significant benefits to many M&E companies, and are equally important to model.

With global expansion a primary road to growth for many in the industry, M&E companies will also want to monitor the territorial tax system proposal. For example, M&E companies should start evaluating the supply chain of global contracts to gain a full appreciation for the location of ownership of film and television IP in addition to the location of the content creation. They will also want to consider the potentially broad ramifications of proposals, such as those related to repatriation, which could have a significant impact within the industry.

The potential loss of any deduction generally means there should be careful planning and analysis to mitigate the potential effect. M&E companies, therefore, should also consider the effects of a potential loss of the interest expense and Section 199 deductions. Accounting method opportunities, including those related to E&P in appropriate circumstances, should be assessed carefully as an integral part of planning related to the anticipated forthcoming legislation.

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