Making Sense of Profit Shifting: Jack Mintz
May 19, 2015
Jack Mintz is the Director of the School of Public Policy and the James S. & Barbara A. Palmer Chair in Public Policy at the University of Calgary.
Cited as one of the world’s most influential tax experts, Dr. Mintz is a leading authority on tax policy, international taxation, business taxation, tax competition, and profit shifting. Dr. Mintz’s research has been widely published in leading scholarly journals, especially in the fields of public economics and public finance.
Dr. Mintz chaired the Canadian government’s Technical Committee on Business Taxation in 1996 and 1997 and is the founding Editor-in-Chief of International Tax and Public Finance. He currently serves as an Associate Editor of International Tax and Public Finance and the Canadian Tax Journal.
Dr. Mintz received the Queen Elizabeth Diamond Jubilee Medal in 2012 for service to the Canadian tax policy community, and The Financial Post named him one of the five most influential Canadians in regulation in 2012.
Dr. Mintz holds a Ph.D. from the University of Essex, a Master of Arts in economics from Queens University, and a Bachelor of Arts in economics from the University of Alberta.
In this interview with the Tax Foundation, Dr. Mintz offers his latest thinking on the profit shifting phenomenon, sharing his unparalleled insight into the Canadian experience with taxing multinational firms. In addition, Dr. Mintz emphasizes the current limitations to understanding profit shifting and shares his thoughts on the future of the corporate tax base. This interview is part of our 2015 Tax Foundation Forum series and has been edited for clarity and length.
Tax Foundation: What is known about profit shifting?
Jack Mintz: I think we know some things. There have been studies that have looked at the sensitivity of the corporate tax base to changes in the corporate rate. Of course, some of that sensitivity could be related to changes in investment, which is not really what we mean by profit shifting, per se, because profit shifting is taking actions, financial transactions or other types of reorganization of a business, in order to shift profits from a high-tax to a low-tax jurisdiction, without necessarily moving a person or moving a machine, in other words capital.
So that could be done through debt financing. It could be done through transfer pricing. It could be done through leasing arrangements or insurance arrangements. It's ways of shifting profits from one jurisdiction to another, even if capital is staying the same.
There hasn't been much work done on actually analyzing how different actions might impact profit shifting. In order words, what is the size of profit shifting, and what are the factors that explain that size of profit shifting. That would require a very different analysis than looking at tax rate sensitivity for the tax base.
TF: So if you would juxtapose the unknown and the known with respect to profit shifting, would you say that more of profit shifting is unknown than known?
Mintz: There's lots of anecdotal evidence in the understanding of profit shifting. We don't know the main ways that companies are shifting profits. We don't know how much profits are actually being shifted.
We know a little bit about the tax base sensitivity to tax rates from the studies that have been done, and that's been useful. But I think there's a long way to go to understanding profit shifting in general and specifically how it impacts investment decisions.
What are the unique factors or drivers underlying the profit shifting phenomenon?
In my view, essentially two of them: First of all, there's been a substantial increase in cross-border transactions in the past 25 years, and this you can see from OECD data on the size of cross-border transactions amongst OECD countries. It's been quite a large increase. It happened in the 1990s and is driven by both communication and transportation technologies that made it easier to operate at an international scale. We truly became much more globalized as a result, and that's been one major factor leading to more opportunities to shift profits across jurisdictions.
The other is simply the competitive pressures that have been placed on companies to reduce their effective tax rates. Otherwise, they can have difficulty competing in particular markets, and that has led to greater incentives to use profit shifting as a way of driving down some of the tax costs associated with doing business.
So differences in tax law amongst countries is one of the key drivers?
Right, but we've had differences in tax law for centuries or at least certainly for decades. But profit shifting became more important in the 1990s, given the globalization of capital. That's why competitive forces have also become stronger on businesses operating at an international level.
On this topic, I would like to discuss a passage from a paper you co-authored with Michael Smart almost 15 years ago: "Income Shifting, Investment, and Tax Competition: Theory and Evidence from Provincial Taxation in Canada." In that paper, you state: "Two aspects of globalization have had important and conceptually distinct implications for business tax competition. Reductions in transportation and communication costs may make real business investment more mobile across jurisdictional boundaries and financial innovation and liberalization may facilitate international tax avoidance by less footloose firms." Which of those two broader forces has had the greatest impact on profit shifting?
I think the latter more than the former, which is the reason why governments have responded by lowering their statutory corporate income tax rates, because financial transactions and restructuring your affairs that way are much easier. It's much easier to do that than try to move real investment across boundaries. Therefore, the second is the bigger driver compared to the first.
How does profit shifting alter the behavior of firms?
First of all, if you are able to undertake certain types of transactions that allow you to drive down your effective tax rate, it can enable you to invest at a cheaper cost in other jurisdictions or your home jurisdiction. So take an example of double-dip interest deductions, which is an area that I have done work in. It's like self-help arbitrage to reduce your effective tax rate, but if you can invest in a foreign jurisdiction by running income through a third-party, which could be a tax haven country or it could be some sort of holding company that has preferential treatment in the country, like Luxemburg, or Netherlands in the past, you can then have a lower cost of capital in the host country. That allows you to compete better and invest more.
That's why there's a very important linkage between opportunities for profit shifting and ultimately the decision where to invest. Similarly, you may have opportunities to even profit shift in such a way that you can drive down your effective tax rate at home, your domestic tax rate, which can encourage more investment at home as well, depending on how the profit shifting operates.
So how does the opportunity to profit shift impact the firm's investment decision?
By setting up these transactions in such a way that you can get a lower cost of capital, it enables you to invest more as a result, because you're able to drive down your cost of capital. The multiple-dip transaction is a good example of that because you can get quite low financing costs and lower cost of capital to make investments.
So if you would enumerate how profit shifting alters the behavior of firms, what are some of the changes that occur?
You could see changes in debt financing, changes in the structuring of holding companies or the corporate group. You could see it in terms of potential usage of stepping-stones where you're investing through entities to go into another country. Instead of having home-and-host subsidiaries or affiliates, you end up having multiple subsidiaries to take advantage of certain opportunities for income shifting.
The academic literature generally discusses transfer pricing, inter-affiliate debt, and licensing/intangibles as channels through which profit shifting occurs. Which one of those channels is most important for shifting profits?
It partly depends on the country. In the case of some of the European countries and Canada, I think the financial restructuring channel is probably the bigger driver of income shifting.
I don't think transfer pricing, per se, has much impact, mainly because there's a very strong legal foundation for determining arm's length pricing. There are areas where you might have some disagreements with the authorities when trying to shift income. But it's a lot harder to shift income in that way because transfer prices, within a bound, become more observable or difficult to alter in terms of the different methodologies for determining transfer prices.
The intangible channel is really a question of licensing, and that's easy to do. It's easy to shift intangibles from one jurisdiction to another, so you need companies that would have significant intangibles to do that. That's a bigger issue for countries with high levels of research and development, such as the U.S., Israel, and maybe Japan, where intangible income can be easier to shift around, compared to countries that might be resource-based, where intangibles play a lot smaller role, or to countries which have a primarily service-type sector where intangibles may not play a big role.
So that's why it depends on the jurisdiction as far as which type of channel is more or less important.
Does profit shifting matter?
Profit shifting raises a few issues as far as why it matters. The first one is the economic efficiency issue that some companies that are able to do more profit shifting than others do create a less level playing field. That could be very important when you're comparing domestic companies to multinationals, since multinationals have more opportunities to shift profits. You get a different cost of capital and, as a result, a different playing field, which can lead to some distortions. That's one type of inefficiency.
Another one is the inter-temporal inefficiency that corporate taxation has in discouraging investment and, to the extent that profit shifting lowers the effective tax rate on capital depending on your view, it certainly will reduce the inter-temporal inefficiency associated with corporate taxation. You might argue that could be a positive, not a negative, aspect in that sense.
The third is that corporations just don't earn income, but some of that income reflects economic rents or above-normal profits. Rent taxation is a relatively good way for countries to tax, in the sense that it's efficient, and so profit shifting can make it more difficult to achieve rent taxation, especially if the rents are moved to low-tax jurisdictions.
Another issue is sharing the international tax base. Some might argue that countries shouldn't have the corporate tax, but it's a tax that helps pay for infrastructure and other public expenditures that can help capital investment in a jurisdiction.
Income shifting actually may reduce, to a certain extent, the amount of the tax base in some countries that would be available to finance public input that helps business capital. In other cases, it might expand the tax base or the tax revenues that are available to a country in order to fund public services, including those that help businesses. So there are differential impacts across countries as a result of income shifting.
Has profit shifting increased over time?
My suspicion is yes, but I'm not sure if we've measured it.
What do you mean?
Well, the question is: What do we mean by profit shifting and how would you measure profit shifting? Let's say there was a neutral tax system, where every country had the same corporate tax rate, the same base, and the same measurement of income. In that scenario, you would argue there's no tax-motivation to shift profits, because no matter where you go, income is going to get taxed at the same rate, at the effective rate. So the question is: In a world where you do have differences in effective rates and that induces profit shifting by businesses, how much profit has moved relative to some neutral system? And I don't think we've ever measured that or answered that question in order to understand the size of profit shifting. My suspicion is that profit shifting probably has increased, because it has become easier to implement tax avoidance structures at the international level, but I haven't seen data to confirm it.
As a follow-up, can economic activity serve as a control for profit shifting?
No, because you can't assume that the profit rates are the same on assets, labor, sales, across industries, across sectors, or across countries. So these factors really are a proxy for how you think profits might be earned in different jurisdictions.
Do you have a sense of to what extent there is profit shifting out of or within Canada?
There have been a number of studies primarily based on the tax base sensitivity that have suggested that profit shifting is possible. An interesting study that hasn't at times received as much focus in the literature, but one that I've always found fascinating, was a paper done for the tax reform commission in Canada about 15 years ago. That's a paper by Vijay Jog, looking at Canadian and U.S. multinationals operating in Canada and the U.S. and analyzing their debt decisions. The Jog paper found that there was considerable profit shifting that occurred between Canada and the U.S. that was associated with the placement of debt. This was a very focused study that I hadn't seen much in the literature. The approximation in the Jog paper was one of the estimates that the Canadian tax reform commission used in order to gauge to what extent revenue, as a result of tax rate changes, might be impacted by income shifting.
What is missing for a better understanding of the profit shifting phenomenon?
It's probably data. One of the problems is trying to understand how corporations operate at the international level through various corporate groups. The work that I did with Alfons Weichenrieder had German data that was quite unique at that time because the Bundesbank took into account where money was being invested, through stepping-stones. You could see several tiers of corporations in the corporate group.
In the data, we could observe capital going from Germany into a country like Luxembourg, and then going on to the U.S., as an example. That was a very unique data set.
I know that type of Canadian data is not available at all. All you can do is observe money going into the very first destination. In Canada, there's an amazing amount of capital invested in countries like Barbados, using the Canada-Barbados treaty. Those are for double-dip transactions, but you can't observe where the Canadian capital goes afterwards. That's a limitation of a lot of foreign direct investment data. You can only observe the capital flows on a first-destination basis.
We need to understand more about how different types of rules can impact investment decisions, both domestic and international decisions. For example, I recently did some work on a federal budget change of an anti-treaty shopping rule that the federal government was proposing in a budget. I could work out what that meant in terms of the cost of capital in Canada. But I couldn't say, "How much of that capital will be affected by that anti-treaty shopping rule?" If I was a minister of finance, I would be asking the question: “What is this going to do to capital investment in Canada, as well as to the amount of tax revenues I'm going get if we adopted this rule?” The data is just not there to do that type of evaluation, although in theory it's not hard to actually work through the results.
So in an ideal world in terms of data access, country-by-country firm-level data with corporate tiers would significantly enhance our understanding of profit shifting?
What solutions are there to address profit shifting?
Some people have argued for a cooperative approach, such as a formula allocation at the international level, and we have effectively done that with global financial traders because it's almost impossible to measure where profits are being earned anyway.
That certainly is one approach, but it's very hard to get international cooperation on a multilateral basis. I know that, in the Base Erosion and Profit Shifting (BEPS) exercise, the G20 and the OECD are hoping to get a multilateral approach, but I'm not confident that's going to happen. I think what will happen is that some countries will do what they want. But then there will be some that might say, "Well, you know what? Let's not worry about the corporate income tax as much anymore. Let's try to raise taxes from businesses in other ways that are less subject to the impact of profit shifting."
So is there a simple policy prescription that can work as a solution for an individual country and/or on a global basis?
No, I know that for domestic corporate taxes I have a very simple one-liner: Keep rates low and bases broad. But when you get to international taxation, a country can't control what other countries are doing, and it's like a third-best problem. You try to do the best that you can, keeping in mind that you want to have a domestic tax system that can be attractive for investment and raising revenue. You also want all your multinationals to develop international markets for export, for earning more rents that could be brought back home. You need a system that isn't too harsh either on international investments.
Because I don’t believe, and this is an important belief, that domestic and foreign investments are substitutes. I believe they are complements for many companies.
In fact, that's the working assumption here in Canada about foreign direct investment. The more you invest abroad, the more you enhance domestic activity at home, because of the complementarity of operations within the multinational.
How do you view a territorial versus a worldwide system in this context? Is any system better?
I always have trouble with the terms worldwide and territorial because, for example, in Canada, we tax corporate income on a worldwide basis, but we have an exemption for dividends from foreign affiliates paid to parents.
And that's what a lot of countries do. They all have worldwide systems, but very few have what I would call real territorial systems. A place like Hong Kong exempts all foreign source income.
We have been observing countries shifting away from taxing dividends or taxing all sources of income at the world level to introducing more exemptions. I do think that makes the tax base more sensitive to tax differentials because of the ease to restructure financing.
On the other hand, it's not easy to keep the other system either, because it's very complex and has all sorts of distortions associated with it. There are even ways of getting around it. Of course, experiencing the greatest cost is the U.S., where you have companies that are parking money outside the U.S. and not bringing it home in order to use as cash financing for investments in the U.S.
What major developments do you expect in the next one to two years?
We're going to see some tightening up. Part of this is reflecting the 2008-2009 financial crisis in which a lot of people were hurt by some very bad decisions made by financial businesses and governments, specifically with respect to mortgage markets in the U.S. and Europe. As a result, there's been anger towards the corporate sector. Politically, it's always valuable to go after corporations, to tax them as opposed to taxing individuals. Right now, there's been this balance that might still take some time—for people to look at other priorities on the agenda.
So essentially, multilateral cooperation will probably not work, and governments will try to find other ways to raise revenue from corporations?
How do you envision the future of the corporate tax base?
Over time, governments are going to be pushed in various directions. Politically, it's hard for governments to eliminate the corporate income tax, unless you have very significant changes in other aspects of the tax system. Countries have been either broadening their tax base because they are keeping their corporate income tax rates low in order to attract profits to their jurisdiction, or they have been shifting towards non-income-related taxation, whether it's some sort of capital tax on assets or payroll tax, or sales and excise taxes on inputs, like fuel taxes or property taxes. There are ways governments can make up the money where the tax base is harder to move internationally.
I know that back in 1997, when I chaired the tax reform commission in Canada I spoke of earlier, we did a very interesting analysis on business taxation relative to business value-added and looked at all the different types of taxes paid by businesses. We showed that over the previous 40 years there had been a quite significant shift away from business income-type taxes to non-profit-sensitive taxes.
See “Is There a Future for Capital Income Taxation?” for an overview of Dr. Mintz’s earlier thinking on the future of the corporate tax base in a world with increasing capital mobility.
What are some of your own favorite papers or resources related to profit shifting?
I mentioned the Jog paper that has some interesting results. I've always liked Harry Huizinga's papers in looking at tax base sensitivity and the work that Jim Hines has done. And also Kimberly Clausing, some of her work has been very interesting.
How about some of your own papers, specifically?
Well, I think the study that Michael Smart and I did was useful, and I know it's a seminal paper in the literature. I always felt my conduit paper and the work that I did with Alfons Weichenrieder, the MIT book, was a very useful statement on a lot of these issues. In fact, the MIT book probably provides the most comprehensive discussion around issues related to international taxation, at least at the time it was published. Probably in five years' time there will be a need for a new book.