Tax Reform Proposal Could Open Door to More Profit Shifting

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Terry Sheridan
Columnist
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Shifting the United States to a territorial tax system akin to what many other countries use could prompt hundreds of financially constrained companies to shift income abroad. But the tax loss would be more modest than naysayers fear, according to a recent study published by the American Accounting Association.

The findings of The Effect of Financial Constraints on Income Shifting by US Multinationals, published in the November issue of The Accounting Review, comes at a time when corporate tax avoidance and reform of international taxation is high on legislators’ agendas.

Key issues are twofold: How to change the way the US taxes corporate foreign earnings, which at 35 percent is the highest in the world and motivates companies to keep earnings offshore. And, would a shift to a territorial system that exempts foreign-earned income from the corporate tax deplete tax revenues?

The study finds that, indeed, hundreds of currently financially constrained companies would shift income abroad. Authors Scott D. Dyreng of Duke University and Kevin S. Markle of the University of Iowa based their findings on the effect of financial constraints (the lack of readily available cash to meet domestic expenses) on income shifting by 2,058 US-based multinationals from 1998 through 2011. The professors caution, however, that their findings do not include all US multinationals.

If a territorial system had been in place during that time span, the financially constrained firms in the study would have shifted $80 billion more of their earnings out of the United States. Assuming that the companies paid the 35 percent corporate rate on the income that wasn’t shifted, the federal government would have lost $28 billion during the 14-year period.

“We estimate that financially constrained firms shift out 20 percent less of preshifted income than unconstrained firms,” the professors wrote. “Translating this percentage to dollar values, the mean (median) constrained firm shifts $16 million ($7 million) out of the US each year while the mean (median) unconstrained firm shifts $321 million ($134 million) out of the US each year.”

The professors estimate that changing to a pure territorial tax system would increase outbound income shifting by US multinationals by 8 percent.

Meanwhile, companies that are not financially constrained, and don’t have to tap into their foreign earnings to pay expenses at home, can let the profits sit in lower-tax countries and defer paying federal taxes on them. That, the professors find, is a de facto territorial system.

To get those benefits, however, US companies must leave the earnings abroad and bear the cost of having them trapped in foreign jurisdictions, the authors state.

“Research suggests that trapped earnings create frictions in internal capital markets, increasing demand for external financing,” they wrote. “Therefore, if a US firm is financially constrained, such that external financing for domestic cash needs is prohibitively expensive, it may not be cost-effective to leave income abroad.”

The professors did not examine shifting that may occur among the foreign subsidiaries of US corporations and did not study shifting to or from the United States by foreign firms. They focused on how financial constraints interact with the US tax policy of worldwide taxation with deferral to influence the amount of income that is shifted out of the United States by US multinationals.

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