The House Ways and Means Committee held a hearing Thursday to examine corporate tax reform and the impact of offshore tax havens on base erosion and profit shifting by multinationals.
In convening the hearing, Ways and Means Chairman Dave Camp, R-Mich., noted that the U.S. has the highest statutory tax rate in the industrial world of up to 35 percent. He has heard comments about that fact ever since the committee issued a discussion draft of international tax reform proposals in October 2011 (see Congressional Republicans Propose International Tax Reforms).
“Nearly all have offered a universal observation—having the highest corporate rate in the developed world along with an outdated international tax system is a barrier to success that leaves our country falling further behind our foreign competitors,” he said in his opening statement. “Academics and economists agreed, and also cautioned, that any solution to these challenges must protect against erosion of the U.S. tax base through the shifting of profits to low-tax jurisdictions. Their concern is not without merit. Oftentimes, multinational businesses reduce their tax liability by separating the jurisdiction in which income is booked for tax purposes from the jurisdiction in which the economic activity occurs. The result of these practices is ‘erosion’ of the tax base in a jurisdiction where the activity takes place.”
Camp acknowledged that there is no perfect system for taxing corporate income. “But it is also important to bear in mind, that these activities are the consequence of bad laws, not bad companies,” he said. “In my mind, the fact that the current Tax Code allows companies to achieve these tax results strengthens the case for comprehensive tax reform. Whether a country has a hybrid system similar to the current U.S. worldwide system or a dividend exemption system like that of our major trading partners, it is important to develop strong base erosion rules that protect against aggressive transfer pricing, anti-migration of intangible property overseas and foreign earnings stripping.”
Camp contended that the most effective anti-base erosion rule would be a lower corporate tax rate, but acknowledged that a low tax rate alone would not be sufficient. The Ways and Means Committee’s International Tax Reform Discussion Draft included three options to mitigate U.S. base erosion. Option C, which Camp called a “carrot and stick proposal” received the most support from the business community. Under that option, all foreign income attributable to intangibles—whether or not owned by the U.S. parent or a foreign subsidiary—would be taxed by the U.S. at a substantially lower rate of 15 percent, minus any credits for foreign taxes paid on the same income.
“This approach provides a deduction for income related to intangibles kept in the United States (the carrot) and an immediate inclusion for income related to intangibles held abroad (the stick),” said Camp. “In other words, companies would feel less pressure to shift income to low-tax jurisdictions because that income would be taxed at the same rate—whether it is earned in the United States or Bermuda.”
According to Camp, this approach would mean that moving intangibles to tax havens would have little or no appeal since the income earned from those intangibles would be taxed at the same rate regardless of location. “In fact, some companies have said that intangibles, which have already been moved to tax havens under our current system, could actually be moved back to the United States because there would not be any tax advantage to owning them abroad,” he said.
Apple’s Tax Strategies
Rep. Sander Levin, D-Mich., the ranking Democrat on the Ways and Means Committee, said that tax reform needs to be about much more than just lower tax rates or labels like worldwide and territorial.
“Entities that truly have a home base in our nation, and experience the many benefits and advantages as a result, are using their presence or their pro-forma presence in other places to lower their tax bills,” he said. “Often the effect is so dramatic that it is difficult for the average taxpayer to believe that such tax avoidance is legal. The fact that it is—and is widespread—only highlights the urgent need to confront it.”
He pointed to a hearing last month in the Senate Permanent Subcommittee on Investigations, chaired by his brother, Sen. Carl Levin, D-Mich., in which the subcommittee looked at Apple’s tax strategy (see Apple Executives to Answer Lawmaker Claims on Tax Avoidance).
“The investigation illustrated how Apple’s international tax planning techniques have enabled the tech giant to dramatically lower its tax bill,” said Rep. Levin. “One example showed how an Irish entity established by Apple Inc. received tens of billions of dollars of income with no tax residence, and as a result, paid no taxes. Other major U.S. corporations like Microsoft, HP and Google have also been shown to use legal tax avoidance techniques to shift income overseas to lower their U.S. tax liability.”
Levin and Camp noted that the problem is not isolated to the United States. “Jurisdictions throughout the world—particularly European Union member nations—are realizing that companies are engaging in complicated structures that often have no economic value or substance simply to avoid taxes,” said Levin. “The response is anger – from businesses that compete to citizens who are facing deep cuts in important government programs. The challenge of ending massive tax avoidance must be at the forefront of any tax reform effort worth its salt.”
He pointed out that no country can compete with a zero percent tax rate. “Any tax reform must end the use of loopholes and base erosion techniques, including addressing how to curtail the shifting of jobs and profits offshore,” said Levin. “Our current Tax Code creates incentives for multinational enterprises to shift money overseas, and with that money goes jobs. The days of so-called stateless income and double non-taxation must end. We cannot participate in a global ‘race to the bottom’ that results in taxing jurisdictions being the big losers. Our Tax Code must not only promote American competitiveness at home and abroad, it must also promote domestic job creation that strengthens economic security for workers and businesses here in the U.S. Reform of our international tax rules cannot be done on the backs of small businesses, domestic companies and individual taxpayers.”
Uneven Playing Field
The committee heard from an official with the international Organization for Economic Cooperation and Development who discussed a recent report by the OECD on base erosion and profit shifting (see OECD Calls for Curbs on Base Erosion and Profit Shifting). Pascal Saint-Amans, director of the OECD’s Center for Tax Policy and Administration, noted that base erosion and profit shifting, or BEPS, often arises because under the existing tax rules of many countries, multinational enterprises are often able to artificially separate their taxable income from the jurisdictions in which their income-producing activities occur. This can result in income going untaxed anywhere, and significantly reduces the corporate income tax paid by multinationals in the jurisdictions where they operate.
“While there clearly is a tax compliance aspect, as shown by a number of high-profile cases, there is a more fundamental policy issue: the common international tax standards may not have kept pace with the changing business environment,” said Saint-Amans. “Domestic rules for international taxation and internationally agreed standards are still grounded in an economic environment characterized by a lower degree of economic integration across borders, rather than today’s environment of global taxpayers, characterized by the increasing importance of intellectual property as a value-driver and by constant developments of information and communication technologies.”
He contended that the ability of some taxpayers to reduce their taxes by separating their income from the jurisdictions in which they operate creates an uneven playing field that undermines competition and economic efficiency because some businesses, such as those operating cross-border with access to sophisticated tax expertise, may profit from BEPS opportunities and receive unintended competitive advantages compared to enterprises that operate mostly at the domestic level. “This, in turn, leads to an inefficient allocation of resources by distorting investment decisions towards activities that have lower pre-tax rates of return, but higher after-tax rates of return,” he added. “Moreover, such a result affects the perceived fairness of the tax system as a whole, which can undermine voluntary compliance by all taxpayers.”
Edward Kleinbard, an influential tax law professor at the University of Southern California, testified about the generation of “stateless income,” and contended that the proposed anti-abuse rules in the Ways and Means Committee’s discussion draft may need to be strengthened because the magnitude of the problem has been understated.
He pointed to a paper by two other researchers, Harry Grubert of the Treasury Department and Rosanne Altshuler of Rutgers University, who recently found that foreign subsidiaries of U.S. firms today enjoy effective tax rates of less than five percent on nearly 37 percent of their total income. Fifty-four percent of U.S. controlled foreign corporations’ total income is taxed at effective rates of 15 percent or lower, according to their findings from examining tax return data.
Kleinbard argued against the “myth” that trillions of dollars of U.S. corporate profits are “trapped abroad” and need to be repatriated at a low tax rate to bring the money back to the U.S. “Some of that $2 trillion is invested in real businesses around the world, but a large fraction is held in cash,” he said. “It is intuitively appealing to argue that all of this ‘trapped’ cash is lying fallow, as if it were buried in a backyard in Zug. But again this is false. The money in fact already is at work in the United States, in the form of loans to the U.S. government or U.S. businesses. What is more, firms like Apple have demonstrated how easy it is to engage in a virtual repatriation of offshore cash on a tax-free basis, and use that virtual transaction to fund current stock buy-backs.”
Instead of transitioning to a territorial corporate tax system with anti-abuse constraints, as the committee’s discussion draft proposed, Kleinbard argued in favor of a simpler alternative that he said would be more resistant to “tax gaming,” as well as competitive and “economically defensible:” That would be “genuine worldwide tax consolidation, combined with a corporate tax rate squarely in the middle of the pack of peer countries’ rates—say 25 percent.”
“Financial accounting norms of course require worldwide consolidation in presenting the results of a multinational firm’s activities,” Kleinbard explained. “The resulting system is simple and, more important, highly resistant to tax gaming, because there are no positive returns to base erosion or profit shifting. What is more, my proposed system is “competitive,” in the proper sense of being competitive with the tax environment that foreign domestic firms actually face in the country in which they operate, rather than a system that, like current law, or like unprotected territoriality, heavily subsidizes foreign investment, at the expense of our own domestic economy. If it helps, one can visualize my proposal as a territorial tax system with a 25 percent worldwide (not per country) minimum tax—the economic effects are the same.”
Whose Tax Base Is Eroded?
Paul Oosterhuis, a partner at the law firm Skadden Arps Slate Meager & Flom LLP, had a different perspective on base erosion and profit shifting in his prepared testimony. “When discussing the problem of profit shifting and base erosion, the first question that must be asked is: whose tax base is being eroded?” he asked. “From a U.S. perspective, the answer to this question is particularly thorny in the context of sales of products outside the United States. Does the profit from those sales properly belong in the United States, or should it be subject to taxation in the first instance in a foreign country, i.e., the ‘market,’ ‘destination’ or ‘source’ country where the good is sold? Where product development activities occur in one country—say, the United States—the funding for that development occurs in another—perhaps an Irish affiliate—and the sale occurs in yet a third country—for example, the United Kingdom—it is not remotely clear that the bulk of the income from that ultimate non-U.S. sale is properly allocable to the United States such that the income can be said to have been inappropriately ‘shifted’ outside the United States if it is reported as earned elsewhere. This is particularly true for consumer products where much of the value lies in consumer preferences and brand awareness, both items of value that typically inhere in the market country and not in the location of product development activities or in the parent’s country of residence.”
He concluded that the issue of corporate profit shifting and tax base erosion must be faced by both governments and corporations. “But any honest and productive discussion of the topic must begin by first considering where profit should be located; only then can we begin to determine whether it has been improperly shifted,” Oosterhuis added. “I would suggest that a corporation’s place of residence or the location of its activities or how much foreign tax it pays are not likely to provide useful—and certainly not complete—measures of profit shifting. A focus that is geared towards the location of sales and the matching of income and expenses is far more likely to produce useful measures of—and thus productive solutions to—the issue of U.S. profit shifting and base erosion.”