Last year, House Speaker Paul Ryan and members of the U.S. House of Representatives unveiled “A Better Way,” the Republican blueprint for tax reform (the “Blueprint”), proposing to redesign the U.S. tax code. A key component of the Blueprint calls for “border adjustments exempting exports and taxing imports” (the “Proposal”). The proposed system of taxing imports purports not to be “through the addition of a new tax but within the context of the transformed business tax system.”
If the border-adjusted tax (the BAT), a feature of the destination-based cash flow tax (DBCFT), is indeed not a “new tax,” then we must weigh the prospects of successfully implementing the Proposal against international trade agreements, and consider existing laws related to the assessment of duties and taxes upon imports, or the customs laws.
First, let’s consider what the BAT really is (not to be confused with a “VAT,” or valued added tax).
The BAT is a move towards a consumption- or destination-based tax approach, meaning that only domestic consumption is taxed. In effect, imported and domestically produced goods consumed in the United States would be subject to the same tax, but exported goods consumed in a foreign country would be exempt from the tax.
Generally speaking, the VAT operates under a system of credits to offset the VAT on imported and exported goods from the tax. Typically, in a VAT system, the tax is assessed at the time of “importation,” similar to a tariff or customs duty, and the tax is zero-rated for exports (not technically exempt).
The zero-rate on a “taxable” export transaction allows exporters to recover, or apply a credit for, the VAT paid on domestic inputs related to the exported goods. Similarly, importers can apply a credit for the import VAT to offset against the VAT on subsequent domestic sale of the imported goods. This import credit puts imported goods on equal footing with domestically produced goods, which generally also benefit from input credits. Thus, the VAT does not increase the cost of imported goods comparatively.
Arguably, the omission of this “credit” feature from the Proposal distinguishes the import BAT from the import VAT and from an “indirect tax” on imports.
While there is currently a lack of details on the Proposal, one possibility is that the U.S. version of the consumption-based BAT will deny a deduction for import costs to the taxpayer, meaning the importer’s taxable base would be much greater in comparison to a taxpayer who produces the same goods domestically but benefits from deductions for its production inputs or cost of goods sold (COGS). This would mean the costs of imports (unlike identical domestic costs) would no longer be tax deductible for businesses, with the increased tax cost on imports likely to be passed on to consumers. It is also contemplated that there will be a full exemption from tax for revenue generated from exports.
International Trade Perspective
The World Trade Organization (WTO) may be concerned whether the BAT is a masqueraded “direct” tax crashing the “indirect tax” party.
Generally, the WTO Agreement on Subsidies and Countervailing Measures (the “ASCM”) prohibits subsidies, which include a full or partial exemption for exports from “direct taxes.”
In addition, Article III.2 of the General Agreement on Tariffs and Trade (GATT) prohibits protectionist or unequal application of “internal taxes” in a manner that is more favorable to domestically produced goods than identical or similar imported goods. This may be particularly problematic given that the Blueprint implicitly suggests it is designed to promote American production, and it is widely perceived that President Trump seeks a more protectionist trade policy.
Arguably, if the BAT is viewed to be merely a transformed income tax (notably the Blueprint itself suggests it is not a new tax), it may potentially be in breach of the ASCM and the GATT. At the very least, this may potentially result in a protracted trade feud, bogged down within the WTO’s Dispute Settlement Body (DSB). For example, should the DSB unmask the BAT to be in fact a “direct tax,” and an actionable subsidy, it may authorize complaining members to take countermeasures, potentially including countervailing duties, against the United States commensurate with the economic injury caused by the export subsidy.
Alternatively, should the BAT be determined to be an “indirect tax” on imports, it may pose other potential conflicts with existing U.S. free trade agreements (FTAs). Generally, U.S. FTAs provide for the elimination of “customs duties” and prohibit an increase or introduction of a new “customs duty” on imports of originating goods from a member country. This prohibition generally applies to charges of any kind imposed in connection with the importation of a good, including any form of surtax or surcharge in connection with such importation. Arguably the BAT may fall within the definition of a customs duty and thus in breach of U.S. FTAs.
U.S. Customs Perspective
Regardless if the tax is named a BAT, VAT, DBCFT, customs duty, indirect or direct tax, it purportedly remains a tax upon imported goods. Therefore, the customs laws will have to be reconciled with any tax reform legislation, and in some cases may present potential opportunities to mitigate the tax. A few examples include:
The U.S. foreign trade zone (FTZ) program, generally allows the importer to defer the payment of duties until the imported goods are subsequently withdrawn from the FTZ for consumption in the United States, and allows exporters to avoid the payment of duties altogether. It will need to be considered whether any similar tax deferral and/or avoidance benefit would attach to goods in an FTZ.
Similarly, the U.S. Customs Border Protection’s (CBP) “duty drawback” program allows a refund of “99 percent of the duties, taxes and fees paid on imported goods” that are subsequently exported within 5 years, including imported goods that have been unused, and imported goods that are used to manufacture goods in the United States (19 U.S.C. § 1313(I)). The potential for a drawback refund of the BAT, if assessed upon imported goods, should also be considered.
Under CBP’s de minimis exemption, generally goods may be imported by one person on one day with a retail value of $800 or less “free of duty and of any tax imposed on or by reason of importation,” under simplified customs entry processes (19 U.S.C. § 1321(a)(2)(C)). The question still remains on whether or how the BAT will be assessed on business-to-consumer (B2C) import transactions. Should the BAT be imposed on a transactional basis, e.g., with collection by customs upon importation, the de minimis exemption should be considered as a potential opportunity to exempt the BAT from B2C import transactions under $800.
Conclusion
- Notwithstanding the current lack of details on the Proposal, and the potential for trade disputes, importers should take steps to evaluate their supply chains’ current risk profiles given the various contingent scenarios for tax and trade reform: Start to model the potential tax and financial impact of the BAT on current operations;
- Consider customs saving programs that may impact the BAT, and undertake a cost/benefit analysis for the potential duty and BAT savings;
- Move forward with implementing customs programs that are likely to yield cost savings, for example, when the potential duty savings alone may be significant;
- Consider supply chain value management and transformation, taking into account various tax, trade, geopolitical, and operational changes and risks under the new administration (e.g., will a foreign B2C or e-commerce distribution model into the United States make sense in the future given the potential exemption under the customs de minimis rule?).
Thus, it may be a good time for U.S. companies to start considering supply chain value management, and possibly dusting off some of those customs programs that may have been on the back burner. These programs may now take on a renewed priority to mitigate import costs when possible.
Luis Abad is a principal with the Trade and Customs Services group of KPMG LLP’s Washington National Tax practice. For more information visit Insights on Trade & Customs.
The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.