Like others who have addressed the DBCFT in general, and border adjustments in particular, we have to make certain assumptions about how the border adjustments would work because the details in the proposal are so scant. Indeed, the description of the DBCFT occupies less than two pages of the proposal, and only a few sentences describe the border adjustments ... Likewise, rather than eliminating transfer pricing, the border adjustments will likely shift its focus, incentivizing multinationals to minimize the cost of imports by U.S. affiliates (because such costs would no longer be deductible expenses) and maximize U.S. affiliates’ revenue from exports (because such income would escape U.S. taxation and possibly even result in tax rebates) ... Consider an example to illustrate this point: A U.S. distributor acquires a product from a foreign manufacturer (FM) for $100 and resells it to U.S. customers for $160. (For purposes of this and the next example, we disregard currency adjustments in the figures, as the principle remains the same and, as seen above, perfect and immediate currency adjustments offering universal relief are unlikely.) The U.S. distributor can’t deduct the $100 paid to FM, meaning the distributor has taxable income of $160, with tax of $32 (at the proposed 20 percent rate). Without the border adjustment (and assuming the same 20 percent rate), the distributor’s tax would be only $12. Inevitably the U.S. distributor will try to push at least some of the economic burden of this additional tax cost onto FM.Both Adidas and Nike are selling my perfect pair of shoes for $160. Each pay $80 per pair (50% of sales) for the design as well as the cost of hiring a Chinese manufacturer. Each incurs $48 per pair (30% of sales) for local sales and marketing expenses. Profits are $32 per pair or 20% of sales, which is divided between the parent corporation and the local distributor depending on the transfer pricing policy. Adidas Germany has established a U.S. distributor – Adidas America – to incur the sales and marketing expenses and in the KKH example, receives a 37.5% gross margin which equates to a 7.5% operating margin or $12 in U.S. profits on my pair of shoes. At a 35% U.S. tax rate, U.S. profits taxes are $4.20. Since the German profits tax rate is only 30%, the CFO of Adidas once wondered why they don’t raise the intercompany price from $100 to $110 but his tax director told him that the IRS team is insisting on their 7.5% operating margin. If DBCFT is adopted, the incentives change as a lower transfer price would eliminate German profits but not change the U.S. tax bill. This was the point of my Trump Toaster Oven example. So yea – transfer pricing manipulation could still exist but now this becomes a German problem. I suspect the German authorities might object if the intercompany price was reduced to $80. But at least the U.S. gets its $22.40 in sales tax – right? That might be true under a retail sales tax arrangement but not necessarily under a VAT. KKH also note that Adidas might scheme DBCFT by asking me to buy my shoes via the internet:
If, instead, FM, which otherwise has no nexus with the U.S., sells directly to the U.S. consumer for $160, it bears no U.S. tax. Without the imposition of a standalone import tax, FM can increase its profit—and even undercut the retail price relative to what U.S. distributors must now charge, while still making a higher profit. In short order, virtually all sales of foreign goods into the U.S. would be made direct to the end consumer, cutting out the tax-costly U.S. middleman.Nike might look at this scheme and lament that the otherwise conservative folks at Adidas had outdone them in terms of transfer pricing aggression. Nike is known for sourcing some of its foreign based profits in Bermuda but credit the IRS on currently insisting that Nike pay the U.S. some of the intangible profits. DBCFT, however, would give Nike a huge tax break on its foreign sourced income. But Nike also realizes that half of its approximately $30 billion in sales per year are to U.S. customers like me. KKH note that Nike could pull the same trick:
Taking this example one step further, a U.S. seller into the domestic market will also have a strong incentive to adopt this same strategy. Assume a U.S. manufacturer sells the same product as in the above example, with a cost of production of $80. It will sell to a U.S. customer at the market price of $160, and would be subject to tax of $16, resulting in an after-tax profit of $64 ($80 – $16). But if it established a foreign distributor (FD) and sold the product to FD for $150, followed by FD’s resale to the U.S. customer for $160, the U.S. seller would have $70 of profit, subject to no U.S. tax—plus the $10 of profit residing in FD, also subject to no U.S. tax (assuming FD otherwise has no U.S. taxing nexus; for that matter, FD need not be related—U.S. sellers would probably find little difficulty locating foreign companies willing to earn modest profits for acting as a go-between).Daniel Hemel noted something similar with respect to Microsoft tax planning. KKH also state:
A more traditional VAT would also be expected to withstand a WTO challenge, be compatible with the U.S.’s existing network of income tax treaties, and enjoy the benefit of other countries’ experiences, which could provide guidance for a VAT’s adoption and implementation. This conclusion may seem obvious, but only if one ignores political realities—there is no appetite in Congress for enacting a ‘‘new tax,’’ particularly one that would ultimately fall on American consumers.Indeed there are simpler ways of accomplishing what Alan Auerbach wants to do but Paul Ryan does not a clear and honest debate over tax policy. Paul Ryan is also making a lot of wonderful sounding claims about DBCFT but then when has Ryan ever been honest about tax policy? Oh well – time to go shopping.