By Susan Kohn Ross and Jeffrey D. Davine
It is far too early to discern the extent of any change to the relationship between the U.S. and Mexico in the face of the oft-repeated insistence of the Trump campaign to “renegotiate” NAFTA, a promise that was reiterated once Mr. Trump was sworn into office. Following a prickly meeting last month between President Trump and Mexican President Enrique Peña Nieto, accounts from Mexico report the government as having started consultations with its business community, a process described as taking 90 days. The results of those consultations and how they might impact any further discussions with the U.S. remain to be seen. Similarly, President Trump and Canadian Prime Minister Justin Trudeau also met last month, but under somewhat more cordial circumstances. Again, next steps with Canada remain an open question. However, the overarching theme is the oft-repeated promise from the Trump Administration that a border tax will be imposed. While nothing concrete has been proposed to date, how such a border tax might work has understandably caused varying levels of concern among American companies. Given there is nothing concrete to examine, in this Alert, we seek to provide a brief explanation of the concepts being bandied about.
As part of a larger overall reformation of the U.S. tax laws, House leadership is proposing the U.S. implement a “border adjusted tax” (“BAT”) on goods that are imported and consumed in the U.S. Additionally, the BAT, as conceived, would provide tax breaks for goods that are exported. Whether these tax breaks qualify as a “subsidy” and so are subject to challenge before the World Trade Organization or under any of the trade agreements to which the U.S. is a signatory remains to be seen and will, of course, be defined by the exact language adopted, but, the WTO Agreement on Subsidies and Countervailing Measures, Article 1.1, defines a subsidy to include a fiscal incentive, such as tax breaks. This is the very argument the U.S. is currently making when complaining about China’s export tax refund regime.
U.S. corporations currently pay income taxes on their taxable income (or profits). The BAT will adjust how these profits are calculated. The BAT is different from the “border tax” that has been talked about by President Trump. The President’s border tax would, as currently articulated, only apply to goods imported from Mexico, whereas the BAT would apply to goods imported from all countries.
The BAT is the brainchild of Alan J. Auerbach, a Professor of Economics and Law at U.C. Berkeley and was first proposed about 20 years ago. The effect of the BAT is to convert the corporate income tax into a “destination-based cash-flow tax.”
A simple example helps illustrate how the BAT could work. Assume that a U.S. manufacturer of jet engines exports those engines to Mexico where they are installed on airplanes that are made in Mexico. The profit the U.S. manufacturer earns when it exports the jet engines to Mexico would not be subject to U.S. income tax. On the other hand, if a U.S. aircraft manufacturer purchases the jet engines from a company in Mexico and imports and installs them on airplanes manufactured in the U.S., the profit the U.S. company makes on the airplanes it sells will be taxed by the U.S. Additionally, the U.S. aircraft manufacturer will not be able to claim a business expense deduction for the amount it paid to purchase the jet engines that it imported, or the labor cost to make those planes, which is the norm under the current tax regime.
One of the principal purposes of the BAT is to lower the tax rates to which U.S. corporations are subject. At present, large U.S. corporations are subject to a tax rate of 35% on their income (but the tax rate can be as high as 39% at certain income levels, and is one of the highest tax rates in the world). The BAT is designed to reduce that tax rate to 20%.
The BAT was conceptualized to provide economic incentive for companies that export their goods, but is anticipated to be detrimental to companies that import goods. Critics of the BAT assert it will result in an increase in the prices of imported goods. This means, for example, the cost to consumers of Chinese made electronic “toys”, found at your favorite big box retailer, would become much more expensive. If that were to happen, the result could well impose inflationary pressure on the U.S. economy. Proponents of the BAT, however, assert its imposition will result in increased foreign demand for products exported from the U.S. This, in turn, could increase the value of the U.S. dollar, which could increase the demand for imported goods and offset their higher prices. Which side wins or where the compromise point is found remain to be determined, but it is important to understand there are two distinct options being discussed.
The border tax is proposed to be levied strictly on Mexico, as noted, and is being discussed as a 20% tax on all goods imported from Mexico. Article 310 of NAFTA addresses Customs User Fees and provides: “[n]o Party may adopt any customs user fee of the type referred to in Annex 310.1 for originating goods”. However, Annex 310.1 specifies only the merchandise processing fee shall be eliminated by a date certain, which has long since happened. No bar to the proposed tax seems to come from this provision. On the other hand, Article 314 provides:
Except as set out in Annex 314, no Party may adopt or maintain any duty, tax or other charge on the export of any good to the territory of another Party, unless such duty, tax or charge is adopted or maintained on:
(a) exports of any such good to the territory of all other Parties; and
(b) any such good when destined for domestic consumption.
It seems a tax on the importation of goods from Mexico into the U.S. would violate this NAFTA provision. Further hampering the potential for imposition of a border tax on goods imported from Mexico only is the provision in Article 318 which defines customs duty to include:
[A]ny customs or import duty and a charge of any kind imposed in connection with the importation of a good, including any form of surtax or surcharge in connection with such importation, but does not include any: “ (a) charge equivalent to an internal tax imposed consistently with Article III:2 of the GATT [i.e., equivalent to a tax that applies to like domestic product or in respect of an article from which the imported product has been manufactured or produced in whole or in part], or any equivalent provision of a successor agreement to which all Parties are party, in respect of like, directly competitive or substitutable goods of the Party, or in respect of goods from which the imported good has been manufactured or produced in whole or in part…” [emphasis added].
Leaving aside the potential consequences of any fallout (political, economic or otherwise), from the deterioration of the relationship between Mexico and the U.S., it is readily apparent a border tax on goods imported from Mexico presents some significant legal challenges to the Trump Administration. One wonders how language could be developed which would get around these legal commitments by the U.S., unless, of course, they no longer existed! The same, however, may not be the fate of the proposed border adjusted tax, but again, until we see the actual language, it is too early to tell. However, when considering the BAT, one has to wonder how a company with strong cross-border operations would be able to determine what is and what is not taxable. What happens when a company moves goods back and forth across the border multiple times so as to take advantage of specialized equipment or unique skills to produce the final product? There are also provisions in existing trade law that provide duty reduction benefits when production moves across borders and products are either returned for repair or partial production takes place (think goods returned under provisions in Chapter 98 of the Harmonized Tariff). Will those be tweaked or eliminated? What about goods that enter a foreign trade zone or other bonded facility?
The potential for accounting challenges is nightmarish. In the end, of course, the devil is in the details and no one knows right now what they will look like. Once they are published, we will all have a better idea of where things stand. The challenge is: what to do in the meantime? And quite honestly, there are no concrete answers to that question right now! We will keep you posted as reliable information becomes available.