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How Offshore Corporate Income Tax Savings Works:

A quick practical example responding unfortunately belatedly to a student who, congrats, graduated a week or so ago and who asked, what was what with proposals from the Obama administration to tax US corporate income parked offshore? I ran across a short Bloomberg article giving a practical example of what's at issue with respect to Microsoft. The issue is this:

Obama on May 4 proposed outlawing or restricting about $190 billion in tax breaks for offshore companies over the next decade. Such business groups as the National Foreign Trade Council, the U.S. Chamber of Commerce and the Business Roundtable have denounced the proposed overhaul.

U.S. tax rules let companies defer paying corporate rates as high as 35 percent on most types of foreign profits as long as that money remains invested overseas. Obama says he wants to end such incentives to keep foreign profits tax-deferred so that companies would invest them in the U.S.

Here's how the current tax arrangements function for Microsoft:

Barry Bosworth, an economist in Washington at the Brookings Institution research center, said many software companies such as Microsoft have exploited tax and trade rules in the U.S. and other countries to achieve a low overall tax rate.

Typically, he said, a company like Microsoft develops a product like Windows in the United States and deducts those costs against U.S. income. It then transfers the technology to a subsidiary in Ireland, where corporate tax rates are lower, without charging licensing fees. The company then assigns its foreign sales to the Irish subsidiary so it doesn't have to claim the income in the United States.

"What Microsoft wants to do is deduct the cost at a high tax rate and report the profits at a low tax rate," Bosworth said. "Relative to where they are now, the administration's proposals are less favorable, so there will be some rebalancing on their part."

There is nothing illegal or unethical about this, of course; the tax rules were developed understanding these effects. It's an asymmetrical relationship; deduct at the high country rate and pay tax abroad at the low country rate. But given that the rules were set up with the effect of giving companies like Microsoft an effective lower tax rate - 26%, according to the article - a change in that rate will cause what Bosworth calls, a trifle blandly, "rebalancing," which is to say adjusting for the tax hit by moving jobs offshore. (It's also not very clear to me how the proposed change leads to increased investment in the US, unless one thinks of the tax paid in the US as a form of investment in the US government's investment plans.) However, good idea or not, the article gives a useful, quick, and real life example of how the current system works drawing on Microsoft.

Missing? (mail):
My understanding was slightly different than what is described here. The profits from those foreign sales (whether or not any IP is assigned to Ireland) are never repatriated to the US, otherwise they'd be subject to US tax under current law. Even if Microsoft in the example chose a high-tax foreign country (instead of a low tax domicile like Ireland), the profits earned overseas won't be taxed in the US unless they're repatriated. By taxing overseas profits whether they are repatriated or not, a company would pay twice for income earned overseas as long as they remain a US company.

Microsoft isn't evading any taxes here, they're obeying the tax treaties the US has signed with foreign countries. If the US decides to tax this income based on where one is headquartered vs. where it is earned (and give no credit for foreign taxes paid), US companies will pay more in tax for the exact same activity as their foreign competitors, as they pay both overseas and again at home for non-repatriated overseas earnings.

My incentive under that scheme would be to minimize my non-repatriated foreign profits subject to the new US tax. How can I do that? By moving more cost--i.e., taxpaying workers--overseas.
6.5.2009 12:14am
Kenneth Anderson:
You're correct - but more than I wanted to put to my student who had somehow mysteriously graduated without taking any tax class, the horror, the horror!
6.5.2009 12:18am
Montana:
"It's also not very clear to me how the proposed change leads to increased investment in the US, unless one thinks of the tax paid in the US as a form of investment in the US government's investment plans."

Presumably the idea is that right now, if Microsoft takes the money they make in Ireland and invests it in the US, they have to pay US tax. Whereas if they invest it in Ireland then they don't. Thus, the incentive is to invest it in Ireland (or elsewhere outside the US). By subjecting the profits to US taxes whether brought back into the US or not, there is no longer this barrier to bringing it back into the US.

Of course, as mentioned above, this will merely cause companies to put their headquarters offshore rather than paying more tax. The correct way to resolve the issue is to *not* tax income earned abroad and invested in the US, so that the disincentive to investing in the US is removed. This theoretically results in less tax revenue rather than more, but given all the investment money this would bring back into the US which would then be taxed when spent, it could end up generating more.
6.5.2009 12:43am
C. Taylor:
Montana - "The correct way to resolve the issue is to *not* tax income earned abroad and invested in the US..."

Or perhaps the true "correct way" is not to tax corporate income at all, regardless of in what country it is earned, in order to attract and stimulate business in the US, especially as all of those taxes paid by "corporations" are actually paid by the people that work for and engage in business with them.
6.5.2009 1:14am
Dave3L (mail) (www):
I agree with Montana. Income should be taxed in the jurisdiction where it is earned. If Microsoft and other companies want to develop software in the US but attribute foreign sales to an offshore subsidiary, that is not a bad thing. That means development jobs in the US, and repatriated profits available for reinvestment. There is a negligible amount of tax revenue lost, and the net effect is beneficial. Remember, the US tax lost is only the difference between the tax paid in the jurisdiction where it was earned, and the applicable US marginal rate.

Further, a territorial-based taxation system would provide benefits for the economies of third word countries. Currently, there are no tax incentives for U.S. capital to invest in Africa and other less developed countries, because upon repatriation any profits would be taxed at US rates (which are obviously high compared to Africa). A territorial-based system would give incentives to foreign direct investment by increasing the after-tax profit margin.

Currently, the situation is this: high-tech companies like Microsoft have incentives to keep profits earned outside the U.S. from being reinvested into development back in the US, because the company gets a better rate of return from portfolio income earned outside the country in a low-tax jurisdiction. Meanwhile, companies with lower-tech products or input demands, or that specialize in raw materials, have decreased incentives to invest in foreign jurisdictions, because they will have to pay US taxes before distributing profits to shareholders. It's lose-lose-lose-lose for the US economy, US workers, third world countries and the companies themselves.

I am currently putting the finishing touches on an article that proposes to incorporate elimination of residency-based taxation systems (such as the one the US has currently) in favor of territorial-based systems as part of a comprehensive Multilateral Agreement on Investment under the WTO. I'll be sending it to the relevant journals through express-o soon, but if any transnational law journals (or law reviews that see their mandate as broader than more boring articles on constitutional interpretation) are interested, drop me a line...
6.5.2009 1:29am
Brian Dell (www):
The United States has the highest statutory corporate income tax rate in the world (although Japan is contender for this honour).

After completing my MBA/law degree (a JD is called a LLB in the Commonwealth, of course) I was hired by the equivalent of the Treasury to advise on financial market policy. The research by the professional economists there showed that corporate taxes are amongst the least efficient form of taxation. Consumption taxes are amongst the most efficient, and indeed in Europe we have seen a move to higher consumption taxes in recent years. A large part of economists' frustration with corporate taxes is that it is difficult to establish which stakeholders bare the burden of them. Employees? Shareholders? Consumers? It is harder to plan policy with these uncertainties. And it was known that investment was indeed hurt by corporate taxes. There was also the fact that a competitive corporate tax rate would poach a lot of internationally mobile corporations. It is found that the USA could cut its corporate rate by 5% and perhaps even 10% and be revenue neutral (without even considering any economic stimulus) - it is one of the few taxes where the Laffer curve really can apply.

So why are corporate rates so high in the US? Economists have long recognized that the US is a very populist society. Americans are not as inclined to defer to bureaucrats and experts as the Europeans are (witness the considerable power of the technocrat-populated European Comission). Americans are the most anti-free trade people in the developed world. And taxing corporations is a populist tactic. See the remarks in the WSJ about the "unseen" by John Hasnas, law professor at Duke.
6.5.2009 2:13am
[insert here] delenda est:

A large part of economists' frustration with corporate taxes is that it is difficult to establish which stakeholders bare the burden of them.

Is it? The answer, assuming a certain degree of capital mobility, is labor. I didn't think that was controversial!

But the problem is that corporate taxes are still reasonably 'efficient' even if only as an integrity measure to the personal income tax system.

You are undoubtedly right, however, that corporate tax cuts are empirically the best free lunch a country can get. Much as I would like it to be otherwise, there really isn't much actual empirical evidence that cutting personal tax rates fosters investment or anything else. There is a lot of abstract and anecdotal evidence, and some compelling logic, but no 'hard' evidence. There is, however, 'hard' evidence for the corporate tax rate encouraging investment and growth.

But then:

Americans are the most anti-free trade people in the developed world.

Isn't Western Europe developed? Their system of government does seem pretty primitive I guess...
6.5.2009 8:56am
Joe Taboe:
The Brookings Institution should have spoken to a tax lawyer before the intereview. If you look at Section 367(d) of the Internal Revenue Code it says if you try what they described you will be taxed in the US on a deemed royalty basis so his explanation is not correct. You could have MS share the costs of development with an Irish sub. That way only part of the expenses are deducted in the US with the rest being deducted in Ireland (which has a lower tax rate and therefore the deductions are worth less). It is called a "cost sharing" agreement. If you split the profits fairly between the US and Ireland fairly that would work but it isn't as sexy as bloomberg describes.
6.5.2009 9:48am
Ian Speir (mail) (www):
Under Section 482 of the tax code (and its regs), outbound transfers of intangibles like that have to comply with certain "transfer pricing" rules. Basically, in this case, it would require the Irish sub to "buy" the intangible from the U.S. corporation at a price that mirrors what independent parties, bargaining at arm's length, would pay. The trouble for the IRS has always been valuing these intangibles, especially where it's not clear what the intangible's profit potential is.

One new proposal in the Obama "Green Paper" is to require intangibles to be valued at their "highest and best use." This is a subtle move away from the above "arm's length standard" and increase IRS authority to impose higher valuations on outbound transfers.
6.5.2009 10:07am
ExPatMoney:
The Obama proposal will only catch little fish -- there are still ways to get around it for big fish such as with long-term licensing and balloon payments, creative lawsuits over contract "breaches" ... it just takes more pre-planning.

Different sources put the amount of un-repatriated foreign profits at 9 to 13 billion dollars. The vast majority of that has been keep offshore for years, and will stay offshore as long as it will be taxed as ordinary profits.

The basic thrust of the response to the financial situation in the US, is to maintain liquidity by using the Fed's balance sheet since the Fed is the only entity with that kind of capital. That's a good move short term. This is also the source of the gnashing of teeth over government getting into private businesses, and meddling in business (al la GM, etc.) and unprecedented deficits.... very bad for the long term.

I suggest we allow repatriation of foreign profits, at zero or a low tax rate of 5%, as long as that money is put into particular use to either directly take assets off the Fed balance sheet (there are many vehicles to do that), or low interest US bonds that mature in some staggered period of years.

Of course, the negative to this is the giant sucking sound coming from the foreign economies if the US profits are pulled out and repatriated.
6.5.2009 10:25am
J.R.L.:
You mean a leftist policy might result in the exact opposite consequences as what was intended? Well, no doubt it would be the first time.
6.5.2009 10:48am
Thales (mail) (www):
I believe there's some (mixed) evidence that the current policy also encourages offshoring of jobs. The real test of that aspect of tax reform would be the net loss or gain of jobs.

As for broader tax policy, I'm not sure that ending system-gaming tax incentives is "leftist" as some commenters suggest. I think Pres. Reagan of all people, attempted to across the board get rid of some of the double benefit of high rate deductions and low rate tax (or long deferral, which amounts to the same thing) in 1986 in exchange for lower statutory rates. I'd actually be all for ending entity-level taxation if there were a proportional adjustment in dividend and capital gain taxation (i.e. treat income as income, whether or not wage-based).
6.5.2009 11:15am
[insert here] delenda est:

One new proposal in the Obama "Green Paper" is to require intangibles to be valued at their "highest and best use." This is a subtle move away from the above "arm's length standard" and

It is also a repudation of international tax law principles and contrary to every single one of America's tax treaties. However, uniquely, those treaties don't apply to Americans as against the American government, so tough luck for American companies.


I suggest we allow repatriation of foreign profits, at zero or a low tax rate of 5%

Bush did basically that in 2004. About $200bn was repatriated, however, on the whole it was believed to have bolstered corporate balance sheets more than it was re-invested. Oh wait, that's exactly what you are suggesting ;)

Don't worry about the giant sucking sound, it will balanced by the sucking out of America to America (Ireland) plc and America (Holland) NL.
6.5.2009 11:18am
Losantiville:
The tax extension to overseas sales will encourage sales of US companies to foreign companies since such sales would eliminate US taxation of foreign source income of foreign companies.
6.5.2009 3:27pm
one of many:


Americans are the most anti-free trade people in the developed world.


Isn't Western Europe developed? Their system of government does seem pretty primitive I guess..
It's kinda dependent on definition. If you accept bloc trading as free trade than Western Europe is far more pro free trade than the US. There are arguments for and against considering bloc trade as free trade but that's far off topic.
6.5.2009 5:10pm
Tulkinghorn:

Or perhaps the true "correct way" is not to tax corporate income at all, regardless of in what country it is earned, in order to attract and stimulate business in the US, especially as all of those taxes paid by "corporations" are actually paid by the people that work for and engage in business with them.


If corporations are to be pass-through entities, let's just treat them that way and abolish limited liability while we are at it. Otherwise, let's tax corporations at a nominal rate and tax dividend income and capital gains as regular income. That would work too, I guess.
6.5.2009 8:00pm
guy in the veal calf office (mail) (www):
I didn't see anything that indicates Ways and Means intends to eliminate offshore deferral. What they intend to eliminate is a current deduction w/r/t an item that creates offshore income that is deferred. Plus a few other tweaks here and there. IN your example, they would disallow (or defer) the amortization of Microsoft's development costs on Windows.

And Congress is running this show, not Obama. Just like the Stimulus Bill, Cap n Trade and so on. Notorious tax scofflaw Charlie Rangle writes the rules so Notoriously confused tax scofflaw Tim Geitner can administer it.
6.5.2009 8:10pm
SFBurke (mail):
As a couple of others haven mentioned, the example given does not accurately state the tax law. Indeed, there are very specific provisions designed to prevent such leakage. I find it somewhat incredible that someone at the Brookings Institute who claims to be an expert on these matters is not aware of these basic provisions. And truly these are basic provisions -- any technology company that operates on any sort of international basis is aware that this scheme would not work -- this is not arcane tax law, it is basic tax law. Unfortunately, I doubt that there are more than a couple members of Congress who have worked enough in the real world to understand what a silly example this is.
6.5.2009 9:08pm
Bruce Hayden (mail):
I find it somewhat incredible that someone at the Brookings Institute who claims to be an expert on these matters is not aware of these basic provisions. And truly these are basic provisions -- any technology company that operates on any sort of international basis is aware that this scheme would not work -- this is not arcane tax law, it is basic tax law. Unfortunately, I doubt that there are more than a couple members of Congress who have worked enough in the real world to understand what a silly example this is.
I wonder if Brookings is in much better shape.
6.6.2009 8:07am
bender:
If the US pays such high corporate taxes, then why did the WTO agree with Europe in the foreign sales corporation case that the US scheme (to my knowledge still unchanged?) operated as an export subsidy?
6.6.2009 12:59pm
Andy F (mail):
The foreign sales exclusion reduced the US income tax for export sales to foreign countries. As such it was deemed an export subsidy and the WTO required that the exclusion be ended.
6.7.2009 4:15pm
Oren:

It then transfers the technology to a subsidiary in Ireland, where corporate tax rates are lower, without charging licensing fees.

Wouldn't such agreements have to charge market value (i.e. be negotiated at arm's length) for the technology, creating profits where they are developed?

At first glance, the core of the strategy seems to be a fraudulent transaction to transfer valuable property for considerably less than it is worth.
6.7.2009 8:51pm

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