Border Adjustment Tax Debate Heats Up

Thoughtware Article Published: Feb 01, 2017
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Among President Donald Trump’s campaign promises was an import tax or tariff to keep U.S. companies from moving production activities abroad and selling their products back into the U.S. However, the potential for comprehensive tax reform in 2017 has brought attention to the Better Way for Tax Reform Blueprint (House Blueprint) by the House Republicans that’s championed by House Speaker Paul Ryan and Ways and Means Committee Chairman Kevin Brady.

Released June 24, 2016, the House Blueprint introduces a significant alternative to our current corporate tax system; it adopts cash flow tax principles with a destination-based tax, commonly referred to as a border adjustment tax. With this destination-based cash flow tax system, companies are taxed where they sell their goods and services. The plan calls for a border adjustment, which means that deductions aren’t allowed for goods and services purchased outside the U.S. and exports aren’t subject to U.S. taxation. There are other House Blueprint nuances, e.g., the elimination of special interest deductions and credits, including the domestic production activities deduction. With the House Blueprint, a business could immediately deduct the costs of its investments, wages and supplies. However, interest expense wouldn’t be deductible, eliminating a preference for debt financing instead of equity financing. The trade-off for the loss of certain deductions is a 20 percent tax rate. The House Blueprint would maintain the current law for research credit. With the plan, individuals would be taxed at 12 percent, 25 percent and 33 percent. Investment income of individuals—interest and dividends—would be taxed at reduced rates.

This example illustrates the destination-based cash flow tax mechanics:

A chart comparing different tax system possibilities.

The taxpayer would pay less tax with House Blueprint system A than with the current system because the tax rate and base are lower—a $500 increase in tax base attributable to imported items and offset by a $1,000 decrease in tax base for export sales. However, the taxpayer in House Blueprint system B will pay a higher tax because all sales are domestic and all costs are imported items. The previous example illustrates the potential adverse effects on a business that buys substantial imported goods and predominately sells products to U.S. customers.

The destination-based cash flow tax is a consumption tax, meaning the tax resembles a value-added tax where goods and services are taxed based on the place of consumption rather than on the income source or residence of the taxpayer within the current U.S. tax system. In general, value-added tax systems tax goods upon importation at the border and are placed on a product at each production stage and final sale. The consumer ultimately bears the tax. Value-added tax systems are employed in 167 countries.

Proponents of the destination-based cash flow tax argue the tax doesn’t violate World Trade Organization (WTO) rules because it’s essentially equivalent to a value-added tax. Value-added tax systems are considered indirect taxes, i.e., WTO compliant. However, the WTO hasn’t previously ruled on a destination-based cash flow tax, and the tax could be challenged, possibly provoking other countries to place retaliatory tariffs on U.S. goods. Proponents also argue the cash flow system will encourage production in the U.S., is less complex than our current tax system and will reduce the current trade imbalance, making U.S. companies more globally competitive.

Many economists believe prices or exchange rates will quickly adjust and could offset some benefits of the border adjustment tax. As the dollar strengthens, foreign customers will purchase fewer U.S. exports as they become more expensive. Since U.S. producers only get to deduct U.S. goods and services in calculating their destination-based cash flow tax, the cost of goods likely will rise, eating into company profits.

Opponents of the destination-based cash flow tax system raise concerns with the system “picking winners and losers.” Companies that heavily rely on imported goods, e.g., oil refiners and retailers, will be adversely affected, driving up the cost of goods to consumers. Some economists also argue that currency exchange fluctuation with the U.S. dollar appreciating relative to other currencies can lead to massive decline in the value of U.S. investment in foreign securities, reducing massive amounts of wealth to U.S. investors.

While the destination-based cash flow tax debate will be heated and long, there appears to be a hint that the U.S. Treasury Department isn’t unfavorably disposed to a destination-based cash flow tax—based on comments in two recent studies issued by the Treasury’s tax staff. With Republicans in control of the U.S. legislative and executive branches, tax reform in the next two years is more likely. BKD will continue to monitor tax legislation, including the destination-based cash flow tax.

Contact your BKD advisor if you have questions.

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