Results of possible tax reform hard to predict
My mind has been on cable news overload in recent weeks given the election, transition, inauguration and confirmation process. There has been a lot of information to digest; trying to filter the hype from reality often takes some effort. Trade and tax policy were some of the hot-button issues that gathered some of the media attention during this time frame.
Tax policy and trade policy have some relationship. Tax policy often is used to influence trade policy. Favorable or unfavorable tax provisions may impact trade and investment decisions made by businesses, both foreign and domestic. The stated intent from a United States standpoint is such policies increase jobs and economic activity in the country. The United States has entered into many formal and informal trade arrangements. The North American Free Trade Agreement (NAFTA) probably has received the most discussion over the past 20-plus years. Many of us recall Ross Perot making it an issue during the 1992 presidential election campaign.
In the past, to encourage trade and create jobs in the U.S, related to export activity, the U.S. enacted specific tax incentives for U.S. businesses to carry on manufacturing activity that resulted in U.S. exports. During my own career in tax, I can recall several export-related tax incentives that have been in effect during my career. These include the (original) Domestic International Sales Corporation (DISC) regime used primarily in the 1970s and early 1980s; the Foreign Sales Corporation (FSC) used in the mid 1980s through the late 1990s; the Extraterritorial Income (ETI) Tax Regime of the early 2000s and the Domestic Production Activities Deduction regime, which was enacted in 2004. In addition, a variation of the DISC, the Interest Charge-Domestic International Sales Corporation (IC-DISC) was enacted in the 1980s and still is used by many businesses that produce goods for export. The original DISC, FSC and the ETI regimes were challenged by our trading partners as illegal trade subsidies and, thus, were ended, and a new export incentive was created. These incentives provided some type of tax exemption, preferential tax rate or some other type of tax incentive to reduce the tax burden of a U.S. manufacturer exporting its products.
Over the years, the U.S. has entered into many trade agreements that have removed many barriers, including reducing custom or duty rates on imported and exported goods. The most recent proposal around imports and exports is not a trade agreement but, rather, the Border Adjustment Tax (BAT) that has received a fair amount of media attention in recent weeks. This proposal rewards export activity and limits deductions related to import costs. The application of the BAT is based on the destination of goods or services. Exports are intended to be exempted from tax, and imports would not be allowed as a deductible expense to a business for income tax purposes. The reality of the BAT’s impact has begun to be considered by some businesses. For example, the possible impact of the BAT sent share prices of retail stocks tumbling on Dec. 22 as the impact on retailers that import many of their products started to be considered.
The BAT has been included in the House Republican blueprint, but the details have been limited. Thus, it has led to some speculation on how such a tax would be assessed and its actual impact on business and consumers. The BAT, when combined with the proposals to reduce corporate tax rates, may result in companies subject to the BAT still seeing a reduction in their overall U.S. tax corporate liability. There also may be some complexity in a BAT system, as the business making purchases would need information on the place of origin of any inputs into its product or service.
Trading partners may have an interest in the impact of a BAT. As has been done with the prior export incentive regimes, it is likely some trading partners of the U.S may take issue with the BAT and perhaps argue it violates trade agreements already negotiated with respect to foreign and free trade. This process often takes years to resolve itself.
On Jan. 17, then President-elect Donald Trump raised some concerns over the BAT. The U.S. Treasury Department also released a report on cash flow-based taxes, such as the BAT, on Jan. 18. The report does provide some discussion and some examples to illustrate how such a tax would actually be computed. The report, “What Would a Cash Flow Tax Look Like for U.S. Companies? Lessons from a Historical Panel,” is available at bit.ly/cashflowtax.
Major changes in trade or tax policy can impact the economy. I am not an economist, but I was trying to pay attention in my economics classes in college. Tariffs often were a tool to collect revenue and regulate trade in the past. One of the more famous tariff legislative items was the Smoot-Hawley tariff, which was proposed in 1929 and enacted in 1930. The Smoot-Hawley tariff is regarded by many as deepening the depth and length of the Great Depression. This legislation reduced not only imports at the time, but the reaction by trading partners reduced the level of U.S. exports.
The lesson to be learned from the Smoot-Hawley experience is trade policy and the related tariff legislation requires significant consideration of the intended and unintended results from enactment and implementation. In 2017, the U.S. economy is more global and different from the economy in 1930 when Smoot Hawley ultimately enacted into law. Thus, the actual impact of major trade legislation today may be difficult to fully anticipate. The reaction by businesses and trading partners may have a bearing on the ultimate success or failure of such a change. Perception can become reality, and the emotion and reaction to such proposals often have an impact on their ultimate success.
As with any tax planning opportunity, there is some effort and due diligence that must be done to fully evaluate the merits, benefits and detriments of any tax planning. There will likely be a number of tax changes in the coming year as the Trump administration and the new Congress look to overhaul various provisions in the tax code. The ultimate result may be as impactful as the Tax Reform Act of 1986. Only time will tell what the results of any tax reform in 2017 will bring us.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP.