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The blueprint for a border-adjustment tax

By Dennis Nerland

The current incentive for multinational corporations with U.S. and Canadian operations is to shift income out of the U.S. corporate tax environment, where the highest marginal federal tax rate currently equals 35 per cent, to an affiliated Canadian corporation, which is generally subject to lower tax. This way, multinationals and their shareholders generally pay a lower effective tax rate than they would otherwise pay if pure business decisions (free from the shackles of tax) steered the helm of the corporate ship.

The methods for income shifting vary from standard, vanilla transactions — such as Canadian-based manufacturing — to exotic transactions — such as inversions — yet the goal remains the same: reduce effective tax rates so that corporations and shareholders have more capital to fund corporate operations and pay dividends. But this incentive could drastically change if the House Republicans’ tax reform plan is adopted.

On June 24, 2016, the House Republicans published a blueprint for U.S. tax reform. The blueprint proposes a fundamental reconstruction of the U.S. corporate tax regime, including reducing the corporate tax from 35 per cent to 20 per cent and a border-adjustment tax. The latter would essentially transform the corporate tax into a destination-based, cash-flow tax resembling a territorial tax system. The blueprint doesn’t fully explain the details — rather it serves as an introduction to the concepts and will likely undergo organic changes if it becomes law.

Based on the blueprint, the current incentive to push corporate profits to Canada (or other lower tax jurisdictions) would be flipped upside down, encouraging multinationals to shift profits (and possibly business operations) to the U.S. because U.S. corporations would not generally get to take the amounts paid for goods or services into account for U.S. tax purposes.

For example, take a Canadian parent company (subject to Alberta corporate tax) that supplies $90 worth of goods to its wholly-owned U.S. subsidiary. The goods are ultimately resold to U.S. consumers for $100. Under the proposed border-adjustment tax, the subsidiary pays U.S. tax on $100 of income, and doesn’t get credit for the $90 paid to its parent, and the parent pays Canadian tax on income of $90. If the highest marginal tax rates and no state taxes apply, the U.S. subsidiary pays $20 of tax and the Canadian parent pays $24.30 of tax ($44.30 total), and the same $90 is subject to tax in both jurisdictions. Thus, the parent is better off if it charges as little as possible to its subsidiary to lower the overall taxes paid by both corporations. Alternatively, if the subsidiary supplies goods to the parent, there is no U.S. tax on the $90 paid to the subsidiary and the parent pays Canadian tax on net income of $10 for tax of $2.70.

The example illustrates one major problem with the Republicans’ proposal: double taxation. One way of tempering the tax consequences is if Canada granted a credit for U.S. taxes paid. But doing so would subsidize the U.S. and likely be burdensome to administer. Time will tell whether this theoretical issue becomes a reality.

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