As President Trump and Congress tackle comprehensive tax reform, one of the most critical and controversial challenges is to effectively enact change on the international tax front.
In today’s highly connected, information driven economy, the U.S.’s existing international tax rules are antiquated and generally uncompetitive by global standards, and these rules govern a regime with the highest statutory corporate tax rate in the developed world. These features of the U.S. tax system encourage businesses to operate outside the United States, move activities (i.e., jobs) outside the U.S., and accumulate capital and profits outside the United States.
Several proposals have emerged to combat these issues as well as to promote the growth and competitiveness of the U.S. economy. The two ideas that have attracted the most attention and discussion are a tax reduction to encourage the repatriation of offshore earnings, and the border adjustment tax.
In a recent survey* of regional business leaders conducted by Friedman LLP, the mixed reactions towards these international tax proposals, particularly towards the border adjustment tax, underscore the uncertainty surrounding such proposals. Incidentally, the border adjustment tax proposal was not included in President Trump’s recently released tax plan— though reports state there is a possibility it may be revisited at a later time.
Repatriating Offshore Earnings
While the border adjustment tax was shelved for the time being, the Trump administration’s tax plan calls for a one-time tax on trillions of dollars held overseas. Addressing the unrepatriated earnings is a critical step in the adoption of a territorial tax regime, another proposal from the Trump administration which, together with the tax rate, is the most significant impediment to an internationally competitive tax system for US multinational corporations.
US corporations have accumulated over $2 trillion of earnings outside the United States. If these earnings were remitted and subject to any real tax, they would generate an enormous windfall for the Treasury, injecting significant capital into the US economy.
There are many different proposals to encourage or require the current taxation of these unrepatriated earnings. Most are mandatory and part of a comprehensive reform program, although there are some proposals that are independent of comprehensive tax reform where the revenues would be applied to infrastructure related projects. The proposed tax rate on these unrepatriated earnings varies, but the plan from Speaker Ryan uses an 8.75% rate for liquid assets and a 3.75% rate for other assets, while the President’s plan uses a 10% rate – both substantially lower than the 35% current corporate rate.
As reflected in our survey results, there is some ambivalence towards a repatriation holiday. Some view a reduced tax rate on repatriated earnings as a reward for companies that manipulated their affairs to shift profits offshore. Others see this as a tax break that predominantly favors large multinationals and not mid-sized and smaller businesses. That may be why only 61% of our survey respondents were in favor of this proposal.
In our survey we also asked, “If your company were able to repatriate overseas profits at a reduced tax rate, what would you do with the funds?” Respondents indicated a mix of actions that would benefit both investors and the overall economy:
- Of those with offshore profits, more than 40% would return some of the money to shareholders. This would be a boost to pension funds and other investors, providing funding for investors to facilitate more consumption or make new investments. It would also provide additional revenue to the Treasury, as shareholders would be subject to tax on the dividends and gains from buy-backs associated with these activities.
- Of the remaining businesses, nearly 23% would invest some of the funds on capital expenditures, and approximately 20% would share the proceeds with employees, presumably through bonuses or salary increases.
Whether the funds are being pumped into the economy through consumption, new investments, salaries or capital expenditures, the vast majority of any repatriated funds would be used to grow the US economy.
Border Adjustment Tax (“BAT”)
The BAT is a destination-based cash flow tax. In its most basic form, it taxes income from goods consumed in the United States and does not tax income from goods exported from the United States. The objective of the tax is to encourage exports, by not taxing income from exports, and discourage imports, by not allowing deductions for the cost of imports.
This regime faces a number of issues, including a possible backlash from trading partners and a potential challenge under the WTO. However, even domestically, this is a highly divisive matter. There are many questions about how a BAT would work, especially with respect to services, the finance sector, and the purchase of goods by US consumers from suppliers outside the United States. While the BAT was noticeably absent from the Trump administrations’ tax reform paper, it is likely to need considerable further study and analysis before it could be introduced.
In our survey, we asked participants, “How would the introduction of a border adjustment tax affect your business?”
Nearly 25% of respondents indicated that the BAT would cause them to pass on the cost to their customers, thus increasing their prices and presumably hurting their sales. This is not surprising. In the case of low margin importers, e.g., in the apparel or electronics industries, the BAT would need to be passed on to consumers as the importers do not have the margins to absorb this cost. Retailers who have built businesses around relatively inexpensive imported goods would be similarly affected.
Interestingly, more than 10% of our respondents indicated that they might shift the focus of their business activities away from the U.S. if the BAT were enacted. A similar number (9%) were concerned that their businesses would be adversely affected by shortages of imported goods.
While the ultimate economic impact of the BAT is uncertain, it is clear that the BAT would create clear winners and losers and be disruptive to the complex trade and distribution networks that have developed over decades—and the lives of people who work in these areas.
Both earnings repatriation and the BAT, if introduced at a later time, would merely be first steps in modernizing U.S. taxation of multinational businesses and cross-border transactions— and not necessarily widely accepted steps. Implementing true international tax reform will require significantly more study and much more work. Based on the views of our survey respondents, it will also require significant buy-in from the many businesses that represent the U.S. in the global economy.
Check out our other tax reform insights in this series:
- Business leaders favor sweeping tax reform proposals, with some hesitancy towards international proposals
- A majority of businesses would offer the same or more health benefits if ACA repealed
- Companies using independent contractors may be at risk for taxes and penalties
- Survey Finds Businesses with Online Sales May Not Be Prepared for States’ Broader Interpretations of Nexus Rules
*Friedman LLP conducted the web-based survey in early 2017 among companies across the United States, with a focus on the New York, New Jersey, Pennsylvania, and Connecticut areas. The survey compiles responses from 483 senior leaders of companies across industries including technology/computer services, manufacturing/distribution/wholesale, healthcare, retail, real estate, financial services, architecture/engineering, marketing and advertising, nonprofits, law, and more. The size of the companies surveyed ranged from below $10 million in annual revenue to over $500 million. The respondents include business owners, company presidents, chief executive officers, partners, directors, chief financial officers, controllers, and managing directors. All insights in this series are based upon the specific responses of the business leaders who participated in our survey.