U.S. Tax Reform Update: Border-Adjusted Tax

"This is a theory wrapped in speculation inside a guess. Nobody knows for sure what will happen."

– U.S. Senator Tom Cotton (Republican – Arkansas), describing the border-adjusted tax

Republican lawmakers, having gained control of the U.S. Congress, are eager to reduce the U.S. federal corporate income tax rate. One of the most-discussed proposals to pay for this reduction is a "border-adjusted tax" (BAT), also referred to as a "destination-based cash flow tax."

How much revenue is expected? In theory, the BAT should generate additional revenue equal to the U.S. trade deficit, multiplied by the corporate income tax rate. If the U.S. trade deficit is $500 billion, and the corporate income tax rate is 20% (reduced from the current 35%), then the additional revenue generated by the BAT would be $100 billion annually.

The BAT favors U.S. exporters. Under the BAT, U.S. exporters would be exempt from tax on sales of goods and services to non-U.S. purchasers and could deduct their costs, including the cost of labor. But U.S. importers would be subject to tax on gross sales of non-U.S. goods and services.

For example, suppose that a U.S. retailer purchases widgets manufactured in Canada for $50 million, then sells the widgets to U.S. consumers for $100 million. For simplicity, assume the future U.S. business income tax rate is 20%.

Ordinarily, the tax owed by the U.S. retailer would be $10 million (20% of the $50 million profit). The after-tax profit would be $40 million. Under the BAT, however, the costs incurred by the retailer would be disallowed. Instead of paying a tax on profits of $50 million, the U.S. retailer would owe a 20% BAT on gross sales of $100 million. The $20 million tax would therefore reduce the U.S. retailer’s after-tax profit from $40 million to $30 million.

In the reverse situation, no tax would apply. For example, suppose a U.S. manufacturer produces widgets at a cost of $50 million and sells the widgets to a Canadian retailer for $100 million. Instead of owing tax, the U.S. manufacturer would recognize a tax loss of $50 million, based on its costs. Presumably this tax loss could be applied to reduce the amount of taxable income resulting from sales of widgets to U.S. retailers.

Not surprisingly, U.S. importers—such as major U.S. retailers and oil refiners—oppose the tax. But in the view of many economists, U.S. importers should be indifferent. According to economic theory, the BAT should cause the U.S. dollar to increase in value, thereby increasing the purchasing power of U.S. importers.

For example, in the scenario described above, some economists predict a 25% increase in the value of the U.S. dollar. In such case, the U.S. retailer would pay only $40 million (instead of $50 million) for the Canadian widgets that it resells to U.S. consumers for $100 million. The BAT would remain $20 million (20% of gross sales of $100 million). The U.S. retailer’s after-tax profit, however, would now be $40 million (gross sales of $100 million, less costs of $40 million and tax of $20 million). This is the same after-tax profit realized in the absence of the BAT. The appreciation in the U.S. dollar would therefore shield the U.S. importer from economic harm.

Economic theory also indicates that U.S. exporters should avoid economic harm. At least in theory, by paying tax at lower rates, U.S. exporters should be able to sell goods and services to non-U.S. buyers at reduced prices. The reduced prices would therefore offset the reduced purchasing power of non-U.S. buyers resulting from the appreciation in the U.S. dollar.

The BAT could have far-flung consequences. Conceivably, the BAT has the potential to turn the U.S. into a tax haven. Companies based in countries with high labor costs, such as Canada, might be pressured to move production and services to the United States—just to remain competitive. U.S.-based technology companies might be induced to move offshored intellectual property back into the United States. U.S. retailers could struggle, particularly if U.S. consumers are able to make on-line purchases directly from non-U.S. retailers free of the BAT. As an additional complication, prices could change in unexpected ways.

The possibility of cascading effects makes it close to impossible for multinational companies to accurately model the impact of the BAT on their businesses. Compounding the problem, the BAT exists only in a conceptual Republican "blueprint." Although the tax has been promoted as a chief revenue-raiser underpinning U.S. tax reform, legislation giving effect to the BAT has yet to be proposed.

What happens next? For now, it seems unlikely for any version of the BAT to be enacted before the end of 2017. In addressing U.S. tax reform, lawmakers face challenges on all fronts. The cost of government is expected to increase: expensive social programs such as Medicare and Social Security have the strong support of the President’s political base, and the President himself has vowed to substantially increase spending on national defense and infrastructure. At the same time, Republican legislators strongly oppose increases in personal income tax rates.

The BAT offers the tantalizing prospect of solving at least part of the revenue puzzle. But the complexity of the BAT, the long Presidential transition period, and intense lobbying campaigns by U.S. importers, in combination, seem likely to fatally wound the pure version of the BAT—at least as the tax originally was proposed in June of 2016.

Consequently, the chief virtue of the BAT may be that it leads U.S. tax reformers to search further afield for answers. Unlike the United States, most other countries tax only "home grown" profits through a "territorial" tax system. Most countries also impose a value-added tax (VAT). Such approaches typically have received little consideration from U.S. lawmakers in the past. But to the extent that legislative wrangling with the BAT upsets the status quo, U.S. tax reformers may finally begin to look to other countries for solutions.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

© 2024 by Torys LLP.

All rights reserved.