Question 1: At a high level, what will the cash flow border adjusted tax do? Essentially, it replaces income with cash flows and taxes only cash flows for activities that take place within the U.S. Thus, the tax rate will fall to 20%, the tax base will change by (i) taxing cash flows rather than income – which should accelerate certain deductions but conceptually not change the tax base over time; (ii) disallow the deduction of the cost of imports – which will increase the tax base; (iii) disallow the deduction of interest, which will also increase the tax base; and (iv) not tax export income, which will reduce the tax base. Note that this is not quite a consumption tax, in that expenses that are incurred in the U.S. in order to generate export sales will be deductible, and therefore will have an impact on tax obligations, which is not true under a pure consumption tax.
Question 2: Will the border adjustment features of the new tax be viewed as unfair from a customs or international tax perspective? This may depend upon whether the analysis focuses of the effects of the new regime on tax alone, or on after-tax income. From a tax perspective, it is clear that sales generated from imports will be taxed as a higher rate – whether measured as a percent of sales or EBIT — than sales generated from domestic activity, and that export sales generated by domestic activity will create a potential negative tax. If revenues are 100, costs are 80 and profits are 20, sales based on imports create a tax of 100 * 20% = 20; sales from domestic activity will create a tax of 100 – 80 = 20 * 20% = 4; and that export sales with deductions for domestic expenses will create a tax of -80 * 20 = – 16. However, proponents of the tax argue that the change in exchange rates will generate offsetting changes in profits, leaving companies with the same or similar after-tax profits. If the appreciation in the value of the dollar lowers import costs from 80 to 64, this increases pre-tax profits on imports from 20 to 36 and after tax profits to 36 -20 = 16, which is equal to the profits on sales based on domestic production.
Question 3: What are likely foreign reactions? There are two major types of potential foreign reactions. First, the new tax could be viewed as violating international trade standards because it is not really a consumption tax like a VAT (it is based on a profit measure; it allows deduction of US expenses that support exports rather than simply leaving them untaxed). If this is the case, then countries would be allowed to impose retaliatory duties on imports from the U.S. Second, given that the new tax would allow a deduction for costs used to manufacture exports but would not tax export income, this would create a “double non-tax” in that export costs would be deducted twice – once in the US and once in the country that is importing the product. The new developments around BEPS would presumably provide at least a colorable reason for disallowing the deduction of the cost of US exports that had not been subject to tax. How likely are such reactions – my crystal ball does not work all that well, but I would say that it is neither de-minimus or certain. A question I will not answer – will it rise to “more likely than not” from financial statement reserve perspective?
Question 4: Will the dollar appreciate as proponents of the new tax expect? A number of respected economists expect the dollar to appreciate if the border tax adjustments are put into effect. Others are more skeptical, pointing out the import and export flows are only one of many factors that impact exchange rates. I would also note the theory behind the exchange rate appreciation assumes that there are symmetric but opposite impacts on imports and exports, and that in this may be a strong assumption as it does not take the impact of the disallowance of interest deductions into account; exporters may not be able to take full advantage of the tax subsidies, difference in circumstances of different companies may create distortions. In short, regardless of the correctness of the theory, it may not take the messiness and uncertainty of the real world into account.
As you may have noticed, my answers to my questions became less certain as I pushed further into details. I suspect that the answers will be more complex and less certain as this aspect of tax reform emerges.