Profit 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.
Why Do Companies Shift Profits?
The key incentive for profit shifting is not the domestic tax rate on foreign income, but the difference between the tax rate on income registered abroad and income registered in the U.S.
Businesses will likely shift profits generated by IP (intellectual property) to lower-tax jurisdictions, and high corporate taxes may lead to lower investment in higher-tax jurisdictions. This is usually done when a multinational parent company registers its IP in a low-tax country and then makes royalty payments to its foreign subsidiary, or when it finances operations from a low-tax country and has deductible interest payments in a high-tax jurisdiction.
A 2018 review notes that studies of profit-shifting levels consistently show that as statutory tax rates rise, reported profits decline. Estimates of profits shifted from high-tax jurisdictions to low-tax jurisdictions range from 5 percent to 30 percent.
This erodes the corporate income tax base in high-tax countries.
Limiting Profit Shifting
The OECD/G20 Base Erosion and Profit Shifting (BEPS) project has led many countries to address profit-shifting opportunities with tighter transfer pricing regulations, controlled foreign corporation rules, country-by-country reporting of tax data, and limits on interest deductibility. Cumulatively, these policies have increased government revenues from corporate taxes while changing the incentives for profit shifting and real investment.
The Tax Cuts and Jobs Act (TCJA) of 2017 sought to address profit shifting by U.S. multinational corporations using several key policy changes: cutting the statutory corporate tax rate from 35 to 21 percent, the Base Erosion and Anti-abuse Tax (BEAT) and the limitation on interest deductions, Global Intangible Low-Taxed Income (GILTI), and the Foreign-Derived Intangible Income (FDII) deduction providing a preferential 13.125 percent tax rate on this income if booked in the U.S.
Combined, the policies substantially reduced profit-shifting incentives for U.S. multinationals.
Today, the OECD is working on a Global Tax Deal that aims to further reduce incentives for tax planning and avoidance by U.S. and foreign multinational companies by limiting tax competition and changing where companies pay taxes. This plan was broken into two pillars: Pillar 1 is focused on expanding a country’s authority to tax profits from companies that make sales in this country but don’t have a physical presence, and Pillar 2 would establish a global minimum tax.
The deal has been met with resistance, but if passed, could increase the effective average tax rate on multinationals by roughly 0.7 percent across the globe and limit tax planning and avoidance.
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