Governments and Multinational Corporations in the Race to the Bottom Rosanne Altshuler (Rutgers University) and Harry Grubert (U.S. Treasury Department)

Tax competition and the “race to the bottom” Focus tends to be on host countries using tax policy instruments such as statutory tax rates and tax incentives to compete for mobile capital, but –neglects role of corporate tax planning by multinational corporations (MNCs) –neglects role of home governments that facilitate this planning through their tax codes There are three parties in the “race to the bottom” –host governments, home governments, and MNCs –tax havens play a passive role only

Goal of paper Understand role of the three parties in explaining the reduction of corporate tax burdens worldwide Use data on operations of US MNCs to illustrate role of each of the actors and how these roles may have evolved –No single data set gives complete picture Country- and subsidiary-level data from Treasury tax files Data on foreign direct investment and country affiliate income from Bureau of Economic Analysis (BEA) Focus on 1992 to 2002 –Emphasis on period after 1996 –Treasury regulations issued in 1997 greatly simplified use of more aggressive tax planning strategies

Plan of today’s talk Background on new tax planning strategies Evidence on tax planning –Changes in firm level effective tax rates –The growth of income shifting at the subsidiary level –The location of income and real capital –Revenue estimate of the tax savings to US companies due to new tax planning strategies

The new tax planning strategies What is a hybrid? –An entity that is incorporated from the host country point of view and a branch from the US point of view (or vice- versa) What is the advantage of using hybrid? –Allows US companies to avoid the current US tax under the CFC rules on inter-company payments like interest, royalties, and dividends –A hybrid entity makes this payment invisible to the US because it all occurs within one combined entity Setting up hybrids simplified by check-the-box regulations passed in Dec and effective Jan. 1, 1997 –All the company had to do to create a “disregarded” entity was check the box on a tax form –Once the box is checked, the entity disappears from the US view

Hybrid entities Parent injects equity into tax haven Tax haven lends to high-tax affiliate High-tax affiliate makes interest payments –Interest would be taxable currently under US CFC rules But, check-the-box on the high-tax affiliate –Transaction invisible to Treasury which regards combined tax haven - high-tax operation as a consolidated corporation Result –Interest escapes current U.S. taxation –Interest deduction in high-tax country –Income deferred in tax haven –Interest not taxed anywhere! Data issue –In reports to the Treasury, the parent can elect to list the surviving consolidated corporation as incorporated in the high-tax location or the tax haven Tax haven affiliate InterestLoan Equity High- tax affiliat e Parent MNC

More tax planning strategies with hybrids Move income across locations without tax implications through payment of inter-company dividends –Typically pay to “holding companies” in countries with favorable regimes (exempt dividends and impose low withholding taxes) Shift income from intellectual property like patents to tax havens –Tax haven engages in a cost-sharing agreement with parent –Haven affiliate licenses resulting technology to other affiliates in exchange for royalty payments. These inter-company payments are invisible with check the box. “Hybrid securities” –Considered debt by host country and equity by company receiving payments (more relevant for dividend exemption countries)

Tax planning and changes in effective tax rates AETR = taxes paid in host country/ E&P in host country Data from Treasury tax files. Average Effective Tax Rates in Manufacturing for 58 Countries

What explains the recent decreases in AETRs? Is country behavior (tax competition) or company behavior (tax planning) responsible? –Simple regression analysis of country level data from 1992 and 1998 –Results suggestive of a tax competition story Countries losing share of U.S. capital relative to their neighbors cut their effective tax rates the most Countries with relatively high AETRs in 1990 and small countries cut their rates more than the average

Company versus country behavior? Add statutory tax rate to analysis –Statutory tax rate indicates incentives for company tax planning at the margin –Find that statutory tax rate plays no role in explaining decreases in AETRs over the period But, the story changes in 2000 –Change in capital share and initial effective tax rates no longer explain differences in declines in AETRs –Statutory tax rate has greater explanatory power Company rather than country behavior seems to be explaining changes in AETRs in the most current data

Tax planning and changes in firm-level ETRs Cannot directly observe extent to which tax planning has lowered ETRS Can look at whether factors explaining the variation in ETRs at the firm-level have changed in recent years –Hybrid entities and securities that allow income to be stripped out of high-tax countries may weaken the relationship between statutory rates and ETRs Compare CFC level data for 1996 and 2000 –Statutory rate is smaller and much less significant determinant of ETRs in 2000 than in 1996 –Role of profitability in explaining differences in ETRs has changed Higher profitability now associated with lower ETRs –R&D intensive CFCs in 2000 have lower ETRs Suggests that companies are able to shift income from R&D projects in high- tax countries to hybrid entities in tax havens through royalty payments

Evidence on the location of income and real capital Growth Total pre-tax earning and profits$160.8$ % Earnings and profits in seven major low-tax countries (Ireland, Singapore, Bermuda, Cayman Islands, Netherlands, Luxembourg, Switzerland) Dividends received in the seven major low-tax countries Tangible capital in all countries (net plant & equipment plus inventories) Tangible capital in five major holding company low-tax countries (Bermuda, Cayman Islands, Netherlands, Luxembourg, Switzerland) Earnings and profits of CFCs with parents in finance in the seven major low-tax countries Dollars in billions. Tabulations from Treasury tax files. All CFCs.

Evidence on income shifting Subsidiary level data from Treasury tax files Compare income shifting behavior in 1996 and 2000 Results –Significant widening in the profitability disparities between high-tax and low-tax countries Possible explanations –High-tax countries may have reacted to increasing tax sensitivity of investment by easing up on transfer pricing and thin cap rules to attract mobile corporations –Some highly profitable subsidiaries in high-tax countries may have disappeared

Evidence of tax planning in the BEA data Information from majority owned foreign affiliates (MOFAs) US parents are instructed to include income from equity investments in foreign affiliates in their report of total income for each MOFA –Advantage: includes information from disregarded affiliates –Disadvantage: double counting of inter-company dividends In fact, almost 100% of the growth of pre-tax income in seven major low-tax locations between 1997 and 2002 is attributable to the equity in the income of other foreign affiliates

Evidence of tax planning in the BEA data Income from equity investments Pre-tax income Income from equity investments Pre-tax income Growth in income from equity investments Growth in pre-tax income All countries$41,781$188,092$120,782$255,225189%36% Selected low-tax countries Ireland1,4149,3598,50226, Luxembourg1,9352,35218,99518, Netherlands9,24917,61215,23820, Switzerland6,3269,70911,51514, Bermuda1,6495,93322,14225,2121, Cayman Islands1,0462,6782,2682, Singapore5785,7652,4657, Total22,19753,40881,125115, Dollars reported in millions.

Inter-company income and worldwide tax payments Inter-company payments may be deductible in host country and thus save host country taxes We estimate inter-company payments deductible in the paying country but exempt from tax in the receiving country saved US MNCs $7 billion in foreign taxes in 2002 compared with 1997 –About 4% of total foreign affiliate income --- a substantial reduction in a short period

Conclusions Suggestive evidence that the roles of the three parties may have changed over the last decade From 1998 on, tax planning by companies seems to be much more significant, facilitated by the more permissive US rules introduced in 1997 Results illustrate importance of including both company tax planning and the cooperation of governments in any accurate depiction of race to the bottom Results show the difficulty of using the data to understand the “real” location of profits and how it has changed over time