House Republicans' tax reform plan promises to dramatically simplify the tax code, but many observers worry that one of its key elements -- switching to a destination-based cash flow tax system -- could create myriad complications that would take years to sort through.
The 2016 tax reform blueprint -- dubbed "A Better Way" -- contains no legislative language and is light on details for implementing a destination-based cash flow tax (DBCFT). But multiple industry watchers who examined the proposal expressed concern about the practical implications of a DBCFT.
In a February 6 interview, Mark Mazur, former assistant Treasury secretary for tax policy, warned that "when you do a tax change this large, you have to be very, very concerned about unintended consequences and opening up different dimensions of behavior and tax planning that may not be an issue in the current system."
Howard Gleckman of the Urban-Brookings Tax Policy Center noted some of the practical issues the plan raises. "Tax writers will have to resolve scores of legal and economic problems before enacting this plan," he wrote in a February 7 blog post (goo.gl/e8uFPN). "Addressing any one will be a complex and time-consuming. Dealing with them all could be a policy nightmare."
Simple Made Hard
Most explanations of how the DBCFT would work in practice use simple examples, such as a car manufacturer exporting vehicles to overseas markets would be exempted, but an overseas car importer would have to pay the border-adjusted tax. The theory is that a strong dollar from currency adjustments would ultimately balance things out, but this simple example can quickly grow complicated when applied to real-world issues.
For example, the uncertainty surrounding how the DBCFT would be applied to various transactions could cause businesses to make supply chain decisions around whether the transaction is considered an import or an export, Mazur said. "I don't know how this is going to look, but at the very cynical level you would think that if you put software in a cloud, you'd try very hard to say that was an export," he said.
Deciding when a transaction triggers the tax also could prove challenging to businesses, according to Christopher S. Rizek of Caplin & Drysdale Chtd. He offered an example: "Your product is software and you are in California, but you're selling your software in Australia or India. Well, I guess that's tax exempt. But suppose the coding is originally done by some guys in India in the first place, and they sell it to you. How do you trace that?"
Another wrinkle is that while a DBFCT bears some similarity to the VAT systems used in many countries, there are still distinct differences, "and that's the rub," Gleckman said. "It means the proposal is likely to generate unique issues which could take even longer to resolve."
Rizek also wondered why the House GOP plan didn't simply adopt a full VAT with a credit-invoice system, rather than the subtraction-method system proposed. Other countries use a credit-invoice system because it's "so much simpler to administer," he said. But with a subtraction-method system, "there's all these tracing issues, supply chain issues, and where-the-tax-falls incidence issues," Rizek said.
Mazur said that by taking this hybrid-VAT approach, House Ways and Means Committee Chair Kevin Brady, R-Texas, seems to be trying to "minimize the amount of dramatic changes that would occur."
Gleckman questioned whether some types of transactions would be exempt from the import tax. "VATs always struggle with this issue. If these activities or entities are carved out, what else would be exempted?" Gleckman asked. He noted that Brady expressed opposition to any exemptions, but wondered how long Brady could hold that position.
Handing the responsibility of administering the DBCFT to the IRS would require a significant shift in resources, but most observers agree that adopting a DBCFT probably would not necessitate major structural changes in the IRS by itself.
Alan Viard of the American Enterprise Institute said that he didn't expect there to be any major reorganization due solely to a DBCFT, but the IRS would still have to take on additional responsibilities. A DBCFT would make some aspects of the tax code simpler by essentially eliminating the need for transfer pricing and reducing the number of itemized deductions. But the IRS would also have to administer border tax adjustments, by verifying exports and detecting imports. The agency "would face a major challenge in writing and enforcing regulations to prevent wages from being turned into pass-through business cash flow," he said.
Rizek agreed that the IRS likely wouldn't need to be totally restructured, noting that the DBCFT proposal appears to leave many basic individual income tax concepts and tax procedures untouched, which would minimize some of the changes in adapting to the new system. But he argued that giving the IRS the responsibility of administering the DBCFT would still probably "shake up the organization." He drew parallels to when the Affordable Care Act was first implemented, which resulted in the IRS reassigning many of its staff, particularly those in counsel, to figure out how to implement the law. "I would think that this [DBCFT] effort would require a lot more training, and they'll have to scrap a lot of [business] income tax concepts and look at the new stuff," he said.
Rizek also said that the last time the IRS underwent a major restructuring effort, the result was that the IRS spent several years "basically focused on reorganizing rather than enforcing the tax law," a result that he suggested could happen here to a lesser extent.
Administering the DBCFT means the IRS and Treasury would now have to navigate a complicated new world of rulemaking to establish clear guidance for businesses. Mazur described a few examples of this: "Suppose you have a special rule for the financial industry, then do you also have a special rule for the manufacturing companies that are engaged in financial transactions?"
What effect a DBCFT might have on the current IRS could be a moot question, though. Separately, the House GOP's tax blueprint calls for a massive reorganization of the IRS anyway, which would restructure it into three units focused on individuals, businesses, and small claims.
Also unclear in the IRS reorganization plan is how exempt organizations would be treated, Rizek noted, and that uncertainty extends to how exempt organizations would be taxed under a DBCFT. "If the Red Cross buys bandages from Czechoslovakia, or radios from Korea, do they pay tax on them or not?" Rizek wondered.
The House tax reform blueprint touts the DBCFT as a way to limit profit shifting and "cause the recent wave of inversions to come to a halt." But if ending profit shifting and base erosion is the goal, Richard Phillips of the Institute on Taxation and Economic Policy isn't convinced that switching to a DBCFT is the way to accomplish it.
"I am not convinced that sales (which is the main basis for taxation under the DBCFT) is inherently harder to shift around compared to profits," Phillips told Tax Analysts in an email. "This is especially true considering that we have decades of experience dealing with profit shifting, have numerous solutions, and have hard won international cooperation to deal with it. In contrast, moving to the DBCFT would be pretty risky in that it would require blowing up the current administrative systems and anti-avoidance rules in favor of building a whole new system."
Rizek wasn't sure what effect a DBCFT would have on tax enforcement, but he said that "there's going to be a very long learning curve in administering the [tax], both at the taxpayer level, the practitioner level, the IRS, and the accounting firms." Figuring out how to make it work is "not an easy task," he added.
All of the commentators agreed that more details on the proposal are needed to delve further into the issue.
The best advice Rizek had for lawmakers advocating for the DBCFT would be to "kick the effective dates out a couple years" so that the IRS, businesses, and accounting firms could have time to adjust. "I would hope that Congress doesn't make this effective" this year, he added.
And despite Gleckman's concerns about how to practically implement the proposal, he said that it "almost certainly" would be an improvement over the current tax system. "But these challenges are an important warning that shifting to such a new system will be much more difficult -- and time-consuming -- than backers suggest," he said.
Rizek, for his part, wasn't convinced that Republicans had fully thought through the proposal. "Maybe this draft will spring fully formed from Kevin Brady's head, but I'm not counting on it," he said.