Corporate tax reform is a top priority of Congress and the Trump administration, with varying proposals calling for replacement of the current corporate income tax with a tax that would be “border adjusted,” sometimes referred to as a “destination-based” tax.
Border-adjusted tax systems are widely employed internationally, but not exactly in the same manner currently being proposed in the United States. Here, a border-adjusted tax would likely shift the business strategy of many U.S. corporate taxpayers and also profoundly affect U.S. trade relations with foreign business partners.
Presently, C corporations are subject to a maximum 35% income tax levied against net profits. In determining a corporation’s net income for tax purposes, corporations must capitalize and depreciate capital investments over a number of years. Foreign-sourced profits also are taxable in the United States, although such taxation generally is often deferred until the time that such profits are repatriated by the corporation and offset by credits for taxes paid on the income in the source country.
Current tax reform proposals would radically alter this framework. The House Republican Plan, also referred to as the blueprint, proposes a tax that would subject a corporation’s net income calculation to border adjustments. These border-adjustment provisions call for revenues earned from non-U.S. buyers to be nontaxable, and costs of goods purchased from non-U.S. sellers to be nondeductible.
Thus, the plan does not involve an import tariff, but rather adjusts a corporation’s income subject to tax. The policy objective is to create a tax that applies only to domestic consumption, thereby exempting from tax the sales of goods and services that are consumed abroad. The border-adjusted tax is projected to raise more than $1 trillion over 10 years, so it is a key component to the plan because it offsets the costs of other tax savings provisions.
The plan touts corporate tax parity between goods produced and consumed in the United States and those produced abroad and consumed in the United States. In either case, a corporation’s tax on consumption spending would be the same. This concept of parity thus disregards the incidence of consumption. In the former case, the domestic consumption by consumers subjects the corporation to tax. In the latter case, it is the corporation’s own consumption that’s subject to tax.
Because the act of consumption is germane to its unique consumer, it may be difficult to rationalize a tax as one based on consumption when the tax disregards the incidence of consumption. The basis of taxation under the plan is tantamount to making the corporation liable for both a sales tax and a use tax on the same product.
Some opponents claim that a border-adjusted tax system would cause the price of imports (e.g., oil, electronics, clothing, pharmaceuticals) to rise as much as 20%, which a business likely would pass along to consumers.
Economists counter these claims by stating that United States currency values will adjust to compensate for this cost. For example, a cost disadvantage involving foreign-produced goods over U.S.-produced goods would create increased demand for U.S. dollars. At the same time, the supply of U.S. dollars abroad would decrease, as fewer products would be purchased from international sellers. Economists theorize that these factors would lead to an increased U.S. currency value that would counteract the rising cost of imports.
Different from VAT
Value-added tax (VAT) systems, employed throughout the world, use a principle similar to the border adjusted tax. But a VAT is not imposed directly on net business income as it is in the United States. For that reason, VAT systems do not violate international trade rules monitored by the World Trade Organization (WTO), which permit border adjustments on indirect taxes, such as sales, excise, and value-added taxes.
In the House blueprint, there’s a notion that the border-adjusted tax should be treated as an indirect, consumption-based tax. But WTO lawyers do not believe the WTO will support this view. They observe that the effective U.S. tax rate on corporations will be lower on goods produced and consumed entirely within the U.S. than the effective tax rate would be on goods produced elsewhere and then consumed in the U.S.
They believe this would breach WTO trade rules, which would then allow WTO states to impose new tariffs on U.S. goods entering their jurisdiction, which would discourage U.S. trade. The WTO has previously held that U.S. tax legislation created export subsidies, overturning the U.S. Foreign Service Corporation rules in 2000 and the extraterritorial income exclusion in 2001.
A number of Republican Senators have recently expressed concerns regarding the potentially adverse impact of a border-adjusted tax on consumer prices and economic growth. President Trump opposed a border adjusted tax as “too complicated,” but has since softened his stance. President Trump has promised a new tax proposal soon, but has been silent on whether it will contain a border-adjusted tax. Some expect he will have more to say about the issue in his address to Congress tonight.
If the policy objective underlying this tax reform is to allow corporations to be more competitive globally with other nations already using similar principles like VAT, the current plan must accommodate WTO trade rules to make these objectives happen.
The idea that the current border-adjusted tax is consumption-based is questionable. Where WTO trade rules generally authorize border-adjustment provisions only with true consumption-based tax systems, the plan’s basis for corporate taxation will need to be altered if border-adjustment provisions are to be retained.
WTO trade rules also stipulate that border-adjustment provisions must only involve indirect taxes on businesses. The House blueprint, however, seems to retain direct taxes, which makes it unlikely to satisfy WTO rules. The necessary changes will not be easy to reconcile with the plan. Removal of the deduction for payroll costs and the direct taxation on companies such deductions imply would effectively turn the tax into a VAT, a concept many are not ready to endorse.
Although many support the proposed border-adjustment provisions in the plan, radical changes are likely to be necessary to realize the plan’s vision.
Nate Smith is a director in the national tax office of CBIZ MHM, a financial and employee business services provider.