The Tax Burden Seesaw

U.S. companies are moving taxable income to foreign subsidiaries for better tax rates, a trend that has grabbed Congress's attention.
Sarah JohnsonSeptember 9, 2008

Large multinational companies’ tax practices will fall under Congress’s scrutiny next year as the heads of the Senate Finance Committee pledge to “tackle tax reform in 2009” following a report that businesses are increasingly shifting their operations — and their taxable income — outside the United States.

With the final days of the 110th Congress waning and the presidential election looming, the committee will put off reviewing the U.S. tax code for now. However, Sen. Max Baucus (D-Mont.), who chairs the finance committee, plans to come up with “full-fledged” tax reform next year and will start with roundtables and hearings on tax policies, his office said.

“This report underscores the need to review business taxes as part of our tax reform efforts in the next Congress,” he said. “Simply put, I do not intend to allow U.S. multinationals to sidestep their fair shares of taxes by moving income offshore.”

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Fueling his declaration is a U.S. Government Accountability Office finding that U.S. businesses have stepped up their foreign subsidiaries’ activities in recent years. Part of the reason may be the incentive to report income earned in other countries where they can get more favorable tax rates. “Differences in tax rates across countries appear to influence how much income corporations report … in particular countries, relative to the amount of other activity in those locations,” the GAO wrote.

Indeed, the GAO noted, the average U.S. effective tax rate in 2004 for large, profitable companies’ domestic income was 25.2 percent, whereas their income earned overseas had an average 4 percent tax rate. Using 2004 data as the most recently available source, the GAO says Bermuda, Ireland, Singapore, Switzerland, the U.K. Caribbean Islands, and China had the lowest rates among the countries where U.S. companies do the most business. Italy, Japan, Germany, Brazil, and Mexico have relatively high rates.

The GAO acknowledges that tax rules inevitably influence where businesses plant their stakes. However, they also give companies the incentive to shift their reported net income to areas outside of where that income was physically generated. Multinationals keep more than 60 percent of their activity on U.S. shores, the GAO noted.

To be sure, the GAO doesn’t accuse companies of doing anything illegal. However, the agency says companies’ ability to transfer their tax liability among jurisdictions “is susceptible to manipulation for tax planning purposes.”

In a joint announcement with Baucus, Senate Finance Committee ranking member Chuck Grassley (R-Iowa) suggested Congress will be looking at transfer-pricing issues. Under the rules, companies give intercompany services arm’s-length prices — a key issue when examining how and where U.S.-based companies report where the income among their subsidiaries was earned. Grassley called transfer pricing of intangible assets “complicated.”

“We’ll continue to work toward a system that’s less burdensome on taxpayers and tax administrators but assures that shared business activities are properly accounted for in how U.S. based taxable income is determined,” he added.