US multinationals have taken advantage of US tax rules permitting the transfer of intangible assets to affiliates in lower-tax jurisdictions for prices that may be low relative to the profits generated by those assets. Certain US tax rules also allow for deferral of US tax on the shifted profits, in spite of the US ‘controlled foreign corporation’ rules. However, these transactions result in an accumulation of ‘trapped cash’ in offshore subsidiaries that cannot be repatriated to the US without a substantial US tax cost, a problem further exacerbated by certain US accounting rules. As public awareness of the US trillions in trapped cash and the US billions in lost tax revenue has increased, so too have calls for reform of US international tax rules.
‘Base erosion,’ the erosion of the tax bases of high-tax countries through the shifting of corporate profits to jurisdictions with lower (or no) taxes, has been attracting increasing attention around the world. The scope of profit shifting in the US is enormous. Profit shifting is estimated to cost the US government approximately $90bn in tax revenue annually, and US multinational companies are estimated to have US$1.7trn of cash in offshore subsidiaries.
A memorandum produced by the US Senate Permanent Subcommittee on Investigations in connection with hearings in 2012, found that some US multinational groups have virtually all of their available cash held by subsidiaries outside the US (US Senate Permanent Subcommittee on Investigations, Offshore profit shifting and the US tax code (20 September 2012)). This cash is ‘trapped’ or ‘locked out’, because it would be subject to tax at a rate of up to 35% if it was repatriated to the US.
This article offers a brief survey of base erosion and profit shifting in the US, with a particular focus on US tax and accounting rules that may encourage base erosion. The article concludes with an overview of the reactions to the issue, including current legislative proposals in the US that would curb base erosion.
Current profit-shifting strategies by US multinationals involve two basic elements:
Intangibles and transfer pricing: The multinationals that benefit most from profit shifting are generally those that derive a substantial portion of their income from intangibles, such as patents, trademarks and copyrights. These intangibles are easily transferred from a US company to an affiliate in a lower-tax jurisdiction. However, in order to avoid reallocation of profit and loss on the transaction by the Internal Revenue Service (IRS), pursuant to s 482 of the US Internal Revenue Code (the ‘code’), a company transferring intangibles must be able to demonstrate that its affiliate paid an arm’s length price for the intangibles. The proper arm’s length price for intangibles is a question of fact, which has often proved difficult for the IRS to establish in court.
One common technique used by US multinationals to establish arm’s length prices that are arguably lower than the ultimate value of intangibles is the cost-sharing agreement (CSA). The premise of a CSA is that an affiliate bearing some risk associated with developing an intangible (by sharing development costs) should later be able to share in the profits of that intangible without additional payments to the parent company. Although this premise is logical and contemplated by US transfer pricing regulations, CSAs have been criticised because of the difficulty in determining an arm’s length buy-in payment. In many cases, the high profit margins of affiliates in low-tax jurisdictions indicate that their buy-in payments may not accurately reflect the value of what they acquire.
The IRS has had mixed success in challenging CSAs. For example, in Veritas Software Corp. v Commr (2009) 133 TC 297, the IRS challenged a CSA between a US software company and its Irish subsidiary. In that case, in 1999 and 2000, Veritas Ireland made US$118m worth of buy-in payments for intangibles being developed by Veritas in the US. The intangibles were highly profitable, and the IRS asserted in 2006 that the proper price for the buy-in should have been substantially higher (ultimately asserting the price should have been US$1.675bn). The US Tax Court, however, found for Veritas, holding that the price was appropriately determined based on information available in 1999 and 2000. In December 2011, the IRS released new regulations meant to reverse the result in Veritas (TD 9568, 22 December 2011; Treas. Reg. § 1.482-7). Under these regulations, CSAs must account not only for direct development costs and risk, but also for resources, capabilities and rights that contribute to developing the intangible (‘platform contributions’ and ‘operating contributions’). The goal is more accurate pricing for CSAs, but the full impact of the new regulations is yet to be seen.
Controlled foreign corporation rules and check-the-box: Generally, US corporations are subject to tax on their worldwide income, and non-US corporations are not subject to tax in the US unless they are engaged in a US trade or business. However, US owners of ‘controlled foreign corporations’ (CFCs) are also subject to tax on passive income (commonly known as ‘subpart F income’) earned by the CFC at the time the income is earned, regardless of whether the income is distributed to the US owner. Generally, any wholly-owned non-US subsidiary of a US company will be a CFC, whether owned directly or indirectly.
Subpart F income is generally interest, dividends, royalties and other income that requires little effort from the CFC (IRC §§ 952(a); 954). The US owners of a CFC are subject to tax on their pro rata share of the CFC’s subpart F income when it is earned by the CFC, potentially before the income is distributed. (IRC § 951(a)). In contrast, tax on non-subpart F income is deferred until the income is distributed to the US owner (IRC § 61(a)(7)). The dividend payment is subject to the general 35% US corporate tax (less any credits for non-US taxes that are available to offset the tax).
Royalties and licensing fees can be treated as subpart F income, but royalties received from or attributable to the ‘active conduct of a business’ are generally not subpart F income (IRC § 954(c)(2)(A)). In addition, there is a ‘look-thru’ exception for amounts received from related CFCs that are attributable to the active non-US businesses of those CFCs (IRC § 954(c)(6)). The look-thru rule in s 954(c)(6) is important to many multinational groups because it permits intangibles held in low-tax jurisdictions to be licensed to affiliates in high-tax jurisdictions. Provided that income from the intangibles is attributable to the business of the high-tax CFC, payments to the low-tax CFC are not subpart F income. The exemption in 954(c)(6) is temporary and must be periodically renewed. It was to expire at the end of 2012, but was extended until 2014 in the end-of-year deal to avert the US ‘fiscal cliff’ (American Taxpayer Relief Act of 2012, Pub. L. 112–240, 126 Stat. 2313, § 323).
The US ‘check-the-box’ rules can also prevent payments between affiliates from being treated as subpart F income. The check-the-box rules permit certain entities to elect to be classified as corporations, partnerships or, if they have only one owner, to be disregarded for US tax purposes (Treas. Reg. § 301.7701-3(a)). If a group of CFCs all elect to be disregarded, payments between them cannot be subpart F income, because for US tax purposes there are no intercompany payments. An example is provided by Google’s apparent European tax structure: an Irish entity owns rights to use Google’s intellectual property, and licenses them to its Dutch subsidiary. The Dutch subsidiary licenses the intangible back to its own Irish subsidiary, which enters into advertising contracts with European affiliates. The lower-tier Irish company and the Dutch company are both disregarded for US tax purposes, so payments received by the lower-tier Irish subsidiary are treated as received directly by the top-tier Irish subsidiary for US tax purposes. The check-the-box rules permit a structure optimised for Dutch and Irish tax purposes, but which does not result in intercompany payments that could be treated as subpart F income in the US.
The unfortunate consequence of tax deferral under the subpart F rules is the ‘lock-out’ of the earnings of the CFC. Although tax on non-subpart F income is deferred, repatriation of the income is subject to tax at the regular corporation tax rate when distributed to the US parent. Because the income has often not been subject to any significant non-US tax, there is little indirect foreign tax credit available to offset the US tax. Bringing the cash back to the US means paying the tax; rather than repatriating offshore cash and paying the tax, most US multinationals have chosen to leave the cash offshore.
US accounting rules – APB 23: Generally, US auditors are required to assume that non-US subsidiaries will eventually distribute earnings to their US parent, and to account for tax on those earnings (Accounting Standards Codification (ASC) 704-30-25-3). If a subsidiary’s earnings are not subject to tax until they are distributed, there is a ‘book-tax difference’ until the distribution is made. This difference is typically accounted for with a deferred tax liability, representing the difference between current and potential future tax liability. This accounting entry reduces shareholder equity and net income in the year it is accrued.
Under an ‘APB 23’ election, however, companies are permitted not to accrue a deferred tax liability if they establish that they have ‘permanently or indefinitely’ reinvested the earnings outside the US (ASC 740-30-25-17). US accounting firms have various standards for determining when a company has overcome the presumption that the earnings will eventually be distributed.
The election is beneficial for US companies, because not accounting for the eventual 35% US tax on offshore earnings makes non-US operations appear more profitable. But, by not accruing the deferred tax liability, cash is shown as fully available for distribution to US shareholders or reinvestment in the US, when the reality is that only 65% of the cash may actually be available. The effect is reversed when cash is distributed: accounting rules require the deferred tax liability to be accrued as soon as it becomes likely that cash will be repatriated (ASC 740-30-25-19). Inclusion of years of deferred tax liability would make financial results in the year of a distribution appear significantly worse than prior years, creating a disincentive for such a distribution. A distribution of cash previously claimed to be permanently reinvested outside the US would also make it harder to establish to an auditor’s satisfaction that other cash will be permanently kept offshore, jeopardising future flexibility in accounting treatment.
2004 repatriation holiday: In 2004, Congress permitted a one-year repatriation holiday of overseas earnings: 85% of dividends from CFCs were exempted from US tax, reducing the effective tax rate on repatriated earnings to 5.25% (IRC § 956). The repatriation holiday was meant to stimulate investment in the United States. However, although US corporations repatriated US$312bn, there was little actual investment in US business. The repatriated cash was primarily used to redeem shares and pay dividends, and many repatriating companies actually reduced their US R&D expenditure and the number of employees (US Senate Permanent Subcommittee on Investigations, Repatriating offshore funds: 2004 tax windfall for select multinationals dated 11 October 2011).
As the amount of offshore cash has grown since 2004, there has been pressure to allow another repatriation holiday. The idea gained some traction in 2010 and 2011, but failed to gain broad support. Considering the perceived failure of the 2004 repatriation holiday, the chances of a second repatriation holiday seem remote. In an atmosphere of budget cuts and tax increases, a substantial tax break for US corporations may be politically impossible.
Other repatriation techniques: To prevent taxpayers from circumventing the 35% tax on dividends from CFCs, certain transactions, such as certain loans and guarantees of US parent company debt, can also be treated as deemed distributions of cash (IRC §§ 951(a)(1)(B); 956). Avoiding tax on trapped cash also means avoiding transactions that would result in deemed distributions. However, taxpayers have attempted to repatriate cash through transactions that return cash to the US without triggering these rules.
One technique to attain tax-free repatriation, generally known as a ‘killer B’ transaction, was to exchange a CFC’s cash for shares of the US parent. The CFC only held the shares temporarily, and disposed of them in a tax-free ‘B’ reorganisation with a newly-formed CFC before the end of the quarter (to avoid a deemed dividend). The new CFC’s ownership of the shares did not trigger a dividend because the new CFC had no historic earnings (IRC §§ 301(c), 316(a)). The US Treasury Department issued regulations in 2008 which effectively prohibited killer B transactions (TD 9526, 19 May 2011; Treas. Reg. § 1.367(b)-10). Taxpayers have attempted to achieve similar results in other transactions, but the IRS has acted quickly to prohibit these transactions when they are detected. (See, for example, Notice 2008-10, 2008-1 C.B. 277, addressing ‘deadly D’ transactions; Notice 2012-39, 2012-31 IRB 95.)
Another approach is to make use of short-term loans. The CFC rules contain an exception for such loans (Notice 2008-91, 2008-2 CB 1001), and some US multinationals have used this short-term exception to ‘permanently’ repatriate cash by having multiple CFCs alternate short-term loans to the US parent company. Although technically compliant with the CFC rules, a staggered loan strategy may be aggressive tax planning because close coordination of the loans raises questions about whether the loans should be considered separate transactions (see Jacobs Engineering v US, 168 F.3d 499 (9th Cir. 1999)).
Shareholder responses: Shareholders of US multinationals that hold substantial amounts of cash offshore have begun to take notice of that offshore cash, and often push for it to be distributed or put to better use. US multinationals have generally resisted these efforts. But shareholders may be becoming more vigorous in pursuing the offshore cash: Greenlight Capital, a US hedge fund, initiated a shareholder lawsuit against Apple, seeking to have Apple issue a special class of preferred stock that would have distributed Apple’s offshore cash to shareholders (Greenlight recently dropped the suit). The size of multinationals’ offshore cash holdings is not only a question for tax administration; it is becoming relevant to the way US companies operate, and their relationships with their investors.
Congressional attention and US legislative proposals: Profit shifting by US companies has received significant attention in the US Congress. The Senate Permanent Subcommittee on Investigations held hearings in September 2012 (focusing on Microsoft and Hewlett Packard) and again in May 2013 (focusing on Apple). The hearings on Apple’s offshore structures attracted significant attention (see, for example, ‘Apple executives face Senate grilling’ (James Politi and Richard Waters), Financial Times, dated 21 May 2013, p 1).
In addition to hearings, a number of legislative reforms that would affect profits shifting are being discussed in both the House and the Senate. The proposal that has received the most substantive discussion is draft legislation proposed by David Camp, the chairman of the House of Representatives Ways and Means Committee, in 2011. The legislation would shift to a territorial basis for taxing US corporations, with a 95% exclusion of dividends from CFCs (meaning non-subpart F income would be taxed at a 1.75% rate). The subpart F rules would also be expanded to reduce base erosion. The discussion draft provides three alternatives for the anti-base erosion provisions: (A) taxing ‘excess income’ from intangibles as subpart F income; (B) treating all low-tax income as subpart F income; or (C) taxing all income from intangibles as subpart F income, but at reduced tax rates. Camp’s proposal represents a fundamental change to the US international tax system for corporations; it would rebalance the system in a way that would likely eliminate base erosion and profit shifting as it currently exists. Other proposals also address specific perceived flaws in the transfer pricing and subpart F regime, generally focusing on issues described above.
The future of the strategies that promote base erosion is uncertain. Although the size and the scope of the issue has attracted increasing attention, addressing it in the US will be difficult and may require fundamental changes to the US international tax rules. The problems generated by the current system may be an impetus towards structural reforms, such as a shift to territorial taxation, but enacting these reforms will require significant effort and cooperation by US lawmakers, which may not be possible in the current political climate. In the meantime, the offshore piles of trapped cash are certain to grow.
