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Tax reform proposals under consideration in Congress this year could have dramatic implications for the retail and consumer products sector. Both President Donald Trump and Republican congressional leaders have said they would like to act swiftly on tax reform that lowers corporate income tax rates and broadens the tax base. Details are still under development, but an initial analysis suggests the impact could vary significantly within the sector based on factors such as a company's mix of exports and imports and its margin.

Many think that the House Republican tax reform "Blueprint," released in June 2016, will be the foundation for forthcoming legislation, though the Senate and the Administration are both expected to issue proposals that could also shape any final legislation. As the Blueprint is the most detailed plan to date, its proposals, and their potential effects on the retail and consumer products sector, are discussed below. However, because the details and transition aspects of the expected legislation have yet to be finalized, companies would be well served to closely follow the debate as more details emerge over the coming months.

International issues

Border adjustments

A substantial element of the Blueprint's tax reform plan would be to transform the 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). Under the BACFT, revenue from export sales would not be taxable, and the cost of imported goods and services would be included in the tax base (or taxed separately). This approach is commonly known as a "border adjustment." The BACFT would apply to all domestic consumption and would exclude any goods and services that are produced domestically, but are consumed outside of the United States.

The principal issue for retailers under such a system would be losing the current tax deduction for imported goods, since many are heavy importers. For consumer products companies that might have more of a mix of imports and exports, the net tax effect could be more neutral. The more a company imports and the less flexibility it has in what it imports, the more it could expect to see its federal tax bill increase, although some suggest the increase in tax might be offset somewhat by changes in prices over time (see the discussion below for economists' predictions about currency adjustments and their potential effects). Companies that manufacture in the United States but export their goods would expect to see a tax benefit. Here is how the proposal might work for an importing company and an exporting company, in basic terms:

Following the example above, under the current system, the entire $1,000 of revenue collected is treated as income, $600 of merchandise purchases (regardless of their source) is deductible as a cost of goods sold, and the $100 of salaries and expenses is fully deductible, resulting in $300 of taxable income. Applying a 35% tax rate, the tax is $105. Under the BACFT, however, export sales are exempt from the revenue base. Accordingly, only the $850 of domestic sales are taxable, but the $400 of import purchases are not deductible. Consequently, this leaves only the $200 of domestic purchases and the $100 of US salaries and other expenses as deductible in determining the tax base. The result is a tax base of $550 subject to tax at the 20% tax rate, or $110 of tax.

Retail and consumer products companies that are net importers would likely be significantly impacted by the BACFT proposal. The impact, of course, will vary depending on the specific tax characteristics of the company. Capital expenditures, for example, are fully expensed, which would reduce the tax burden. In addition, the domestic costs incurred that relate to export sales remain deductible, despite the export sales being entirely exempt from tax.

Economists have suggested that border adjustments would have little long-term effect on the balance of trade because of offsetting changes in real price levels that would occur through changes in currency exchange rates. Once international prices fully adjust, they argue, businesses' real after-tax incomes would generally be unaffected by border adjustments.

However, it is hard to predict how long it would take for such currency corrections to occur and if they would be large enough to provide the offset that proponents suggest. Many companies have a mix of both exports and imports, which makes their situations far less clear-cut than the scenarios described above. Companies that have slim margins, a high level of imports and a narrow mix of goods could face risks to their bottom line or even their long-term viability.

These border adjustments would apply not only to the sale of goods but also to sales of services and intellectual property. They also don't necessarily provide for exemptions for transactions among divisions of the same business. Thus, companies that have functions such as information technology departments or call centers overseas, for example, may also be greatly affected if such services are subject to the border adjustment provisions. Similarly, companies that make royalty payments to foreign licensors would not be able to deduct those payments, while US licensors to foreign companies would receive tax-exempt royalties. Companies across all industries — not just retail and consumer products — are well advised to pay close attention to the definitions and language of the proposal as it is developed, and model the potential impact the proposed changes would have on their current business.

Shift to territorial system

Other international provisions contained in the Blueprint could also affect consumer products companies that have overseas earnings. The Blueprint would shift the United States from a worldwide tax system, in which US tax can be deferred on foreign active business income until it is repatriated, to a territorial system allowing a 100% exemption for dividends from foreign subsidiaries. As part of the transition to this system, a mandatory 8.75% tax is proposed on all previously untaxed accumulated foreign earnings held in cash or cash equivalents, with a lower 3.5% tax rate applied to noncash accumulated earnings. Taxpayers could pay this tax liability in installments over eight years. This so-called "deemed repatriation" proposal could come into play for those that have significant overseas earnings.

Companies in such a situation might consider tax planning ideas (e.g., accounting methods for foreign earnings and profits) and structuring changes that could reduce their levels of accumulated overseas earnings and profits and/or reduce the amount of overseas earnings held in cash in advance of any shift to a new system.

Domestic issues

Reduction in corporate tax rate vs. loss of deductions

For the many US retailers that are primarily or solely domestic businesses, the Blueprint's lower tax rate and the elimination of many current deductions and most business credits — including the interplay between these two elements — would be significant. The Blueprint would lower the corporate tax rate to 20%, impose a new 25% top rate for active business income passed through to individuals, and repeal the corporate alternative minimum tax (AMT). On the other hand, businesses would be able to immediately expense the cost of all investments, both tangible and intangible property (but not land).

While the Blueprint would retain the research and development credit and the last-in, first-out accounting method for inventory, most other credits would be discontinued, including the deduction for net interest expense and the ability to carry back net operating losses (NOLs). NOLs could be carried forward indefinitely with interest but could not offset more than 90% of the taxpayer's tax base in any one year.

The relative effects of each of these changes would differ depending on the taxpayer's cash position and the effective dates for the proposals. Grandfathering or transition provisions, as yet to be spelled out in legislative language, could determine how a business might plan for these changes.

Generally, because lower tax rates reduce the value of existing deductions, credits and deferred tax assets such as NOLs, taxpayers might want to consider deferring income recognition and accelerating deductions (e.g., through accounting method changes) in advance of any potential rate change. They might also consider delaying capital expenditures in light of the immediate expensing provision in the Blueprint. Those that use the net interest expense deduction might also consider changes to their capital structure if that deduction is no longer available. Modeling out these proposals can provide a better sense of the interplay among these potential changes and can help businesses make planning decisions in advance.

State and local tax implications

Yet to be fully considered in the tax reform debate are the state and local tax implications to retail and consumer products companies. Nearly all states in some way, shape or form tie their business tax system to determinations of federal taxable income. Depending upon how the states conform to the federal tax base, federal tax law changes could be felt at the state level as well. More importantly, while most states tie to the federal tax base, they do not automatically tie to federal tax rate reductions. Thus, as the federal tax base expands under tax reform, unless states that conform to that expanded federal tax base respond with reductions to their tax rates, taxpayers could experience increased tax burdens without such states taking any legislative action.

As each state's taxing system varies in its approach and conformity to federal tax law changes, retail and consumer products companies should address the impact the proposed federal tax law changes will have not only on their federal tax liabilities but also on their state business tax liabilities as well. Doing so will put such businesses in the best position to identify and execute planning strategies to reduce the state and local tax impact of the proposals while enabling them to utilize relevant attributes efficiently. In addition, such businesses will be in a better position to engage state and local lawmakers as they too begin to prepare to respond to forthcoming federal tax reform measures.

Conclusion

Companies within the retail and consumer products sector have much to consider in the Blueprint tax reform proposals. The potential effects will depend greatly on a company's mix of imports and exports, its cash position, and the timing and transitions the legislation ultimately provides for potential tax changes. As Congress works toward refining the general proposals in the Republican Blueprint into more specific legislative language, companies have an opportunity to model the impact the changes may have on their federal and state tax liabilities, analyze the interplay of proposals on their specific situations and provide valuable input to policymakers. Given President Trump's and congressional leaders' goal of advancing tax reform legislation later this year, companies need to engage now in the debate.

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