Border Adjustment and the Triple Taxation Threat

Apparel and footwear company executives throughout the country increasingly are focusing on the Border Adjustment Tax (BAT) provisions in a package of tax reform proposals that are pending before the U.S. House of Representatives.

If enacted, the BAT will fundamentally change the way in which apparel and footwear executives structure their businesses. Among other things, it will result in triple taxation of most clothing and shoe imports.

That's right. Triple taxation.

Let's see how this would work.

Tax #1
Going forward, these articles (except for imports under free trade agreements) will still have to pay the applicable import duty when they cross the border. The duty is assessed as a percentage of the value of the imported item. Average duties for apparel and footwear equal about 13 percent, although for some footwear the rate exceeds 65 percent. In 2015, the U.S. government collected about $14.5 billion on apparel and footwear imports, approximately 42 percent of all duties collected by the U.S. government.

Tax #2
Under the BAT proposals, companies will not be able to deduct the cost of goods sold (COGS) — a practice they can do now — from their income taxes when those costs are associated with imports. This means that the value of imported goods — the same value on which the duty is assessed — will also be taxed, but at the corporate income tax rate. This would be a new tax, but assessed on the same goods already being taxed for duty purposes. Under the proposed 20 percent rate, this new tax would generate another $22.5 billion on the $112.7 billion on clothes and shoes made offshore.

Tax #3
Denying the ability to deduct the COGS means companies will also be unable to deduct the costs associated with the import duties they pay on those goods. This means companies will be required to pay yet another tax – assessed at the corporate income tax rate – on the import duty paid on those goods. As noted before, import duties on apparel and footwear equaled $14.5 billion, so the tax on those duties (using the same 20 percent corporate income tax rate) would equal another $2.9 billion.

Taken together, apparel and footwear companies importing goods will now pay two separate taxes on the same transaction (duties at the border, and the tax on COGS), and then pay a third tax on the duty costs that are included as a COGS expense.

That's triple taxation.

So what happens with all this money that the government is now collecting? Informal estimates suggest that this proposal will generate close to $1.2 trillion in revenue over the next 10 years. This money will be used to offset (government speak that means “pay for”) the revenues the government will no longer collect because of provisions in other parts of the tax reform package, such as the decrease in overall tax rates, the exclusion of export revenue from taxation, and another provision to enable full and immediate deductions of capital expenditures.

Many in our industry have expressed concerns that this triple taxation will result in a huge increase in their tax bill — one that may even exceed their profits. Some folks tell us they will have to raise prices to survive, dramatically cut their U.S. workforce, or both.

Some economists believe such dire outcomes will not come to pass because foreign exchange rates will adjust to offset any damage. But that seems unlikely, especially when there has been no definitive correlation between exchange rates and apparel and footwear prices during the past 10 years — when we have seen volatility in both indices. Further, most purchasing contracts for shoes and clothes are already denominated in dollars, so they would be resistant to any changes in exchange rates.

Another concern focuses on how other countries may react in response to this change in U.S. tax law. If history is any guide, other countries will sue the U.S. through the World Trade Organization (WTO) for violating international trade obligations. They will claim that we are subsidizing exports, or treating imports and domestic production differently. In fact, the U.S. lost a similar case about 10 years ago. That suit compelled a change in U.S. law to avoid the imposition of punitive duties on U.S. exports.

The alternative to this would be for the U.S. government not to change its laws to come into compliance, and instead choose to weather those punitive tariffs. This is what happened a few years ago when Europe successfully imposed punitive tariffs on U.S. exports of skinny jeans. Of course, some countries may not want to wait for the WTO and just go ahead and retaliate much sooner.

None of these scenarios seems attractive.

Like many in the business community, we are strong advocates of tax reform that will support economic growth and simplify our overly complicated tax system. But reform that triply taxes some parts of the economy — leading to job losses, stirring inflation, and exposing the economy to retaliation by other countries — doesn't seem like a good fit.

To learn more about this new proposal and to find out what you can do to help, please contact us at [email protected]. Additionally, AAFA will host an open-industry meeting at MAGIC on Feb. 22. More information is available here.

Stephen Lamar is executive vice president at the American Apparel & Footwear Association (AAFA), responsible for the design and execution of AAFA lobbying strategies on a series of issues covering trade, supply chains, and brand protection. In these roles, he also advises AAFA member companies on legislation and regulatory policies affecting the clothing and footwear industries.