The Hidden Entitlements
Multinational corporations, whether American- or foreign-owned, are supposed to pay taxes on the profits they earn in the United States. In addition,American companies and individuals aren't supposed to gain tax advantages from moving their operations or investments to low-tax offshore "tax havens." But our tax laws often fail miserably to achieve these goals.
3. Tax breaks for multinational corporations
For example, IRS data show that foreign-owned corporations doing business here typically pay far less in U.S. income taxes than do purely American firms with comparable sales and assets. The same loopholes that foreign companies use are also utilized by U.S.-owned multinationals, and even provide incentives for American companies to move plants and jobs overseas.
The problems in our taxation of multinational companies stem mainly from the complicated, often unworkable approach we use to try to determine how much of a corporation's worldwide earnings relate to its U.S. activities,and therefore are subject to U.S. tax. In essence, the IRS must try to scrutinize every movement of goods and services between a multinational company's domestic and foreign operations, and then attempt to assure that a fair, "arm's length" "transfer price" was assigned (on paper) to each real or notional transaction.
But companies have a huge incentive to pretend that their American operations pay too much or charge too little to their foreign operations for goods and services (for tax purposes only), thereby minimizing their U.S. taxable income. In other words, companies try to set their "transfer prices"to shift income away from the United States and shift deductible expenses into the United States. A May 1992 Congressional Budget Office report found that "[i]ncreasingly aggressive transfer pricing by . . . multinational corporations" may be one source of the shortfall in corporate tax payments in recent years compared to what was predicted after the 1986 corporate tax reforms. Variants on the transfer-pricing problem--such as ill-advised"source" rules and statutory misallocations of certain kinds of expenses--expand the tax avoidance opportunities.
The official list of tax expenditures in the international area--totaling$95 billion over the next seven years--focuses on congressionally-enacted loopholes in the current "transfer pricing" approach. Thus, the list includes items such as indefinite "deferral" of tax on the profits of controlled foreign subsidiaries, misallocations of interest and research expenses, "source" rules that treat certain kinds of U.S. profits as foreign, and the Puerto Rican "possessions tax credit."7
- Let's say a big American company has $10 billion in total sales--half in the U.S. and half in Germany--and $8 billion in total expenses--again half and half (in reality). With $1 billion in actual U.S. profits and a 35% tax rate, the company ought to pay $350 million in U.S. income taxes.But suppose that for U.S. tax purposes, the company is able to treat 5/8th of its expenses--or $5 billion--as U.S.-related. If you do the arithmetic,you'll see that leaves it with zero U.S. taxable profit. Although our tax system has rules to mitigate this kind of abuse, companies still have plenty of room to maneuver.
- Here's a real-world example: In its 1987 annual report to its stockholders,IBM said that a third of its worldwide profits were earned by its U.S. operations.But on its federal tax return, IBM treated so much of its R&D expenses as U.S.-related that it reported almost no U.S. earnings--despite $25 billion in U.S. sales that year. As a result, IBM's federal income taxes for 1987 were virtually wiped out.
- Recently, Intel Corp. won a case in the Tax Court letting it treat millions of dollars in profits from selling U.S.-made computer chips as Japanese income for U.S. tax purposes--and therefore exempt from U.S. tax--even though a tax treaty between the U.S. and Japan requires Japan to treat the profits as American--and therefore exempt from Japanese tax! As too often happens,the profits thus became "nowhere income"--not taxable anywhere.
- Another of the classic tax avoidance games that multinational companies play is illustrated by a tax break that goes to the many drug companies and electronics firms that have set up subsidiaries in Puerto Rico. They assign "ownership" of their most valuable assets--patents, trade secrets and the like--to their Puerto Rican operations, and then argue that a very large share of their total profits is therefore "earned"in Puerto Rico and therefore eligible for the tax break. Reforms in 1986 tried to scale back this tax dodge, but it still costs more than $3 billion annually. Although encouraging jobs in Puerto Rico might be a nice idea(although perhaps not at the expense of mainland employment), it has been estimated that many of the Puerto Rican jobs cost the Treasury upwards of$70,000 a year each because the tax break is so abused.
Fixing these problems in the current system would be a good idea. But even better would be to replace the current, complex "transfer pricing"rules with a much simpler formula approach that taxes international profits based on the share of a company's worldwide sales, assets and payroll in the United States. Exactly how much revenue could be gained by this kind of comprehensive international tax reform is unclear, but some estimates are on the order of $15-20 billion annually.
Not listed in the official tax expenditure budget, but a major tax break nonetheless is the tax exemption for interest earned in the United States by foreigners. Such interest (on loans to American companies and the U.S.government) was exempted from U.S. tax under the Reagan administration in 1984. At the insistence of the proponents of the change, this interest income is not reported to foreigners' home governments, and as a result, tax evasion is said to be the norm. As a result, the United States has become a major international tax haven. There is evidence that not only foreign tax cheats,but also Americans posing as foreigners have been taking advantage of this loophole. Reinstating the tax has been proposed, with a waiver of the tax if a foreign lender supplies the information necessary to report the interest income to the foreign home government.
President Clinton pledged major international tax reforms in his 1992 campaign,but Congress rejected even the rather timid changes he proposed in 1993.The President's 1997 budget proposes $6.3 billion in international tax reforms over the 1997-2002 period, while congressional tax plans call for about a quarter that much. In addition, both sides want to scale back the $3 billion a year tax break for corporations in Puerto Rico by about half a billion dollars a year.
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