Shearman & Sterling Offers a Primer on House Blueprint for Tax Reform

The election of Donald Trump in November has substantially increased the likelihood of major tax reform in the near future. While it is uncertain what shape such reform will take, there has been renewed interest in the so-called “Blueprint” for tax reform released by House Republicans on June 24, 2016.[1] The Blueprint’s stated aims are to promote economic growth for American business, incentivize companies to remain in the United States and greatly reduce the complexity of the current tax system. To promote these objectives, the Blueprint advocates the replacement of the current corporate income tax with what is referred to as a “destination-based cash flow tax” (the “DBCFT”) at a 20% rate. Two primary concepts of the DBCFT are its move towards a cash flow tax (rather than an income tax) and its use of border adjustments. The Blueprint argues that a DBCFT would level the playing field for American business, eliminate the distortive effect of taxes on economic decision-making and reduce compliance costs through a simpler and more streamlined corporate tax code. While the Blueprint is incomplete in many respects, this memorandum offers a general overview of the DBCFT while raising several important questions that remain unanswered.

Border Adjustments

Perhaps the most controversial aspect of the DBCFT is its border adjustments provision. The proposed border adjustments are meant to level the playing field with trading partners that currently impose a value-added tax regime with border adjustments. The proposed DBCFT’s border adjustments would remove imports and exports from a corporation’s tax base—in other words, revenue from exports would not be taxable and no deduction would be provided for the cost of imports. As a result, the proposed DBCFT would effectively ignore cross-border transactions in calculating a business’s tax base and would transform the US corporate tax system into a tax on the location of consumption rather than production.

According to the Blueprint, adding border adjustments would eliminate the existing self-imposed export penalty and import subsidy by moving to a destination-basis tax system.[2] Although border adjustments seemingly promote exports and disfavor imports, the consensus in economic literature suggests that a DBCFT is trade-neutral. Economists point to the currency appreciation the DBCFT is expected to create as the mechanism for creating trade-neutrality. It is estimated that the DBCFT as proposed would lead to appreciation in the US dollar of approximately 25%. As a result, currency appreciation should leave foreign purchasers with 80% of their buying power for US goods (similarly, costs of imports should be reduced by 20%). The basic thinking relating to the effect of currency appreciation under the DBCFT is that taxing imports (via removal of a deduction for their cost) would reduce domestic demand for imports which, in turn, would cause fewer dollars to end up overseas. Correspondingly, exempting exports from tax would increase demand for US goods and US dollars. The relative scarcity and increased demand for the US dollar should raise its value relative to other currencies. Some economists have expressed significant concern that the US dollar would not appreciate as much as predicted, in which case the cost to consumers of imported goods could increase substantially.

One challenge to imposing border adjustments is that the World Trade Organization (“WTO”) permits border adjustments upon exports only with respect to indirect taxes. In other words, border adjustments are prohibited by the WTO under an income tax regime. This prohibition appears to be a primary reason for the Blueprint’s other primary concept—a move away from an income tax and towards a cash flow tax.

Cash Flow Tax

The second major pillar of the Blueprint’s corporate tax reform is a move from an income tax towards a cash flow tax. A pure cash flow tax calculates a business’s tax base by including cash inflows while deducting cash outflows and is meant to reflect a tax on consumption rather than income.[3] Under the DBCFT, the amount paid for a business asset (other than land), including intangible assets, would be deducted up front, rather than incorporated in the basis of the asset. Concepts such as realization, basis, capitalization and depreciation or amortization, all of which play a role in the current corporate income tax system, would be eliminated under the plan. No attempt would be made to match the timing of income with related deductions—a general tax and accounting principle, though not always reflected in current law.[4]

A simple numerical illustration is helpful in demonstrating the difference between an income tax and a cash flow tax. Suppose a corporation spends $100 on an asset. That asset will generate $10 a year in revenue, is depreciable at a constant rate over a period of 20 years (i.e., the asset produces depreciation deductions of $5 per year) and will be sold at the end of year five for $90. Under current law, the corporation takes a $100 basis in the asset, recognizes $5 of net income each year ($10 of revenue minus a $5 depreciation deduction) and reduces its basis in the asset by $5 a year (on account of depreciation). In year five when the asset is sold, the corporation will take into account $15 of income ($90 sale price minus $75 basis). The corporation will include a total of $40 in taxable income over the course of holding the asset.

Under a cash flow tax, the corporation will simply deduct $100 up front for the purchase (for the purpose of this example, it is assumed the corporation has sufficient revenue to offset against the deduction, otherwise the deduction will create a net operating loss (an “NOL”)). The corporation will then include $10 of revenue each year as taxable income. In year five, the corporation will include year five’s revenue of $10 plus the $90 of proceeds from the sale. Total taxable income remains the same under each approach.

Tax Regime Year 1 Taxable Income Year 2 Taxable Income Year 3 Taxable Income Year 4 Taxable Income Year 5 Taxable Income Total Taxable Income
Current $5 $5 $5 $5 $20 $40
DBCFT ($90) $10 $10 $10 $100 $40

As part of the transition to a DBCFT, the Blueprint would modify the current treatment of interest expense by allowing a business to deduct its current interest expense only against its current interest income. The excess of current interest expense over current interest income (referred to as “net interest expense”) could be carried forward indefinitely and allowed as a deduction against net interest income in future years. The Blueprint asserts that continuing to allow a deduction for net interest expense in addition to providing a full deduction for an initial outlay would be distortive and result in a tax subsidy for debt-financing. The Blueprint’s treatment of interest would significantly alter the way many corporations finance their operations.

The ability to fully expense an investment would lead many corporations to operate at a taxable loss in years of heavy spending. The Blueprint would allow NOLs to be carried forward indefinitely and the economic value of such NOLs would be preserved through adjustments for inflation and for a real return on capital. The deduction allowed with respect to an NOL carryforward in any year would be limited, however, to 90 percent of the taxpayer’s net taxable amount for such year, determined without regard to the carryforward (a similar approach to the current rules for net operating loss carryovers under the Alternative Minimum Tax). Carrybacks of NOLs would not be permitted.

A Comparison of the DBCFT to Current Law: Examples

The following examples provide a comparison of the border adjustments provision under the DBCFT to the current income tax regime (assuming a 20% rate for each).

Facts: Net Exporter

A US corporation has $100 in revenue of which $40 arises from exports and $65 in deductible expenses of which $25 arises from imports.

Total Revenues Deductible Expenses Exports Imports
$100 $65 $40 $25

Taxable Income Under Current Law and the DBCFT

Under current law, the corporation would have a taxable base of $35 and would end up with $28 in after-tax proceeds.[5] Under the DBCFT the corporation would have a taxable base of $20 and would end up with $31 in after-tax proceeds.

Tax Regime Taxable Revenues Non-Taxable Revenues (Exports) Deductible Expenses Non-Deductible Expenses (Imports) Total Taxable Base Tax (20% rate) After-Tax Proceeds
Current $100 $0 $65 $0 $35 $7 $28
DBCFT $60 $40 $40 $25 $20 $4 $31

Facts: Net Importer

A US corporation has $100 in revenue of which $20 arises from exports and $65 in deductible expenses of which $45 arises from imports.

Total Revenues Deductible Expenses Exports Imports
$100 $65 $20 $45

Taxable Income Under Current Law and the DBCFT

Under current law, the corporation would have a taxable base of $35 and would end up with $28 in after-tax proceeds. Under the DBCFT, the corporation would have a taxable base of $60 and would end up with $23 in after-tax proceeds.

Tax Regime Taxable Revenues Non-Taxable Revenues (Exports) Deductible Expenses Non-Deductible Expenses (Imports) Total Taxable Base Tax (20% rate) After-Tax Proceeds
Current $100 $0 $65 $0 $35 $7 $28
DBCFT $80 $20 $20 $45 $60 $12 $23

Trade-Neutrality and Currency Effects

These examples demonstrate why net exporters generally support the proposed DBCFT while net importers generally oppose it. As mentioned previously, economists argue that a DBCFT is actually trade-neutral owing to currency effects created by the tax regime. The tables below demonstrate the effect of the DBCFT’s predicted US dollar appreciation of 25%.

After-Tax Profits Without Currency Effects

  Tax Regime Taxable Revenues Non-Taxable Revenues (Exports) Deductible Expenses Non-Deductible Expenses (Imports) Total Taxable Base Tax (20% rate) After-Tax Proceeds
Net Exporter Current $100 $0 $65 $0 $35 $7 $28
  DBCFT $60 $40 $40 $25 $20 $4 $31
Net Importer Current $100 $0 $65 $0 $35 $7 $28
  DBCFT $80 $20 $20 $45 $60 $12 $23

After-Tax Profits with Currency Effects[6]

  Tax Regime Taxable Revenues Non-Taxable Revenues (Exports) Deductible Expenses Non-Deductible Expenses (Imports) Total Taxable Base Tax (20% rate) After-Tax Proceeds
Net Exporter Current $100 $0 $65 $0 $35 $7 $28
  DBCFT $60 $32 $40 $20 $20 $4 $28
Net Importer Current $100 $0 $65 $0 $35 $7 $28
  DBCFT $80 $16 $20 $36 $60 $12 $28

If the US dollar appreciates by 25% as estimated, foreign purchasers would have only 80% of their pre-currency adjustment buying power for US goods. Similarly, in such a case, the real cost of imports would be only 80% of their pre-currency adjustment cost. Thus, assuming these currency adjustments take place, the DBCFT is expected to be roughly trade-neutral.

Arguments For and Against the Implementation of a DBCFT

Advocates of the Blueprint’s DBCFT generally point to its reduction in corporate rates, simplification and fairer approach to cross-border transactions as reasons to implement it. As previously mentioned, the largest trading partners of the United States already use a tax system that includes border adjustability (see footnote 2). The Blueprint argues that when two trading partners each has a tax system that uses border adjustments, the effects in both directions are offsetting and the tax costs borne by imports and exports should roughly offset. If one country does not use border adjustments, however, such as the United States, its products are placed at a disadvantage relative to its trading partners. Thus, implementing border adjustments in the United States would level the playing field with its trading partners. In terms of simplicity, proponents argue that the DBCFT would eliminate the need for complex provisions existing under current law relating to topics like transfer pricing, depreciation and amortization, controlled foreign corporations and foreign tax credits, among others.[7] In addition, advocates of the DBCFT believe that US corporations would no longer desire to move operations overseas since the Blueprint offers a tax rate that is competitive with, or lower than, neighboring jurisdictions and a complete exemption for distributions of current earnings from foreign subsidiaries. Furthermore, the DBCFT would remove the existing incentive to finance investments with debt instead of equity. Supporters estimate that the DBCFT would raise tax revenues by $1.1 trillion over its first decade.[8]

Those that object to a DBCFT point primarily to the unknown effects of implementing such a radical departure from current law. Depending on the nature of their businesses, the DBCFT would affect each business in distinctive ways. Exporters (e.g., companies like Dow, Boeing and General Electric) generally support the proposal as it would reduce their taxable base (potentially into negative territory) while importers (e.g., retailers such as Walmart, Crate & Barrel and Target) generally oppose the proposal as it would have the opposite effect on them by increasing their taxable base by denying a deduction for import costs. While many economists argue that currency appreciation would make the DBCFT trade-neutral, it is not certain that currency would appreciate as much as estimated and, even if such currency appreciation occurs, how quickly it would happen.[9] Opponents also argue that the DBCFT is regressive in nature and would lead to higher consumer prices in the United States, hurting those least able to afford it.

It is uncertain how the DBCFT would affect the international tax framework currently in place. Arguably, the backbone of international corporate taxation resides in the treaty network presently in place and treaties generally are negotiated under the assumption that both countries will retain a traditional corporate income tax. Would the DBCFT be considered an income tax for treaty purposes? If the DBCFT is not considered an income tax and is not covered under the existing treaty framework, taxpayers would not have access to the bilateral dispute mechanisms provided therein. Furthermore, due to the lack of clarity regarding how the DBCFT would operate, it is unclear if the DBCFT would be considered a direct tax and consequently run afoul of the WTO rules.[10]

Finally, the appreciation in the US dollar anticipated to accompany the implementation of the DBCFT would create a one-time major event for certain groups. US persons owning foreign assets would experience a major depreciation in the value of their investments (when measured in US dollars) should the US dollar appreciate as estimated. US pension funds holding overseas assets are wary of the DBCFT for this reason. On the other hand, foreign persons holding US assets would receive a considerable windfall resulting from the appreciation in the value of their US assets.

Some Remaining Questions

While the DBCFT offers a general framework, it leaves open many questions including, but not limited to, the treatment of financial institutions and financial transactions, negative tax liability, pass-through vehicles and existing depreciable assets.

Financial Institutions

The Blueprint provides little guidance on how the DBCFT would apply to financial institutions and financial transactions. It provides that “the Committee on Ways and Means will work to develop special rules with respect to interest expense for financial services companies, such as banks, insurance, and leasing, that will take into account the role of interest income and interest expense in their business models.” How financial institutions and financial transactions would be treated under the House Plan remains a mystery. However, commentators have suggested a few possibilities.

One possibility is that financial transactions would be ignored entirely. A financial institution’s profit often bears little resemblance to its cash flows—profit is typically made on small spreads on transactions of large denominations. Consumption taxes generally ignore financial transactions, so such an approach would not be unprecedented (a consumption tax is designed to tax ultimate consumption, not income). The Blueprint, however, seems to suggest that financial transactions would be considered in the tax base for individuals. Leaving financial transactions in the tax base for individuals but not for businesses would be highly problematic—for example, individuals could shift tax liability easily by transacting through a business.

A second possibility is that financial transactions would be treated just like non-financial transactions under the DBCFT. Such an approach would produce results likely bearing little resemblance to economic reality. Would a business investing in a bond be entitled to an immediate deduction for such purchase? While not explicitly mentioned, the logic of the DBCFT suggests the answer is yes and the proceeds of such bond upon maturity would then be included in income. If such a system were in place, it becomes apparent that financial institutions (and potentially other types of businesses) could easily zero out any year-end tax liability by making investments or loaning cash.

A third alternative would be to impose the DBCFT on non-financial transactions and continue to tax financial institutions under the rules currently in effect. Such a system would create numerous line-drawing problems and would do little to promote simplification. Further, imposing a different tax regime on financial transactions opens the door for taxpayers to use financial transactions or financial intermediaries to transfer tax benefits from one business to another.

Negative Tax Liability

Under the DBCFT, net exporters could end up with a negative tax base. Would these businesses receive a tax rebate? The Blueprint suggests the answer is no because it discusses only NOL carryforwards. Without the use of rebates, businesses with excess tax benefits would be incentivized to shift these tax assets to other businesses that could benefit from them. One would expect to see mergers between net exporters and net importers for reasons having nothing to do with non-tax economic benefits. A system promoting such behavior is at odds with the current crackdown on transactions primarily driven by tax benefits such as certain inversions. Some literature suggests that absent a rebate, the economic principles under the DBCFT, such as currency appreciation, might not necessarily work as expected.

Flow-Through Vehicles

The Blueprint provides little guidance on the treatment of flow-through vehicles other than stating that the tax rate applying to small business and pass-through income would be capped at 25%. Compensation to owner-operators would be deductible and such compensation would be subject to tax at the graduated rates for families and individuals. Would partnerships and S Corporations be subject to the DBCFT? Would they be subject to different rules?

Existing Assets

The Blueprint provides for an immediate deduction for capital expenditures (other than land) in lieu of depreciation deductions and interest deductions. The Blueprint is silent with respect to depreciable assets currently held by businesses. Would these corporations get an immediate deduction for the undepreciated amount of the asset? Would they be allowed to continue having depreciation deductions? Or would they receive no further benefit at all?

Along the same lines, it is unclear whether a taxpayer with existing debt would continue to be able to deduct its net interest expense with respect to that debt and, if so, whether such deductibility would continue after such debt is refinanced.

These are just a few of the questions left unanswered by the Blueprint.


[1]  Ways and Means Committee, US House of Representatives, A Better Way Forward (2016).

[2]  The Blueprint states that all of the major trading partners of the United States raise a significant portion of their tax revenues through value-added tax regimes and “border adjustability” is a key feature of each. Because the US tax system does not provide for border adjustments, exports from the United States implicitly bear the cost of the US income tax while imports into the United States do not bear any US income tax. The Blueprint argues that the effective result of these factors is a subsidy for US imports and a penalty for US exports.

[3]  The proposed DBCFT would effectively operate as a tax on domestic consumption due to the fact that domestically produced goods and services consumed in other countries would escape taxation while goods and services produced in other countries but consumed domestically would be taxed.

[4]  As a general observation, the ability to fully expense an investment may not create results that are dramatically different for certain businesses due to the accelerated and bonus depreciation rules for particular assets existing under current law.

[5]  For purposes of simplicity, we ignore the effect of additional state and local income taxes throughout these examples.

[6]  The boxes in black highlight the changes from the table above that does not take into account currency effects.

[7]  Some commentators suggest, however, that there would still be a need for similar types of provisions that are no less complex to deal with specific items such as intangibles and services and to prevent abuse of the system.

[8]  The border adjustments provision is imperative to these revenue estimates—without it, the Blueprint would have to impose a higher rate of tax than the currently proposed 20% rate to support the cost of the plan.

[9]  There are a multitude of factors that can affect a currency’s value, thus making it difficult to isolate the effect of the DBCFT. In addition, there is no guarantee that trading partners of the United States would not adjust their monetary and tax systems in response.

[10]  The Blueprint provides a plan that moves towards a cash flow tax but all of its facets are not entirely consistent with a pure cash flow tax. As an example, the deduction allowance for wages is atypical in countries imposing a consumption tax (an argument in favor of the Blueprint’s deduction for wages is that it maintains progressivity at the individual level).

This post comes to us from Shearman & Sterling LLP. It is based on the firm’s publication, “House Blueprint’s Destination-Based Cash Flow Tax: A Primer,” dated March 9, 2017, and available here.


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