The Blueprint's Border Adjustment: Basis for Challenge Under the WTO and Bilateral Income Tax Treaties
Reproduced with permission from Tax Management International Journal, Vol. 46, No. 3, p. 140, 03/10/2017. Copyright 2017 by The Bureau of National Affairs, Inc. (800.372.1033) http://www.bna.com.
Introduction
The last time the White House, Senate and House of Representatives were controlled by a single party — the Democratic Party — the Affordable Care Act was passed, making sweeping changes to the U.S. health care system. The presidency and Congress are again aligned — this time under the Republican Party. The time is ripe for major reform. One reform that has been touted by both President Trump and members of Congress is tax reform.
In June 2016, the Tax Reform Task Force created by Speaker Paul Ryan (R-Wis.) published a “Blueprint” 1 outlining the House Republicans' proposals for tax reform. On the international side, the Blueprint provides a shift towards a destination-based cash flow tax (DBCFT). A principal component of the DBCFT is that a corporate tax should be imposed where products and services are consumed, not produced. This is accomplished through the immediate write-off of investments, eliminating deductions for net interest expense and applying a border adjustment which taxes imports and exempts exports. 2
Critics of the border adjustment provision have questioned whether it complies with World Trade Organization (WTO) rules and U.S. income tax treaties. The debate turns on whether the DBCFT functions more as an income tax or as a value-added tax (VAT). Under the WTO rules, an indirect tax, such as a VAT, may have border adjustability. However, the WTO rules do not allow border adjustability with a direct tax such as an income tax. Thus, if the DBCFT is a direct tax, it may run afoul of WTO rules and it could violate U.S. income tax treaties.
What Is the Border Adjustment?
Under the border adjustment, income related to exports is exempt from tax, but sales related to imports are subject to tax. 3 More specifically, businesses would not be allowed to deduct the cost of goods sold (COGS) from the sale of imported goods and would exclude taxable receipts from the sale of goods as exports.
It is helpful to walk through a barebones example to understand the implications of the border adjustment. Consider the retailer (USCo) in Figure 1 that buys inventory within the U.S. for $60 and then sells those goods to a U.S. consumer for $100. Under the current tax system, USCo has $100 of income and deducts its COGS of $60. The resulting $40 of income is taxed at 35 percent, leading to a corporate tax of $14. Post-tax, USCo has net income of $26. This is the result regardless of where the goods are purchased or sold.
With the border adjustment, USCo has a better result. USCo still has $100 of income from selling goods within the U.S. and deducts its COGS of $60, resulting in $40 of income. Assuming the reduced corporate rate of 20 percent proposed in the Blueprint, 4 USCo pays corporate tax of $8, resulting in post-tax net income of $32.
Now consider USCo, if inventory is imported from foreign manufacturers and sold within the U.S. Under the border adjustment, USCo can no longer deduct its COGS from its income. USCo has $100 income and owes $20 of tax. However, USCo paid $60 for the goods initially. Thus, USCo's post-tax net income for book purposes is $20 (the $100 income, less tax paid of $20, less COGS of $60), as compared to the $32 in the fully domestic deal under the Blueprint, or even $26 under today's law.
Rather than importing goods, suppose USCo is an exporter, purchasing inventory in the U.S. and selling goods to foreign consumers. USCo excludes its income from sales to foreign consumers. With no income, USCo pays no tax on its $100 income from the sale of goods. USCo has net income of $40 for book purposes and has not paid any U.S. tax. Presumably, 5 USCo would also have a $60 net operating loss, due to its deduction attributable to the purchase of U.S. goods.
For the sake of completeness, consider the final example of the USCo that purchases goods abroad and sells to foreign consumers. Due to the exclusion of income from sales to foreign consumers, USCo has no income and pays no tax. Unlike the scenario where USCo purchases locally, USCo does not have a deduction for its COGS.
These scenarios are summarized in Table 1 below.
Tax Paid | Cash on Hand After Transaction |
|
---|---|---|
Current Tax System | $14 | $26 |
Border Adjustment | ||
Buy U.S./Sell U.S. | $8 | $32 |
Importer: Buy Foreign/Sell U.S. | $20 | $20 |
Exporter: Buy U.S./Sell Foreign | $0 ($60 NOL) | $40 |
Buy Foreign/Sell Foreign | $0 | $40 |
A key takeaway is that the border adjustment is going to be extremely harmful to importers. Importers will either have to settle for lower net income or have to raise the price of products to compensate for the lack of deductibility of the COGS. Retailers, who generally are large importers, are already pushing back. Major retailers, such as Walmart, Target and Nike, have joined the Americans for Affordable Products group to lobby against the border adjustment. 6 Steve Forbes, editor-in-chief of Forbes magazine, has said that the border adjustment “will cost American consumers at least a trillion dollars over the next ten years.” 7 Indeed, countries that have enacted a VAT have historically seen a rise in prices of approximately 60 percent of the VAT rate. 8
Economists do not predict the same dire results that retailers expect. 9 Although the price of goods is expected to increase, economists do not think the border adjustment will distort international trade. According to the economists, while the border adjustment would initially encourage exports and discourage imports, this would be offset by a stronger dollar. The general idea is that a stronger dollar makes U.S. goods more expensive abroad and makes foreign goods more expensive in the United States, offsetting the seeming increase in exports and decrease in imports. In addition, the stronger dollar boosts buying power, essentially lowering the COGS. Whether the stronger dollar completely offsets the trade imbalance created by the border adjustment and how quickly currency exchange rates are expected to respond are beyond the scope of this article.
Border Adjustments Imposed by Countries Besides the United States
More than 140 countries, including all the countries in the OECD besides the United States have a type of border adjustment implemented through a VAT. 10 The general concept is that companies are taxed on the value of their outputs less their inputs at each stage of production. A key feature of a VAT is that labor is irrelevant — the costs are neither deductible by the business nor includible by an individual. 11
There are three general methods of calculating a VAT: the credit-invoice method, the subtraction method, and the addition method. The majority of countries with a VAT employ a credit-invoice method, 12 in which the tax is applied to the sales price. The seller receives a business credit for his purchases, but the final consumer does not get a credit.
For example, X sells a widget to Y for $10, who sells it to Z for $15, who, in turn, sells it to a final consumer for $25. If the VAT is 10 percent, the end consumer pays a VAT of $2.50. Z has a liability of $1.50 and Y has a liability of $1, but each of Z and Y can offset that with a business credit, resulting from the final consumer's payment of $2.50.
The subtraction method VAT applies the tax to the difference between sales and purchases. Tax is collected and remitted to the government at each stage of distribution. At each stage, the purchaser subtracts the purchase price from the sales price to determine the amount due. Using the prior example, there would be a tax of $1 (10 percent of $10 – $0) imposed on the sale to Y, a tax of $0.50 (10 percent of $15 – $10) imposed on the sale to Z and a tax of $1 (10 percent of $25 – $15) imposed on the sale to the final consumer.
The addition method VAT is the opposite of the subtraction method VAT. Rather than looking to the difference between inputs and outputs, the addition method looks to the added inputs that are not purchased from others. Using the above example, X added $10 of value, Y added $5 of value and Z added $10. Each is subject to tax on their additional value added.
The DBCFT Compared to a VAT
The Blueprint explicitly states that the proposal “does not include a value-added tax (VAT).” 13 However, the border adjustment is similar to a subtraction method VAT in that it is imposed on cash flow. 14 As discussed in the examples above, a VAT is generally applied to the difference between the sales income and the purchase of inputs.
A major difference between a subtraction-method VAT and the DBCFT is the base that the tax is applied to. Under a subtraction-method VAT, no deduction is given for labor. In comparison, labor costs are a permitted deduction in calculating the tax under the DBCFT. 15
Consider the above example where, X sells a widget to Y for $10, who sells it to Z for $15. Z then hires a worker to increase the value of the product from $10 to $25, and pays the worker $5. Z sells to the final consumer for $25.
Applying a 10 percent subtraction-method VAT results in a total tax of $2.50 (a tax of $1 (10 percent of $10 – $0) imposed on the sale to Y, a tax of $0.50 (10 percent of $15 – $10) imposed on the sale to Z and a tax of $1 (10 percent of $25 – $15) imposed on the sale to the final consumer).
In contrast, a 10 percent border adjustment under the DBCFT would result in tax of $1 (10 percent of $10 – $0) imposed on the sale to Y and a tax of $0.50 (10 percent of $15 – $10) imposed on the sale to Z. However, when Z sells to the final consumer, the tax imposed is $0.50 (10 percent of $25 – $15 – $5 wages). The worker pays income tax at his graduated rate on the $5 income he earned. Assuming the worker is in the 0 percent bracket, the total tax paid under the DBCFT is $2, compared to $2.50 under the subtraction method VAT.
The deduction of labor costs in calculating the tax due under the DBCFT means that the border adjustment applies to a lower tax base than would a VAT. The border adjustment is imposed on the total amount paid minus COGS minus labor, while a VAT is imposed on the total amount paid minus COGS. This is an issue for two reasons.
First, wages are not taxed at the same rate as business income. Wages are taxed at the individual level at graduated rates, not the Blueprint's proposed corporate rate of 20 percent. Although the highest proposed rate for individuals is 33 percent, many individuals are taxed at the lower 12 percent or 25 percent brackets. In addition, the 0 percent tax rate applies to a large number of individuals due to the earned income tax credit. The Blueprint also notes that due to the larger proposed standard deduction, there will be a larger 0 percent bracket under the Blueprint, than in the current tax system. 16
Second, economists' predictions that a stronger dollar offsets the export subsidy may be misplaced as different exports are subsidized to different degrees due to the extent of the labor deduction. Under the economists' analysis, the stronger dollar offsets the export subsidy. Although exports are cheaper to foreign purchasers, the stronger U.S. dollar can buy more goods. Exports benefit from the DBCFT's export subsidy to the extent labor factors into the production costs. Goods with a larger deduction for labor receive a greater subsidy. However, the price of all goods is affected equally due to a change in the exchange rate. 17 Thus, the stronger dollar may not offset the amount of the subsidy for all goods.
The DBCFT's exclusion of labor from the tax base may seem like a small difference but raises concern with the WTO.
Potential WTO Concerns Regarding the DBCFT
The WTO governs trade among its 164 members, including the United States. 18 In 2014, the WTO's members represented 97.8 percent of the world's trade in commercial services and 95.0 percent of the world's merchandise trade. 19 The WTO's Agreement on Subsidies and Countervailing Measures (SCM) disallows subsidies that provide a preference for domestic goods over imported goods. 20 Annex I of the SCM clarifies that a border adjustment is allowed if it is an “indirect tax.” 21 A border adjustment that is viewed as a “direct tax” is a prohibited export subsidy and could subject the U.S. to trade sanctions.
A footnote in Annex I of the SCM defines an “indirect tax” as a “sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges.” A “direct tax” is defined as “taxes on wages, profits, interests, rents, royalties, and all other forms of income and taxes on the ownership of real property.” 22 Thus, the DBCFT needs to be characterized as an indirect tax, such as a VAT, in order for the U.S. to avoid trade sanctions with over 95 percent of the world's economy.
Because the border adjustment permits a deduction for labor in its determination of taxable income of a corporation, while a VAT does not, the DBCFT could be considered a direct tax, subject to challenge at the WTO. In order to pass muster with the WTO, the United States would need to argue that the DBCFT is actually a VAT. However, it is unclear whether the DBCFT could be considered a VAT, as the DBCFT allows a deduction for labor costs that other VATs do not. It would be difficult for the United States to argue that the DBCFT is a VAT when the Blueprint explicitly states it is not. Furthermore, an architect of the Blueprint, House Ways and Means Committee Chairman Kevin Brady (R-Texas), has insisted in public appearances that the DBCFT is not VAT. 23
Some academics have suggested that United States could defend the DBCFT at the WTO by arguing that it is a modified consumption-style tax imposed on an income base. This type of tax would not be considered a border adjusted tax under the WTO's rules. 24 However, if the United States treated the DBCFT as border adjustable, it likely will be challenged at the WTO. Indeed, Jyrki Katainen, vice-president at the European Commission, who oversees EU trade policy, has indicated that he would contest the DBCFT and other arbitrary trade barriers. 25 A senior trade official in Geneva has also noted that the “first assessment is that it is definitely not going to be compatible with the WTO.” 26
Impact on Tax Treaties
The DBCFT could also have implications for U.S. income tax treaties. The U.S. is currently a party to bilateral income tax treaties with 68 countries. 27 Article 2 of the U.S.’s model treaty states that the treaty applies to “taxes imposed on total income, or on elements of income” and on “substantially similar taxes.” 28
Assuming the United States defends the DBCFT as an income tax exempt from WTO rules, it would be hard-pressed to argue that the DBCFT is not an income tax for purposes of U.S. tax treaties. It would be an almost impossible stretch for Congress to argue that the DBCFT is an income tax in one forum, but a consumption tax in another. The inconsistency of such a position almost ensures that these arguments could not both succeed.
Assuming the DBCFT is determined to be a tax on income, it raises three main concerns under U.S. income tax treaties: (i) taxing goods and services regardless of whether there is a permanent establishment (“PE”), (ii) taxing imported intangibles, and (iii) the non-discrimination provisions. 29
First, the border adjustment runs afoul of the rules for PEs. Article 7 (Business Profits) of the model treaty only allows business profits to be taxed in another country if the business has a PE in that country and the profits are attributable to that PE. However, the DBCFT imposes a tax on all goods sold in the U.S., regardless of whether the taxpayer has a PE. If the U.S. follows the treaty provision and does not tax imports that cannot be attributed to a PE, then those goods effectively would be subsidized, a result that would be contrary to the intent of the DBCFT, which is to subject all imports to tax. But taxing all imports regardless of whether there is a PE would clearly violate Article 7 of the treaty.
Secondly, the border adjustment would be imposed on all imports, including intangibles such as royalties. Under Article 12 of the model treaty, royalties are taxed only in the state where they are beneficially owned. Allowing imported intangibles to escape taxation would undermine the intent of the DBCFT, as not all imports would be subject to tax. Additionally, exempting royalties from the border adjustment would provide an incentive for taxpayers to classify income as royalties rather than business profits.
Finally, the border adjustment might violate the non-discrimination provisions of U.S. tax treaties. Article 24 of the model treaty provides that the U.S. may not tax nonresidents more heavily than its residents. Yet the border adjustment creates advantages for domestic exporters over foreign importers and might violate this provision.
Conclusion
Regardless of whether the DBCFT is classified as an income tax or a VAT, it presents unique problems beyond the immediate concerns of U.S. retailers that fear it would impose unfair burdens on major importers and, by extension, on U.S. consumers. It is a near certainty that the border adjustment provision of the House Blueprint will face opposition from the WTO, but how will the United States resolve the conflicts with its own tax treaties? Will the tax treaties continue to apply, even if in a limited way? And if they do not, what kind of complications will arise for U.S. corporate taxpayers operating abroad if those companies no longer have access to the dispute provisions of the tax treaties?
Endnotes
1 Tax Reform Task Force, A Better Way: Our Vision for a Confident America — Tax (June 24, 2016), http://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf (hereinafter, A Better Way).
2 Id. at 27.
3 Id.
4 Id. at 25.
5 Unfortunately, the Blueprint does not provide specifics on how this would work.
6 Information on the Americans for Affordable Products is available at https://keepamericaaffordable.com/.
7 Steve Forbes, Forbes Media Chairman & Editor-In-Chief, available at https://www.forbes.com/sites/steveforbes/2017/01/11/omg-house-republicans-are-preparing-to-hit-consumers-with-a-horrible-new-tax-that-will-harm-trump-and-hurt-the-economy/?sh=1509f9341fe8.
8 Michael J. Graetz, The Known Unknowns of the Business Tax Reforms Proposed in the House Republican Blueprint, Columbia Law and Economics Working Paper No. 557 (Feb. 2, 2017). Available at SSRN: https://ssrn.com/abstract=2910569.
9 See Alan. J. Auerbach and Douglas Holtz-Eakin, The Role of Border Adjustments in International Taxation, 4 (Dec. 2, 2016).
10 Joint Committee on Taxation, Background on Cash-Flow and Consumption-Based Approaches to Taxation, at 23 (Mar. 22, 2016). Available at: http://www.nationalsmallbusiness.net/Issues/Consumption.Based.Taxes.JCT.03-22-16.pdf.
11 Id. at 36.
12 Id. at 24.
13 A Better Way, at 15.
14 Reuven Avi-Yonah and Kimberly Clausing, Problems with Destination-Based Corporate Taxes and the Ryan Blueprint, at 6 (Feb. 5, 2017), Univ. of Mich. Law & Econ. Research Paper No. 16-029. Available at SSRN: https://ssrn.com/abstract=2884903.
15 Id. at 7–8.
16 A Better Way, at 17.
17 Avi-Yonah and Clausing, at 9.
18 Afghanistan to Become 164th WTO Member on July 29, 2016, WTO: 2016 News Items (June 29, 2016). Available at: https://www.wto.org/english/news_e/news16_e/acc_afg_29jun16_e.htm.
19 WTO Members' share in world commercial services trade, 2014. Available at: https://www.wto.org/english/res_e/statis_e/its2015_e/charts_e/chart09.pdf.
20 Agreement on Subsidies and Countervailing Measures, Uruguay Round Agreement, Article 3 (hereinafter, SCM).
21 Id. at Annex 1(e).
22 Id. at n. 58. Emphasis added.
23 Sean Hackbarth, Brady Pitches Tax Reform to the Business Community, Above the Fold (Jan. 27, 2017). Available at: https://drustaging.uschamber.com/above-the-fold/brady-pitches-tax-reform-the-business-community.
24 Avi-Yonah and Clausing, at 9.
25 Shawn Donnan, Barney Jopson, and Paul McClean, EU and Others Gear Up for WTO Challenge to US Border Tax, Financial Times (Feb. 13, 2017).
26 Id.
27 List of U.S. income tax treaties https://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z.
28 U.S. Model Income Tax Convention (2006).
29 Avi-Yonah and Clausing, at 14–15.
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