Taxing Multinational Corporations
Earlier this month, I attended a very interesting conference on the taxation of multinational corporations. It included a case study of how SABMiller avoids paying tax in Africa. While many of the points presented are undoubtedly familiar to this blog’s readers, the conference put it all together with a clarity that I attempt to reproduce below.
The Trouble with Transfer Pricing
A significant amount of international trade consists of transfers between subsidiaries of the same corporation. The prices that the corporation charges itself determine how its profits are divided between different countries for tax purposes.
Imagine that a corporation produces an input in country A and then ships it to manufacture a finished product in country B. By changing the price at which subsidiary A sells the input to subsidiary B, the corporation can shift its profits between the two countries.
If country A has a higher tax rate, the corporation might try to lower the input price until subsidiary A just breaks even on producing it. Then all of the corporation’s profits would accrue to subsidiary B and be taxed at country B’s lower rate.
This scheme can be foiled if the same input is also traded between unrelated corporations. Country A’s tax authorities can calculate what subsidiary A’s profits would have been had it sold the input at market prices, and tax the corporation accordingly. That is basically the OECD’s position on transfer pricing: corporations should charge themselves the same prices as would prevail in arm’s-length transactions.
Services, Intangible Assets and Debt
Transfer pricing becomes more problematic for specialized items not readily comparable to identical items traded on an open market.
Imagine that country C has ultra-low tax rates. The corporation could set up subsidiary C in this tax haven and have it sell “business services†to subsidiaries A and B. It is difficult for tax authorities to determine what such services are actually worth or to prove that they are just an excuse to shift profits to country C.
Perhaps the corporation sells its finished product under a popular brand name. The corporation could decide that subsidiary C owns this brand and that subsidiaries A and B must pay royalties to use it. Even if the brand is valued accurately, the profits from it can be allocated wherever the corporation wants.
The corporation could have subsidiary C make loans to subsidiaries A and B. Even if the loans are at market interest rates, the corporation can shift profits between countries in setting the size of these loans.
Formulary Apportionment: A Solution?
An alternative to transfer pricing is to tax each multinational corporation as a single entity. The American federal government does so by taxing the worldwide profits of US-based corporations minus taxes already paid to foreign governments (up to the US federal rate). However, this approach does not stop American multinationals from playing around with transfer pricing before repatriating their profits to the US.
To replace transfer pricing, one would need a global system of formulary apportionment. The worldwide profits of each multinational corporation would be divided among countries using a formula based on tangible measures of where it sells products, where it employs workers, where it has physical assets, etc.
While this idea may seem fanciful, federal countries actually use formulary apportionment to divide corporate profits between sub-federal jurisdictions. For example, if a corporation operates in more than one Canadian province, Ottawa allocates its profits among provinces based on its sales and payrolls.
In the US, Washington allocates corporate profits among states based on sales, payrolls and physical property. The European Union is developing a system of formulary apportionment to distribute profits among member states.
Where there is a governing authority capable of applying formulary apportionment, this system has been chosen over transfer pricing. Globally, there is no such governing authority. Agreeing on a common formula was difficult for Canadian provinces and could be even more difficult for different countries.
Since a global system of formulary apportionment looks to be far away, it seems reasonable for international economic organizations like the OECD to continue trying to make transfer pricing workable. However, such organizations should also start discussing international formulary apportionment as an option rather than rejecting it out of hand. (Travis may contend in the comments section that we need to start discussing nationalization as an option.)
Foreign Takeovers: A Canadian Epilogue
Foreign takeovers, a hot topic in Canada, did not come up at the conference. One problem is that the costs of financing a takeover are often deducted from the profits of the acquired enterprise.
When a multinational mining company buys a Canadian mining company, the multinational company now has the right to deduct the takeover costs in calculating its Canadian taxes. Under formulary apportionment, the same takeover would give the Canadian government the right to tax a portion of the multinational corporation’s global profits.
Thanks for your very lucid exploration of a business practice I was totally unaware of. You have made a potentially arcane subject very understandable to the layperson, and helps to amply demonstrate something we all know to be true, i.e., that the majority of corporate entities have very little commitment to anything other than their profits.
Enron showed the world how to do this. The government of Ireland encouraged companies to set up branches there, and with virtually non-existent taxes on corporations, many did. Microsoft for one; they maxed out profits there from Europe. Even in the recent crisis (certainly not over yet), the Irish government insisted that they would not surrender this key policy. Which was backed by the Irish trade union leadership.
A few years ago I asked a few key people in the Saskatchewan government how they were monitoring transfer pricing among transnational corporations operating in the province. I got no answers. My guess is that they don’t have the capacity to do this.
In principle, the federal government should be monitoring international transfer pricing. Once a corporation’s Canadian profits are determined, they are allocated among provinces through formulary apportionment (as opposed to interprovincial transfer pricing). However, as a check on federal enforcement, it might make sense for the Saskatchewan government to develop some capacity to monitor the international transfer pricing of the most significant corporations in the province (e.g. PCS).
Case in point:
Google Inc. cut its taxes by $3.1 billion in the last three years using a technique that moves most of its foreign profits through Ireland and the Netherlands to Bermuda. Google’s income shifting — involving strategies known to lawyers as the “Double Irish†and the “Dutch Sandwich†— helped reduce its overseas tax rate to 2.4 percent, the lowest of the top five U.S. technology companies by market capitalization, according to regulatory filings in six countries.
Google, the owner of the world’s most popular search engine, uses a strategy that has gained favor among such companies as Facebook Inc. and Microsoft Corp. The method takes advantage of Irish tax law to legally shuttle profits into and out of subsidiaries there, largely escaping the country’s 12.5 percent income tax. (See an interactive graphic on Google’s tax strategy here.)
The earnings wind up in island havens that levy no corporate income taxes at all. Companies that use the Double Irish arrangement avoid taxes at home and abroad as the U.S. government struggles to close a projected $1.4 trillion budget gap and European Union countries face a collective projected deficit of 868 billion euros.
[…] As a strategy for limiting taxes, the Double Irish method is “very common at the moment, particularly with companies with intellectual property,†said Richard Murphy, director of U.K.- based Tax Research LLP. Murphy, who has worked on similar transactions, estimates that hundreds of multinationals use some version of the method. The high corporate tax rate in the U.S. motivates companies to move activities and related income to lower-tax countries, said Irving H. Plotkin, a senior managing director at PricewaterhouseCoopers LLP’s national tax practice in Boston. He delivered a presentation in Washington, D.C. this year titled “Transfer Pricing is Not a Four Letter Word.†“A company’s obligation to its shareholders is to try to minimize its taxes and all costs, but to do so legally,†Plotkin said in an interview.
Google’s transfer pricing contributed to international tax benefits that boosted its earnings by 26 percent last year, company filings show. Based on a rough analysis, if the company paid taxes at the 35 percent rate on all its earnings, its share price might be reduced by about $100, said Clayton Moran, an analyst at Benchmark Co. in Boca Raton, Florida. He recommends buying Google stock, which closed yesterday at $607.98.
Google is “flying a banner of doing no evil, and then they’re perpetrating evil under our noses,†said Abraham J. Briloff, a professor emeritus of accounting at Baruch College in New York who has examined Google’s tax disclosures.“Who is it that paid for the underlying concept on which they built these billions of dollars of revenues?†Briloff said. “It was paid for by the United States citizenry.â€
The U.S. National Science Foundation funded the mid-1990s research at Stanford University that helped lead to Google’s creation. Taxpayers also paid for a scholarship for the company’s cofounder, Sergey Brin, while he worked on that research. Google now has a stock market value of $194.2 billion. [Con’t …]
http://www.bloomberg.com/news/2010-10-21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes.html
What do you mean by “takeover costs”?
I mean interest payments on money borrowed to finance the takeover.