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Making Sense of Profit Shifting: Douglas Shackelford

21 min readBy: Erik Cederwall

Douglas Shackelford is the Dean of the Kenan-Flagler Business School at the University of North Carolina at Chapel Hill and the Meade H. Willis Distinguished Professor of Taxation.

A world-renowned authority on taxation and business strategy, Dr. Shackelford has studied the 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. phenomenon since its early stages. His current research focuses on the taxation of multinational firms, disclosure of corporate 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. information, and the effects of shareholder taxes on equity prices. Dr. Shackelford has published widely in leading academic publications in the the fields of accounting, economics, law, and finance.

Dr. Shackelford has testified before Congress on domestic and international tax issues on multiple occasions, is a Research Associate at the National Bureau of Economic Research (NBER), an International Research Fellow at the Centre for Business Taxation at Oxford University, and founder of the UNC Tax Center.

He received his Ph.D. from the University of Michigan and his undergraduate degree from the University of North Carolina at Chapel Hill.

In this interview with the Tax Foundation, Dr. Shackelford provides a careful examination of the profit shifting phenomenon, specifically emphasizing the limitations to the current understanding of profit shifting, the need for the U.S. corporate tax system to converge with the corporate tax systems of its major trading partners and the OECD, and why the corporate tax might be analogous to a person in need of a succession plan.

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?

Douglas Shackelford: We know that taxes matter. We know that companies are responsive to both the rates and the bases of countries, and they will arrange their affairs accordingly.

For evidence, look to the extreme cases. Things are different in Ireland than they were a generation ago. We can also look at subnational jurisdictions. State taxes matter. Municipal taxes matter. I think that's the biggest single takeaway at the corporate level: Taxes do matter.

The next thing we can take away is that—and this is not unique to the international area— companies do not want to distort their production, marketing, finance, and other functions if possible. They will engage in transactions that minimize their taxes but don't distort those other factors.

If companies can route their monies through jurisdictions without actually having to rearrange their manufacturing units and lower their tax bill accordingly, then they will do that. Companies will opt for a reporting or a timing change before they will change a real activity in the international arena. Thus, there is more profit shifting going on than there is shifting of real activity going on.

Those are the two biggies I would take away from it. It matters but it affects real activities less than reporting and timing decisions.

TF: How about the unknown? What lies in the unknown with respect to profit shifting and is that significant?

Shackelford: I think the unknown is very significant. We still do not know what companies actually do. For years I have said that a research paper that would be incredibly illuminating would be a full description of how a company reports all of its income across all the countries that it operates in.

Let's take a major multinational that operates in a hundred countries and files tax returns for hundreds of companies in numerous subnational jurisdictions. If we could observe everything that the company sees and does, that would be incredibly revealing.

All we see now are footprints in the sand. We typically see numbers seem surprisingly large or surprisingly small in certain jurisdictions or that transactions of certain types seem higher or smaller than we might anticipate. We really have very little evidence of direct activity. What we need to be able to do is state: “This company produced here and sold there, and here's how they reported it for tax purposes.

I have a recent paper that's forthcoming in the Journal of Accounting and Economics. In the empirical findings, the Netherlands comes up regularly, appearing to be a tax haven.

We make some statements about the importance of the Netherlands in international tax avoidance, but we still can't tell you exactly what the companies are doing with Dutch holding companies, how they're doing it, and what transactions flow in and out. We can only report anecdotally that this is what we hear. We can't look at the data and tell you exactly how these things happen.

So, we're a long ways from having a full and complete understanding of what goes on. As a result, we're left to speculate. Therefore, people are probably left with the ability to read into research studies what they want to. By that I mean: If you think the problem is a huge problem, then you can probably look at the data and see that result. If you think it's not nearly as great as some do, then you can probably see that in the results as well.

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

It starts with the fact that we don't have one global tax system, any more than we have one set of global pollution regulations or one global judicial system.

There are more than 200 countries in the world and tons of subnational systems, and everyone sets their legal system and their tax system differently. Then we have companies, which are trying to operate in those jurisdictions. Buying and selling really has no respect for these somewhat arbitrary judicial boundaries.

Conflicts are inherently going to arise. Among other aspects, the different legal systems don't integrate perfectly, so there are some forms of income that are taxed twice. There are also other forms of income that potentially might not be taxed by any country anywhere.

The lack of the systems fitting together and the fact that even if they were to fit together, the same income might face a different rate in different countries means that there will be conflict.

What we would like to do, of course, is construct a world in which those frictions are as unimportant as possible, but that's easier said than done.

So the key underlying driver to profit shifting is differences in tax law among countries?

That's right. The fact that companies understandably are going to want to interpret the law and want to work with these differences in a way that minimizes their worldwide tax payments.

Is there any other factor you would like to highlight?

I think that's the key one. Anything else derives from that.

So now that there exists an opportunity to shift profits, how does profit shifting alter the behavior of firms?

As soon as there is an opportunity—and let's just say in the extreme that all I have to do is cross the street —then I can do the same thing that I would do on this side of the street and I won't be taxed. If I'm on this side, I'll face a significantly higher tax and thus I'm apt to move to the low-tax side. But presumably there was a reason as to why it was better for me to be on the high-tax side of the street where I started out.

With that simple illustration, I have decided to go to a sub-­‐optimal place to do my work because the after-­‐tax returns will be better if I move.

That's a simple example. Once we start talking about complex global organizations operating across a hundred countries, one can just see that the opportunities become almost limitless for ways to restructure and reduce the tax liability.

On top of that, the tax system depends heavily on observable transactions. It's one that's built on an accounting system that was founded in times when physical capital was dominant. We now find ourselves in a world in which much of the economic activity is in some sense unobservable and centers around intangibles and human capital, which is much harder to observe. We now have economic activity in which it's very hard to determine when the value is added, when the possible venture was undertaken, and where it was undertaken.

This just adds a level of complication that significantly increases income shifting possibilities, complexities, and disagreements, because it's one thing to try to income shift when we're talking about a large plant that makes concrete. That's pretty hard to do.

If we're in the cyberspace business, we've got smart people who live around the globe. And it's really hard to figure out when we made money, where we made it, who should tax it, and what rates should be applied.

Does profit shifting matter?

It definitely matters. First of all, it affects the revenues that countries collect. Second of all, it affects the ways that companies report their taxes. Third, it affects the ways companies structure themselves because that will affect the way their taxes are computed.

Fourth, it probably gives an incentive to convert as much of the value-add of the organization as possible toward an intangible-­‐based nature because intangibles provide more opportunities for income shifting and thus lower taxation than tangible-­‐based goods do.

If a company makes bricks, it's undeniable as to where the manufacturing is. It's undeniable where the inventory is. However, with such companies, I would want to claim that the real value of the company lies in the brand name. We might call it Jim's Bricks, because Jim's Bricks has a connotation of a finer brick than anybody else's bricks. The real value is in the brand name. Then I might be able to place that brand name in a low-tax location because it's an intangible.

That brand name might be in a location that has a lower tax rate than where the actual bricks are manufactured or the inventory sits. Thus, I've converted my business from heavily tangibles-­‐based to a more intangibles-­‐based business, which I can shift to other locations.

For which countries does profit shifting matter the most?

It’s probably most important for open countries. That is, those countries that are small and have the greatest amount of trade. Thus, there's no reason, going back to my geographical analogy, why you can't cross the street.

Also, it would matter most for those countries that are furthest out of line in tax systems with their trading partners. If you had a tax system that looks identical to the country that's across the street, even though it might be easy to cross, why would you do it because once you get over there you have the same tax system. If we have open economies and we have very different tax systems, then income shifting would matter the most.

I should say that income shifting cuts both ways. We usually make an assumption that all income lands somewhere. Then, for some countries, it may be that income shifting ends up being a net revenue increase. Ireland might be an example of that: More income, albeit taxed at a low rate.

Has profit shifting increased over time?

I think it has as the economy has become more intangibles-­‐based, as the economy has become more globally intertwined, as trade alliances among countries have increased, and as the tax planning community has become more skilled. All of these things have been occurring over the last 30 years or so.

Has multinationals’ responsiveness to tax rate differentials also increased over time?

Except perhaps the U.S., countries are becoming more homogeneous in their tax systems over time because trade is increasing over time. That would work against income shifting.

However, I'm hard-­‐pressed to think of any company that over the last generation has not become more global. We've gone from companies, and let's just take American companies, that only do business domestically to companies that do business in North America. The companies that used to do business just in North America now do business in North America and Europe. The companies that used to do business in North America and Europe now do business on every continent. So, companies have more income shifting, if for no other reason than that they have become more globally based.

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

I have never done any estimates myself, so I would leave that to someone else to take a stab.

Is there any resource you would refer to for that type of measure?

I've seen some different estimates. I think people are trying their best. It's a very hard thing to get our hands on for some of the reasons I've mentioned earlier. Any estimate is going to be based on what we can observe, and what we can observe is limited at best.

What is missing for a better understanding of profit shifting?

From a researcher's perspective—I would go back to something I said earlier—we need a better understanding of how companies engage in profit shifting. I hear people say things at conferences, but I hear people from companies, and I hear people who consult with companies. I frankly never have felt like I have the whole picture. I feel like I have bits and pieces of the picture.

We need an autopsy of a company to understand that issue better. Instead, we end up looking at data that are financial accounting numbers or maybe government numbers. We have to infer that relationships look unusual or different than we would expect in the absence of income shifting. From that, we infer income shifting, but I think a more complete understanding of the inner workings of the company is lacking from the researcher's perspective.

I completely understand the confidentiality of why companies are not forthcoming and want to share that information. From a researcher's perspective, it'd be wonderful if there were researchers who were able to study such a thing and help us understand how all the pieces fit together.

Is there a good enough understanding at this point to make insightful policy decisions?

I think we can give directional suggestions. I would not want to say, “Let's be silent until we can get perfect data,” because we might never move and do things.

We've learned a lot of things. We know a lot more than we used to know. We can use that to try to enhance policy. It's just that, from a perspective of how far we have to go, there's still quite a ways that we could go to improve things and tighten down on things like estimates.

What possible solutions are there to address profit shifting?

So let's go back to what I said was the underlying issue. The underlying issue is that every country is going to set its own laws and companies are going to rearrange their affairs given that. At that point, we need to sit back, take a breath, and say, "OK, nothing short of one world government is going to solve that situation.” In some sense, this is an inherent issue because we have a single world marketplace, while we have arbitrary judicial borders. We need to recognize that that part of what we have is inherently going to occur.

Then the next thing is to say, "OK, given that, then what perhaps is of such a nature that we could begin to trim back and not do damage to economic expansion and growth and not infringe on countries' freedom to govern as their people wish them to do.

So is multilateral cooperation the solution, at least in theory, to resolve profit shifting?

I wouldn't make a statement as strong as that. You're not going to solve it, because it's going to be around as long as we have countries and companies. But I think it takes us in the right direction. I'll give you an example of something that I think is good. It's good that countries are sharing information in ways that they once did not. Countries sharing information is a step in the right direction. I think multinational arrangements are good. I think countries sitting down and jointly resolving a situation about a company is wise.

There are some situations where two countries are both claiming the same income for one company. Those two countries need to sit down and say, “Who is going to get that?” The company is put in an impossible situation. They can't pay full tax on that income to both countries.

Those sorts of things begin to reduce some of the problems that naturally have evolved from this fact that we have all these different countries and all these different companies.

So that is in the direction that we want to move.

In contrast, the direction we don't want to move in is countries going alone or seeming to be taking actions that are out of step with the rest of the world. I don't see that as good because it, in some sense, just increases the nature of the problem or increases “opportunities” for exploitation of breakdowns because countries don't fit together in a global tax system.

What is your thinking on a worldwide versus a territorial system? And let's talk about the U.S. for a moment.

We have to start with that no country has a true worldwide system and no country has a true territorial system. There's a little bit of a false dichotomy there. I think that, and I have felt this way for some time, this is an example of where the U.S. would be well served to be more in step, along the continuum from worldwide to territorial taxation, with where the rest of the world has gone.

We would benefit from shifting more toward the territorial end of the spectrum. And I'm a little baffled that we think in this increasingly integrated world, in which we will increasingly become a smaller portion, that it's best for us to go alone. What may have made sense in the 1950s and the 1960s, when the world was a very differently place, isn't necessarily the tax system that is “optimal” for the U.S. in the 21st century.

Does a corporate tax rate reduction fit into this? Is it necessary?

I would put it this way. Let's step away from a reduction for a minute and say something along the lines of a, “tax rate convergence.” If you want to weaken the forces creating incentives toward international tax planning or avoidance, whatever word you would prefer, then what you would do is try to have global tax systems converging as opposed to diverging.

Right now in the U.S., our tax rate, at least our statutory tax rate, is higher than just about any other country’s tax rate. For us to become more mainstream, we need to reduce that rate. I think that's just about agreed upon by everybody. The reason it hasn't happened is because of the political impasse that is holding back policy, not just only in the tax area, but in a lot of areas right now.

How do you see legal frictions in preventing profit shifting?

I think all of those things, particularly if you move toward a territorial system, are useful to make it more difficult to easily exploit some of the situations that arise in a more intangibles-­‐based economy.

They all play their roles there. Once you have one country that goes one route and one that goes another route, though, we're back to diverging in our tax systems and opening up new opportunities to play games across countries.

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

At least from my situation a couple of states away from D.C., it seems to me unlikely we're going to have major tax legislation. Here in the U.S., I just don't see much of anything happening. Will we have something after 2016? I think it just depends on how the elections shake out.

My view on a lot of this is that I really think the policy wonks on the right and on the left are not nearly as far apart on some of these issues, and particularly in the international tax area, as the politics have driven things. We could get some of these things resolved, but first we've got to have some political reconciliation.

What are your thoughts on major developments for multilateral cooperation?

Groups like the OECD will continue to move along. In the U.S., I think whether we adopt things and to what extent we are part of those changes, again, is wrapped up in our political situation. I need to be able to read the political crystal ball better before I can say to what extent we get involved.

Other parts of the world, to the extent their politics allow them, will continue to respond to the ever-­‐changing globalization and growth in this highly linked intangibles-­‐based world, which is going to continue to have an impact on our tax system.

From a researcher's perspective, what do you expect can happen in the next 1-­‐2 years?

On the researcher’s side, data is becoming cheaper and more available. The same data analytics that are changing the corporate world are changing the academic world. I think that we can expect to see better research, better estimates, and a better understanding of what's going on—better papers coming out continually. So I'm quite encouraged by what the availability of better data is going to enable us to learn on the research front.

How do you envision the future of the corporate tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. ?

I've said before that we have a problem that I think is under-appreciated in the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. community. That is, the income tax system is based on financial accounting. Financial accounting was developed in a bricks and mortar economy. Think of the steel mills and the automobile factories in this kind of world. It works really well in that heavy property, plant, and equipment—big inventory environment.

It doesn't work very well when the primary asset is human capital and how smart your engineers are, your brand, your marketing, and your research and development. If you look at the companies that are on that cutting edge, if you look at their balance sheets, they have few of those things on their balance sheet because accounting doesn't know how to record those things.

As a result, financial accounting struggles to be as useful for intangible-­‐based companies as for tangible-­‐based companies. Since our tax system overlays and uses that structure, I think of our tax system as a house with a very bad foundation. That foundation is weakened as our economic system becomes more and more intangibles-­‐based.

If you look ahead 25 years from now, I have no reason to think that things have not become far more intangibles-­‐based than it is now in countries like the U.S. Thus, I think it entirely possible that we're going to find it more and more difficult to be able to structure a reliable, administrable corporate income tax. I've sometimes given the analogy that the corporate income tax is a very old person, and we need to be thinking about a succession plan.

Does it have five more years? Probably so. Ten more? Maybe so. Maybe it has 20 more. I don't know, but it's not going to live forever.

It's because of this foundational issue: The structure on which it's built, the accounting system, is not designed for the world that we currently have. Accountants have not come up with something that works well with that world. I don't see anything out there to think that they're going to be able to. So, I'm kind of bearish, if you will, on the corporate income tax system.

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

I do have a paper that's coming out in the Journal of Accounting and Economics in the April-­‐ May edition, in which we look at what we call the equity supply chain line.

We have U.S. companies, and they're doing actual real operations through a subsidiary located in Brazil. Most of those American parents will go through a number of subsidiaries before they get to their Brazilian subsidiary. Those subsidiaries will be bouncing around a bunch of countries. We have traced those paths that they go through and try to ask the question: “Why do they go through those countries and what's going on?” It's our backdoor attempt to try to understand what's happening in the income shifting arena.