Forum on International Tax Avoidance and Evasion Tax Havens: International Tax Avoidance and Evasion

Abstract – The federal government loses both individual and cor- porate income tax revenue from the shifting of profi ts and income into low-tax countries, often referred to as tax havens. Tax havens are located around the world with concentrations in the Caribbean and Europe. Corporate profi t shifting may cost up to $60 billion in revenue and remedies are likely to involve tax law changes. Indi- vidual income tax losses more often arise from tax evasion, and are facilitated by the lack of information reporting; remedies involve administrative changes, especially in requirements for information reporting. Losses may be as much as $70 billion per year.

he federal government loses both individual and cor- Tporate income tax revenue from the shifting of profi ts and income into low-tax countries. The revenue losses from this tax avoidance and evasion are diffi cult to estimate, but the U.S. Senate Subcommittee on Investigations (2008) has suggested that the annual cost of offshore tax abuses may be around $100 billion per year. International tax avoidance can arise from wealthy individual investors and from large multinational corporations; it can refl ect both legal and illegal actions. Tax avoidance is sometimes used to refer to a legal reduc- tion in taxes, while evasion refers to tax reductions that are illegal. Both types are discussed in this paper, although the dividing line is not precise. A multinational fi rm that constructs a factory in a low-tax country rather than in the United States to take advantage of low corporate tax rates and deferral of U.S. tax is engaged in avoidance, while a U.S. citizen who sets up a secret bank account in the Caribbean and does not report the interest income is engaged in evasion. Many activities, particularly by corporations, often referred to as avoidance, could be classifi ed as evasion. One example Jane G. Gravelle is transfer pricing, where fi rms charge low prices for sales Congressional Research to low-tax affi liates but pay high prices for purchases from Service, Library of them. If these prices, which should be at arms-length, are set Congress, Washington, artifi cially to reduce total taxes paid, this activity might be DC 20540 viewed as evasion, even if such pricing is not overturned in court because evidence is lacking. National Tax Journal Most of the international tax reduction of individuals Vol. LXIl, No. 4 refl ects evasion, and this amount has been estimated by December 2009 Guttentag and Avi-Yonah (2005) at $40–70 billion a year. This 727 NATIONAL TAX JOURNAL evasion occurs in part because the United ing, and possibly withholding. Avoidance States does not withhold tax on many may be more likely to be remedied with types of passive income (such as interest) changes in the tax code. paid to foreign entities; if U.S. individuals Several legislative proposals address can channel their investments through international tax issues, including propos- a foreign entity and do not report these als by President Obama, H.R. 3970 (110th earnings on their U.S. tax returns, they Congress), the Stop Tax Haven Abuse evade a tax that they are legally required Act (S. 506 and H.R. 1265, 111th Congress) to pay. In addition, individuals investing arising out of investigations of the Senate in foreign assets may not report income Permanent Committee on Investigations, from them. Estimates of corporate tax and draft proposals circulated by the Sen- reductions also vary substantially, ranging ate Finance Committee, with the Senate from $10–60 billion. bills largely aimed at individual evasion. In addition to the differences between In addition, S. 386 (111th Congress) would corporate and individual activities and include tax evasion in its money-launder- between tax evasion and avoidance, ing provisions and provide additional there are variations in the features used Justice Department funding, and S. 569 to characterize tax havens. Some restric- would require states to determine the tive defi nitions limit tax havens to those benefi cial owners of corporations formed countries that, in addition to having low under their laws. or non-existent tax rates on some types of The fi rst section of this paper reviews income, also are characterized by a lack what countries might be considered tax of transparency and information sharing, havens. The next two sections discuss allow for bank secrecy, and require little corporate profi t shifting mechanisms and or no economic activity for an entity to evidence on the magnitude of profi t shift- obtain legal status. The Organisation for ing activity. The following two sections Economic Development and Cooperation provide the same analysis for individual (OECD) used such a narrow defi nition tax evasion. The paper concludes with in their tax shelter initiative. A broad overviews of alternative policy options. definition might characterize as a tax haven any low-tax country with a goal of I. WHERE ARE THE TAX HAVENS? attracting capital, or simply any country that has low or non-existent taxes on The Organization for Economic Devel- capital income. This paper addresses tax opment and Cooperation (1998) initially havens in both their broader and narrower defi ned the features of tax havens as no senses. or low taxes, lack of effective informa- International tax avoidance issues can tion exchange and transparency, and no also be differentiated by the measures that requirement for substantial activity. Other might be taken to reduce the associated lists are provided in legislative proposals revenue losses. In general, revenue losses and by researchers. from individual taxes are associated with evasion and narrowly defi ned tax havens, A. Formal Lists of Tax Havens while corporate tax avoidance occurs in both narrowly and broadly defi ned tax The Organisation for Economic Co- havens and can arise from either legal operation and Development (2000) cre- avoidance or illegal evasion. Evasion is ated an initial list of tax havens. The same often a problem of lack of information, list, excluding the U.S. Virgin Islands, was and remedies may include resources for used in S. 396 (110th Congress), which enforcement, increased information shar- would treat fi rms incorporated in certain 728 Forum on International Tax Avoidance and Evasion

tax havens as domestic companies. The Europe, locations close to large developed Stop Tax Haven Abuse Act (S. 506, H.R. countries. 1265, 111th Congress) uses a list taken from IRS court fi lings, but has many countries B. Developments in the OECD Tax in common with the OECD list. The OECD Haven List excluded some low-tax jurisdictions thought by many to be tax havens, such as The OECD list, the most prominent Ireland and Switzerland. These countries list, has changed over time. Nine of the were included in a study of tax havens by countries in Table 1 did not appear on the Hines and Rice (1994). Organization for Economic Development Table 1 shows 50 countries appearing and Cooperation (1998) list. Countries on various lists, arranged by geographic not appearing on the original list tend location. These tax havens tend to be to be more developed larger countries, concentrated in certain areas, including including some OECD members (e.g., the Caribbean and West Indies and Switzerland and Luxembourg). As dis-

Table 1 Countries Listed on Various Tax Haven Lists Caribbean/West Indies Anguilla, Antigua and Barbuda, Aruba, Bahamas, Barbados,d,e British Virgin Islands, Cayman Islands, Dominica, Grenada, Montserrat,a Netherlands Antilles, St. Kitts and Nevis, St. Lucia, St. Vincent and Grenadines, Turks and Caicos, U.S. Virgin Islandsa,e

Central America Belize, Costa Rica,b,c Panama

Coast of East Asia Hong Kong,a,b Macau,a,b Singaporeb

Europe/Mediterranean Andorra,a Channel Islands (Guernsey and Jersey),e Cyprus,e Gibralter, Isle of Man,e Ireland,a,b,e Liechtenstein, Luxembourg,a,be Malta,e Monaco,a San Marino,a,e Switzerlanda,b

Indian Ocean Maldives,a,d Mauritius,a,c,e Seychellesa,e

Middle East Bahrain, Jordan,a,b Lebanona,b

North Atlantic Bermudae

Pacifi c, South Pacifi c Cook Islands, Marshall Islands,a Samoa, Nauru,c Niue,a,c Tonga,a,c,d Vanuatu

West Africa Liberia Notes: The Dharmapala and Hines (2009) paper cited above reproduces the Hines and Rice (1994) list. That list was more oriented to business issues; four countries, Ireland, Jordan, Luxembourg, and Switzerland, appear only on that list. The Hines and Rice list is older and is itself based on earlier lists; some countries on those earlier lists were eliminated because they had higher tax rates. St. Kitts may also be referred to as St. Christopher. The Channel Islands are sometimes listed as a group and sometimes Jersey and Guernsey are listed separately. S. 506 and H.R. 1245 specifi cally mention Jersey, and also refer to Gurensey/Sark/Alderney; the latter two are islands associated with Guernsey. aNot included in S. 506, H.R. 1245, 111th Congress. bNot included in original OECD tax haven list. cNot included in Hines and Rice (1994). dRemoved from OECD’s List, which subsequently determined they should not be included. eNot included in OECD’s “gray” list as of July 8, 2009; currently on the OECD “white” list. Note that the “gray” list is divided into countries that are tax havens and countries that are “other fi nancial centers.” The latter clas- sifi cation includes three countries listed in Table 1 (Luxembourg, Singapore, and Switzerland) and fi ve that are not (Austria, Belgium, Brunei, Chile, and Guatemala). Of the four countries moved from the “black” to the “gray” list, one(Costa Rica) is in Table 1 and three (Malaysia, Uruguay, and the Philippines) are not. Sources: Organization for Economic Development and Cooperation (2000); Dharmapala and Hines (2009); Tax Justice Network (2007), The OECD’s “gray” list as of April 2, 2009 is posted at http://www.oecd.org/data oecd/38/14/42497950.pdf. The countries in Table 1 are the same, with the exception of Tonga, as the countries, in U.S. Governmental Accountability Offi ce (2008b).

729 NATIONAL TAX JOURNAL cussed in the paper by Nicodème (2009) and individual evasion. The provision of in this Forum, the OECD subsequently public funds to banks has also heightened focused on information exchange and public interest. The tax haven issue was removed countries from the blacklist if revived at a meeting of the G-20 indus- they agreed to cooperate. OECD initially trialized and developing countries that examined 47 jurisdictions and identifi ed proposed sanctions; Faiola and Jordan some as not meeting the tax haven cri- (2009) report that a number of countries teria; it also excluded six countries with indicated commitments to information advance agreements to share information sharing. (Bermuda, the Cayman Islands, Cyprus, The OECD currently has three lists: a Malta, Mauritius, and San Marino). The “white list” of countries implementing 2000 OECD blacklist included 35 coun- an agreed-upon standard, a “gray” list of tries. The OECD also subsequently found countries that have committed to such a that three countries should not be on the standard, and a “black” list of countries list (Barbados, the Maldives, and Tonga). that have not committed. On April 7, 2009 Over time, as more tax havens made the last four countries on the “black” list agreements to share information, the (not included on the original OECD list), blacklist dwindled until it included only Costa Rica, Malaysia, the Philippines and three countries: Andorra, Liechtenstein, Uruguay, were moved to the “gray” list. and Monaco. As noted below, all countries The gray list includes countries not identi- were eventually dropped from the black fi ed as tax havens but as “other fi nancial list; many of those countries are on a gray centers.” Stewart (2009) reports that Hong list of those committed to but not having Kong and Macau were omitted because of implemented changes. objections from China, but are mentioned Sharman’s (2006) study of the OECD in a footnote as having committed to the initiative fi nds the reduction in the num- standards; he also noted that new commit- ber of countries on the OECD list was ments brought 11 jurisdictions, including not because of actual progress towards Austria, Liechtenstein, Luxembourg, Sin- cooperation, but refl ected the withdrawal gapore, and Switzerland onto the gray list. of U.S. support in 2001. As a result the Many countries on the OECD’s original OECD focused on information exchange blacklist protested the resulting nega- upon request and did not require reforms tive publicity. Many now point to hav- until all parties had agreed to cooperate. ing agreed to negotiate tax information That is, countries only had to commit to exchange agreements (TIEA), and some reform. This analysis suggests that the have negotiated such agreements. The large countries were not successful in this identification of tax havens can have initiative to rein in tax havens. Spencer legal ramifi cations if laws and sanctions and Sharman (2008) also suggest little real are contingent on that identifi cation, as progress has been made in reducing tax in the Stop Tax Haven Abuse Act in the haven practices. United States and potential sanctions by Interest in tax havens has increased international bodies. recently. The Joint Committee on Taxation (2009a) discusses the scandals surround- C. Other Jurisdictions with Tax Haven ing the Swiss bank UBS AG (UBS) and the Characteristics Liechtenstein Global Trust Group (LGT), which led to legal actions by the United Major countries, such as the United States and other countries and focused States (including three states, Delaware, greater attention on international tax Nevada, and Wyoming), the United issues, primarily information reporting Kingdom, the Netherlands, Denmark, 730 Forum on International Tax Avoidance and Evasion

Hungary, Iceland, Israel, Portugal, and includes in its list of tax havens Delaware, Canada have been charged with having Wyoming, and Puerto Rico, along with the tax haven characteristics. A number of Netherlands, Campione d’Italia, Sark, the smaller countries or areas in countries, United Kingdom, and Canada. such as Campione d’Italia, an Italian town The Economist (2009) reported a study located within Switzerland, have also that experimented with setting up sham been characterized as tax havens. corporations; the author incorporated in Altshuler and Grubert (2006) and van Wyoming and Nevada, the United King- Dijk, Wyzig, and Murphy (2007) describe dom and several other places, demon- the Netherlands as a corporate tax haven, strating that one can incorporate without as it allows fi rms to reduce taxes on divi- identifying benefi cial owners. McIntyre dends and capital gains from subsidiaries (2009) discusses three U.S. practices that and has many treaties that reduce taxes. aid international evasion: failure to col- O’Brien (2006) reports that Bono and the lect information on interest income paid U2 band moved their music publishing to foreign entities, the system of foreign company from Ireland to the Netherlands institutions that act as qualifi ed interme- after Ireland changed its tax treatment of diaries (see the discussion below) but do music royalties. not reveal their clients, and the practices Gnaedinger (2009a) reports that the of states such as Delaware and Wyoming Luxembourg Prime Minister urged other that allow people to keep secret their EU members to challenge the United identities as stockholders or depositors. States for tax havens in Delaware, Nevada, Gnaedinger (2009b) reports that Edu- and Wyoming. One website offering off- ardo Silva, of the Cayman Islands Finan- shore services1 mentions, in their view, cial Services Association, claimed that several overlooked tax havens: the United Delaware, Nevada, Wyoming, and the States, the United Kingdom, Denmark, United Kingdom were the greatest offend- Iceland, Israel, Portugal’s Madeira Island, ers with respect to, among other issues, Hungary, Brunei, Uruguay, and Labuan tax fraud. He suggested that Nevada and (Malaysia). For the United States, the Wyoming were worse than Delaware website notes the lack of reporting and because they permit company bearer exemption of certain passive income paid shares, allowing anonymous ownership. to foreign entities, the limited liability Indeed, S. 569 would require disclosure corporation organizational form which of benefi cial owners in the United States allows a fl exible tax exempt corporate Any low-tax country could be a poten- vehicle, and the ease of incorporating in tial income shifting location. In addition to certain states (Delaware, Nevada, and Ireland, three other countries in the OECD Wyoming). Another website offering2 lists not included in Table 1 have tax rates Austria, Campione d’Italia, Denmark, below 20 percent: Iceland, Poland, and Hungary, Iceland, Madeira, Russian Fed- the Slovak Republic.4 In addition, most eration, United Kingdom, Brunei, Dubai, non-OECD eastern European countries Lebanon, Canada, Puerto Rico, South have tax rates below 20 percent.5 Africa, New Zealand, Labuan, Uruguay, The Tax Justice Network (2005) prob- and the United States. A third website3 ably has the largest list of tax havens, and

1 See http://www.offshore-fox.com/ offshore-corporations/. 2 See http://www.mydeltaquest.com/ english/. 3 See http://www.offshore-manual.com/ taxhavens/. 4 See http://www.oecd.org/ document/ 60/ 0,3343,en _2649_34897_ 1942460 _1_1_1_1,00.html.). 5 See http://www.worldwide-tax.com/index.asp#partthree. 731 NATIONAL TAX JOURNAL includes some specifi c cities and areas. In foreign jurisdictions. Most countries have addition to the countries listed in Table 1, some form of anti-abuse rules similar to they include: in the Americas and Carib- Subpart F. bean, New York and Uruguay; in Africa, If a fi rm can shift profi ts to a low-tax Mellila, Sao Tome e Principe, Somalia, jurisdiction from a high-tax one, its taxes and South Africa; in the Middle East and will be reduced without affecting the Asia, Dubai, Labuan (Malaysia), Tel Aviv, economic activity of the company. Since and Taipei; in Europe, Alderney, Belgium, the United States taxes all income earned Campione d’Italia, City of London, Dub- within its borders as well as imposing a lin, Ingushetia, Madeira, Sark, Trieste, residual tax on income earned abroad by Turkish Republic of Northern Cyprus, and U.S. persons, tax avoidance relates both Frankfurt; and in the Indian and Pacifi c to U.S. parent companies shifting profi ts oceans, the Marianas. The only country abroad to low-tax jurisdictions and the listed in Table 1 and not included in their shifting of profi ts out of the United States list was Jordan. by foreign parents of U.S. subsidiaries. Grubert (2003) suggested that about half II. METHODS OF CORPORATE TAX the difference between profitability in AVOIDANCE low-tax and high-tax countries of U.S. multinationals was due to transfers of U.S. multinationals are not taxed on intellectual property (or intangibles) and income earned by foreign subsidiaries most of the rest through the allocation until it is repatriated to the U.S. parent of debt. However, Pak and Zdanowicz as dividends, although some passive and (2002), examining import and export related company income that is easily prices, suggest a very large effect of trans- shifted is taxed currently under anti-abuse fer pricing in intermediate goods. Some rules referred to as Subpart F. (Foreign evidence of the importance of intellectual affi liates or subsidiaries that are majority property can also be found from the types U.S.-owned are referred to as controlled of fi rms that repatriated profi ts abroad foreign corporations and many of these following a temporary tax reduction related fi rms are wholly owned.) Income enacted in 2004; Redmiles (2008) shows that is repatriated (or, less commonly, that a third of the repatriations were in earned by branches and taxed currently) pharmaceuticals and medicine and almost is allowed a credit against U.S. tax for 20 percent in the computer and electronic foreign income taxes paid. (A part of a equipment industry. parent company treated as a branch is not a separate entity for tax purposes, and all A. Allocation of Debt and Earnings income is part of the parent’s income.) Stripping Foreign tax credits are limited to the amount of tax imposed by the United A common profi t-shifting method is to States, so that they, in theory, cannot off- borrow more in high-tax jurisdictions and set taxes on domestic income. This limit less in low-tax jurisdictions. A more spe- is imposed on an overall basis, allowing cifi c practice is earnings stripping, where excess credits in high-tax countries to either debt is associated with related fi rms offset U.S. tax liability on income earned in high-tax countries or unrelated debt in low-tax countries, although separate is not subject to tax by the recipient. For limits apply to passive and active income. example, a foreign parent may lend to its Other countries either employ this system U.S. subsidiary or an unrelated foreign of deferral and credit or, much more com- borrower that is not subject to U.S. tax on monly, exempt active income earned in interest income might lend to a U.S. fi rm. 732 Forum on International Tax Avoidance and Evasion

The U.S. tax code contains provisions to not adopted. The AJCA mandated a Trea- address interest deductions and earnings sury Department study on this and other stripping. It allocates the U.S. parent’s issues; that study (U.S. Department of the interest to determine the foreign tax credit Treasury, 2007) focused on U.S. subsidiar- limit. Foreign source income is reduced ies of foreign parents and was not able to when part of U.S. interest is allocated to fi nd clear evidence of the magnitude of it and the maximum amount of foreign these effects. tax credits taken is limited, a provision Treasury’s mandated study noted that affects fi rms with excess foreign tax relatively straightforward evidence that credits. There is no allocation rule, how- U.S. multinationals allocate more inter- ever, to address deferral, so that a U.S. est to high-tax jurisdictions, but found parent could operate its subsidiary with the assessment of earnings stripping by all equity fi nance in a low-tax jurisdiction foreign parents of U.S. subsidiaries more and take all of the interest on the overall diffi cult, because the entire fi rm’s accounts firm’s debt as a deduction. President are not available. The Treasury study Obama’s budget includes a proposal to compared these subsidiaries to U.S. fi rms, disallow deductions for a portion of the but was not able to provide conclusive evi- parent’s interest and other overhead costs dence of profi t shifting out of the United until the income is repatriated. States due to high leverage rates for U.S. While allocation-of-interest approaches fi rms, except for inverted fi rms. could address debt shifting by U.S. multi- nationals, they cannot be applied to U.S. B. Transfer Pricing subsidiaries of foreign corporations. To limit earnings stripping in either case, the A second way that firms can shift United States has thin capitalization rules. profi ts is through the pricing of goods (Most of the United States’ major trading and services sold between affi liates. To partners have similar rules.) Section 163(J) properly refl ect income, prices of goods of the Internal Revenue Code applies to and services sold by related companies a corporation with a debt-to-equity ratio should be the same as prices that would be above 1.5 and net interest exceeding 50 paid by unrelated parties. By lowering the percent of adjusted taxable income (gen- price of goods and services sold by parents erally taxable income plus interest plus and affiliates in high-tax jurisdictions depreciation). Interest in excess of the 50 and raising the prices of their purchases, percent limit paid to a related corporation income can be shifted from the high-tax is not deductible if the corporation is not jurisdiction. subject to U.S. income tax. This restriction An important and growing transfer also applies to interest paid to unrelated pricing issue is transfers of intellectual parties and not taxed to the recipient. property rights, or intangibles. If a pat- The possibility of earnings stripping ent developed in the U.S. is licensed to a received more attention after a number low-tax foreign affi liate, income will be of U.S. fi rms inverted, that is, arranged shifted if the royalty or other payment is to move their parent fi rm abroad so that lower than the true value of the license. the U.S. operation became a subsidiary For many goods, similar products are sold of the foreign parent. The American Jobs or other methods (such as cost plus a mark Creation Act (AJCA) of 2004 addressed up) can be used to determine whether inversions by treating fi rms that subse- prices are set appropriately. However, quently inverted as U.S. fi rms for a period intangibles such as new inventions or of time. Proposals for increased earnings new drugs tend not to have comparable stripping restrictions were considered but products, and it is very diffi cult to know 733 NATIONAL TAX JOURNAL the royalty that would be paid in an arms- market may be in Germany and it would length transaction. Therefore, intangibles be desirable to manufacture in Germany. present particular problems for policing But to earn profi ts in Germany with its transfer pricing. higher tax rate does not minimize taxes. Investment in intangibles is favorably Instead, the Irish fi rm may contract with treated in the United States because a German fi rm, who will produce the item research costs, other than tangible assets, for cost plus a fi xed markup. Subpart F are expensed and eligible for a tax credit. ensures that certain profits from sales Advertising to establish brand names is income are taxed on a current basis, so also deductible. These treatments tend the arrangement must be structured to to produce an effective low, zero, or qualify as an exception from this rule. negative tax rate for overall intangible Chip (2007) discusses the complex and investment even when earnings are fully changing regulations on this issue. taxed, because of the magnitude of the up- front benefi ts. Thus, there are signifi cant D. Check-the-Box, Hybrid Entities, and incentives to make these investments in Hybrid Instruments the United States. If profi ts on successful investments in intangibles can then be Another technique for shifting profi t shifted to a low-tax jurisdiction, these to low-tax jurisdictions was greatly investments can be subject to signifi cantly expanded with the “check-the-box” pro- negative tax rates. visions. These provisions were originally Transfer pricing rules with respect to intended to simplify questions of whether intellectual property are further compli- a domestic fi rm was a corporation or a cated because of cost sharing agreements, partnership. Their application to foreign where different affi liates contribute to the circumstances through the “disregarded cost. If an intangible is already partially entity” rules, however, has led to the developed by the parent fi rm, affi liates expansion of hybrid entities, where an contribute a buy-in payment. It is dif- entity can be recognized as a corporation fi cult to determine arms-length pricing by one jurisdiction but not by another. in these cases where a technology is par- For example, a U.S. parent’s subsidiary tially developed and the outcome is risky. in a low-tax country can lend to its sub- McDonald (2008) found some evidence sidiary in a high-tax country, with the that fi rms with cost sharing arrangements interest deductible because the high-tax were more likely to engage in profi t shift- country recognizes the fi rm as a separate ing. As discussed by Nadal (2009), Trea- corporation. Normally, interest received sury Decision 9441 issued new proposed by the subsidiary in the low-tax country regulations that, among other features, would be considered passive or “tainted” would provide for periodic examination income subject to current U.S. tax under of outcomes cases involving intangibles. Subpart F. However, under check-the-box rules, the high-tax corporation can elect to C. Contract Manufacturing be disregarded as a separate entity. From the U.S. perspective there is no interest When a subsidiary is set up in a low-tax income paid because the two are the country and profi t shifting occurs, as in same entity. Check-the-box and similar the acquisition of rights to an intangible, hybrid entity operations can also be used a further problem occurs: this low-tax to avoid other types of Subpart F income, country may not be a desirable place to for example from contract manufacturing actually manufacture and sell the prod- arrangements. As discussed by Sicular uct. For example, an Irish subsidiary’s (2007), this provision, which began as a 734 Forum on International Tax Avoidance and Evasion regulation, has been effectively codifi ed, Because firms can choose when to albeit temporarily. repatriate income, fi rms with income from Hybrid entities relate to issues other jurisdictions with taxes in excess of U.S. than Subpart F. Calianno and Cornett taxes can use their excess credits to offset (2006) discuss a “reverse hybrid” entity— U.S. tax due on income from low-tax juris- the entity is structured so that it is a dictions. A study by the U.S. Government partnership for foreign purposes but Accountability Offi ce (2008a) suggested a corporation for U.S. purposes—that that because of crediting and deferral U.S. allows U.S. fi rms to receive foreign tax multinationals typically pay virtually no credits without recognizing the underly- U.S. tax on foreign source income. ing income. A U.S. parent can set up a The ability to reduce U.S. tax due to holding company in one country that is cross-crediting is increased, it can be treated as a disregarded entity, which argued, when U.S. source income is owns a corporation treated as a partner- treated as foreign source income, raising ship in another foreign jurisdiction. Under the foreign tax credit limit. This sourcing fl ow through rules, the holding company rule relates to the U.S. tax law and does is liable for the foreign tax and, because not affect foreign taxes paid; hence, it is it is not a separate entity, the U.S. parent benefi cial to fi rms with excess foreign tax corporation is also liable and thus receives credits. This income includes U.S. export the foreign tax credit, while the income income because a tax provision allows can be retained in the foreign corporation half of export income to be allocated to which is viewed as a separate entity from the country in which the title passes. the U.S. viewpoint. Another important type of income con- In addition to hybrid entities that sidered foreign source and thus shielded achieve tax benefi ts by being treated dif- from U.S. tax with foreign tax credits is ferently in the U.S. and the foreign juris- royalty income from active businesses. diction, there are also hybrid instruments This benefi t can occur in high-tax coun- that can avoid taxation by being treated tries because royalties are deductible from as debt in one jurisdiction and equity in income. (Note that the shifting of income another. These instruments are discussed due to transfer pricing of intangibles, by Foley (2007) and Kraymal (2005). advantageous in low-tax countries, is a different issue.) Interest income is another E. Cross-Crediting and Sourcing Rules type of income that may benefi t from this for Foreign Tax Credits foreign tax credit rule. Since royalties arise from investment Income from a low-tax country can in the United States, one could argue that escape taxes because of cross-crediting: it is appropriately U.S. source income, or the use of excess foreign taxes paid in that it should be put in a different foreign one jurisdiction or on one type of income tax credit basket so that excess credits to offset U.S. tax on other income. At generated by dividends cannot be used one time, the foreign tax credit limit was to offset taxes on such income. Two stud- calculated on a country-by-country basis, ies, by Grubert (2005) and by Grubert although that rule proved to be diffi cult and Altshuler (2008) have discussed this to enforce given the use of holding com- sourcing rule in the context of a proposal panies. Foreign tax credits are separated to eliminate the tax on active dividends. into different baskets to limit cross- In that proposal, the revenue loss from crediting; these baskets were reduced exempting active dividends from U.S. from nine to two (active and passive) in tax would be offset by gains from taxes 2004. on royalties. 735 NATIONAL TAX JOURNAL

III. THE MAGNITUDE OF CORPORATE Table 2 PROFIT SHIFTING U.S. Company Foreign Profi ts Relative to GDP, G-7 Profi ts of U.S. Controlled This section examines the evidence on Foreign Corporations as a Country Percentage of GDP the existence and magnitude of profit Canada 2.6 shifting and the techniques that are most France 0.3 likely to contribute to it. Germany 0.2 Italy 0.2 Japan 0.3 United Kingdom 1.3 A. Evidence on the Scope of Profi t Weighted Average 0.6 Shifting Source: Based on data from Mahoney and Miller (2004) and Central Intelligence Agency World Fact- There is ample, and readily under- book, at https://www.cia.gov/library/publications/ standable, evidence of profi t shifting to the-world-factbook. Most GDP data are for 2008 and based on the exchange rate for that year, but for some low-tax countries that is inconsistent with countries earlier years and data based on purchasing an economic motivation. This section power parity were the only data available. examines the profi t share of income of U.S.-controlled corporations compared to their share of gross domestic prod- Table 3 uct (GDP). Three groups of reference U.S. Foreign Company Profi ts Relative to GDP, countries are considered. The fi rst is the Larger Countries (GDP At Least $10 billion) remaining G-7 countries; they account for on Tax Haven Lists and the Netherlands 32 percent of pre-tax profi ts and 38 percent Profi ts of U.S. Controlled Corporations as a of rest-of-world GDP. The second group Country Percentage of GDP is larger countries from Table 1 (GDP of Costa Rica 1.2 at least $10 billion) plus the Netherlands, Cyprus 9.8 which account for 30 percent of earnings Hong Kong 2.8 Ireland 7.6 and 5 percent of rest-of-world GDP. The Luxembourg 18.2 third group of smaller tax haven countries Netherlands 4.6 Panama 3.0 accounts for 14 percent of earnings and Singapore 3.4 less than 1 percent of rest-of-world GDP. Switzerland 3.5 As indicated in Table 2, profi t-to-GDP Taiwan 0.7 ratios in the large G-7 countries range Source: See sources for Table 2. from 0.2–2.6 percent. Overall, this income as a share of GDP is 0.6 percent. Outside the United Kingdom and Canada, the Table 4 U.S. Foreign Company Profi ts Relative to GDP, share is 0.2–0.3 percent and does not vary Small Countries on Tax Haven Lists with country size (Japan, for example, Profi ts of U.S. Controlled has over twice the GDP of Italy). Table 3 Corporations as a reports the share for the larger tax havens Country Percentage of GDP for which data are available. U.S. profi ts Bahamas 43.3 Barbados 13.2 as a percentage of GDP are considerably Bermuda 645.7 larger than those in Table 2. In the case of British Virgin Islands 354.7 Luxembourg, these profi ts are 18 percent Cayman Islands 546.7 Guernsey 11.2 of output; profi t shares are also very large Jersey 35.3 in Cyprus and Ireland. In all but two cases, Liberia 61.1 profi t shares are well in excess of those in Malta 0.5 Marshall Islands 339.8 Table 2. Table 4 examines the small tax Mauritius 4.2 havens listed in Table 1 for which data Netherland Antilles 8.9 are available. In three of the islands off the Source: See sources for Table 2. 736 Forum on International Tax Avoidance and Evasion

U.S. coast (in the Caribbean and Atlantic), (2008a), and U.S. Department of Treasury profi ts exceed total GDP, and are well in (2000). excess of GDP in four jurisdictions. In other jurisdictions they are a large share B. Estimates of the Cost and Sources of of output. These numbers clearly indicate Corporate Tax Avoidance that the profi ts in these countries do not appear to derive from economic motives There are no offi cial estimates of the related to productive inputs or markets, cost of international corporate tax avoid- but rather refl ect income easily transferred ance; nor are there offi cial estimates of the to low-tax jurisdictions. individual tax gap, a point made by the Evidence of profit shifting has been U.S. Department of Treasury Inspector presented in other studies. Grubert and General for Tax Administration (2009). Altshuler (2008) report that profits of Nevertheless, the magnitude of corporate controlled foreign corporations in manu- tax avoidance has been estimated in sev- facturing relative to sales in Ireland are eral studies using a variety of techniques. three times the group mean. The U. Some address only avoidance by U.S. S. Government Accountability Office multinationals and not by foreign parents (2008a), hereafter GAO, reported higher of U.S. subsidiaries, and some focus only shares of pretax profits of U.S. multi- on a particular source of avoidance. nationals than of value added, tangible Estimates of the potential revenue cost assets, sales, compensation or employees of income shifting by multinational corpo- in low-tax countries. Sullivan (2004a) rations vary, with some estimates as high reports the return on assets for 1998 aver- as $60 billion. The U.S. Department of the aged 8.4 percent for U.S. manufacturing Treasury (1999) provides the IRS estimate subsidiaries, but 23.8 percent in Ireland, of the international gross tax gap (not 17.9 percent in Switzerland, and 16.6 accounting for increased taxes collected percent in the Cayman Islands. More on audit) related to transfer pricing based recently, Sullivan (2008b) noted that of on audits of returns. They estimate a cost the ten countries that accounted for the of about $3 billion, based on examinations most foreign multinational profi ts, the of tax returns for 1996-1998. This estimate fi ve countries with the highest manufac- reflects not legal avoidance, but non- turing returns for 2004 (the Netherlands, compliance. One limitation is that an audit Bermuda, Ireland, Switzerland, and does not detect all non-compliance, and it China) all had effective tax rates below would not detect avoidance mechanisms 12 percent while the fi ve countries with which are, or appear to be, legal. lower returns (Canada, Japan, Mexico, If most of the profi t in low-tax countries Australia, and the United Kingdom) had has been shifted there to avoid U.S. tax tax rates in excess of 23 percent. Note rates, the projected revenue gain from that effective tax rates for some countries ending deferral would provide an idea differ depending on the source of data; of the general magnitude of the revenue according to the U.S. Government cost of profi t shifting by U.S. parent fi rms. Accountability Offi ce (2008b), the Neth- The Joint Committee on Taxation (2008b) erlands would be classifi ed as a low-tax projects the revenue gain from ending country based on data on controlled for- deferral to be about $11 billion in FY2010. eign corporations but as high-tax based This estimate could overstate the cost of on U.S. Bureau of Economic Analysis tax avoidance because some of the profi ts data. Econometric studies of profi t shift- abroad accrue to real investments in coun- ing focusing on this issue are reviewed in tries that have lower tax rates than the Hines (1999), Joint Committee on Taxation United States and do not refl ect artifi cial 737 NATIONAL TAX JOURNAL shifting. It could be an understatement their own analysis fi nds that multination- because it does not refl ect the tax that als saved $7 billion more between 1997 could be collected by the United States and 2002 due to the check-the-box rules. rather than foreign jurisdictions on profi ts However, some of this gain may have been shifted to low-tax countries. For example, at the cost of high-tax host countries rather Ireland has a tax rate of 12.5 percent and than the United States. the United States a 35 percent rate, so Christian and Schultz (2005) using tax that ending deferral (absent behavioral return data on asset returns estimated $87 changes) would only collect the excess of billion was shifted in 2001, which at a 35 the U.S. tax over the Irish tax on shifted percent tax rate implies a revenue loss revenues, or about two thirds of lost of about $30 billion. This estimate may revenue. be too large because of the inability to The U.S. Offi ce of Management and determine how much was shifted out of Budget’s (2009) estimates for ending high-tax foreign jurisdictions rather than deferral are slightly larger, over $14 the United States. Economic theory also billion. Grubert and Altshuler (2008) indicates that the returns should be lower, estimate for 2002 that the corporate tax the lower the tax rate, so the results could could be cut to 28 percent if deferral were understate the overall profi t shifting and ended, and based on corporate revenue the revenue loss. in that year the gain is about $11 billion. Pak and Zdanowicz (2002) used export That year would likely produce a low and import prices to estimate that the lost estimate because of the recession; if the revenue due to transfer pricing of goods share remained the same, the gain would alone was $53 billion in 2001. This estimate be around $13 billion for 2004 and $26 should cover both U.S. multinationals billion for 2007. and U.S. subsidiaries of foreign parents. Researchers have looked at differ- In a paper in this forum, Clausing (2009) ences in pretax returns and estimated regresses profi ts on tax rates with cross the revenue gain if returns were equated. country data (1982–2004) and estimates Sullivan (2004b), using U.S. Commerce a total revenue loss in 2002 of over $85 Department data, estimates that, based on billion. Her methodological approach differences in pre-tax returns, the revenue differs from others that involve direct cost for 2004 was between $10–20 billion, calculations based on returns or prices and $75 billion in profi ts were artifi cially and is subject to the econometric limita- shifted to low-tax countries. If all of that tions associated with cross country panel income were subject to U.S. tax, it would regressions. In theory, however, her esti- result in a gain of $26 billion for 2004. mate included both outbound shifting by Some income might already be taxed U.S. parents of foreign corporations and under Subpart F, some might be absorbed inbound shifting by foreign parents of by excess foreign tax credits, and the effec- U.S. corporations, covering all techniques. tive tax rate may be lower than the statu- Clausing and Avi-Yonah (2008) estimate tory rate. He concludes that the estimate the revenue gain from moving to formula of between $10–20 billion is appropriate. apportionment based on sales of $50 Sullivan (2008a) subsequently reports an billion per year. This estimate is not an estimated $17 billion increase in revenue estimate of the loss from profi t shifting loss from profi t shifting between 1999 and (since sales and income could differ for 2004, which may be due to the check-the- other reasons) but it is suggestive of the box rules. Altshuler and Grubert (2006) magnitude of total effects from profi t shift- suggest that Sullivan’s methodology may ing. Shackelford and Slemrod (1998), who involve some double counting; however, applied formula apportionment based on 738 Forum on International Tax Avoidance and Evasion an equal weight of assets, payroll, and of tax avoidance, while Grubert (2003) sales found a similar result. suggests that the main methods of profi t It is difficult to develop a separate shifting are leverage and intangibles. The estimate for U.S. subsidiaries of foreign estimates for pricing of goods may, how- multinational companies because there ever, refl ect errors or money laundering is no way to observe the parent fi rm and motives rather than tax motives. Pak and its other subsidiaries. Several studies, Zdanowich (2004) fi nd that much of the reviewed by the U.S. Department of the shifting was associated with trade with Treasury (2007) and Grubert (2008), fi nd high-tax countries; for example, Japan, these fi rms have lower taxable income Canada, and Germany accounted for 18 and some have higher debt-to-asset ratios percent of the total. At the same time, than domestic fi rms. There are many other about 14 percent of the estimate refl ected potential explanations of these differing transactions with countries that appear on characteristics. In addition, domestic fi rms tax haven lists: the Netherlands, Taiwan, that are used as comparisons also have Singapore, Hong Kong, and Ireland. incentives to shift profi ts when they have Some evidence that points to the impor- foreign operations. No quantitative esti- tance of intangibles can be developed mate has been made. Blouin, Collins and by examining the sources of dividends Shackelford (2005) found no differences in repatriated during the “repatriation taxes of fi rms before and after acquisition holiday” enacted in 2004, reported by by foreign versus domestic acquirers, but Redmiles (2008). This provision allowed, the problem of comparison remains and for a temporary period, dividends to be their sample was very small. Some evi- repatriated with an 85 percent deduction, dence of earnings stripping for inverted leading to a tax rate of 5.25 percent. The fi rms was reported in U.S. Department pharmaceutical and medicine industry of Treasury (2007) and Seida and Wembe accounted for $99 billion in repatria- (2007), who estimate $0.7 billion in revenue tions or 32 percent of the total. The com- loss from four fi rms that inverted. Inverted puter and electronic equipment industry fi rms may, however, behave differently accounted for $58 billion or 18 percent from foreign fi rms with U.S. subsidiaries. of the total. Thus, these two industries, which are high tech fi rms, accounted for C. Importance of Different Profi t Shifting half of the repatriations. Mock and Simon Techniques (2008) found benefi ts highly concentrated in a few fi rms. Also, as shown in Table 5, Some studies have attempted to iden- tify the importance of different profi t- Table 5 shifting techniques. Grubert (2003) has Source of Dividends from “Repatriation Holiday”: estimated that about half of income Countries Accounting for at Least 1 Percent of Dividends shifting was due to transfer pricing of Country Percentage of Total intangibles and most of the remainder to Netherlands 28.8 shifting of debt. Altshuler and Grubert Switzerland 10.4 (2006) fi nd that multinationals saved $7 Bermuda 10.2 billion more between 1997–2002 due to Ireland 8.2 Luxembourg 7.5 the check-the-box rules. Canada 5.9 Some of the estimates discussed above Cayman Islands 5.9 confl ict with respect to the source of profi t United Kingdom 5.1 Hong Kong 1.7 shifting. The Pak and Zdanowich (2002) Singapore 1.7 estimates suggest that transfer pricing Malaysia 1.2 of goods is an important mechanism Source: Calculated from Redmiles (2008). 739 NATIONAL TAX JOURNAL which lists all countries accounting for at a trade or business, and certain rents least one percent of the total of eligible are taxed, although treaty arrangements dividends (and accounting for 87 percent reduce or eliminate tax on dividends. of the total), most of the dividends were The Joint Committee on Taxation (2009a) repatriated from countries that appear on discusses how new techniques have, tax haven lists. through derivatives, transformed divi- dends subject to withholding into exempt IV. METHODS OF AVOIDANCE AND interest. EVASION BY INDIVIDUALS The elimination of tax on interest income was unilaterally initiated by the Individual evasion of taxes may take United States in 1984, and other countries different forms, facilitated by growing began to follow suit, as discussed by Avi- international fi nancial globalization and Yonah (2008). Currently, fears of capital ease of making transactions on the Inter- fl ight are likely to keep countries from net. With little or no information report- changing this treatment. However, this ing, individuals can purchase foreign elimination has been accompanied with a investments directly (outside the United lack of information reporting that allows States), such as stocks and bonds, or put U.S. citizens, who are liable for these money in foreign bank accounts and not taxes, to avoid them whether on income report the income. They can also use invested abroad or income invested in structures such as trusts or shell corpora- the United States channeled through tions to evade tax on investment income, shell corporations and trusts. Citizens of including income on investments made foreign countries can also evade taxes, in the United States, taking advantage of and the U.S. practice of not collecting U.S. tax laws that exempt interest income information contributes to the problem and capital gains of non-residents from for other countries. U.S. tax. Rather than using withholding or Guttentag and Avi-Yonah (2005) information collection, the United States describe a typical way that U.S. indi- largely relies on the Qualifi ed Intermedi- viduals can easily evade tax on domestic ary (QI) program where benefi cial owners income through a Cayman Islands opera- are not revealed. To the extent any infor- tion. The individual, using the Internet, mation gathering from other countries is can open a bank account in the name of done, it is through bilateral rather than a Cayman corporation that can be set up multilateral information exchanges. The for a minimal fee. Money can be electroni- European Union has developed a mul- cally transferred without any reporting tilateral agreement but the United States to tax authorities, and investments can does not participate. be made in the United States or abroad. Investments by non-residents in interest- A. Tax Provisions Affecting the Treatment bearing assets and most capital gains are of Income by Individuals not subject to a withholding tax in the United States. U.S. fi rms or individuals may avoid tax Foreign trusts may involve a trust pro- on U.S. source income because the U.S. tector who is an intermediary between does not withhold taxes on many sources the grantor and the trustees, but whose of income paid to foreigners. In general, purpose may actually be to carry out interest and capital gains are not withheld. the desires of the grantor. Some taxpay- Dividends, non-portfolio interest (e.g., ers argue that these trusts are legal, but interest payments by a U.S. subsidiary to in any case they can be used to protect its parent), capital gains connected with income from taxes, including those from 740 Forum on International Tax Avoidance and Evasion

U.S. investments, while retaining control QI program in 2001, under which foreign over and use of the funds. banks that received payments must certify the nationality of their depositors and B. Limited Information Reporting reveal the identity of any U.S. citizens. Sul- Between Jurisdictions livan (2009) and the Joint Committee on Taxation (2009a) discuss this program and The international taxation of passive its origins. Although QIs are supposed to portfolio income by individuals is easily certify nationality, apparently some rely subject to evasion because there is no mul- on self-certifi cation. They are also subject tilateral reporting of interest income. Even to audit. UBS, the Swiss bank involved in bilateral information sharing treaties, a tax abuse scandal for helping clients set or TIEAs, have limits. Avi-Yonah (2009) up offshore plans, was a QI. notes that most agreements are restricted A non-qualifi ed intermediary must dis- to criminal matters, which are a minor close the identity of its customers to obtain part of the revenues lost and pose diffi - the exemption for passive income such as cult issues of evidence. These agreements interest and or the reduced rates arising may require that activities related to the from tax treaties, but there are questions information sought constitute crimes in about the accuracy of disclosures. both countries, which can be a substantial hurdle in cases of tax evasion. The OECD D. European Union Savings Directive has adopted a model agreement dealing with the “dual criminality” requirements. The European Union has developed TIEAs usually allow for information only an option under which both member upon request, requiring the United States countries as well as some other countries and other countries to identify potential must either have information reporting or tax evaders in advance and they do not a withholding tax. Three member states, override bank secrecy laws. (However, Austria, Belgium, and Luxembourg, have some countries are abandoning secrecy elected the withholding tax. While this agreements.) multilateral agreement aids these coun- In some cases, countries have little or tries’ tax administration, the United States no information of value. Jackson (2009), is not a participant. for example, discusses the possibility of an information exchange agreement with V. ESTIMATES OF THE REVENUE the British Virgin Islands, a country with COST OF INDIVIDUAL TAX EVASION more than 400,000 registered corpora- tions. Its laws require no identifi cation of Estimates of individual tax evasion rely shareholders or directors and no fi nancial on data reported on assets. Individual records. Even if the country signed an evasion is difficult to estimate, given agreement, it is not clear what information limited information on untaxed assets could be exchanged. held abroad. Guttentag and Avi-Yonah (2005) esti- C. U.S. Collection of Information on U.S. mate $50 billion in individual tax evasion, Income and Qualifi ed Intermediaries based on an estimate of $1.5 trillion of non-U.S. holdings held by high net worth Under the Qualifi ed Intermediary (QI) individuals, using a 10 percent rate of program the United States itself does return and a 33 percent tax rate. They also not require U.S. fi nancial institutions to summarize two other estimates of $40 bil- identify the true benefi ciaries of interest lion by the IRS, and $70 billion by an IRS and exempt dividends. The IRS set up the consultant in 2002. 741 NATIONAL TAX JOURNAL

To the extent that the earnings are inter- rules, and include signifi cant restrictions in est, the 10 percent rate of return may be too deferral or allocation of income and capital. high, while if it is dividends and capital gains, the tax rate is too high. Using a tax 1. Repeal Deferral rate of 15 percent (currently applicable to One approach to mitigate the rewards capital gains and dividends) would lead to of profi t shifting is to repeal deferral, or an estimate of about $23 billion. For equity to institute true worldwide taxation of investments, if a third of the return is in foreign source income. Firms would be dividends, half of capital gains is never subject to current tax on the income of realized, and the tax rate is 10 percent, the their foreign subsidiaries, although they estimate falls to $15 billion. During 2002 would continue to be able to take foreign and beginning in 2011, the relevant tax tax credits. According to the estimates rate on capital gains and dividends is 20 cited above, this change currently would percent, implying a loss of $20 billion. For raise from $11–14 billion per year. interest, since investors can earn tax free Traditionally, economic analysis has returns in the neighborhood of 4–5 percent suggested that eliminating deferral would on domestic state and local bonds, to earn increase economic efficiency, although a 5 percent after-tax return at a 35 percent recently some have argued that this gain tax rate would require a pre-tax yield of would be offset by the loss of production about 7.7 percent. The estimate of revenue of some effi cient fi rms from high-tax coun- loss would then be $40 billion. tries. These economic issues are discussed The Tax Justice Network (2005) has in Gravelle (2008, 2009). estimated a worldwide revenue loss for all Repeal of deferral would largely elimi- countries of $255 billion from individual nate the planning techniques discussed in tax evasion, basically using a 7.5 percent this paper. There are concerns, however, return and a 30 percent tax rate. These that fi rms could avoid the effects of repeal assumptions would be consistent with a by inverting, that is, having their parent $33 billion loss for the United States, using incorporate in other countries that con- the $1.5 trillion fi gure. tinue to allow deferral. This technique was restricted in 2004: fi rms with 80 percent V. ALTERNATIVE POLICY OPTIONS continuity of ownership would be treated TO ADDRESS CORPORATE as U.S. fi rms for the next ten years and PROFIT SHIFTING fi rms with at least 60 percent continuity of ownership would be subject to tax on the Since much of the corporate tax revenue transfer of assets. More permanent restric- loss arises from activities that either are or tions might need to be considered. Merg- appear to be legal, this loss is diffi cult to ers would be another method to counter address with actions other than tax law eliminating deferral, although mergers changes. Outcomes would be better with involve real changes in organization that international cooperation. Possibilities for would not likely be undertaken to gain international cooperation appear greater a small tax benefi t. Another possibility for individual evasion than for corporate is that more direct portfolio investment avoidance. (i.e., buying shares of stock by individual investors) in foreign corporations will A. Broad Changes to International Tax occur. There has been a signifi cant growth Rules in this form of direct investment, although the evidence suggests this investment has The fi rst set of provisions would intro- been due to portfolio diversifi cation and duce broad changes in international tax not tax avoidance (Gravelle 2008, 2009). 742 Forum on International Tax Avoidance and Evasion

2. Targeted or Partial Elimination of Deferral ing this proposal would require tracing Some narrower proposals to address sales to a third party for resale. Admin- deferral and tax avoidance would tax istrative issues also arise with a more income in tax havens currently, or tax restrictive proposal made by Senator some additional income of foreign sub- Kerry during the 2004 presidential cam- sidiaries. These proposals include: paign. He proposed to eliminate deferral except when goods are produced and sold • Eliminating deferral for specified in the controlled foreign corporation’s tax havens; jurisdiction. This approach would be • Eliminating deferral in countries likely to signifi cantly restrict opportuni- with tax rates that are below the U.S. ties for artifi cial profi t shifting, since most rate by a specifi ed proportion; of the income in tax havens or low-tax • Eliminating deferral for income on jurisdictions does not arise from real activ- the production of goods that are in ity and these jurisdictions are too small in turn imported into the United States; many cases to provide a market. • Eliminating deferral for income on A fi nal option that would not go as far as the production of goods that are eliminating deferral altogether would be exported; and to require some minimum share of equity • Requiring a minimum payout share. income to be paid out as dividends.

Eliminating deferral for tax havens would 3. Allocation of Deductions and Credits with address some of the problems associated Respect to Deferred Income/Restrictions with transfer pricing and leveraging. on Cross-Crediting Defining tax havens would be crucial President Obama and H.R. 3970 (110th and to be comprehensive would need Congress) proposed to disallow a share to include low tax rate countries and of the parent company’s deductions countries with special regimes (such as and credits until income is repatriated. the Netherlands). Listing specific tax According to U.S. Department of the haven countries might make cooperative Treasury (2009) and Joint Committee on approaches, such as tax information shar- Taxation (2009b) estimates, this proposal ing treaties, more diffi cult. would raise $9–10 billion (after revising An alternative would be to restrict the check-the-box rules). The disallowed deferral when tax rates are lower than the deductions would refl ect the share of for- U.S. rate. The French, who have a territo- eign deferred income in total income and rial tax, tax income earned in jurisdictions would primarily refl ect interest deduc- with tax rates one-third lower than the tions. (President Obama’s proposal does French rate. For the U.S., this ratio would not allocate research and experimentation indicate a tax rate lower than 24 percent. expenses). The foreign tax credit allocation Such a rule might not, however, capture rule would allow credits for the share of countries like the Netherlands. foreign taxes paid that is equal to the share A proposal directed to “runaway” plans of foreign source income repatriated. Dis- would eliminate deferral for investments allowed deductions and credits would be abroad involved in the production of carried forward. goods that are exported to the United The allocation-of-deductions provi- States. S. 1284 (110th Congress) would sion would decrease the tax benefi ts of expand Subpart F income to include sheltering income in low-tax jurisdictions, income attributable to imports of goods encourage repatriation of income relative produced by foreign subsidiaries of U.S. to current law, and presumably reduce fi rms into the United States. Administer- profi t shifting, as well as decreasing the 743 NATIONAL TAX JOURNAL benefi ts of real investment abroad. The Real distortions in the allocation of capital foreign tax credit allocation rule could would remain, since capital would still have offsetting effects. It would make fl ow to low-tax jurisdictions, but paper foreign investment abroad less attrac- profits could not be shifted easily. An tive because it would increase the tax allocation system based on assets becomes on income when repatriated, it would more diffi cult when intangible assets are discourage investment in low-tax jurisdic- involved, as it is probably as diffi cult to tions that could no longer be sheltered by estimate the stock of intangible invest- foreign tax credits, and it could discour- ment (given lack of information on the age repatriation of earnings on existing future pattern of profi tability) as it is to activities because of the potential tax to allocate it under arms-length pricing. be collected. With allocation based on sales, profi ts The allocation of credits accomplishes that might appropriately be associated some of the restrictions on cross-crediting with domestic income as they arise from that could also be achieved by increasing domestic investment in R&D would be the number of baskets or providing a allocated abroad. Moreover, new avenues per country basket limit, but is probably of tax planning, such as selling to an simpler. intermediary in a low-tax country for resale, would complicate the administra- 4. Formula Apportionment tion of such a plan. Whether the ben- Apportioning income through a for- efi ts are greater than the costs is in some mula would be a major change in the dispute. international tax system. With formula If the Untied States adopted formula apportionment, income would be allo- apportionment there could be double cated to different jurisdictions based taxation of some income and no taxation on shares of some combination of sales, of other income. The European Union assets, and employment, an approach has been considering an apportionment used by the U.S. states and the Canadian formula based on property, gross receipts, provinces. In the past, a three-factor number of employees, and cost of employ- apportionment formula was used, but ment. This proposal and its consequences some states have moved to a single factor for different countries are discussed based on sales. Shackleford and Slemrod by Devereux and Loretz (2008). If the (1998) estimate a 38 percent revenue European Union adopted such a plan it increase from an equally-weighted three- would be easier for the United States to factor system. Clausing and Avi-Yonah adopt a similar apportionment formula (2008) estimate that a sales-based formula without as much risk of double or no would increase corporate tax revenue by taxation with respect to its major trading about 35 percent, or $50 billion annually partners. from 2001–2004. The ability of a formula apportionment 5. Eliminate Check-the-Box, Hybrid Entities, system to address some of the problems and Hybrid Instruments; Foreign Tax Credit of shifting income becomes problematic Splitting From Income with intangible assets. Some of these Proposals have been made to eliminate problems are addressed by Altshuler and the check-the-box rules, and to adopt Grubert (2009). If all capital were tangible, rules that would require that legal entities a formula apportionment system based be characterized in a consistent manner on capital would at least lead to the same by the United States and the country in pre-tax rate of return for tax purposes which the entity is established (McIntyre, across high-tax and low-tax jurisdictions. 2009). President Obama’s plan would 744 Forum on International Tax Avoidance and Evasion not allow a foreign subsidiary to treat its includes a provision to restrict the credit- own subsidiary as a disregarded entity. ing of taxes that are in exchange for an It also includes a provision to prevent economic benefi t (such as payments that foreign tax credits without U.S. taxa- are the equivalent of royalties). tion of the associated income, which can McIntyre (2009) has proposals to deal currently be accomplished with reverse with transfer pricing, including making hybrids. The U.S. Department of Treasury transfer pricing penalties nearly automatic (2009) estimates a gain of $8–9 billion for taxpayers who have not kept contem- for the fi rst proposal and $2 billion for poraneous records, and using formula the second, but the Joint Committee on apportionment as a default for transfer Taxation (2009b) estimates $3 billion and pricing for non-complying taxpayers, $1 billion. In general, this particular class so the IRS does not have to conduct a of provisions that undermine Subpart F detailed transaction by transaction assess- and the matching of credits and deduc- ment for the court. President Obama’s tions with income could be addressed proposals would clarify that intangibles by rules that require legal entities to include workforce in place, goodwill, and be characterized in a consistent man- going concern value and that they are ner by the United States and the host valued at their highest and best use. The country and the denial of tax benefits plan would allow the IRS Commissioner that arise from inconsistent treatment of to aggregate intangibles if that leads to a instruments. more appropriate value. These propos- als would likely have small effects. Any B. Narrower Provisions Affecting signifi cant solution to the transfer pric- Multinational Profi t Shifting ing problem, especially for intangibles, is diffi cult to devise short of the elimination A number of narrower provisions affect- of deferral. ing profi t shifting could be considered. A fi nal proposal relevant to interna- The 2004 House proposal would have tional tax avoidance and evasion is a eliminated the debt-to-asset test and codifi cation of the economic substance lowered the interest share standard to 25 doctrine, where tax savings arrange- percent for ordinary debt, 50 percent for ments without economic substance can guaranteed debt, and 30 percent overall be disallowed by the courts. The proposal, for earnings stripping. President Obama’s included in President Obama’s budget, plan lowers the interest share to 25 percent would require a transaction to meet both for inverted fi rms for related party non- an objective test (profi t was made) and guaranteed debt. a subjective test (profi t was intended). One issue surrounding the cross-cred- Penalties would be imposed if the test iting of the foreign tax credit is the use of were not passed. Supporters argue that excess credits to shield royalties from U.S. the stricter test would reduce tax avoid- tax on income that could be considered ance and make treatment more consistent U.S.-source income. Grubert (2005) and across the courts. Some tax attorneys have Grubert and Altshuler (2008) discuss argued that more specific rules might two options: sourcing these royalties as provide a roadmap to structuring arrange- domestic income for the foreign tax credit ments that will pass the test. or putting them into a separate foreign tax President Obama’s plan would revise credit basket. The same approach could the rule on reorganizations when prop- be used for the income from exports to erty as well as stock is received to treat be allocated to the country in which the distributions as dividends in the case of title passes. President Obama’s proposal cross-border transactions. 745 NATIONAL TAX JOURNAL

VI. OPTIONS TO ADDRESS could be shown). Further cooperation INDIVIDUAL EVASION with the OECD and the G-20 has been suggested. Proposals have also been made Most options for addressing individual for the U.N. to develop a global coopera- evasion involve information reporting tion standard, set up a panel to determine and enforcement. There are options that compliant states, and deny recognition to would involve fundamental changes in non-compliant jurisdictions. Proposals the law, such as shifting from a residence have also been made for the International to a source basis for passive income. That Monetary Fund and World Bank country is, the United States would tax this pas- assessments to address tax compliance. sive income earned in its borders, just as is the case for corporate and other active 2. Expanding Bilateral Information Exchange income. This change involves many other An increase in the scope of bilateral economic and effi ciency effects that are information treaties to provide for regular probably not desirable. The remainder and automatic exchanges of information of the proposals discussed here do not would require U.S. banks to increase involve any fundamental changes in the their collection of information. One sug- tax law, but rather focus on administration gestion is to adopt the model OECD Tax and enforcement. Information Exchange Agreement. This The options discussed below are drawn information exchange would relate to from many sources, including academics civil as well as criminal issues, would not and practitioners, organizations, the Inter- require suspicion of a crime other than tax nal Revenue Service, and legislative pro- evasion, and would override bank secrecy posals. These are discussed in Tax Justice laws. Non-tax havens could be induced Network (2009), Guttentag and Avi-Yonah to make agreements to obtain ownership (2005), and Sullivan (2009) and have been information and collect information on addressed in congressional testimony by interest payments by banks and fi nancial Avi-Yonah (2008, 2009), Blessing (2009), institutions. Treasury has proposed such Shay (2009), Shulman (2009), Blum (2008), a plan for 16 countries, but Guttentag and McIntyre (2009). and Avi-Yonah (2005) suggest there is no reason to restrict the provision in this way. A. Information Reporting Treasury could use existing authority not to exchange information that might be Expanded information reporting can misused by non-democratic foreign gov- involve multilateral efforts, changes in ernments. Sullivan (2009) suggests that the current bilateral treaties, or unilateral automatic information exchange might changes. be the only way to stop evasion, which would require renegotiating existing 1. Multilateral Information Sharing or agreements and a major policy change. Withholding; International Cooperation The Stop Tax Haven Abuse Act requires The option likely to recover most of automatic information exchange for a the evaded revenues would be to join in country to stay off the tax haven list. the EU Directive, which would require information reporting on all income paid 3. Unilateral Approaches: Withholding/ to foreign entities by U.S. banks and other Refund Approach; Increased Information institutions. If the benefi cial owner can- Reporting Requirements not be identifi ed, withholding could be The United States could impose with- imposed (a refund would be allowed if holding taxes on interest income and evidence of reporting to the home country other exempt income received from U.S. 746 Forum on International Tax Avoidance and Evasion sources by foreign intermediaries, and 2. Qualifi ed Intermediaries provide a refund upon proof that the Several proposals relating to the QI benefi cial recipient was eligible. Alter- program have been made. These pro- natively, withholding could be imposed posals include independent verifica- unless the names of customers including tion of owners of foreign corporations, benefi cial owners were provided. Presi- reporting of non-U.S. income of U.S. dent Obama’s proposals would impose taxpayers, electronic submission of infor- withholding requirements with a refund mation, withholding for bearer bonds, mechanism, but only on non-qualifi ed and strengthened audits with U.S audit intermediaries. oversight and a ban on auditors who sell The Stop Tax Haven Abuse Act would tax shelters. Another possible change is require banks and QIs to fi le 1099 infor- to require QIs to share information about mation returns for U.S. owners, based on foreign customers to U.S. treaty partners benefi cial ownership (already required to (although this might be too severe a be known under anti-money-laundering requirement). Shell corporations should rules) any fi nancial institution that estab- not be accepted as the benefi cial owner lishes a trust, corporation, or bank account and penalties for failure to enforce could in a tax haven country would be required include withholding on capital gains as to report it to the IRS. President Obama’s well as interest and dividends. The IRS proposals contain similar provisions and could require U.S. payors to issue form also require information reporting by 1099s when they know or suspect the ben- U.S. fi nancial intermediaries, by QIs on efi cial owner is a U.S. citizen (rather than transfers of funds, and by U.S. persons the W8-BEN which provides evidence of and QIs on the formation or acquisition foreign status). President Obama’s pro- of a foreign entity. The Stop Haven Abuse posals would require that QIs can qualify Act would also require reporting by only if all of their affi liates are QIs. U.S. shareholders and persons forming, sending or receiving assets from Passive 3. Burden of Proof Foreign Investment Corporations (PFICs). Several proposals would shift the burden of proof to taxpayers in a variety B. Other Measures That Might Improve of ways, especially when large amounts Compliance are involved, and some proposals would allow criminal penalties. 1. Carrot and Stick Approaches to Tax Havens 4. Treat Shell Corporations as US Firms Since little of the benefi t of tax havens fl ows to their sometimes needy residents, The Stop Tax Haven Abuse Act would transitional aid to move away from these treat any fi rm that is publicly traded or activities might be paired with withhold- has assets over $50 million (including ing for non-cooperating tax havens. The hedge funds) as a U.S. corporation. This Stop Tax Haven Abuse Act would extend provision would not affect subsidiaries of to tax enforcement the money launder- multinational fi rms because decisions are ing sanctions of the Patriot Act, ranging made by the parent fi rm. Sullivan (2009) from increased reporting on transactions argues that such a provision would have a to prohibitions. Sullivan (2009) points devastating effect on the U.S. hedge fund out that the U.S. government has used industry, where offshore fi rms generally the Patriot Act sparingly, however, and attract tax exempt U.S. investors and questions whether this change would be foreigners who wish to avoid fi ling tax a credible threat. returns, as well as U.S. tax evaders, and 747 NATIONAL TAX JOURNAL that legislative relief for U.S. tax exempt along with due diligence on the part of investors (pension funds, university tax preparers to determine if it should be endowments) would be likely. fi led. Reporting large transactions could also be required. 5. Restrictions on Foreign Trusts Any powers held by trust protectors 11. John Doe Summons could be attributed to the trust grantor, The Stop Tax Haven Abuse Act provides any U.S. person who benefi ts could be that the court is to presume tax compli- treated as a formal benefi ciary, a future or ance is at issue in cases involving offshore contingent benefi ciary could be treated as secret accounts, allowing the IRS to issue a current one, loans of assets and property John Doe summons for large investigative would be distributions, and art and jew- projects. elry would be contributions. 12. Strengthening Penalties 6. Treat Dividend Abuse Increased penalties are included in The Stop Tax Haven Abuse Act would several proposals. These include: penal- treat dividend equivalents as dividends. ties for failure to fi le FBARs; basing the President Obama’s plan treats equity FBAR penalty on the highest amount in swaps as dividends. a period rather than on a particular day; and increased penalties on abusive tax 7. Statute of Limitations shelters, failure to fi le information on for- Several proposals would extend the eign trusts, and certain offshore transac- statute of limitations from three to six tions. President Obama’s proposals would years, or possibly 10 years. double accuracy-related penalties for foreign transactions and increase penalties 8. IRS Resources for trusts and permit them to be imposed Suggestions include expansion of if the amount in the trust cannot be IRS resources for overseas tax abuses, established. Legal opinions that take the eliminating pressures on agents to give position that a transaction is more likely up diffi cult cases because of short term than not to prevail for tax purposes could performance goals, and sharing suspi- no longer shield taxpayers from penalties. cious activity reports fi led by fi nancial The Fraud Recovery and Investment institutions under anti-money laundering Act, S. 386, would introduce criminal pen- acts with the civil side of the IRS. alties. Coder (2009) suggests that some tax attorneys have questioned whether these 9. Make Civil Cases Public to Improve proposals are too harsh or might under- Visibility and as a Deterrent mine amnesty or voluntary compliance. All settlements involving offshore The attorneys are concerned that money schemes in excess of $1 million could be laundering charges would not have to excluded from the restrictions that require be approved through the Department settled civil cases to be confi dential. of Justice’s tax division, that penalties of up to 20 years gives prosecutors too 10. Revise Rules for FBAR (Foreign Bank much power, that the provisions may Account Reports) trap taxpayers who want to participate The FBAR report on foreign bank in IRS voluntary disclosure, and that they accounts is fi led separately from the tax would also discourage “quiet disclosure” return. Several proposals would require where taxpayers simply report past this form to be fi led with the tax return, information.

748 Forum on International Tax Avoidance and Evasion

13. Address Tax Shelters; Codify Economic intangible assets between U.S. multina- Substance Doctrine tionals and their subsidiaries, may only The proposed Stop Tax Haven Abuse be addressed with fundamental changes Act would make a number of additional in the U.S. tax law, such as ending deferral. changes to address tax shelters, including The main problem with collecting taxes prohibiting the patenting of tax shelters, from individuals is evasion: failure to developing a bank examination procedure, report asset income earned abroad, includ- disallowing fees contingent on tax savings, ing income derived from U.S. sources and removing communication barriers between funneled through sham corporations and enforcement agencies, codifying regula- trusts in low-tax countries. While recent tions (including the economic substance initiatives to reduce bank secrecy and pro- doctrine), clarifying that prohibition of dis- vide voluntary information sharing by tax closure by tax preparers does not prevent haven countries may help, these changes congressional subpoenas, and providing will likely have limited effects because the standards for tax shelter opinion letters. tax authorities must identify the specifi c taxpayers for information on request. The 14. Regulate State Incorporation Rules. most effective remedy for international tax evasion by individuals is automatic, U.S. Limited Liability Companies multilateral information sharing, which (LLCs) could be required to have a tax- has already been initiated in the European payer ID number, and record-keeping Union. More limited measures, such as and identifi cation of benefi cial owners of requiring more oversight of and informa- corporations and LLCs (and perhaps part- tion from foreign banks that act as qualifi ed nerships and trusts) would be required. intermediaries, may also be effective.

VII. CONCLUSION ACKNOWLEGMENTS

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