I had the privilege of testifying before the Ways and Means Committee yesterday. Below is the text of my oral testimony. The official witness testimony can be found here. And the excellent pamphlet by Joint Committee on Taxation is here.
- Mr. Chairman, Ranking Member Camp, members of the committee: Thank you for this opportunity to testify. I greatly appreciate the invitation.
Mr. Chairman, there is overwhelming evidence of inordinate profit shifting by U.S. multinationals to tax havens like Bermuda, Switzerland, Ireland, Singapore, and the Cayman Islands.
Average per-employee profitability in these five tax havens compared to other foreign jurisdictions is ten times larger than in other countries.
Over the last decade, the transfer pricing problem has gone from bad to worse. Between 1997 and 2008 foreign profits of U.S. multinationals grew by 163 percent while measurable business activity grew by only 97 percent.
The excess profit over this period added $28 billion per year to the revenue cost of transfer pricing. the total annual revenue loss from transfer pricing easily could be double that figure.
Tax planning done by the pharmaceutical industry is a prime example of the transfer pricing problem.
There has been a tremendous shift --in drug company profits--out of the United States. The share of profits booked here dropped from two-thirds in 1997 to less than one quarter in 2008.
Drug company foreign profits are not commensurate with their foreign business activity. For example, Pfizer booked more than 90 percent of its profits outside the U.S. even though only about 40 percent of the company’s sales and assets were outside the U.S.
The Joint Committee on Taxation has published an outstanding pamphlet on profit shifting techniques.
The Ways and Means Committee could gain important additional insight by re-opening the Senate Finance Committee investigation into the APA program. The results of the investigation--conducted at considerable taxpayer expense--were never made public.
What about the economic effects of abusive transfer pricing?
For decades policymakers and experts have debated the correct guiding principle for international taxation.
According to one view--called “capital export neutrality”—a foreign subsidiary operating Ireland should pay tax at the U.S. rate of 35 percent.
And according to a second view--called “capital import neutrality”—a subsidiary in Ireland should only pay Irish tax at the 12.5 percent rate. .
Profit shifting though aggressive transfer pricing erodes the U.S. tax base. Not only are FOREIGN profits free of U.S. tax, but also large amounts of U.S. profits go tax free.
This drives the effective tax rate on foreign investment below the foreign rate—in our example, below 12.5 percent. In essence, lax transfer pricing enforcement violates both capital export AND capital import neutrality.
In fact, in many cases lax transfer pricing rules make the effective tax rate negative. That means the U.S. Treasury is not just giving investment in Ireland a tax holiday. That means the U.S. treasury department is subsidizing investment in Ireland. It is no different than, say, the commerce department sending checks directly to companies. This is corporate welfare available only to businesses investing abroad.
Subsidies due to aggressive transfer pricing do not promote competitiveness. Instead, they represent government intervention in the marketplace. As with all subsidies, proponents will point to the jobs created in the subsidized sector. but basic economics tells us that in the overall economy jobs will be lost.
Irrespective of your views about the best guiding principle for international tax policy, we should all be able to agree that the inefficiency of subsidies, provided through aggressive transfer pricing, is a drag on economic growth and job creation.
So, what should Congress do about inappropriate transfer pricing?
Well, one option is to continue as usual and delegate nearly all responsibility for transfer pricing to the Treasury Department.
For decades hard-working Treasury officials have contended with intense political pressure, unfavorable court decisions, and—most of all—a flawed framework that gives primacy to the arm’s length standard. These factors have made it impossible for them to stem the tide.
I remember the 1990 Pickle hearings on transfer pricing. I was on the JCT staff then sitting there [pointing to the podium] listening Treasury officials sitting here [pointing the witness table] assuring the Committee that new IRS rules would solve the problem and that Congress merely needed to be patient.
It is time for Congress to take a hands-on approach.
Around the world, governments protect their tax bases with a wide variety of anti-deferral rules. These rules serve as backstop to transfer pricing rules.
Representative Doggett’s proposal to end deferral for certain sales and royalty payments is fully consistent with this approach.
Also in this vein is the Administration’s proposal to end deferral for excess profits of intangibles in low-tax countries.
Both proposals, IF they are not watered down, can curtail aggressive transfer pricing practices. Personally, I believe the Administration proposal could be improved by restructuring it as a 10-percent minimum tax on foreign profits.
But the best option would be for Congress to take the arm’s length standard off its pedestal and adopt a formulary apportionment approach. A good place to start is the “residual profit split” proposal from Professor Avi-Yonah, Kim Clausing, and Michael Durst.
Let me close with one final point: multinationals corporations and the IRS are not to blame for transfer pricing problems. The core problem is the arm’s length standard that blocks effective enforcement.
It is up to Congress to act.
Thank you for inviting me here today.