03/20/2013 10:27 am ET Updated May 20, 2013

Are Foreign Multinationals Paying Their Fair Share of U.S. Tax?

Vivid press reports of U.S. companies not paying their fair share of tax in the United Kingdom has motivated the Conservative-led government to take the lead on coordinating international efforts to curb aggressive tax avoidance. The last time the U.S. public got upset about foreign corporations not paying U.S. tax was in 1990. The focus of attention then was Japanese multinationals. Of course, elevating the drama was the fear at that time -- non-existent now -- that Japan's economic engine was going to outclass the United States. In the end the Treasury promised to get tough, the Congress did next to nothing, and now more than two decades later the problem of profit shifting is greater than ever.

Citing U.K and U.S. press reports about profits shifting into tax havens, the O.E.C.D. has issued a new study acknowledging "a growing perception that governments lose substantial corporate tax revenue because of planning aimed at shifting profits in ways that erode the taxable base to locations where they are subject to more favorable tax treatment." This is a big deal because the OECD has been the big defender of the status quo. The next flash point is May 2013 in Moscow when tax administrators of the OECD and G20 nations will meet to discuss the problem.

There are two main ways multinationals shift profits out of the countries where they actually do business and into tax-haven holding companies: (1) aggressive adjustment of the prices (the "transfer prices") that one part of a multinational charges another for goods, services, technology, and trademarks; and (2) arranging for finance holding companies in low-tax countries to lend -- and charge interest -- to operating affiliates in high-tax countries.

Although both foreign-controlled ("inbound") and U.S.-controlled ("outbound") multinationals can shift profits out of the United States, outbound transfer pricing gets the lion's share of attention. This is in large part due to the fact that the available data make it easier to observe outbound profit shifting. Another factor is that an official 2007 Treasury study concluded that there was no clear evidence in the tax return data that foreign-headquartered multinationals engaged in profit shifting.

There are several reasons not to let the Treasury study lead us to be complacent about profit shifting by foreign-controlled U.S. corporations. First, the study was based on analysis of 2004 data. Since then, foreign corporate tax rates of the countries where foreign multinationals investing in the U.S. are headquartered have declined by more than five percentage points, and further declines in the U.K. and in Japan are scheduled. Even if there was no profit shifting by foreign-controlled U.S. corporations in 2004, in response to the greater incentive due to the enlarged rate differential, they may certainly be doing so now.

Second, all the less systematic evidence -- anecdotes, evidence of increased profit shifting by newly "inverted" companies (that is, former U.S. companies that changed the location of corporate citizenship for tax purposes), and common sense that companies which have the capability under current law will shift profits -- suggests there is significant shifting of profits out of the United States by foreign-headquartered firms.

Third, and most importantly, the Treasury study compared the profitability of foreign-controlled U.S. corporations with domestically-controlled U.S. corporations, and not finding foreign companies to have low rates of profit in comparison, concluded there was no evidence that foreign-controlled firms were profit shifting. But this is a flawed comparison. The bulk of profit of U.S. controlled corporations is generated by large multinationals who themselves have abnormally low profits in the United States because they too shift profits to tax havens.

Current law section 163(j) of the Code, enacted in 1989, is intended to limit profit shifting by foreign-controlled U.S. corporations. It says that if interest payments exceed 50 percent of cash flow, interest paid to a related-company in excess of that amount cannot be deducted in the United States. Many other countries also have limits on interest deductions they suspect are being used to shift profits. These base-protection rules are referred to as "thin capitalization" and "earnings stripping rules." (Ways and Means Committee Dave Camp has included as part of his discussion draft for international tax reform a rule similar to 163(j) to limit interest deductions paid by a U.S.-headquartered company to its foreign subsidiaries. And so if the Camp proposal were adopted, the U.S. would, like Germany and Italy, have earnings stripping rules that apply to both inbound and outbound investment.)

My preferred approach to limiting interest in the multinational context is to allocate worldwide interest of a multinational group so only that portion of worldwide interest in proportion to U.S. gross profits is deductible in the United States. This rule could apply to both U.S.- and foreign-controlled corporations doing business in the United States. (Martin A. Sullivan, "An Automatic Brake on Profit Shifting in a Territorial System," Tax Notes, July 30, 2012.)

As Congress searches for revenue to pay for lower corporate tax rates, limiting interest deductions should always be given prime consideration. Unfortunately, because deductions for corporate interest are not on any list of tax expenditures, they have not received the attention they deserve. Deductions for corporate interest favor debt over equity financing. This distorts the efficient allocation of investment and it contributes to financial instability. So even if there was no profit shifting problem at all, Congress should consider limiting interest.

There are other proposals out there to limit profit shifting that would be particularly helpful for preventing profit shifting by foreign-controlled corporations. (Current controlled foreign corporation (CFC) rules and proposed changes to these rules only apply for U.S. controlled corporations operating abroad.) Michael Durst has proposed limiting U.S. deductions for payments made to related foreign affiliates if those payments are to a low-tax country and they generate profits above a designated level. (Michael C. Durst, "Congress: Deduction Curbs May Be Most Feasible Fix for Base Erosion," Tax Notes, March 11, 2013.) Professor Bret Well has proposed a rule, similar to Mexico's, that would not allow deductions for payments to related foreign companies if those payments exceeded U.S. manufacturing income (computed under section 199). (Bret Wells, "What Corporate Inversions Teach about International tax Reform," Tax Notes International, July 26, 2010.)

Martin Sullivan is chief economist at Tax Analysts.