The Border Adjustment: What Companies Need to...

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The Border Adjustment: What Companies Need to Know

Tim Reichert and Perry Urken1

Abstract: This paper examines the Border Adjustment (“BA”) concept found in the House Ways and Means Committee

tax policy proposal entitled “A Better Way” (also known as the “Blueprint”). We demonstrate that the adoption of the

BA by the US will cause both double taxation of import flows and non-taxation of export flows. This is inconsistent

with the principles of international tax treaties currently in place. Our analysis demonstrates that the BA will give rise

to a significant and highly variable increase, across firms and over time, in the overall corporate tax burden of US-

based companies. The increased burden, and increased uncertainty, will be pronounced for firms whose imports into

the US exceed their US exports. However, we show that if losses in firms’ export divisions are not credited against

positive cash flow in their import divisions, the BA will cause a tax increase even for those firms whose US exports

materially exceed the value of their imports. Because the BA is essentially a form of trade policy effected through tax

policy, it is conceivable that other countries will adopt similar tax policies – tantamount to trade retaliation. We show

that if all countries adopted a BA and adjusted import and export prices to zero, a company’s effective tax rate will

equal the weighted average of the corporate tax rates in each country in which it has import and domestic operations,

weighted by the cash flows earned by these operations (net of any applicable credits for the export division’s losses).

If no export loss credits are available in a BA equilibrium, even in some countries, general adoption of a border

adjustment will give rise to very high effective tax rates. We demonstrate that transfer pricing considerations will

remain relevant under the BA, contrary to assertions made by some. We also express skepticism of the argument that

exchange rate adjustments will offset the effects of the BA on import intensive businesses.

Introduction: the “Blueprint”

In June 2016, Representative Kevin Brady, the Republican chairman of the House Ways and

Means Committee, issued a Tax Reform Task Force “Blueprint” which proposed a broad array

of overhauls to the United States (“US”) tax code. Included in this Blueprint is a sweeping

redesign of the country’s current corporate tax framework. The tax framework suggested by

the Blueprint is referred to as a destination-based cash flow (“DBCF”) based policy.

A DBCF tax is not intuitive and the DBCF framework is not part of the common lexicon of tax

policy. Given the novelty of the concept and since the main characteristics of the Blueprint’s

corporate tax proposal are a function of it, we begin our analysis by outlining the main

principles of a DBCF-based tax policy below.2

Destination-based Tax. The Blueprint proposes that corporate tax should be assessed

exclusively on the basis of where products and services are consumed. As proposed, this means

1 Dr. Timothy Reichert is the President of Economics Partners, LLC. Perry Urken is the Washington, DC Office

Leader and a Partner at Economics Partners. The authors wish to thank Dr. Clark Chandler and Ian Gray for their

insightful comments and assistance. Both are Partners at Economics Partners, LLC.

2 This summary is prepared based on a review of the Tax Reform Tax Force Blueprint as well as publications from

Alan J. Auerbach, an economist from the University of California Berkeley whose proposals form the basis of the vast

majority of the corporate tax proposals contained in the Blueprint. See Auerbach, A., “A Modern Corporate Tax”,

Center for American Progress/The Hamilton Project, December 2010 and Auerbach, A. and Holtz-Eakin, “The Role of

Border Adjustments in International Taxation”, American Action Forum, November 30, 2016

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that if a US-based business exports products for sale abroad, value associated with these exports

would not be taxable in the US. In contrast, value associated with products sold by US-based

business in the U.S. market, and the value of products sold by foreign businesses to the US (i.e.,

imports) would be taxable in the US. Thus, tax would apply to both domestically produced and

imported goods sold to US customers.

“Cash Flow” Tax. While the Destination-based nature of the tax is similar in some respects to a

sales tax, the tax is not assessed on revenues. Nor is it assessed on “business profits” reported

by firms. Rather, it is based on a cash flow concept. “Cash flow,” as presented in the Blueprint,

is defined as revenues from domestic sales less a set of “deductions” limited to corresponding

cash outflows for domestic salaries, inputs and capital investments.3 While cash flow is

generally defined as the cash left over in each period after a business deducts all of its cash

outlays from its revenues, the destination-based feature of the Blueprint means that businesses

would not be permitted to deduct amounts paid for foreign-based inputs from domestic

revenues. Non-deductible foreign-based inputs include finished goods, components, capital

equipment, services, and intangible property procured from non-US sources.4

In what follows, we examine the key characteristic of the DBCF’s destination-based concept –

namely, the non-deductibility of imports and non-recognition of exports. This feature is

referred to in the Blueprint as the Border Adjustment (“BA”). The BA, as the name implies, is

an “adjustment” made to prices received or paid for exports or imports, respectively. As

proposed (and as implied by the foregoing) the BA adjusts both import and export prices to

zero. Other components of the Blueprint, such as the proposed reduction in the statutory

corporate tax rate and the expensing of capital investments are not directly addressed in the

analyses presented below.

3 Note that as part of the Blueprint’s proposal, cash outflows for capital investments would be immediately deducted

as opposed to the current practice of capitalizing and depreciating these investments.

4 Nor would businesses be permitted to deduct interest expense. This means that the DBCF emphasizes enterprise

cash flow, as opposed to shareholder cash flow.

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The Border Adjustment is Double Taxation of Imports and Non-Taxation of Exports

Double taxation is generally defined as a circumstance in which some or all of the income

earned by a business enterprise is taxed by more than one taxing authority.5

It is straightforward to demonstrate that the BA represents double taxation of import value and

complete non-taxation of exports. Correspondingly, for non-US trading partners, the BA gives

rise to double taxation of exports to the US, and non-taxation of imports from the US. As we

discuss later, both the resulting double taxation and non-taxation are inconsistent with the

principles of international tax treaties.

Imports

Examining the BA’s effects on imports first, we see that prior to the implementation of the BA,

import prices would be subtracted from a US importer’s revenues when arriving at taxable

income. That is, but for the BA import values (i.e., import prices) would be a tax deduction.

This deduction is eliminated through the BA.

The imported goods will generally be resold at a markup, or profit.6 This resale price is of

course taxable. However, because the value (price) of the imported good is not deductible,

taxable cash flows are higher by the amount of the import price. Thus, the import’s value is

contained in taxable cash flow, and is therefore taxed in the US.

Now consider the foreign counterparty selling the imported good to the US importer – that is,

the foreign exporter. The foreign exporter will recognize the export price (the US importer’s

import price) as revenue, and subtract as tax deductions the value of any associated

components, labor, and capital that was used to produce the export good.

At first blush, this seems to imply that what is taxed on the non-US side of the transaction is

limited to the profit associated with the export to the US. That is, the seeming implication is

that there is double taxation only of the capital returns embedded in the export to the US (i.e.,

the profit on the exporter’s side is taxed, which is only a portion of the US importer’s price

which is taxed in full). However, this seeming implication is incorrect – what is double taxed is

the portion of the price of the product imported into the US that is attributable to inputs whose

origin is outside of the US. To see this, we simply need to recognize that the foreign exporter’s

deductions (costs) include purchased components and capital from other non-US companies, as

well as local labor deductions, all of which are recognized and taxable in non-US jurisdictions –

either through corporate or personal income taxation. These components and capital assets, in

5 Other forms of double taxation – such as the taxation of income at the corporate level and dividends paid to

shareholders – involve different issues and are not addressed in this paper.

6 The imported good will be resold with a markup whether the importer is a retailer, distributor, or manufacturer

that uses the imported product as a component in its manufacturing process. This is because capital and labor inputs

will in all cases be applied to the imported good by the importing firm.

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turn, also include the value of non-US manufactured components and capital purchases, which

are recognized as taxable abroad – and so on. Application of this logic to the entire supply

chain shows that, of the import price paid by the US importer, the entire portion that results

from non-US labor and capital inputs is double taxed.

Thus, we see that in a global tax system in which virtually all corporate income is taxed at its

“source” – that is, income is taxed where it is created – the unilateral adoption by the United

States of the BA to import prices gives rise to double taxation.

Exports

Currently, to arrive at taxable income, a US exporter would recognize the value of exported

goods (price received times quantity sold) as revenue, and would deduct the value of any

associated components, capital depreciation, labor, and other inputs used in the process of

producing the exported product. However, the requirement to recognize the price of the

exported product is eliminated by the BA, since the BA does not assess tax on export flows. As

a result, the implementation of the BA in the US would result in the non-taxation of the value of

US exports by the IRS.

As for the foreign counterparty that purchases the US exporter’s product (i.e. the foreign

importer), the price paid for the US exporter’s product is deductible. Its value is not included in

taxable income. Thus, we see that while the BA results in double taxation of imports, it also

gives rise to complete non-taxation of exports. Neither the US Internal Revenue Service, nor the

foreign counterparty’s taxing authority, taxes the value of exports from the US under the BA.

It bears noting here that, depending upon the details of potential future Treasury regulations,

the US exporter may still be able to recognize the costs (deductions) pertaining to capital, labor,

and components that it used to produce the exported good in the computation of its US tax base

even as the income received from the exports is untaxed. If so, the US exporter would have

negative taxable cash flows pertaining to its exports that could, in principle, be applied as an

offset to (deduction or credit against) profits realized on domestic and import-related activity of

a US taxpayer. However, the availability of this credit is by no means certain or clear from the

Blueprint. For example, it is possible that a destination-based framework will be interpreted

such that the notional losses on a US exporter’s cash flow statement are not available for use as

a credit or deduction against profits on the firm’s import and domestic activity, simply because

export activity may be interpreted as falling outside of the taxing jurisdiction of the IRS in a

destination-based framework. We address the question of the utilization of these deductions,

and the relationship between loss utilization and US companies’ effective tax rates, below in our

discussion of “Divisionalization.”

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Double Taxation, International Tax Treaties, and the Arm’s-Length Principle

As noted, double taxation is generally defined as a circumstance in which the same income

earned by a business enterprise is taxed by more than one taxing authority. Such a

circumstance is broadly viewed within the international community as undesirable, generating

a potentially significant negative impact on international commerce. This view is directly

reflected by the Organization for Economic Cooperation and Development (“OECD”), which

states that: “[D]ouble taxation is undesirable and should be eliminated whenever possible,

because it constitutes a potential barrier to the development of international trade and

investment flows.”7

In order to prevent double taxation, countries have entered into an extensive network of tax

treaties. These govern negotiations regarding transfer pricing disagreements that may arise

between the countries and the taxpayers that make transfers between them.8 The United States

is currently party to 68 separate bilateral tax treaties with other countries.9 A study published in

2007 found that 2,351 such treaties were in place globally and that the parties to these treaties

encompassed nearly all OECD countries and account for a very large proportion of global

foreign direct investment flows and stocks.10

The terms of many of these treaties are based on those presented in three prominent “Model

Tax Conventions” (“Conventions”), which are published by the OECD, the US Treasury

Department and the United Nations (“UN”). These “models” are intended to serve as

templates for use by other nations in drafting their own treaties.

International tax treaties generally contain an extensive framework for defining the process and

standard by which international tax disputes can be resolved in a manner that avoids double

taxation. All three Model Tax Conventions adopt the “arm’s-length principle” as the standard

for this purpose. The arm’s-length principle, as reflected in these Conventions, holds that

taxation of controlled affiliates of multinational groups operating within their respective

jurisdictions should be based on the “business profits” that each affiliate might be expected to

7 OECD Transfer Pricing Guidelines

8 The titles of many of these treaties directly reflect the importance of avoiding double taxation as a motivating factor

for their creation. For example, the tax treaty between the U.S. and the U.K. is titled as follows (underlining added):

“Convention Between the Government of the United States of America and the Government of the United Kingdom

of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion

with Respect to Taxes on Income and on Capital Gains”.

9 https://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z

10 Fabian Barthel , Matthias Busse and Eric Neumayer, “The Impact of Double Taxation Treaties on Foreign Direct

Investment: Evidence from Large Dyadic Panel Data Revised Version May 2009,” Contemporary Economic Policy, 28

(3), 2010.

https://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z

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earn if it were a distinct and independent enterprise engaged in the same or similar activities

under the same or similar conditions.11

The application of the arm’s-length principle as the basis of transfer pricing administration was

pioneered by the US in 1928. A comprehensive study undertaken by the US Treasury

department as a result of the Tax Reform Act of 1986 (the 1988 “White Paper”) re-endorsed the

arm’s-length principle as the appropriate means of administering transfer prices. Over time, the

vast majority of other countries have also adopted the arm’s-length principle. At present, as

described by the OECD, “the application of the arm’s-length principle…is the international

consensus on transfer pricing.” In fact, our research indicates that countries that administer

international transfer pricing based on the arm’s-length principle account for over 96 percent of

global gross domestic product.

Over decades of application, multinational corporations and tax authorities have developed

common understandings of how the arm’s length principle should be applied in various

circumstances. The OECD observes that “experience under the arm’s length principle has

become sufficiently broad and sophisticated to establish a substantial body of common

understanding among the business community and tax administrations. This shared

understanding is of great practical value in achieving the objectives of securing the appropriate

tax base in each jurisdiction and avoiding double taxation.” While substantive concerns

regarding the administrability of the arm’s-length principle have been raised, the international

consensus reflected in the OECD’s recent Base Erosion and Profit Shifting (“BEPS”) initiative, in

which the United States has played a leading role, is that the best course of action going

forward is to attempt to build upon this “body of common understanding” by improving the

application of the arm’s-length standard to address these concerns. In fact, largely as a result of

the BEPS initiative, the arm’s-length standard has begun to evolve in a manner that targets the

elimination of global non-taxation of corporate income, along with the avoidance of double

taxation.

The Uncertain Effect of the BA’s Double Taxation on the Overall Corporate Tax Burden

Putting aside questions of whether the BA is consistent with international norms and treaties, a

pressing question at the moment is whether and how it will affect overall corporate taxes paid.

We can begin to understand this using a simple algebraic model that compares corporate taxes

under the existing system to corporate taxes given imposition of the BA.

We begin with some assumptions and definitions. First, in order to focus our analysis solely on

the impact of the BA on corporate tax burdens, we assume that cash flow and profit are the

same. That is, we isolate the effects of the DBCF’s BA from the impact of its proposal to move

11 See, for example, Article 7, Paragraph 2 of the 1996 US Model Tax Convention.

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from a tax on profits that are computed using accrual accounting concepts (e.g., matching of

capital depreciation with revenues) to a tax on cash flows (e.g., immediate deduction of capital

expenditures).12

Second, we initially abstract from three important questions related to the prices surrounding

imported goods: 1) whether the increased tax cost to shareholders stemming from the non-

deductibility of imports is passed on to customers (and if so, to what degree); 2) whether the tax

will be partially borne by the exporters from whom imports are purchased (and if so, to what

degree); and 3) whether the tax on imports and subsidy on exports is reflected in a more

expensive US dollar (dollar appreciation), and if so to what degree. Once we have modeled the

basics of the BA, we incorporate these considerations.

Third, our model considers US enterprises as having three divisions: a domestic division, an

export division, and an import division. We assume that cash flow statements can be

constructed for each, and refer to this process as “Divisionalization.”

As noted earlier, depending upon how Treasury Regulations are written, divisional cash flow

statements may or may not consolidate into a single divisional cash flow statement. That is, it

may be the case that Treasury Regulations embodying the BA will require separate computation

of the taxable cash flows of the firm’s export, import, and domestic divisions. It is plausible, for

example, that the destination-based features of the DBCF will be interpreted such that revenues

and costs attributable to US exports (i.e., all export activity) are deemed to constitute non-

recognized revenue and costs for tax purposes – that is, neither would factor into the

determination of US taxable cash flows. Alternatively, the Regulations could be written to

effectively adjust export revenue to zero while maintaining the ability to use the costs of the

labor, component, and capital inputs employed for exports as a “credit,” or deduction, against

the taxable cash flows reported by the import and domestic divisions.

The ability to employ an “export cost credit” therefore represents a key issue for the DBCF.13 In

an effort to draw attention to the importance of this issue, we model the BA with and without

the export credit.

We begin by defining variables. For each division (domestic, export, and import), these fall into

six standard economic categories: prices, quantities, variable costs per unit, fixed costs, capital

stocks, and rates of return.

12 The independent impact of the proposed immediate deductibility of capital expenditures may be significant in

many cases given the significant timing differences relative to current rules.

13 Importantly, we note that the ability to use export-related costs as a credit is equivalent to consolidation of the three

divisions for purposes of computing taxes due. We note also that the ability to use an “export cost credit” in this

manner could have additional implications. For example, firms that are net importers from a US perspective could

have material incentives to acquire firms that export more from the US market than they import, potentially leading

to large increases in the market values of such “net exporter” firms.

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PD = Quantity weighted average price of the domestic division’s products

QD = Quantity sold by the domestic division

PX = Quantity weighted average price of the export division’s products

QX = Quantity sold by the export division

PM = Quantity weighted average price of the import division’s products

QM = Quantity sold by the import division

a = Domestic division variable cost per unit

b = Fixed cost domestic division

c = Export division variable cost per unit

d = Fixed cost export division

e = Import division variable cost per unit

f = Fixed cost import division

RD = Economic rate of return on capital stock of domestic division14

KD = Capital stock of domestic division15

RX = Economic rate of return on capital stock of export division

KX = Capital stock of export division

RM = Economic rate of return on capital stock of import division

KM = Capital stock of import division

These variables allow us to form a simple version of the cash flow statements for each division.

These are as follows:

PDQD – aQD – b ≡ RDKD, or cash flow for the domestic division.

PXQX – cQX – d ≡ RXKX, or cash flow for the export division.

PMQM – eQM – f ≡ RMKM, or cash flow for the import division.

The above expressions are identities because the capital stock for each division is defined as

historical capital expenditures less economic depreciation. That is, cash revenues minus cash

costs is by definition equal to the firm’s realized internal rate of return on its in-service capital

investments (capital investments less economic depreciation) times its historical capital

investments depreciated using economic depreciation.16

14 This is the internal rate of return on the firm’s investments given that K is defined as capital expenditures less

economic depreciation.

15 Capital stock less economic depreciation.

16 Economic depreciation is the change in the present value of gross returns (operating profit before reinvestment) to

capital investments, using the internal rate of return as the discount rate.

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The Border Adjustment Given Export Loss Credit

The effect of the BA can be seen, under Divisionalization with an export loss credit, by

subtracting taxes but for adoption of the BA from taxes given adoption of the BA. The terms t

and ΔT stand for the tax rate and incremental taxes given adoption of the BA, respectively.

(1) ΔT = t(RDKD + RXKX – PXQX + RMKM + eQM) – t(RDKD + RXKX + RMKM).

Equations (2) and (3) then expand and simplify equation (1).

(2) ΔT = t(PDQD – aQD – b – cQX – d + PMQM – f) – t(PDQD – aQD – b + PXQX – cQX – d + PMQM – eQM – f).

(3) ΔT = t(eQM – PXQX).

Equation (3) tells us that the incremental tax paid after adoption of the BA, given

Divisionalization with an export division loss credit, is equal to the tax rate times the difference

between the value of imported goods and the value of exports. That is, firms whose import

costs are greater than their export revenue will experience a tax increase following adoption of

the BA, and vice-versa. As is intuitive, equation (3) also tells us that a credit on the export

division’s cash losses is far more attractive than Divisionalization without credit. Crediting

export losses means that the relative values of import and export shipments determine the effect

of the BA on total taxes paid.

Equation (3) implies that the condition, for each firm, under which the BA causes no

incremental tax is:

(4) ΔT = 0 → eQM = PXQX.

That is, the value of imports – i.e., their weighted average price times quantity – is equal to the

value of exports.

This, in turn, allows us to derive the following expression:

(5) QX = (e / PX)QM.

Equation (5) is provides a simple way of showing the effect of the BA – in both the short and

long runs – on corporate taxes paid. That is, equation (5) can be thought of as expressing the

quantity of exports required in order for incremental taxes to be zero given a firm with a

particular quantity of imports and a particular relative price ratio of imports to exports (i.e., its

terms of trade). The graph below shows this.

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Figure 1

Graphical Depiction of Required Export Quantity for a Firm with Imports of QM

Figure 1 shows a firm with imports of QM, a weighted average import price of e, and a weighted

average export price of PX. QX(A) in Figure 1 represents the firm’s actual exports, and QX the

level of exports needed in order for the firm’s tax burden to be unaffected by the BA. This

implies that the firm’s “Export Gap” – that is, the additional quantity of exports needed in order

for the firm to experience no increase in taxes as a result of the imposition of the BA – is equal to

QX – QX(A). Firms with positive Export Gaps will, all else equal, experience tax increases of

tPX(QX – QX(A)).

Figure 1 is intentionally drawn with an import price / export price ratio greater than 1, and a

ratio of imports to exports of roughly 3. The reason for this, as we show in Appendix C, is that

this ratio is consistent with the aggregate relationship between multinational firms’ related

party imports into the US and their US exports to affiliates. While the data available to us

provide only the relative values of MNC imports and exports (price times quantity), we know

from our own practice with large MNC clients that the slope (e / PX) and quantities shown are

Exports Qx

Required

For Zero = e / Px

Incremental

Tax (QX)

And Actual Qx

Exports (QX(A))

Export Gap

= Qx - Qx(A)

Qx(A)

QM

Actual Imports

QM

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consistent with the position of many large MNCs. That is, many MNCs have very large Export

Gaps.

Proponents of the BA argue that the it will ultimately have a muted impact on taxes – that is,

tPX(QX – QX(A)) will, on average and over the intermediate to long run, be small. Their argument

is that market adjustments will occur that will offset the incremental BA tax burden faced by US

companies. These include: 1) appreciation of the US dollar relative to the currencies of our

trading partners; and 2) increased exports and decreased imports. These effects are shown in

Figure 2.

Figure 2

Currency Changes and Changes in Import and Export Quantities: Effects on the Export Gap

Figure 2 shows a two-step, two market, response. First, there is a currency market response to

the Border Adjustment. That is, proponents and other commentators have argued that there

will be an appreciation in the US dollar. This, in turn, decreases the cost of imported products –

as shown by the change in slope of the terms of trade line from a ratio of (e / PX) to (Ɛ / KX),

where Ɛ is the new weighted average import price and KX is the new weighted average export

price. This currency market change has the effect of decreasing the export gap. Second, a goods

Exports Qx

Required

For Zero = e / Px

Incremental

Tax (QX) = Ɛ / Kx

And Actual Qx ①

Exports (QX(A))

Required Exports Decrease

As Dollar Appreciates

Qx(A)' Actual Imports Decrease

Qx(A) ② And Actual Exports Increase

QM' QM QM

Actual Imports

Final (Long Run)

Export Gap

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market response is shown, in which imports decline and exports rise. This, too, has the effect of

decreasing the export gap.

Other commentators have pointed out that a portion of the increase in the cost of imports, and a

portion of the decrease in the cost of exports, will be passed on to customers. It bears noting

here that this has the effect of muting the US dollar appreciation shown in Figure 2. That is, to

the extent that export cost decreases are passed on, the increase in demand for US dollars is

muted. Similarly, to the extent that import cost increases are passed on, the decrease in the

derived demand for imports (and therefore foreign currency) is muted.

Figures 1 and 2 also illuminate an important story about the variability and uncertainty of the

BA’s effect on corporations’ tax burden. In short, its effect is highly variable across firms, and

highly uncertain over time. First, firms can be thought of as differing according to their relative

import prices and quantities, and their relative export prices and quantities. To illustrate, if we

simplify by assuming prices and quantities are either “high” or “low,” firms can have high or

low import prices, high or low import quantities, high or low export prices, and high or low

export quantities – a total of 16 combinations.17 Second, firms differ according to their exposure

to different foreign exchange markets. In some cases, firms face foreign exchange markets that

float freely and quickly in response to trade flows, and in others they face markets that are

arguably manipulated or are more strongly influenced by monetary policies (interest rates) than

by trade flows. Third, firms differ in the demand elasticities that they face – both the

downstream elasticity of demand for resold imports or products with high import content, and

the elasticity of demand for exports. These relative elasticities differ across products and

markets, and determine the strength and direction of “step 2” in Figure 2 above.

Our own experience confirms this. Our firm’s clientele includes firms with high export prices

and quantities, coupled with low import prices and quantities; firms with “low-low” exports

and “high-high” imports; and every combination in between. Similarly, our clientele contains

firms whose treasury departments have very different views of the degree to which foreign

exchange responses are likely to occur in response to the BA (dependent largely on the

countries in which their related affiliates operate), and sales and procurement personnel with

divergent views of the degree to which they can or should pass on cost changes resulting from

the BA. Thus, our modeling of the BA’s effect, and the nature of the dynamics considered by

our clients, confirms that the economic uncertainty generated by the BA is extremely high.

17 In our experience, most US-based multinational firms fall into the “high-high” combination for imports and the

“low-low” combination for exports. That is, they have high weighted average import prices and high import

quantities, relative to their export prices and quantities. The reason for this is that, at present, most MNCs have a

large portion of the productive capital (physical and intellectual) that pertains to goods that they sell in the US

market located outside the US. Similarly, they locate a small portion of the productive capital pertaining foreign

markets in the US.

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One implication of this is that the BA is not simply a new feature of our tax policy. It is also

trade policy, given that trade policy can be defined as the set of government policies,

regulations, standards, and rules that directly affect international trade. Further, it is trade

policy that will affect all firms, rather than being confined to firms operating in markets that

protectionists care about. Finally, it is trade policy whose effect at the level of individual firms

is highly uncertain – involving numerous variables whose predictability, particularly taken

together, is low.

In light of this, we find statements such as “the BA is a very good deal,” and “the BA will not

affect trade because it will be offset by foreign exchange rate changes” puzzling. We would ask

in reply “how can you know?” Surely the variation across firms’ terms of trade, expected

foreign exchange rate changes, quantities of imports and exports, and various price elasticities,

together mean that the effect of the BA is less certain than the effects of other more traditional

and targeted forms of protectionist trade policy (i.e., tariffs). Yet, precisely because the BA is tax

policy rather than trade policy, this uncertainty would be placed on all firms.

The Border Adjustment Given No Export Loss Credit

As noted earlier, it is possible that Treasury Regulations related to the Border Adjustment will

not allow the deductions (labor, component, and capital costs) associated with the export

division to be taken against import-related cash flows. While the prevailing view is that this

credit will be allowed, some have commented that if economists who assert that foreign

exchange rate changes will offset the BA are assumed to be correct, then those whose

motivation for the BA is trade policy-related (i.e., protectionist) will have an incentive to

interpret the “destination-based” concept within the DBCF as liberally as possible. That is, they

will have an incentive to disallow the utilization of losses from the export division against the

now higher taxable cash flows of the import division.18

In addition, while these credits are incorporated in the analyses of publications from

proponents of the BA19, it is worth noting that the Blueprint neither endorses, nor mentions, the

availability of export credits. In fact, the Blueprint states that under the BA, “tax jurisdiction

follows the location of consumption rather than the location of production.”20 If interpreted

strictly, this language could be construed as implying that under the BA the US government

would not have taxing rights for US firms’ export operations, since they would fall outside of

the scope of jurisdiction defined by the destination-based framework. In traditional source-

based territorial taxation systems, governments do not maintain taxing rights for the profits

18 We also note that the ability to use an “export cost credit” in the manner assumed in the prior section could have

additional implications. For example, firms that are net importers from a US perspective could have material

incentives to acquire firms that export more from the US market than they import, potentially leading to large

increases in the market values of such “net exporter” firms. 19 For example, see Auerbach, A. and Holtz-Eakin, “The Role of Border Adjustments in International Taxation”,

American Action Forum, November 30, 2016 20 Tax Reform Tax Force Blueprint, “A Better Way”, p. 27.

14

reported by multinationals’ foreign affiliates, since they fall outside of the defined territory of

taxation rights. The profits (or cash flows) of US firms’ export activities would similarly seem to

fall outside of the defined US taxation territory as defined by the destination-based framework

outlined in the Blueprint.

If so, the model given above changes in the following way. Once again the effect of the BA can

be seen by subtracting taxes but for adoption of the BA from taxes given adoption of the BA.

This leads to a modified version of equation (1)

(6) ΔT = t(RDKD + 0 + RMKM + eQM) – t(RDKD + RXKX + RMKM).

The first bracketed set of terms on the right hand side of equation (6) is taxes paid given

adoption of the BA. This says that tax under the BA is equal to the tax rate times domestic cash

flow, plus the tax rate times zero for the export division given that no credit is available for

domestic division losses, plus the tax rate times cash flow for the import division, plus the value

of imports.21 The second set of terms on the right hand side is simply taxes paid but for

adoption of the BA.

As earlier, equations (7) and (8) expand and then simplify equation (6).

(7) ΔT = t(PDQD – aQD – b + PMQM – f) – t(PDQD – aQD – b + PXQX – cQX – d + PMQM – eQM – f).

(8) ΔT = t(eQM – RXKX).

Equation (8) tells us that the incremental tax paid after adoption of the BA, given no export

division loss credit, is equal to the tax rate times the difference between the value of imported

goods and the cash flow on exports.

It is obvious from equation (8) that disallowance of the export losses (no export loss credit)

would give rise to a much steeper “required exports” line than that shown in Figure 1, all else

equal. This can be seen as follows.

First, equation (8) tells us that, absent the export loss credit, the condition that must be satisfied

in order for incremental taxes to be zero is:

(9) ΔT = 0 → eQM = RXKX.

That is, the value of imports – i.e., their weighted average price times quantity – must be equal

to the cash profit earned on exports. We can express export cash profit per unit as ПX = RXKX / QX,

implying:

(10) ΔT = 0 → eQM = ПXQX.

This in turn gives us the slope of the required exports line as before:

21 With respect to imports from controlled affiliates, the value of imports represents the transfer price.

15

(11) QX = (e / ПX)QM.

All else equal, equation (11) will have a much steeper slope than equation (5). This is because

the quantity weighted average profit per unit of exports will always be lower than the weighted

average price per unit of exports. This is shown in Figure 3, wherein the green line represents

equation (11) and the blue line equation (5) as before. As shown, all else equal the export gap

will be higher for, all firms, given no export loss credit.

16

Figure 3

Export Loss Credit versus No Export Loss Credit

Exports Qx

Required

For Zero = e / Пx

Incremental

Tax (QX)

And Actual Qx

Exports (QX(A))

= e / PX

Export Gap = Qx - Qx(A)

Qx(A)

QM

Actual Imports

QM

17

The following table illustrates this, using a hypothetical example of a multinational with

domestic, import, and export activities in the US market. The example given assumes that the

revenues received by the multinational from end-customers for each of these three segments are

equal. For simplicity, the rate of return on capital realized by the firm is also assumed to be

consistent across these segments. Lines 7 and 8 present the derivation of taxes payable by the

firm under the current tax regime (as governed by international treaties to which the US is

party) assuming a 35 percent tax rate. Lines 9 and 10 present the firm’s taxes assuming the

implementation of the BA by the US given Divisionalization and no export loss credit. As

shown, the tax base for the Import division under the BA is higher than the current regime by

the value of imports, which are non-deductible under the proposal. The Export division is not

taxed under the BA, and thus the tax faced by the firm is lower on these activities under the

current regime.

Line 11 derives the difference between the total taxes due under the current and BA regimes (an

increase of $24 in our example). In Line 12, we compute the same value using the formula

presented in Equation (8) above. Thus, ΔT = t(eQM – RXKX) = tax rate (value of imports – cash

flow of exports) = 0.35(76-7) = 24.

Table 1

Hypothetical Example: Impact on Corporate Tax Burden from Implementation of the BA

Equation (8) demonstrates that, given Divisionalization without credit, firms whose import

costs are greater than their export profits (cash flows) will experience a tax increase following

Line Item Domestic Imports Exports Total

1 Revenue 100 100 100

2 COGS 73 76 88

3 Op Expenses 18 22 5

4 Business Profit 9 2 7

5 Capital 88 22 70

6 Return on Capital (Line 4 / Line 5) 10% 10% 10%

Current Tax Regime

7 Taxable Flows 9 2 7

8 Tax (Line 7 * 35%) 3 1 2 6

Border Adjustment

9 Taxable Flows 9 78 0

10 Tax (Line 9 * 35%) 3 27 0 30

11 Difference (Line 10 - Line 8) 24

12 Difference Using Equation (8) [Imports - Export profits]*35% 24

18

the adoption of the BA by the US, and vice-versa. This is consistent with the notion expressed

in some of the commentary on the BA – specifically, that multinationals, being on the average

very large net importers, can be expected to experience a material tax increase from the

unilateral implementation of the BA by the US. Importantly, however, Equation (8) tells us that

without an export loss credit many US firms that are not net importers will still experience an

increased tax burden. In the hypothetical example above, the third party sales of imported

product is equal to that of exports, and overall taxes under the BA are still roughly 5 times

higher than under the current regime.

Appendix A provides a set of results for MNCs given a version of the BA without an export loss

credit. These show that under reasonable assumptions, multinationals whose export flows from

the US are well more than double that of their US imports would still realize a material increase

in their overall tax burden as a result of the implementation of the BA. The models in Appendix

A also show that if we assume that rights to all intellectual property employed in cross border

transactions are owned in the jurisdiction of the products’ destination,22 even multinationals

whose revenues from US exports are more than seven times higher than their revenues from US

imports will still bear an overall tax increase from the BA.

As referenced above, however, the value of multinationals’ US affiliate imports (i.e. imports

procured by US affiliates from their non-US affiliates) has consistently been much larger than

the value of these US affiliates’ exports to non-US affiliates. As summarized in Appendix C,

data compiled by the US Census Bureau from customs filings on US related party imports and

exports demonstrate that the aggregate value of US imports from affiliates is generally just

under three times as large as the value of US exports to affiliates. For example, in 2013 related

party imports into the US market were approximately $1.1 trillion while the value of exports

made by US entities to foreign affiliates was about $390 billion. By employing the same

assumptions presented in Table 1 above, but changing the relative scale of import and export

flows to reflect the actual aggregate relationship between related party imports and exports, we

also show in Appendix A that the tax burden realized by the hypothetical firm increases to a

level that is approximately 11 times higher than under the current regime.

The Possibility of Tax Policy Retaliation

The potentially very high incremental tax burden generated by the BA may indeed provide

sufficient incentives for firms to relocate some of their foreign manufacturing operations to the

22 As discussed further in a subsequent section of this paper, the BA may provide clear incentives for the migration of

intellectual property rights for products and services traded in cross border transactions to destination jurisdictions.

Cash flow realized on export transactions (which are not taxed under the BA) can be expected to be materially lower

in cases where the importer rather than the exporter owns the intellectual property rights, minimizing the tax benefit

realized from the DB’s treatment of export flows.

19

US.23 However, the unilateral imposition of the Blueprint by the United States would also

create an inconsistency between US tax policy and the terms of existing treaties. It seems

reasonable to believe that foreign governments may be motivated to address both the double

taxation borne by exporting multinationals based in their jurisdictions, as well as the non-

taxation of exports from the US.

One means that foreign governments could employ to address these concerns is to enact their

own version of the BA. In fact, leaders from a number of countries including China have

already threatened to retaliate if the US implements policies deemed to be protectionist in

nature.24

If foreign trading partners decide to implement regulations with similar provisions to the BA,

one can conceive of an eventual result that we refer to as a “BA Equilibrium.” In a BA

Equilibrium all major trading partners subsidize exports and penalize imports through border

adjustments. Assuming that all countries adopting a BA adjust import and export prices to

zero, a company’s effective tax rate will equal the weighted average of the corporate tax rates in

each country in which it has import and domestic operations, weighted by the cash flows

earned by these operations (net of any applicable credits for the export division’s losses).

The ultimate impact of this on the corporate tax burden would depend on whether net

importing and large domestic market countries have higher or lower tax rates than net

exporting and small market countries. If net import and large domestic market countries have

higher corporate tax rates than net export and small domestic market countries, corporate

effective tax rates will rise. It bears noting here that the US has the largest domestic market, is a

very large net importer, and has one of the highest corporate tax rates.

Putting tax rate differentials aside (that is, assuming tax rates are the same across jurisdictions

for purposes of isolating the impact of the BA on firms’ tax burdens), firms’ tax burdens will not

be impacted by their respective balances of imports into and exports from the US. This will be

the case both in scenarios where an export credit is available and in scenarios where it is not.

However, the availability of the export credit is enormously important to firms’ tax burdens in a

BA Equilibrium. If an export credit is available, the BA will not have any impact on the overall

23 The Blueprint does not explicitly present the on-shoring of foreign manufacturing operations as a benefit of the

DBCF policy. Rather it states that the policy will eliminate incentives for inversions and will allow firms to “make

location decisions based on the economic opportunities, not the tax consequences”.

24 See, for example, McDonald, J, “China is preparing to retaliate against Donald Trump’s tough trade stance, warns

American Chamber of Commerce”, Financial Post, 18 January 2017,

http://business.financialpost.com/news/economy/china-is-preparing-to-retaliate-against-donald-trumps-tough-trade-

stance-warns-american-chamber-of-commerce. The Wall Street Journal recently speculated that this retaliation could

take the form of similar border adjustment taxes (Rubin. R., “Trump Tax Idea for Wall Echoes House GOP Plan”,

Wall Street Journal, 26 January 2017, http://www.wsj.com/articles/white-house-says-tax-on-mexican-imports-could-

pay-for-border-wall-1485463326?mod=trending_now_4

http://business.financialpost.com/news/economy/china-is-preparing-to-retaliate-against-donald-trumps-tough-trade-stance-warns-american-chamber-of-commerce

http://business.financialpost.com/news/economy/china-is-preparing-to-retaliate-against-donald-trumps-tough-trade-stance-warns-american-chamber-of-commerce

http://www.wsj.com/articles/white-house-says-tax-on-mexican-imports-could-pay-for-border-wall-1485463326?mod=trending_now_4

http://www.wsj.com/articles/white-house-says-tax-on-mexican-imports-could-pay-for-border-wall-1485463326?mod=trending_now_4

20

tax burden relative to the current tax regime.25 This is because the penalties assessed with

respect to imports in one jurisdiction are effectively offset by the use of exports as a credit in the

other jurisdiction (assuming the same transfer price is respected for a given transaction in both

jurisdictions).

However, in a scenario where an export credit is not available, the tax burden for all firms

engaged in material degrees of international commerce will likely be extremely high. As

demonstrated in Appendix B, under these circumstances the tax burden will vary based upon

two factors: 1) the consolidated operating cash flow margin realized by the firm with respect to

cross border transactions; and 2) the magnitude of the importing affiliate’s operating expenses

relative to revenues which, under the BA, can be deducted in the destination market. All else

equal, non-deductible prices paid for foreign inputs by importers will represent a lower share of

revenue and business profits for firms with higher consolidated profit margins for a given cross

border transaction, which reduces the impact of the resulting double taxation on imports.

Higher levels of value added contributions in the destination market associated with import

activities can also generally be expected to lead to reductions in tax burden under the BA, in

contrast to transactions where most value added is performed by the exporter (which leads to

relatively higher non-deductible prices for imports). Appendix B presents analyses which

demonstrate the potential for an extremely high tax burden under a BA Equilibrium without

export credit and how this burden varies given the levels of the two variables defined above.

Exchange Rate Adjustments as a Potential Offset to the Tax Increase

As referenced above, some proponents of the BA have argued that the impact of tax increases

described above are unlikely to impact the dollar value of trade balances because the BA will

cause the US dollar to appreciate in response to increased US exports and decreased US

imports. That is, exchange rate (i.e., price) movements will offset the change in net exports (i.e.,

quantity).

While this argument is not necessarily inconsistent with exchange rate theory, we are not

entirely convinced by it. There are several reasons for this.

First, the arguments in favor of this offsetting exchange rate movement have not been entirely

clear. That is, proponents of the exchange rate offset argument have not been clear as to

whether they are arguing that exchange rates will immediately adjust in anticipation of increased

net exports, or that they would adjust ex post in response to actual trade patterns (increased net

exports).

25 This assumes identical tax rates in each jurisdiction. As mentioned, if tax rates differ, the BA with credit will give

rise to an effective tax rate equal to the weighted average tax rate weighted average of the corporate tax rates in each

country in which it has import and domestic operations, weighted by the cash flows earned by these operations (net

of any applicable credits for the export division’s losses).

21

The argument that exchange rates will fully adjust ex ante, and thus the pattern of trade will be

unaffected, assumes that the BA’s effect on trade flows can be inferred by the market. Knowing

firsthand the complexity of large MNC’s trade patterns and tax structures, we believe that this

is highly unlikely.

Alternatively, if the argument is that exchange rates will adjust after a change in net exports has

been induced by the BA, we find it even less appealing. This argument is effectively saying that

the BA is protectionist, and not protectionist, at the same time. That is, it is saying that the BA

will first cause the pain of high effective tax rates for importers, this will then change trade

patterns (increase net exports), and this change in trade patterns cause dollar appreciation that

will alleviate the pain of higher effective tax rates. This seems to us to be a sort of intellectual

sleight of hand – someone must bear the cost of tax-induced changes in trade patterns, or there

would be no change in trade patterns.

We note finally that exchange rates are not well behaved, and their movement is not fully

understood by economists. We do know that exchange rate movements are strongly influenced

not only by the supply and demand of exports and imports (i.e., a country’s net exports), but

also by monetary policy and other factors that economists have not been able to reliably

identify. As a result, it is by no means certain that US dollar appreciation will readjust the BA –

ex ante or ex post.26

On the Importance of Transfer Pricing Under the Border Adjustment

Proponents of the BA have also argued that one of its merits is that it decreases the importance

of intercompany transfer prices for multinational firms. That is, because the transfer prices of

imports from, and exports to, controlled foreign affiliates are adjusted to zero, the BA eliminates

or decreases the incentives to manipulate transfer prices.

This argument is true only in a superficial sense. It is true that the transfer prices for imports

and exports are adjusted to zero – that is, they are always equal to zero when deriving the

taxable cash flows of a US taxpayer. However, because the BA causes double taxation of

imports and non-taxation of exports, the transfer price is the measure of import double-taxation

and a primary determinant of the level of export non-taxation. This simple fact creates a

number of incentives related to intercompany transfer pricing. Assuming the availability of an

26 For example, Rogoff indicates that “The extent to which monetary models (or, indeed, any existing structural

models of exchange rates) fail to explain even medium-term volatility is difficult to overstate. The out-of-sample

forecasting performance of the models is so mediocre that at horizons of one month to two years they fail to

outperform a naïve random walk model.” (Rogoff, K, “Perspectives on Exchange Rate Volatility”, International Capital

Flows, 441-453. Chicago: University of Chicago Press and NBER, 1999, 441-453). A Goldman Sachs research report

titled “What Would the Transition to Destination-Based Taxation Look Like?” on December 8, 2016 also expresses

significant skepticism regarding the extent to which exchange rate adjustments will offset trade distortions resulting

from the BA. http://www.usfashionindustry.com/pdf_files/Goldman-Sachs-Destination-Tax-Report.pdf

http://www.usfashionindustry.com/pdf_files/Goldman-Sachs-Destination-Tax-Report.pdf

22

export credit and that the BA is applied unilaterally by the US, transfer prices remain central to

the determination of multinationals’ tax burdens. Consequently, under these circumstances

multinationals will have a strong incentive to migrate any intangible property to the US market

that pertains to imported goods to the United States from foreign affiliates. This will have the

effect of lowering import prices. Equation (3) shows us the advantage of these transfer price

amendments. Multinationals will also have a strong incentive under these circumstances to

locate intangible property ownership rights for US exports in the US market, since this will have

the effect of increasing the value of non-taxed export revenues.

Under Divisionalization with no export loss credit, there will be a strong incentive, all else

equal, to shift costs from the export cash flow statement to the import and domestic divisions’

cash flow statements. In addition, the incentives present under a scenario with available export

credits with respect to the domestication of intangible property rights for US imports would

also apply in this scenario. Only under the “BA Equilibrium” scenario where both the US and

its trading partners adopt BA policies is the importance of transfer pricing truly eliminated.

Conclusion

This paper has demonstrated that the adoption of the BA by the US will cause both double

taxation of import flows and non-taxation of export flows. This is inconsistent with the

principles of international tax treaties currently in place.

Our analysis demonstrates that the BA will give rise to a significant and highly variable

increase, across firms and over time, in the overall corporate tax burden. This increased burden

will be pronounced for firms whose imports into the US exceed their US exports. However, we

show that if losses in firms’ export divisions are not credited against positive cash flow in their

import divisions, the BA will cause a tax increase even for those firms whose US exports

materially exceed the scale of their imports into the US.

Because the BA is essentially trade policy effected through tax policy, it is conceivable that other

countries will adopt similar tax policies – tantamount to trade retaliation. We show that if all

countries adopted a BA and adjusted import and export prices to zero, a company’s effective tax

rate will equal the weighted average of the corporate tax rates in each country in which it has

import and domestic operations, weighted by the cash flows earned by these operations (net of

any applicable credits for the export division’s losses). If no export loss credits are available in a

BA equilibrium, even in some countries, general adoption of a border adjustment will give rise

to very high effective tax rates.

Separately, we demonstrate that transfer pricing considerations will remain relevant under the

BA, contrary to assertions made by some. We also express skepticism in the argument that

exchange rate adjustments will offset the effects of the BA on import intensive businesses.

23

Appendix A: Derivation of Various Results Under BA with No Export Loss Credit

In this appendix, we expand our analysis of the conditions under which MNCs’ overall tax

burdens will be unchanged given adoption of the BA with no export loss credit.27 This

discussion assumes a set of transactions involving a US distributor of imports from a foreign

affiliate (the import division), and a US manufacturer exporting to a foreign affiliate (the export

division).28

We begin with Equation (8) introduced in the body of the paper:

ΔT = t(eQM – RXKX).

Next, we rearrange the equation to derive the following condition whereby the change in tax

burden is zero:

eQM = RXKX.

Next we employ equations that present the value of imports, the cash flow of exports, and other

key terms as percentages of revenue. This allows us to think in terms of profit and cost margins

when solving for the relationship between exports and imports in the no incremental tax

condition.

We define the following variables:

SI = Third party revenues for imported products

SE = Third party revenues for exported products

OE%D = Distributor expenses as % of revenues OM%C = Consolidated operating margin (with respect to subject transaction)

MD = Markup for routine distribution functions MM = Markup for routine manufacturing functions

Below, we use these variables to derive the value of imports. We present two alternative

formulas for this computation. Both formulas assume, as is commonly the case, that intellectual

property rights (“IP”) give rise to any rents in the consolidated MNC system. The first formula

assumes that such IP is owned in the country of destination for the product. The second

assumes that the intellectual property rights for the exports are owned by the US exporter.

Alternative 1: IP Ownership in Destination Country

Value of Imports = [Revenues] – [US Distributor Expenses] – [US Distributor Profit]

Value of Imports = [SI] − [OE%DSI] − [(OM%CSI) − (SI − OM%CSI − OE%DSI)MM]

27 As with other analyses in this study, this analysis examines the impact only of the BA as defined above, as opposed

to other components of the Blueprint such as the reduction in the statutory tax rate and the expensing of capital

expenditures.

28 We assume away intermediate transactions with third parties.

24

Alternative 2: IP Ownership in Source Country

Value of Imports = [Revenues] – [US Distributor Expenses] – [US Distributor Profit]

Value of Imports = [SI] − [OE%DSI] − [OE%DSIMD]

We can now use these same variables to derive the cash flow of exports. Again we present two

alternative formulas.

Alternative 1: IP Ownership in Destination Country

Cash Flow of Exports = [US Value − Added Cost of Exports29] ∗ [Markup]

Cash Flow of Exports = [SE − SEOM%C − SEOE%D][MM]

Since in this formula we assume that the IP ownership is in the destination country, the profits

for the US exporter are derived by applying a routine return on value-added expenses incurred

(akin to the cost of capital applied to the economically depreciated capital investments).

Alternative 2: IP Ownership in Source Country

Cash Flow of Exports = [Consolidated Profits] − [Non − US Distribution Profits]

Cash Flow of Exports = [SEOM%C] − [SEOE%DMD]

In Alternative 2, given that the IP ownership is in the source country, the export cash flow

incorporates a return to this intellectual property.

Next, we combine the above equations such that the value of imports is equal to the cash flow of

exports, beginning with Alternative 1.

[SI]– [OE%DSI]– [(OM%CSI) − ((SI − OM%CSI − OE%DSI)MM)] = [SE − SEOM%C– SEOE%D][MM].

Rearranged, this gives us:

𝐒𝐄 =[𝐒𝐈]−[𝐎𝐄%𝐃𝐒𝐈]−[(𝐎𝐌%𝐂𝐒𝐈)−((𝐒𝐈−𝐎𝐌%𝐂𝐒𝐈−𝐎𝐄%𝐃𝐒𝐈)𝐌𝐌]

𝐌𝐌−𝐌𝐌𝐎𝐌%𝐂−𝐌𝐌𝐎𝐄%𝐃.

Similarly, for Alternative 2:

[SI] − [OE%DSI] − [(OE%DSI)(MD)] = [SEOM%C] − [SEOE%DMD]

Which yields:

𝐒𝐄 =[𝐒𝐈]−[𝐎𝐄%𝐃𝐒𝐈]−[(𝐎𝐄%𝐃𝐒𝐈)𝐌𝐃]

𝐎𝐌%𝐂𝐎𝐄%𝐃𝐌𝐃.

The ratio of SE relative to SI as derived above represents the relative scale of the value of third

party sales of exported products to third party sales of imported products which generates no

change in tax burden for a given MNC. As presented below, the ratio varies depending on

29 Used as a proxy for capital employed for purposes of this example.

25

which of the two alternatives is employed (i.e., where IP is held). With the use of Alternative 2

(which assumes that IP rights are held by the exporter, as opposed to the importer), the ratio

varies depending on both the consolidated operating profitability of the cross border

transaction and the level of the importer’s deductible expenses relative to sales.

The following table shows that, given reasonable assumptions for these two inputs, we derive

ratios where exports exceed imports by factors of between roughly 2.5 and 5.0. Thus, even

companies whose exports are more than double their imports will see a significant increase in

their overall tax burden under the BA, if no export loss credit is provided.

Table A-1

Ratio of Third Party Revenues of Exports Relative to Import Revenues

At Which the Aggregate Impact of the BA is Zero (IP Owned by Exporter)

However, when we assume that the IP rights are owned by the importer, the ratio is not

affected by variations in the consolidated operating profitability of the cross border transaction

or the level of the importer’s deductible expenses relative to sales. Given this, under the

assumption that IP rights are held in the destination jurisdiction and using the same parameter

assumptions used to derive Table A-1, we find that if IP rights are owned in the destination

country (i.e., by the importer) firms must have export revenues approximately 7.7 times higher

than imports for the BA to result in no increase in the overall tax burden.

But this ratio of seven to one in terms of exports relative to imports is far from the average ratio

for multinationals’ activities with respect to the US market. Aggregate US import value from

affiliates is in fact approximately three times the aggregate value of US exports sold to affiliates.

Given this, the following table illustrates a scenario in which the hypothetical example

presented in Table 1 of the body of the report is adjusted so that imports are three times higher

than exports.

Importer Deductions Consolidated Operating Margin

as% of Sales 20% 30%

10% 4.9 3.1

30% 4.6 2.7

26

Table A-2

Example Using Actual Ratio of Aggregate US Related Party Imports and Exports

We see that for a US company whose trade balance mirrors the aggregate US ratio of exports to

imports, the implementation of the BA will increase the firm’s overall tax burden to a level that

is approximately 11 times higher than under the current regime, if no export loss credit is given.

Row Item Domestic Imports Exports Total

a Revenue 100 300 100

b COGS 73 227 88

c Op Expenses 18 66 5

d=a-b-c Business Profit 9 7 7

e Capital 88 66 70

f=d/e Return on Capital 10% 10% 10%

Current Tax Regime

g=d Taxable Flows 9 7 7

h=g*35% Tax (@35%) 3 2 2 8

Border Adjustment

i=d+imports Taxable Flows 9 234 0

j=i*35% Tax (@35%) 3 82 0 85

k=j/h Tax Burden Increase Factor 10.8

27

Appendix B: Derivation of Various Results in BA Equilibrium

As discussed in the body of this paper, we consider a scenario where foreign trading partners

decide to implement regulations with similar provisions to the BA, i.e. a “BA Equilibrium” and

where the “export credit” discussed in the body of the paper is not available. In a BA

Equilibrium all major trading partners subsidize exports and penalize imports through border

adjustments. As explained in the paper, the ratio of US exports to imports has no impact on the

overall tax burden of a multinational under BA Equilibrium.

The following table presents a summary of the results of our modeling exercise. This exercise

relied on two primary assumptions: 1) consistent with the incentives resulting from the BA,

discussed later in this paper, we assume that the ownership of intellectual property employed

for cross border transactions is owned in the destination market; and 2) in order to isolate the

impact on the tax burden of the BA we assume that tax rates in all jurisdictions are the same.

The results, presented in Table B-1 below, correspond to alternative assumptions for

consolidated operating profitability and the magnitude of importers’ deductions relative to

revenues. As presented, our results indicate that multinationals’ overall tax burden on cross

border activity will increase by between 56 percent and 1,800 percent depending upon

variations in the two identified inputs. The modeling in support of these results again assumes

no export loss credit, and is provided in Appendix B.

Table B-1

Increase in MNC Tax Burden Resulting from BA Equilibrium

Given Different Cross Border Profitability and Importer Value Added Activity

Below, we present the computations used to derive the results presented in Table B-1. Rather

than presenting support for each value presented, we present our computations for the

minimum resulting value, an intermediate resulting value, and the maximum resulting value.

Importer Deductions Consolidated Operating Margin

as% of Sales 5% 15% 30% 45%

5% 1800% 533% 217% 111%

15% 1600% 467% 183% 89%

30% 1300% 367% 133% 56%

Summary of U.S. Census Data

28

Table B-1

BA Equilibrium Results: 45% Consolidated Operating Margin, Importer Costs 30% of Sales

Inbound Flows Outbound Flows Domestically Produced Consolidated Cross-Border Inputs

Exports from Trading Partner to US Exports from US to Trading Partner and Sold Product Operations A Total Exports 100

Taxing Jurisdiction: Non-US US Total US Non-US Total US Total Total

Legal Entity Function: Exporter Importer (after elims) Exporter Importer (after elims) Relative Transaction Flows

Line Column: 1 2 3 4 5 6 7 8 9 B Imports as % of Total Sales 10%

Base Financials C Exports as % of Total Sales 77%

1 Revenues See Note 1 13.0 13.0 100.0 100.0 17.4 130.4 113.0 D Domestic as % of Total Sales 13%

2 Direct Operating Costs See Note 2 3.3 3.9 7.2 25.0 30.0 55.0 9.6 71.7 62.2 E Ratio of Imports to Exports 0.13

F Ratio of Domestic to Imports 1.33

Transfer Prices and Profit

Current Regime & Blueprint Operating Results

3 I/C Payment = (Line 2) + (Line 4) 3.8 (3.8) 0.0 28.8 (28.8) 0.0 0.0 0.0 0.0 G Consolidated OM 45%

4 Business Profit = (Line 2)*(Input B) 0.5 5.4 5.9 3.8 41.3 45.0 7.8 58.7 50.9 H Importer Costs as % of Sales 30%

Taxation Transfer Pricing

Current Regime I Cost Plus (routine manufacturer) 15%

5 Tax Base = (Line 4) 0.5 5.4 5.9 3.8 41.3 45.0 7.8 58.7 50.9 J Berry Ratio (routine distributor) 1.2

6 Tax = (Line 5)*(Input K or L) 0.2 1.9 2.1 1.3 14.4 15.8 2.7 20.5 17.8

7 Tax as % of Business Profit = (Line 6) / (Line 4) 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 0.4 Statutory Tax Rate

K US Tax Rate 35%

Blueprint (Unilateral) L Non-US Tax Rate 35%

8 Tax Base See Note 3 0.5 9.1 9.6 0.0 41.3 41.3 7.8 58.7 50.9


10 Tax as % of Business Profit = (Line 9) / (Line 4) 0.4 0.6 0.6 0.0 0.4 0.3 0.4 0.4 0.4 Difference in Tax Burden (Unilateral vs Current)

= Column 9, (Line 10) - (Line 7) 0%

Blueprint (Equilibrium)

11 Tax Base See Note 4 0.0 9.1 9.1 0.0 70.0 70.0 7.8 87.0 79.1

12 Tax = (Line 11)*(Input K or L) 0.0 3.2 3.2 0.0 24.5 24.5 2.7 30.4 27.7 Difference in Tax Burden (Equilibrium vs. Unilateral)

13 Tax as % of Business Profit = (Line 12) / (Line 4) 0.0 0.6 0.5 0.0 0.6 0.5 0.4 0.5 0.5 = Column 9, (Line 13) / (Line 10) 56%

Notes:

1) Column 6 of Line 1 is equal to Input A. The remainder of the items in Line 1 are derived from Column 6 using Inputs E and F.

2) The Direct Operating Costs are inferred from the Revenues in Line 1 using Inputs G and H.

3) In the Unilateral Blueprint scenario, the Tax Base is derived in 3 different ways. The Non-US Exporter, Non-US Importer, and Domestic Tax Base all equal Business Profit; the US Importer Tax Base

equals Revenues less Direct Operating Costs; and the US Exporter Tax Base equals 0 (since export revenue is untaxed under the BA).

4) In the Equilibrium Blueprint scenario, the Tax Base for the US Importer, the US Exporter, and the Domestic remain the same as in the Unilateral scenario, but the Tax Base for the Non-US Exporter

goes to zero, and the Tax Base for the Non-US Importer is equal to Revenues less Direct Operating Costs.

29

Table B-2














4 Business Profit = (Line 2)*(Input B) 1.1 2.8 3.9 8.3 21.8 30.0 5.2 39.1 33.9 H Importer Costs as % of Sales 15%



5 Tax Base = (Line 4) 1.1 2.8 3.9 8.3 21.8 30.0 5.2 39.1 33.9 J Berry Ratio (routine distributor) 1.2



K US Tax Rate 35%


8 Tax Base See Note 3 1.1 11.1 12.2 0.0 21.8 21.8 5.2 39.1 33.9


10 Tax as % of Business Profit = (Line 9) / (Line 4) 0.4 1.4 1.1 0.0 0.4 0.3 0.4 0.4 0.4 Difference in Tax Burden (Unilateral vs Current)



11 Tax Base See Note 4 0.0 11.1 11.1 0.0 85.0 85.0 5.2 101.3 96.1


13 Tax as % of Business Profit = (Line 12) / (Line 4) 0.0 1.4 1.0 0.0 1.4 1.0 0.4 0.9 1.0 = Column 9, (Line 13) / (Line 10) 183%

Notes:







30

Table B-3














4 Business Profit = (Line 2)*(Input B) 1.8 (1.1) 0.7 13.5 (8.5) 5.0 0.9 6.5 5.7 H Importer Costs as % of Sales 5%



5 Tax Base = (Line 4) 1.8 (1.1) 0.7 13.5 (8.5) 5.0 0.9 6.5 5.7 J Berry Ratio (routine distributor) 1.2

6 Tax = (Line 5)*(Input K or L) 0.6 (0.4) 0.2 4.7 (3.0) 1.8 0.3 2.3 2.0


K US Tax Rate 35%


8 Tax Base See Note 3 1.8 12.4 14.2 0.0 (8.5) (8.5) 0.9 6.5 5.7

9 Tax = (Line 8)*(Input K or L) 0.6 4.3 5.0 0.0 (3.0) (3.0) 0.3 2.3 2.0

10 Tax as % of Business Profit = (Line 9) / (Line 4) 0.4 (3.9) 7.6 0.0 0.4 (0.6) 0.4 0.4 0.4 Difference in Tax Burden (Unilateral vs Current)



11 Tax Base See Note 4 0.0 12.4 12.4 0.0 95.0 95.0 0.9 108.3 107.4


13 Tax as % of Business Profit = (Line 12) / (Line 4) 0.0 (3.9) 6.7 0.0 (3.9) 6.7 0.4 5.8 6.7 = Column 9, (Line 13) / (Line 10) 1800%

Notes:







31

Appendix C: Relative Values of U.S. Related Party Imports and Exports

Table C-1

Summary of U.S. Census Bureau Data (millions of USD)

Year US "Related Party"

Imports

US "Related Party"

Exports

US Related Party Imports

Relative to Exports

(a) (b) (c=a/b)

2009 740,481 261,332 2.8

2010 922,202 314,489 2.9

2011 1,056,215 365,014 2.9

2012 1,131,902 381,695 3

2013 1,122,570 390,896 2.9

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