The Destination-Based Cash Flow Tax: Tax Reform or Tax Chaos?

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Lawrence J. Zlatkin

By Lawrence J. Zlatkin Stamford, Connecticut

The tax reform debate has moved into new territory, with experts, pundits and policy strategists focused on more radical proposals, such as the destination-based consumption or cash flow tax (DBCFT). While the DBCFT is not new, it has migrated from the province of academics to the real world, and many in government and business now view it as a panacea to the “broken” international and corporate tax system in place.

This commentary discusses the new DBCFT from the practical perspective of an international tax professional who has practiced in this area for over 30 years. While the new DBCFT is appealing, in practice, it is unnerving since it moves the United States off the international tax grid into unchartered territory. In the past, when the U.S. was the dominant global tax and economic leader by far, perhaps this shift would have been acceptable, but my fear is that the “law of unintended consequences” and the painful transition to a new tax regime could cause the costs of the DBCFT to far outweigh its benefits. If the U.S. were inventing its tax system in a new world, as when the income tax was introduced before World War I, the debate in favor of DBCFT would be compelling. But, 100 years later, in a complicated and more global U.S. economy, we would be better served by more incremental change.


The existing net corporate income tax system is antiquated and dysfunctional. Much like our bridges, tunnels and airports, it creaks along, but it is complicated, laden with inefficiencies (debt vs. equity, anyone?), weighed down by interlocking and confusing laws and regulations and, ultimately, unable to keep up with the sophistication of private tax planners. This leaky system encourages the worst of all practices: while the tax rate is among the highest in the world (excepting India), U.S. multinationals thrive on the foreign tax credit and foreign income tax deferral, producing effective tax rates that are much lower. More and more companies prefer exiting the U.S. tax system entirely through inversions or integration with foreign companies that offer the refuge of a lower tax rate. But others are stuck: U.S. domestic retailers or small businesses lack the ability to escape.

It wasn't always this way. Early in my career, I remember how the U.S. tax rate was among the lowest in the world, and we were flush with enthusiasm from the enactment of the Tax Reform Act of 1986. Even if we had nine foreign tax credit baskets, passive activity losses and worldwide taxation of financial services, we had a system that worked and encouraged growth and investment in the U.S. economy.

What changed? In short, the U.S. economy has become more global, and the rest of the world has moved on. Most major U.S. companies have gone global, and more inbound foreign investment has changed the landscape of the U.S. economy. Nothing is going to bring us back to 1986, 1970 or the 1950s. And, while tax planning has helped companies in their global ambitions, in the end, these forces are driven more by pre-tax imperatives — very few business decisions are made on taxes alone.

Thus, the goal of tax reform should not just be to fix a creaky system, but to eliminate tax bias as much as possible. But no matter what form it takes, tax reform is not going to change the bigger picture. Any changes should be viewed through the lens of making incremental progress rather than radical overhaul.


Much has been made about the simplicity of the DBCFT and how it is pro-growth, pro-export and pro-America. In a simple world, this might be the case. But, we don't live in a simple world.

Throughout his campaign, President Trump spoke frequently about how U.S. companies are prejudiced in exports because a sale of goods to a value-added tax import-based tax regime, such as Mexico's, results in an “input VAT” tax, while a similar export from the same country to the U.S. enters free of taxes, including customs duties (true for Mexico) under the North American Free Trade Agreement. Without going into the differences between VAT and customs duties, the simple fact is that the U.S. has no VAT, while most of the world does. So, it is true that imports to the U.S. bear no input VAT, while U.S. producers face that burden on goods they export to countries that impose a VAT.

This is not discriminatory taxation. It's just a business fact of life in the U.S. as long as we don't have a VAT. Many commentators have argued that the U.S. should adopt a VAT to fund U.S. revenue needs. If we did, the same input VAT would apply and equalize the tax treatment decried in Trump's 2016 presidential campaign.

The DBCFT is not a VAT in the conventional sense. It is not invoice-based as are other VAT regimes around the world. The proposal is more complicated, based on a subtraction method, coupled with a wage credit. Rather than supplement the corporate- or business-level income tax, the DBCFT would replace it entirely. That itself is radical. In the U.S., the corporate income tax has been around since the 19th century and adopted, in its modern form, after ratification of the 16th amendment. The tax generates as much as, if not more than, 10% of the federal tax base. The corporate income tax is also the basis of the tax systems of most other countries in the world, in varying forms, including those countries that maintain a VAT.


It's not clear why the authors and proponents of the new system don't adopt the invoice-based system in place almost everywhere else in the world. Perhaps that will follow if and when negotiations proceed in Congress.

In theory, however, the new destination-based method of taxation would bring simplicity and vitality to the tax system. Out with the old and in with the new. It would mean an end to disputes over source-based taxation, deductions, income, credits, reorganizations, disguised dividends, device, economic substance, separate entity taxation, transfer pricing and more. The tax ledger would be based solely on revenue, and the only question would be whether the revenue were domestic or foreign — end of story. No net income. No complex reconciliations. Cash would be king.

Rates would be lower also — limited to 15%, 20% (or perhaps high as 25%). In a world of a statutory maximum corporate tax rate of 35% (even higher, taking into account state corporate income taxes), that change alone would bring welcome relief and reinstate the U.S. as a model of tax moderation. Those regimes with a double tax classical corporate tax system and high rates — France and India to name two — would instantly become uncompetitive, at least from a tax perspective.

Presumably, investment income would be taxed separately. Current anti-deferral rules, in place since at least 1962 and designed to tax “passive” income, would have an ongoing role and result in current-level taxation — at what rate is an open question. How this would work in practice is a matter of debate. Lots of examples have been offered in the press and in tax articles and reviews over the past months. However, I would caution that many of these examples are simple cases, where the lines between exports and imports are clearly drawn and easy to understand. The reality in a complex world will be much different.


While the allure of no corporate income tax and a destination-based VAT is compelling, the challenges are enormous and no less compelling. It is these challenges that likely would result in confusion, if not chaos, in the near term. And, while we all should live in the long term, we also know what Keynes said about that.

Consider the following.

1 — Supply Chain, Services and the Modern Economy

Much of the modern U.S. economy is globally integrated, with component parts and supplies generated in multiple places. How would the DBCFT apply in these important and growing contexts? This is not simplicity.

How would exports be defined in a world of the cloud and multijurisdictional intangibles and the supply chain? These are not esoteric concerns, since the engine of growth in the U.S. economy has been derived from these new and evolving business models.

Assume Company A has a global contract with Company B for the supply of an advanced industrial product that has been manufactured in multiple countries, with software, R&D and engineering supplied from multiple countries. In the corporate income tax context, we have established principles, albeit debatable ones, on transfer pricing, intangibles and other income producing activities. In the newer DBCFT, this will be much harder to apply — the supplies and imports could be all over the place and counted more than once — and it is not at all clear how the DBCFT would be understood in the context of avoiding double taxation in the classic international tax system. These issues will take years to resolve, leaving considerable uncertainty for multi-jurisdictional economic actors.

2 — Treaties and Integration with Other Countries

What would happen to our treaty obligations and the benefits of these treaties for U.S. businesses? I'm not referring to the WTO and our global trade agreements, although much has been said about whether the destination-based VAT is compliant with our existing trade obligations or just an export subsidy. I'm referring to our tax treaties, which provide a major benefit to U.S. residents who operate and invest in more than 50 countries.

If a U.S. company and treaty resident funds a new start-up or derives rents or royalties from personal or intangible property in a treaty country, will reduced rates continue to be applicable? Without an income tax to pay, the U.S. company no longer will be U.S. treaty-resident. Withholding tax rates, historically reduced, would rise considerably.

What about other U.S. taxpayers — what incentive would other countries have in negotiating favorable tax treaties with the U.S.? Permanent establishment or branch thresholds, tailored and negotiated under Organization for Economic Cooperation and Development (OECD) norms for decades, would no longer apply. Maybe that's the price to pay for a more efficient domestic tax system, but tax treaties are major facilitators for U.S. trade, historically relevant and not easily discarded.

Another more practical question is how the DBCFT would be interpreted by other countries. The DBCFT is treated as an export enhancer, but the reality is that exports would be subject to input VAT by the non-U.S. importer, no different than U.S. exports today. Some have argued that the absence of an income tax and the replacement of DBCFT should favor exports. That remains to be seen. Exports would still be taxed through the non-U.S. VAT system and ultimately paid by the end user.

However, under the DBCFT, since it is not a pure VAT, the new tax on imports would be borne by U.S. businesses, not by the ultimate consumer (unless goods are imported directly by consumers, which is unusual and presents its own challenges at enforcement). Of course, businesses would need to pass on this cost to their end users, indirectly increasing the cost to consumers.

3 — International Tax Cooperation and BEPS

The U.S. is an active member of and leader in OECD tax bodies. Fiscal cooperation within the OECD is a key element of international tax stability, promoting tax treaties, bilateral and multilateral cooperation and efficient, informed and stable tax administration. More recently, the U.S. has been an active participant, some would say a little unwillingly, in the Base Erosion and Profit Shifting (BEPS) project. While BEPS and the new multilateral instrument have been criticized as anti-American in scope, it is important that the U.S. play an active and tempering role in OECD tax proceedings.

But the new DBCFT at best will be viewed by the OECD member states as aggressive tax competition and at worst as non-compliant with U.S. treaty obligations, including the WTO arrangement. While some in Congress may be willing to dispense with international cooperation as a price for U.S. tax efficiency in the DBCFT, it's unclear whether the resulting hardship and distance arising from the rest of the developed world's tax community is in the U.S. interest.

As I noted earlier, the DBCFT is neither a pure VAT nor an income tax. Its effects therefore would be hard to predict in the international setting, making the U.S. an outlier. Economically, the DBCFT replaces the corporate income tax with a new VAT type arrangement, with the tax on imports replacing corporate tax receipts. So long as the U.S. has a trade deficit, this could create a boon to tax receipts, and many in Congress are expecting this newly expected revenue stream to be a panacea to the current “failed” tax system. But, that result is not entirely clear or necessarily foregone — foreign exchange is supposed to clear up the extra tax cost — and my point here is that non-U.S. governments will react in their own way and may (if not will) upset the apple cart. The “law of unintended consequences” needs to be considered.

With the rest of the world moving along with BEPS, the multilateral instrument, and common reporting standards, throwing it all away in the U.S. will not be viewed as constructive or help U.S. business in their overseas arrangements. We should expect reaction, potential double taxation and other adverse consequences.

And, in many ways, this will be a problem for small business, not for the bigger multinational corporation. While the bigger company can localize and solve cross-border antagonisms, albeit at a price, small business cannot. This would hamper U.S. exports from the nascent small business community, the intended beneficiary of the DBCFT. So, Caterpillar and Boeing will be fine. But, the small widget maker or new IT venture will confront a new “wall” against their global aspirations.

4 — Financial Services and Insurance

And, there are the complexities for financial services, insurance and other parts of the economy that have a vested interest in tax stability and which don't easily fit the DBCFT/VAT mold, even in more established VAT regimes. How would the new DBCFT apply to these industries? Some have argued that they should be exempt, but how so? And why? And, how do we define these sectors in the first place — not all of them are regulated or as easily defined, but their business model is similar.

Consider the interest deduction. Under the DBCFT, net interest will be taxable. And, the interest deduction will be restricted. But, the lifeline or “cost of goods sold” for finance companies is interest. And, this is no less true for real estate and leasing, both of which are major segments of the U.S. economy and which thrive and depend on debt.

Economists understandably have been arguing forever for the equalization of debt versus equity. And, the existing U.S. tax system has evolved largely in favor of debt versus equity. But, it is a radical shift to major sectors of the economy to make this change in short order or even after a transition.

Other important sectors of the U.S. economy — real estate, municipalities and governments, non-profits, regulated investment companies (RICs) and real estate investment trusts (REITs) — don't easily fit into the new DBCFT. Their exclusion from the new DBCFT paradigm requires creative and thoughtful analysis. Their current state of development has been built on a corporate income tax that has evolved over decades, and it cannot be reformulated instantly overnight.

5 — State Taxes

Another segment of the U.S. tax system that by definition needs to be integrated with the DBCFT, but where work has yet to begin, is state taxation. Since most states follow federal law on income taxation, what happens when the federal income tax is abolished and replaced? One solution would be harmonization, similar to how the Canadian goods and service tax (GST) has been implemented in many of Canada's provinces, but this bears further discussion and coordination, which won't be easy with 50-plus jurisdictions that have themselves developed their tax laws over decades.

6 — Pass-Through Entities

Yet another area of unchartered waters is the role of pass-throughs. In fact, as often observed, most businesses in the U.S. operate in transparent form through LLCs, LLPs, S corporations and other similar structures. How will business activities in non-corporate form be treated under the DBCFT, and how will the resulting complexities be managed? If business income is subject to tax at 15% or even 20%, but compensation income is taxed at 30% or higher, how will this differential be overseen and abuses limited? It's not an easy task, and this likely is a bigger source of confusion than corporate taxation.

Once again, the small business community may suffer the most. It will be less prepared and more sensitive to the cost of a new tax system. Of course, time will and should solve these and other points of potential confusion, but the pain should not be underestimated.

7 — Financial Statement Harmonization

A whole parallel universe exists under U.S. GAAP (Generally Accepted Accounting Practices) and IFRS (International Financial Reporting Standards). Lots of open questions will arise on whether the DBCFT is above the line (VAT) or below the line (income tax). Since it is a hybrid, with a wage credit, there is no immediate answer. But, the implications for publicly traded companies or any company that manages its performance with GAAP are significant.

For a global company, the new DBCFT presumably will be de-linked from other non-U.S. income taxes. That will add new layers of complexity to reporting and measurements, some of which will be income tax based (outside the U.S.) and others of which will be VAT based (U.S. and foreign VAT systems). Lots of new territory will need to be developed and refined.

8 — Compliance and Education

New forms will be needed and new training will be required. For the tax professionals who fear there will be no work when the corporate income tax is abolished, there is a safe assumption that the new system will require lots of talented tax lawyers and accountants to work within the confines of the new system.

The Internal Revenue Service also will need to be reorganized and re-energized to manage the new tax system, arguably at the same time as the existing corporate income tax system in transition. Given the brain drain and downsizing of the IRS over the past few years, this will not be an easy task. And, it is not at all clear that a Republican Congress and President will deploy the talent and resources needed to execute an entirely new tax system efficiently and methodically.


So, where do we go from here? We are at a fork in the road. We need tax reform, but we also need stability and a system that works, not a system in the making. And, this is where the DBCFT is at its weakest. If we were inventing (not reinventing) the tax system, and we agreed to disregard the progressive appeal of the corporate tax layer, a consumption tax or hybrid DBCFT would be an interesting if not compelling choice. Even if we were still in 1950 and half of the world's economy, or in 1980 when we were still dominant, the choice would have its allure. But, we are where we are, an important economy, but not the dominant global economic power we once were and after decades of a classical double tax system that mirrors the rest of the world.

I understand the desire to start anew. It sounds bold and creative. And, we need a vision of how to compete in a new world where we are only one of many. But, the tax system permeates the entire economy, and its potential disruption to economic flows (macro, micro, global) is too hard to ignore. Reforming health care itself, which is 20% of the economy, is a challenge, and Obamacare compromised by accepting much of the status quo to preserve stability. The tax system is bigger, and I'm in favor of incrementalism rather than bluster — tax reform rather than tax chaos.

And, I haven't even mentioned the other significant macro changes that would arise under DBCFT that would take years to be absorbed. Much has been made about the fiscal benefit of DBCFT as a revenue raiser for a U.S. economy that has a stubborn trade deficit. Perhaps initially, but the DBCFT also is expected to have a major impact on currency exchange rates and other more macro flows that ultimately should balance the deficit and offset the pain for importers. Once these forces are unleashed, the impact will be immediate and unpredictable.

Let's start with rate reduction and the international tax reform package proposed by former House Ways and Means Committee Chairman Dave Camp (R-Mich.). That package would have lowered rates and eliminated tax preferences, but was also revenue neutral. We can build from there. Repatriation also is sensible progress, and coupled with a reduced tax rate of 15–20% should impede the rush to exit door. Greater corporate/individual integration makes sense too, as Senator Orrin Hatch (R-Utah) has been exploring. As the first few weeks of the Trump administration have proven, bold is not necessarily strong — it needs to be thoughtful, reasoned and in sync with reality. Big business will survive chaos, but the average American will be hurt, and we need a strong tax system for everyone.

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