Making Sense of Profit Shifting: Pam Olson
June 18, 2015
Pam Olson is the U.S. Deputy Tax Leader and Washington National Tax Services Practice Leader at PwC.
Ms. Olson is one of the foremost experts on U.S. domestic and international tax policy. She is a frequent speaker on tax and federal budget matters and has testified before Congress on multiple occasions.
Previously, Ms. Olson served as Assistant Secretary for Tax Policy at the U.S. Department of the Treasury and Head of the Washington Legislative Practice at Skadden, Arps, Slate, Meagher & Flom.
Ms. Olson is the first woman to serve as Chair of the American Bar Association Section of Taxation and has been included repeatedly in Chambers USA: America’s Leading Lawyers for Business and the Best Lawyers in America for tax law.
Ms. Olson received her B.A., M.B.A., and J.D. from the University of Minnesota.
In this interview with the Tax Foundation, Ms. Olson discusses tax competition, the importance of a consensus on taxing jurisdiction in the international trading regime, multilateral cooperation and the BEPS project, challenges in determining value added on a geographic basis, and why the focus on profit shifting is misdirected. This interview is part of our 2015 Tax Foundation Forum series and has been edited for clarity and length.
Tax Foundation: How is the profit shifting phenomenon changing international taxation?
Pam Olson: The first thing I want to do is take issue with the question because it begins without taking notice of the way business operations have changed in recent years. To my mind, the appropriate way to view international taxation is to begin with the way global companies operate today. Even if we were talking about a domestic company, it would likely be a part of a global supply chain or its products and services would feed into a global supply chain in some way. If a company isn't directly engaged in the global marketplace, it's indirectly there because it's providing goods and services to a company that's engaged in the global economy.
Once a company is engaged in the global economy, then it has to determine where value is added because it will have to file returns and pay tax in each country where it has operations. That's relatively easy if you're dealing with a third party. But if the company is dealing with a related party, say it's an intra-company transaction that's crossing borders, then the company has to figure out the proper way to price products and services so that it has the right amount of profit allocated to each of the jurisdictions where the company has operations.
That might be on the assembly or manufacturing side, or through the initial R&D to develop a product or intangible, or through the provision of services, or in the context of a marketing and distribution chain. There may be value added in any of those contexts.
Determining where and how much value is added is complicated in the best of circumstances and a somewhat subjective exercise. It's increasingly so today, because supply chains are increasingly complicated. There are much more sophisticated operations required in both provision of services as well as in the process of product assembly or manufacture of goods. The need to price goods as they cross borders among related parties has long been a requirement of the tax law, but it's become increasingly complex.
Today's turbulent tax environment means that the only certainty a company has when determining the appropriate income to allocate to the jurisdictions where R&D, manufacturing, and marketing occur is that each of those jurisdictions is likely to ask for more. Tax authorities around the world seem emboldened by the OECD’s BEPS project to claim a larger piece of global profits for themselves, justified by reference to their “fair share.” Traditional norms around uniform international tax rules are being discarded in favor of expanded domestic tax bases.
The high U.S. tax rate (and our worldwide system) is a disincentive for U.S.-based companies to locate within the U.S. high-value intangibles that are meant, in particular, for markets outside the U.S.
Many arrangements have been put in place through which companies develop intangible property in a jurisdiction that has a lower tax rate or a system that is more conducive to global operations than the U.S. system. Globalization and challenges from foreign competitors operating under more competitive tax regimes only increase the pressure for U.S. companies to do so.
The bottom line is that whether it’s a U.S. headquartered company or a company headquartered somewhere else, there are the same kinds of issues: where to engage in the activities that generate high-value, intangible property, and where to retain ownership of the property so that it is advantageous both from the standpoint of taxes and of protecting the intellectual property.
TF: How about for governments? How is the profit shifting phenomenon changing government interaction?
Olson: In some sense we have two exercises. One is a real exercise and one is an exercise that is politically driven. As the global economy has expanded and companies have started reaching into markets in more countries around the globe—whether to sell their goods and services or as part of their supply chain—there is increasing investment in those countries. As investment increases, there's an increased interest on the part of governments to make sure that they're taxing the appropriate share of the profits of the multinational enterprises engaged in business within their borders.
That's the real exercise—the need to make sure that any company doing business within a jurisdiction is filing the appropriate returns, appropriately calculating taxable profits in that jurisdiction, and then paying tax on that amount.
The politically driven exercise is that a lot of governments recently have been questioning whether they're getting an appropriate share of profits from multinational firms. Demands for greater tax revenues are growing, driven by budget deficits and pressures for social spending, and large businesses, particularly large foreign (meaning “U.S.” to the rest of the world) businesses can be a politically expedient target. And that's probably the principal driver for the OECD’s BEPS project—the political rhetoric that abounds and that has gained populist support in a lot of different countries about whether or not their tax base is being eroded through the operations or actions of multinational businesses.
What are the unique factors or drivers underlying the profit shifting phenomenon?
Again, I'm going to take issue with the focus of the question on a profit shifting phenomenon. Phrased that way it’s a bit of a catch-22—the real question is about profit “determination” or “allocation,” which every multinational has to engage in to determine its worldwide tax liabilities under the established rules. Any tax authority seeking a greater piece of the tax pie will claim “profit shifting” has occurred. But setting that aside, there is a global tax competition. It's a global competition for investment. For a number of years, countries have seen that they could raise their citizenry’s standard of living and their gross domestic product by attracting foreign investment.
All the foreign investment that's occurred for several decades now has made the global banking institutions less important as a source of investment capital, in the developing world, in particular. Both developing and developed countries are always looking for more inbound investment, and one of the ways they can attract investment is by reducing their corporate tax rates, by putting in place incentives for research and development, or for the development of different kinds of innovative products, even if they're not the subjects of patents.
So governments have enacted incentives for companies to put patents in particular locations or to put innovations in particular locations.
Some of those incentives have been focused on the transfer on a nominal basis of a patent or some kind of innovation, technology, or know-how so that the government could attract a piece of the profits that it would tax at a low and attractive rate. As these governments see it, a small piece of a big number is much better than a large piece of nothing. Incentives based on nominal ownership have been under scrutiny by the OECD as an erosion of tax bases, and governments have agreed to eliminate regimes without substance after a transition period.
Lots of incentives have been put in place to attract investment. I think of Ireland as the leading example. Ireland recognized decades ago that a low corporate rate was a very good way of attracting foreign investment. They've been very successful at attracting investment, and it's not just nominal investment.
Companies have invested in research and development facilities and centers of excellence in Ireland. Various pharmaceutical companies, high-technology companies, and medical device companies have located manufacturing facilities and R&D facilities in Ireland. Ireland has developed the academic infrastructure and research infrastructure around those industries so that the country has become a magnet for that kind of investment, because it has the educated talent to add to the value of the products the companies seek to develop.
You mentioned you take issue with the notion of a “profit shifting” phenomenon. Why?
The terminology “profit shifting” implies that everything that's going on is a question of, ”How do I move dollars or profits?” as opposed to, ”Where do I put operations? How do I price those operations? How do I allocate global profits among the many countries in which I operate?" There is less profit shifting than movement of productive activities in response to a number of economic forces, tax being one of them, and figuring out how to assign the appropriate share of profits to the activity.
The shifting of profits to a low-tax jurisdiction or a no-tax jurisdiction certainly occurs, often in response to government incentives, but it is a small part of what is reflected in the profits reported in various jurisdictions around the world. “Profit shifting” seems to be used pejoratively to include any situation where profits associated with real economic activity and investment have been “shifted” to a lower-tax jurisdiction which becomes the new home for that activity and investment. It should be limited to situations involving the shifting of profits unaccompanied by those factors.
Profit shifting is getting all the attention, but it's less important than the sourcing of productive activity that is occurring and the real issues that surround how to value those activities. They’re the issues that are most important. There is a danger, however, that emotional appeals to stamp out “profit shifting” will be used to support an anti-tax competition movement. That’s a significant development. Traditionally, countries have utilized multinational organizations like the OECD to develop uniform, standardized tax rules for international trade in order to prevent double taxation that would harm international commerce—not to stifle competition among countries to be the source of jobs and investments.
You have highlighted the concept of value added a number of times, and I'd like to focus for a moment on the challenges in determining where that occurs on a geographic basis. So what are some challenges in determining where—in what jurisdiction—value added occurs or where the income of multinational firms should be booked?
So let's suppose we're dealing with a hypothetical high-technology company. Say it has 80-90 percent of its R&D activity here in the U.S. That’s where most of the scientists, engineers and researchers are. Then when it comes to assembling the product, they go to a low-cost manufacturing center of excellence like China, Vietnam, or Malaysia. They have the routine R&D done in, say, India, Israel, or Ireland.
The company's customers are around the globe. Some of its products may be specialized for the local markets, so there may be some level of activity in Europe, in Asia, in Latin America, and in the U.S. that is dedicated to making the product attractive to the markets in those areas of the world.
So now we've got global profits of, suppose, $1 billion. How do we divide up those profits among all the different countries where activities have occurred? We've got a lot of R&D here in the US. We've got manufacturing somewhere in Asia. We've got a little bit of R&D going on somewhere else in Asia. We've got some other kinds of R&D or product specialization efforts going on in Europe, Asia, and Latin America. And we've got sales everywhere around the globe.
Who gets to tax the global profit and what share of it?
Each country may have a different view of the share of that $1 billion of profit that they should be allowed to tax within their jurisdiction. For decades, we've used the arm's-length standard to price intra-company transactions, but some governments don't like the result the arm's-length standard produces and are contending for a different result.
Part of what's going on in the BEPS project is that countries are saying, for example, ”We want to look at the number of employees and since the company has more employees in our country, we think that we should get the bulk of the company's profits here.” Or: ”We're going to look at the size of the markets, and we think the market that is most significant is in our country, so on the basis of where the bulk of the sales are, we think the profits should be taxed here.”
On that basis, you will have countries arguing about how much of the $1 billion they should be allowed to tax.
The U.S. would look at this issue based on the long-standing arm's-length standard. Assuming that the value stems primarily from the R&D work that's being done in the U.S., then the U.S. should get the bulk of the profits.
Now, let's suppose the company did a cost sharing arrangement so that they shared the cost of the R&D work with Ireland, and Ireland had the right to sell the technology to the rest of the world outside of the U.S.
In that case, Ireland would have a claim on the profit from the sale of the product outside the U.S. that is attributable to the IP owned in Ireland.
Given the value of the R&D, other countries should get a smaller percentage of global profits based on the value of what they're contributing, because their activities—manufacturing or marketing and distribution—are routine. They don't generate large returns.
Every company is going to be different depending on where the value lies in their supply and distribution chains. There are many products today where parts of the manufactured item come from different countries. One small part will come from Malaysia, another from Singapore, or China, or Japan. Then maybe all the product parts go to another country, perhaps the U.S., and are assembled there for shipment around the world.
All those transactions—if they're intra-company transactions within the multinational group—have to be priced at an appropriate level so that the appropriate amount of profit gets assigned to each of the countries where the company has operations and is taxed there.
So are you suggesting that it’s essentially technically infeasible to accurately define where value added occurs on a geographic basis?
What I'm saying is that it's difficult to do. There are a lot of long, detailed rules for doing so, both in the U.S. regulations and in the OECD Transfer Pricing Guidelines. But detail and length should not be equated with precision. There is a significant amount of subjectiveness in what may appear to be objective, technical rules. We apply the arm's-length standard and try to determine how, if there were unrelated parties engaging in the transaction, they would price the transaction.
If each of these steps were between unrelated parties, at what price would they sell to another party? Conceptually, that seems like the right approach. No one will defend it as a perfect system, and it is subject to many legitimate criticisms, but it is better than any of the alternatives.
Why and for whom is it important to address profit shifting?
Multinational companies have to know, first and foremost, where to properly allocate the profits from their operations when there are goods and services that are crossing borders. Clear rules are needed simply to comply with tax and other reporting obligations.
Next, it’s important that, among governments, there is a consensus on taxing jurisdiction in the international trading regime. If countries don’t view the international tax rules as functioning or fair anymore, they're going to want to redraw the lines. That's what is happening in the BEPS project as a practical matter, even though that wasn't supposed to happen. We have governments that are effectively redrawing the lines about who gets to tax what income.
Assume, for example, we have a simple world, with just Canada and the U.S., and we trade with each other. Canada wants to make sure that it knows what share of a multinational company's profits should be taxed in Canada, and the U.S. wants to know the same.
So long as there is a clear consensus between the two governments on how profits are split between the two governments, it's easy.
What we have now is a lot of countries that are unhappy with the current regime, because they think they should get a greater share of multinationals’ profits.
Governments have come up with lots of interesting theories about how taxable income should be allocated among jurisdictions. Some governments will say: "Multinationals are getting huge value from our market, and that means we want an additional share of the companies’ profits."
That kind of claim wouldn't hold up under the arm's-length principle, which has been the worldwide standard for transfer pricing for decades. If a multinational sold its product at the country's border to an unrelated party for distribution and sale, the price at which the product crossed the border wouldn't change, assuming the multinational priced its intercompany transactions on an arm's-length basis. It would sell at the same price to the third party distributor as the intercompany transfer price.
All else being equal, that third party's profits would be the same as the share of profits the multinational would allocate to the market country. If the multinational does the distribution in the country itself, it shouldn't alter the result. Yet some governments are promoting the idea that the market access entitles them to a larger share of a multinational's global profits. Some governments have gone even further with novel proposals for finding that multinational businesses that don't operate within their borders nonetheless have a nexus that allows them to impose tax on a share of the profits. Taxation based on agreed principles seems to be getting short shrift recently, in favor of taxation based on results.
How can multilateral cooperation and the BEPS project help address profit shifting, or the intentional and artificial reallocation of income to tax-favorable jurisdictions?
I think that multilateral cooperation in trying to figure out where income should be taxed is key.
I said in the written version of my testimony before the Senate Finance Committee in March that there is no better organization to help sort out the competing rights of governments to tax income than the OECD. That is a role the OECD has played since it was first formed 50 plus years ago, taking over for the League of Nations and the UN. Since then, the OECD has been constantly involved in trying to help governments reach agreement on how to allocate profits.
Going back to the League of Nations, our guidepost has been the arm's-length standard. What we have right now is governments walking away from the arm's-length standard. And the OECD has had the difficult task of insisting that we adhere to the arm's-length standard at the behest of the U.S. and other developed countries, while recognizing that countries are walking away from it.
The OECD has played a critical role, and it is the only institution that at this point has the capacity to get governments to work together to retain an agreement on how to allocate profits.
But the OECD is not a legislative body. What it does is provide a framework that must be reflected in laws and in the cross-border treaties that governments enter into with other governments. And the unique confluence of events which led to the BEPS project seems to be testing, as never before, the ability of the OECD to maintain a framework based on uniform, consensus-backed rules.
What could the BEPS project mean for U.S. lawmakers, U.S. firms, and U.S. tax revenues?
The OECD will through the BEPS project try to set standards intended to determine how governments allocate profits and how they resolve disputes over the allocation of profits.
Then it's up to Congress to decide what to do with it. Other governments have parliamentary systems, so when their Treasury Department equivalent agrees to something at the OECD, it's pretty much a given that that government will then enact legislation that will implement whatever it is they agreed upon at the OECD.
We don't have a parliamentary system in the U.S. We have a system that Bill Thomas, a former Chairman of the House Ways and Means committee, used to describe as, ”The President proposes and Congress disposes.”
Congress doesn't have to follow whatever the Administration agrees to at the OECD. That's one of the shortcomings of the way the BEPS exercise has unfolded: the Administration did not go to Congress and have a discussion with Congress before it helped launch the project. As a result, it's not clear that Congress is behind the Administration.
For U.S. multinationals, the project has been quite a negative. The hope when the project started was that it would help to resolve growing disputes among governments as to which government had the right to tax the profits of multinationals. Instead of resolving those disputes, it seems to have resulted in more disputes.
Companies are increasingly finding governments taking positions that may have been considered as part of the BEPS project but that were not embraced as part of it. And they're doing it legislatively and through the audit process. So companies are finding themselves subject to assessments that are not consistent with current law and aren't consistent with the way the BEPS project is expected to come out.
Even in the developed world, we have governments taking unilateral actions. On April 1, the UK implemented something it calls a “diverted profits tax,” which has been nicknamed for an American company in the UK press. Australia last week said they were going to follow suit and enact their own so-called “diverted profits tax.” In the brief period since the BEPS project came to prominence, there have been a slew of unilateral taxation measures around the world aimed at American companies. Tax and trade agreements have historically included nondiscrimination protections to catalyze international trade and investment, but concerns have arisen that new rules purported to address base erosion and profit shifting issues are masking protectionist policies implemented through tax rules that discriminate against U.S. companies.
The heated rhetoric surrounding BEPS has turned out to be very negative for U.S. multinationals. The negative consequences for U.S. multinationals are also a negative for the U.S. Treasury, because U.S. multinationals will be paying increased taxes to foreign governments. Higher taxes paid to foreign governments means higher foreign tax credits being claimed in the U.S. and lower tax receipts to the U.S.
If Congress eventually enacts legislation along the lines of a territorial system, the BEPS impact will still mean lower tax revenues in the U.S. because additional foreign taxes will reduce the value of U.S. companies' stock prices. Less cash available for dividends and lower stock value means lower capital gains. That translates into diminished prospects for American workers. So, in total, a net negative for the U.S. Treasury and U.S. economy.
What major developments do you expect in the next 1-2 years with respect to international taxation?
I certainly hope that we'll see U.S. international tax reform over the course of the next year. If we don't get it over the course of the next few months, then politics likely dictates that we won't get reform until after the presidential election.
I think the BEPS project will be finalized and that we will see foreign governments begin to implement whatever is agreed to through the BEPS project. We're also going to see some foreign governments implementing things that were not agreed to as part of the BEPS project. That's going to have an adverse effect on U.S. companies, and ultimately it's likely to have an adverse effect on cross-border trade and investment.