Making Sense of Profit Shifting: Kenneth Klassen

Kenneth Klassen is the Deloitte Professor and Director of the Waterloo Centre for TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ation in a Global Economy at the University of Waterloo.

Professor Klassen is a leading tax scholar and expert on international taxation and profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. . His research is frequently published in leading accounting journals and is actively driving the profit shifting discourse.

Professor Klassen is currently Editor of the Journal of the American Taxation Association. He received his Ph.D. in Accounting from Stanford University.

In this interview with the Tax Foundation, Professor Klassen shares his latest thinking on the nature, drivers, and economic effects of the profit shifting phenomenon—highlighting the issues that follow from the current unsettled definitions of profit shifting, the importance of firm heterogeneity with respect to profit shifting, why the magnitude of profit shifting remains unclear, and how further multilateral cooperation is a necessary step to improve the status quo in global tax. This interview is part of our 2015 Tax Foundation Forum series and has been edited for length and clarity.

Tax Foundation: What is known about profit shifting?

Kenneth Klassen: I think there’s been an improvement in the level of knowledge about income shifting by those outside of the multinational companies and their advisors, who of course are well-versed in it. And I think the research in international tax planning and some of the work by the OECD has both directly and indirectly brought a lot of this attention to the public domain as well.

Now, what we know depends on what specifically you’re talking about. I think a fundamental issue is: What exactly is “profit shifting”? And I think that’s really what has been a problem in some of the debate. It’s a significant challenge to define what profit shifting actually means, because shifting implies some basis. So relative to something, companies are shifting profit, and it’s only against a particular standard that you can actually measure this. So the issue is: How much lower profit is reported then the profit that you would expect to see reported?

So, for example, if a company moves the manufacturing plant to another country and all the profits that are associated with that manufacturing move with the plant, is that profit shifting? I think it depends on who you ask.

And often it’s said, “Well, all right, what’s the tax rate in that other country?” If it’s really low, then people will probably call that profit shifting, but if the tax rate there is actually higher than the home country, then maybe it’s not.

Another part of this is that most countries auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. international companies with great frequency and lots of energy, and so the transactions that are often blamed for profit shifting are almost always reviewed by at least the high-tax country. And rarely do we see court cases and disputes over the specific amounts. Obviously there are some disputes in the audit process. But it’s widely viewed that the profit shifting transactions that are considered inappropriate are all basically legal and within the laws of the various countries. So if companies are engaged in legal activities, is that really profit shifting?

So one argument is that there really isn’t anything going on, at least not outside of what’s legal.

In terms of thinking about the profit shifting debate, if we haven’t at least spent a bit of time articulating exactly what it is, it is hard to really nail down what we’re talking about, how to measure it, or how to think about it.

In my own work, I try to use the definition that a normal profit level moves with economic activity, and if a company decides to locate its activities in various countries, then I wouldn’t regard that as profit shifting. I would just regard that as globalization. And so if the country happens to have a relatively low tax rate, I wouldn’t necessarily call it profit shifting.

Now, if you move the activity and then because it is a low-tax country, you move as much profit as you possibly can get away with under the existing laws, then I think that piece of it might be considered to be profit shifting.

TF: Which areas of profit shifting are currently unknown or most unknown to researchers?

Klassen: I think we’re struggling as researchers to identify how much profit shifting occurs, although we agree that there’s definitely some profit shifting. There are lots of stories. In some of the OECD papers that have been produced, they list a variety of transactions that companies routinely undertake, which move profits or create scenarios where some profits are not taxed by any jurisdiction.

And I think that does happen. The question is: How big is that? Is that a few isolated situations or is it pervasive? Does it threaten the corporate tax system worldwide? Clearly that’s not true because companies do pay taxes. Governments raise revenue through a corporate tax.

So somewhere the question is: How much is it? And I think we don’t know the answer to that question. I don’t think the data are strong enough to tell us yet.

Although the magnitude of profit shifting remains unclear, is the extent to which profit shifting occurs significant?

No, I don’t believe we can draw that conclusion.

What are the unique factors or drivers underlying the profit shifting phenomenon?

I think competitive pressure is a large driver in this. As companies uncover various forms of competitive edge, others will recognize that and follow suit. As with other innovations—whether it’s supply chain management, marketing, or better production processes—as one company discovers a way to enhance its profitability, other competing companies largely have to follow suit.

Now, we notice that different companies have a different balance between the benefits and costs of tax planning, and we see that some companies are more heavily engaged in it than others.

But at the end of the day, there’s competition for capital and labor. So companies are basically responding to those pressures. I think what has happened over time is that international tax planning has become more normalized, and so it basically becomes expected by the participants in the economy. At some point, it just becomes the way you do business.

And if you take one step further back, is this competitive pressure a result of discrepancies in tax law around the world? So this competitive pressure would not occur if the same set of rules applied in all countries?

Yes, and it’s a balance. There are two sides: There are tax rates and then there are tax rules. If those were harmonized, there would be no motive to profit shift. If profits are taxed at 25 percent no matter what country it’s earned in, you can move the profits from one country to another, but it won’t matter for your tax liability. So why would you bother?

So differences in tax rates creates the incentives. That’s on the benefit side. And the cost side or the opportunity side comes from mismatches of tax rules across countries. Various countries have their own incentives. Some countries will essentially facilitate tax planning because they can actually glean a fair amount of revenue from that process. They are self-interested, so there’s competitiveness amongst the countries as well.

And governments will offer varying incentives within their country to have companies locate various activities there. Patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. es are probably a recent example. As soon as one country introduces an incentive like that, there’s an incentive for companies to use that tax incentives. But that profit that they’re going to report there, as a result, is coming from somewhere else.

How does profit shifting alter the behavior of firms?

In many cases, international tax motives push companies to become more international. In the early days of international tax planning, there was some relocation of physical assets and people to lower-tax jurisdictions. But a lot of the profit shifting we hear about is achieved by moving intangible assets, virtual processes, or altering capital flows amongst countries.

With governments around the world attracting business activity on the one hand and preventing the loss of tax revenues on the other, there’s probably going to be an increasing trend to match profits with economic activities.

I think that part is, in fact, one of the goals of some of the work of the OECD’s BEPS project. And based on my earlier definition, one would argue that that actually is not profit shifting. But sometimes it gives the opportunity for a little extra bump in profits.

Profit shifting is going to affect the behavior of firms more in the future than it has in the past. And by behavior I mean moving physical assets and people.

How about the firm’s structure? How does the firm itself change in its corporate structure because there is an opportunity to profit shift?

Companies have created complex structures to facilitate profit shifting, and I think that’s fairly widely understood. So in order to, for example, capture some of the benefits or to engage in certain types of profit shifting transactions, you may need four or five corporations in various places rather than just one. So the use of non-corporate or hybrid organizational forms is also often needed or useful.

Does profit shifting matter?

I would say, yes. Of course, that I’ve done research for a long time on this topic also suggests, yes, at least in my view. And I think that research, not just my own but that of others in the area as well, has demonstrated that not all firms engage in aggressive profit shifting. Because some firms do and some firms don’t, we can infer that there’s a difference in opportunity and cost amongst firms.

So I think that is also evidence that it matters. It matters to some because they’re willing to bear those costs, and those costs are significant enough that other companies are not willing to bear them.

As a straightforward example, if a company can lower its tax rate from around 30 percent to 20 percent, that would represent approximately a 14 percent increase in net income available to shareholders. That’s a pretty big increase in profitability.

Again, it comes with costs, so some companies would be willing to bear that cost, other companies not.

From another perspective, I would say that the work of the OECD, which was sanctioned by the G20, also suggests that it matters to governments. There are a lot of resources in the international policy realm being devoted to this particular topic. And that suggests to me that governments feel that this is an important topic that matters to them.

Let’s expand on an area you just touched upon: Firm heterogeneity. Multinationals are often portrayed in the discourse as a homogeneous group with respect to profit shifting. Is that the case?

No, that’s definitely not the case.

Companies face very different environments, so they will respond to those environments in different ways, as you might expect. It’s a disservice to say all companies are trying to do exactly the same sorts of things. I have a paper that’s under consideration in Contemporary Accounting Research that uses a survey of U.S. tax executives. In that survey, we asked the question, “What are the objectives of your tax department?” And, among other responses, about half of them responded along the lines of, “The amount of the cash taxes that we pay.” But about half of them essentially said, “We are just trying to get it right. We’re just trying to comply with the law.”

And when we use the answer to that question and compare it to the company’s behavior, we find that, in fact, the effective tax rates differed significantly between those two groups of companies, consistent with what they’re saying.

I don’t know if a 50-50 division is broadly correct, but it does suggest that some companies do emphasize the tax planning element and that in other companies the tax department is just really focused on trying to comply with the law and get the answer right.

Has profit shifting increase over time?

The answer almost certainly is, yes. In one of my papers from 2012, we try to estimate the change in income shifting by major U.S. companies in the 20-year period from 1989 to 2009. This paper, in part, leads me to believe that it’s very difficult to estimate these numbers. But no matter how you think about it, it does appear that there has been a significant rise in income shifting by U.S. multinationals, particularly starting in the late 1990s.

Again, it’s a balance of incentives. The U.S. has maintained its tax rate largely unchanged throughout this 20-year time period. Other countries have dropped their rates quite dramatically. Canada, for example, dropped its corporate rate from around 42 percent in the year 2000 to about 26 percent now, and that includes typical provincial income taxes. So there’s been a significant shift in the benefits of moving income out of the U.S. over the time period that we studied.

On the cost side, again, it’s a balance. And the U.S. has generally led the world in enforcement for many years, and most would say it continues to do that. Other countries used to really not do much in terms of enforcing international tax compliance. But over the last couple of decades, and the last decade for sure, other countries have become much more active than they used to be. So as companies balance the expected enforcement actions of the countries in which they operate, the balance has shifted as the other countries rise towards the U.S. enforcement level, and companies will rationally say, “OK, well, we used to shift a lot of profit to the U.S. because the other side just isn’t going to look at it. Now both sides are going to look at it, so we’ll just rebalance towards other countries and away from the U.S.”

Another feature that has happened over time is that, in the late 1990s, the U.S. introduced the “check-the-box” rules, which were beneficial for certain elements of the tax system. But it turns out they are now being used fairly extensively for international tax planning. And that lowers the cost of shifting income out of the U.S.

So all these balances have pushed everything in one direction: Less profit in the U.S.

What is the best estimate or a range of profit shifting out of the U.S.?

I don’t have an estimate or a range to provide that I think is reliable.

The data are not good enough for me to put a number on the degree of profit shifting. You’ll notice in our 2012 paper that we estimate profit shifting for a small group of companies for which we were able to get suitable data. But even that estimate is rough. But extrapolating that to the U.S. economy, in my view, is impossible.

What is missing for a better understanding of profit shifting?

We need better data. There are good theories that one could apply. But the detailed understanding of how a broad sample of companies structure themselves is very difficult to come by. And that’s really what we need.

I think that better data have become available on European companies. In Europe, they require companies to disclose some of their financial information. And while it’s not tax return information, per se, we can start to infer some things from that data. But, of course, in North America, corporate data are generally considered to be private, except as needed for public exchanges.

The European data are at the entity- or the affiliate-level, not at the corporate group-level, so you can actually look inside at the way the companies’ structure themselves to some degree. But better data would allow one to answer the questions better.

What difference is there between tax return data and financial statement or accounting data? Is there a significant difference between what those two types of data can tell us?

Yes, the financial statement data, of course, is designed for external users to understand the economics of the organization. And tax return data is designed to comply with the tax law.

And so the ways in which income is calculated can be quite different, particularly when you get into the more complex structures that involve, for example, hybrid entities. So the accounting data generally would classify things according to the economic implications or features, whereas tax data are based on the legal form and structure of an entity. To the extent that those two methods are different, you can get tax data reported quite differently compared with accounting data.

Let’s discuss possible solutions to address profit shifting, and I would like to start with multilateral cooperation. Can multilateral cooperation be a solution to profit shifting?

It’s a necessary step, in my view, to create a new international view on corporate tax amongst tax policy setters. As I noted earlier, most of the profit shifting plans are perfectly legal. They have been challenged, but they haven’t been overturned. Many of them are actually well-known, and the BEPS project documents a number of structures which are quite commonly used.

So it really has to start with the policy setters, at least to some degree, and coordination or cooperation are probably the key drivers there. So, for example, it’s probably over-generalized, but various governments apply different tax rules to the same income. And by doing so, they allow companies to re-characterize or report the same economic activity differently in the different countries, and that’s one of the bases of some of the profit shifting strategies.

I’m a little doubtful that coordination alone can offset all aspects of this because governments will continue to be self-interested. And they really should be. They are the government of a particular country, and they have to work on behalf of that country’s interests. So it’s a balance between being a good neighbor and protecting your own property, to use a bit of a metaphor.

So a number of profit shifting strategies are facilitated by particular structures that are allowed within specific countries. And why would a country do that? Well, they can create tax revenue for their country with very little cost by allowing companies to establish structures in their country. Why would Barbados want intellectual property in their country? Well, because they generate tax revenue from that.

So there’s a strong element of self-interest on the part of the country’s government as well, and coordination will definitely help to change the way country’s view international tax planning, which is a necessary first step.

What major developments do you expect in the next 1-2 years?

It’s always hard to speculate, but I think that in the global perspective, the work of the OECD will continue. And I think this will be very important to the way that the landscape forms in international tax.

I expect that the common disclosure rules that are being put forward at the moment will come into existence in some form. And financial accounting research has demonstrated fairly clearly that disclosure does change behavior, so I would expect that these disclosure rules would probably have a dampening effect on the most aggressive forms of international tax planning.

Beyond that, there are some proposals to change treaties and various other types of rules. Those are just very challenging things to coordinate, so I think that will be a longer-term process than two years.

I think many countries will wait to see how the new landscape emerges, and they will be waiting for some of the major economic players in the world: the U.S., the UK, Germany, and Japan. It’s really going to be a question of whether those countries take up the charge and start to adapt some of the changes that the OECD’s BEPS process suggests.

The OECD work is the consensus work, so one would expect that what they recommend has reached some level of consensus within the specific countries. But again, it’s then up to the individual country to decide, through its own political process, whether to actually implement those rules. So that’s going to be a challenging process for many countries.

How about from a researcher’s perspective? What do you expect in the next 1-2 years in terms of major developments?

There’s a lot of interest in this topic in the research community, which is driven by policy, because researchers try to develop new thoughts ahead of and while the debate is ongoing.

So I think there will continue to be significant research devoted to this, and I think through that we will gain a better understanding of the types of profit shifting that are occurring. My hope is that we could get to understanding what types of companies are doing more of it and why. And finally, ideally, I would like to see some more reliable estimate of how big of an issue this is.

What are some of your own favorite papers or resource related to profit shifting?

I would recommend the three-paper series I have with Stacie Laplante. One of the papers in that series is especially interesting, because it ties a link between profit shifting and the repatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. decision. Basically, one could see those as two sides of the same coin.

Related to that, there are a couple of interesting papers by a group of authors, Alex Edwards, Terry Shevlin, Ryan Wilson, and a handful others, that look at the trapped cash phenomenon and the effect that has on cross-border mergers and acquisition activities.

I think those provide some calibration of some of the costs of the current U.S. tax situation and move us forward in our thinking.

Professor Klassen’s three-paper series with Professor Laplante features the following articles: “Are U.S. Multinational Corporations Becoming More Aggressive Income Shifters?,” ”A Model of the Cost of Income Shifting with an Application to Tax Planning and E-Commerce,”and ”The Effect of Foreign Reinvestment and Financial Reporting Incentives on Cross-Jurisdictional Income Shifting.”

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