Tax Analysts Blog

A New Proposal to Promote American Manufacturing

Posted on Mar 25, 2013

In recent years U.S. multinationals have restructured themselves in a manner that allows them to greatly reduce their worldwide tax bill. This restructuring has been described in detail by the OECD andil and by the Joint Committee on Taxation. In a March 15 presentation at a conference on taxation and manufacturing at the Brookings Institution, expert tax attorney Paul Oosterhuis explained why in the wake of these restructurings U.S. tax rules provide a powerful incentive for U.S. multinationals to keep their manufacturing outside the United States.

First, let me provide some background that skips a lot of detail but hopefully provides the essence of what the multinationals are doing. To further simplify, I will only describe income related to foreign sales.

Total income from foreign sales can be divided into four parts: income from (1) the manufacture of goods; (2) the sale and distribution of goods; (3) the risk associated with and the management of (1) and (2); and (4) the value of a multinational’s intellectual property (“IP” or, in tax lingo, “intangible property”) such as patents, trademarks, know-how, etc.

In general, the majority of R&D performed by U.S. multinationals is conducted in the United States. This research creates product and production intangible assets like patents and new manufacturing processes. The enhancement of value of intangibles related to sales (trademarks, customer loyalty) is more decentralized. It has become commonplace for multinationals to transfer the rights to U.S.-created intangibles used in foreign value-chain to holding companies in low-tax countries. This is done through a cost sharing arrangement where the holding company—often referred to as the “principal”—pays the U.S. parent for rights to existing intangibles (with a buy-in payment) and for intangibles being developed by paying a share of costs (e.g., research) incurred for developing those intangibles. The share of costs is a fraction roughly equal to the foreign share of the multinational’s profit or sales.

There is a great deal of controversy about whether U.S. parents are adequately compensated for the transfer of intangibles to tax havens. But for right now let’s just focus on the fact that the principal holding companies in low-tax countries generate a lot of profit because of the transferred intangibles. This IP profit will be proportionately larger for multinationals that use and sell products with a lot of a technology.

The principals also generate income by assuming the risk associated with the manufacturing and sale of products for foreign markets. This allows the principals to claim a larger share of the income from manufacturing and from sales. This also allows the multinational to shift profit from foreign manufacturing and sales subsidiaries (often in high-tax countries) to the holding company (definitely in a low-tax country).

The net result of all this is that only the income from (1) and (2)—basic manufacturing and distribution functions—are potentially subject to high-tax. Income from (3)—the risk element of manufacturing and distribution—is shifted to a tax haven. Income from (4)—intellectual property—much of it arguably attributable to the United States—is also shifted into a tax haven.

Before the Treasury Department enacted “check-the-box” rules in 1996 it was difficult for multinationals to set up these types of structures. That’s because rules established in 1962 to prevent profit shifting from high- to low-tax countries got in the way. (Basically, these rules subjected profit shifting from high- to low-tax foreign countries to immediate U.S. tax. Under check-the-box rules, foreign subsidiaries can in a legal sense be merged into a single entity inside a single country and avoid those rules because the profit shifting for U.S. purposes is considered to be within a single country.)

Oosterhuis points out that one unintended consequence of all this is that the highly attractive, tax-minimizing restructuring is only feasible when the holding company sets up a contract manufacturing facility outside the United States. Therefore, U.S. multinationals—particularly those in high-tech—have a large disincentive to manufacture in the United States. To solve this problem, Oosterhuis suggests that the United States relax its foreign tax rules so that a U.S. manufacturing subsidiary could sell to a multinational’s foreign subsidiaries without triggering U.S. tax and that a U.S. manufacturing subsidiary could pay royalties to the foreign holding company without triggering U.S. tax.

Oosterhuis’s proposal is reminiscent of that made by NYU Law Professor David Rosenbloom in 2004. Rosenbloom suggested that if multinationals could escape U.S. tax on sales subsidiaries in tax havens that multinationals should be able to set up subsidiaries that undertake the same sale functions in the United States and pay no tax.

One of the most commonly voiced arguments against providing generous tax treatment of foreign profits of U.S. multinationals is that it provides an incentive to create jobs outside the United States. Oosterhuis and Rosenbloom would level the playing field not by reducing tax benefits for foreign operations but by extending advantageous tax treatment received by foreign operations to U.S. operations that perform the same activities.

These are intriguing ideas from very clever tax lawyers. They deserve serious consideration, but they are unlikely to go far because they are too complicated for the public to grasp and they have no natural political constituency. Big businesses are not asking for these changes. They have other priorities in the international arena. And although the Obama Administration has a strong interest in tax benefits for manufacturing, it has also made a top priority of cutting tax benefits to multinationals.

Read Comments (3)

niclas virinMar 25, 2013

Another way to solve the problem would be to skip corporate tax altogether. The
only long term losers would be tax lawyers and scholars.

The VAT BastardMar 25, 2013

"There is a great deal of controversy about whether US parents are adequately
compensated for the transfer of intangibles to tax havens."

I just laughed so hard I spilled my coffee. What compensation? Marty is being
far too polite here. Migrating intangibles largely explain why the modern
corporate income tax has acquired a quasi-discretionary flavor. Multinationals
pay it to the extent they don't feel like pushing an aggressive CSA. Deferral +
Separate entity accounting + toothless CFC rules = Trouble for domestic
manufacturing. Everybody knows this, but nothing changes. Somehow it was
pre-determined that "globalization" means it's okay to throw manufacturing
under the bus.

In Detroit, no one can hear you scream.

vivian darkbloomMar 25, 2013

Another good article by Mr. Sullivan who is one of the few persons writing on
tax policy who actually understands how the tax code works. Most persons
writing on tax policy, even (perhaps especially) those working for the major
"think tanks", have a background in ivory tower economics and little
understanding of how the existing tax system actually works. One would think
those folks would first try to figure out what is, particularly in the real
world out there, before they set their minds to tell us what should be.
Sullivan fills a needed void here. Alas, here's why people like Sullivan and a
few others like him don't get enough press in the mainstream media debate over
tax policy:

"They deserve serious consideration, but they are unlikely to go far because
they are too complicated for the public to grasp and they have no natural
political constituency."

Very true. Yes, journalists and politicians would much rather grasp onto an
sound bite from a supposed 'tax policy expert". These pundits specialize on
politics, not tax policy, and those politics are usually restricted to the
issue of "progressivity" (aka "who gets what").

This is the type of thing that makes Tax Analysts a publication worth its
name. I don't expect that blog posts such as this one will get a lot of
attention in the mainstream media. But, don't lose faith. The people in the
tax writing committees probably do pay attention.

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