© 2015 Prof. Farok J. Contractor, Rutgers University
NOTE: This post was updated on the main site May 5, 2016:
Tax Avoidance by Multinational Companies: Methods, Policies, and Ethics
A version of this article was also published in AIB Insights, Vol. 16, No. 2 (2016).
Recommended Citation:
Contractor, Farok J. Tax avoidance by multinational companies: methods, policies, and ethics. Rutgers Business Review, Vol. 1, No. 1, pp. 27–43 (2016).
Also see other posts: The [2016] G20 Summit in China: An Annual “Talking Shop”? Or a Potential Bedrock of Global Civilization? and Tax “Amnesty” for Multinationals—But Not for Illegal Immigrants.
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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
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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
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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.
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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.
As a result, as of 2015 between $2 and $3 trillion in accumulated foreign affiliate profits (after paying foreign corporate income tax) have not been brought back to the US. After reading SEC filings, the Citizens for Tax Justice and the U.S. Public Interest Research Group (U.S. PIRG) Education Fund (organizations normally critical of multinational firms) concluded[1]:
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Apple alone held $181 billion in un-repatriated foreign profits.
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GE’s foreign operations had accumulated, but not repatriated back to the US, $119 billion.
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“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.[2] 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.)
3. Inversions
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) study[3] using 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
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Take advantage of the several international transfer pricing maneuvers;
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Relocate tangible (physical) operations to low-tax nations or tax havens;
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Transfer (intangible) assets such as patents and brands to holding companies in Bermuda or Luxembourg;
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Defer additional US tax on foreign source income indefinitely; and
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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[4] 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.
Conclusions
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?
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