High-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. countries have increasingly raised concerns that corporate profits are shifted to low- or no-tax jurisdictions. According to a literature review by economist Nadine Riedel, the range of estimates for 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. by multinational businesses stretches from less than 5 percent to more than 30 percent of their income earned at high-tax affiliates being shifted to lower-tax entities. Although this is a wide range, there is little doubt that profit shifting takes place at least to a certain extent.
Tax havens, or “offshore financial centers,” can be defined as small, well-governed tax jurisdictions that do not have substantial domestic economic activity and impose low or zero tax rates on foreign investors. By doing so, they attract a considerable amount of capital inflow, particularly from high-tax countries. Tax havens levy fees, charges, and in some cases low tax rates on that foreign-sourced capital to raise government revenue.
However, there’s a difference between tax havens and countries that opt to provide a competitive tax environment to attract real foreign investment and to stimulate domestic investment. For instance, a country setting a competitive 15 percent corporate rate for businesses with substantial economic activity is a policy choice to become an attractive location for real investment and differs from tax havens aiming to attract revenue from other tax jurisdictions.
As multinational businesses shift profits out of high-tax countries, these jurisdictions lose corporate tax revenue. However, academic research reveals that high-tax jurisdictions may also have something to gain from tax havens.
A 2018 paper by Juan Carlos Suárez Serrato, economist at Duke University, shows that eliminating tax havens can negatively impact high-tax economies. The author studied the 1996 repeal of Section 936 of the U.S. Internal Revenue Code. Section 936 provided a tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. for the full amount of U.S. tax on income earned in U.S. possessions, such as Puerto Rico. Since this foreign-source income was fully exempt from U.S. taxation, it provided an incentive for U.S. multinationals to shift profits to Puerto Rico to take advantage of the credit. Serrato found that the businesses affected by the repeal of Section 936 reduced global investment and shifted investment abroad, reducing U.S. investment by 38 percent and employment by 1 million jobs.
A 2004 paper by economists Mihir Desai, C. Fritz Foley, and James Hines also finds a complementary relationship between haven and non-haven activity. They found that tax havens indirectly stimulate the growth of businesses in non-haven countries located in the same region. In line with the literature review mentioned above, their affiliate-level data also reveals that U.S. multinational firms use tax haven affiliates to reallocate taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. away from high-tax jurisdictions and to defer home country taxes on foreign income, effectively reducing domestic tax liability.
These findings suggest that although high-tax countries can lose tax revenue due to profit shifting, tax havens can indirectly facilitate economic growth in high-tax countries by reducing the cost of financing investment in those countries.
As a response to many countries’ rising concerns about profit shifting, the OECD, since 2013, has been coordinating a multilateral anti-tax avoidance effort. Since it published its Action Plan on Base Erosion and Profit Shifting (BEPS), anti-tax avoidance measures such as Controlled Foreign Corporation (CFC) rules, patent box nexus rules, thin-capitalization rules, transfer pricing regulations, and Country-by-Country Reporting have been either implemented or tightened by countries around the world.
According to a recent OECD report, these efforts, specifically the automatic exchange of information, have decreased bank deposits in tax havens by 20 to 25 percent over the last decade, a first indicator that tax havens might have become less attractive in the face of anti-tax avoidance measures. But, as some BEPS measures are still being implemented, it is yet to be seen to what extent they will hinder tax avoidance.
As mentioned, eliminating access to tax havens can lead to lower investment in high-tax countries. This can pose a trade-off facing the OECD in tackling profit shifting to tax havens and should be considered in their efforts.
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