“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.

  

New Business Tax Provisions

So what are the key business tax changes from the American Tax Relief Act of 2012? Here are the ones that caught my eye:

(1)  Bonus depreciation extended through 2013.

The bonus allows one to immediately deduct 50% of the cost of qualifying assets.  If you buy a backhoe, for example, you can immediately expense one-half the cost – and you get to depreciate the remaining half.  

(2)  S corporation built-in gain tax recognition period

OK, this one is somewhat obscure. Suffice to say that a C corporation that switches to an S corporation cannot sell its business until after several years have run. It used to be that the period was 10 years, then reduced to 7 and then to 5 years. The Act extends the 5 years for sales through 2013.

What this is about is allowing tax planners to restructure businesses, or parts of businesses, for sale, in the hope of spurring – or at least not deterring – business and job activity.

 

(3)  Expensing for certain film and television activities

If Peter Jackson had filmed The Hobbit in the United States, he would have been able to expense the first $15 million in production costs. Three-fourths of the movie production must take place in the U.S.

The Act extends this break through 2013.

(4)  Increase in Section 179 expensing

Section 179 allows taxpayers to immediately expense equipment used in a business. Normally this type of expenditure would be depreciated over time (barring the bonus depreciation discussed in (1) above). Section 179 however has a limit on the amount that can be expensed and the amount of assets you can purchase and still qualify for the break.

In 2011 the amount that could be expensed was $500,000 as long as assets purchased did not exceed $2 million. That dropped to $125,000 and $500,000 for 2012. The Act retroactively changes 2012 to and sets 2013 at $500,000 and $2 million.

(5)  Faster depreciation of leasehold improvements

The Act extends the 15-year depreciation period for qualifying leasehold, retail and restaurant leasehold improvements.  

For example, the new Mad Mike’s at the Newport Levee would have been depreciated over 39 years. Now it can be depreciated over 15 years.

(6)  Research tax credit 

The Act extends the research credit through 2013.           

This credit is available for improvements in the production process as well as to the product itself. Think Apple and Pfizer.

(7)  Work opportunity tax credit 

This is the tax credit for hiring individuals on welfare, being released from prison, collecting social security disability and so forth.  

The credit is not insignificant: 40% of the first $6,000 in wages. 

Who is this credit important to? Think Cracker Barrel and ....

(8)  Veterans credit 

Technically this is a subset of the work opportunity credit from (7) above. 

Unemployed and disabled veterans are a qualifying category for the tax credit, although the credit amount can vary from $2,400 to $9,600 depending on how long the veteran has been unemployed and whether disabled. 

(9)  The Nascar loophole 

If you were thinking of building a “motorsports entertainment complex,” the Act will allow you to take accelerated depreciation. You have to build it soon, though.

 This one could not be more obvious if Jeff Gordon ran over you.           

(10)   Cover over of the rum excise tax 

There is an excise tax of $13.50 on every gallon of rum sold in the United States. That would normally be a business-breaker, but the government refunds almost all the tax - $13.25 – to Puerto Rico and the Virgin Islands in the form of economic aid. This is called the “cover over.” 

By far most of the money goes to Puerto Rico.

However... 

Do you know Diageo? They are based in London and produce  – among others - Captain Morgan rum. A few years ago, they moved their production of Captain Morgan from Puerto Rico to St. Croix, which is in the Virgin Islands. It seems that the USVI was able to provide a (1) 90% tax break, (2) a bigger kickback of the cover over, and (3) an exemption from property taxes.  

     

(11)    The “Subpart F active financing exception”

You ever wonder how a company like General Electric can pay no corporate income tax?           

Well, one way is that they lost a lot of money in previous years. This provision is another way.  

The U.S. (generally) considers interest earned by a U.S. corporation anywhere in the world to be a passive business activity. Makes sense, as accountants could easily move interest from country to country. By calling it passive, the goal is to make the interest taxable to the U.S. There are exceptions, of course, and this is one. 

This provision came into being in 1997 and with a significant amount of lobbying by General Electric. Why? Think G.E. Capital, and you are on the right track. It allows one to establish a captive finance company overseas, generate profits there but not pay taxes on the profits until the money is brought back to the U.S. 

This provision has been extended many times since 1997. It has now been extended again.