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Border adjusted tax proposals may impact exporters and importers

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As 2017 begins, and a new Congress and president are sworn in, a comprehensive tax overhaul appears to be near the top of the legislative agenda. Included in the tax policy proposals put forward by Speaker Paul Ryan and the House GOP during the election season was a potentially significant change in U.S. international tax policy. They have proposed a destination-based tax, where income from goods and services are taxed based on where they are consumed, as opposed to where they are produced and sold. As described in the House Republican Tax Reform Blueprint, this would be facilitated by so-called border adjustments which would result in generally taxing imported goods and services while exempting exported goods and services from U.S. tax.

While the Blueprint is light on implementation details, the proposal is likely based on a more detailed proposal from the report of the President’s Advisory Panel on Federal Tax Reform (issued during the George W. Bush administration), allowing some concepts to be outlined.  However, at this time the specific parameters of this border adjusted tax (BAT) are far from clear, with many potential variations possible.

How a BAT might work

One of the border adjustments that might be included in a destination-based tax system is an exemption for sales of good and services outside the United States.  Thus, a domestic manufacturer that sells a product abroad is not subject to tax on the gross revenues from its foreign sales.  Under another adjustment, the taxpayer may deduct its domestic cost of goods sold (CGS) but not its foreign CGS.   Determining which costs are foreign vs. domestic is easier said than done but presumably actual legislative language will shed light on this point, whenever it emerges. 

Just as a destination-based system would exempt exports from U.S. tax, it would likely subject imports to U.S. tax.  As set forth in the report of the President’s Advisory Panel, “Purchases from abroad are taxed by either making them nondeductible to the importing business or by imposing an import tax.” The Blueprint does not suggest which of these methods would be adopted, although it does indicate that the move to a destination-based system will not involve a new tax, suggesting that costs incurred for imported goods would not be deductible. 

Royalties on intellectual property held in the United States may become an exempt export, providing a powerful incentive for U.S. companies to keep their intangible assets home, however, this is still unclear.

These rules outline a simple approach to a BAT.  The following examples illustrate how it would apply to importers and exporters.

Example 1

Let’s first consider the case of an importer.  Under current law, a company that imports goods from abroad for resale in the United States or incorporation in goods sold in the United States (such as retailers or domestic manufacturers) might have a federal tax calculation that looks like this:

If the BAT rules described above were to apply, the taxpayer’s liability would be radically different.  Assuming a corporate tax rate of 20 percent (the rate proposed in the GOP Blueprint), and no other proposed blueprint adjustments, the taxpayer’s federal BAT calculation would be as follows:

 

Since the entirety of the taxpayer’s CGS arises from import purchases, no deduction for those expenses would be allowed.  This results in the taxpayer being taxed almost entirely on gross sales. The magnitude of this impact is inversely proportional to an importer’s gross margin.

Example 2

Alternatively, consider a U.S. manufacturer that primarily produces for export, deriving 80 percent of its sales from customers located outside the United States.  Assume that this manufacturer’s gross revenues and expenses are identical to those of the importer, except that all raw materials, labor costs and other production inputs are incurred domestically.  Without border adjustments, this manufacturer might have a simplified tax calculation under current law that is identical to that of the importer considered above as follows:

 

However, under a BAT approach, the exporter’s tax treatment diverges dramatically from the importer’s BAT treatment:

 

Since the export manufacturer derives 80 percent of its sales from customers outside the United States, only 20 percent of its sales are subject to tax.  However, the manufacturer can still deducts its U.S.-based costs. As a result, the manufacturer has a large taxable loss, one that could be expected to recur every year, as long as the manufacturer’s customer and cost base remains the same.

Why pursue a BAT?

The GOP Blueprint suggests that the move to a destination-based tax system with border adjustments should boost exports and reduce imports, thus reducing the United States’ overall trade deficit and boosting U.S. manufacturing and domestic employment. Some economists, as well as the original report of the President’s Advisory Panel, however, suggest that macroeconomic changes brought about by switching to a destination-based system (appreciation of the U.S. dollar being one example) would serve to offset any overall trade effects of the change. For example, suppose that an exemption for export sales allows primarily exporting U.S. manufacturers to reduce the price of their goods without initially impacting after-tax profit. Although this would drive up the quantity of the manufacturers’ goods demanded, it would also result in increased demand for U.S. dollars with which to buy those goods, driving up the value of the dollar relative to other currencies. If the increase in dollar valuations cancels out the aggregate reduction in dollar prices of U.S. exported goods, no overall trade impact should result.

Other economists, however, have signaled skepticism that exchange rate shifts to counter the imposition of border adjustments would be either immediate or complete. For example, currencies that are pegged to or otherwise adjusted with respect to the U.S. dollar would be expected to show more or less of an adjustment against the dollar than the total offset theory would suggest. Even barring state action, the appreciation of the U.S. dollar would need to be quite significant to offset a proposed border adjustment, more significant perhaps than current markets are willing to allow.

Another cited benefit of moving to a destination-based system is ease of administration. In our current system, which generally attempts to impose tax where value is created (an origin-based system), multinational enterprises must construct complex intragroup pricing arrangements, to assign income within their group (and, by extension, amongst the various countries where they operate). These arrangements are often the subject of lengthy and expensive examinations and challenges, as the United States and other governments try to ensure that income is not being improperly shifted to low-tax or no-tax jurisdictions. With a move to a destination-based system, US tax authorities will be less concerned with the assignment of income throughout the value chain, as any export revenue and import deductions would be wholly excluded from the tax base.

Some commenters have also mentioned that the interaction of a destination-based system with another portion of the GOP Blueprint, which would allow net operating losses to be carried forward only, will result in undesirable, non-economic merger activity. As an example, a company that only produces for export can expect to have a net taxable loss from every year of operation, which would be of no benefit to it if losses can only be carried forward and refunds cannot be obtained. Another company that is a consistent importer, however, would see value in such a loss, and may seek to merge with exporting companies. Because of the powerful tax incentive at work, this merger may occur whether or not it would otherwise make economic sense.

Finally, there are serious concerns that a destination-based income tax system would run afoul of World Trade Organization (WTO) rules against export subsidies. While the WTO trade rules allow border adjustments for indirect taxes, such as a VAT, the rules do not allow them for direct taxes (e.g., income taxes).  The GOP Blueprint indicates a belief that its reform proposals, when viewed together, would shift the nature of the U.S. business tax enough that it would become an indirect tax, thereby allowing the BAT to be consistent with WTO rules.  This view is not universally shared, however, and the consequences of an unfavorable ruling at the WTO can be severe.  A previous U.S. tax provision excluding extraterritorial income was challenged by the EU at the WTO and ruled illegal, allowing the EU to impose heavy retaliatory tariffs on U.S. products.  These tariffs, imposed in 2004, led directly to the swift repeal of the extraterritorial income exclusion later that year.

Conclusion

The debate on the propriety of a BAT is just beginning, as the president-elect formally takes office this January.  However, both the new president and the Congress have placed great emphasis on passing measures that will stimulate domestic employment and they have both publicly endorsed imposing a tax on goods produced abroad and imported into the United States.   Accordingly, we believe there is a significant possibility that a provision containing some form of BAT may be enacted if international tax reform occurs.  Because this may happen as soon as later this year, we believe taxpayers should begin to analyze the impact of these proposals as soon as a bill is introduced in the Congress, or sooner.

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