U.S. Corporate Tax Reform: The Potential Effects

13 th Global Conference on Business & Economics ISBN : 9780974211428

U.S. Corporate Tax Reform: The Potential Effects

Danielle Quiggins

The University of Texas at Dallas

Email: danicombes@gmail.com

Keywords: Corporate Tax Reform, International Tax Reform, Effective Tax Rate, Transfer

Pricing, BEPS, OECD, Patent Box, Innovation Box

November 22-23, 2015

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13 th Global Conference on Business & Economics

Abstract

ISBN : 9780974211428

Purpose: This paper is a review of the empirical studies, proposals, and controversies surrounding U.S. Corporate tax reform and International tax reform. This paper serves to expose and analyze the prominent ideas and problems relevant today.

Design/methodology/approach: A review of empirical literature and current policy.

Findings: The majority of economists and vested parties agree that there is an essential need for

U.S. corporate tax reform and international action against BEPS. The real argument is what kind of reform? The proposals vary substantially, down to the underlying foundation of the U.S. tax system and current international tax implications. Without restricting the use of tax havens, most current proposals will fail at resolving the global tax avoidance problem. The OECD’s BEPS project is at a minimum, a move in the right direction, but requires domestic supplementation.

Research limitations: Currently, transparency is limited in MNC’s financials in regards to their

CFC’s.

Originality/value: As an aspiring tax accountant with macroeconomic interest and impartial political views, this research was performed with objectivity. Although there is a strong focus on the U.S. tax system, this research was conducted and relayed as it pertains to the welfare of globalization, not just one country, industry or entity.


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Introduction

ISBN : 9780974211428

U.S. corporate tax reform is on the horizon and long overdue. The Internet has aided in constant aggressive global economic growth and the U.S. tax implications have not changed accordingly. The U.S. corporate tax rate is considerably higher, at 35% compared to competing countries in the 20% range. The current undesirable corporate tax rate paired with the complex and outdated tax code, encourages domestic companies to seek favorable tax treatment elsewhere by creating controlled foreign corporations (CFC’s) and profit shifting. The technically legal, but questionable, tactics used by multinational corporations (MNC’s) to shift profits are discussed as they pertain to a solution. This paper reviews the pros and cons of the current corporate tax reforms proposed, transfer pricing, base erosion and profit shifting. Global trade is more affluent than ever. Studies have shown that there is a positive relationship between domestic growth and trade partner prosperity. It is in the interest of the free world trade partners and globalization for each economy to thrive domestically.

Literature Review

Background

The current U.S. tax system is outdated and not serving its purpose as effectively as it used to. The current state of the U.S. economy is proof of economic scarcity; tax revenue, or the lack thereof, being a source. As Senator Levin and Senator McCain (2013, p.3) explained, “At the same time as the U.S. federal debt has continued to grow – now surpassing $16 trillion – the

U.S. corporate tax base has continued to decline, placing a greater burden on individual taxpayers and future generations.” The corporate tax revenue makes up a much smaller portion of the annual tax generated, than it did years ago. Keightley and Sherlock (2014, p. 1) found that,

“At its post-WWII peak in 1952, the corporate tax generated 32.1% of all federal tax revenue. In


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2013, the corporate tax accounted for 9.9% of federal tax revenue.”

MNC’s who profit in a foreign country, by means of a CFC, pay foreign taxes. If need be, or if they so choose, to repatriate the profits to fund operations in the U.S., a foreign tax credit is applied. At which point the company is taxed at the difference of the foreign effective tax rate and the U.S. 35% tax rate. There is no time requirement for repatriation of the monies.

Consequently, it is not advantageous for the U.S. parent company to return the profits to the U.S.

Rather, it is more efficient to leave the funds in the CFC and defer the additional U.S. taxes.

In certain countries with unrealistically generous corporate tax laws, known as tax havens, it is vastly profitable to abuse transfer pricing and shift profits to their jurisdictions. As it pertains to the U.S., Desai (2003) concluded that approximately 34% or around $150 billion of U.S. tax revenue in 1998 was misplaced by utilizing tax havens (Desai, 2003 cited in Clausing and Lahav,

2011, p.103). On an international scale in 2004, it was estimated that although tax havens only accounted for approximately 3% of the global GDP, at a minimum half of the world’s profits moved through these jurisdictions (Christensen, Coleman and Kapoor, 2004, p. 3). The utilization of tax havens is at the core of the international tax tribulations and should take precedent over other concurrent issues. The Organisation for Economic Co-operation and

Development (OECD) is currently working on a solution to this problem, the Base Erosion and

Profit Shifting (BEPS) project.

U.S. Corporate Tax Proposals

Although the U.S. currently has one of the highest corporate tax rates, in comparison to the other 33 OECD members at 35%, it also has generous corporate tax expenditures. The result is explained by Keightley and Sherlock (2014, p.1), “The U.S. corporate tax system also contains a number of deductions, exemptions, deferrals, and tax credits, often referred to as “tax


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13 th Global Conference on Business & Economics ISBN : 9780974211428 expenditures.” Collectively, these provisions reduce the effective tax rate paid by many U.S. corporations below the 35% statutory rate.” The effective tax rate imposed on profits earned in the U.S. by corporations operating in the U.S. can be comparative to profits earned in other jurisdictions. Furthermore, Keightley and Sherlock (2014, p.1) estimated that “the United States collects less in corporate tax revenue relative to Gross Domestic Production (GDP) (2.3% in

2011) than the average of other OECD countries (3.0% in 2011).” The problem is that the tax laws have not advanced to the extent that global operations have.

Dittmer (2011), an adjunct scholar of the Tax Foundation, compiled a series of studies conducted to estimate the effective corporate tax rate in the U.S. and compare it to the OECD average. The compilation included 13 studies conducted using academically credible calculations. The three types of approaches were, sample of financial reports, hypothetical firm calculation, and IRS aggregate statistics. The studies were executed over various lengths of time, between the years of 2005 and 2011. The series of studies showed that the U.S. effective rate range was between 23% and 34.9% (Dittmer, 2011). The corporate tax expenditures currently allotted in the U.S. tax system makes estimating the average effective corporate tax rate challenging. A 10% variation, as shown in Dittmer’s (2011) compilation, is the difference of the

U.S. being average on corporate taxation and the highest effective rate. Part of the challenge is that many different industries take advantage of various types of expenditures and in turn pay varying effective rates. A more simplistic tax system with a lower statutory rate could be a solution to the complexity, and unfairness, across industries that the current system dictates.

Hodge (2015), with the Tax Foundation, found through their TAG model that cutting the corporate tax rate from 35% to 26.3%, with no base broadening, would increase GDP by 2%.

The TAG model used IRS data to calculate the effects of a policy change on the taxpayers


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13 th Global Conference on Business & Economics ISBN : 9780974211428 involved. Then it used those results to calculate an economic growth or decline based on the repercussions the policy change will have in two primary areas, “the cost of labor and the cost of capital” (Hodge, 2015). Current reformers want to cut the rate in addition to eliminating expenditures. This could yield adverse effects because not enough of the expenditures exist to offset the tax cut. Essentially, lowering the tax rate in itself would increase the GDP by 2% over the next ten years resulting in recuperation of most of the static revenue loss over the long run

(Hodge, 2015).

The GDP projection is promising, but simply lowering the statutory rate does not prevent

MNC’s from profit shifting to a jurisdiction that has little to no corporate tax bills. The Obama

Administration is currently proposing a 19% tax on all foreign earned income, among other alterations to the tax code (Department of the Treasury). Where foreign tax is paid on foreign profits above 19% the U.S. would not impose further taxation. Where the foreign rate paid is less than 19%, regardless of repatriation, the U.S. would require a tax that equals the difference between the foreign rate and 19%. For example, where a CFC is taxed at 5%, the U.S. would inflict a 14% tax on the CFC’s profits. The 19% in conjunction with a reduction to the statutory rate could limit profit shifting and allow MNC’s to lower their effective rate domestically, in an attempt to combat further movement of MNC’s overseas.

Innovation Box

Governments, to promote investment in innovative activities that require high skilled jobs and leads to intellectual property development and rights, use innovation boxes, also known as, patent boxes. The innovation box rewards companies for holding active patents in their home country by allotting them tax breaks on profits earned from the intellectual property (Haydn,

2011). Intellectual property is highly mobile and hard to value. Evers, Miller and Spengel (2014,


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13 th Global Conference on Business & Economics ISBN : 9780974211428 p. 503) explain the tax complications, where “Intangible assets constitute a major input and value driver for multinational companies. Often, the related intellectual property, including patents, trademarks, brands and copyrights, does not have a clear geographical location. Firms can use this flexibility to reduce tax payments.”

It comes at no surprise that a large portion of U.S. MNC profits are shifted by means of aggressively transfer pricing intellectual property (Keightley and Sherlock, 2014) . Grubert

(2003) concluded, from empirical evidence, that almost half of U.S. MNC income shifted to lower tax jurisdictions can be attributed to intangibles in connection with R&D (Grubert, cited in

Evers, Miller and Spengel, 2014, p. 503). A complete tax reform in the U.S. is likely to take a long time, but implementing the proposed Innovation Box regime could entice MNC’s to bring back their intellectual property and profits, immediately. Being of such a large portion of profits lost, the Innovation Box regime is gaining momentum and a movement that both parties in the

U.S. can get behind.

The current Innovation Box proposal in the U.S. is called the Innovation Promotion Act of 2015.

The provision to the current law (which allows no deductions) is as follows (Boustany and Neal, 2015):

“A corporation would be allowed to deduct 71 percent of its innovation box profits derived from qualifying intellectual property (IP) or 71 percent of the corporation’s taxable income, if less. A 71-percent deduction would translate into an effective tax rate of 10.15 percent on all innovation box profits.[...]Tentative innovation profit would equal qualified gross receipts reduced by cost of good sold and other expenses properly allocable to such gross receipts. Qualified gross receipts would consist of gross receipts derived from the sale, lease, license or other disposition of “qualified property” in the


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13 th Global Conference on Business & Economics ISBN : 9780974211428 ordinary course of a U.S. trade or business. Qualified property would include patents, inventions, formulas, processes, know how, computer software, and other similar IP, as well as property produced using such IP.”

In addition to allowing an ongoing tax break, the innovation box would allow the U.S. parent company to receive the appreciated intellectual property from its’ CFC as a dividend excluded from subpart F implications. The U.S. parent would be allowed a 100% dividend received deduction for the appreciation thereby, triggering no tax consequence (Boustany and Neal,

2015). This would allow MNC’s to bring back the rights to their intellectual property, with no tax responsibility and with a carryover basis. 12 European countries are currently utilizing a form of the innovation box in their tax systems (Evers, Miller and Spengel, 2014). It is of no question that it’s more advantageous to house intellectual property rights elsewhere. In addition to actions against profit shifting, implementing the innovation box in the U.S. is necessary.

Transfer Pricing and Profit Shifting

As transfer pricing applies here, Hunter, Herr and Heyland (2015, p.1) explain, “in the context of international corporate taxation, transfer pricing is the pricing and valuation of goods, intangibles, services, and financial instruments transferred amongst members of the same enterprise.” Transfer pricing is used in an attempt to fairly distribute taxable profits among taxing jurisdictions involved in the production and sale of the service or product. To better explain transfer pricing; a domestic MNC will produce a product, service or intellectual property in its home country and sell it to its CFC (sale 1). At which point the CFC will sell it to the public (sale 2). The MNC’s government taxes the profits made on sale 1, from the domestic

MNC to its CFC. The CFC’s government taxes the profits made on sale 2, from the CFC to the public (Radaelli, 1998).


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Schindler and Schjelderup (2010, p. 375) reviewed empirical literature that found

“substantial evidence for tax-motivated transfer pricing where differences in statutory tax rates seem to be the driving force.” When motivated by tax repercussions, transfer pricing is abused by pricing the product, service or intellectual property below a realistic market value at the time of sale 1. Consequently, the profit margin for sale 2 increases, substantially. Furthermore, the parent MNC will assume tax benefits from the production of what was ultimately sold for a high profit elsewhere. This creates tax base erosion in the MNC’s home country and is accomplished by profit shifting during the transfer price allocation at sale 1.

Different jurisdictions have varying rules on setting the transfer price to a market value at sale 1, but generally the price that would occur within an arm’s length transaction is what is expected. An arm’s length transaction is one where the buyer and seller are completely independent of one another (Holtzman and Nagel, 2014). Generally, in an arm’s length transaction, the buyer is looking for the lowest and best price while the seller is looking for the highest and best price. When a domestic MNC sells a product or service to its CFC, it is essentially the buyer and seller, therefore motivated by the highest overall profit. The more profit made in the lower tax jurisdiction yields the smallest tax bill and boosts overall profits. This motivation is the reason many MNC’s stray from a realistic arm’s length transfer prices and, in due course, shift profits. Because intellectual property is so hard to value, it is one of the most abused areas while setting a transfer price.

Developing countries are especially at risk to international transfer pricing misuse. They fear discouraging foreign investment, which is essential to their economy. Developing countries lack the resources to investigate and enforce transfer pricing policies, so they are often exploited

(Borkowski, 1997, 2001). A UK food MNC recently caught bad press about exploiting Zambia,


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Africa by profit shifting to avoid taxation. Zambia is a state plagued with childhood starvation

( Boffey, cited in Alexander, 2013, p.545). Abusing transfer pricing leaves a negative domino effect through the country where taxes are avoided. It is hard for an MNC to claim social responsibility or patriotism when light is shed on the aftermath (Sikka and Willmott, 2010).

Apple Inc., an American success story, is currently under scrutiny for its use of transfer pricing and tax havens. The company’s responsibility is to its shareholders, so it is understandable to push the limits and profit as much as possible, but at what expense? How much is too far?

Alexander (2013, p. 548) suggests that, “Tax transparency accompanied by international tax reform may also provide opportunity for a tax director to clean up all the company’s tax strategies that do not serve a legitimate purpose.” Tax transparency, a primary focus of the

OECD’s BEPS project, is essential, as the exposure may alter the way an MNC acts behind the curtains, to an extent.

Domestic economy effect on globalization

It is important to understand that the traditional use and meaning of the word competition does not apply to trade partner economies competing. In Krugman’s (1994, p. 34) empirical research he finds that; world trade is well advanced but the national living standards were determined by domestic capabilities, not by competition between countries to occupy markets.

Keightley and Sherlock (2014) went a step further by concluding that there was a positive correlation between one country doing increasingly well and a trade partner prospering. With an aggressively emerging global economy, it is important to understand this relationship and act with trade partners, not against or in “competition”.

However, there is still strong evidence that competition for larger tax bases exists.

Although countries are not competing for market penetration, they do compete for taxing of


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13 th Global Conference on Business & Economics ISBN : 9780974211428 more profits within their jurisdiction. That could explain the steady decline in corporate tax rates over the past decade. This competition is not likely to dissipate, countries with limited resources will always benefit from undercutting the corporate tax rates by serving as tax havens and further, driving down the average rate. This poses a real problem in the foundation of our current international tax system, one that the OECD BEPS project is not fully addressing. Devereux and

Vella (2014) explain this quandary,

“If countries acting in their own interests believe that they have an incentive to undermine the international consensus, then that international consensus cannot provide a stable long-run system. There is ample evidence that countries have been doing precisely that. Furthermore, quite beyond the current uncertainty surrounding the outcome of the

OECD BEPS initiative, even if it is successful on its own terms the BEPS initiative will not eliminate these competitive forces.”

Without agreement amongst most countries to implement an interchangeable tax system, it is unlikely that rate slashing will disolve (Devereux and Vella, 2014). The idea of countries coming together on a global basis and setting standards is unrealistic, at best, as expressed by Graetz and

Doud (2013).

It is essential to combat rate slashing and profit shifting domestically, in addition to the OECD BEPS project implications.

The U.S. 19% Minimum Tax on Foreign Income proposal could do just that. Graetz and

Doud, (2013, p. 426) suggested that “a unilateral U.S. modification may not be practical, although such a change might be acceptable if it were to occur in the context of a minimum tax with a relatively low corporate rate.” If other free world countries would come to the understanding that competing for a larger tax base serves no economy in the long run and impose a similar foreign minimum tax, defeating tax shelters is a foreseeable outcome. The international


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13 th Global Conference on Business & Economics ISBN : 9780974211428 tax war should be every country against the collective tax haven countries, not each country for itself. The competition and rate slashing is becoming destructive to every jurisdiction and globalization, while the MNC’s are reaping the rewards. Corporate tax rates are at an all time low, it is impractical to let this continue to decline. The time is now to have a serious conversation about hindering the use of tax shelters on a global scale. Although the BEPS project has a much-needed agenda, it is a temporary fix to a much larger problem that will continue to arise. Transparency is essential, but exposing what is being accomplished legally, simply serves to embarrass some MNC’s. Only to the extent of their conscious, will the profit shifting reduce when the laws are still supporting such actions.

OECD’s BEPS Action Plan

According to Pascal Saint-Amans, director of the OECD Centre for Tax Policy and

Administration, and Raffaele Russo (2014), the 0ECD/G20 venture consists of a 15-point Base

Erosion and Profit Shifting (BEPS) action plan. The first action is to “Address the challenges of the digital economy”(Russo and Saint-Amans, 2014). Saint-Amans and Russo (2014) go on to explain how “The digital economy can exacerbate BEPS risks due to the importance of intangibles, the mobility of users, network effects and multi-sided business models.” The Internet has made available to MNC’s the ability to make sales from a remote location and reap the benefits of that jurisdictions lower taxes. This can be done virtually without there being a physical location in the foreign jurisdiction. The digital advancements have also aided in MNC’s ability to completely avoid taxation.

One of the major concerns about implementing the plan is that it could be costly.

Countries may be unwilling to implement the OECD’s suggestions because it may over complicate their already confusing tax system (Smith, 2014). This projection couldn’t be truer


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13 th Global Conference on Business & Economics ISBN : 9780974211428 for the U.S. with its current overly complicated tax system. Tax planning is extensive, expensive and essential in the U.S., adding the BEPS action plan would be bothersome. The global economy is only going to progress, as global traders, the free world countries need to work together. Most importantly, the OECD proposes suggestions, none of which will substantially reduce the use of tax havens. A large focus of the BEPS project is to increase MNC financial transparency among all jurisdictions. At which point a more accurate understanding of where, when and how international profits are being sourced and taxed will materialize. It is of the upmost importance that each country halt profit shifting to tax havens domestically.

The BEPS action plan is being created to serve globalization. With an international plan posing changes for 34 different countries to follow, it would be impossible to maximize benefits per each country. Each country need consider the domestic repercussions and then reform their respective tax laws accordingly. The BEPS action plan is far from flawless, but at a minimum, a move in the right direction.

Conclusions

With a startling national debt, it is important the U.S. moves forward with caution when considering tax reform. The issues discussed here are complex and I have barely begun to scratch the surface. The purpose of this research was to look at the big picture, start a dialogue and acknowledge that the current proposals are insufficient to solve a core global problem of profit shifting to tax havens. MNC’s and tax haven jurisdictions have colluded to exploit the rest of the world, this serves no country or entity other than the tax haven and MNC’s. Although there is a strong focus on combating BEPS, the approaches are not strictly preventing the use of tax havens. The only way to compete with the tax laws in a tax haven is to become a tax haven,


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13 th Global Conference on Business & Economics ISBN : 9780974211428 which is unrealistic and ineffective. Profit shifting must be combated on a global scale but with strong focus on domestic tax reform.

Tax planning is an essential part of running any successful business, but tax avoidance should not be a key strategy in profiting. Tax slashing and competing for larger tax bases should be no goal of corporate tax reforms, as it serves no legitimate objective and is quite destructive in the long-term. The free world countries should be highly concerned with the continued use of tax shelters as it adversely affects all free world countries and threatens globalization. Once BEPS is controlled domestically, reforming the code to address other outdated issues such as the high statutory rate and the implementation of an innovation box is necessary.

Future research

Only six of the 34 OECD members still tax domestic corporations on a worldwide scale, the U.S. being one of them. The U.S. has a tax system defined as a hybrid but show more similarities to a worldwide system. In the past two decades 13 OECD countries have transferred to a territorial tax system that excludes most if not all of foreign earned income from homeland taxes (Lundeen, 2015). Has the territorial tax system gained popularity as part of the competition, to have the most attractive corporate tax laws? Is a territorial tax system an efficient way to go while globalization advances? In depth research into the potential outcomes of implementing a territorial system alongside a solution to profit shifting in the U.S. is recommended.

Research into the corruption of the U.S. government is also recommended, more specifically the campaign money politicians accept that enslave them to MNC's. Research into the complications of getting proposals passed is necissary. There is a lot of talk and no action


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13 th Global Conference on Business & Economics ISBN : 9780974211428 when it comes to tax reform. With startling debt, the U.S. is in more of a need now than ever for capital, it is unbelievable that movement towards greater tax income is stale.

An empirical cost benefit analysis of the implementation of BEPS in the U.S. has yet to be done or discovered. Further review into the BEPS action plan is beyond the scope of this paper but poses a subject for future research. A study on the implementation of BEPS alongside domestic tax reform is essential. Further research into the repercussions of implementing a 19% minimum tax on foreign income and dropping the statutory rate to 26.3%, without widening the tax base, for corporations is recommended.

Countries have been dropping the statutory corporate tax rates steadily over the past decade. This poses a concern about the competition and if there is a race to the bottom. How low is to low for corporate tax rates to realistically drop? Studies into the continuation of corporate tax rate cuts if countries do not work together now to stop devastating tax bases. Future research should include; estimates of the results to the global GDP and government revenues if the free world/OECD/G20 countries worked together on international taxation and dissolve competition with each other, rather collectively combat the MNC’s frivolous avoidance tactics.


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