A taxing issue for ethanol producers?

Will a possible US tax reform and border adjustability affect ethanol producers in the US? K·Coe Isom’s Brian Kuehl and Donna Funk, unpick this issue.

As the 115th US Congress begins in Washington, DC, comprehensive tax reform is set to be one of the top priorities for congressional leadership and for the new Trump administration. There is a high likelihood that comprehensive tax reform legislation will become law during 2018 and that much of the debate and formulation of the legislation will occur throughout this year.

Because of this, it is critical that ethanol producers are engaged in this discussion now and that they begin planning for how tax reform could affect their profitability and competitiveness.

In the US House of Representatives, tax reform discussions will be based on the Republican Tax Reform Blueprint released by speaker Paul Ryan in June of 2016.

This blueprint proposes to lower the top corporate tax rate to 20%, provide for the immediate expensing of capital purchases, and place significant limits on the deduction of interest expenses.

One of the most significant changes proposed by the blueprint would be for the US to adopt a tax system that includes “border adjustability.” Under border adjustability, the US would move toward a destination based tax system similar to a value-added tax (VAT) used by many other countries (except with continued deductibility for wages).

Under border adjustability, if a US plant were to sell ethanol or distillers grains to a domestic purchaser, the revenue from those sales would be taxed as income.

However, if the plant were to sell ethanol or distillers grains overseas, the revenue from those sales would not be treated as income under the Internal Revenue Code (IRC).

By extension, if a US refinery or blender were to purchase ethanol from a domestic plant, the cost of that purchase would be deductible as a business expense. By contrast, if the refinery or blender were to purchase ethanol from Brazil or other foreign sources, the cost of that purchase would not be deductible as a business expense under the IRC.

The practical effect of this new tax structure is to increase the cost of imports by 25%. If a US company were to purchase $100 (€95) of ethanol from a domestic producer, the true cost of that purchase would actually be $80, since the cost of that purchase would be deductible as a business expense and would reduce the purchaser’s income tax by $20. By contrast, if one were to purchase $100 of ethanol from a foreign producer, the actual cost of that purchase would be $100, since it would not be deductible as a business expense. As a result, the foreign-sourced ethanol would have an effective cost 25% higher than domestic-sourced ethanol.

Concerning developments

While this sounds like a great thing for domestic producers (and not such a good thing for importers), proponents of border adjustability argue that the real cost increase on imports will be negligible or non-existent, since the US dollar will strengthen as a result of this change to the US tax code, thereby offsetting any cost increases.

Putting aside the concerns that a strong US dollar would make agricultural exports less competitive, other analysts are not optimistic that appreciation of the US dollar will perfectly offset increased prices on imports. Among their concerns is that many US trading partners, including

China, have currencies that do not float freely. Because of concerns that the tax system would disadvantage industries reliant on imports, some of the nation’s largest importers, including retail stores and the petroleum industry, have begun lobbying against the border adjustability plan.

Another key concern with border adjustability is that it could trigger retaliatory tariffs under the World Trade Organization (WTO). Under the WTO, countries are permitted to adopt a tax thatis border adjustable if it is an “indirect” tax. By contrast, a border adjustable “direct” tax is considered an export subsidy that is prohibited by WTO rules. While the House Republican plan argues that the US border adjustable tax would be indirect and thus WTO compliant, others are convinced that the tax would be direct and would violate WTO rules. Regardless, it is a near certainty that if the US adopts the border adjustability proposal, the law will lead to WTO challenges.

This, in turn, could result in retaliatory tariffs being placed on US-sourced ethanol and other agricultural products.

With these concerns about border adjustability and with large retailers and the petroleum industry lining up against the proposal, it may be tempting to assume that border adjustability will end up on the cutting room floor when Congress finalises the rewrite of the tax code. There is good reason why that may not be a safe assumption.

Since the US is a large net importer, shifting toward a border-adjusted tax system is projected by the Tax Policy Center to generate almost $1.2 trillion in federal revenue during the first decade. Given this, border adjustability is best seen as integral to the House Republican tax plan – without the federal revenue generated by border adjustability, Congress will not be able to reduce taxes to the pledged 20% corporate rate.

Adapting to the changes

So how will comprehensive tax reform affect ethanol producers’ businesses?

The only way to answer this question is to conduct an analysis that considers their individual circumstances. If a producer is a US company currently paying income taxes, it will want to consider the combined effect of all of the proposed tax code changes (lower rates, immediate expensing of equipment, border adjustability, etc.).

Another thing to consider is the effect of changes in the strength of the US dollar and potential retaliatory tariffs that could impact the business.

If the company is a foreign corporation that currently does not pay US income taxes, it will want to recognise that the revenue from its imports may become subject to US taxation and that purchasers of the products may no longer be able to deduct such purchases as business expenses.

Fortunately, whether a US or foreign company, there are many steps ethanol producers can take today to position themselves to maximise their profitability and competitiveness under a new US tax system.

As the US’ leading agricultural accounting and consulting firm representing corn producers and the ethanol industry, K·Coe  Isom recognises that the outcome of the tax reform debate will have dramatic effects on many businesses. The company’s objective is to help customers analyse and understand how tax reform could affect their operations, while helping them to design adjustments to their businesses to best position them for growth in the coming years.

K·Coe Isom’s federal affairs team in Washington, DC, has been working behind the scenes with Congress and with key organisations such as the National Corn Growers Association to analyse the effects of tax reform and to shape legislative proposals to protect our industries’ interests.

This article was written by Brian Kuehl, director of federal affairs, and Donna Funk, principal at K·Coe Isom and first appeared in Biofuels International's January/February 2017 edition.