The question of multinational companies avoiding taxes is inevitably going to become a hot issue for the US, Europe, and other major economies. Voices from both the political left and right have an ax to grind.
Moreover, three separate tax issues—(1) the average tax US-based multinationals actually pay, (2) accumulated, but not repatriated, profits of US-based multinationals’ foreign affiliates,and(3) inversions—are often conflated, creating muddled perspectives.
The observations below may help to separate and clarify the issues.
Three Related—But Separate—Tax Issues
1. The Average Tax US-based Multinationals Actually Pay
The marginal corporate tax rate in the US is indeed among the highest in the Organisation for Economic Co-operation and Development (OECD) group of rich nations. But few US-based multinationals come even close to paying the 35% marginal rate because
They know how to take advantage of “transfer-pricing” techniques, including
– Export shipment invoicing (for tax and tariff avoidance)
– Licensing (royalty payments) between affiliated entities
– Intracorporate loans
– Charging central fixed costs and overheads to various affiliates
They shift intellectual assets such as patents and brands to tax-haven subsidiaries, such as Bermuda or Luxembourg, and then make the tax-haven subsidiary a licensor, charging substantial royalties to the rest of the company’s network. This has the effect of sucking away taxable profits from affiliates in high-tax jurisdictions to Bermuda, Luxembourg, etc., where the effective corporate tax rate is closer to zero.
In general, multinationals have the discretion to locate value-added and profit-generating activities in lower-tax nations such as Ireland, where (so far) corporate tax rates are capped at 12.5%.
So multinational companies effectively pay a rather low average effective tax rate because they can shift and relocate tangible (e.g., factories) as well as intangible (e.g., patents) from one nation to another—thus lowering global total tax liability.
Many observers confuse the marginal 35% US tax rate with the often much lower effective average tax rate actually paid by multinational firms. Incidentally, domestic US companies, especially medium and small firms, do not have the luxury of taking advantage of the myriad available deductions and loopholes, and so end up paying a much higher average tax. (No wonder, then, that the Tea Party base consists of small- and medium-size company owners and employees.)
2. Accumulated, But Not Repatriated, Profits of US-based Multinationals’ Foreign Affiliates
The US is one of the few countries that taxes corporate profits, not only on US operations, but also on US multinational companies’ foreign affiliates. That means that the foreign affiliates of US firms not only first pay tax to the country in which they do business, but their profits are additionally taxable in the US. This sounds like double taxation and a huge disadvantage to American firms, compared with European or other multinationals whose governments tax only profits generated in the home country. Is the US policy of double (or additional US) taxation a big drawback?
But then, there is a huge loophole—big enough to drive a truck through—because US regulations allow indefinite deferral of the additional US tax on foreign income until the money is actually remitted back to the US. Effectively, this means that a US multinational’s foreign subsidiary profits are not taxed—even for decades—as long as those profits are not actually remitted back to the US parent company.
Unsurprisingly, US multinationals simply keep their foreign affiliate profits outside the US and do not bring those profits home. Why should they? Besides, there is no shortage of investment capital in the US for additional investment for the American market. Foreign affiliate profits either accumulate in tax havens abroad or are reinvested in faster-growing countries outside the US.
Apple alone held $181 billion in un-repatriated foreign profits.
GE’s foreign operations had accumulated, but not repatriated back to the US, $119 billion.
“At least 358 companies, nearly 72 percent of the Fortune 500, operate subsidiaries in tax haven jurisdictions as of the end of 2014,” and “all told these 358 companies maintain at least 7,622 tax haven subsidiaries.”
Other observers estimate the total accumulated amount is in excess of $3 trillion. (It is worth noting that voices from both the left and the right intentionally, or ignorantly, make the mistake of stating that the US corporate tax rate is 35%. On the right, this 35% figure is periodically trotted out to support the assertion that US taxes are too high. On the left, the 35% figure is used to miscalculate and overstate the dollar profits that US firms would pay if foreign affiliate profits were actually repatriated.Both groups ignore the fact that the maximum rate of 35% is reached only after several brackets of income, the lowest being 15%, and that several hundred pages of the tax code—deduction after deduction—allow firms, especially multinationals, to greatly reduce their tax liability.)
When an American company acquires or merges with a foreign firm, it can then declare that the US is no longer the headquarters of the firm. The American company then becomes non-American, and thereafter is not subject to US regulations except for its US operations. Specifically, the company’s subsidiaries outside the US are no longer subject to additional US taxes. After the shift of headquarters, future non-US affiliate earnings are completely removed from additional US tax liability. The company continues to pay tax in the US for US operations’ profits as well as on past accumulated, but not repatriated, profits of non-US affiliates.
Are US Corporate Taxes Onerously High?
US corporate taxes do seem, on superficial examination, to be onerous. With a high 35% marginal tax rate (to say nothing of additional state and local taxes, which can bring the marginal rate above 39%) and with regulations that also tax foreign operations (unlike most other countries), the US sounds like a high-tax country.
But marginal should not be confused with average, or effective actual tax paid, after accounting for the literally thousands of deductions and loopholes, ranging from R&D credits, to deductible healthcare costs, to indefinite deferral of additional tax on foreign income—as long as foreign profits are not repatriated back to the US.
A PwC (Price Waterhouse) studyusing International Finance Corporation data comparing 189 nations concluded that the actual tax paid by all US companies—which are mostly domestic—was 27%. This is somewhat or significantly above the OECD average.
By contrast, multinational companies based in the US pay far less. They can
Take advantage of the several international transfer pricing maneuvers;
Relocate tangible (physical) operations to low-tax nations or tax havens;
Transfer (intangible) assets such as patents and brands to holding companies in Bermuda or Luxembourg;
Defer additional US tax on foreign source income indefinitely; and
Ultimately even shift headquarters away from the US.
Data on multinational companies’ tax payments are difficult to come by. But a Citizens for Tax Justice study examining filings between 2008 and 2012 by 288 large US multinationals found that they paid an average effective tax of 19.4%, and that one-third of the studied companies paid less than 10% on average.
US marginal tax rates are high. But then, hundreds of pages of deductions and loopholes exist in the US tax code, so that the effective average tax paid by corporations is substantially lower than the highest marginal federal bracket of 35%. In particular, US-based multinationals have the acumen, motivation, and international flexibility of shifting operations, intangible assets, and proprietary invoicing (transfer pricing) so as to pay much lower taxes.
In a world of increasing global business and a greater willingness of multinational firms to maneuver operations, two competing obligations seem to collide. How do we reconcile a government’s need to collect reasonable revenues to pay for social services, defense, roads and bridges, and so forth versus a company’s duty to shareholders to maximize after-tax income by taking advantage of loopholes passed by the same governments?
Stay tuned for more on the techniques, maneuvers, and ethics of international taxation in a future post.
Permission to Reproduce: A version of this post was published as “The Chinese prefer investing overseas; dummy companies may ease transfers and devalue renminbi” by YaleGlobal Online, September 10, 2015; it was the number-one story in a Google search for “China FDI” that day and is also available as a podcast.
The Sudden RMB Devaluation in August 2015
The global panic in financial markets in August 2015 was catalyzed by the relatively sudden devaluation of the Chinese yuan or renminbi (from 6.2 to 6.4 RMB/$). The Chinese government may have had several reasons for setting the daily reference rate for the RMB at a lower level, for example to signal greater market flexibility or to support its exporters. However, the fact is that enormous amounts of liquid money held by Chinese individuals and companies has—for many years—been anxiously trying to leave China (i.e., leave the RMB as an asset) and park itself in non-Chinese assets such as a Manhattan or Sydney condominium, US stocks, a Singapore bank account, or simply luxury goods. That has created the devaluationary pressure in the exchange markets.
Figure 1: RMB to Dollar Exchange Rate Changes – Summer 2015
The reasons are clear. China is getting richer, and by some accounts (using the World Bank’s implicit estimate for the purchasing power parity [PPP] theoretical exchange rate for the RMB) it may already be coequal with the US as the world’s largest economy. In short, trillions of RMB in liquid assets are trapped inside China. Why trapped? Because the current rules do not allow the Chinese to convert RMB into other currencies without a commercial justification.
A company or individual cannot just go to a bank in China with RMB and ask that they be converted into, say, US dollars. The request would be refused unless the form you fill out shows documentary proof that you are a sanctioned importer, or your child’s tuition in an American university needs to be paid, or that the Chinese firm has a foreign subsidiary that needs funds. In short: you need a provable justification.
Foreign Direct Investment (FDI) Outflows from China and the Difficult-to-Believe Statistics
One stratagem likely used by Chinese companies for getting permission to move funds out of China is to create dummy companies in Hong Kong and the Caribbean. As far back as 2011, the OECD (Organization of Economic Cooperation and Development) reported that as much as 57.4 percent of all outbound FDI capital went to Hong Kong affiliates or subsidiaries, and another 12.7 percent to Caribbean entities. (See Figure 1.) By contrast, Chinese companies’ outflow of FDI capital used to invest in European or US affiliates totaled a mere 8.2 percent.
Figure 2: Hidden Patterns in Chinese Companies’ Outward FDI
That means that as much as 70.1 percent of Chinese outbound FDI capital flows (exceeding $100 billion per year since 2011) has gone to two tiny economies, the Caribbean and Hong Kong. Moreover, data gleaned from UNCTAD (United Nations Conference on Trade and Development) shows a suspiciously large number of Chinese FDI-affiliated companies outside China. (See Figure 2.) For the world as a whole, the number of multinational companies (headquartered mainly in North America, Europe, and Japan) totaled 103,786. Of these, the UN data show 12,000—or 11.6 percent of all multinational firms in the world—as being headquartered in China. This appears plausible, as Chinese companies are indeed increasing their global reach. But then, in Figure 2, look at the number of foreign affiliates or subsidiaries of Chinese companies, said to total a remarkable 434,248 in number—or 48.7 percent of the world total.
If this is to be believed, Chinese multinational parent companies each had as many as 36 foreign subsidiaries or affiliates, as against the rest of the world whose multinational parent firms averaged only 5 foreign subsidiaries. Are the Chinese Ministry of Commerce numbers to be believed? Yes. With a 2,000-year-old bureaucracy, the Chinese usually do keep meticulous data. The numbers appear to be authentic, but they reveal a hidden story—that a significant fraction of the Chinese company subsidiaries in the Caribbean and Hong Kong are mere shell companies. Many of these dummy firms are likely created for a principal reason: to create a justification for the conversion of RMB into foreign currencies. In other words, the fake companies facilitate a hidden capital outflow that is not really intended for business purposes, but to get money out of China on behalf of the owners.
It is true that a fraction of the mainland China FDI outflow that goes to Hong Kong affiliates comes back to the mainland for investment purposes in a “round trip” (since a Hong Kong company can pose as a “foreign” investor and enjoy benefits such as cheap land that a purely domestic investor may not get). Other Hong Kong affiliates may be intended to mitigate the perceptual drawback of an investor originating from mainland China. But a significant (unknown) fraction of the outward FDI emanating from China and going to Hong Kong—plus most all of the outflows going to Caribbean havens—is intended for owners to get money out of China for tax benefits or to invest in a Singapore bank account, US equities, Australian property, or a Manhattan luxury apartment.
A World Awash in Cash and Liquidity (It’s Not Just the Chinese)
In 2015, Chinese purchasers topped the list of foreign buyers of Australian and US real estate. In the 12 months up to March 2015, the Financial Times reported that Chinese buyers spent $28.6 billion to buy US property and that Chinese are the top buyers of housing in New York, Vancouver, London, Sydney, and Auckland. Hundreds of multimillion-dollar Manhattan apartments lie empty, functioning merely as an investment for wealthy foreign buyers that rarely visit.
But it is not just the Chinese who have become richer and seek to diversify their asset holdings out of China. The world as a whole is awash in liquidity (i.e., cash and quickly sellable assets), conservatively estimated upwards of $75 trillion and likely exceeding $100 trillion. Worldwide, mutual fund assets alone exceed $30 trillion, with probably double that amount in bank or bank-like deposits.
In an important respect, this is a thrilling story. Probably a billion-and-a-half or two billion people around the world have become affluent enough to have investable savings. But then this worldwide flood of money is seeking places and financial instruments to invest in. And in a global arena, this creates the need to convert from one currency to another. When there is a sudden, collective rush to sell billions of one currency (and buy another), its value can go down sharply, despite government counter-purchases—as seen in the August 2015 devaluation of the RMB.
Global Panics, Manias, and Exchange Rate Crises: A Thundering Herd of 500 Million Savers
Worldwide, a billion-and-a-half to two billion middle-class to affluent individuals—or, say, 500 million heads of households who actually manage the family’s savings—are aware of investment options and seek a place to park their savings. Likely, almost all of them have an Internet connection that amplifies news reports, fears, phobias, and panics. When all is said and done, in August 2015 no deep, fundamental economic reasons existed for the simultaneous swoon of stock markets around the world. The Chinese economy is slowing down, from the heady days of over 10 percent annual growth rate to a mere 6 or 7 percent. But so absurd is the news hype and consequent global angst, amplified by the Internet and media, that a 6 or 7 percent growth rate—which ordinarily would be the envy of most nations—instead gets protrayed as a reason to sell assets. Similarly absurd is the portrayal of a mere 3 percent devaluation of the RMB (from 6.2 to 6.4 per dollar) as cause for panic, selloffs, and crashes.
A global civilization that is intimately interconnected and awash in liquidity is also one that is prone to collective global psychology, manias, and herd instinct. Be prepared for more thundering hooves and market gyrations in the future.
America has been using a single currency since 1793, when the United States Mint in Philadelphia first began issuing US dollar coins. However, it is not the longevity of a currency that determines whether it succeeds, but institutional mechanisms. Such mechanisms are weak or lacking in Europe. To understand why, we need to examine how such mechanisms could help countries in a common zone to ride out economic cycle “booms and busts.”
When a country gives up its own currency (say, the drachma) in favor of a supranational one (such as the euro), it loses two important levers to help soften the blow of a recession: (1) It cannot unilaterally adjust its interest rates downward to stimulate its own economy in a downturn; interest rates could be held uncomfortably high by the supranational monetary authority if the economies in the other member states remain healthy. (2) And it is unable to devalue its currency in order to stimulate the nation’s exports.
For a single currency to function well, three conditions, or institutional pillars, must be in place: (1) fiscal discipline by member states, (2) labor and capital mobility, and (3) inter-regional balancing through transfer payments managed by a central government.
Fiscal Discipline by Member States
While American states are free to set their own budgets and raise money through taxes and borrowing, their excesses are curtailed by state constitutions that recommend or mandate balanced budgets; by an informed media that flags profligate spending; and by the discipline that the bond market imposes. Almost all US states manage to restrict their deficits to a few percentage points.
When the eurozone was introduced in the early 2000s, participating countries that gave up their own currencies made pious promises that they would restrict their budget deficits to no more than 3 percent. But no enforcement mechanism was put in place, and in the go-go years between 2000 and 2007 countries such as Greece ran up sovereign debts well in excess of that limit. By early 2015, Greek debt was estimated to be 177 percent of GDP—in short, unpayable—according to a recently leaked IMF report. In fact, previous Greek governments must have known they were taking huge risks because they hired investment banks such as Goldman Sachs to devise complex swap instruments that hid the true size of their borrowings from other EU states and the public. In 2010, Angela Merkel called this “scandalous.” But she could do nothing about the situation without an EU enforcement mechanism in place.
Labor and Capital Mobility
Recessions and economic downturns impact states differently. If a worker in an Ohio “rust-belt” factory is laid off, he may consider selling his home and loading the family and Golden Retriever into the minivan and driving to Houston or Silicon Valley, where jobs are available. On average, 42 percent of Americans do not reside in the state of their birth. This willing mobility reduces the impact of recessions and unemployment, decreasing the pain in the most affected states. According to the US Census Bureau, after age 18 Americans will move 9.1 times during the rest of their lives.By contrast, 47 percent of Italians, for example, live within 5 kilometers of their mamas. And although jobs are still going begging in Germany, the almost 30 percent of Greeks who are unemployed in 2015 do not wish to relocate because of cultural unfamiliarity and reluctance.
Europe is still a collection of separate cultures, employment regulations, and languages, and therefore labor immobility does not provide the smoothing-out effect seen across the United States. Capital, too, is less mobile across the EU, compared with the US, because varying company regulations and foreign-market unfamiliarity reduce the likelihood of a firm relocating or expanding outside its nation.
Inter-regional Balancing Through Transfer Payments Managed by a Central Government
In the US, most taxes are collected by a centralized federal government, which then allocates money to the states according to their needs. In Europe, each state collects its own taxes and is then reluctant to share any significant amount with the other “foreign” nations in the eurozone. On average in the US, a decline of one dollar in a state budget is offset by a transfer of 28 cents from the federal government.More can be made up by additional taxes raised by the state, providing a cushion to smooth out the bumps over a recessionary period.
True, the EU (Brussels) does reallocate some funds to member states, but these are very small compared with US transfers from the federal government to US states. Moreover, most of the funds Brussels redistributes are project-specific rather than designed to alleviate recessionary suffering or boost flagging economies. Bailouts such as those given to Portugal or Greece have to be painfully negotiated each time and agreed to by all EU member states. And the member states have veto powers. So Brussels really is not a central government, by any means.
Conclusion: Monetary Union Without the Three Institutional Pillars
The euro is a noble experiment designed to foster a sense of pan-European identity (and, incidentally, to reduce currency risk and transaction costs for firms). Its architects had hoped that the façade of unity would then be followed by the construction of three institutional pillars to solidify the structure. Fifteen years hence, European institutions have barely evolved enough to build such pillars or, in other words, to fulfill the three requirements of a monetary union. An appetite for a central fiscal authority is lacking, as is a mechanism to restrain individual states from excess borrowing to boost their budgets. For cultural reasons, cross-border migration of labor remains sluggish, and transfer payments from the rich nations of the EU to support their poorer neighbors is already running into such resistance that countries such as the UK threaten to withdraw from the EU altogether.
Can the noble experiment survive?
Certainly, other nations that received bailouts, such as Portugal, have not only turned the corner, but have begun to pay back their debts. It is possible that the shock of recent events can stem the profligacy of loose fiscal policies, especially if conditions are imposed on them. But the euro will remain a fragile construct, vulnerable to future shocks, whose survival will depend on the continued generosity of the richer members of the EU.
This archive contains 2014 & 2015 posts discussing international business issues, focused on both economics and culture, in an unbiased manner. Managers, students, policy makers, and educated laypeople will gain insights on current issues, future trends, and historical perspectives.