The Potential Effects of Tax Reform on Manufacturers Engaged in International Trade

By: Allan Peiser

June 2017

The current set of leaders in the federal government rose to power on the promise of both saving 25 million high-paying manufacturing jobs for American workers and delivering greater profitability for corporate manufacturers, despite the fact that those two goals have traditionally been at odds.

The plan was to turbocharge the industrial economy with tax code reforms that would attract and “onshore” a wave of OEMs (original equipment manufacturers), powering a new economic surge. To reach that same goal, Republicans in the House of Representatives introduced a proposal called “A Better Way,” highlighted by a cut in the corporate tax rate from 35 down to 20 percent. Similarly, the Trump administration’s proposed tax reforms proposed an even more favorable 15 percent corporate pass through tax rate.

If changes like these ever make it through Congress to the status of law, the industry could be highly impacted, because almost two-thirds of manufacturers are organized as pass-throughs, and many of them have to pay marginal tax rates of more than 40 percent at present.

Here are some details on three more proposals that could make a big difference for U.S. manufacturers:

1. The Territorial Tax
One of the big changes would eliminate the existing U.S. worldwide tax and replace it with a territorial tax modeled on European taxation systems. Specifically, the dividend-exemption system would impose a mandatory “deemed” repatriation tax of 8.75 percent for cash or cash equivalents and a rate of 3.5 percent for other kinds of accumulated foreign earnings. The plan recognized that there would have to be transition rules that would go into effect as manufacturers switched over to the new reporting rules. There would have to be assistance for businesses moving to a destination-based cash-flow business tax system, although this is something the industry would have to work out at a later date. The new rules would have to cover changes to accounting and reporting for banking, insurance, and leasing business activities under the proposed cash-flow tax system.

The point of this change is to put a stop to double taxation for American-based manufacturers that currently have to pay taxes in the country where goods and services are sold and pay a second set of taxes on goods and services when they repatriate their revenues. In many countries around the world, businesses are already able to repatriate foreign business earnings with little or no residual home-country taxes, lowering the costs of their supply chains and improving balance sheets.

2. Immediate Write-Offs for New Plant Equipment
The final impact of this tax change would vary greatly based on the how the government implements the other pieces of the reform. For example, it could chill the purchase of new equipment if new investment expensing was combined with the elimination of deductions for interest expenses that exceed interest income. On the other hand, if the territorial tax mentioned above goes through first, then the positive impacts of foreign sales could outweigh the offset of additional taxes. If a company elects to immediately expense capital investments, which comes with the requirement to give up the deduction for interest expense, it would still be able to revoke that decision within three years and amend prior year returns. In the big picture, this plan would completely remake the U.S. economy from an income-based tax system to a consumption-based tax system. Also, deductions for most credits and domestic production activities would go away for good. Only R&D credits would remain.

3. America-First Supply Chains
The “border adjustment” tax, proposed by House Republicans and under consideration by the Trump plan, may be the most controversial element of the reform strategies. This provision would impose tax penalties on companies with supply chains partners outside the U.S. Companies based here could not take a deduction for the cost of raw materials or finished products imported into the country. Naturally, manufacturers would pass on those costs to consumers in some manner, which could have unpredictable effects on the consumer confidence, the price index, inventories, and exports. The nonprofit Tax Foundation concluded that “Most economic literature dating to the 1950s agrees on the theory that destination-based taxes are fundamentally trade-neutral and that border adjustments do not afford a trade advantage or change the balance of trade. Most literature also agrees that theoretically, prices change mainly through adjustments in exchange rates.”

In the Eurozone, a similar border adjustment resulted in a temporary domestic stimulus, and it appeared that the tax was passed along into inflation of both prices and wages. On the other hand, in countries with flexible exchange rates like the U.S., those exchange rates adjusted rapidly to offset the changes in prices due to the border adjustment.

The proposed tax reforms by the Trump administration and House Republicans are still at a very early stage, with little chance of coalescing into a coherent plan before 2018. Lowering corporate tax rates, imposing stiffer import penalties and alterations in the supply chain are likely to be part of the final proposal as it emerges, but a series of crisis management initiatives on the political front has greatly delayed the timeline. Many financial analysts like those at Goldman Sachs are pinning their hopes on 2019 or beyond, but there could be substantial changes on the political landscape by then.

The tax professionals at Goldin Peiser & Peiser have extensive experience in international tax issues and working with manufacturers domestically and abroad. Contact GPP today!

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