International tax proposals and profit shifting

Correction (08/25/2021): Due to a minor error in our multinational tax model, many of the calculations in the original version of this article were incorrect. This error has now been corrected and this analysis has been updated accordingly.

Profit shifting by multinationals poses a major challenge in international taxation. The ability of multinational companies to shift the location of profits from high tax jurisdictions to low tax jurisdictions and tax havens erodes the corporate tax base in high tax countries. For example, a multinational whose patents are owned by an Irish subsidiary may transfer profits from high tax countries to Ireland, where those profits are subject to a low effective tax rate.

The Tax Cuts and Jobs Act (TCJA) of 2017 aimed to combat profit shifting by U.S. multinationals using three key policy changes. First, it reduced the statutory corporate tax rate from 35% to 21%, pushing the United States from one of the highest-taxed countries in the world to near the world average and among developed countries.

The TCJA has also taken a stick and carrot approach to reduce incentives to shift profits overseas. First, it created a surtax on recorded profits in controlled foreign corporations (CFCs) owned by US multinationals, through the Global Intangible Low-Taxed Income (GILTI) policy. This provision created a minimum tax of 10.5 percent on foreign income deemed attributable to intangible assets, defined as income in excess of 10 percent profit from tangible assets. Although it is intended to impose a minimum tax in the range of 10.5 to 13.125 percent, the effective tax of GILTI may exceed this expected maximum rate.

The GILTI provides for a penalty for recognizing profits abroad, but the TCJA also created a positive incentive to recognize profits in the United States with the foreign derivative intangible income (FDII) deduction, offering a rate 13.125% tax on such income if recognized in the United States. , the lower corporate tax rate, GILTI’s incentive not to report profits overseas, and FDII’s incentive to report profits in the United States significantly reduced the incentives for profit shifting for American multinationals.

However, the Biden administration opposed the low tax rates on intangible income of GILTI and FDII, arguing that U.S. multinationals should pay higher taxes. As a result, the administration’s “Made in America tax plan” proposes to increase taxes on US multinationals by: raising the corporate tax rate to 28%; raise the GILTI minimum tax rate to 21 percent; repeal the exemption for tangible fixed assets in the GILTI; calculate the GILTI country by country instead of pooling all foreign income; repeal the FDII deduction; and deny deductions attributed to types of foreign income that the tax system deliberately excludes from taxable income.

The administration claimed that by increasing tax rates on foreign income, these tax hikes would “drastically reduce” profit shifting by multinationals. But this claim ignores that the main incentive for profit shifting is not the tax rate on foreign income, but in fact the tax rate differential between income recognized abroad and income recognized in states. -United. the increase in the corporate tax rate to 28% and the repeal of the FDII deduction reinforce this incentive.

In a recent Tax Foundation analysis that takes these offsetting incentives into account, I found that the Biden administration’s proposals would actually increase profit shifting by US multinationals. The analysis examined four potential changes to the taxation of US multinationals: the Biden administration’s proposal; a partial version of this proposal reflecting the difficulties in obtaining congressional approval for such large tax increases; a revenue neutral proposal that resolves unintentional issues with GILTI in return for a higher GILTI tax rate; and restructuring GILTI to resemble the OECD / G20 Pillar 2 proposal for global minimum taxes.

The following table shows the effects of profit shifting on federal tax obligations on corporations of US multinationals. The first column presents purely static results, in which multinationals do not react to changes in corporate tax. The second column presents the main results, assuming a profit transfer semi-elasticity of 0.8, which means that a 1 percentage point increase in the tax rate on foreign income relative to the rate of Taxation on domestic income reduces the profits transferred to that foreign jurisdiction by 0.8. percent. The third column uses semi-elasticities from recent work by economists Tim Dowd, Paul Landefeld and Anne Moore, who estimated much larger benefit transfer semi-elasticities for tax havens and smaller ones for non-paradise countries. .

Effects of Profit Shifting on Federal Tax Obligations on Corporations of U.S. MNEs (Billions of Dollars)

Change in CIT liabilities

Transfer of loss to profit

Proposal Static ET = 0.8 DLM SE ET = 0.8 DLM SE
Biden’s proposition 1394.4 1315.9 1152.6 -78.5 -241.8
Partial biden 615.6 579.5 522.3 -36.1 -93.3
GILTI fix -2.5 0.0 11.4 2.5 13.9
Pillar 2 111.3 106.0 105.5 -5.2 -5.8

Note: This table shows the 10-year change in federal corporate income tax obligations of U.S. multinationals in billions of dollars for each proposition. The first three columns show the variation of these liabilities of each proposition under different profit transfer assumptions. Static estimates do not use any benefit shift response. The second column uses the moderate profit shift response, with a semi-elasticity of 0.8 to the tax rate differential between the United States and each CFC. The third column uses the benefit shift response from Dowd, Landefeld and Moore (2018), with a semi-elasticity of 4.16 for tax havens and a semi-elasticity of 0.684 for other countries. Tax havens are identified by the Congressional Research Service. The last two columns show the income losses due to profit shifting, calculated by subtracting the static results.

Source: Cody Kallen, “Options for Reforming the Taxation of US Multinationals”, Tax Foundation, August 12, 2021, https://taxfoundation.org/us-multinational-tax-reform-options-gilti/.

Key estimates in the document show that the profit shift reduced revenue from the Biden administration’s proposal by $ 78.5 billion over a decade. Using the Dowd, Landefeld, and Moore semi-elasticities produces even larger effects, with the proposal losing $ 241.8 billion to a decade-long profit shift.

Contrary to the administration’s claim that its proposal would result in a “virtual elimination” of profit shifting, its proposal exacerbates it. To understand why, let’s look at the impact on tax rates.

In my analysis, the Biden administration’s proposal would increase the combined average tax rate on CFC profits from 16.3% under the current law to 20.2%, an increase of 4.9 percentage points. percentage. However, increasing the corporate tax rate from 21% to 28% increases the national income tax rate by 7 percentage points. Combined with the repeal of the FDII, the administration’s proposal increases the tax rate on domestic income by about 9 percentage points, far more than the 4.9 percentage point hike on foreign income. On the net, this dramatically increases the incentives to shift profits out of the United States.

Although the administration has proposed to replace the FDII deduction with an unspecified R&D incentive, this is unlikely to change the outcome of the profit shifting, as the proposal increases the profit shifting even without taking into account the FDII. Additionally, a revenue neutral R&D subsidy to replace the FDII deduction is unlikely to work better as an incentive to recognize intangible profits in the United States.

This same pattern occurs for the partial version of the administration’s proposal, albeit to a lesser extent, as the increases in tax rates on foreign and domestic income are lower than the full Biden administration proposal.

There are many ways that the international tax rules of the United States could be changed, reformed, improved or made worse. Reflexively raising the taxes of US multinationals does not necessarily achieve the goal of reducing or eliminating profit shifting, and it would in fact make it worse. A well-designed international tax reform proposal should alleviate these problems, not exacerbate them.

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