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The IRS Multibillion-Dollar Subsidy for Ireland

Posted on July 18, 2005 by Martin A. Sullivan
Document originally published in Tax Notes
on July 18, 2005.

The story of Ireland's rise from rags to riches is the kind of success story Americans love — especially those 35 million of Irish descent. Two decades ago the country was an economic basket case, and its relationship with the United States, while always a strong one, was based largely on a shared culture. Now this nation of four million has the second highest gross domestic product per capita in Europe. (Luxembourg has the highest.) As shown in Figure 1 on p. 288, Ireland surpassed Germany and France in per capita income in 1998 and is fast approaching the level of the United States. Figure 2 on p. 289 shows that the unemployment rate in Ireland is less than half that of France and Germany and is well below the U.S. rate.

In today's Ireland, ties with the United States go beyond music, literature, and sentiment. Ireland has adopted a distinctly un-European approach to economic policy. And U.S. corporations — such as Intel, Microsoft, Apple Computer, Pfizer, Oracle, Merck, AOL, Abbott Laboratories, IBM, and Lucent Technologies, to name a few — have responded with an avalanche of investment in state-of-the-art facilities. According to the Irish Development Authority, foreign corporations employ more than 130,000 Irish residents. About 70 percent of those jobs are with subsidiaries of U.S. corporations.

Economists attribute several factors to Ireland's attraction for foreign capital. They include free trade within the European Union (so Irish subsidiaries serve as "export platforms" for companies selling in Europe), investment in education (particularly in science and engineering), EU subsidies for infrastructure, good labor-management relations, relatively nonrestrictive labor laws, and — not least of all — low business taxes.

Ireland's corporate tax rate is 12.5 percent. Despite a general reduction in corporate tax rates across Europe over the last decade, Ireland's rate is still far below those of the larger European economies — like Germany (38 percent in 2004), the United Kingdom (30 percent), France (34 percent), and Italy (37 percent) — as well as the U.S. rate (35 percent). Those differences in and of themselves are significant incentives for foreign corporations to locate in Ireland, but they are not the whole story. Indeed, as explained below, they are only a small part of the story. It is the combination of (A) the low tax rate and (B) the ability to shift profits to Ireland that provides the greatest incentive to invest in Ireland. In other words, if the IRS were able to put a lid on aggressive transfer pricing and other income shifting techniques, the economic incentive to invest in Ireland provided by its low corporate tax rate would be greatly diminished.

Billions at Stake



According to the latest data available from the U.S. Commerce Department, subsidiaries of U.S. corporations reported $18.3 billion of profit from operations in Ireland in 2002. By any measure, that's a lot. It is equal to 15.1 percent of Irish GDP in that year. By way of comparison, corporate profits generated in the United States by domestic and all foreign-owned businesses in 2002 equaled 8.3 percent of GDP.

To determine if subsidiary corporations' profits (and so also the transfer prices) are reasonable, economists compare the subsidiaries' reported profits with profits of comparable stand-alone businesses. For example, a manufacturing subsidiary of a multinational corporation should have a rate of return on assets similar to the rate of return on assets of a stand-alone company in the same industry and in the same market. Of course, those comparisons are fraught with caveats and exceptions, and they usually require extensive adjustments as well as considerable exercise of judgment about what constitutes "comparability." (And this is why the transfer pricing consulting business is enormous.)

To get a back-of-the-envelope estimate of the amount of "excess" profits U.S. corporations have shifted into Ireland, the calculations described below employ the same general method, without all the adjustments and fine-tuning. As shown in the table on p. 290, the average return on assets in Ireland during the years from 1998 through 2002 was 11.4 percent (versus 2.6 percent in rest of the European Union). The average return on sales was 20.3 percent (versus 5.8 percent in the rest of the European Union). Thus, profitability in the rest of Europe according to these measures was 23 percent and 29 percent, respectively, of the profit rate in Ireland. The average of the two — 26 percent — is our estimate of the percentage of profits in Ireland that are attributable to normal return on capital. The remaining 74 percent of profit in Irish subsidiaries of U.S. corporations is attributable to inordinate profit shifting.

That means that of the $18.3 billion of profit reported by Irish subsidiaries of U.S. multinationals in 2002, $13.7 billion did not belong there. With a statutory tax rate of 12.5 percent, Ireland collected approximately $1.7 billion of extra corporate tax on that shifted profit. That's pure gravy for the Irish Treasury. At the same time, U.S. corporations enjoyed a 22.5 percentage point lower rate (35 percent minus 12.5 percent) as a result of shifting income from the United States to Ireland. On $13.7 billion of profit, that is a tax reduction of $3.1 billion. Combining the two, the total U.S. subsidy for Ireland attributable to profit shifting in 2002 equals $4.8 billion. For those who prefer to do their math with pictures, Figure 3 on p. 289 illustrates the calculation.


Figure 1
Per Capita Income in the United States, Ireland, Germany, and
France, 1990-2002



Source: Organization for Economic Cooperation and Development,
OECD Statistical Profile 2005, http://www.oecd.org.

Foreign Aid

Although it is wrapped in a cloak of complexity, the $4.8 billion tax subsidy is equivalent to an economic development grant from the U.S. Treasury payable in part to the Irish government and in part to corporations investing in Ireland. In size, it is approximately equal to the combined foreign aid payment by the United States to its second and third largest recipients of foreign aid, Israel ($2.82 billion in 2004) and Egypt ($1.87 billion).

The subsidy may also be evaluated in terms of the tax economist's favorite measure — the effective tax rate. If there were no inordinate profit shifting, a U.S. corporation making an investment in Ireland that yielded one dollar of profit (and kept that dollar in Ireland) would pay only 12.5 cents in tax to the Irish government.

If instead that same investment allowed an additional three dollars of profit to be artificially shifted, the effective tax rate on that investment income is minus 55 percent. That's because each dollar of real (unshifted) income generated in Ireland results in Irish tax of 12.5 cents and a U.S. tax reduction of 67.5 cents. The ability to shift profits into low-tax Ireland means that tax incentives for investment are far greater than suggested even by the low 12.5 percent rate.

Caveats



The key to the subsidy calculation is the belief — based on the data — that the level of profitability of U.S. subsidiaries in Ireland is way out of line with any norms. To the extent evidence can be presented that profit levels are not inappropriately large, then subsidy estimates presented here should be reduced. For example, high levels of profitability may be due to unique advantages available to investment in Ireland. Or it may be the case that the specific profit level indicators (for example, return on assets) are higher in some industries than in others and that Ireland has a larger share of those industries in its economy than does the rest of Europe. As far as we can tell, no such evidence exists.

Figure 2
Unemployment Rates in Ireland, France, Germany, and the
United States, 1991-2003



Source: Organization for Economic Cooperation and Development,
OECD Statistical Profile 2005, http://www.oecd.org.

Figure 3
Analysis of $18.3 Billion in Profit in Ireland in 2002



The $4.8 billion estimate also relies on the assumption that high levels of profit in Ireland are being shifted from the United States and not from other subsidiaries of U.S. multinationals operating in high-tax Europe. If profits were being shifted to Ireland from, say, Germany, a subsidy similar to the one described above would still exist, but it would instead be coming in the form of reduced German tax instead of reduced U.S. tax.

The main reason to believe profits are being shifted to Ireland from the U.S. headquarters rather than from non-Irish foreign subsidiaries has to do with the nature of the mechanics of transfer pricing. In the typical scenario, products are developed in the United States, manufactured or modified in Ireland, and then sold either back to the United States or into Europe. Given the wide range of activities performed in the United States (and the large amount of profit that goes along with it), there is a lot more flexibility for adjustment in transfer prices between the U.S. parent and the Irish subsidiary than between the Irish subsidiary and another European subsidiary (with limited activities and profits). That being the case, it seems unlikely that more than, say, one-third of profits shifted into Irish subsidiaries of U.S. corporations came from Europe instead of the United States. If that were the case, the $4.8 billion estimate would be reduced to $3.2 billion.

The above estimate assumes that profits generated in Ireland are never repatriated to the United States and subject to U.S. tax. Until enactment in 2004 of the temporary 5.25 percent tax rate on repatriated foreign dividends, that was a good working assumption for at least two-thirds of the profits generated in Ireland. If one-third of profits were repatriated and subject to U.S. tax, the adjusted $3.2 billion estimates would be reduced further by one-third to $2.2 billion.

Finally, if all unrepatriated profits generated in Ireland in 2002 took advantage of the temporary low rate in 2005, the net subsidy from the United States would be further reduced because the United States would receive tax revenue equal to 5.25 percent of those profits. That would further reduce the amount by 15 percent (= 5.25/35), so the final adjusted estimate is $1.9 billion.

 _____________________________________________________________________


        Measures of Before-Tax Operating Profitability of U.S.
             Multinational Corporations, 1998-2002 Average
 ---------------------------------------------------------------------
                                         Return on        Profit
                Return on   Return on    Net Physical     Per
                Assets      Sales        Capital          Employee
 ---------------------------------------------------------------------
 In Ireland      11.4%       20.3%        145.5%          $147,930

 In European
 Union (14)       2.6%        5.8%         26.2%           $19,690

 EU (14) as %
 of Ireland
 [line 2/
 line 1]         23.0%       28.7%         18.0%             13.3%
 ---------------------------------------------------------------------
 Source: Author's calculations using data from the Bureau of
 Economic Analysis (http://www.bea.gov) of the U.S. Department
 of Commerce. The numerator of the statistics shown in lines 1 and 2
 is net-after-tax profit, plus foreign income taxes paid, minus
 income from equity investments.
 _____________________________________________________________________

Conclusion

This article presents estimates between $1.9 billion and $4.8 billion for the annual subsidy paid by the U.S. Treasury to Ireland and to U.S. companies doing business in Ireland. As usual in economics, there is much uncertainty about the precise numbers. A figure at the lower end of the range is probably the more plausible. But in any case, the nontechnical reader should have little doubt about the order of magnitude of this estimate. The combination of the low Irish tax rates and leaky U.S. transfer pricing rules is a multibillion-dollar subsidy program for the Emerald Isle.

Liberals reading this article may look on it as another bit of evidence that corporate tax avoidance has gone too far, and that U.S. transfer pricing rules either should be tightened (for example, the IRS should issue new cost-sharing regulations, as promised) or should be revised by replacing "arm's-length" pricing with a system of formulary apportionment (analogous to that employed by most U.S. states) that allocates worldwide profits using more easily measurable factors, like employment or sales or capital stock.

Conservatives can point to this article as more evidence of the inadministrability and the inevitable demise of the corporate tax in a world where capital is increasingly mobile. Economists have long known that the corporate tax should be eliminated. Now governments in Europe (particularly in the eastern part) are realizing they must lower corporate tax rates to raise or maintain revenue.

Both views are correct. It would be sensible for the United States to both tighten its transfer pricing rules and significantly lower its corporate tax rate. Not only would that encourage real investment in the United States, it would put an end to profit-shifting maneuvers that serve no business purpose.