The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
A House Republican plan to radically overhaul the international tax system has raised ample interest—but also a lot of skepticism.
The plan, which would convert the U.S. corporate tax system into a sales-based cashflow tax, could stem international tax avoidance and prevent alleged profit shifting through abusive transfer pricing.
“It's one of the chief virtues of the idea,” said Ed Kleinbard, a professor at the University of Southern California School of Law and a persistent critic of the current international tax system. “It is not the only way to address stateless income gaming, but it definitely is a reasonably robust strategy.”
The so-called destination-based cash-flow tax, first unveiled in the House Republican “blueprint” in June 2016, would retain but heavily tweak the current U.S. corporate income tax. While reducing the rate from 35 percent to 20 percent, it would eliminate the deduction for interest while allowing the full, immediate deduction for expensing and capital investment, as well as employee wages, and apply a border adjustment so it only applies to domestic activity and imports.
The plan would also exempt foreign earnings of U.S. companies from taxation, creating a territorial tax system.
While not precisely the same as a sales-factor formulary system—which consolidates all worldwide income of a U.S. company and taxes a percentage as income, based on its recorded sales within the jurisdiction—it achieves a similar dynamic. The location of sales would be the primary basis of taxation, rather than the location of valuable intangible assets such as patents or trademarks.
Many proponents of a sales-based approach to taxation are convinced they see devils in the details, however—especially the complicated maneuvers the House plan uses to achieve a sales-based taxation system while satisfying the demands of both domestic and international politics.
“It has theoretical potential. That’s what it’s designed for, it has the chance to change the transfer pricing game,” said Chuck Marr, director of federal policy for the Center on Budget and Policy Priorities. “This is all on a theoretical plan. It hasn’t been done before, it hasn’t been written. Money is like water, it’s a very powerful force, and there are very smart tax planners out there who are ready to game things.”
While perhaps not as difficult to pin down as transfer pricing, consumption taxes have dealt with difficult issues of gaming, especially as more commerce moves online. The Organization for Economic Cooperation and Development’s recent project to combat tax base erosion and profit shifting dealt with VAT-related profit shifting by advocating that, in situations where the physical location of a transaction is difficult to identify, the usual residence of the consumer is used as a proxy.
Many tax experts imagine situations in which the location of an online good or service is difficult to pin down, especially as the U.S. seeks to impose an enforcement mechanism unilaterally.
“We are doubtful that the line between U.S. and foreign markets can be drawn precisely where services and intangibles are concerned, where there can be no enforcement of the tax at the border,” wrote University of Michigan Law Professor Reuven Avi-Yonah and Reed College Economics Professor Kimberly Clausing in a draft paper released Dec. 14.
Daniel Hemel, an assistant professor at the University of Chicago, imagined in a blog post a situation in which Microsoft Corp. sold its operating system to the U.S. through an independent Irish distributor—"ShamrockSoft.” The company would be able to sell the operating system to U.S. consumers at a markup, thanks to the lower Irish tax rate, while Microsoft would make a killing selling to Ireland thanks to the exemption for foreign sales.
In addition to these vexing enforcement issues, lawmakers will also have to deal with the World Trade Organization, which may see the border adjustment principle as a tariff, and thus encourage retaliation against the U.S.
For instance, the U.S. would need to conceive a way to tax foreign companies that do business with U.S. consumers entirely online.
“It might be doable,” Hemel said. “But in doing so, we would need an explicit 20 percent tariff on cross-border business-to-consumer sales, which is going to make the proposition that much more difficult to pass the WTO.”
Avi-Yonah, who has long advocated for a sales-factor apportionment system, said the system would cut down on some types of tax avoidance while heightening others.
“There’s no point in inflating imports from related parties,” Avi-Yonah said. “There are other ways of gaming the system, and also there are some really disturbing elements that you may or may not define as gaming.”
Avi-Yonah said hedge fund managers in the U.S. may find ways to manage offshore funds in low-tax jurisdictions, thus declaring the services to be an export and claiming the exemption.
Some attributed the issues related to the border adjustment as resulting from the awkwardness of creating a system similar to the value-added tax—while avoiding it directly, due to political aversion to the concept, especially within the Republican caucus.
“It seems like what’s going on here is House Republicans and Kevin Brady are trying to convince the Freedom Caucus that this is not a VAT, while at the same time convincing the WTO and trading partners that this is a VAT,” Hemel said. “And all the while, not leverage the decades of experience from VAT countries with respect to implementation details.”
But a bigger objection to many is that the border adjustment, while dealing with tax gaming, would impose a high cost on consumers by raising prices. Advocates of the plan say it will cause an increase in the value of the U.S. dollar—as foreign buyers purchase more U.S. goods thanks to lower costs—which will negate the impact on American consumers. But skeptics aren’t so sure the transition will be clean.
“You picture all of these working-class people who shop at Wal-Mart,” Marr said. “There’s this assumption that the dollar corrects that immediately. That’s a big assumption. That’s a risk these people shouldn’t have to make.”
Bill Parks, founder of Idaho-based sporting equipment manufacturer NRS and an advocate of a sales-factor formulary system, said his business experience gave him skepticism that the House Republican plan would work as advertised.
“In theory, it makes sense,” Parks said. “But right now, we’re locked into our prices and virtually everything we purchase around the world is locked in, for as much as 18 months, in some cases much longer.”
A conundrum faces those sympathetic to the destination principle but wary of other parts of the bill, as its structure is highly interdependent. The cash-flow principle, applied to corporations, requires changes to the individual tax rates, dividends, and flow-throughs in order to prevent distortions.
“This works if a whole bunch of other things happen to the tax code, that may or may not happen,” said Hemel.
Alan Auerbach, a professor of economics and law at the University of California, Berkeley, and an early advocate of the cash-flow tax, defended the idea that currency adjustments would protect U.S. consumers.
“I have some sympathy for people being uneasy about these things, given that it’s a big change,” Auerbach said. “But I think we have enough experience with exchange rates to know that.”
Auerbach also said a cash-flow tax could use Europe’s lessons of enforcing the VAT, while also avoiding the pitfalls of creating a new tax from scratch.
“Those are destination-based taxes too, and the simplest way to do it is based on the residence of the person,” he said.
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