Recommendations to Reform
International Corporate Tax Rules
ICRICT Meeting
New York, NY
March 18, 2015
© Ednaldo Silva, Ph.D.
[email protected]
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Agenda
My presentation addresses two requests posed by the ICRICT Commissioners:
1) The impacts of the current international corporate taxation framework on the constituents. For this
purpose, the constituents are tax administrations and corporate taxpayers, including domestic
uncontrolled and foreign controlled corporations (affiliated entities belonging to a controlled
group (MNE)).
2) Recommendations for the reform of the international corporate tax rules and related institutional
frameworks. For this purpose:
a) Short term objectives are to collect statutory taxable income from all corporations
(reduce the disparity between statutory and effective tax rates), and to simplify
transfer pricing rules to ensure tax parity between controlled and uncontrolled
corporations.
b) Long term objective is to introduce corporate tax based on business receipts
independent of deductions. This would eliminate the dichotomy between
corporations with and without taxable income, and ensure tax parity between
controlled and uncontrolled corporations.
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2
Why Transfer Pricing?
International corporate taxation covers many complex areas (tax code, regulations,
deferrals, audit enforcement), so I focus on transfer pricing, which is my area of
expertise. Also, I focus in the U.S. because it is the progenitor of tax regulations
governing the international (or cross-border) transactions between affiliated
companies belonging to a controlled group.
1) Transfer pricing is important because controlled transactions are significant in
domestic economies and international trade.
2) Transfer pricing is important also because it is a major channel of tax base
erosion and profit shifting between different tax jurisdictions, including from
countries with (and without) foreign exchange control.
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3
Share of Related Party Trade in the U.S.
50%
40%
41.7% 41.3% 41.0% 40.7%
41.7% 41.6%
39.8% 40.2% 40.8% 40.5%
30%
20%
10%
0%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Related-party total goods trade is based on imports and exports.
Source: https://www.census.gov/foreign-trade/Press-Release/2013pr/aip/related_party/rp13.pdf
For U.S. imports, a related party transaction is a transaction between two parties in which “any person directly or
indirectly owning, controlling or holding power to vote, 5 percent or more of the outstanding voting stock or shares of
any organization.” 719 U.S.C. § 1401a(g)(F). For U.S. exports, a related party transaction is “a transaction involving
trade between a U.S. principal party in interest and an ultimate consignee where either party owns directly or indirectly
10 percent or more of the other party.” Foreign Trade Regulations, 15 C.F.R. § 30.1.
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Foreign-Controlled Domestic & All Corp., U.S. 2011
(All figures are estimates based on samples. Money amounts are in million of U.S. dollars)
Foreign-Controlled
Domestic Corporations
100%
76,793 100%
58%
33,358
43%
All Corporations
Number of returns
Number with net income
5,823,126
3,384,712
Total receipts
Income subject to tax
Total income tax after credits
Effective tax rate
28,335,601
994,393
220,894
22.2%
100%
3.51%
0.78%
4,586,774
130,503
35,705
27.4%
100%
2.85%
0.78%
Source: http://www.irs.gov/uac/SOI-Tax-Stats-Foreign-Controlled-Domestic-Corporations.
IRS, Statistics of
Income Division, Foreign-Controlled Domestic Corporations, August 2014. All domestic corporations include
controlled and uncontrolled corporations. “Controlled” (related party) means U.S. corporations that have a foreign
entity that owns 50% or more of the corporation’s voting stock. Effective tax rate is total income tax after credits
over income subject to tax.
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5
Total Receipts of All Domestic Corp.
& Total Income Tax After Credits
(Money amounts are in trillion of U.S. dollars)
28.8
28.6
24.8
25
Total Receipts
20
26.2
28.3
1.2%
1.15%
15
1.4%
1.0%
0.80%
0.83%
0.85%
0.8%
0.78%
10
0.6%
0.4%
5
0.2%
0
0.0%
2007
2008
2009
2010
Percentage of Total Income Tax
After Credits on Total Receipts
30
2011
Source: http://www.irs.gov/uac/SOI-Tax-Stats-Corporation-Data-by-Type-of-Return#_1120all
All domestic corporations include controlled and uncontrolled corporations. “Controlled” (related party) means U.S.
corporations that have a foreign entity that owns 50% or more of the corporation’s voting stock.
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Tax Returns of Active Corporations, U.S.
(Money amounts are in million of U.S. dollars)
2007
2008
2009
2010
2011
Number of returns
5,868,849 5,847,221 5,824,545 5,813,725 5,823,126
9,221,635 9,466,524 9,613,451 9,875,410 10,225,875
Depreciable assets
496,865
587,260
628,841
661,360
757,032
Depletable assets
Intangible assets (amortizable) 4,065,564 4,156,369 4,463,117 4,577,893 4,827,472
28,762,924 28,589,771 24,772,531 26,198,523 28,335,601
Total receipts
24,217,396 24,718,122 21,584,886 23,058,235 25,197,648
Business receipts
26,974,257 27,686,727 23,943,765 24,944,311 27,092,729
Total deductions
2,085,113 1,658,636 1,069,664
888,206
860,102
Interest paid
174,279
183,749
191,333
192,449
196,054
Amortization
598,724
758,554
712,240
727,800
873,889
Depreciation
277,413
266,796
241,469
255,674
263,564
Advertising
1,248,285
978,153
894,850 1,022,175
994,393
Income subject to tax
331,374
228,523
204,996
222,969
220,894
Total income tax after credits
Source: http://www.irs.gov/uac/SOI-Tax-Stats-Corporation-Data-by-Type-of-Return#_1120all
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7
Top 10 U.S. Advertising Spend, 2013
(Money amounts are in billion of U.S. dollars)
Procter & Gamble
4.991
AT&T
3.268
General Motors
3.150
Comcast
3.082
Ford Motor
Verizon
L’Oreal
American Express
Toyota Motor
Chrysler
2.559
2.438
2.335
2.191
2.090
1.974
Source: http://adage.com/article/datacenter-advertising-spending/100-leading-national-advertisers/293054/
Total advertising expenses of these 10 corporations in 2013 was $28.1 billion.
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Foreign-Controlled Domestic Corporations, U.S. 2011
(All figures are estimates based on samples. Money amounts are in million of U.S. dollars)
Number of returns
Business receipts
EBIT
EBIT margin
Income subject to tax
Total income tax after credits
Effective tax rate
All Industries Manufacturing Wholesale Trade
(1)
(12)
(34)
76,793
7,119
18,317
4,203,240
2,026,412
1,092,143
-115,149
26,225
4,520
-2.7%
1.3%
0.4%
130,503
54,160
20,878
35,705
14,437
6,069
27.4%
26.7%
29.1%
Source: http://www.irs.gov/uac/SOI-Tax-Stats-Foreign-Controlled-Domestic-Corporations.
Published as Corporation Complete Report (Publication 16), Table 24. “Controlled” indicates U.S. corporations that
have a foreign entity that owns 50% or more of the corporation’s voting stock. Numbers in parentheses (1, 12, 34)
represent the column numbers in the original SOI table. Income subject to tax is positive because total deductions are
offset by non-operating income (interest, royalties, rent, capital gains and dividends). EBIT is defined as business
receipts minus total deductions (except for taxes and interest paid). Effective tax rate is total income tax after credits
over income subject to tax.
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Potential Benchmark
U.S. Publicly-traded Nonfinancial Corporations, 2011
(Money amounts are in million of U.S. dollars)
All Industries
Number of companies
Revenue
EBIT
EBIT margin (Q3)
EBIT margin (Median)
EBIT margin (Q1)
4,078
15,010,639
2,273,039
26.91%
13.58%
6.79%
Manufacturing
Wholesale Trade
(SIC Codes 2 and 3) (SIC Codes 50 and 51)
1,272
5,557,550
711,801
16.07%
9.93%
5.5%
135
871,977
27,167
7.06%
4.21%
2.43%
Source: RoyaltyStat®/Compustat®. Searches were done on March 10, 2015 for corporations incorporated in the U.S.
with positive business receipts (revenue) and positive EBIT in 2011. The RoyaltyStat®/Compustat® database is
updated every business day, so searches done on different dates may produce different results. Nonfinancial
corporations exclude companies classified as finance, insurance, or real estate.
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Tax Gap
Foreign-Controlled Domestic Corporations, U.S. 2011
(Money amounts are in million of U.S. dollars)
All Industries
Number of returns
Business receipts
EBIT margin (as reported)
What if EBIT is set at Q1?
Adjusted EBIT to Q1
Likely tax gap
Manufacturing Wholesale Trade
76,793
4,203,240
-2.7%
6.79%
7,119
2,026,412
1.3%
5.5%
18,317
1,092,143
0.4%
2.43%
400,549
515,698
85,228
59,003
22.019
17,498
Source for raw data is http://www.irs.gov/uac/SOI-Tax-Stats-Foreign-Controlled-Domestic-Corporations and
RoyaltyStat®/Compustat®. EBIT is defined as business receipts minus total deductions (except for taxes and
interests paid). Adjusted EBIT is calculated as (Q1 − EBIT Margin (as reported)) × Business receipts.
Preliminary estimates. Likely tax gap is calculated as Adjusted EBIT − EBIT (as reported). More research is
needed to determine a more reliable estimate of the tax gap between foreign controlled and uncontrolled
domestic corporations.
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Why Tax Gap?
The gap between statutory and effective corporate tax revenue, and between
controlled and uncontrolled corporations, result from fuzzy tax rules and
enforcement disarray expressed in several areas, including:
1) Controlled transactions and corporate reorganizations without “economic
substance” (misalignment between functions, assets, and taxable income), including
the migration of intangibles and shared services. Tax-driven migration of business
functions and intangible assets that erodes the corporate tax base.
2) Fuzzy transfer pricing rules. Comparability standards are devoid of economic
learning (e.g., profit margins for tax purpose are not correlated with market share).
Reliance on comparables that cannot meet numerous qualitative and subjective
comparability factors. See Appendix 7.
3) Little enforcement of applicable corporate tax rules, such as “commensurate with
income” of Internal Revenue Code (IRC) § 1.482, which requires periodic
adjustments to match future income forecast compared with reported income.
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Fuzzy Transfer Pricing Rules
1) Existing transfer pricing rules are complex and vague, including a colloquial
standard (arm’s length) that is difficult to translate. See appendices to these slides.
2) Canonical principles are flawed:
a) The arm’s length standard defined in terms of “comparables” has limited
applicability, because most countries (or industries within a country) have a
small number of potential comparables.
b) The requirement that a transaction be analyzed on a case-by-case basis is
ineffective because:
i) Requires building a large staff of skilled auditors and analysts;
ii) Causes the audit cycle to extend over several years;
iii) Makes taxable income subjective, exposing tax administrations and
taxpayers to arbitrary, capricious, and unreasonable behavior; and
iv) Makes it difficult to ensure tax parity between controlled and
uncontrolled entities.
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13
Preamble to Recommendations
1) “Competing tax theories intertwined to produce … a [U.S.] tax policy that, for all
its warts, still managed to finance a stable government and a thriving economy.”1
Today, “progressive” means to advocate corporate tax rate increases, and
“conservative” means to advocate corporate tax cuts.
2) In my view, “progressive” is to accept that governments must have the
responsibility to correct failures in the business sector and ensure:
a) Full employment; and
b) An incomes policy of non-decreasing wage share.
3) Governments can finance these objectives (2(a) and (2(b)) without increasing
corporate tax rates by increasing the tax base to include all business receipts without
allowable deductions.
1 Eugene
Steuerle. Contemporary U.S. Tax Policy (2nd Edition), Washington DC, Urban Institute, 2008, Chapter 13. This
view is one-sided (unacceptable) because it does not recognize the breakdown of incomes policy reflected in decreasing
wage shares (increasing profit shares).
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Recommendations
These recommendations are topics for discussions (because I have not made an impact
analysis on the constituents), except to indicate that they would lead to simplification of tax
administration and to increased corporate tax revenue without an increase in tax rates.
1) Short term, enforce statutory tax rules. This requires capacity building (train tax auditors
on transfer pricing matters and provide IT and ancillary resource library). This cannot
happen without a frisson, and requires political will to collect more corporate income tax.
2) Mid-term, restrict “legislative grace.” This requires reducing allowable deductions, e.g.,
separate CAPEX (R&D, advertising) from ordinary expenses, disallowing amortization of
acquired goodwill, and reducing or eliminating tax credits.
3) Long term, simplify tax rules and change tax base. This requires reducing the maximum
corporate “tax rate” and expanding the “tax base” to business receipts without deductions.
This would ensure tax parity between controlled and uncontrolled taxpayers and end NOL.
The specter of “double taxation” will prevent this simplification and change of tax base from
gaining momentum.
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Recommendations (Read more)
1)
General tax rule: tax all corporations (Form 1120, 1120-A, 1120S) based on business
receipts (revenue) independent of deductions (using tiered corporate tax rates), and
replace tax enforcement on a case-by-case basis with objective rules in which all
corporations pay revenue taxes, without analyzing each company individually. This
general rule would abolish the distinction between corporations with and without
taxable income, and would ensure tax parity between controlled and uncontrolled
corporations.
2)
Particular tax rule applicable to controlled corporations (in case the general tax rule is
politically unfeasible) (this particular rule would require no change on §482 tax code):
a)
b)
Simplify transfer pricing rules by abandoning the arm’s length paradigm defined in
terms of comparables, and replacing it with safe harbors using specified corporate
tax rates on business receipts before deductions (as opposed to the current tax on
income after deductions) (formula apportionment may be more difficult to
administer); or
Disallow or limit cross-border inter-company deductions, including qualifying
intangibles before payment is allowed, and limiting royalties, management fees, and
interest payments. Limits don’t apply to dividends.
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Appendix 1: Simple Code (IRC § 482 (1954))
Section 482: Allocation of Income and Deductions Among Taxpayers
“In any case of two or more organizations, trades, or businesses (whether or not
incorporated, whether or not organized in the United States, and whether or not
affiliated) owned or controlled directly or indirectly by the same interests, the
Secretary may distribute, apportion, or allocate gross income, deductions, credits, or
allowances between or among such organizations, trades, or businesses, if he
determines that such distribution, apportionment, or allocation is necessary in order
to prevent evasion of taxes or clearly to reflect the income of any of such
organizations, trades, or businesses.”
(Aug. 16, 1954, ch. 736, 68A Stat. 162; Oct. 4, 1976, Pub. L. 94-455, title XIX, Sec.
1906(b)(13)(A), 90 Stat. 1834)
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Appendix 2: Amendment to IRC § 482 (1986)
The Tax Reform Act of 1986 added at the end of IRC § 482:
“In the case of any transfer (or license) of intangible property (within the meaning
of section 936(h)(3)(B)), the income with respect to such transfer or license shall be
commensurate with the income attributable to the intangible.”
(Oct. 22, 1986, Pub. L. 99-514, title XII, Sec. 1231(e)(1), 100 Stat. 2562)
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Appendix 3: Arm’s Length Standard
In the Regulations, not the Code
Treas. Reg. § 1.482-1(b)(1): “In determining the true taxable income of a
controlled taxpayer, the standard to be applied in every case is that of a taxpayer
dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction meets
the arm’s length standard if the results of the transaction are consistent with the
results that would have been realized if uncontrolled taxpayers had engaged in the
same transaction under the same circumstances (arm’s length result). However,
because identical transactions can rarely be located, whether a transaction produces
an arm’s length result generally will be determined by reference to the results of
comparable transactions under comparable circumstances. See Section 1.482-1(d)(2)
(Standard of comparability). Evaluation of whether a controlled transaction
produces an arm’s length result is made pursuant to a method selected under the
best method rule described in Section 1.482-1(c).” (Emphasis added)
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Appendix 4:
Complex Tax Rules: § 1.482-1 to § 1.482-9 [1994]
& OECD MTC [1963]
1) Treas. Reg. § 1.482-1(a)(1): “The purpose of section 482 is to ensure that
taxpayers clearly reflect income attributable to controlled transactions and to
prevent the avoidance of taxes with respect to such transactions. Section 482 places
a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining
the true taxable income of the controlled taxpayer.”
2) See also Article 9 (Associated Enterprises) of the OECD Model Tax Convention
[1963]: “[Where] conditions are made or imposed between the two [associated]
enterprises in their commercial or financial relations which differ from those which
would be made between independent enterprises, then any profits which would, but
for those conditions, have accrued to one of the enterprises, but, by reason of those
conditions, have not so accrued, may be included in the profits of that enterprise
and taxed accordingly.”
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Appendix 5: Complex U.S. Regulations
(Not an Ideal Model)
The Treas. Reg. § 482 have nine sections that have been subject to several revisions
after they were finalized in 1994. E.g.:
1) Temporary and proposed regulations on controlled services transactions were
issued in 2006, and finalized in 2009 (Treas. Reg. § 1.482-9).
2) Temporary regulations on cost sharing agreements were issued in 2009, and
finalized in 2011 (Treas. Reg. § 1.482-7).
3) The “developer-assister” rules in the 1994 regulations (including the “cheese
example”) were replaced in 2009 by the “sole owner” rule. Former Treas. Reg. §
1.482-4(f)(3) and current § 1.482-4(f)(3)(i)(A).1
1
The legal owner of intangible property pursuant to the intellectual property law of the relevant jurisdiction, or the
holder of rights constituting an intangible property pursuant to contractual terms (such as the terms of a license) or
other legal provision, will be considered the sole owner of the respective intangible property for purposes of this
section unless such ownership is inconsistent with the economic substance of the underlying transactions.
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Appendix 6: Complex Regulations
1) Treas. Reg. § 1.482-4, -7 and -9 are labyrinthian, tangled and convoluted. They
reflect inadequate capacity building, and legal over reaching.
2) Theory is important (measurement without theory is unacceptable). A major
problem of Treas. Reg. § 482 is that it deals with economic transactions but does
not adhere to a discernable economic theory. The OECD Transfer Pricing
Guidelines (“OECD Guidelines”), which follows the U.S. § 482 Regulations after a
certain delay, suffer from similar opacity.
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Appendix 7: Factors Determining Comparability
OECD Guidelines, 2010
1)
The OECD Guidelines list in ¶ 1.36 five “factors that may be important when
determining comparability”:
a)
b)
c)
d)
e)
Characteristics of property or services;
Functions performed;
Contractual terms;
Economic circumstances; and
Business strategies.
2) Each of these five comparability factors is further divided into multiple “subfactors,” making comparability analysis subjective and amenable to game playing. In
fact, pervasive game playing by taxpayers and tax administrations is a major discredit
to the arm’s-length principle based on comparables.
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Appendix 7.1: Characteristics of property or services
The OECD Guidelines, ¶ 1.39 provides details on what is important to consider
regarding the characteristics of property or services. This comparability factor is
further divided depending on the transaction:
1)
In the case of transfers of tangible property: the physical features of the
property, its quality and reliability, and the availability and volume of
supply;
2)
In the case of the provision of services: the nature and extent of the
services; and
3)
In the case of intangible property: the form of transaction (e.g. licensing or
sale), the type of property (e.g. patent, trademark, or know- how), the
duration and degree of protection, and the anticipated benefits from the
use of the property.
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Appendix 7.2: Functional analysis
The OECD Guidelines, ¶ 1.42 provides details on what the functional analysis seeks
to identify and compare:
1)
Economically significant activities;
2)
Responsibilities undertaken;
3)
Assets used (employed); and
4)
Risks assumed.
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Appendix 7.3: Contractual Terms
1) The OECD Guidelines, ¶ 1.52 defines the contractual terms analysis as “the
explicit or implicit responsibilities, risks and benefits are to be divided between the
parties, which should be part of another comparability factor, the functional
analysis.”
2) It requires the analyst to “examine whether the conduct of the parties conforms
to the terms of the contract or whether the parties’ conduct indicates that the
contractual terms have not been followed or are a sham.”
In practice this information is scarce or inexistent, except if the transaction being
examined is a license or service agreement.
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Appendix 7.4: Economic Circumstances
The OECD Guidelines, ¶ 1.55 describes “economic circumstances that may be relevant to
determining market comparability” as including:
1) Geographic location;
2) Size of the markets;
3) Extent of competition in the markets and the relative competitive positions of the
buyers and sellers;
4) Availability (risk thereof) of substitute goods and services;
5) Levels of supply and demand in the market as a whole and in particular regions, if
relevant;
6) Consumer purchasing power;
7) Nature and extent of government regulation of the market;
8) Costs of production, including the costs of land, labor, and capital;
9) Transport costs;
10) Level of the market (e.g., retail or wholesale);
11) Date and time of transactions.
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Appendix 7.5: Business Strategies
The OECD Guidelines, ¶ 1.59 details business strategies as “tak[ing] into account
many aspects of an enterprise,” such as:
1)
2)
3)
4)
5)
6)
7)
8)
Innovation and new product development;
Degree of diversification;
Risk aversion;
Assessment of political changes;
Input of existing and planned labor laws;
Duration of arrangements;
Market penetration; and
Other factors bearing upon the daily conduct of business.
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Please send questions and comments to
Ednaldo Silva, Ph.D.
[email protected]
+1 (202) 468-3102
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