“It’s so strange. Everything can be going along just great, and then one day, whack, you’re blindsided — a lousy, crammy blow you didn’t see coming.” - James Patterson

One thing we have written about extensively is that a country or a company should not rely on tax or regulatory arbitrage as a key to its long-term sustainable advantage. A competitive edge or moat really results from only a handful of factors which revolve around doing something at a lower cost or doing something better. When the Republicans swept the government this November, we perceived little compelling threat to Bermuda and focused myopically on the Democrats’ historic tendency to sponsor bills that attacked the island’s reinsurance market; we were wrong. The fact is, Paul Ryan’s “A Better Way: Our Vision for a Confident America” could become a huge risk for Bermuda and ultimately be the event that adversely effects the largest segment of our international business industry.

Trump tax and “A Better Way”

In general, Trump’s tax policies on corporate tax are dramatic in scope and implications. Paul Ryan’s tax plan is also very much in line with Trump’s philosophy. Both Ryan and Trump are keen on reducing corporate tax. Ryan wants a 20 per cent top tax rate and Trump takes this even further by suggesting a 15 per cent rate. Both are also in favour of overseas repatriation at a lower rate — Ryan advocates taxing overseas profits at 8.75 per cent and Trump at 10 per cent. Ryan wants immediate tax write-offs for capital investment while Trump prefers a slower period of deductions. What all this means is that the Trump plan and the Ryan plan are nearly identical in ideology and only differ slightly on particulars. Therefore, it is not a stretch to assume that they get it done. With full control of the government, the Republicans now have the ability to enact sweeping changes. As a result, something is very likely to get done and passed in some form over the next year, which means the tax plans coming out of Washington need to be considered seriously and not taken lightly. This also means that any Ryan/Trump policies regarding international taxation and cross-border dealings are vital. This is where a huge issue for Bermuda surfaces.

A key negative tax implication

On page 28 and 29 of the “Better Way” the following is written (bold is my emphasis):

“For the first time ever, the United States will be able to counter the border adjustments that our trading partners apply in their VATs. The cash-flow based approach that will replace our current income-based approach for taxing both corporate and non-corporate businesses will be applied on a destination basis.

“This means that products, services and intangibles that are exported outside the United States will not be subject to US tax regardless of where they are produced. It also means that products, services and intangibles that are imported into the United States will be subject to US tax regardless of where they are produced.

“This will eliminate the incentives created by our current tax system to move or locate operations outside the United States. It also will allow US products, services, and intangibles to compete on a more equal footing in both the US market and the global market …. Under WTO rules, the United States has been precluded from applying the border adjustments to US exports and imports necessary to balance the treatment applied by our trading partners to their exports and imports.

“With this Blueprint’s move towards a consumption-based tax approach, in the form of a cash-flow focused approach for taxing business income, the United States now has the opportunity to incorporate border adjustments in the new tax system consistent with the WTO rules regarding indirect taxes …

“Because this Blueprint adopts a destination-based approach for cross-border transactions that levels the playing field and eliminates the tax incentives for moving jobs and profits offshore in the first place, there no longer is a need for this web of archaic technical rules.

“Under the Blueprint, the bulk of the subpart F rules, which were designed to counter tax incentives to locate overseas, will be eliminated because there no longer will be any tax incentive to locate outside the United States. Businesses will be able to make location decisions based on the economic opportunities, not the tax consequences.”

So what exactly does this mean? Bermuda’s largest export is reinsurance and its largest trading partner is the United States. If laws are passed to tax all imports of services and counter any tax advantage for companies importing services into the United States then the whole insurance industry is now witnessing a major geopolitical event.

The risk, of course, is that the economics of offering reinsurance offshore becomes uneconomical once any US tax is levied to premiums or some form of deductibility is denied.

Companies wanting to compete with onshore US firms will effectively need to move and domicile operations into the US to avoid taxes and/or penalties in order to compete on a more even footing. Ultimately, this could result in a huge shift of business becoming onshored and leaving Bermuda.

If you are required to have a fully staffed office of underwriters and if management must be within the US to avoid reinsurance taxes on imported reinsurance, then you most likely will do so. The shuttering of the insurance industry in Bermuda would be similar to the collapse of the manufacturing industry within the US rust belt. The loss of jobs, government taxes and people would be devastating.

Why it may not happen

One of the largest arguments against these border adjustments is the fact that it could end up costing American consumers more for their everyday goods. While these import duties would likely benefit the few Americans who compete in these industries by making their products more competitive with foreign competitors, the net result would be an increase in costs borne by American consumers.

In essence the imposed tariff would get passed on to end users or consumers. This may be true but it is worth noting that the strengthening dollar could and may offset some of this cost on imports done in a foreign currency so this inflationary effect may not be so negative.

The ultimate net equation is impossible to determine but the negative inflationary effects from cross-border taxing could somewhat be offset by a much strengthened dollar. This of course would not matter for Bermuda exports which are priced in dollars so there may be no natural offset for this escalating cost.

As a result, it is more obvious that a lack of exemption on reinsurance imports could result in an unavoidable jump in insurance costs for Americans. A study by Dr. J. David Cummins of Wharton School along with the Brattle Group’s Michael Cragg and Bin Zhou, even suggests “the price of insurance would increase by 2.1 -2.4 per cent, on average, or $11 billion to $13 billion more per year for the same coverage” if deductions for offshore affiliated reinsurance was denied.

Right now there is no definitive tax plan or policy before Congress. The ultimate dire consequence of Ryan’s and Trump’s policies of putting America First may not evolve exactly as noted or with so much extremity.

Regardless of your own personal feelings however, it would be very cavalier at this stage to simply dismiss this risk. The Republicans have carte blanche. If they ever really wanted to enact wide sweeping tax reform this is their time. It is also likely that they will move quickly on this.

Bermuda’s geopolitical risk ranking has just been elevated to code red. The threat of huge disruption to its largest industry and foundation of the entire economy is real and may result in a severely adverse scenario if the worst case unfolds.

Sources:

Paul Ryan’s Tax Blueprint Looks a Lot Like Trump’s:

https://www.bloomberg.com/view/articles/2016-06-27/paul-ryan-s-tax-blueprint-looks-a-lot-like-trump-s

A Better Way: Our Vision for a Confident America: https://www.novoco.com/sites/default/files/atoms/files/ryan_a_better_way_policy_paper_062416.pdf

The Impact of HR 3424 on the US Insurance Market:

http://www.brattle.com/system/publications/pdfs/000/004/227/original/The_Impact_of_HR_3424_Law360_Cragg_Zhou_072210.pdf?1378772097

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own. Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.