What the US Senate heard about offshore profit shifting
The Senate examined the shifting of profits offshore by US multinational corporations (MNCs) at a hearing on “Offshore Profit Shifting and the US Tax Code” on September 20.
In the world of international taxation, transfer pricing remains a hot topic of conversation.
The media have recently published notable pieces on transfer pricing with the intent of showing how companies such as Google and Apple avoid billions of US tax dollars.
Adding to the media coverage, in an article published on July 30, Lee Sheppard, a contributing editor of Tax Analysts, issued a comprehensive critique in a piece entitled “Is Transfer Pricing Worth Salvaging”. Sheppard went as far as to say that the transfer pricing is “the leading edge of what is wrong with international taxation”. Looking forward, Sheppard predicts that “the transfer pricing guidelines are a sorry vestige of a system that will be gone in 10 years”.
In keeping with this theme of scrutinising transfer pricing, the Senate’s Permanent Subcommittee on Investigations conducted a hearing on “Offshore Profit Shifting and the U.S. Tax Code” on September 20. This hearing examined the shifting of profits offshore by US multinational corporations (MNCs).
Opening statement and key issues
In his opening statement, Senator Carl Levin, chairman of the Senate Permanent Subcommittee on Investigations, laid out the four primary issues the subcommittee found from its most recent investigations into US MNCs’ foreign activities:
1. Transfer pricing abuse, particularly in the licensing and/or selling of intangible property (IP) to low-tax jurisdictions:
The subcommittee claims that MNCs shift profits to foreign subsidiaries located in low-tax countries by selling or licensing IP to those foreign subsidiaries at artificially low prices. To demonstrate this abuse, the subcommittee presented a case study of select IP transactions conducted by Microsoft. While these IP transactions met the transfer pricing regulations in place, Levin characterised these transactions as complying with the letter of the law, but violating the intent of the law.
2. Undermining subpart F using check-the-box and the controlled foreign corporation (CFC) look-through rule:
Deferral of US tax is permissible for active, foreign business operations, but not for passive income, that is, royalty, interest, or dividend income (26 USC section 954(c)(2010).
Subpart F rules were designed to prevent MNCs from artificially lowering their tax position. Levin claims that the original intent of the subpart F rules has been undermined by two measures: (i) the check-the-box tax regulations issued by the Treasury Department in 1997; and (ii) the CFC look-through rule, enacted by Congress in 2004. While the check-the-box rules were originally founded on the principle of simplifying the tax rules, Levin believes they have led to several tax avoidance schemes.
The look-through rule is a temporary rule that began in 2006 through section 954(c)(6) and expired after December 31 2009. The law provided look-through treatment for certain payments between related CFCs, and granted an exclusion from subpart F income for certain dividends, interest, rents and royalties received or accrued by one CFC from another related CFC. Through the Tax Relief, Unemployment Insurance Reauthorisation, and Job Creation Act of 2010, the provision was retroactively reinstated for 2010 and extended through 2011
3. Repatriation techniques to avoid US taxes:
The hearing then proceeded to discuss how MNCs have exploited gaps and holes in US tax law to return offshore profits to the US. In particular, the subcommittee highlighted the use of short-term intercompany loans as a means to repatriate profits back to the US while avoiding US taxes.
Under section 956, a loan made by a CFC to a related US entity is subject to US tax but MNCs have used are a variety of exclusions and limitations to avoid US taxes. For instance, a loan made by a CFC to a related US entity is excluded if it is repaid within 30 days and all of the loans made by the CFC throughout the year are outstanding for less than 60 days in total for that year (IRS Notice 88-108 and General Legal Advisory Memorandum (GLAM) 2007-016). The subcommittee presented Hewlett Packard (HP)’s revolving loan programme as a case study of this tax avoidance scheme.
4. Manipulating earnings through Accounting Standard Accounting Principles Board (APB) 23:
The subcommittee discussed the issue of MNCs’ artificially inflated foreign earnings through the exploitation of APB 23. As a result of the FASB Accounting Standards Codification (ASC) project, this subject is now classified under Income Taxes, Special Areas 740-30-25 (ASC 740). APB 23 was issued in 1972 by Accounting Principles Board with Opinion No 23, Accounting for Income Taxes – Special Areas.
According to US tax law, companies are required to account for any future tax bill they would face from foreign profits if they intend to repatriate those funds in the future. U.S. MNCs are allowed to avoid this financial reporting requirement under APB 23 by asserting that their foreign earnings are permanently or indefinitely reinvested. In 2011, the subcommittee found that more than 1,000 MNCs made such an assertion, reporting more than $1.5 trillion that is or is intended to be reinvested offshore.
Levin believes companies are simply holding money offshore to avoid taxes and pointed to a couple reasons why:
• MNCs’ lobbying effort:
Multinational corporations have launched a large-scale lobbying effort, promising to bring these offshore profits back to the US if they are granted a repatriation holiday. Levin points out that on the one hand, these companies claim that they intend to hold this money offshore, yet on the other hand, they promise to bring these funds back home as soon as Congress grants them a tax holiday.
• 2010 survey findings:
In a survey of nearly 600 tax executives, “60 percent of the respondents indicate that they would consider bringing more cash back to the US even if it meant incurring the US cash taxes upon repatriation, if their company had to record financial accounting tax expense on those earnings regardless of whether they repatriate”.
• 2004 repatriation holiday case:
After the repatriation bill passed, the total amount of permanently reinvested earnings declined by $84 billion. As soon as the repatriation period ended, the total amount of earnings these companies claimed as permanently or indefinitely reinvested offshore increased significantly and grew by 20%, or more, every year since 2005.
To address these core issues, the subcommittee also released a short list of recommendations:
· Reform tax provisions that encourage offshoring of profits;
· Issue APB 23 guidance; and
· Use anti-abuse rules.
These recommendations presented by the subcommittee are very broad in nature and will require several iterations of rigorous review and refinement before they shape into practical and actionable policy recommendations. For now, taxpayers should be aware of the issues that the subcommittee is focusing on and ensure that their own company’s positions regarding these issues are defensible.
The hearing then proceeded to host several panel discussions involving, for example, witnesses from multinational corporations (Microsoft and HP)), the Internal Revenue Service (IRS), and the Financial Accounting Standards Board (FASB).
Microsoft and HP panel discussions
A major theme underlying the Microsoft and HP discussions revolved around the issue of economic substance. For instance, during the Microsoft discussion, instead of exploring the distribution of risk that comes with cost sharing agreements, Levin focused on the licensing revenues and the number of employees that these entities had. By focusing on the number of employees and the revenues realised by Microsoft’s foreign entities, the senator was drawing attention to the lack of enforcement related to economic substance in transfer pricing law.
This theme continued with the subcommittee chairman’s discussion with an HP representative where he gave special attention to HP’s foreign-entity lending programmes. In these discussions, the senator presented internal HP documents to indicate that HP used short-term foreign entity loans to fund ongoing operations and acquisitions. While all these loans were compliant with tax code section 956, in substance, Levin was implying that they acted as tax-exempt repatriated profits.
While Levin did not explicitly state that he thought these transactions were noncompliant with transfer pricing regulations, he did state:
Our report lays out some very significant evidence that it is highly dubious [to claim] that some of these practices comply with existing IRS regs. ... some of the loopholes that have been used, in fact, are not true loopholes ... quite to the contrary, that the practices are using form over substance and under court decisions the IRS is able to pierce through forms which are phony and get to the substance. They do that in many cases which have been decided and it’s very important that the IRS continue on that course.
Discussion with IRS and FASB representatives
In concluding the hearing, the subcommittee discussed possible remedies to the offshore profit shifting. Neither the IRS nor the FASB representatives had anything of real substance to add to the discussion. What was made clear during this part of the hearing was Senator Colburn and Senator Levin’s bipartisan desire to revise the tax code.
Defending your position
The Senate hearing did not bring about any groundbreaking topics or issues surrounding international tax. However, the hearing served to reinforce the positions held by the Senate subcommittee and those held by the MNCs.
The subcommittee is convinced that MNCs are using complex structures and aggressive transfer pricing schemes to avoid US taxes. While many of these activities may be within the letter of the law, the Senate subcommittee believes that many of them violate the spirit of the law.
On the other hand, the MNCs maintain that they are just operating within the confines of the regulatory frameworks and incentive structures in place. Multinational corporations further claim that they are simply following the mandate that any for-profit enterprises should pursue – reduce costs and maximise value for shareholders.
What is also clear from this Senate hearing is that many government entities are dissatisfied with the tax code and that there is a strong initiative for tax reform. Based on the discussion during the Senate hearing, we may see tax reform focused on economic substance, check-the-box and intercompany financing.
A less likely situation involves an overhaul of the existing tax code. We should wait and see what proposals arise from the Senate Subcommittee’s broad recommendations. It is advisable that taxpayers consult their own transfer pricing service providers to discuss the topics highlighted in this article within their own company’s context to determine how defensible their positions are.
Rebel Curd (firstname.lastname@example.org) is a vice president;
Sean Ton-That (email@example.com) a consulting associate; and
Harrison Vale (firstname.lastname@example.org) is an analyst with Charles River Associates