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Making Sense of Profit Shifting: Halftime Report, Part 1

4 min readBy: Erik Cederwall

Tax Foundation Forum: Making Sense of Profit Shifting has reached its midpoint. In this halftime report, we provide a synopsis of the first nine of the 18 interviews in the series. This two-part review summarizes the key takeaways to this point and focuses on the interview series’s six underlying themes:

  1. What is actually known about 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. and which areas remain ambiguous;
  2. The drivers and mechanics of profit shifting;
  3. The magnitude and directional trend of profit shifting;
  4. Missing pieces for a better understanding of profit shifting;
  5. Solutions to profit shifting, with a focus on the feasibility or desirability of multilateral cooperation;
  6. The status quo and future of 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. and international taxation.

Part I of the halftime report compares and contrasts opposing views for themes one through three.

The single most important takeaway from the first nine interviews is the substantial degree of differences in viewpoint that exist among participants, specifically in relation to the current depth of understanding of the profit shifting phenomenon.

1. What Is Actually Known about Profit Shifting and Which Areas Remain Ambiguous?

The purpose of this question is to survey the landscape of profit shifting, better understand how much is truly know about profit shifting, and whether there exists a consensus in that area. So far, there is a significant discrepancy among interviewees regarding what is curently known about profit shifting.

Within the realm of the known, there is unanimous agreement that profit shifting occurs on a regular basis. There is a similar degree of consensus that firms—in terms of reported income—are responsive to 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. rate differentials across jurisdictions. Moreover, participants generally have the same view on which channels for shifting profits are most important: Transfer pricing (with an emphasis on intellectual property and intangible assets and the creation of royalties and cost sharing agreements) and intra-firm or inter-affiliate debt are frequently highlighted. Finally, interviewees view the core underlying drivers of profit shifting—which we will discuss in the next section—in a relatively similar fashion.

The main areas cited as still within the realm of the unknown include: the magnitude of profit shifting, including implications for tax revenues, the ways and extent to which there are real distortions associated with profit shifting, and the corresponding costs of engaging in profit shifting.

However, there are substantial differences in views on which areas are in the domain of the unknown. Some interviewees view the realm of the unknown as minute, while others see the realm of the unknown as greater than the realm of the known.

2. The Drivers and Mechanics of Profit Shifting

The four core drivers of profit shifting that are commonly highlighted among participants include: 1) Differences in tax rates across jurisdistions; 2) Globalization of production and production chains; 3) Increasing capital mobility; and 4) The growing importance of intellectual property and intangible assets.

However, participants also mentioned other underlying drivers—which in some cases partially overlap with the four aforementioned core drivers—such as the strategic incentives of host and residence countries, the increase in competitive pressures on global firms, the particular legal and regulatory aspects that facilitate profit shifting (e.g. check-the-box, the 2004 tax holiday), stateless income planning opportunities (using not only tax rate differentials, but also differences in tax law across jurisdictions to minimize tax liability), and the characteristics of firm managers/executives (tax director, CFO).

In general, participants agree in principal on which channels are most important for profit shifting. There are, however, opposing views on the granularity of the understanding of how firms use these channels.

Participants see the use of intellectual property or intangibles as the most important method for shifting profits. This technique can be placed under the broader category of transfer pricing. In the 1990s, the transfer pricing channel of shifting profits mainly pertained to the mispricing of intra-firm trade of input goods, such as piece of metal. Today, participants view the mispricing of firms’ intangible assets as the key practice under the category of transfer pricing and for profit shifting in general.

In addition, interviewees view firms’ strategic use of intra-firm debt as an important channel; though, the consensus is that the importance of this channel has decreased over time. Furthermore, a substantial degree of participants highlighted the use of stateless income planning strategies, through which company income could be taxed in no jurisdiction at all.

3. The Magnitude and Directional Trend of Profit Shifting

So far, the key takeaway from participants is that estimating the magnitude of profit shifting is associated with significant challenges and uncertainties, which might make the exercise infeasible at this point.

Regarding the directional trend of profit shifting, a majority of participants indicate profit shifting has increased over time. Nevertheless, there are opposing views that suggest a decrease in the magnitude of profit shifting might have occurred.

Part II of this halftime report will be published tomorrow, on Wednesday, May 27, and includes a review of themes four through six.