At a hearing in Washington, D.C., last fall, U.S. Senator Carl Levin (D-Michigan) accused U.S.–based multinational corporations of systematically manipulating laws and regulations to avoid paying taxes. They may not be breaking the law, he said, but their "tax practices and gimmicks range from egregious to dubious validity."
The companies Levin singled out at the hearing do indeed use intricate strategies that enable them to lower their tax obligations. These same strategies are frequently used by global corporations based in Silicon Valley and other high-tech hubs. Some are huge companies with household brands: Google, Apple, Amazon. Others—start-ups and smaller tech companies—are also availing themselves of these complex tax strategies, which involve shifting ownership of intangible assets—primarily intellectual property—to overseas subsidiaries. "Every U.S. multinational and high-tech company of any significant size now has these international structures in place," says Eric Ryan, a tax lawyer at DLA Piper in Palo Alto. "It's routine at this point."
It may indeed be routine, but at a time when the United States and other countries face record budget deficits and legislators debate how to increase revenues, these practices are coming under heavy scrutiny. U.S. lawmakers accuse corporations of gaming the system by moving profits offshore so they can pocket billions of dollars that should be going into the nation's coffers. The Internal Revenue Service is cracking down on companies it believes are employing dubious practices to reduce their tax obligations to Uncle Sam. Compounding the issue, foreign governments that are struggling with deficits and revenue shortfalls are pointing fingers at multinational corporations headquartered in the U.S., angrily accusing them of manipulating the system and not paying their fair share of taxes overseas.
"There's no question, there's been an increased focus on these strategies," says John Warner, a partner at Buchanan, Ingersoll & Rooney in Washington, D.C., who specializes in international and corporate tax matters. "Regulators, legislators, and foreign governments are all taking interest."
The scrutiny is largely focused on a common corporate practice called "transfer pricing"—a term that describes how a multinational corporation allocates income and expenses among its worldwide affiliates for tax purposes. The practice, long-accepted under the U.S. tax code, has been used by companies for all types of goods and services for years, and more than 60 countries have adopted rules governing transfer pricing transactions.
But now companies are shifting their intangible assets—namely their intellectual property—to low-tax jurisdictions offshore and attributing expenses to countries with a higher tax rate. Critics say the companies are doing this strictly to lower their tax bills. And many, they attest, are a bit too creative with their accounting, so the valuations placed on their assets will work to the company's tax advantage. These types of profit-shifting arrangements cost the U.S. government as much as $60 billion in annual revenue, according to a study by Kimberly Clausing, an economics professor at Reed College in Portland, Oregon.
"At a time when we face such difficult budget choices, and when American families are facing a tax increase and cuts in critical programs from education to health care to food inspections to national defense, these offshore schemes are unacceptable," Levin said in a statement prior to the fall hearing.
What are these transfer pric ing schemes? There are variations, but they all involve arranging transactions between subsidiary companies to take advantage of the idiosyncrasies of varied national tax codes. The techniques are most prominently used by tech companies, which can easily shift large portions of profits to other countries by assigning intellectual property rights to subsidiaries abroad.
In one of the more popular and complex schemes used, a company will route profits through subsidiaries in Ireland, the Netherlands, and the Caribbean—all of which are low- or no-tax jurisdictions. A parent company will transfer some of its IP to an Irish incorporated subsidiary—a holding company "tax-resident" in a no-tax jurisdiction, such as Bermuda. The Irish company will then sublicense the IP to another subsidiary, which is tax-resident in the Netherlands. Both of these companies may have few, if any, employees and may even operate from a post office box. The Dutch company will in turn sublicense the IP to a second Irish subsidiary that is wholly owned by the first Irish company. That second Irish subsidiary, which is an operating company with an office and employees, will sublicense the IP to other corporate subsidiaries outside the U.S.
This intricate system enables a company to save on taxes in multiple ways: The second Irish company receives royalty payments for the licenses, but it only keeps a small amount of these, passing the rest to the Dutch subsidiary. It pays tax only on what it retains, and the royalties paid to the Dutch company can be deducted against the royalty income received. The Dutch subsidiary keeps a small amount and passes the rest to the first Irish subsidiary. Since that company is based, for tax purposes, in a tax haven such as Bermuda, those royalties are not taxed.
Subscribe to Corporate Counsel
