After Donald Trump unexpectedly won the U.S. presidential election last November, it would have been hard for most CFOs not to be hugely optimistic about their companies’ tax positions, if not about the entire U.S. economy.
Not only had the pro-business Republicans taken the executive branch, they’d held the House and flipped the Senate. Suddenly, the proposal candidate Trump had made to lower the corporate tax rate from 35% to 15% seemed to go from being a pipe dream to a near lead-pipe cinch.
Further, in the blink of a bleary post-election-day eye, the finance chiefs of U.S.–based corporations holding big profits offshore now could reasonably expect to be able to repatriate that cash at a one-time tax rate of 10%. In addition, U.S. manufacturers could expect to be able to declare their capital expenditures as an expense for tax purposes, a boon for them even though they would lose the deductibility of interest expenses.
On top of the then-President-elect’s proposed tax breaks was the prospect of more-permanent and deeply rooted reforms contained in “A Better Way,” the tax-reform “blueprint” issued by House Republicans in June 2016. The reforms, which would likely have languished in Congress under a Hillary Clinton presidency, included elimination of the alternative minimum tax and a territorial tax system under which companies would be taxed only in the country where their income was earned — rather than taxed again when they repatriated it.
Inconceivable until last November, this wholesale revision of the corporate income tax system has become a real possibility. “It would be the most substantial sea-level change in the way we tax corporations in memory,” says Matthew Gardner, a senior fellow at the Institute on Taxation and Economic Policy, a research organization.
Yet, not all companies are celebrating a key element of the House Republicans’ plan: a “border-adjusted” tax system that appears to draw a sharp dividing line between winners and losers.
In an attempt to follow a “made in America” agenda, the plan would penalize U.S. importers and provide a tax break to the nation’s exporters. Under the border-adjusted system, U.S. companies would get rebates on income taxes paid on the goods and services they produce here if they export them. At the same time, “products, services, and intangibles that are imported into the United States will be subject to U.S. tax regardless of where they are produced,” according to the blueprint.
In a reversal of the current state of affairs, tax would no longer be charged where goods are made, but where they’re consumed or used. That would put U.S. companies on a more level playing field with competitors located in countries that already have border-adjusted systems, according to “A Better Way.”
Today, such countries tend to tax U.S. imports while subsidizing their own exports to the United States. “In the absence of border adjustments, exports from the United States implicitly bear the cost of the U.S. income tax while imports into the United States do not bear any U.S. income tax cost,” according to the blueprint.
A whole lot is riding on the House leadership’s supposition that the border-adjustment system will become law. Overall, the Republican tax reform plan would slash federal tax revenue by a total of $2.4 trillion (including individual and corporate taxes) over the first decade, excluding the gains the cuts could theoretically spur by stimulating the economy, according to an analysis by The Tax Foundation, a tax-policy nonprofit. The blueprint counts on border adjustments to make up for $1.1 trillion of the revenue lost to tax cuts.
Despite the Republican majority in Congress, it’s far from certain that border-adjustment will be enacted. For one thing, it’s received a mixed response from President Trump, who sometimes seems to favor punitive tariffs as a means of tax collection at the border. (Some expect he will have more to say about the issue in his address to Congress tonight.) Retailers, energy businesses, and other large importers are up in arms about the idea of the border tax. World Trade Organization rules may forbid it. And pro-growth advocates close to the administration have questioned the need to fund the cuts at all.
No Time to Delay
In such an uncertain environment, tax planning is becoming a big challenge for corporate America, experts say. A big, across-the-board corporate tax cut could very well be the centerpiece of the tax reform legislation House Speaker Paul Ryan and Senate Majority Leader Mitch McConnell reportedly expect to be enacted by August. But beyond that the picture is blurry. CFOs, of course, can’t afford to delay decisions on such things as remaining in locales or shifting operations to different ones, investing in capital equipment, and changing the tax status of their companies—all of which can have a big impact on a corporation’s tax rates.
Yet to continue formulating their plans, CFOs need a basis for forecasting the laws and rules that will govern them. Experts agree that President Trump’s spoken and tweeted pronouncements are too sketchy to be the basis for forecasts. Instead, some advise that the House blueprint is the most solid foundation.
Jeff LeSage, vice chairman, tax services, at KPMG, advises companies to examine their most recent tax returns and financial statements and analyze how those would be “affected by the proposals that are out there, especially the blueprint.”
Under Trump, the prospects for the enactment of legislation based on the blueprint are as good as they’ve ever been, he reasons. But even if such comprehensive reform is signed into law, it’s sure to affect industries differently.
“CFOs have to model their own companies according to what tax reform will look like for them,” LeSage says. “Just a pure rate reduction wouldn’t necessarily be a benefit” if the reforms are revenue neutral.
Among the proposals, for instance, is a plan to eliminate the deduction of interest expenses against net income. Companies that use leverage in a significant way to fund their operations could be hit hard by the loss of the deduction, he notes. The real estate industry and private equity firms are two notable examples.
How much could the removal of the interest-expense deduction cost a company? To answer that question, assumptions have to be made about the terms of the debt, the interest rate, and other factors, he says. For example, assuming the otherwise allowable interest expense on $1 billion of debt was $50 million, the “cost” of the disallowance would be the tax rate (assumed to be 20% under the Blueprint) multiplied by the interest expense ($50 million), or $10 million.
But the big dividing line between winners and losers would be border adjustment. “Energy, automobiles, and any business that has a significant component imported through its supply chain is going to be negatively impacted,” says LeSage. “Even if there’s a significant tax cut, they’re going to get no deduction for a significant piece of their costs.”
The Great Divide
Domestic retailers would especially be hurt by an import tax, notes Heléna Klumpp, a former vice president of global taxation at Baxter International who is now deputy editorial director for Bloomberg BNA Tax & Accounting. “If you’re Walmart and about to enter into an agreement with an offshore supplier who will sell you T-shirts, you could end up in a bad position if there’s a border adjustment that doesn’t allow you to deduct the cost of those T-shirts when you earn a profit from selling them in the U.S.,” she says.
Klumpp elaborates on her example: “If a retailer is paying $1 for a package of T-shirts from a manufacturer in Bangladesh, and [the retailer sells] those T-shirts for $5 in the U.S., it would have taxable income of $4, ignoring other deductible expenses. But under the border-adjusted system, no portion of the price paid to the foreign manufacturer would be deductible, and the whole $5 earned on the sale would be taxable.”
Retailers facing a situation like that would do well to devise contingency plans. “A company may want to enter into a shorter-term agreement and see what happens with this border adjustment,” Klumpp says. “Then it would be better positioned for next year, when the adjustment is enacted, to enter into an agreement with a domestic supplier.”
The issue may also be more complex than it seems. Less than 5% of the products that Ulta Beauty sells, for example, are private-label finished goods. Since the company, which owns cosmetic and fragrance department stores, may directly import such items, it would have to pay the full tax if the border adjustment plan is adopted, notes Scott Settersten, the firm’s CFO.
That probably wouldn’t amount to as big a tax bite for Ulta as it would for U.S. toy retailers that import the bulk of their finished goods from China. But more than 90% of Ulta’s inventory falls into the category of “indirect imports,” products made by large U.S.–based international cosmetics companies like Estee Lauder and Coty, according to Settersten. “Those companies are getting things cross-border,” he says.
In such cases, “bits and pieces” of a finished product may be imported from differing locales by U.S.–based multinationals. For example, the plastic case of a beauty compact might be made in one country, while the powder and powder puff in two others.
Complying with a border-adjusted system could involve a snarl of red tape and added cost, in addition to increased taxes for indirect importers like Ulta. “The intention is to make the tax code easier, and this would certainly not do that,” Settersten says, referring to candidate Trump’s goal of a simpler system. “It would impose administrative burdens on us and many others.”
Big exporters like GE, on the other hand, are looking at border adjustments as a potentially bountiful gift. “If a company is a net exporter, you could envision that, under border adjustability, … it would pay a lot lower tax rate,” GE CFO Jeff Bornstein told analysts during the company’s fourth-quarter earnings call. “There is an incentive for exporters to export more because there is essentially no tax on exports,” he added.
Nevertheless, any tax planning based on border adjustability could prove a waste of time. Before his inauguration, President Trump criticized the plan as too complicated, according to a January 16 story in The Wall Street Journal. “Anytime I hear border adjustment, I don’t love it,” he said in an interview with the newspaper. “Because usually it means we’re going to get adjusted into a bad deal. That’s what happens.” Ten days later, however, the WSJ reported that the Trump administration had shifted its position on adjustability, seeing it as a way to recoup some of the costs of the wall the President has ordered built on the U.S.–Mexico border.
So how do CFOs come up with a solid estimate of their companies’ taxes over the next year or two? One thing to consider in planning is that the Trump administration’s way of communicating legislative aims is “very different than any other [presidential] administration,” says Dean Zerbe, a former senior counsel to the U.S. Senate Finance Committee and now a national managing director of Alliantgroup, a tax services firm.
Previously, presidents tended to make sharply defined legislative pronouncements that had been worked out in advance with fellow party members in Congress. Such pronouncements included items the president considered non-negotiable. Not so for Trump, who makes broad “aspirational” statements without prior congressional negotiations, according to Zerbe, who says he can’t recall previous Republican presidents ever having so much “daylight between them and the congressional Republicans.”
But such distance can be healthy, because it can enable the president to depart from a prior pronouncement if Congress offers a better proposal, Zerbe says. Similarly, Trump has been able to issue strongly worded statements that move House and Senate Republicans quickly away from legislation he deems ill-advised—as when, in response to a Trump tweet, they decided to shelve a plan to reduce oversight of potential ethics violations.
It’s a kind of triangulation, the consultant says, referring to a successful Clinton administration strategy in which the president stakes out a position incorporating the two political sides but remains above the fray. Thus, Zerbe’s advice to CFOs is to “not be over- or under-anticipatory when Trump says something.”
The bottom line? Expect a big push for significant tax cuts and a whole lot of uncertainty, at least until summer.