“Destination-Based” “Border Adjustment” “Indirect Tax” … What?

The destination-based border adjustment tax.

I  have been reading about it recently.

If you cannot distinguish it from a value-added tax, a national sales tax, a tariff or all-you-can eat Wednesdays at Ruby Tuesday, you are in good company.

Let’s talk about it. We need an example company and exemplary numbers. Here is one. Let’s call it Mortimer. Mortimer’s most recent (and highly compressed) income statement numbers are as follows:

Sales			10,000,000
Cost of sales			(3,500,000)
Operating expenses			(4,000,000)
Net profit			2,500,000

How much federal tax is Mortimer going to pay? Using a 34% federal rate, Mortimer will pay $850,000 ($2,500,000 * 34%).

Cue the crazy stuff….

A new tax will bring its own homeboy tax definitions. One is “WTO,” or World Trade Organization, of which the U.S. is a part and whose purpose is to liberalize world trade. The WTO is a fan of “indirect taxes,” such as excise taxes and the Value Added Tax (VAT). The WTO is not so much a fan of “direct taxes,” such as the U.S. corporate tax. To get some of their ideas to pass WTO muster, Congressional Republicans and think-tankers have to reconfigure our corporate income tax to mimic the look and feel of an indirect tax.

One way to do that is to disallow deductions for Operating Expenses. An example of an operating expense would be wages.

As a CPA by training and experience, hearing that wages are not a deductible business expense strikes me as ludicrous. Let us nonetheless continue.

Our tax base becomes $6,500,000 (that is, $10,000,000 – 3,500,000) once we leave out operating expenses.

Not feeling so good about this development, are we?

Well, to have a prayer of ever getting out of the Congressional sub-subcommittee dungeon of everlasting fuhgett-about-it, the tax rate is going to have to come down substantially. What if the rate drops from 35% to 20%?

I see $6,500,000 times 20% = $1,300,000.

Well, this is stinking up the joint.

VATs normally allow one to deduct capital expenditures. We did not adjust for that. Say that Mortimer spent $1,500,000 on machinery, equipment and what-not during the year, What do the numbers now look like? 

• Sales                                       10,000,000
• Cost of Sales                            3,500,000
• Operating Expenses                 4,000,000
• Capital Additions                       1,500,000 

I am seeing $5,000,000 ($10,000,000 – 3,500,000 – 1,500,000) times 20% =  $1,000,000 tax.

Still not in like with this thing.

Let’s jump on the sofa a bit. What if we not tax the sale if it is an export? We want to encourage exports, with the goal of improving the trade deficit and diminishing any incentive for companies to invert or just leave the U.S. altogether.

Here are some updated numbers:

• Sales                                        10,000,000 (export $3,000,000)
• Cost of Sales                             3,500,000
• Operating Expenses                  4,000,000
• Capital Additions                        1,500,000 

I see a tax of: (($10,000,000 – 3,000,000) – (3,500,000 + 1,500,000) * 20% = 2,000,000 * 20% = $400,000 federal tax.

Looks like Mortimer does OK in this scenario.

What if Mortimer buys some of its products from overseas?

Oh oh.

Here are some updated, updated numbers:

• Sales                                       10,000,000
• Cost of Sales                            3,500,000 (import $875,000)
• Operating Expenses                 4,000,000
• Capital Additions                       1,500,000 

This border thing is a two-edged blade. The adjustment likes it when you export, but it doesn’t like it when you import. It may even dislike it enough to disallow a deduction for what you import.

I see a tax of: ($10,000,000 – (3,500,000 - 875,000) – 1,500,000) * 20% = 5,875,000 * 20% = $1,175,000 federal tax.

Mortimer is not doing so fine under this scenario. In fact, Mortimer would be happy to just leave things as they are.

Substitute “Target” or “Ford” for “Mortimer” and you have a better understanding of recent headlines. It all depends on whether you import or export, it seems, and to what degree.

By the way, the “border adjustment” part means the exclusion of export income and no deduction for import cost of sales. The “destination” part means dividing Mortimer’s income statement into imports and exports to begin with.

We’ll be hearing about this – probably to ad nauseum – in the coming months.

And the elephant in the room will be clearing any change through the appropriate international organizations. The idea that business expenses – such as labor, for example – will be nondeductible will ring very odd to an American audience.

  

Tax Break for Exporters

We are taking a look at an Interest Charge – Domestic International Sales Corporation (IC-DISC).

As you can guess, this has to do with a company which exports. I remember the DISC as providing a tax deferral, but it has another tax feature that we like as much or more.

Here is quick breakdown of how the IC-DISC would work:

(1) There is an exporting company (ExCo)

(2) ExCo (or its owners) set up a second company (DISC) and elect to be treated as an IC-DISC.

(3) ExCo pays DISC a commission

(4) DISC pays no tax on the commission (up to a point) as long as 95% of its activities and assets are export-related.

NOTE: Do you see what is happening? DISC pays no tax on the commission. ExCo deducts the commission and reduces its tax.

(5) DISC may pay dividends to its shareholders.

(6) If DISC does not pay dividends, there will a charge to the shareholders. The charge will vary depending on whether the shareholders are individuals or a corporation. Individuals will pay interest (hence “Interest Charge – DISC”). There is a different tax treatment for corporations.

The DISC can be a “paper” company. That is, it does not have to perform any substantial economic functions. It does not have to have employees or office space, for example. Pretty much the only thing it has to do is keep its own books and records, which an accounting department can do. You incorporate, print some new stationary and continue doing what you were doing before. How much easier can this be?

There are of course limits on how to calculate the commission; otherwise you would have a product selling for $50 with a thousand dollar commission tacked onto it. The commission is 4% of the qualified export receipts or 50% of ExCo’s taxable income, whichever is greater.

The DISC can defer $10 million in commissions EVERY year. There is even a way to increase this limit.

The tax deferral is sweet, but Rick and I like the dividend treatment as much or more. We expect the DISC to be an S corporation, and its shareholders to be the same as those for ExCo. We can also see a wealth transfer opportunity here by having the younger generation as the owners of the DISC, while mom and dad (or grandmom and granddad) still own ExCo. We are thinking of having the DISC distribute every year. Under this scenario there is no deferral. We want to move money out of the main company (ExCo), which would otherwise be taxed at the maximum rate, and push it to DISC, whose dividends are taxable at 15 percent. This would be an immediate 20% tax savings.