The Lawletter Vol 42 No 4
The one area of taxation that is recognized on both sides of the political aisle as badly needing reform is the federal corporate income tax. One fact that signals the need for reform is that the maximum tax rate for the ordinary income of U.S. corporations is at 35% on taxable income exceeding $10 million (Internal Revenue Code of 1986, § 11(b)(1)(D)), among the highest marginal rates in the world (e.g., Ireland 12.5%; Germany 29.65%). As a result, and as prominently reported in recent months, a number of U.S. corporations (notably Apple and Alphabet (Google)) have shifted the locus of intangible assets and/or corporate headquarters to countries with favorable tax rates (a procedure known as a "corporate inversion"). United States corporations are subject to federal income tax on their global profits, but by not repatriating their profits attributable to a foreign situs, those corporations avoid paying taxes by simply not bringing those profits back to the United States.
The central feature of the current proposals for corporate income tax reform is to change the incidence of the tax from one on the corporation's profits to a tax on the corporation's cash flow, regardless of the location of the corporation's headquarters or intangible assets. The tax, characterized as a "destination cash flow tax with border adjustment" or a "border adjustment tax" (“BAT”), would eliminate any benefit now gained by a corporation's parking its profits in a favorable tax jurisdiction (the tax would be imposed in the year of the sale, not in the year of the repatriation of profits). It is the border adjustment feature of the tax that becomes the key. The determining factor becomes where the corporation's products are sold.
There would be three categories of sales, each with its own tax consequences: (1) selling goods in the United States that were made in the United States (after a deduction for the cost of goods sold, the revenue would be taxed at the rate of 20%); (2) selling imported goods in the United States (no deductions would apply and the 20% tax rate would apply); (3) selling goods made in the United States abroad (such exports would not be taxable in the United States, but foreign taxes would apply but with the credit against U.S. tax liability for taxes paid to a foreign country applicable).
The following examples are taken from Time Magazine (Mar. 27, 2017): If a company makes a T-shirt in Oklahoma and sells it in California, it may deduct capital and labor expenses and would pay a 20% tax on the remainder. If a company imports a T-shirt from China and sells it in California, no deduction for the cost of the T-shirt is allowed and the 20% BAT is applied. If a company makes a T-shirt in Oklahoma and sells it in France, there is no imposition of a BAT.
The sticking point is that a BAT would favor U.S. corporations with significant exports (no BAT on foreign sales), while corporations dependent upon imports for their sales in the United States would be faced with BAT, not alleviated by deductions (with such burden passed on to U.S. consumers through higher prices). The answer provided by economists who favor a BAT is based on the theory that once it becomes likely that a BAT will be adopted, its effect of subsidizing exports and penalizing imports will have the effect of strengthening the dollar by as much as 25%. This would make imports cheaper and exports more expensive and, under this theory, an initial short-term price hike in consumer goods would be offset, with consumer prices returning to normal. Whether Congress would take a chance on the validity of this scenario is open to question.