President Trump and Congressional Republicans appear eager to move onto federal tax reform given their recent failed attempt to repeal and replace the Affordable Care Act. But, enacting the first major overhaul to the Internal Revenue Code since the Tax Reform Act of 1986 will be no small task, especially considering that the proposed legislation greatly differs in its effects on corporate taxpayers.
The House Republicans’ blueprint for tax reform, better known as “A Better Way, Our Vision for a Confident America,” calls for a new destination-based tax regime where jurisdiction to tax follows the location of consumption, not the location of production. As such, imported items would be subject to US tax while exported items would not. One of the primary components of the blueprint is the Border Adjustment Tax (“BAT”). As currently envisioned, the BAT would deny a deduction for the costs of goods and services (“COGS”) incurred outside the United States but allow a deduction for domestically produced or purchased goods and services.
For those states that automatically conform to the Internal Revenue Code by either starting with federal taxable income when defining state taxable income or through “rolling date conformity,” the BAT creates a potential constitutional violation absent state action or decoupling. Specifically, the Commerce Clause of the US Constitution provides that “[t]he Congress shall have Power . . . [t]o regulate Commerce with foreign nations . . . .” Similar to how the Dormant Commerce Clause may prohibit a state from favoring its own economic activity at the expense of another state, the Foreign Commerce Clause prohibits a state from favoring domestic commerce over foreign commerce, even when the state is merely conforming to the federal tax treatment of the same activity. Because the BAT favors domestic production / commerce while disfavoring foreign production / commerce through the disparate treatment of the COGS deduction, state conformity with the BAT may run afoul of Kraft v. Iowa Department of Revenue, 505 U.S. 71 (1992).
At issue in Kraft was the constitutionality of Iowa’s tax regime that allowed corporations to deduct dividends received from domestic subsidiaries while denying a deduction for dividends received from foreign subsidiaries. Even though Iowa’s disparate treatment was in conformity with the federal treatment of these dividends, the US Supreme Court held that Iowa violated the Foreign Commerce Clause of the US Constitution. “The adoption of the federal system in whole or in part cannot shield a state tax statute from Commerce Clause scrutiny.” Id. at 82. The Supreme Court rejected Iowa’s argument that its discrimination against foreign commerce was justified by a legitimate goal of promoting administrative convenience for taxpayers achieved through federal and state conformity.
Of particular importance, the Supreme Court stated in Kraft that “the constitutional prohibition against state taxation of foreign commerce is broader than the protection afforded interstate commerce, . . . , in part because matters of concern to the entire Nation are implicated . . . .” Id. at 79. To illustrate this broader protection, when determining whether a state law violates the Foreign Commerce Clause, the Supreme Court confirmed that the state law does not even need to advance or provide a benefit to the state’s local economy. For a state law to violate the Foreign Commerce Clause, all that matters is that the state law demonstrates a preference for domestic commerce over foreign commerce.
It is difficult to successfully distinguish the discriminatory treatment of the deductibility of dividends received from domestic and foreign subsidiaries in Kraft from the BAT’s proposed disparate treatment of the deductibility of domestic and foreign COGS. While the federal government may enact such discriminatory laws, individual states cannot, absent Congressional approval/authorization provided under its Foreign Commerce Clause authority. Accordingly, one way to eliminate potential constitutional violations by those states that ultimately conform with a federal BAT would be for Congress to expressly authorize the states’ discrimination in conjunction with the enactment of federal tax reform or sometime thereafter. Without Congress’ intervention in this area, however, states may be forced to decouple from the BAT to eliminate the discriminatory treatment by either (1) providing a COGS deduction to all taxpayers regardless of whether such costs are incurred domestically or internationally or (2) eliminating the COGS deduction altogether.
Congress and President Trump face myriad challenges in enacting comprehensive federal tax reform. If their efforts are successful, the states will need to examine whether they want to conform to those provisions affecting the computation of the state tax base. Absent Congressional authorization/approval, specific conformity with the BAT could result in states’ unconstitutional discrimination against foreign commerce in violation of the Foreign Commerce Clause. States may be forced to decouple or face taxpayer litigation on the issue.