The biggest news to hit recently was the failure of the House plan for the repeal and replacement of the Affordable Care Act, with a scheduled vote delayed and then cancelled as it became clear that the bill did not have sufficient support from conservative and moderate Republicans. Despite a brief revival effort last week, it appears that health care legislation will be a secondary priority for the foreseeable future. The Trump administration and Congress now turn to tax reform, though there is a question of who will take the lead on a tax reform bill. The White House has insisted that it will be the primary force behind drafting a tax reform plan, while some members of Congress have pushed for legislators to draft a tax reform plan.
With the health care debate relegated to the sidelines, tax reform now takes center stage in Congress. One of the most notable provisions of the House Blueprint is the proposed border adjustment tax (BAT). The BAT would radically alter the way corporations and businesses are taxed. Instead of paying tax on all worldwide income (in the case of a U.S. business) or U.S. source income (in the case of a foreign business), all businesses would be subject to tax only on products imported or sold in the U.S. The border-adjusted tax is projected to raise a trillion dollars in tax revenue over a 10-year period. The following is a deeper dive into how this would work for sellers of goods.
How Would the Border-Adjusted Tax Work?
The mechanics of the BAT have not been fully vetted, however some details are beginning to emerge. First of all, the BAT is structured to integrate with the existing income tax system, and will not be a new or separate tax (such as a tariff). The BAT would deny importers a current deduction against their taxable income for the costs of imported products. The result for importers is that their profits would be calculated by subtracting domestic costs from domestic sales without allowing a subtraction for the cost of imported goods. This would result in a higher tax bill for serial net importers such as retailers and oil producers.
On the other hand, net exporters could have a consistently negative tax liability. The formula for a net exporter would remain as domestic sales minus domestic costs; foreign sales are not part of the equation. Domestic costs associated with foreign sales remain as a subtraction for a net exporter, so conceivably such costs would outpace the domestic sales of a net exporter. Under the Blueprint, the net exporter would not receive a refund for the net negative tax liability. Instead, the excess of costs over sales would be deferred to a subsequent year as a Net Operating Loss (NOL), which would have an unlimited carryforward. Some versions of the proposal offer that a net negative tax liability could also be used to offset payroll taxes.
There are a few economic uncertainties surrounding the BAT. Briefly, these are:
- Whether the dollar will increase in value sufficiently to offset price adjustments caused by the tax, such that the effective prices for products do not increase;
- Whether the rebate/NOL will be sufficient for net exporters to price exports competitively on the world market;
- How the tax will be collected, and who the responsible party will be for payment;
- Whether domestic industries can increase production to take full advantage of the more favorable tax treatment;
- Whether the proposal will retain a denial of the deduction for interest expenses in most situations;
- Whether other nations, through the World Trade Organization, would retaliate against the BAT through new tariff measures of their own; and
- Whether the proposal would require renegotiation of foreign tax treaties and information sharing provisions.
How Can Businesses Prepare for the Border-Adjusted Tax?
Tax planners are already discussing ways to take advantage of components of the BAT to reduce the impact of the proposed import tax. There are two types of mergers that might accomplish this goal.
The first is a foreign inversion, something border adjustability is designed to discourage. In this scenario, a U.S. and foreign company might merge to take a full deduction for development and labor costs in the U.S. while deducting interest expenses in a foreign county. For example, a new product would be developed in the U.S. and would be sold to the foreign parent. The consequences are that the development costs could be deducted against any domestic sales (labor and capital expenses), and the sale to the foreign parent would be not subject to tax as an export; the foreign parent could deduct any interest expense to finance the purchase in the foreign jurisdiction.
A less complicated merger structure could also be used to reduce the combined company’s tax burden. Under this method, an exporter who commonly has a recurring negative tax liability would merge with an importer who has a high tax liability, thereby allowing the importer to use the exporter’s unused deductions.
It should also be noted that transfer pricing incentives could be inverted under the BAT. Currently, there is an incentive to price products to foreign subsidiaries or parents very low in order to pay lower U.S. income tax on the sales proceeds. Under the BAT, exports to a foreign subsidiary or parent would create a larger tax deduction with a high price.
For those wondering about how the BAT would affect service industries, stay tuned for a future issue as that is a more involved question. Also, look for features that will include projections about what the border adjustment tax will do to specific industries and the economy.
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