You may already be modeling out the tax impact on your company’s financial statements of various tax reform scenarios, just as we have been doing for a number of our clients. In addition to the impact that tax reform might have on your company’s effective (as well as cash) tax rate, the conventional wisdom among economic experts seems to be that tax reform will also have a significant impact on foreign currency exchange rates (i.e., on the value of the U.S. dollar). Thus, it may also be important for your modeling to address the impact on your company’s financial statements of selected assumptions as to potential changes in FX rates.

This edition of Tax Advisor Weekly highlight several aspects of proposed tax reform measures that may have an impact on the relative value of the U.S. dollar and, as a result, your financial statements.

Economic Factors That Can Impact the Value of the Dollar

Experts tell us that the relative value of the dollar is a function of many competing factors, including the following, to name a few:

• The balance of trade (the difference between imports and exports);
• Political stability;
• Monetary policy;
• Fiscal policy (e.g., government spending for entitlements, defense, etc.);
• The national debt;
• Net monthly increases or decreases in jobs;
• Gross domestic product;
• Retail sales;
• Interest rates;
• Industrial production;
• Home sales;
• Gas prices;
• Inflation;
• Currency trading;
• Terrorism; and
• The relative popularity of the U.S. president.

To the layperson, predicting the impact of these and other factors on the relative value of the U.S. dollar is a daunting task, if not a mission impossible. But economic experts do this sort of thing every day. In fact, several renowned economists have already testified before congressional committees and published scholarly papers on the impact that recently proposed tax reform measures will have on the value of the dollar.

So, as futile as it may seem (to us mere mortals) to reliably predict movements in the relative value of the U.S. dollar, it would be equally careless (if not negligent) to ignore the predictions of those who are widely recognized as experts in that area. Their predictions may turn out to be inaccurate. But ignore them (in your modeling efforts) at your own peril.

Factors Potentially Affected by Current Tax Reform Proposals

Background

It is unlikely that tax reform will affect all of the factors that impact the value of the dollar. But it does appear that tax reform will affect some of them in a significant way. So the challenge is to identify whether and, if so, how tax reform will affect those factors, as well as how its effects on those factors will impact the relative value of the dollar. What follows in this section are a few observations as to factors that may be significantly affected by tax reform and, therefore, factors you may want to consider in your modeling.

The Balance of Trade

One factor listed above that may be significantly affected by tax reform is the balance of trade. An important feature of the tax reform proposal set forth in the Republican “Blueprint for Tax Reform,” released this past July is what is referred to as “border adjustments.”

The Blueprint calls for a destination-based cash-flow tax (the “DBCFT”). What makes the proposed DBCFT “destination-based” are its border adjustments, which would consist of a complete exemption for export revenues and a complete disallowance of any deductions or cost recovery with respect to imports.

The Blueprint acknowledges that the proposed border adjustments to a cash-flow-based income tax might be a violation of international trade law. (Perhaps for that reason, the Blueprint raises the possibility of "going bolder," which may be a hint that a VAT is not beyond the realm of possibility.) But according to several renowned economic experts, a tax incentive for exports coupled with a tax penalty for imports would not alter the balance of trade; and therefore, they should not constitute a violation of international trade law.

One might wonder what the legislative purpose of border adjustments could possibly be, if not to alter the balance of trade (i.e., to stimulate exports and stifle imports). But legislative intent aside, the prevailing macroeconomic theory seems to be that the real effect of the border adjustments would be a significant increase in the relative value of the U.S. dollar, which would exactly offset the impact of the tax incentive for exports and the tax penalty for imports that would result from the border adjustments. So, if we respect the views of the economic experts, our modeling should take into account their predictions in regard to the rise in the value of the dollar that would result from the border adjustments.

In the next issue in this series of articles (entitled “Trade-Neutral Border Adjustments: First Assume a Ladder”), we challenge this assertion by the economic experts that the proposed border adjustments would not alter the balance of trade.

Fiscal Policy

In addition to its effects (if any) on the balance of trade, tax reform would also involve the implementation of fiscal policy in the form of the tax expenditures and revenue increases included in the legislation. Presumably, once those budgetary impacts are quantified, economists will be able to predict the resulting impact on the value of the dollar.

The National Debt

A policy that has guided recent tax reform efforts has been a requirement for revenue neutrality (i.e., an increase in tax expenditures must be offset by an equal increase in tax revenues). To the extent that upcoming tax reform diverges from that trend, there would presumably be an increase in the national debt and possibly a need for Congress to approve an increase in the present debt ceiling. Here again, once those impacts are quantified, the economists will presumably be able to predict the resulting impact on the value of the dollar.

Interest Rates

Another important aspect of the Blueprint is that the DBCFT would limit deductions for interest expense to the amount of a company’s interest income. Presumably that would reduce the market demand for debt financing, which may in turn have the effect of reducing interest rates. That, in turn, may affect the value of the dollar.

Other

Other factors impacting the value of the dollar that might conceivably be impacted in a significant way by tax reform would include GDP, retail sales, industrial production and home sales.

Alvarez & Marsal Taxand Says:

Regardless of whether border adjustments are included in tax reform legislation, it appears likely that tax reform could have a number of significant effects on the value of the dollar. In any event, the moral of the story here is that in addition to modeling out the impact of tax reform on your company’s effective tax rate, it may also be prudent for you to model out the impact of a few selected assumptions in regard to the impact of tax reform on FX rates as we have done for some of our clients.

Upcoming Editions

In our next three editions of Eye on Tax Reform: A&M Impact Series we will:

• challenge the assertion of several respected economists that border adjustment be trade neutral;
• discuss the potential World Trade Organization reaction to the border adjustment rules; and
• explain why the border adjustments that are contained in many (if not all) VAT systems are not illegal export subsidies.

Disclaimer

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand

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