The Destination-Based Cash Flow Tax: International Considerations

The GOP blueprint released in June 2016, A Better Way: Our Vision for a Confident America, presents the most significant tax reform in the United States since the Tax Reform Act of 1986. The blueprint would lower the corporate tax rate (from 35% to 20%), shift to a territorial tax system, and introduce a destination-based cash flow tax with border adjustments (the "DBCFT").

A New System of Taxation. The DBCFT would be a significant departure from the current corporate income tax, which taxes U.S. businesses on their worldwide income. The DBCFT is a consumption tax on business income that would establish tax jurisdiction based on the location of consumption (or final sale).

The DBCFT would tax all products actually consumed within the United States, regardless of where the product was produced. Domestic products exported for foreign consumption would be exempt from the DBCFT, while still subject to any applicable foreign taxes. The tax on imports and exemption on exports would be administered through border adjustments.

The blueprint would also allow businesses to fully expense capital investments and would deny deductions for net interest expense.

Impacts on International Trade. The imposition of the DBCFT on imports (and exemption on exports) would, one might reasonably expect, increase the demand for U.S. exports and decrease the demand for U.S. imports. However, many argue that any trade advantage would be entirely offset by changes to the currency exchange rate. There is significant economic support to suggest that the value of the U.S. dollar would increase by the value of, thus offsetting any changes in demand created by, the DBCFT.

The cash flow aspect of the DBCFT may also impact the balance of treatment between domestic and imported products. The DBCFT would allow U.S. businesses to deduct payroll expenses, including wages, bonuses, benefits, etc. Because this deduction would be available only to U.S. businesses and not to foreign businesses exporting products into the United States, domestic products would have a lower effective tax rate than imports.

This disparate treatment of domestic and imported products appears to implicate international trade rules imposed by the World Trade Organisation ("WTO").

Compliance with WTO Rules. The purpose of the WTO, as embodied in their mission statement, is “to ensure that trade flows as smoothly, predictable and freely as possible.” WTO members may raise trade disputes, and the United States, as one of the four largest members (by world trade), is subject to biennial trade policy reviews.

The WTO is the successor to the 1948 General Agreement on Tariffs and Trade ("GATT"), the terms of which, are still in effect through the WTO framework. The GATT and the WTO Agreement on Subsidies and Countervailing Measures ("SCM Agreement") contain rules that may be implicated by the DBCFT.

Articles II and III of the GATT provide a “national treatment” prohibition on trade policies. Article II provides that members must accord imports “no less favourable” treatment than domestic products, and Article III states that members shall not impose a tax on imports "in excess of those applied, directly or indirectly, to like domestic products."

In conjunction with Articles II and III of the GATT, the SCM Agreement prohibits certain tax subsidies on exports which may cause imports to be treated less favorably. The SCM Agreement generally exempts from this prohibition, subsidies on "indirect" taxes.

The SCM Agreement defines an indirect tax as “sales, excise, turnover, value added, franchise, stamp, transfer, inventory and equipment taxes, border taxes and all taxes other than direct taxes and import charges.” It defines a direct tax as any tax on "wages, profits, interests, rents, royalties, and all other forms of income, and taxes on the ownership of real property."

Under the WTO rules, the DBCFT does not clearly fit into the definition of a direct tax or an indirect tax. Although the GOP blueprint specifically states that the DBCFT is not a value-added tax ("VAT"), there are undeniable similarities between them. A VAT is a consumption tax that attaches liability at each stage in the production process. A VAT generally allows for the expensing of capital investments and denies deductions on net interest expense. A traditional VAT does not, however, allow a payroll deduction. A payroll deduction is arguably more indicative of a direct tax.

What to Expect. The DBCFT is still in its infancy. After all, the Tax Reform Act of 1986 took over two years to progress from conception to enactment. During those two years, the underlying bill was fiercely fought by politicians and special interest groups, and was nearly killed so many times that it became known to some as the "Phoenix Project." The DBCFT will have to survive reform procedures that are just as precarious as they were in 1986.