As the Trump administration and the House Republicans put the finishing touches on their tax package, one component remains front and center—the border adjustment, a proposal to change the ways goods and service are taxed depending on where they are manufactured and where they are consumed. Let’s take a closer look at what is being proposed and what effect it might have on U.S. companies.
Background
In 2016, House Republicans released a tax plan, “A Better Way,” part of which lowers the corporate tax rate to 20 percent and converts it into a destination-based cash-flow tax (DBCFT). A significant feature of this plan is the border adjustment, which applies the tax to imports and exempts exports. Supporters of the plan want to eliminate the so-called “Made in America” tax by eliminating the ability of companies to deduct the cost of imports and also eliminate the tax on income attributable to exports. Let’s examine this more closely.
From Origin- to Destination-Based Taxes
Generally, a country has two options when choosing a tax base—it can levy a tax on the production of goods and services within a country, or levy a tax on the sale of goods and services in a country.
The current U.S. tax system uses an origin-based tax—one that applies to the production of goods and services within the U.S. In other words, that means goods are taxed on where they are produced, regardless of where they are consumed. The president’s DBCFT proposal would switch the system to a destination-based tax—one that applies to the consumption of goods and services in the U.S. That means goods would be taxed based on where they are consumed, regardless of where they are produced.
Under the border adjustment proposal, there would be no tax deduction for the cost of goods manufactured abroad, or for imports. Additionally, there would be no tax on revenue attributable from sales abroad, or exports.
In short, entities that import goods for sale within the U.S. would not be allowed a tax deduction for the imported goods, and thus would pay a higher effective tax rate. However, revenue from U.S. produced goods that are exported would be exempt; in this case, entities would pay a lower effective tax rate.
Expected Long-Term Effects
While economists don’t expect the DBCFT proposal to result in a trade advantage, it would make many strategies of profit shifting under current law impossible, a topic that was hotly debated during the 2016 presidential campaign because it erodes the tax base under our current corporate income tax. In other words, the incentive to import cheaper goods from a foreign subsidiary and then deduct those costs is eliminated.
The border adjustment could also lift some of the anti-base erosion provisions that typically come with origin-based tax systems. Finally, the border adjustment could raise a significant amount of revenue in the budget window, which is essential in financing other important proposed reforms, such as full expensing and lower marginal tax rates.
A Look Ahead
However, with every proposal comes challenges. For example, retailers, automakers and oil refiners, among others, have voiced opposition to the border adjustment tax because of the concern about higher prices for consumer goods. Proponents insist that a 25 percent increase of the U.S. dollar would offset the higher prices. President Trump has expressed some misgivings about the proposal and may offer an alternative in the way of import tariffs.
Further, it’s uncertain whether the destination-based tax will comply with World Trade Organization (WTO) rules. For example, WTO rules do allow for border adjustments in imports and exports, but only in certain situations. It is also possible that exporters could come up on the short end of the stick by being overtaxed in certain situations. Another ironic result could be an incentive for some countries to apply stricter anti-base erosions and name the U.S. a tax haven as a means to avoid foreign taxes.
We will keep you informed of further developments as the tax reform package evolves. Do you have questions about the proposed tax plans, international tax regulations or other tax-related issues?
For more information on the above article or business tax services, contact Marty Williams, CPA by calling (334) 887-7022 or by leaving us a message below.
