on October 4, 2004.
This article is for nonexperts, such as most journalists, in search of a better understanding of international tax policy. It describes in a nontechnical way how a U.S.-headquartered multinational corporation can reduce its taxes using current international tax rules. At the expense of precision and in the interest of simplicity, technical tax terms have been omitted.
Under international tax rules, there are two key prerequisites for making money for U.S. companies. First, you must be able to shift profits out of the United States or another high-tax country to a tax haven. Second, you must avoid complex, but porous, U.S. rules designed to prevent that by imposing tax on profits shifted to tax havens.
But first a word about multinational business.
Slicing the Profits Pie
All the complex business of a large corporation usually can be boiled down to three categories: (1) manufacturing, (2) selling, and (3) developing and owning patents, trademarks, trade names, know-how, and other intangible assets. (Corporations in the service industries do only (2) and (3).) For our purposes, manufacturing and selling are more or less generic activities. On the other hand, the development and ownership of intangible assets are what give a company its special or unique value.
Profits are what a company earns after paying all expenses, including interest. The company generates profits from all three sources. The figure on this page illustrates a profit "pie" for a typical large multinational corporation. Except for tax purposes (and sometimes to track performance of different divisions), the corporation usually does not care where the profits are located geographically.
It is a relatively straightforward task to assign geographic location to profits attributable to manufacturing and selling. First, the amounts are easy to determine. Manufacturing profit is estimated as a percentage markup over cost (for example, 30 percent). Profit from selling is like a commission, estimated as a percentage of the sales price (for example, 15 percent). Second, the locations are easy to determine. Manufacturing profit is generated where the factory is located. Selling profit flows from the location of product sales. When a dispute about the amount of profit from manufacturing and selling arises, it is usually about the percentages, and the difference of opinion usually involves a few percentage points.
The size and location of profits from patents, trademarks, and know-how is another story. Because by their nature they are unique, there is more art than science involved in estimating their value and the profits they generate. Second, because they are concepts that exist only on paper, their geographic location is primarily a legal matter — involving the shifting of paper rather than infrastructure and jobs.
Slicing a Multinational's Profit Pie
Example: Total Worldwide Profit = $100
To reduce overall foreign taxes and reduce U.S. taxes, corporate tax planners try to move as much of their real business operations as possible to low-tax countries. People on the business side may have different objectives. For the most part, they want to locate selling activities close to their markets and manufacturing activities where labor costs are low.
In most cases, particularly in the short term, the tax planner is confined to devising ways to shift profits without shifting real business activities. Ideally, manufacturing and selling would be attributed to low-tax countries. But because major markets are generally located in high-tax countries, the usual goal is to attribute profit to manufacturing if it is located in a low-tax country.
But the biggest and most lucrative slice of the pie for tax purposes is the profit attributable to patents, trademarks, and know- how. Whenever possible, ownership of valuable assets — almost always developed in the United States and other high-tax countries — is transferred to tax havens. Alternatively, income from high-profit patents is attributed to manufacturing and selling activities in low- tax countries.
The First Step: Shifting Profits
In this section we'll discuss three general ways of shifting profits from one country to another. All of them involve cross-border transactions between different parts of a single multinational corporation.
Transfer Pricing — Example: Irish Manufacturing. Suppose a U.S.-headquartered corporation has an affiliate that manufactures computer components in low-tax Ireland. Each component sold to ultimate customers in the United States for $50 costs the Irish subsidiary $10 to produce.
Because the Irish operation has an efficient and relatively simple manufacturing process, a reasonable return for the Irish subsidiary would be 50 percent over costs, or $5 per component. Therefore, a reasonable price for sales from the Irish subsidiary to the U.S. parent is $15 per item.
The U.S. company, however, asserts that the engineers in Ireland have made considerable product improvements and, with no help from the U.S. parent, Irish managers have made considerable developments in the process of manufacturing the components. The company also argues that because of advances made by competitors, the U.S. patent no longer has high value. It also asserts that the U.S. trade name is comparable to other trade names that are licensed for royalties of less than 5 percent of the U.S. sales price (that is, less than $2.50).
For all those reasons, a price of $25 is claimed for the transfer from the Irish subsidiary to the U.S. parent. The IRS agrees to the claim because it is under pressure to settle cases promptly and because it does not have the resources to audit all transfer pricing issues. That leaves the Ireland subsidiary with profits ($15) at triple the appropriate level ($5). The inflated profits are subject to low Irish tax rates, rather than higher U.S. rates.
Cost sharing — Example: Patent Transfer to Bermuda. A U.S. pharmaceutical company anticipates that concerns about excessive levels of protein in human blood will soon be a major health issue in the United States. It also realizes that, as the result of prior research, it has already developed a compound (intended to treat an unrelated ailment and never brought to market) with the "side effect" of reducing that protein.
The remaining additional product development, including drug trials, will take place in the United States. The compound will be sold primarily in the United States, where the company already has a well-trusted name, through extensive efforts by the U.S. sales force. Without any tax planning, all profit from the new product would be generated in the United States.
The U.S. corporation decides to set up a company in Bermuda to hold the patent rights to the new drug. To achieve that, the Bermuda affiliate must "buy in" to rights to the existing compound by making an up-front payment. Because the previously disregarded compound had been considered to be nearly worthless, valuation experts are able to make the case that the buy-in payment from the Bermuda affiliate — and therefore the U.S. profit from the sale of the technology — should be small. Subsequent research payments by the Bermuda subsidiary are not large relative to expected sales revenues.
The hoped-for result is soon realized. The repackaged compound is a blockbuster, and most of the profit is attributed to the Bermuda subsidiary. The company is able to do that because it successfully argues that most of the profit was created by the Bermuda-funded research. Profits attributable to U.S. sales efforts and the trade name are, however, subject to U.S. tax.
Intracompany loans — Example: Luxembourg Lending. A U.S. company has a profitable subsidiary in France. It also has an affiliate in low-tax Luxembourg. The Luxembourg affiliate makes a loan to its French sister that is large enough to ensure that interest paid by the French firm to the Luxembourg company nearly eliminates profit in France. The business profit formerly generated in France has been transformed into interest profit in Luxembourg. Consequently, profits avoid French tax and become subject to very low tax in Luxembourg.
The Second Step: Avoiding U.S. Tax
Generally under U.S. tax law, there is no U.S. tax on foreign profits until those profits come "home" in the form of dividends. There are, however, important exceptions to that rule.
The first exception applies when profits have all the appearances of being artificially routed through tax havens by means of related-party transactions. For example, a subsidiary of a U.S. company operating in high-tax Germany might first sell goods ultimately destined for the United States to its subsidiary in low- tax Switzerland so that profits properly attributable to manufacturing in Germany and selling in the United States are booked in Switzerland. Because that type of behavior is recognized as abusive under U.S. statutes, the United States taxes the Swiss profits currently — even though they have not been distributed to the U.S. parent.
The second exception involves profit generated from portfolio- type investments not related to that subsidiary's core business. The United States often will tax interest, dividends, rents, royalties, and capital gains on investment held by foreign subsidiaries of U.S. companies.
The rules for taxing undistributed foreign profits were devised in the early 1960s when U.S. companies conducted most of their business operations in high-tax countries using subsidiary corporate entities. In those days, most transactions within the controlled group were simple buy-sell arrangements. As we shall see, the new wave of international tax avoidance gets around the 1960s' rules by using partnerships and other noncorporate entities and by having affiliates conduct services for one another without the physical exchange of goods or materials.
Loans From Low-Tax Affiliates. As illustrated earlier, it is easy to move profits from one country to another by having the part of a company in a low-tax country make a loan to another part of the same company in a high-tax country. The tricky part is successfully avoiding the U.S. tax rules designed to penalize and prevent that behavior by taxing the interest earned in the low-tax country.
If the two related affiliates on each side of the loan are corporations, the United States taxes the interest immediately. The income is not sheltered, and instead of paying tax to the high-tax country, as it was doing before the loans, the corporation is paying tax to the United States. But there are ways around this rule. A good tax planner takes advantage of the differences between U.S. and foreign tax laws. The inconsistencies allow the profits to be shielded from current taxation in the United States and allow the shifting of profits to a tax haven. Two techniques are described here.
In the first example, the lending entity is a subsidiary of the corporation in the high-tax countries but incorporated in the low-tax country under that country's laws. The high-tax country respects the interest payments to that corporation and allows deductions. So far, everything is normal. But then — because of rules introduced in the late 1990s designed to simplify U.S. law — the entity in the low-tax country can choose to be a branch for U.S. tax purposes. Because it is an unincorporated branch (as opposed to an incorporated subsidiary), it is not considered a separate entity for U.S. tax purposes. What foreign law sees as two separate entities, U.S. law sees as a single consolidated entity. So for U.S. purposes, there is no loan, and there is no interest subject to U.S. tax.
In the second example, the U.S. company takes advantage of differences in U.S. and foreign tax law. Under U.S. law, a corporation is considered located in the country where it legally has incorporated. Often under foreign law, a corporation is considered located where it conducts business. As in the previous example, the company wants to shift profit to a low-tax country by having its affiliate there make a loan to another affiliate in a high-tax country. This time the entity in the low-tax country formally incorporates in the high-tax country — so for U.S. purposes there are two incorporated subsidiaries in a high-tax country. But because the entity conducts business from the low-tax country, the high-tax country considers it incorporated in the low-tax country and allows deductions for interest payments to it. The United States does not tax the interest paid to the lending affiliate because of an exception under the law that allows interest paid from one corporation to another related corporation in the same country to be exempt from U.S. tax.
Not Selling — Just Contracting. As shown above, routing goods through tax havens and then adjusting transfer prices is another method of lowering international taxes. Because a transaction with a related-party subsidiary in which no significant business activity takes place is a hallmark of tax avoidance (especially because the subsidiary is in a tax haven and profits accumulate there at unusually high rates), U.S. law reaches the low-tax subsidiary and taxes that profit immediately.
Suppose a subsidiary of a U.S. company manufactures in Germany and then sells its products to a French distribution subsidiary of the same U.S. company. If a Luxembourg subsidiary gets in the middle of the transaction — buying from Germany and then selling to France — the United States would tax that Luxembourg profit.
To get around U.S. tax law, the Luxembourg subsidiary buys raw materials needed by the German manufacturing subsidiary and hires the German subsidiary as a contract manufacturer to make products according to the Luxembourg company's specifications. Further, on the selling side, the Luxembourg subsidiary hires the French subsidiary to sell the goods on a commission basis.
The German company never owns the raw materials or the finished goods, so there are no "sales" to Luxembourg. The French company never takes possession of the goods either, so there are no related-party "sales" in France. Because of the way U.S. tax law is structured (the focus is on related-party sales), there is no U.S. tax on the profit earned in Luxembourg.
Tax Treaty Instead of Tax Haven. The following tax- motivated structuring takes place entirely within a high-tax foreign country. Suppose the United States has a tax treaty with the country under which much of the profit earned in that country by U.S. residents is exempt from foreign tax.
A U.S. company with a subsidiary doing business in the high-tax country sets up a second financing affiliate there. The second affiliate is structured as a partnership under foreign law, and for that reason it is not subject to foreign corporate tax. The partnership makes a loan to the related corporation, and the corporation deducts the interest. The partnership earns interest that flows through to its partner — the U.S. parent. Under the tax treaty, the payment to the partner is exempt from tax in the high-tax country. But because of the flexible U.S. tax rules (discussed above), what is considered a partnership under foreign law can be a corporation under U.S. law. Because the two subsidiaries that are party to the loan are in the same country, interest profit earned by the financing subsidiary is not taxed in the United States because of the treaty.
Tax Haven Offsets to High Foreign Taxes. Sometimes it is beneficial to generate profits in a low-tax country even when the profits cannot be deferred and are subject to U.S. tax. That can happen because of the way the foreign tax credit — more precisely, the way the limitation on the foreign tax credit — is calculated.
To prevent double taxation of foreign profits, the United States could just tax domestic profits and exempt foreign profits from tax. Instead, the United States taxes worldwide profits and provides a tax credit equal to foreign corporate taxes. So, in the simplest case, a subsidiary of a U.S. corporation that pays $25 of foreign tax on $100 of foreign profits generates a $25 foreign tax credit. Because the U.S. corporate tax rate is 35 percent, U.S. tax on foreign profits — which would be $35 in the absence of the credit for foreign taxes — is $10.
The credit, however, is limited to the U.S. tax rate, 35 percent of profits. So if a foreign subsidiary of a U.S. corporation earns $100 of profit that's subject to foreign tax at a rate of 45 percent, only $35 of foreign tax credit is allowed.
The tax magic happens when the U.S. parent has subsidiaries in both low-tax and high-tax countries. For example, suppose a U.S. corporation is paying foreign tax of $45 on $100 of profit. If through some sort of profit shifting the corporation can get $50 of that profit in a country with a 25 percent tax rate, its average foreign tax rate would be 35 percent, and all foreign taxes would be creditable against U.S. tax.
Alternatively, if only (about) $22 of foreign profit is shifted to a zero-tax jurisdiction, the foreign tax rate will also be reduced to (about) 35 percent. Again, all foreign taxes would be creditable against U.S. tax.
In both cases, foreign taxes are reduced by profit shifting. There is no U.S. tax either before or after profits are shifted.
This article attempts to provide a basic understanding of some current international tax-planning techniques. In addition to more complex versions of the transactions described here, there are ways other than those described here to use U.S. international tax rules to avoid U.S. taxes. For example, a U.S. company can generate extra tax deductions for otherwise nondeductible payments by using foreign "captive" insurance companies. Tax planners also spend an enormous amount of time shifting losses and various types of expenses to maximize foreign tax credits.
Another major issue for international tax planners, especially now that undistributed foreign earnings are accumulating at an accelerated rate, is how to bring profits back home without triggering U.S. tax. A legislative answer is currently in the works. The House of Representatives and the Senate both have passed legislation that would provide — for a limited time only — a substantial tax break for dividends (profits) received by U.S. corporations from their controlled foreign corporations. At this time, the outcome of the conference committee negotiations to determine a final version of this legislation is uncertain.
Note to the Reader
The following commonly used technical terms were intentionally omitted from this article: deferral, antideferral, repatriation, subpart F, foreign base company income, foreign personal holding company income, foreign base company sales income, foreign base company services income, commissionaire, hybrid, reverse hybrid, check-the-box, dual resident, excess limit, excess credit, manufacturing exception, branch rule, passive, and active, as well as all references to specific Internal Revenue Code sections, Treasury regulations, and IRS pronouncements. If you want more details and want to learn the jargon, read some of the excellent articles in the references listed below.
The weakness of U.S. transfer pricing rules (section 482) is well known. Two interesting examinations have been written by Stephen Shay, former Treasury international tax counsel who's now with Ropes & Gray, and H. David Rosenbloom of Caplin & Drysdale. Shay writes:
The reality is that the IRS is unable to meaningfully audit most transfer prices. The practical effect of the transfer pricing regime is to constrain transfer pricing that is significant enough to attract attention and allow a substantial amount of moderate income shifting.
Rosenbloom observes that transfer pricing has more to do with negotiating skill than with the arm's-length principle (which at one point he characterizes as "nonsense"):
The promised impartiality of the [arm's length] method dissipates into a familiar trading of horses in light of the relative leverage . . . between taxpayer and tax administrator when a controversy surfaces. Taxpayers in the United States can threaten to extend the examination using a variety of procedures and means at their disposal; the administrator can threaten penalties and rely on the expense of litigation. Some things never change.
The rules taxing foreign active income shifted to tax havens currently are needed to take pressure off transfer pricing rules. In other words, if transfer pricing (and other income-shifting practices) could be effectively policed, a lot of antideferral rules would not be necessary.
There are massive problems with the existing cost-sharing regulations, as noted by Avi Lev, David Hardy, and Treasury itself (2002). The Treasury intends to issue new regulations soon.
Rosenbloom has argued that related-party debt is nothing like debt between unrelated parties and that it should not be respected for tax purposes, especially because it is almost always used for tax avoidance. He notes that "related-party debt is a principal tool of the tax planner." He writes that only a tax professional would treat related-party debt as equivalent to a loan from an unrelated party, and only a tax professional would treat interest on a related- party loan "as a legitimate cost of the funds needed to operate a business." He adds, "The application of this rationale in a related-party context, where no funds are being raised, is one of the tax miracles of our time."
The use of entities that are partnerships for U.S. purposes but corporations under foreign law — so-called hybrids — has been described by the IRS, the Treasury, Lowell D. Yoder, and Lee Sheppard. The use of hybrids took off in the late 1990s because of Treasury's issuance of the "check-the-box" rules. The Treasury's attempt to issue regulations to prevent the use of hybrids was thwarted by Congress, which threatened to overturn the regulations if they were issued.
The advantages of corporations that are resident in one country for U.S. purposes and in a second country for purpose of foreign law (so-called dual resident corporations) have been described by Treasury, Yoder, Sheppard, and Shay.
The use of contract manufacturing and "commissionaire" arrangements to avoid the reach of subpart F rules — which tax foreign income not yet paid as a dividend to the U.S. parent — is described by Treasury, Yoder, and Shay.
Reverse hybrid foreign entities — that is, foreign affiliates of U.S. corporations classified as partnerships under foreign law but as corporations under U.S. law — are described by Treasury, Yoder, Sheppard (search "reverse hybrid"), and Shay.
"Cross-crediting" is not a recent innovation. Its advantages have been described in many places (for example, by the Joint Committee on Taxation).
- Internal Revenue Service, Notice 98-11, 1998-1 C.B. 433.
David R. Hardy, "Assignment of Corporate Opportunities — The Migration of Intangibles," Tax Notes, July 28, 2003, p. 527.
Joint Committee on Taxation, Factors Affecting International Competitiveness, JCS-6-91, May 30, 1991.
Avi M. Lev, "Migration of Intellectual Property: Unintended Effect of Transfer Pricing Regs," Tax Notes, Dec. 9, 2002, p. 1345.
Burgess J.W. Raby and William L. Raby, "Captive Insurance — Some Lights in the Fog," Tax Notes, Dec. 30, 2002, p. 1711.
H. David Rosenbloom, "Banes of an Income Tax: Legal Fictions, Elections, Hypothetical Determinations and Related-Party Debt," Tax Notes International, Dec. 15, 2003, p. 989.
H. David Rosenbloom, "Why Not Des Moines? A Fresh Entry in the Subpart F Debate," Tax Notes International, Dec. 8, 2003, p. 895.
Stephen E. Shay, "Exploring Alternatives to Subpart F," Taxes, March 2004. p. 31.
Lee A. Sheppard, "Rethinking Subpart F," Tax Notes, Jan. 8, 2001, p. 149.
Lee A. Sheppard, "Turbo-Charged Income Stripping," Tax Notes, Nov. 25, 2002, p. 994.
Lowell D. Yoder, "Planning Techniques Described in Treasury's Subpart F Study," Tax Management International, May 11, 2001, p. 221.
U.S. Department of Treasury, The Deferral of Income Earned Through U.S. Controlled Foreign Corporations, December 2000.
U.S. Department of Treasury, Corporate Inversion Transactions: Tax Policy Implications, May 2002.