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Recent global political developments could mean significant changes on the horizon for the automotive industry. US President Donald Trump campaigned, in part, on promises of trade reform, and the leading tax reform plan put forward by US Congressional Republicans, who have a majority in both chambers, includes border adjustments as part of broader corporate tax reform. The potential changes in US trade positions and tax policy could intensify effects automakers are already expected to experience globally as a result of the UK's exit from the EU (Brexit).

US trade and NAFTA

The automotive trade among the United States, Mexico and Canada has increased substantially over the last 20 years under the North American Free Trade Agreement (NAFTA). NAFTA's elimination of tariffs among the three large North American economies has enabled a burgeoning regional trade. Products manufactured in any NAFTA country that meet certain rules of origin can be considered "NAFTA originating," and as such can be imported into any NAFTA country without payment of duties. This has led to a high degree of integration in the production chains of items manufactured and sold in NAFTA countries, particularly in the automotive industry.

President Trump has suggested automakers that produce in Mexico will face a "big border tax," without providing specific details as to what that tax would look like. Trump has also made several statements regarding his intention to amend, or potentially even withdraw from, NAFTA. Any potential amendment to NAFTA could come quickly as Trump has said it would be one of his early priorities once in office.

The imposition of new border taxes would have significant trade implications for the Americas region, particularly for companies with regionally integrated production, as is common in the automotive sector. US withdrawal from NAFTA would also have a significant effect. Withdrawal from NAFTA would likely increase the duty rate for automotive products imported in the United States from Mexico to 2.5%, which is the "most favored nation" rate treatment and applies under US law for World Trade Organization (WTO) members (those same products are currently duty-free under NAFTA). In Mexico's case, however, "most favored nations" tariff rates for automotive products are significantly higher than those in the United States, generally ranging from 5% to 20%. Importers of US automotive products into Mexico would likely be subject to these rates, instead of NAFTA duty-free treatment. The situation with trade between the United States and Canada is harder to evaluate, as there is a 1998 free trade agreement between the two countries that was suspended when they approved NAFTA.

Before deciding to withdraw from NAFTA, the United States is more likely to pursue amending or renegotiating the agreement. Any proposal to amend NAFTA will almost certainly include changes to product-specific rules of origin that could affect qualification for duty-free treatment. The specific rules of origin for vehicles, for example, could be affected by amendments to NAFTA's vehicle tracing rules, by increases to the regional value content needed to qualify a vehicle as NAFTA originating, or by use of different methods of calculating regional value content. Auto parts rules could be similarly affected. Whether amendments would be advantageous or detrimental to any particular situation is highly fact-dependent, and it is key for businesses to have a detailed understanding of their NAFTA trade footprint in order to properly plan for and influence potential changes.

US tax reform

Leading US House Republicans have shown somewhat less enthusiasm for increasing tariffs but have put forth a tax proposal, known as a border adjustment, that is similarly aimed at boosting US exports while reducing imports in favor of domestic production. This border adjustment approach, coupled with a myriad of other proposed changes intended to broaden the tax base, would transform the current US corporate income tax into a destination-based tax on domestic consumption that can best be described as resulting in a 20% border adjusted cash flow tax (BACFT). The BACFT was included in the House Republican's "Blueprint" for tax reform released in June 2016, which many consider to be a starting point for forthcoming tax reform legislation.¹

A border adjustment is a way to tax imports and refund (or credit) taxes paid on business purchases used in the production of exports. Under the BACFT, revenue from export sales would not be taxable, and the cost of imported goods and services would be in the tax base (or taxed separately). The BACFT would apply to all domestic consumption and would exclude any goods and services that are produced domestically, but consumed elsewhere. Cash flow from exports (i.e., US export sales) would be excluded from the tax base. Cash flow used to purchase imports would be included in the tax base (e.g., no cost of goods sold deduction).

Some have questioned whether the BACFT would be consistent with WTO rules imposing restrictions on export subsidies. The proposal has also come under fire from representatives of industries that rely heavily on imports who say it would force them to increase consumer prices. It is also uncertain whether such border adjustments would, in fact, lead to the shift in trade they aim to achieve; many economists believe resulting currency adjustments would offset the border adjustments' intended effect.

Like a rolling-back of NAFTA, the border adjustment provisions of the BACFT would have a disproportionate effect on the automotive industry relative to many other sectors (see Figure 1). Automotive companies in general could see substantially larger costs, but the effect would not necessarily be evenly distributed within the industry either, as some companies rely more heavily on imports for their US sales than others. Those that currently have significant manufacturing operations in Mexico, for example, might find it quite costly to move operations into the United States and would have to weigh those costs against the tax implications of remaining offshore under a border adjustment scenario.

Figure 1. Estimated change in tax liability from border adjustments under the Blueprint, by select industry

Next steps

NAFTA

US efforts to amend NAFTA could materialize very quickly. In anticipation, Mexico announced on February 1, 2017, the opening of a 90-day consultation period with industry on the effect of possible amendments to NAFTA.² This presents a significant opportunity for automotive companies to assess current rules of origin and suggest changes that could enhance North American production. Understanding the details of how products currently qualify as NAFTA originating, and how the origination is utilized by customers, is key to recommending approaches that optimize ongoing NAFTA qualification. With this assessment in place, a company will also be in a position to provide input to policymakers in the United States and Canada, as appropriate, as both countries are likely to engage with business in a similar manner, and the timeframes to provide input may be similarly short.

Businesses will also want to be sure they have insight into the amounts that may be at stake if the United States withdraws from NAFTA, or if specific provisions in NAFTA are eliminated. Elimination of some NAFTA provisions, such as the Article 303 restrictions on using duty deferral programs or drawback schemes for NAFTA trade, could prove beneficial for many businesses in the United States as well as Mexico. Elimination of other provisions could be quite costly; in either instance businesses will want to be sure that input is provided.

US tax reform

US tax reform discussions are in early stages, and to date no proposed statutory language has been released. There is enough information in the Blueprint on the BACFT, however, to model the change to federal and state tax liabilities if the BACFT is adopted. With that in place as a baseline, businesses can begin to review their "end-to-end" supply chain, understanding the original origin of components and ultimate destination of finished products. "What if" outcomes can then be modeled considering, for example, alternative sourcing options, tax costs embedded in indirect imports, capital expenditure plans, alternative transactional structures, options for location of personnel performing shared services, new export market expansion opportunities and related trade costs.

Finally, as many of the policy objectives of tax and trade reforms overlap, companies will be well served by monitoring both tax and trade proposals, and considering both tax and trade effects of any specific proposal. Having data readily available and organized to rapidly conduct assessments as proposals are detailed will be critical to timely taking action to mitigate adverse consequences, as well as to take advantage of opportunities that may be created.

¹ See Tax Alert 2016-1111.

² See Tax Alert 2017-257.

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