Governments and Multinational Corporations in the Race to the Bottom

1
Governments and Multinational Corporations in the
Race to the Bottom

• Rosanne Altshuler (Rutgers University) and
• Harry Grubert (U.S. Treasury Department)

2
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

3
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

4
Plan of todays 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

5
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. 1996 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

6
Hybrid entities
Parent MNC

• 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

Equity
Tax haven affiliate
Interest
Loan
High-tax affiliate
7
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)

8
Tax planning and changes in effective tax rates
Average Effective Tax Rates in Manufacturing for
58 Countries
AETR taxes paid in host country/ EP in host
country Data from Treasury tax files.
9
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

10
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 1992-1998
  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

11
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
• RD intensive CFCs in 2000 have lower ETRs
• Suggests that companies are able to shift income
  from RD projects in high-tax countries to hybrid
  entities in tax havens through royalty payments

12
Evidence on the location of income and real
capital
13
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

14
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

15
Evidence of tax planning in the BEA data
Dollars reported in millions.
16
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

17
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