Tax Analysts Blog

Are Foreign Multinationals Paying Their Fair Share of U.S. Tax?

Posted on Mar 18, 2013
Vivid press reports of U.S. companies not paying their fair share of tax in the United Kingdom has motivated the Conservative-led government to take the lead on coordinating international efforts to curb aggressive tax avoidance. The last time the U.S. public got upset about foreign corporations not paying U.S. tax was in 1990. The focus of attention then was Japanese multinationals. Of course, elevating the drama was the fear at that time—non-existent now—that Japan’s economic engine was going to outclass the United States. In the end the Treasury promised to get tough, the Congress did next to nothing, and now more than two decades later the problem of profit shifting is greater than ever.

Citing U.K and U.S. press reports about profits shifting into tax havens, the O.E.C.D. has issued a new study acknowledging “a growing perception that governments lose substantial corporate tax revenue because of planning aimed at shifting profits in ways that erode the taxable base to locations where they are subject to more favorable tax treatment.” This is a big deal because the OECD has been the big defender of the status quo. The next flash point is May 2013 in Moscow when tax administrators of the OECD and G20 nations will meet to discuss the problem.

There are two main ways multinationals shift profits out of the countries where they actually do business and into tax-haven holding companies: (1) aggressive adjustment of the prices (the “transfer prices”) that one part of a multinational charges another for goods, services, technology, and trademarks; and (2) arranging for finance holding companies in low-tax countries to lend—and charge interest—to operating affiliates in high-tax countries.

Although both foreign-controlled (“inbound”) and U.S.-controlled (“outbound”) multinationals can shift profits out of the United States, outbound transfer pricing gets the lion’s share of attention. This is in large part due to the fact that the available data make it easier to observe outbound profit shifting. Another factor is that an official 2007 Treasury study concluded that there was no clear evidence in the tax return data that foreign-headquartered multinationals engaged in profit shifting.

There are several reasons not to let the Treasury study lead us to be complacent about profit shifting by foreign-controlled US corporations. First, the study was based on analysis of 2004 data. Since then, foreign corporate tax rates of the countries where foreign multinationals investing in the U.S. are headquartered have declined by more than five percentage points, and further declines in the U.K. and in Japan are scheduled. Even if there was no profit shifting by foreign-controlled U.S. corporations in 2004, in response to the greater incentive due to the enlarged rate differential, they may certainly be doing so now.

Second, all the less systematic evidence—anecdotes, evidence of increased profit shifting by newly “inverted” companies (that is, former U.S. companies that changed the location of corporate citizenship for tax purposes), and common sense that companies which have the capability under current law will shift profits—suggests there is significant shifting of profits out of the United States by foreign-headquartered firms.

Third, and most importantly, the Treasury study compared the profitability of foreign-controlled U.S. corporations with domestically-controlled U.S. corporations, and not finding foreign companies to have low rates of profit in comparison, concluded there was no evidence that foreign-controlled firms were profit shifting. But this is a flawed comparison. The bulk of profit of U.S. controlled corporations is generated by large multinationals who themselves have abnormally low profits in the United States because they too shift profits to tax havens.

Current law section 163(j) of the Code, enacted in 1989, is intended to limit profit shifting by foreign-controlled U.S. corporations. It says that if interest payments exceed 50 percent of cash flow, interest paid to a related-company in excess of that amount cannot be deducted in the United States. Many other countries also have limits on interest deductions they suspect are being used to shift profits. These base-protection rules are referred to as “thin capitalization” and “earnings stripping rules.” (Ways and Means Committee Dave Camp has included as part of his discussion draft for international tax reform a rule similar to 163(j) to limit interest deductions paid by a U.S.-headquartered company to its foreign subsidiaries. And so if the Camp proposal were adopted, the U.S. would, like Germany and Italy, have earnings stripping rules that apply to both inbound and outbound investment.)

My preferred approach to limiting interest in the multinational context is to allocate worldwide interest of a multinational group so only that portion of worldwide interest in proportion to U.S. gross profits is deductible in the United States. This rule could apply to both U.S.- and foreign-controlled corporations doing business in the United States. (Martin A. Sullivan, “An Automatic Brake on Profit Shifting in a Territorial System,” Tax Notes, July 30, 2012.)

As Congress searches for revenue to pay for lower corporate tax rates, limiting interest deductions should always be given prime consideration. Unfortunately, because deductions for corporate interest are not on any list of tax expenditures, they have not received the attention they deserve. Deductions for corporate interest favor debt over equity financing. This distorts the efficient allocation of investment and it contributes to financial instability. So even if there was no profit shifting problem at all, Congress should consider limiting interest.

There are other proposals out there to limit profit shifting that would be particularly helpful for preventing profit shifting by foreign-controlled corporations. (Current controlled foreign corporation (CFC) rules and proposed changes to these rules only apply for U.S. controlled corporations operating abroad.) Michael Durst has proposed limiting U.S. deductions for payments made to related foreign affiliates if those payments are to a low-tax country and they generate profits above a designated level. (Michael C. Durst, “Congress: Deduction Curbs May Be Most Feasible Fix for Base Erosion,” Tax Notes, March 11, 2013.) Professor Bret Well has proposed a rule, similar to Mexico’s, that would not allow deductions for payments to related foreign companies if those payments exceeded U.S. manufacturing income (computed under section 199). (Bret Wells, “What Corporate Inversions Teach about International tax Reform,” Tax Notes International, July 26, 2010.)

Read Comments (1)

vivian darkbloomMar 18, 2013

This is a necessary and useful discussion. Too much of the rhetoric on tax
reform has centered on US-based multinationals and how they are not paying
"their fair share" (whatever that may be). This talk largely serves political
rather than policy objectives.

Whatever "fair share" may be, I'm comfortable in saying that "fair" means
US-based (and owned) companies should be taxed on the same basis as
foreign-based or controlled companies doing business in the US. The system
should not give an undue tax advantage based on the location of owners as
regards their US business activities.

A lot of attention is given to the fact that US multinationals can avoid
(mostly non-US) tax through transfer pricing and other arrangements and thereby
reduce their global tax rate (often confused as US tax rate) and, perhaps at
the same time defer, maybe indefintely, US tax on that income.

But, there's an important distinction as far as the US Treasury is concerned.
The US tax that is avoided by foreign-owned enterprises largely escapes US tax
forever. If a US company is able to defer foreign tax, the current system will
eventually recapture that when profits are repatriated (if ever). The increase
in value of a US enterprise that results from avoiding foreign (or even US tax)
often comes back to the US Treasury in indirect ways, such as increased share
prices and US capital gain revenues. Given that non-US enterprises often find
it easier to reduce their tax bills due to the lack of home-country rules such
as Subpart F, FPHC, PFIC and tax credit rules, etc;, they may be at some
competitive advantage. I think it is for this reason that Treasury adopted the
check-the-box rules.

Any move to reform corporate taxation needs to carefully consider not only the
rules regarding inbound investment, but also ensure that taxation of inbound
and outbound investment is taxed, as nearly as possible, on a basis that is
neutral to the place shareholders reside. There are a lot of moving parts to
the tax policy calculus (as with economics generally). The US wants foreign
investment and they want foreigners to pay "their fair share". Those two goals
are not necessarily consistent. In general, though, moves to reduce the US
corporate tax rate and eliminate some deductions would probably serve both
goals and reduce the incentives for foreign corporations to play the earnings
stripping game in the US.

For far longer than I'd like to admit, I've been predicting that Congress will
revise the earnings stripping rules for interest. I've given up on that,
having cried wolf too often.

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