Why `Border Adjustment' Is the Talk of Washington: QuickTake Q&A

(Bloomberg) -- President Donald Trump and the Republican-controlled Congress want to undertake the biggest overhaul of the U.S. tax code in three decades, with steep rate cuts across the board for businesses and individuals. But some House Republicans want something else as well: a radical shift in the way U.S. corporations are taxed. They’d scrap the 35 percent corporate income tax rate in favor of a system described as -- brace yourself -- a “border-adjusted, destination-based cash-flow tax."

1. What does that mean?

The House plan would tax products based on where they’re consumed -- that is, their destination -- rather than where they’re produced. “Border-adjusted” means that corporations’ exports wouldn’t be taxed, only their imports. "Cash-flow" means the tax is based on a company’s patterns of revenues and expenses, not just its income. To sum up: The plan calls for collecting corporate taxes based on the value of goods and services sold domestically. That’s a tectonic shift away from the current system, which is aimed at collecting taxes on companies’ worldwide income.

2. What would the rate be?

20 percent, making the U.S. corporate rate competitive with that of other developed nations.

3. Example, please?

Say an American company makes widgets at a factory in North Carolina. If it sells those widgets in the U.S., they’ll be taxed at 20 percent. If it exports them to Iceland, they won’t be taxed. Now say a second American company makes widgets out of components it buys from a factory in Ensenada, Mexico. If it sells those widgets in the U.S., they’ll be taxed at 20 percent. If it exports them to Iceland, it would pay the equivalent of a 20 percent tax on the materials it imported from Mexico. That’s the key difference: The House Republicans’ plan allows companies to deduct the cost of domestic materials used in their products -- but not imported products. It’s the functional equivalent of a tax on imports.

4. Who’s pushing this idea?

Its key advocates include House Speaker Paul Ryan and House Ways and Means Committee Chairman Kevin Brady, who has been working hard to sell the measure at policy conferences. But border adjustments are meeting growing resistance inside Congress and from coalitions of powerful corporate interests, including retailers and Koch Industries. Senator Tom Cotton, an Arkansas Republican, recently called it "like something from Orwell’s newspeak" and an idea "so stupid only an intellectual could believe" it.

5. Is Trump on board?

Not yet, it seems. He once called the border-based tax “too complicated,” though he later appeared to warm to it. Trump’s public ambivalence has traders doubting the tax will be implemented in full. He differs from House Republicans as well on the overall corporate tax rate, proposing 15 percent to their 20 percent.

6. How would this affect companies?

U.S. companies that rely heavily on imported materials or goods -- think Wal-Mart Stores Inc., which buys heavily from China, clothing makers that have their production plants overseas, and energy companies that import oil -- say they’d pay higher taxes compared to competitors that use domestic materials. Leaders of Target Corp., J.C. Penney Co., Gap Inc. and other retailers met with Trump at the White House to explain their concerns.

7. Why are lawmakers recommending this approach?

House Republicans say their plan would make the U.S. tax system more competitive while eliminating the incentives that have led companies to defer taxes on an estimated $2.6 trillion in profits that they’re holding overseas. U.S. companies would no longer see a need to shift profit offshore, because their profit wouldn’t be taxed in the U.S.

8. How would that work?

U.S. policy makers worry that the current tax system gives companies incentives to shift their profit -- and, in some cases, their manufacturing jobs or their corporate tax addresses -- overseas. (Trump’s mentioned this as well, of course, on more than one occasion.) Those incentives stem from unusual features of the U.S. tax code: The 35 percent corporate tax rate is the highest in the developed world, the tax is applied to global profits, and companies can defer paying U.S. taxes on their foreign earnings indefinitely. As long as they don’t try to return an overseas subsidiary’s income to the U.S. parent, they don’t have to pay any tax on that income.

9. Why focus on cash flow instead of income?

Accounting rules give multinational companies lots of flexibility in terms of determining how, when and where to book income. Companies can set up business structures and transactions -- such as transferring key intellectual property to offshore subsidiaries and then licensing it back to other units -- that shift income to low-tax countries and expenses to high-tax countries. Shifting to a cash-flow basis -- dependent on a company’s domestic sales -- removes that flexibility. Sales are defined events; in principle, the change creates a more immediate way for corporate tax dollars to flow to the Internal Revenue Service.

10. What would become of the $2.6 trillion in offshore profit?

The House plan proposes to transition to the new system by taxing companies’ accumulated foreign profit at a one-time, reduced rate. Profits held in cash or cash equivalents would be taxed at 8.75 percent; otherwise, the rate would be 3.5 percent. (Trump’s called for a 10 percent rate on that money.) Once that one-time tax is paid, companies would be free to bring their offshore earnings back to the U.S. -- a move known as repatriation. Going forward, any dividends paid to U.S. companies by their offshore subsidiaries wouldn’t be subject to federal taxes.

11. Isn’t this like a tariff on imports?

Maybe. Proponents argue that border adjustments are neither tariffs nor export subsidies -- both of which might be frowned upon by the World Trade Organization. Why? Because a tax on domestic sales combined with a tax on imports creates “paired and equal adjustments that create a level playing field for domestic and overseas competition,” in the words of economists Alan Auerbach and Douglas Holtz-Eakin. Opponents say that using border adjustments with a direct tax, like the cash-flow tax envisioned in the House plan, would violate WTO rules that allow for them only on so-called indirect taxes, like value-added taxes.

12. What does the WTO say?

The House proposal would be uncharted territory for the trade organization. The U.S. is a WTO member, but Trump has said repeatedly that he would seek to renegotiate U.S. trade agreements.

The Reference Shelf

• Three charts show markets aren’t betting on the border adjustment tax.
• The tax would create short-term uncertainty but boost long-term growth, two tax lawyers write.
• Retailers are no fans of the proposed tax.
• Neither is Koch Industries.
• A QuickTake explainer on how U.S. companies bypass taxes with profit shifting.
• Repatriating $2.6 trillion in profits might not be such a boon for the U.S. dollar.
• The Tax Foundation analyzed the House Republican tax reform plan.

To contact the reporter on this story: Lynnley Browning in New York at lbrowning4@bloomberg.net.

To contact the editors responsible for this story: John Voskuhl at jvoskuhl@bloomberg.net, Laurence Arnold