Corporate tax reform has been a hot-button issue for Washington lawmakers for years, and now that President Trump has taken office, fixing what many perceive as a broken system will be one of the new administration's top priorities. Yet there has been some discord among Republican leaders, as House Speaker Paul Ryan's call for a border adjustment tax earned the president's criticism as being "too complicated." Nevertheless, as the two leaders begin working together in earnest, some form of border adjustment tax might well end up in final tax reform proposals. Below, we'll talk about what a border adjustment tax really is and how it will affect both corporations and the American public.
What is a border adjustment tax?
A border adjustment tax generally imposes a tax on imported goods while exempting exports from tax. Most countries other than the U.S. have what's known as a value-added tax or VAT, which has the same impact of imposing a tax on imported goods as the proposed border adjustment tax would have here.
In the context of Ryan's proposal, the idea behind the border adjustment provision is to try to put domestically manufactured goods and imported goods on an equal footing. Currently, if a U.S. company buys goods from a domestic supplier, then that supplier has to pay U.S. tax on its profits from the transaction. However, if the buyer purchases goods from a foreign supplier, then the foreign country is exempt from tax. The proposed border adjustment tax would impose the same border adjustment tax rate on imported goods that domestic companies would pay on their regular taxes on profits.
How would a border adjustment tax system differ from the current corporate tax structure?
The border adjustment tax is only one part of a broader proposal with respect to corporate tax. Under current law, U.S. corporations get taxed at a 35% rate on worldwide profits, regardless of where they're earned. However, corporations can defer the tax they earn from foreign sources if they leave those profits overseas. Only when they repatriate their foreign profits do they then have to pay the tax, and they're entitled to a partial for full credit on any taxes they paid to foreign governments on that income.
The Ryan proposal creates a territorial or destination-based system of taxation, which is more consistent with what most countries around the world use. Under such a system, the U.S. would collect taxes based on where the produced items get used. In essence, profits derived within the U.S. would be subject to tax, regardless of whether a U.S. corporation or a foreign corporation earned those U.S.-based profits.
Combining destination-based taxation with border adjustments creates a much different tax system than the U.S. currently has. Under a destination-based system with border adjustments, the U.S. would no longer tax the income that companies earn overseas at all. Even if they immediately brought profits back into the U.S., corporations wouldn't have to consider that foreign income as part of their tax base for U.S. corporate tax purposes.
Is border adjustment tax simpler or more complicated than the current system?
It's understandable why President Trump and other critics of the Ryan proposal see border adjustment tax as being complicated. However, that assessment depends on your starting point.
Current tax law governing cross-border transactions is exceptionally complex, even among tax law experts. Under the worldwide income system, U.S. multinational corporations had an incentive to use controlled foreign corporations as a way of sheltering what would otherwise have been taxable income from the IRS. It took sophisticated provisions to recapture some of that potentially lost tax revenue, and even so, it remains a challenge for the federal government to stay ahead of companies seeking to avoid the tax with sophisticated new strategies.
A territorial system with border adjustment would get rid of many of the incentives that multinationals had to game the tax system, because no exceptional steps would be required to escape tax on foreign-source income. In that sense at least, the new system would be simpler than current tax law.
Will the border adjustment tax become law?
Despite initial criticism, the Trump administration is reportedly working more closely with the House Speaker and lawmakers in considering the border adjustment tax provision. Where they'll end up is uncertain at this point, but with tax reform having a high priority for the new president, we're likely to get answers relatively quickly.