A recently released Congressional Research Service (CRS) Report finds that the magnitude of profit shifting—i.e., using tax planning strategies to avoid, delay, or reduce U.S. tax on income earned overseas—may be significant.It notes that American corporations are reported to be engaged in profit shifting with increasing frequency, including some of the most well known companies: Amazon, Apple, Caterpillar, Cisco, Google, Pfizer, and Starbucks.The CRS Report is intended to assist Congress as it considers what, if any, action to take to curb profit shifting. Click here for CRS’s “Corporate Tax Base Erosion and Profit Shifting (BEPS): An Examination of the Data: (R44013, April 30, 2015).
Background.In theory, the U.S. taxes U.S. corporations on their worldwide income under a “worldwide” (or resident-based) tax system.In contrast, a “territorial” (or source-based) system would tax U.S. corporations only on income earned within the U.S.’s physical borders.In reality, neither the U.S. nor any other major economy has a pure worldwide or territorial tax system.Current U.S. law allows taxes to be deferred on certain income earned abroad until it is repatriated (returned) to the U.S.(In addition, foreign taxes paid in one country may be used to offset income earned in other countries, i.e., cross-crediting.) Deferral is a benefit because delayed taxes are a reduced tax expense to firms due to the time value of money.In the extreme, deferral could allow a U.S. corporation to completely avoid U.S. taxation on foreign source income if they never repatriate their overseas income, either because the income was being held abroad in financial assets or because it was permanently reinvested (e.g., in plant and equipment).
The income earned by foreign branches of U.S. corporations cannot be deferred.
Economists have estimated that profit shifting results in significant tax revenue losses annually, implying that reducing the practice could help address deficit and debt concerns.Profit shifting and base erosion are also believed to distort the allocation of capital as investment decisions are overly influenced by taxes.Fairness concerns have also been raised: if multinational corporations can avoid or reduce their taxes, other taxpayers (including domestically focused businesses and individuals) may perceive the tax system as unfair.On the other hand, policymakers are concerned that American corporations could be unintentionally harmed if careful consideration isn’t given to the proper way to reduce profit shifting.
Corporate profits by country.American companies reported earning profits of just over $1.2 trillion abroad in 2012, according to the U.S. Bureau of Economic Analysis (BEA).The 10 most popular places to report profits were responsible for approximately 65% (or $789 billion) of the total $1.2 trillion in overseas earnings.The countries are ranked below with the profits (listed in millions) followed by what percentage of overseas profit that is.
- Netherlands $172,250 (14.1%);
- Ireland $122,328 (10%);
- Luxembourg $96,079 (7.9%);
- Bermuda $79,706 (6.5%);
- United Kingdom $74,141 (6.1%);
- Canada $70,782 (5.8%);
- Switzerland $57,930 (4.7%);
- Singapore $42,395 (3.5%);
- U.K. Caribbean Islands $40,881 (3.4%); and
- Norway $32,961 (2.7%).
Of the $1.2 trillion in overseas profits, $600 billion was attributed to seven “tax havens” or “tax-preferred” countries: Bermuda, Ireland, Luxembourg, the Netherlands, Singapore, Switzerland, and the U.K. Caribbean Islands.Among the non-tax-preferred countries, the U.K. and Canada are major industrialized nations that are historically close U.S. trading partners, and Norway is the biggest oil producer in Europe, and the third largest exporter of natural gas in the world.
Policy options and considerationsThe CRS Report notes that debate over reducing profit shifting and reforming the international tax system includes a number of options that may involve a number of policy considerations and trade-offs:
- Move closer toward worldwide taxation. If the U.S. were to transition toward a more pure-form worldwide system, the easiest way to do this would be to eliminate deferral while still allowing a credit for foreign taxes paid. U.S. investments would be taxed at the same total tax rate (foreign plus U.S.), regardless of where investments were made. As a result, investment decisions would be made based on real economic returns and not on any differential between U.S. and foreign tax rates. However, if accompanied by a per-country foreign tax credit limit (to eliminate cross-crediting), U.S. corporations would have to allocate income and expenses between domestic and foreign activities and allocate income and expenses between affiliated foreign subsidiaries. To the extent that firms were in an excess credit position (i.e., had credits they could not use because of the foreign tax credit limit), there would be an incentive to shift profits to lower-tax countries. Without the ability to defer income, however, excess credits would likely be reduced. Without proper safeguards in place, it’s likely that a true worldwide tax system would encourage corporations to shed their U.S. corporate charter by reincorporating abroad via “inversion.” There is also concern that a true worldwide system would reduce America’s international competitive position.
- Move closer toward territorial taxation. If the U.S. were to transition toward a more pure-form of a territorial system it would forgo taxing income earned outside its borders. U.S. investments would be taxed at the rates that exist where the investments are made. As a result, investment decisions would no longer be based solely on real economic returns, but on after-tax returns that would vary country by country. In turn, this would lead U.S. corporations to allocate more investment to lower-tax countries than they otherwise would. Tax policy would no longer affect corporations’ decisions to repatriate income because there would be no tax consequence for doing so. While it’s argued that a more territorial system would enhance the competitiveness of U.S. firms relative to their foreign competitors, a territorial system still raises some of the same concerns on profit shifting. Specifically, profit shifting could increase under a territorial system without the proper anti-abuse provisions in place. With a territorial system, income earned abroad would be exempt from U.S. tax. Multinational corporations would have an incentive to attribute as much income as possible to operations outside the U.S. Anti-abuse provisions particularly focused on the transfer of intangible assets (patents, intellectual property, etc.) out of the U.S. may be the most useful at curbing profit shifting under a territorial system.
- Note: Twelve European Union (EU) countries currently have, or are planning, regimes that offer low tax rates, averaging less than 10%, for patents and other types of intellectual property (IP) income, according to an April 15th letter from the Alliance for Competitive Taxation (ACT), a group of leading American companies. These countries recognize the “spillover benefits” from the innovation, productivity, and wages of innovative companies with significant intangible property and are using tax policy as a “carrot” to attract these companies.
- Minimum tax. A worldwide minimum tax could potentially allow for some balance to be struck between multinational corporations’ concerns over tax burdens and governments’ concerns over profit shifting. With a minimum tax, income earned in countries with a tax rate below a specified threshold would be subject to immediate U.S. taxation at the threshold tax rate. Income earned in countries with a tax rate above the threshold would be exempt from U.S. tax or eligible for deferral. Typically, a credit would be allowed for foreign taxes paid, but the credit would be calculated on a country-by-country basis to prevent cross-crediting. However, if the minimum tax only applied to low-tax-rate countries it could still leave an incentive to shift profits to countries with a tax rate just above the minimum tax. This problem could be avoided or at least mitigated by setting the minimum tax rate appropriately high enough (for example, at the average of the countries not considered tax havens). There is also concern that designing a minimum tax may be too complex. The President’s FY2016 budget includes a proposed 19% minimum tax on U.S. corporations’ overseas income.
- Note: The proposed 19% minimum tax has received much criticism from the tax community. For instance, in its letter, the ACT expressed its opposition to the proposed 19% foreign minimum tax, calling it an effective U.S. headquarters tax that will disadvantage U.S. multinational companies.
- Formula apportionment. The current system requires U.S. corporations to price transactions between affiliated companies to determine the allocation of income and expenses. This provides an opportunity to shift profits to low-tax countries. An alternative would be to pool profits earned around the world and then allow countries to tax a share of the total profits, eliminating the need for transfer pricing. The share each country could tax would be determined by a formula that measures real business activity conducted in each country. However, if the apportionment formula can be easily manipulated, then its impact on profit shifting may be limited, although a sales-based formula may be less susceptible to manipulation. There is concern that without extensive recordkeeping or a tracking system, nothing would stop a multinational corporation from setting up a chain of subsidiaries in low-tax countries to which intermediate components are sold on their way to their final destination, which could be a high-tax country. The increasing role of intangible assets (patents, trademarks, copyrights, etc.) may also limit a formula apportionment regime’s capacity to reduce profit shifting. In addition, formula apportionment may also require international cooperation. It is possible that if countries unilaterally establish a formula-apportionment-type system, some income could either face no taxation or double taxation.
- Modify Subpart F rules. In contrast to a minimum tax, which targets the income earned in particular low-tax countries, Congress could target the types of income firms use to shift money to tax havens. Congress could choose to modify the active financing exception, which allows deferral for certain types of passive income earned by U.S. corporations that operate banking, financing, and insurance lines of business abroad through 2014: it could extend the provision again for 2015 or, if Congress believes the exception is used more to avoid taxes than to finance real operations, allow it to actually expire. Another option would be to expand the definition of Subpart F income. Under current law, U.S. shareholders of controlled foreign corporations (CFCs) cannot defer U.S. taxation on Subpart F income earned by the CFC. For example, the President’s FY 2015 and 2016 budgets both included an expanded definition of Subpart F income that would include “foreign base company digital income,” or income derived from selling or licensing digital products and services. Expanding the definition of Subpart F income to encompass more income related to intangible assets may help curb profit shifting; a significant share of profit shifting is believed to be associated with intangible assets.
- Reduce corporate tax rates. Reducing the 35% top statutory U.S. corporate tax rate would decrease the incentive to shift profits by reducing the tax savings from such behavior. Companies engage in profit shifting to take advantage of the differential between the U.S. tax rate and rates in low-tax countries. By reducing this discrepancy, the incentive to shift profits would be reduced as well. However, reducing the U.S. tax rate to within the range typically suggested, 25% to 28%, would still leave the U.S. as a high-tax country relative to tax havens, which would mean that the incentive to profit shift would remain. A reduction in the top tax rate may also reduce federal revenue because of lower tax rates being applied to corporate net income. It is argued that combining a rate reduction with a broadening of the corporate tax base and strong anti-base erosion provisions would help to offset any revenue loss.
OECD’s BEPS.The completion of the Organisation for Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) initiative is also on the horizon. At the request of the G20 finance ministers, the OECD initiated the development of an Action Plan on BEPS with the goal of developing 15 detailed actions governments can take that would reduce non-taxation of corporate and individual income and prevent the double taxation of income.Some of the actions would require coordination and information sharing between governments, and potentially the amendment of over 3,000 existing tax treaties.In addition, harmonization of tax bases and anti-abuse policies could potentially call for modification to the Internal Revenue Code. Accordingly, success of the Action Plan would likely depend on widespread participation by G-20 and OECD member countries as well as nonmember countries.Congress may want to consider the implication of the BEPS Action Plan even though it is still being formalized. The objective of the OECD’s project is to build consensus among countries on a more coherent and transparent international tax system, and even if the U.S. doesn’t implement any of the proposed actions, U.S.multinationals would likely still be impacted.