Corporate CEOs are already sweating the logistics should their supply chains be disrupted by tough new proposals from Republicans aimed at pushing business back to the United States.
Now comes a challenge for company CFOs: how to address the tricky tax implications of making adjustments to the supply chain.
President Donald Trump and the GOP want to change rules to bring more production and jobs to the U.S. They’re proposing changes to U.S. tax policy to prompt corporations to cut imports and increase exports, invest more in domestic manufacturing, and move foreign operations to the U.S.
All these proposals present corporations with a new set of tax considerations for their supply chains, but also an opportunity to take advantage of the changes if they start taking a hard look now.
“This will be a game changer — a whole new set of rules. Companies need to start planning now so they’re not at a disadvantage when the new rules are put in place,” said Brian Murphy, Tax partner, Consumer and Industrial Products (CIP) practice at Grant Thornton LLP.
Here’s a look at how the proposals might force companies to modify their supply chains, and how those changes could affect corporate tax planning.
Corporations perhaps face the greatest supply chain challenge and opportunity with a proposal to eliminate tax deductions for imports while exempting exports from taxation. House Republicans included this provision as part of their blueprint for tax reform that they released last year.
Under current law, if a manufacturer or retailer, or any U.S. corporation, imports a product costing $100 and sells it for $110, the company would have $10 in taxable income after deducting the $100 cost of goods sold. Under the GOP proposal, the $100 cost would not be deductible, making the taxable income the whole $110.
On the flip side, U.S. companies would not face a tax on exports. These proposals should nudge U.S. companies to evaluate their current source of supplies and destination of their products.
“If you are a U.S. company and you no longer get a tax deduction for imports, it will be an incentive to focus and consolidate activity and sourcing in the U.S.,” said Douglas Wood, national managing principal of Grant Thornton’s International Tax practice.
Some economists believe the U.S. dollar would strengthen in value with border adjustment, offsetting price increases for corporations and consumers. If this is the case, the economics of international supply chains wouldn’t change much. But it’s unclear how long it would take for the dollar to strengthen — if at all — leaving other economists in doubt about the prospects of currency adjustment.
“Currency adjustment is extremely controversial, and the arguments among economists go back and forth,” said Dustin Stamper, director, Grant Thornton’s Washington National Tax Office.
Concerns about border adjustment taxes come from many quarters. Manufacturers interviewed as part of a recent Grant Thornton/National Association of Manufacturers survey expressed fears about how a tax on imports would disrupt their supply chains and whether they could find suitable domestic suppliers as replacements. Retailers have sounded similar alarms. And even Trump has expressed skepticism.
Another hurdle may be the World Trade Organization (WTO), which facilitates international trade. The WTO typically allows only indirect taxes like value-added taxes (VATs) to be border adjusted. If the WTO rules that the border adjustment is an impermissible export subsidy, it could expose the U.S. to sanctions. The House GOP argues that the U.S. border adjustment resembles a VAT and should therefore be allowed by the WTO.
As the debate swirls, companies should be evaluating their supply chains and trying to determine whether continuing to import goods would be cheaper than finding domestic suppliers, and how they would absorb the additional expenses.
“For domestic companies, there are a number of questions,” Wood said. “Where do I buy the same goods in the U.S.? Is it still cheaper to import, even with the tax? And how do I recoup costs? Do I pass it along to the customer, or can I even do that?”
Territorial tax system
The United States currently operates under a worldwide tax system. Foreign income is subject to tax, but companies can generally defer this tax until the foreign earnings are distributed — or repatriated — to the U.S.
The House GOP Blueprint calls for a shift to a territorial system that would generally exempt foreign income from U.S. tax with a 100% dividend deduction.
In his campaign, Trump proposed to keep the worldwide tax system and end the deferral to immediately make all income subject to U.S. taxes. But under this approach, foreign tax credits would be allowed so that his system would operate more like a global minimum tax on offshore earnings taxed at a rate lower than 15%.
Under either vision for international reform, U.S. companies would no longer have a tax incentive to keep their earnings overseas. The hope is that U.S. companies would bring dollars back to the U.S., sparking more domestic investment in manufacturing and jobs, and strengthening the domestic supply chain.
“There is broad agreement that the U.S. must shift to a territorial tax system. Even before the election, Democrats and Republicans discussed the possibility of bipartisan legislation,” Stamper said.
To transition to the new system and help pay for reform, Trump and the GOP Blueprint propose a one-time mandatory tax on repatriated earnings. Under this plan, a one-time tax would be imposed on all foreign-based earnings held by U.S. companies before tax reform becomes effective. Trump has proposed a tax of 10%, while the GOP Blueprint calls for an 8.75% tax on cash and cash equivalents, such as stocks and bonds, and 3.5% for noncash assets.
Both Trump and the GOP want to lower the corporate tax rate to make it more attractive for companies to do business in the U.S. Trump wants to cut the current 35% corporate tax rate to 15%. The House GOP Blueprint calls for lowering the rate to 20%.
Lowering the corporate tax rate would bring the United States in line with the rates of other foreign countries and encourage economic investment in the U.S.
The supply chain is driven in part by tax considerations. Under current tax laws, U.S. companies face higher tax rates on operations they keep in the U.S. than in operations they grow in many foreign countries. Ireland, for example, has a corporate tax rate of 12.5%.
U.S. multinationals often believe they are at such a disadvantage compared with foreign competitors that it’s become more common to see inversions, in which a company relocates its legal domicile to a lower-tax nation, usually while retaining its material operations in its higher-tax country of origin.
Another activity is transfer pricing, in which a multinational company will use a foreign subsidiary in a low-tax jurisdiction to purchase goods, and then resell them to the U.S. subsidiary to reduce the tax consequences.
All these strategies might be rendered unnecessary if corporations could take advantage of a lower U.S. tax rate.
“The current system is extremely complicated, and it’s been in place for decades,” said Murphy, of Grant Thornton’s Tax practice. “Under the proposed new system, the complications and perceived disadvantages associated with the U.S. global tax system would be radically affected.”
“With Republicans pivoting from health care reform to tax reform, businesses shouldn’t wait, but use this time to consider the proposed changes and develop an action plan ahead of any new legislation,” Murphy said.
“Companies should model out the various proposals and, based on the results, ask how they should respond and react. What alternatives are there?” Murphy said. “Keep in mind that under the new tax system, nimble companies that quickly adopt beneficial strategies can level the playing field or even leapfrog their competitors. This will be like hitting the reset button on your planning.”