With President Trump in the White House and a Republican majority in both the House and Senate, tax reform is once again high on the agenda. Several weeks ago, President Trump promised “a tax reform bill that will reduce our trade deficits, increase American exports, and will generate revenue from Mexico that will pay for the wall if we decide to go that route.” Last week, the White House revealed that the President is considering a so-called “border adjustment tax” — a tax advocated for by UC Berkeley Professor Alan Auerbach for about a decade under the name “destination based cash flow tax.”
Under the proposed border adjustment tax, a company pays taxes based on where its products are consumed, rather than where the company is headquartered — or the intellectual property (IP) covering the products are located. When a company sells products in the United States, it will have to pay taxes on the profits made on those sales, even if the products were manufactured abroad. Conversely, if a company sells its products overseas, it will not need to pay U.S. taxes on profits made on those overseas sales. The border adjustment tax accomplishes this dynamic by disallowing a tax deduction for the cost of imported goods. Labor costs, however, would be deductible. Further, the general corporate tax rate would be reduced from 35% to 20%, thereby benefiting purely U.S. domestic companies as well — i.e., those that purchase, manufacture, and sell only in the United States.
So how could this affect foreign IP holding companies? U.S. companies are currently able to shift their profits to a foreign jurisdiction having a low corporate tax rate by transferring their IP to a holding company in that foreign jurisdiction and paying the holding company license fees to use the IP. The license fees that the U.S. company pays to the foreign IP holding company are deductible under the current tax regime. Under the proposed border adjustment tax, those licensing fees would no longer be deductible, and thus could not be used to reduce the U.S. company’s U.S. tax liability. Indeed, the use of a foreign IP holding company would increase a company’s overall tax liability, if the foreign jurisdiction imposes any taxes at all on the foreign IP holding company’s income.
In addition, not only is the proposed border adjustment tax expected to kill IP holding companies, it also incentivizes U.S. companies to conduct their R&D operations within the United States rather than developing their technology abroad or purchasing products with technology developed abroad. This is because labor costs remain deductible under the proposed tax, while the cost of imported goods (which includes R&D costs) are not. Thus, although the company pays a real expenditure for those goods, for tax purposes, those expenditures are treated as taxable profit. In other words, a company will not have to pay taxes on labor costs associated with IP developed in the United States, but will have to pay taxes on such labor costs abroad. Thus, if the border adjustment tax gets passed, Trump may very well “bring back IP and IP-creating jobs again.”