Problems with destination-based corporate taxes and the Ryan blueprint

by on April 1, 2017 at 1:10 am in Current Affairs, Economics, Law, Uncategorized | Permalink

That is a recent paper by Reuven S. Avi-Yonah and Kimberly Clausing.  It has content throughout, but this struck me as the most interesting section:

1. A U.S. pharmaceutical with foreign subsidiaries could develop its intellectual property in the United States (claiming deductions for wages, overhead and R&D), and then sell (i.e., export) the foreign rights to its Irish subsidiary (at the highest price possible). The proceeds would not be taxable. Ireland would allow that subsidiary to amortize its purchase price. This creates tax benefits in each jurisdiction by reason of the different regimes. If the Irish subsidiary manufactures drugs, the profits could be distributed up to the U.S. parent tax-free under a territorial system. If the Irish subsidiary is in danger of becoming profitable for Irish tax purposes, the U.S. parent would just sell it more IP.

2. If an Irish parent owns a U.S. subsidiary, the Irish parent can issue debt to fund the purchases of the IP. The U.S. subsidiary then invests the cash to generate more IP (expensing all equipment and deducting all salaries) and sells the IP to its parent.

3. If an Irish parent has purchased the U.S. IP rights, it would not want to license the rights to the U.S. subsidiary (income for Irish parent under Irish tax law and no deduction for U.S. subsidiary). So it just contributes the rights to another U.S. subsidiary. Could the U.S. subsidiary amortize the parent’s basis under the Blueprint? When one U.S. subsidiary licenses to another, no net tax would be paid. Any royalties would be taxable to the licensor but deductible for the payor.

4. How does the Blueprint work for services? If a U.S. hedge fund manager provides services to an offshore hedge fund, is that considered an export that is tax exempt? What if the U.S. manager develops a trading algorithm and sells it (or licenses) it to an offshore hedge fund? Are the proceeds and royalties exempt? If so, then the hedge fund becomes a giant tax shelter to the manager, because he would not pay 25% on this income–he would pay zero, with no further tax. This is much better than the current carried interest provision, which has attracted bipartisan condemnation because it enables individuals with income of many millions to pay a reduced rate. The Blueprint result is much worse.

1 prior_test2 April 1, 2017 at 2:03 am

Nothing actually new about the Irish tax avoidance schemes, though this particular iteration is dying out –

‘What is the ‘Double Irish With A Dutch Sandwich

The double Irish with a Dutch sandwich is a tax avoidance technique employed by certain large corporations, involving the use of a combination of Irish and Dutch subsidiary companies to shift profits to low or no tax jurisdictions. The double Irish with a Dutch sandwich technique involves sending profits first through one Irish company, then to a Dutch company and finally to a second Irish company headquartered in a tax haven. This technique has allowed certain corporations to reduce their overall corporate tax rates dramatically.

BREAKING DOWN ‘Double Irish With A Dutch Sandwich
This technique is just one of a class of similar international tax avoidance schemes. Each involves arranging transactions between subsidiary companies to take advantage of the idiosyncrasies of varied national tax codes. These techniques are most prominently used by tech companies, because these firms can easily shift large portions of profits to other countries by assigning intellectual property rights to subsidiaries abroad.

The double Irish with a Dutch sandwich is generally considered to be a very aggressive tax planning strategy. It is, however, famously used by some of the world’s largest corporations, such as Google, Apple and Microsoft. In 2014, it came under heavy scrutiny, especially from the United States and the European Union, when it was discovered that this technique made it possible to send several billion dollars annually tax-free to tax havens.

How it Works
The technique involves two Irish companies, a Dutch company and an offshore company located in a tax haven. The first Irish company is used to receive large royalties on goods, such as iPhones sold to U.S. consumers. The U.S. profits, and therefore taxes, are dramatically lowered, and the Irish taxes on the royalties are very low. Due to a loophole in Irish laws, the company can then transfer its profits tax-free to the offshore company, where they can remain untaxed for years.

The second Irish company is used for sales to European customers. It is also taxed at a low rate and can send its profits to the first Irish company using a Dutch company as an intermediary. If done right, there is no tax paid anywhere. The first Irish company now has all the money and can again send it onward to the tax haven company.
The End of the Double Irish With a Dutch Sandwich

Due largely to international pressure and the publicity surrounding Google’s and Apple’s uses of the double Irish with a Dutch sandwich, the Irish finance minister, in the 2015 budget, passed measures to close the loopholes and effectively end the use of the double Irish with a Dutch sandwich for new tax plans. Companies with established structures will continue to benefit from the old system until 2020.’

That’s right, this should continue to benefit Google and Apple to the tune of billions, regardless of what happens in this session of the House.

2 Jpe April 2, 2017 at 11:14 pm

“The U.S. profits, and therefore taxes, are dramatically lowered”

Not so much. The US anti-abuse rules kick in and preclude deduction of royalties to a related party.

I assume this proposed regime would have similar rules.

3 Larry April 1, 2017 at 3:19 am

Foreigners visit US. Does deductibility ensue? If not, does foreign tourism collapse following currency adjustment?

4 dan1111 April 1, 2017 at 4:43 am

Hypothesis: all complex taxes are bad.

5 ¯\_(ツ)_/¯ April 1, 2017 at 8:32 am

I think so. Sales tax that changes at the city level makes no sense in a modern economy. Tax lures to attract factories or stadiums are madness.

Just pick the fraction of GDP you want to collect, and do it in some broad and uniform way. A national VAT with distribution to States based on population.

6 gordon April 1, 2017 at 9:16 am

Reality: U.S. tax code is complex beyond human comprehension

7 rayward April 1, 2017 at 7:12 am

As the authors point out in their conclusion, taxing foreign earnings currently would eliminate the current tax incentives (deferral) to shift earnings to foreign affiliates (including those located in a tax haven) and not to repatriate the those earnings (because repatriation ends the deferral). On the second point (deferral), it’s a fallacy that the unrepatriated earnings are stuck overseas since those earnings are usually invested in U.S. capital markets, but the unrepatriated earnings can’t be distributed to shareholders who might reinvest in worthwhile projects in the U.S. The authors’ point is that there’s a simple solution to the problem, while the proposal for the destination-based tax would create lots of uncertainty, even more complexity than under current tax rules, and may not even solve the problem. My observation is that the purpose of the proposal isn’t actually to solve the problem but to cut the current tax rate while creating an illusion that it solves the problem and promotes exports. In other words, the proposal is no less a sham than the Double Irish with a Dutch Sandwich.

8 AlanG April 1, 2017 at 8:54 am

” My observation is that the purpose of the proposal isn’t actually to solve the problem but to cut the current tax rate while creating an illusion that it solves the problem and promotes exports. In other words, the proposal is no less a sham than the Double Irish with a Dutch Sandwich.”

Absolutely, and it’s just flim-flam from the someone who is regarded as a tremendous policy wonk. I suspect that the average poster on MR is more savvy about almost anything than our Speaker of the House.

Corporate tax departments will quickly find any hole in a new tax code unless it is so simple that the average person can understand the way revenue will be raised. IMO, the only viable approach is to try to remove as many tax preferences as possible, lower the corporate tax rate as low as possible, eliminate shadow corporations so they cannot take advantage of this new low tax rate, and make up the difference with a VAT.

9 Dan Culley April 1, 2017 at 8:55 am

To be fair, these are less problems with the proposed tax than they are with being the only country imposing such a tax. At some level, if you are going to change regimes, you have to accept there will be some transitional issues until everyone sees the light.

That said, I still find this far too complex. If Aurchbach is right, and the system is equivalent to a VAT and a payroll tax cut combined, then why don’t we just do that? Everyone agrees on WTO treatment, we can draw on lots of experience implementing them, and Trump can claim that everyone’s wages went up because of him (nevermind the price increase). Of course, you’d cross the Freedom Caucus members who are religiously opposed to VATs, because, I guess having one will magically turn us into a European welfare state? (I have never quite understood the logic.)

10 Dan Culley April 1, 2017 at 8:57 am

Also Alan Auerbach… Damn autocorrect.

11 ChrisA April 1, 2017 at 10:04 am

Here is my idea of a simple non-distortionary tax system;

Zero profit based taxes on companies, but implement a withholding tax on both dividends and interest (at 20%) to eliminate debt preference. Land tax based on value of land, not buildings. 20% Withholding taxes on any net rental income received from property privately held outside of companies. VAT on all sales at 20%. 20% Flat rate tax for all individuals on earned income outside dividends and interest received. No deductions for anyone or any firm or charity.

12 Troll Me April 1, 2017 at 10:16 am

Isn’t it more profitable to pay lower prices on an input in the first place than to pay higher prices and get a higher writeoff?

Cost of living, etc. etc. are higher in the US. Development costs would be higher in the US.

This is like arguing “I will save money by locating myself in a more expensive location because I can write off those costs as a tax deduction”. But that’s dumb, because you’re still paying more money. I see that there’s something to the argument being presented, but I think this logic would very possibly dominate.

13 Troll Me April 1, 2017 at 11:11 am

I see, taxation of exports versus taxation of domestic production.

But most US laws on these things are based on where the work was performed, not where the company that the work was done for is registered.

So, for example, I’m technically not allowed to work on some projects while in the USA or clients would be contravening labour laws and export rules at the same time. So surely the US hedge fund manager cannot be employed by a foreign subsidiary to perform work in the USA which is then not taxed in the USA. That is, unless the billionaires have a systemic advantage over the little guy that goes beyond their wealth.

14 Ricardo April 2, 2017 at 5:21 am

“But most US laws on these things are based on where the work was performed”

Not under current law. U.S. corporations are taxed on their worldwide profits. However, U.S. corporations can get around this if they shift work out to a foreign subsidiary (not a branch office but a legally independent entity registered with a foreign government) and don’t remit the profits from that subsidiary back to the U.S. U.S. citizens are also taxed on their worldwide income with the exception of the first $100,000 or so of wage income if that income comes from performing work abroad and certain foreign residency requirements are satisfied. The U.S. tax system is not, for the most part, territorial.

The proposed new tax system also does not take account of where work was performed. It is apparently “destination-based” which means it taxes profits based on where the final sale of a good or service occurs.

15 TMC April 1, 2017 at 12:38 pm

Many, many costly lawyers and accountants involved. Corporations are willing to spend $4 to save $5 in taxes, which is quite wasteful. Better just eliminating the corporate tax altogether.

16 Bill April 1, 2017 at 2:43 pm

Actually, this is very similar to what happens today. Transfer the US IP asset to a low tax country (considering valuation and transfer pricing issues); with the earnings from the foreign IP asset finance US R&D, resulting in a patent which is owned by the foreign sub which then charges the US entity high royalties which go back to the foreign sub which is taxed at a low rate.

There is a reason why 20% of the largest US companies pay no taxes.

17 Jpe April 2, 2017 at 11:18 pm

The US parent doesn’t pay royalties to the foreign sub. Those payments would be taxable to the parent under subpart F (so a deduction and income in the same amount = zero benefit).

Rather, what they do is sell IP rights for foreign distribution. They’re not shifting US profit abroad, but preventing foreign profits from having to repatriated due to the royalties that would otherwise have to be paid to the US company.

18 DC tax wonk April 19, 2017 at 12:49 pm

The commenters here are too pessimistic about the DBCFT. Yes, it is true that the DBCFT does not solve all of the profit-shifting shenanigans. But it doesn’t make them worse. And it does solve the problem of corporate inversions.

Regarding the points of the quoted section of the paper:

1. If the Irish subsidiary sells the drugs in the US they will pay US tax. If they sell the drugs outside the US, then yes, all else equal, that will be tax-advantaged. But exchange rate adjustment will offset the tax advantages.

2. This is not a bug but a feature. The DBCFT will encourage multinationals to develop R&D in the US. The idea is to increase investment and jobs in the US.

3. Presumably the subsidiary would not be allowed to amortize the parent’s basis. (No deduction for imports). And yes, there would be no net tax on royalties paid by one US firm to another. This is a consumption tax, not a financial transactions tax. How is this gaming the system?

4. I agree that services are a murky area that needs to be clarified. If a multinational consultant does some analysis for another multinational firm, when would US tax be triggered? The case of hedge funds is also a good example. The rules surrounding issues like these are what threatens to make this an overly complex tax system.

In the end, I think the switch to a destination based tax is doomed. Too many hurdles on both the technical aspects and the politics. Moving to a cash flow tax with fewer deductions and lower rates is more feasible. Such a system would be a marked improvement on the current corporate tax. Let’s hope we get there.

I see too many people saying “just lower the rates”. The cash flow part is key. Our current system heavily subsidizes debt. This is a structural weakness in our economy. And changing to a source-based cash flow tax would significantly reduce the complexity of the corporate tax.

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