Two weeks ago the Senate Permanent Subcommittee on Investigation (PSI) had a hearing on Apple's ability to put a large portion of its worldwide profits outside the United States and in Ireland. Last week the OECD and a bunch of business groups held a two-day conference in Washington D.C. on the OECD's efforts to address base erosion and profit shifting (BEPS). And this Thursday the House Ways and Means Committee will hold a hearing on tax planning strategies used by multinationals to shift income out of the United States and into low-tax jurisdictions. Meanwhile, in Paris on May 29 at the meeting of the OECD Council at Ministerial Level, representatives of national governments declared that BEPS "constitutes a serious risk to tax revenues, tax sovereignty and the trust in the integrity of tax systems of all countries."
Even for experienced international tax experts the technical and conceptual issues involved in determining where multinational profits should be located is enough to make one's head spin. Allow me to suggest a simple way to think about the key issue: where should multinationals book the profits generated by their valuable intellectual property (patents, trademarks, etc, a.k.a. "intangibles")?
One view is that profit from intangibles should be booked where the intangibles are developed. This is the view adopted by PSI Chairman Carl Levin and ranking Republican John McCain at the Apple hearing. In other words, because Apple does most of its R&D and product development in the United States, profits arising from those R&D and development efforts should be taxed by the United States. This is a reasonable point of view.
Another view is that profits from these intangibles should be booked where sales occur. Apple's CEO took this approach to justify Apple's allocation of profits to the United States. About one-third of Apple's sales are in the United States, so about one third of its profits are in the United States. Although very different from the Levin-McCain view, it is a view that many academics have adopted. (See here, for example.)
Neither of these approaches would get large amounts of profits into tax havens because research and sales to final customers rarely occur in tax havens.
Multinationals are pushing a third view. Basically what they are saying is that if a subsidiary owns an intangible asset, it is entitled to the profit it generates no matter where real business activity (e.g., sales, R&D) occurs. It is easy for multinationals to shift ownership from the United States to a tax haven. The multinational contributes capital to its subsidiary, the subsidiary purchases IP from its parent, and then -- according to this view -- the subsidiary is entitled to the profit the IP generates. (The usual method for this transfer is something called a cost sharing agreement.) Thus, profit is shifted to a tax haven (and there need not be any transfer pricing abuse for the profit shift to occur). To see why this approach is problematic, imagine if anybody with a business (say, an export business that manufactured in the U.S. and sold into Europe) could set up a corporation in a tax haven, put assets of the business into that corporation, and claim that income is foreign source income neither subject to U.S. or foreign tax. The major industrial economies would have their corporate tax bases depleted very quickly. This is the "base erosion" they are constantly talking about. The OECD and the IRS want to limit circumstances where this would be allowed to a very small number of cases where certain conditions are met. Multinationals want as few restrictions as possible.
Marty Sullivan is chief economist at Tax Analysts. He also blogs at taxanalysts.com.