BY JOHN MULLIN

Corporate Across Borders Governments across the globe recently reached agreement in principle on measures to counter the avoidance strategies of multinational corporations

icrosoft’s The details have varied over the colorfully named strategies — such as Irish subsidi- years, but the basic idea has remained the “double Irish with a Dutch sand- ary “Microsoft the same. International allows wich” and the “single malt” — to shift Round Island multinational corporations to place income associated with European sales One” made their intellectual property in subsid- away from Europe and toward interna- an astonish- iaries that reside in low-tax jurisdic- tional tax havens. In a similar manner, ing $315 billion tions. This move allows a multina- multinationals have engineered corpo- Mprofit last year — an amount surpass- tional’s intellectual property holding rate structures that allow them to shift ing half of Ireland’s GDP. The subsidi- subsidiaries to collect royalty fees income associated with U.S. sales away ary was able to accomplish this without from the firm’s operating subsidiar- from the and toward any employees other than its directors. ies that sell goods and services and low-tax havens. Moreover, it did so without paying any collect revenue in jurisdictions with The story extends well beyond corporate income taxes. relatively high rates. The Microsoft. Amazon, Facebook, Google If this sounds like an impres- royalty payments serve to shift taxable owner Alphabet, Netflix, and Apple sive accomplishment, then welcome income away from affiliates in high-tax have also been accused of using to the world of cross-border corpo- jurisdictions and toward affiliates in accounting maneuvers to pay taxes rate taxation. Microsoft Round Island low-tax jurisdictions. significantly below what they would One received its income from other The largest U.S. tech firms have have otherwise been obligated to pay, Microsoft affiliates, and it avoided been extremely adept at using sophis- based on statutory tax rates. paying income taxes due to its hybrid ticated strategies to reduce their global Recognizing multinationals’ abil- status as a firm registered in Ireland taxes. Microsoft was one of the early ity to shift operations and income but tax domiciled in Bermuda, which adopters of financial engineering tech- across borders, governments across the does not levy a corporate . niques designed to minimize taxes, globe have repeatedly lowered statu- It’s just one example of strategies used having begun to establish a complex tory tax rates in a competition to retain by multinational corporations to reduce web of interrelated foreign entities and attract corporations as investors their global tax bills by using techni- in the 1990s. Since then, tax avoid- and residents. Indeed, statutory tax cally legal maneuvers that allow them ance strategies have proliferated. U.S. rates among advanced economies have to shift to affiliates in multinationals have drawn the ire of declined substantially since the 1980s. low-tax jurisdictions. European Union (EU) officials by using (See chart.) Economists have mixed

14 econ focus • second/third quarter • 2021 Share this article: https://bit.ly/corporate-taxation A Race to the Bottom? Statutory corporate tax rates (federal plus state or provincial) views about the trend. Many see lower 70 corporate income taxes as an unal- loyed positive, primarily based on the 60 long-standing argument that the corpo- rate income tax is an inefficient way 50 for governments to raise revenue. In 40 contrast, other economists view the

corporate income tax as an indispens- PERCENT 30 able part of the U.S. tax system and believe that the tax cutting trend has 20 become a harmful race to the bottom. 10 As part of an effort known as the “OECD/G-20 Base Inclusive 0 Framework,” governments around the 1980 1985 1990 1995 2000 2005 2010 2015 2020 globe have been working together since 2013 to establish mechanisms for coun- Germany UK Japan US tering multinational income shifting and . Until recently, an SOURCE: Organisation for Economic Co-operation and Development (OECD) Corporate Tax Statistics Database agreement appeared elusive, and several countries had acted independently to institute “digital service taxes,” which which is based on the income that third parties would pay or receive mainly impact the largest U.S. tech corporations earn from their operations in the open market. “Even in the companies. But a breakthrough came on U.S. territory, whether the corpora- most straight-forward cases involv- recently, when numerous governments tions are headquartered in the United ing manufactured parts, the arm’s agreed in principle to a broad frame- States or abroad. Most advanced econ- length principle can leave firms some work designed to curb multinational tax omies employ territorial tax systems, wiggle room,” says Eric Toder, co-di- avoidance and stop what many perceive but since many countries have lower rector of the Urban-Brookings Tax as a race to the bottom. statutory corporate tax rates than Policy Center. “But people feel that the United States, corporations have this works pretty well for goods and THE INCENTIVE TO SHIFT an incentive to maximize their after- services that are not unique and tax global profits by shifting income where there is a ready market.” The The corporate income tax hinges on to lower-tax territories. The shifting wiggle room for setting prices and the measurement of income. In prin- can be done in two mutually compat- shifting income across borders greatly ciple, a corporation’s income should ible ways. A corporation can change expands when the service is unique — represent a fair estimate of its reve- its operations by making substantive which is often the case with intellec- nues minus costs during the period economic changes such as moving tual property licensing agreements. under consideration. In practice, earn- production abroad. But a corporation In addition to the territory-based tax, ings are difficult to pin down, even can also — without necessarily chang- the U.S. corporate tax code has a world- for purely domestic firms. Generally ing its operations — make use of its wide component that applies to the accepted accounting methods can yield legal and accounting latitude to shift foreign-sourced income of U.S. resident estimates that are very different from reported income abroad. (See “Policy firms. Until 2017, the foreign income of methods dictated by tax authorities. Measures and Countermeasures,” an U.S. resident corporations was taxed at On top of this, firms sometimes have a online supplement at https://bit.ly/ the U.S. statutory rate, but only after great deal of latitude in terms of when corp-tax-policy.) the profits were repatriated as dividends they recognize and book certain reve- Measuring a multinational firm’s to the U.S. parent. In practice, however, nues and costs. territorial U.S. income is not a trivial U.S. multinationals regularly deferred The incentive for multinational firms task. For a firm with foreign affiliates, the repatriation of profits — a prac- to shift income among their cross-bor- the calculation of domestic profits tice that created the so-called “lockout” der affiliates is built into the structure requires that the firm assign “trans- phenomenon of U.S. firms holding an of the U.S. tax code and its relationship fer prices” to the goods and services estimated $2.1 trillion of accumulated to the tax codes of competing foreign that it explicitly or implicitly sells profits overseas by 2015. jurisdictions. The quantitatively most to and buys from the foreign affili- With the enactment of the significant part of the U.S. corporate ates. Transfer prices are supposed to and Jobs Act (TCJA) of 2017, U.S. tax code is its territorial component, correspond to prices that unrelated resident firms became subject to a

econ focus • second/third quarter • 2021 15 minimum tax on global income based Massachusetts Institute of Technology, a country’s from 10 percent to on a new concept bearing the acro- Edward Maydew of the University of 5 percent causes more income shift- nym GILTI, for “Global Intangible North Carolina at Chapel Hill, and ing into the country than a decline in Low-Taxed Income.” The GILTI tax Jacob Thornock of Brigham Young the country’s tax rate from 30 percent applies to what are called the “resid- University found that the ETR for U.S. to 25 percent. This result is consis- ual” foreign profits of U.S.-based multi- multinationals trended downward tent with income shifting being more nationals — specifically, foreign prof- from roughly 34 percent in 1988 to sensitive to tax rate changes among its in excess of a “normal” return on roughly 24 percent in 2012. All of this tax havens than among those coun- foreign invested capital, a hurdle that occurred during a period in which the tries with higher tax rates. It suggests lawmakers set somewhat arbitrarily at top U.S. statutory rate remained rela- that most advanced countries may find 10 percent. tively constant. They found evidence it hard to attract corporate income by The vast majority of U.S. corporate suggesting that the decline was driven incrementally lowering their statutory is raised by the tax code’s partially by U.S. multinationals becom- rates. territorial component rather than the ing more global and intangibles based It is difficult for outsiders to gauge global component. But this does not and partially by declining foreign stat- the extent to which multinational mean that the GILTI tax is irrele- utory rates (which presumably lowered income shifting reflects real opera- vant. The U.S. code’s global component the effective taxes U.S. multinationals tional changes that go beyond mere works as a disincentive for firms shift- paid on their foreign earnings). changes in corporate legal structures ing income abroad. “It is not just a lot Some of the study’s results are diffi- and accounting ledgers. Standard of noise,” says Toder, “because the idea cult to interpret. Surprisingly, the economic models predict that corpo- behind taxing foreign income is really researchers found a similar downtrend rate income tax increases will tend to to protect the domestic tax base.” But in the ETRs of purely domestic U.S. decrease investment, and the predic- the protection provided by the global corporations. Moreover, they found tions have been confirmed by statisti- tax has a cost: It arguably provides an that U.S. multinational corporations cal research. In some cases, however, incentive for firms to shift their resi- consistently had higher ETRs than U.S. it appears that plant and equipment dence abroad. domestic-only corporations, although have been moved overseas to provide the two rates show very similar justification for income shifts that were TAX AVOIDANCE TRENDS patterns over time. While this does not originally accomplished via accounting contradict the notion that U.S. multina- latitude. Since the issue of tax avoidance is tionals increasingly used cross-border often front and center in discussions of income shifting during the period to THE TAX CUTS AND JOBS ACT corporate , it may be useful reduce their taxes, it invites the obvi- to look at how much U.S. multina- ous question: How did domestic-only The enactment of the TCJA provided tionals have actually paid in corpo- firms accomplish the task? Economists economists with something of a real- rate income taxes. Economists have have looked at various possible expla- world experiment about the effects of estimated that, during 2009-2018, nations, such as the timing of peri- corporate tax changes. The cut in the publicly traded U.S. multinationals paid ods when the IRS allowed accelerated U.S. federal government’s territorial over $2.7 trillion in income taxes to write-offs, but there does not appear to tax rate to 21 percent from 35 percent governments globally — which trans- be a good explanation so far. was expected on both theoretical and lates into an effective tax rate, or ETR, Researchers have uncovered a great empirical grounds to stimulate invest- of roughly 25 percent of their pretax deal of statistical evidence about ment in the United States and encour- earnings. Some may view the glass as the income shifting behavior of U.S. age corporations to shift income back half full because the dollar amount is multinationals. In a 2017 article in into U.S. territory. Many observers held high. Others may see the glass as half the Journal of , Tim out hope that investment would also be empty because the 25 percent ETR was Dowd, Paul Landefeld, and Anne stimulated by changes in the structure well below the 39 percent U.S. statu- Moore on the staff of Congress’ Joint of the U.S. global tax — in particular, tory tax rate during most of the period Committee on Taxation provided the provisions that ended tax deferrals (for federal and state taxes combined). further confirmation that such income and freed up the deferred profits held by Economists have devoted much shifting can be highly responsive to U.S. multinationals’ overseas affiliates. research to the variation of ETRs changes in cross-border tax differen- But the consensus view appears to across firms and across time. In a tials. Moreover, they found that the be that the response of U.S. investment 2017 article in the Journal of Financial responsiveness of income shifting was to the new tax law was underwhelm- Economics, Scott Dyreng of Duke much greater when the tax rates are ing. “In theory, cutting corporate taxes University, Michelle Hanlon of the already quite low. That is, a decline in should stimulate investment, but it did

16 econ focus • second/third quarter • 2021 not,” says Dhammika Dharmapala of The case that GILTI increased the on a proposal for a global minimum the University of Chicago Law School. global tax burden of U.S. multination- tax of at least 15 percent. There was In a 2018 National Tax Journal article, als has been bolstered by event studies also an agreement in principle on a he argued that the historical experience that have found that the shift to GILTI revenue sharing concept that would suggests that while repatriation holi- caused U.S. multinationals to lose value apply to the “largest and most profit- days and cuts in repatriation taxes can relative to purely domestic U.S. corpora- able” companies: At least 20 percent of dramatically increase repatriation of tions. According to Dharmapala’s 2018 their profits in excess of a 10 percent cash reserves held in overseas subsid- journal article, “The TCJA increases hurdle rate should be allocated toward iaries, these flows of cash to the United the tax burden on U.S. residence for the countries that buy their products States have had no detectable effects on many, and perhaps most, U.S. MNCs … and services. This arrangement could U.S. investment or employment levels. [and will] create substantial distortions upend the traditional perspective that He noted that there is evidence that to the ownership of assets, both in the profits should be taxed in the territo- some cash-constrained U.S. multina- United States and around the world.” ries where value is created — a stan- tionals may have responded by increas- dard that has become difficult to apply ing their domestic investment. But COUNTERING THE “RACE TO in cases where production no longer based on studies of a previous repatria- THE BOTTOM” takes place on factory floors. tion , mandated by the 2004 The global minimum tax would also American Job Creation Act (AJCA), he Treasury Secretary Janet Yellen did come in lieu of the digital services argued that the general consensus in the not mince her words. “We’ve had a taxes that have been imposed on large literature “is that the primary impact global race to the bottom in corporate tech firms by some European coun- of increased repatriations is an increase taxation, and we hope to put an end tries. Indeed, the framework’s polit- in shareholder payout” (in other words, to that,” she testified at a recent hear- ical success in the United States may dividends or stock buybacks). ing of the House Financial Services very well hinge on the removal of these Some analysts have criticized the Committee. She views the U.S. corpo- taxes, which many observers see as TCJA’s changes in the U.S. global tax rate income tax as an important source discriminating against U.S.-based firms. on the basis that they will increase of funding for the Biden adminis- The path from an agreement in prin- the overall tax burden of U.S. resi- tration’s planned expenditures on ciple to a fully operational global pact dence. This conclusion appears to infrastructure investment and social is likely to be long and arduous. In the hinge on the premise that the GILTI services. Moreover, she sees it as a EU, where such agreements require the tax will prove to be more burden- source of revenue that needs to be unanimous assent of member govern- some for U.S. multinationals than the bolstered — particularly since U.S. ments, the pact faces opposition from previous system of full but indefinitely government revenues from corporate several low-tax countries, including deferred taxation of foreign earn- income taxes shrunk to just 1 percent Ireland, Estonia, and Hungary. And ings. “It may seem on the surface that of GDP following the enactment of the in the United States, it faces opposi- GILTI is lower,” says Dharmapala. “But TCJA, the lowest share since World tion from those who are against corpo- most U.S. multinationals did not take War II. rate income taxes in any form as well advantage of the tax holiday created The Biden administration, which as those who are concerned that the by the AJCA. We can therefore say sees international cooperation as vital pact would put U.S. multinationals at that the upper bound on the burden of to tackling tax avoidance and shoring a disadvantage to the extent that other the deferred tax was about 5 percent, up corporate tax revenues, achieved countries hold out. Eventual success which is the tax rate that they would early successes in June and July would require policymakers to gain the have paid during the holiday to repatri- when the G-7, OECD, and G-20 each support of many diverse and competing ate profits.” reached an agreement in principle interest groups. EF

READINGS Dharmapala, Dhammika. “The Consequences of the Tax Cut Dyreng, Scott, and Michelle Hanlon. “Tax Avoidance and and Jobs Act’s International Provisions: Lessons from Existing Multinational Firm Behavior.” In C. Fritz Foley, et al., eds., Global Research.” National Tax Journal, December 2018, vol. 71, no. 4, Goliaths: Multinational Corporations in the 21st Century Economy. pp. 707-728. Washington, D.C.: Brooking Institution Press, 2021. Dowd, Tim, Paul Landefeld, and Anne Moore. “Profit Shifting of Dyreng, Scott, Michelle Hanlon, Edward Maydew, and Jacob U.S. Multinationals.” Journal of Public Economics, April 2017, Thornock. “Changes in Corporate Effective Tax Rates Over the vol. 148, pp. 1-13. Past 25 Years.” Journal of Financial Economics, June 2017, vol. 124, no. 3, pp. 441-463.

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