This article appears in the Fall 2016 issue of The American Prospect magazine. Subscribe here.
Imagine we started a coffee business, Really Great Coffee USA, Inc., ten years ago. We had venture-capital backing to build our global coffee supply chain. We established prime retail locations across America and other countries, creating a world-beating brand that signifies quality, taste, and happiness.
Really Great Coffee, Inc. (RGC USA), has gone public. We as founders are now very wealthy because of our innovative and profitable business model-also because our tax and legal advisers had wonderful solutions to avoid U.S. corporate taxes. The U.S. statutory rate is 35 percent of taxable income, but because of various shelters it is effectively just over 27 percent. But even that 27 percent rate only applies to earnings booked as U.S. income. So the true rate can be far lower.
Early on, RGC USA set up subsidiaries in tax havens-countries with low populations and absurdly low tax rates. Our valuable brand and our coffee preparation patents are owned by RGC Luxembourg, a subsidiary created for the express purpose of avoiding taxes. Our lawyers wrote a contract saying that RGC USA must pay 6 percent of each sale to RGC Luxembourg for royalties. (Luxembourg has an effective corporate tax rate of just 1.1 percent.) And there are others to choose from.
Our tax advisers said RGC USA can buy the world's best coffee beans, but that our subsidiary in the Cayman Islands should roast the beans, mark them up, and sell them to our Bermuda subsidiary. Our lawyers set up these subsidiaries and wrote another contract for RGC Cayman Islands to sell high-priced roasted coffee beans to RGC Bermuda. They said the high price was justified due to our special roasting processes, which may or may not exist. The effective tax rate in the Cayman Islands is less than 5 percent.
RGC Bermuda then grinds the roasted beans and sells them to RGC USA with a generous markup. Our lawyers said we do not need to justify the price, other than to agree with RGC Bermuda that the price is "fair and reasonable." RGC Bermuda makes a lot of money-the effective tax rate in Bermuda is zero.
These purely internal transactions are accounting fictions, and we save a fortune in taxes. Our advisers called it "transfer pricing" and "profit shifting." RGC USA reports virtually no taxable income to the Internal Revenue Service on U.S. sales. But we can and do report very high company profits to our shareholders because our RGC Luxembourg, RGC Cayman Islands, and RGC Bermuda make a lot of money.
Our tax advisers said that shifting our profit on U.S. sales to our foreign subsidiaries is perfectly legal tax "management." We can defer taxes until we bring the money back to the United States. We do not plan to repatriate these profits anytime soon. In fact, RGC USA can borrow the money from our foreign subsidiaries, use the money to grow, pay interest to those same subsidiaries, and deduct even more from our U.S. taxable income. Our duty is to our shareholders, not the IRS.
"PROFIT SHIFTING" IS THE biggest lawful tax avoidance strategy in the United States and the world. Tax professor Kimberly Clausing of Reed College estimates that 31 percent of corporate tax revenue was lost due to profit shifting in 2012. In other words, the IRS collected $242 billion in corporate tax revenue that year, but should have collected another $111 billion if profit shifting to foreign jurisdictions did not exist. The problem rapidly accelerated from 2004 to 2012, and continues to increase dramatically. In 2016, it is possible that more than 40 percent of potential corporate tax revenue will be lost.
Some reformers on the Democratic side may be missing the mark when focusing on tax loopholes, tax breaks, and statutory rates while preserving the taxation of U.S. corporations' worldwide income. Most developed countries tax income generated in their country; this is called a "territorial" income tax system. While the worldwide taxation system we have may, at first, seem like a good idea to progressives who want U.S. multinationals to be taxed properly, our system is having the opposite effect, and it can't be corrected through tinkering.
Professor Clausing of Reed College puts it this way:
Unlike most trading partners, the U.S. system purports to tax the worldwide income of multinational companies at the statutory rate of 35 percent, granting a tax credit for taxes paid to other countries. Yet, because U.S. taxation is not triggered unless income is repatriated, multinationals can avoid residual tax by indefinitely holding income abroad. … As a result, the U.S. "worldwide" system of taxation is substantially more generous to foreign income than many alternative systems of taxation.
Republicans want lower statutory corporate tax rates (and some want to eliminate the corporate tax entirely). They also advocate "territorial taxation," which taxes only that corporate income generated in the United States. They rightly point out that most developed countries have territorial taxation and that we apply a territorial, not worldwide, tax on foreign companies doing business here. This is indeed unfair to U.S. companies. But the Republican goals are unworkable without addressing the problem of profit shifting to tax havens.
Representative Sander Levin of Michigan is the ranking Democratic member of the tax-writing Ways and Means Committee. In a 2011 speech, Levin said of the GOP's push for a territorial system:
We need to move beyond the current easy rhetoric about a move to a territorial system because it does have the potential to encourage American corporations to shift more of their income, and possibly jobs, overseas. If we are going to consider a territorial system, we will need to strengthen our transfer pricing rules, address the allocation of expenses, and consider provisions to deal with tax havens.
Put simply, if Congress were to adopt a territorial system to tax only U.S.-originated revenue without addressing profit shifting, corporations would continue to artificially book income in tax havens. Tax revenue would continue to plummet. There is a remedy that fixes profit shifting, adopts a territorial tax, and solidifies tax revenue, by adapting a variation of the corporate tax system already used at the state level.
This approach is called "sales factor apportionment" (SFA). Here's how it works. SFA would apportion U.S. corporate tax on worldwide company income based upon the ratio of U.S. sales to worldwide sales. Despite the complex name, the principle is very simple. SFA disregards all internal corporate transfer pricing between subsidiaries, so a "sale" to a true customer outside the company is all that matters. In other words, the internal profit shifting in our RGC example becomes not only useless but stupid, as it lacks a business rationale. SFA also achieves the Republicans' territoriality goal in a way that is good for the country while achieving the Democrats' goal of eliminating tax avoidance and maintaining tax revenue. In fact, the U.S. states adopted this system long ago, to avoid artificial income shifting from high-tax to low-tax states. So it is hardly an alien concept, because U.S. companies already comply with it.
The U.S. corporate tax rate is indeed high among developed economies, but is so ineffective that it collects less revenue as a percent of GDP than foreign countries with lower tax rates. SFA ends the charade.
A PROGRESSIVE MULTINATIONAL tax reform program should have three objectives: end the egregious tax avoidance practiced by many global companies; level the playing field between domestic and multinational companies; and stop the pernicious practice of "tax inversions" whereby U.S. companies abandon their U.S. citizenship to move to low-tax countries, while continuing to operate and manage from the United States. The current multinational tax system fails on all three counts.
How would SFA work for the U.S.? Really Great Coffee, Inc., has operations in the United States, Canada, and Mexico. Let's assume its actual sales to consumers (not internal subsidiaries) are 50 percent in the United States, 30 percent in Canada, and 20 percent in Mexico. If RGC earns $10 million in a given year, that $10 million would be allocated, or apportioned, to those three countries.
Since Mexico contributed 20 percent of sales, it would be allocated $2 million of profit that it could tax. The Mexican corporate tax rate would apply. Canada could impose its tax on $3 million of profit. The United States would tax $5 million of RGC's profit.
Sales are used as a proxy for economic activity, rather than "income" as it is defined now. While income is simple in theory, in practice the theory fails because income is revenue minus costs and, as we have seen, the cost part of the equation is readily manipulated by transfer pricing. Sales of goods and services are the true source of income, and the location of sales is much easier to determine and harder to manipulate in most circumstances.
For example, when Uber began to accelerate its growth, and its valuation climbed from millions to billions, the company had already put in place systems to ensure that virtually all its foreign profits would not be taxed in the United States or anywhere else. This strategy has become common for many corporations operating globally. Take the case of the emblematic global tech company, Apple.
In May 2013, the Senate Homeland Security Permanent Subcommittee on Investigations laid out Apple's aggressive tax planning in astounding detail. Despite increasing corporate profits, the committee reported, "the U.S. corporate tax base has continued to decline, placing a greater burden on individual taxpayers and future generations."
The subcommittee staff detailed in page after page how U.S.-domiciled (incorporated) companies devise complex webs of subsidiary entities, and transactions between those entities, to avoid the appearance of income being generated in the United States.
This was not a newly discovered problem. The Joint Committee on Taxation, with members of the House and Senate, had said in 2010 that the "principal tax policy concern is that profits may be artificially inflated in low-tax countries and depressed in high-tax countries through aggressive transfer pricing that does not reflect an arms-length result from a related-party transaction." And in 2007, the Treasury Department under George W. Bush studied the issue of increased corporate tax revenue loss, stating that improper profit shifting was "most acute with respect to cost sharing arrangements."
Former Senator Carl Levin, who was chair of the Permanent Subcommittee on Investigations, held a hearing in May 2013 that was driven by his staff's report. Apple, Inc., was featured because subcommittee staff unearthed Apple's complex entity structure that had everything to do with tax avoidance and little to do with rational business decisions.
Apple CEO Tim Cook testified. Cook talked about all of the jobs Apple creates in the United States and all the economic activity generated. He then asserted that Apple pays a 30.5 percent tax rate on its U.S. income. That sounds pretty fair until you start digging into what "U.S. income" is. Martin Sullivan, a former Treasury Department economist, told Bloomberg, "Apple has shifted enormous amounts of profits from the United States to an untaxed entity overseas."
The core of the Apple tax evasion spiderweb was Apple Operations International, Inc. (AOI), its primary offshore holding company that is incorporated in Ireland but has not declared tax residence in any jurisdiction. "Despite reporting net income of $30 billion over the four-year period 2009 to 2012, Apple Operations International paid no corporate income taxes to any national government during that period," said the staff report.
Remember that the world believes Apple is headquartered in Cupertino, California. That is economically and practically true. But the graphic shows a web that challenges that premise. There are several Irish companies, which seems strange except for the fact that not only is Ireland a low-tax, low-population island, but Apple negotiated an even lower 2 percent corporate tax rate with the government of Ireland.
Apple Sales International, Inc. (ASI), one of the Irish subsidiaries, apparently joins its sister company, AOI, in paying no tax. But it enjoys substantial profits. Senator Levin's committee staff found that ASI "is the repository for Apple's offshore intellectual property rights and the recipient of substantial income related to Apple worldwide sales, yet claims to be a tax resident nowhere and may be causing that income to go untaxed."
A late-August ruling against Apple by the European Commission Directorate-General for Competition is further proof that internal profit shifting simply cannot be solved by better tax enforcement, but must be eliminated from the tax question. Apple's Celtic strategy was spurred by the Irish government cutting a special deal granting Apple lower tax rates than other companies. The Irish tax authorities also allowed Apple to avoid recognizing income in Ireland, leaving billions of dollars untaxed by any jurisdiction.
Spurred by the European competition chief, Margrethe Vestager, the European Commission found:
… that two tax rulings issued by Ireland to Apple have substantially and artificially lowered the tax paid by Apple in Ireland since 1991. The rulings endorsed a way to establish the taxable profits for two Irish incorporated companies of the Apple group (Apple Sales International and Apple Operations Europe), which did not correspond to economic reality: almost all sales profits recorded by the two companies were internally attributed to a "head office." … As a result of the allocation method endorsed in the tax rulings, Apple only paid an effective corporate tax rate that declined from 1% in 2003 to 0.005% in 2014 on the profits of Apple Sales International.
As an example of the profit-shifting fiction, Vestager said, "No matter if you buy an iPhone in Berlin, Rome, or somewhere else, contractually, you are buying from Apple International in Cork, Ireland."
As the EU works to clamp down on tax evasion, albeit with only a partial solution, the U.S. Treasury Department is trying to block their efforts. Treasury Secretary Jacob Lew wrote a protest letter to the president of the European Commission, and followed up with an August white paper, warning them against going after Apple's back taxes.
Why? Because Apple is a U.S.-incorporated company and its worldwide income is subject to taxation when repatriated to the United States. The result of the EU ruling, if upheld on appeal, is a $14.8 billion windfall to Ireland. It will directly reduce U.S. tax revenue because Apple can claim a foreign tax credit to offset its U.S. tax bill. The $14.8 billion credit would equal nearly one-twentieth of total U.S. corporate tax revenue in 2015.
The Apple/Ireland/EU/U.S. kerfuffle is the wrong battle. When tax codes permit intra-company profit shifting between jurisdictions, they simply legitimize economic fictions. Whether Ireland's rate was too low is a side issue. Sales factor apportionment is the only reliable way to eliminate fiction layered upon fiction-because it only considers income from real sales to real third parties from any part of the consolidated company.
The problem will continue metastasizing. Post-Brexit Britain immediately signaled that it wants Apple to move to the United Kingdom and is willing to cut its corporate tax to attract the company. The U.K. will not be encumbered by the European Commission's ruling and has the power to transform itself into a tax-haven country.
You don't need a high-tech operation to avoid taxes. Professor Edward Kleinbard of the University of Southern California showed that while Starbucks is hugely successful in the United Kingdom, it still showed a loss in the U.K. but a substantial profit in the Netherlands. The RGC example above was relatively simple, and loosely based upon Starbucks's scheme.
Sales factor apportionment would make both Apple's spiderweb and Starbucks's subsidiary structure irrelevant and ineffective. Instead of saving taxes, the structures would suddenly be transformed into costly accounting nightmares with no business purpose.
INVERSIONS, WHICH HAVE gotten some press attention and have justifiably aroused indignation, are only the latest variation on the theme of tax avoidance. Because domestic companies are taxed globally, but foreign corporations are only taxed on their U.S. income, U.S. corporations are increasingly "inverting" or reincorporating elsewhere. Bloomberg reported:
More than 50 U.S. companies have reincorporated in low-tax countries since 1982, including more than 20 since 2012. A lot of drug companies are doing it, and low-tax Ireland is a popular corporate home. They're doing it despite a 2004 law that legislators had promised would end the practice, and despite rule-tightening by the Obama administration.
For instance, Caterpillar paid PriceWaterhouseCoopers tens of millions to create an inventory system that transferred the ownership of inventory in Morton, Illinois, to a Swiss subsidiary so that the profit on those parts could be booked in low-tax Switzerland rather than high-tax United States.
These accounting games present massive enforcement challenges to a thinly stretched IRS. The IRS often challenges companies on whether the transfer price between subsidiaries was fair and reasonable according to an "arms-length standard." The agency tries to determine what the price would have been if it were a real transaction to a true third party. But even if the IRS wins a case with a finding that the transfer price was unreasonable, the fact remains that income was shifted in an internal tax-avoidance transaction.
The remedy is to ignore these internal transactions as accounting fictions. It's impossible to fix the problem with better accounting standards or audits. Sales factor apportionment taxation ignores the "origin of income" question among separate subsidiaries, which can be manipulated, by focusing upon the proportion of global sales to real customers in each tax jurisdiction. Apple, for example, would be taxed on a worldwide consolidated basis, disregarding its separate entities. If 50 percent of Apple's sales occurred in the United States, then 50 percent of Apple's global profit would be subject to tax here.
Is this system of sales factor apportionment perfect? No. But it is largely tamper-proof if done properly. It has proven to be a workable, effective system among U.S. states and elsewhere.
Why then has it not received more attention from reformers? There are several reasons. One reason is simple lack of awareness. Most members of Congress, and many of their tax staffers, have not heard of SFA taxation, even though many U.S. states use a version of it. My congressional meetings are usually focused on educating tax staffers about what SFA is and how it works in their states.
A second reason is that tax avoiders do not want SFA because their effective tax rate would increase.
Third, tax experts make a lot of money designing and implementing complex business arrangements. Tax complexity is profitable to them. Apportionment is too simple. They would lose money.
A substantive reason given by some tax experts, including some in the Treasury, is that international tax treaties will need modification, requiring a long, multilateral negotiation process. Reuven Avi-Yonah, a tax professor at the University of Michigan School of Law, and Kimberly Clausing have rebutted that argument by showing how SFA is consistent with tax treaties. Tax treaties are designed, in large part, to provide mechanisms to handle different taxation systems among countries, including avoiding double taxation or zero taxation of company profits and providing some basic standards and definitions. They are not designed to harmonize all countries' tax systems or prevent improvement to address new challenges. The United States has made unilateral tax-system changes in the past that were initially resisted but later resolved through informal or formal discussion mechanisms that those very treaties provide.
Lastly, tax haven countries would likely be opposed to SFA, because their strategies to attract wealthy U.S. companies would be neutered.
Who should support it? Everybody else.
U.S. companies that are smaller and pay at or near the full tax rate should be supportive. Small American corporations pay more than their fair share of taxes, taking up the slack when tax avoiders stiff us. Under SFA, small U.S. companies, big U.S. multinationals, and foreign companies would pay the same tax rate based upon the proportion of their U.S. sales.
U.S. multinationals that currently support lower corporate tax rates and do not aggressively shift profit overseas should also support SFA. A broader tax base would enable statutory rate reduction while preserving revenue.
Pro-export policy-makers and companies that export U.S. products should be supportive, too, because apportionment incentivizes U.S. exports. A Pittsburgh tooling and machining company that exports 20 percent of its products to Europe or Asia currently is taxed on 100 percent of its income because it does not have RGC's tax and legal advisers. Under SFA, that company reduces its U.S. tax bill by 20 percent.
Democrats should support SFA because it fixes their biggest tax revenue–loss problem and because it provides more fairness than any other tax fix. Republicans should support it because it enables territorial taxation and a fix to the tax base–erosion problem that prevents a bipartisan agreement on a lower statutory rate. The "base erosion through profit shifting" problem could be costing us more than 40 percent of our tax revenue this year. No other reform proposal, by any party, comes close to solving this.
The entire deferral debate could be easily resolved. Tax committees are arguing about how to incentivize U.S. corporations to repatriate the money "earned" by foreign subsidiaries. That question becomes irrelevant for future tax years because we would not tax foreign sales and we would ignore fictitious transfers of income to foreign subsidiaries.
If Apple sells 50 percent of its products in the United States, it owes tax on 50 percent of its worldwide consolidated profit at the U.S. statutory rate. If other countries set low tax rates, that is their problem. And Apple can no longer shift its profit to any other country through fictitious internal transactions.
Though few details have been offered, the June 2016 Blueprint by the GOP does envision a destination-based corporate income tax, which could open the door to serious consideration of SFA.
Sales factor apportionment holds much promise to fix the massive problems we face in multinational corporate taxation. Its advantages should please progressives, Democrats, and Republicans. Progressives are rightly concerned about any tax reform efforts under a Republican-dominated system. But the ability to block partisan Republican legislation, combined with the availability of a good tax reform proposal that is true to progressive values and achieves several Republican goals, should result in serious consideration of sales factor apportionment.
