Border Adjustments and Transfer Pricing – the Case of iProducts

I promised to mull over the Auerbach and Holtz-Eaton claim that the House GOP’s Destination-Based Cash Flow Tax would eliminate the need to enforce transfer pricing and the answer is contained in the proposal under “border adjustments”. As the Tax Foundation notes:

In the context of a value-added tax, a border adjustment works by applying the tax to imports, but exempting exports from the tax. The GOP’s business tax is not a VAT, but the mechanism that makes it border adjustable is similar. In order to make the corporate tax border adjustable, the revenue from sales to nonresidents would not be taxable, and the cost of goods purchased from nonresidents would not be deductible.

This is an unbelievably bad proposal at some many levels. Let’s take the Tax Foundation’s first example:

So if a business purchases $100 million in goods from a supplier overseas, the cost of those goods would not be deductible against the corporate income tax.

The foreign profits on those goods would be taxable so how do the proponents of this idea address the prospect of double taxation? Of course a Canadian manufacturer would be tempted to price their goods at production cost so as to have no Canadian taxable income. That would eliminate the double taxation but no sane person would think the Canadian Revenue Agency would accept this non-arm’s length transfer pricing. But let’s have the Tax Foundation give the flip side:

if a business sells a good to a foreign person, the revenues attributed to that sale would not be added to taxable income.

The ultimate tax giveaway! Imagine some firm in Seattle that designs and distributes iProducts for sale here as well as abroad. Apple does not manufacture their products outsourcing production to Foxconn. Let’s assume that Foxconn sells the products for $200 while Apple sells them for $400 - $200 in value-added for Apple and its distribution affiliates. Before we get into the details of taxation, let’s note this early Trump failure:

One of those famed promises of Donald Trump's is that his policies, now that he's President-elect, will make Apple bring back their iPhone manufacturing to America…For all the expensive and really productive parts are already made in the U.S., with a little bit going to Japan. China has just the assembly--and that's such a trivial part of the process that it's simply not something worth worrying about at all.

Tim Worstall is right that Foxconn only assembles iPhones but I think most of the expensive parts are sourced from other Asian suppliers. But at the end of the day, the $200 is an arm’s length price with the income tax revenues going to the Chinese assembler and the Asian suppliers of components. So let’s focus on the $200 per product that goes to Apple. Let’s reasonably assume that the foreign distributors incur $40 per product in operating expense and deserve profits equal to $10 per product under arm’s length pricing. In our story - $150 per product represents the profits attributable to the intangible assets created in Seattle. The House GOP proposal would effectively say we do not get to tax these profits. And yes I know that Apple has found a way to get all these profits sourced to Bermuda anyway. But this was the whole point of Senate hearings on May 21, 2013. This proposal would entirely just give up on combatting Base Erosion and Profit Shifting. At times, I have suggested that certain Republicans in Congress really want to shut down enforcement of section 482. It seems I was correct. Did I say this was a horrible idea?