David: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week, the do-over. Though the ink is barely dry on the Tax Cuts and Jobs Act, we're going to look and see what is seen by some as a missed opportunity to fundamentally change how corporations are taxed.
While the tax bill cuts rates on companies and ends the old system of worldwide taxation with deferral, it left in place existing rules for determining where income is taxed. The new tax bill, however, did introduce several new acronyms into the international tax system, such as BEAT, the base erosion and antiabuse tax, FDII, or foreign-derived intangible income, and my personal favorite, GILTI, or global intangible low-taxed income.
To determine how much tax multinationals owe in various countries where they operate, tax administrations apply a complex set of rules known as transfer pricing. Under these rules, transactions between related companies are priced as if they were done by unrelated companies. This is known as the arm’s-length standard. It is even written into the U.S. tax code under section 482. The system requires the use of a variety of methods, often involving comparing related-party transactions to similar transactions by unrelated parties. While this may seem easy in principle, significant problems arise when goods and services are tied to intangibles such as trademarks and other intellectual property. For example, it might be easy to determine the value of components of a smartphone, but how much is the total price of that phone when you factor in the Apple logo on the back?
This question of pricing has some major implications for tax administration. In March of 2017, the IRS found itself on the losing end of a tax dispute over the value of intangible assets transferred by Amazon to its Luxembourg subsidiary. Using its method, Amazon determined the value of those intangibles to be $250 million. However, under the method used by the IRS, the value was found to be $3.4 billion. It's disagreements like these that have some experts looking for a better way to apportion income. While some would like to see a formulary apportionment system that uses some combination of sales, payroll, and assets to determine where income is reportable, some are advocating an even simpler approach that looks only at the sales factor.
Recently, I spoke by phone with Bill Parks, a retired finance professor and founder of NRS, an Idaho-based paddle sports accessory maker, and professor Reuven Avi-Yonah, the Irwin I. Cohn Professor of Law at the University of Michigan, about this idea. Bill, Reuven, welcome to the podcast.
We'll have Bill answer this question first. What is the current state of the corporate tax as you see it now that the Tax Cuts and Jobs Act has passed?
Bill: Well, I think that in many ways it's the former situation. Reuven would have a much better idea of the changes. But what it basically does is it switches from a worldwide to a territorial system. And then it puts a finger in the dike in all the ways that it hopes that it will stop companies stripping income out of the U.S. into foreign countries. These reforms — I think Reuven would be more the expert to talk about — but they're called GILTI, and FDII, and BEAT. And they're just all ways to try to stop the profit shifting strategies. The company won't get off scot-free, but it'll pay a penalty tax that is, however, less than the 21 percent paid by domestic than others on U.S. taxes. Multinationals can still manipulate the cost of goods sold, and that, I think, is the center of the problem.
For instance, what is a transmission worth? Say, it's not any transmission, it's a Toyota or a BMW transmission. So if Toyota charges a high price to the U.S. subsidiary for the transmission, that is going to reduce the taxable income in the U.S. And the same thing with BMW. It's not just a transmission; it's a BMW transmission.
Gavin Ekins of the Tax Foundation says that any system that maintains, really, any shred of transfer pricing has to be rejected. And this one still has transfer pricing.
David: Okay, Reuven, how about your sense of where things stand now that the Tax Cuts and Jobs Act has passed?
Reuven: I will say it's a big improvement over previous law. For one thing, I mean just cutting the tax rates from 35 to 21 [percent] has reduced the incentives to shift, although obviously there's still a remaining incentive because there are plenty of places in the world where you can have an effective tax rate that's lower than 21.
And the three provisions that Bill mentioned today, GILTI minimum tax, the FDII provision, and the BEAT, together reduce the incentive or the ability to shift. GILTI enacts essentially a minimum tax on the foreign profits of companies that are controlled by U.S. multinationals. So even if you engage in transfer pricing, for example, if the profit that’s shifted is too high — like we certainly had in past years, that's why we got $3 trillion accumulated offshore in low-tax jurisdictions — but in going forward, if you do that, then the GILTI minimum tax will hit you and so there's a natural limit to how much you can do it. And in the FDII case, the point is that there's a lower tax that's available for exports that are done from the United States. And it has its own problem, but obviously that too reduces the incentive to shift because essentially it gives you the same rate for domestic exports as you would if you were doing the same things offshore. And the BEAT, which is a major innovation, affects outbound payments, not just by U.S. companies, but also by U.S. subsidiaries of foreign multinationals and reduces the ability to a significant extent to reduce the U.S. domestic tax base.
So I think altogether these three reforms are a great improvement over prior law, and I think even though we now have territoriality — which is to some extent a misnomer — what you really have is an exemption for dividends that is relatively narrow. For example, it has to be treated as a dividend in the paying country, too. And that it is hedged by all of these other provisions so that the income that actually can be earned offshore at low tax rates and repatriated with no further tax in the U.S. is a relatively low rate. And there's also a significant, higher than most people expected, tax on the past accumulation. So altogether the international provisions of the TCJA, I think, are a significant step forward, although it is far from perfect and I'm sure we'll discuss some of the problems with it.
David: Now, Bill, as I understand it, you are very much concerned with the current tax system maintaining the existing transfer pricing rules. Now, as a full disclosure, before I became the editor of Worldwide Tax Daily, I was the transfer pricing beat reporter. So this is an area that's close to my career here. So tell me, what is it about the transfer pricing system that you see as the major problem here?
Bill: Well, I think as Gavin Ekins said as I quoted earlier, if you have any part of the transfer pricing system in the system, then you have an opportunity to move profits. And you're always going to move profits from a high tax to a lower tax or to a no tax.
I mean if the BMW transmission comes in and it's purchased by a subsidiary in, say, Bermuda, which then adds a little bit of profit, and its logistics company in the Cayman Islands, and it's insured in another company, it can leave Germany at a low price and arrive at the U.S. at a much higher price, and thereby reduce the profitability in Germany and in the U.S., and so I don't think anything that does that should be there. And the second thing is when you move the profits out of the U.S., even if you tax them in certain ways, the states all have what's called a water's-edge limitation that came in back in the 80s. And so they lose about $18 billion of taxes from multinationals that they would get if you had sales factor apportionment. Or, really, if the states would just get rid of their limitation, and tax on the basis of worldwide, apportion sales.
David: Okay, let's move on. To Bill, you have written about your idea for how to replace the current transfer pricing system with the sales factor test. Why don't you tell us about that?
Bill: Well, actually let me start, though, by saying that the thing that got me started on this was Reuven's and Kim Clausing’s article from 2007. So I may have added a lot to it, but I think I have to mention that the source of my understanding of that has been Reuven's. So here's the simple thing. One of the things that won't move if you put the legislation correctly is the customer, the person, or company, or whatever, the entity that consumes the good that is produced. And so you can't shift profits and so forth away if you base the profits on where the sale occurs. So for the U.S., calculations that were made by the Coalition for a Prosperous America a year ago puts the amount of additional revenue at $116 billion a year if you make no other changes. And that $116 billion represents multinationals that are stripping the income out of the U.S. and so they're paying much less tax than a domestic company producing exactly the same product and making, in effect, exactly the same amount of profit on it. And because of the so-called water's-edge thing, the states lose about $18 billion from it. So if you put it in, it levels the playing field, and I just don't know any other system that levels the playing field like that, aside from the fact that it would, over 10 years, bring in more than $1 trillion under the old system. It would probably reduce the deficit by maybe $600 [billion] in the U.S. over 10 years, and it would increase the revenue for the states by maybe $180 billion. These are large numbers. And it's my feeling because I founded a company that for many years — it's now 100 percent employee-owned — but it paid taxes at the rack rate. And so all of the people who say, yes, but the effective rate was, what they mean is the effective rate for the multinationals was lower, but most domestic companies paid at or close to the rack rate.
David: Under your idea, Bill, it would be only the location of the sales that would factor in, rather than the arm's-length price, which, as you say, is far less susceptible to manipulation, correct?
Bill: Yes, that's correct. If you tax on other things such as payroll or property, it gives the companies an incentive to move those out of the high-tax jurisdictions, which is just what we don't want. We want to encourage property and payroll to be located in the U.S. And because under SFA — sales factor apportionment — the exports are not taxed at all, the incentives are to locate the factories and the people in the U.S. rather than outside.
David: Reuven, how do you feel about the idea of moving from the arm's-length standard to a sales-factor-only test?
Reuven: So as Bill mentioned, this has long been something that I've been in principle in favor of, I think for a variety of reasons. I mean, you have to start with the fact that the way modern multinationals operate is as an integrated operation, they have global value chains and all of that. The problem with the arm's-length is that it essentially takes every box, every separate company within a multinational and treats it as if it was dealing with every other box on an arm's-length basis. And that's simply not the reality of the world that we operate in now, and I don't know if it ever was, but certainly not with the modern integrated multinationals. And as a result, it is basically impossible to correctly operate the arm's-length standard because you can't find comparables, which is what it is best for, for the majority of transactions that happened within multinationals, especially in regard to intellectual property. So in principle I think this was a great idea, and the other big advantage of it as I mentioned before is that it doesn't discriminate between U.S.-based and foreign-based multinationals, whereas the current system definitely does. And as a result, we get inversions and various things like that. So that's the good part. And I think if you're going to go in that direction and I think for the reasons that Bill mentioned, it makes sense to start at least with a sales-based formula. A, because as he mentioned, the customer base is less subject to tax competition than other bases. And B, because we do not want to incentivize the departure of payroll and assets, tangible property out of the United States. But there are lots of issues with it that need to be resolved before we can implement something like that. And the most obvious and prominent ones, which we already ran into in the context of the ramp-up to this current bill, is the current tax treaty network does not permit sales-based apportionment because it requires a permanent establishment to be existing in a country before you can tax a multinational and sales into it. Now, that's under a lot of pressure at the moment, but that's still the standard in all the treaties. And we have to deal with that to some extent. And second, the WTO rules do not allow for sales-based apportionment for the same reason because you cannot impose a direct tax on a border-adjustable basis. That is, you cannot exempt the export and apply to imports, which is what the so-called destination-based cash flow tax ran into. This is also the issue that arose when the House version of the tax bill tried to impose a 20 percent tax on cost of goods sold. So the people said immediately that's an issue. That's also an issue with the FDII, which is a provision in the current law that is based on the notion of destination basis, that it applies only to exports, and because of that it’s a violation of the WTO export subsidy rules and it's going to get challenged for sure. And we're going to have to try to defend it and we'll see where that goes. There are elements in the current law — the BEAT is to a significant extent a tax on imports, although not on all of them. The FDII is an exemption to exports in part. Both of those are to some extent arguably problematic. The BEAT arguably is a violation of the nondiscrimination provision of the treaties. The FDII is almost definitely a violation of the WTO subsidies code. We'll see where that goes. I just think that while in principle sales-based formulary apportionment is a good idea, it's not quite something that is ready to be implemented into law yet.
The world is changing, though, and it's moving in that direction. The EU is contemplating doing away with the permanent establishment threshold for electronic commerce or digital economy. If that happens, that'll be a major change in the right direction, and we may well see more movement in that direction in the next decade or so. And I would welcome that. In principle, I think it's a good idea. I just think that in the context of this tax reform or immediately fixing this tax reform, it's not something that is possible to do right at the moment.
David: Now, if the system were to change to sales-based, does that, at least in some sense, mimic a consumption tax since you're basing the corporate tax on sales?
Reuven: Well, I don't think so. I mean, this is a common misconception because the difference is that, in a consumption tax, you would tax the entire value of an import. That is, everything that goes into the United States, the full value of that would be subject to the consumption tax. That's how a value added tax works, for example. And then presumably be passed onto the consumer. And the full value of an export will be exempt or zero-rated, as they say in the VAT area. Now, this is different because what you will do is you'll only take the profit of the multinational, the global profit, and you allocate it among countries based on their location of sales. So yes, it is based on the location of the consumption, and the rules for determining where the location of the consumption takes place can be similar to the rules that the VAT employs, for example. And we already have, to some extent, rules like that, and we're going to need more of them for the FDII purpose, for example, because that is also based on the location of consumption. But it's not the same because, for example, if a multinational is in a global loss position, doesn't have any profit, it would still pay VAT in all the countries that have a VAT, other than the United States, where it will pay zero under sales-based formulary apportionment because there will be nothing to allocate to the U.S. if it doesn’t have a profit.
David: Now, the current system, there are competitive pressures that keep countries from raising tax rates. If your only apportionment aspect is the sales in that country, and it's agnostic to where a factory is built or other issues like that, would there be the same pressure to keep tax rates down the way there is now?
Bill: I don't think so. I think you can look at the states and you see that the highest rates that are charged in the states are charged in the states that are sales-only. Iowa, California, Pennsylvania, New York, and some others have pretty high rates for a state tax. But they don't seem to be getting any blowback on the rate. Whereas, if you have three-factor, which includes the payroll and the property, those states tend to have a lower rate. So I would say no. The only reason to reduce the taxes would not be competitively but in terms of the economy and how much of a drag it puts on the economy.
David: So could this change wind up resulting in higher tax rates, I guess is what I'm asking?
Reuven: It's certainly possible. I mean, at the moment, obviously, there is a significant downward trend in corporate taxes. It's been going on for quite a while. I mean, corporate tax used to provide 25 percent of total federal revenues and now it's 10 percent or less and it's the same all over the OECD. And if you look at the general movement of the rate, it's now, generally speaking, in the 20s and it used to be in the 30s and in the 40s and so on. But, in fact, the corporate tax has proven to be more robust than what people have predicted when they said the tax competition would drive you down to zero. That hasn't happened. And part of it is because there has in fact been a movement in the direction of taxing more based on the location of consumption because you can see all over the world a downward pressure on what is defined as a permanent establishment. More and more countries, like India, for example, are finding ingenious ways of taxing foreign multinationals on sales into the country in the absence of what would normally be regarded as the minimal threshold.
And you can say the same, of course, at the state level where we now have a Supreme Court case about the abolition of the physical presence for sales tax collection purposes. So by and large, I think this has been the trend for a while, and it is a limiting factor precisely because of the reason that Bill mentioned earlier, which is that the fundamental consumption location doesn't change and the majority of the market will not change. And that is obviously an advantage for a country like the United States or other large market jurisdictions, like China and India and Brazil and so on, and in the EU. And it is a disadvantage to small jurisdictions. The big losers from a move to sales-based formulary apportionment would be smaller countries that rely more on exports and less on imports. And the big winner would be the bigger market countries.
David: Would this require international coordination?
Reuven: I think the basic issue with moving in this direction now is that it would be significantly better to do this on some kind of multilateral basis rather than the U.S. adopting it unilaterally. And that's one reason, that is that you need to change the treaties, and we are probably moving in that direction given the current pressures. And the WTO is the other main reason. And the third reason — which is that other countries would prefer a different, more balanced formula. And I think on the state level, the better formula is probably the more balanced one — the one that does take payroll and assets into consideration because it takes into account the interest of the production as well as the consumption jurisdiction. If we did go to the system on a worldwide basis, I think it will be a significant improvement to have a balanced formula rather than sales-only, precisely because you would have fewer winners and fewer losers. That's not what you would do if you were just the United States, for the reason that we discussed before. But I think if we go in that direction, I think it is imaginable to think that the world can get to a consensus on some kind of formula just like the states did a century ago.
Bill: Yeah, one thing that I would add is that states with a significant natural resource — such as North Dakota or Oklahoma — out of the seven that keep three-factor apportionment, I think five of them have significant natural resource components to their economy. And the fifth one that I'm doing is saying that Hawaii's natural resource is its climate and its beaches. But at any rate, the idea is that if you have a significant economic thing, that you're better off perhaps to have some part of beyond sales. But for most states, they've decided that the best thing is to do sales factor alone. Most of them do not have multifactor parts. And when they do, they double or triple weight sales, so I think the movement is toward sales.
Reuven: Yes, I agree with that. I think that's definitely been the movement, and I think the example of the destination-based VAT, where you don't need a coordinating treaty or a multilateral agreement shows that that is the natural inclination to move because everybody likes the idea of exempting exports and imposing the tax on imports. So I think that it's reasonable to begin from that. But I also do think that it would be wise to consider at least having modification of exemptions, for example in the case of natural-resource-rich countries, which there are quite a few of them, and in general, to be open to balancing of the formula rather than rely entirely on sales.
David: Reuven, Bill, it's been a fascinating discussion. Thank you both for being here.
Reuven: Thank you.
Bill: Thank you.
David: That's it for this week. My guests were Bill Parks and Reuven Avi-Yonah. You can find out more about their thoughts on the corporate tax system in the pages of Tax Notes at taxnotes.com. As always, you can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future podcast, you can email us at podcast@taxanalysts.org. Be sure to subscribe to us on iTunes or Google Play to make sure you get the next episode of Tax Notes Talk.
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