International Tax Evasion: What Can Be Done?

Multinationals save hundreds of billions of dollars by offshoring income and manipulating their books—and it's perfectly legal. By Reuven Avi-Yonah / The American Prospect May 30, 2016 Photo Credit: Shutterstock.com/Jeff Wasserman Sam Wyly is a rich Texas businessman. In 2006, Forbes estimated his net worth as $1.1 billion. He and his brother Charles made their money in computers, a steakhouse chain, and Michael’s Arts and Crafts, which they bought in 1982 and sold in 2006 to a group of private equity firms, including Bain Capital, for $6 billion. Sam is a major philanthropist: A $10 million gift resulted in the naming of Sam Wyly Hall at the University of Michigan Ross School of Business. He is also an avid Republican. In 2004, Sam Wyly helped finance the “Swift Boat” ad campaign that scuttled John Kerry’s bid for the presidency. But Sam Wyly is now bankrupt. In 2006, a hearing of the U.S. Senate Permanent Subcommittee on Investigations (PSI) revealed that he had been evading U.S. tax laws by hiding his money in trusts in the Isle of Man, a notorious tax haven. He began by transferring stock options from his various companies to the trusts, which were managed by Isle of Man trustees. The nominal trust beneficiaries were two foreign charities, but the six Wyly children were contingent beneficiaries, and the trustees understood that at Sam’s death the children would become the true beneficiaries and collect the funds. In the meantime, the trusts were free to exercise the stock options and use the stock for investments, with the understanding that ten years down the road they would have to make annuity payments to Sam. Sam obtained an opinion from a law firm that this arrangement worked to defer taxes on the income gained from exercising the options until he began receiving annuity payments years later. But the linchpin of the legal opinion was that the offshore trusts were independent actors when, in fact, Sam exercised total control over the trust assets, secretly using the investment profits to operate businesses and buy real estate, jewelry, and artworks in the United States. The Wylys’ secret control over their offshore funds was revealed in the PSI hearing. In 2010, the SEC charged Sam and Charles Wyly with securities fraud based on Sam’s hidden control of the offshore trusts. In 2014, a jury found him liable. To avoid paying a $300 million judgment, he filed for bankruptcy, which triggered a tax assessment for his failing to pay any taxes on hundreds of millions of dollars in offshore income since 1992. He is currently battling the IRS in bankruptcy court over a tax assessment totaling more than $2 billion. How many Wylys are hiding their money from the IRS, with no PSI hearing to bring their misdeeds to light? We will probably never know. A recent estimate of the global costs of illegal tax evasion by the economist Gabriel Zucman was $200 billion, but this is probably too low since estimates for the U.S. alone range from $20 billion to $70 billion. Every time a Swiss banker talks, many billions in U.S. tax evasion are revealed. The IRS Offshore Voluntary Disclosure Program has netted over $6 billion and counting. And this is only for illegal tax evasion by individual taxpayers. Because the evasion hides taxable income, it’s hard to quantify with any precision. Corporations are another story, because what they are doing is legal tax avoidance—manipulating their books to avoid taxation—and therefore the magnitudes can be better quantified. As of the end of 2015, U.S. multinationals had more than $2 trillion in offshore profits in low-tax jurisdictions. This amount, which translates to about $700 billion in U.S. taxes avoided, is mostly income that was economically earned in the U.S. and shifted offshore to jurisdictions like Singapore, Ireland, or Luxembourg, which have effective tax rates in the single digits. The Corporate Tax Dodge How do the multinationals do it? A couple of examples can suffice. Apple Inc. is the world’s largest company by market capitalization. Most of its billions in profits relate to intellectual property developed at its headquarters in Cupertino, California. But for tax purposes, most of the profit is booked in its Irish subsidiaries—let’s call them Apple Ireland. Importantly, none of the actual work is done by Apple Ireland. Apple just gives Apple Ireland the money and Apple Ireland pays it back as its contribution to the research costs. Some of the profit-shifting is achieved through a “cost sharing agreement.” Cost sharing is a concept developed in IRS regulations in the 1980s, but it became more significant due to the increasing importance of intellectual property. The idea behind cost sharing is this: When a U.S. multinational begins a new research project (for example, a search for a drug to treat a certain disease), it can agree to share the costs of development with its offshore subsidiaries. Then, if the project is successful, the parties share the profits in the same proportions. For example, if Apple Ireland contributed 80 percent of the costs of developing the iPhone 6, it would get 80 percent of the profit. Importantly, none of the actual work is done by Apple Ireland. Apple just gives Apple Ireland the money and Apple Ireland pays it back as its contribution to the research costs. Why would the IRS regulations permit this? Because if the research failed, then the taxpayer would lose its ability to deduct the costs sent offshore. The more of the cost sent offshore, the more deductions would be at risk. So the IRS thought there was a natural limit to taxpayer willingness to share costs with offshore affiliates. That analysis may have been true for Big Pharma, which usually waits to enter into cost sharing with an offshore affiliate until a drug has passed its initial trials and is well on its way to a patent, and then battles the IRS over valuation issues at the time the cost-sharing agreement was executed. But the same analysis makes no sense for Apple, since if there is anything certain in business, it is that a new version of the iPhone will sell. There is another trick involved in Apple Ireland’s profitability. Another portion of its profits derive from countries where Apple sells the iPhones. Apple Ireland licenses the right to use Apple’s brand and intellectual property to Apple affiliates in other countries. Those affiliates in turn pay Apple Ireland hefty royalties, which operate to shift the sales profits gained in those countries to Ireland. Before 1997, such a scheme would not have worked, because the royalties received by Apple Ireland would have triggered a tax in the U.S. under so-called Subpart F, which was designed to prevent foreign corporations from taking advantage of inconsistencies between U.S. and foreign tax law. But in 1997, the Clinton administration adopted a rule called “check the box.” Under “check the box,” Apple Ireland can, for U.S. tax purposes, treat all of its foreign affiliates as if they did not exist as separate entities, and treat the money they paid to Apple Ireland as income earned in Ireland. The result is that, for U.S. tax purposes, there are no royalties and no U.S. tax triggered by them, because Apple Ireland treats the money as its own sales income. The Obama administration came in promising to repeal “check the box”; this was the biggest international revenue raiser in the first Obama budget. But by its next budget in 2010, the administration recanted under pressure from the multinationals. Recently, Obama signed into law a five-year extension of a provision (first enacted by a Republican Congress as a “temporary” measure in 2006) that enshrines “check the box” in the tax law. Finally, the Senate hearing revealed two Irish-specific tricks used by Apple. Ireland has a tax rate of 12.5 percent, far below the U.S. rate of 35 percent. But Apple did not want to pay even 12.5 percent. Its solution was ingenious: For U.S. tax purposes, Apple Ireland is treated as an Irish company because it is incorporated in Ireland, so it is not taxed by the U.S. But for Irish tax purposes, Apple Ireland was treated as an American company because it is “managed and controlled” from California. As a result, Apple Ireland claimed it was a tax resident nowhere. On top of that, it negotiated a sweetheart tax deal with Ireland for its Irish income, which resulted in its paying a tax rate of less than 2 percent. These types of tricks are used by most U.S. multinationals. If the primary driver of value of a U.S. multinational is intellectual property developed in the U.S., the Apple scheme can simply be replicated. But what if the value derives from more traditional, tangible items? Some U.S. multinationals do pay higher taxes (e.g., the car companies). But others try to avoid tax nevertheless. Caterpillar Inc. is a good example. Caterpillar does not make a lot of money on the heavy equipment it manufactures. But it makes a bundle on replacement parts, because once you buy a Caterpillar bulldozer, you will need parts, which you can obtain only from Caterpillar at a huge markup. Caterpillar prides itself on its ability to deliver parts within 24 hours anywhere in the world, including the Arctic tundra (where its equipment is used in mineral extraction). Before 1999, Caterpillar bought the parts from unrelated manufacturers and stored them at its warehouse in Morton, Illinois. When a dealer requested a part for a customer overseas, Caterpillar “sold” (but did not actually ship) the part to a Swiss subsidiary, which in turn sold the part to the unrelated dealer. The problem, according to accounting firm PricewaterhouseCoopers, was that Caterpillar’s sale of the part to its Swiss subsidiary triggered U.S. taxes. Much better, PwC said, would be if the parts were sold by the manufacturer directly to the Swiss subsidiary, which could then sell them to the dealer. The result was that Caterpillar continued to run its parts business from the U.S., but declared 85 percent or more of the parts profits in Switzerland. Fine, said Caterpillar, but we do not want to change our operations. So in exchange for more than $55 million in fees, PwC came up with a way to lower Caterpillar’s U.S. tax without changing its operations. PwC’s solution was for the manufacturers to bill the Swiss subsidiary for the parts but continue to ship them to the Illinois warehouse, which continued to transport them to Caterpillar’s foreign customers. If the parts were shipped overseas, they were deemed to have been “owned” by the Swiss subsidiary, and PwC devised a virtual inventory to track them, even though the parts were indistinguishably commingled in the warehouse. The result was that Caterpillar continued to run its parts business from the U.S., but declared 85 percent or more of the parts profits in Switzerland. The IRS has now challenged this billing arrangement, which resulted in shifting some $2.4 billion in Caterpillar profits from the United States to Switzerland. A grand jury has issued subpoenas under a criminal investigation for tax fraud. But the disturbing fact is that the whole story would not have come to light but for a whistleblower, who alerted both PSI and the IRS. And while Caterpillar is facing a court challenge, in most cases of corporate tax avoidance, like Apple, the IRS’s hands are tied, because what Apple did may have been legal under the U.S. tax code. Addressing Tax Evasion What might be done to reform this massive loss of revenue? Consider first outright tax evasion. In the case of tax evasion like Sam Wyly’s, Congress has acted decisively. In 2010, it enacted the Foreign Account Tax Compliance Act (FATCA). Under FATCA, any foreign bank or other financial institution has to report to the IRS accounts held by American citizens and residents. The penalty for failure to comply is a hefty 30 percent tax on the foreign bank’s U.S. income. FATCA has real teeth, as the chorus of complaints by foreign banks and their governments shows. It also led to real developments. The Offshore Voluntary Disclosure Program, which has netted more than $6 billion in taxes, is a child of FATCA. So are more than 100 “intergovernmental agreements” (IGAs) that the U.S. Treasury has negotiated with various countries. Under the IGAs, the foreign banks can disclose the information about U.S. account holders to their government, which can turn it over to the IRS. This avoids legal problems from the banks dealing directly with the IRS, which is illegal in most countries. Even Switzerland has signed an IGA. In addition, more than 80 countries (including the U.S.) have signed a Multilateral Agreement on Administrative Assistance in Tax Matters (MAATM), which envisages automatic exchange of tax information among the signatories, using a common reporting standard developed under FATCA. U.S. Ambassador to Moldova William Moser and Moldovan Finance Minister Anatol Arapu sign an intergovernmental agreement to implement the Foreign Account Tax Compliance Act (FATCA) in 2014. But problems remain. First, FATCA itself is vulnerable because it can be avoided by using a foreign bank with no U.S. exposure. In addition, its disclosure obligations apply only to larger accounts and can be avoided by tax cheats opening smaller accounts at multiple banks. So secret offshore accounts are still possible, although the cost of tax evasion and the risk of discovery have increased. Second, these agreements depend on compliance by long-standing tax havens, an outcome that is far from certain. In addition, the IGAs require reciprocity from the U.S., and while U.S. regulations that require U.S. banks to collect the information for reciprocal exchanges have prevailed in initial court proceedings, they are still subject to vigorous judicial challenges. Third, the U.S. has signed, but not ratified, MAATM, and it seems unlikely that it can be ratified in a Republican-controlled Senate. Finally, the entire edifice rests on an uncertain foundation. For exchange of information to work, every single tax haven needs to cooperate, because otherwise the funds will flow to the non-cooperating havens. Total tax haven cooperation seems unlikely, to say the least, absent stiff sanctions that go beyond the U.S. 30 percent FATCA tax, such as a mechanism to cut off an offending tax haven’s banks from the international wire-transfer system. In the past, world leaders have threatened sanctions against uncooperative tax havens, but never actually imposed them. Economists like to imagine universal solutions to the tax-evasion problem (such as the global tax on wealth proposed by Thomas Piketty, or the universal registry of financial assets advocated by Gabriel Zucman), but in the world we have, such solutions are utopian. Automatic universal exchange of information is likewise a nice ideal that may be implausible in practice. There is an easier solution. The key observation is that funds cannot be invested in tax havens because they are too small (even Switzerland is a small economy if one ignores the banking sector). And they must be invested in the U.S., the EU, or Japan to avoid undue risk since most portfolio investors do not invest directly in emerging markets because of the political and economic risk. Therefore, if the U.S., the European Union, and Japan were to agree to impose a tax on income flows to tax havens, the tax-evasion problem would largely be solved without the need for cooperation from the havens. Using a 30 percent tax (the U.S. rate under FATCA) will do the trick. Investors will be faced with the choice of paying 30 percent on their gross interest, dividends, or capital gains, or declaring the income to their home jurisdictions and paying a net tax at that jurisdiction’s rates. What prevents this obvious solution from happening is that the U.S. is willing to aid and abet tax evasion by Europeans, while the EU is willing to aid and abet tax evasion by Americans. This reflects the political power of corporations on both sides of the Atlantic. What prevents this obvious solution from happening is that the U.S. is willing to aid and abet tax evasion by Europeans, while the EU is willing to aid and abet tax evasion by Americans. This reflects the political power of corporations on both sides of the Atlantic. (In contrast, Japan already imposes such a tax, demonstrating its feasibility.) What may change the status quo is that both sides have come to realize that U.S. residents can pretend to be Europeans, and EU residents can pretend to be Americans, widening the incidence of tax evasion in both countries. To stop the tax cheating, the EU is willing to impose anonymous withholding taxes on foreign account-holders; even Switzerland entered into such an agreement with the U.K. The U.S. should go along. Importantly, given likely Republican control of Congress, no change in law is necessary: The U.S. code already provides that withholding taxes can be imposed on payments to countries that do not have effective exchange of information. The Obama administration could apply this provision tomorrow if it had the political courage to do something about tax evasion. Battling Tax Avoidance Ideally, the solution to tax avoidance by multinationals is for each country to tax the value that was economically generated by them in their locale. Many such proposals have been advanced. Most call for some type of “unitary taxation” in which the global profit of the multinational is allocated by formula, like the way American states allocate profit among themselves for corporate tax purposes, based on where sales are generated and where property and personnel are located. The most recent proposal along those lines is from the European Commission. The problem is that such unitary-tax/formulary-apportionment proposals face fierce opposition. The recent Base Erosion and Profit Shifting (BEPS) project of the G20 and the Organisation for Economic Co-operation and Development has summarily rejected the idea of unitary tax solutions. Moreover, unitary tax would require rewriting more than 2,500 tax treaties that are based on treating each company in a corporate group as a separate taxpayer. This is a tall order. Some progress along these lines can be made under BEPS, such as the new requirement that multinationals reveal to tax administrations (but not to the public) how much profit they made in each jurisdiction they operate in. But it will take many years to develop a workable unitary tax proposal. The EU proposal is only for operations within the European Union. While unitary taxation is technically feasible and may be the best long-term solution to taxing multinationals, the fierce political opposition means that it is not likely to happen in the near term. What can be done in the meantime about the $2 trillion that U.S. multinationals report in low-tax jurisdictions? The multinationals themselves are clear: They want to be able to bring this money back to the U.S. without paying taxes on it. This is the point of recent bipartisan proposals, like the one developed by Senators Chuck Schumer and Rob Portman, for a “territorial” tax system. But this makes no sense. Even if the U.S. should care primarily about the competitiveness of its multinationals, competitiveness clearly is not affected when the U.S. taxes income that has already been earned. The U.S. can and should tax the $2 trillion in full. $700 billion is a lot of revenue, even in Washington. For the future, the best solution is for the U.S. to cut its corporate tax rate but apply it to all the earnings of its multinationals currently. Abolishing “deferral,” as the ability to delay tax on offshore earnings is called, can enable a revenue-neutral corporate tax reduction from the current nominal rate of 35 percent to about 30 percent. If we also abolish other useless tax expenditures, like accelerated depreciation and the credit for domestic manufacturing, the rate can be brought down to 28 percent, which is about average for the G20. This proposal has bipartisan support as well. But the multinationals are predictably opposed, arguing that taxing them currently would harm their ability to compete and lead more of them to expatriate to places like Ireland—Pfizer recently announced its plans to do so by merging with Allergan, a formerly U.S.-based multinational that expatriated to Dublin. In my opinion, the economic threat of such expatriations, or “inversions,” is a red herring—if Congress will only act to prevent the tax losses. Most of these inversions involve mergers with other U.S. corporations. In reality, nothing much changes in these transactions, because the corporate headquarters and the jobs that go with it remain in the U.S. So I do not think the threat of inversions is something the U.S. should really care about, although the U.S. could prevent revenue loss by, for example, defining any corporation whose headquarters is in the U.S. as a U.S. resident for tax purposes. (This would also prevent the Apple Ireland “tax nowhere” residency trick.) Moreover, reducing the corporate rate and even adopting “territoriality” will not stop inversions, because there will always be lower rates somewhere. The main reason to invert is to shift profits from the U.S. to the new residency jurisdiction. Even if the U.S. rate is 25 percent and we have territoriality, as the Republicans have proposed, a U.S. multinational can still cut its tax bill in half by inverting to Ireland and shifting profits there. If the offshore income were taxed currently, then they could bring it home at any time without further tax consequences. The advantage of imposing a lower U.S. corporate tax rate on all the profits of U.S. multinationals is that it would solve the “lock-out” problem, in which the $2 trillion is “trapped” offshore because the multinationals will not pay the 35 percent tax on bringing the money home. If the offshore income were taxed currently, then they could bring it home at any time without further tax consequences. Taxing U.S. multinationals at 28 percent on worldwide income is unlikely to put them at a competitive disadvantage, for two reasons. First, the effective tax rate on worldwide income of their main competitors from the EU and Japan is similar, because these countries have tougher rules about profit-shifting than the U.S. They do not have “check the box,” and, in general, they tax currently any subsidiary that does not have real operations in its country of residence and that is subject to a low effective tax rate there. Apple Ireland or Caterpillar Switzerland would have been taxed in full had they been owned by parent corporations from France, Germany, or Japan. Second, the Japanese already apply this rule to all their subsidiaries, and the European Commission has proposed it for all subsidiaries of EU-based multinationals. Under the EU proposal, any subsidiary would be taxed currently in full on income that derives from investments or from sales to related parties if it is subject to an effective tax rate below 40 percent of the home-country tax rate. Therefore, if the U.S. taxed its multinationals currently at 28 percent on worldwide income, the other G20 nations (none of which have a corporate tax rate below 20 percent) are likely to go along. No competitive disadvantage would result. A useful analogy is the prohibition on overseas bribes. Prior to 1977, there were no domestic limits on multinationals paying bribes overseas to obtain contracts from corrupt government officials. In 1977, following several scandals, the United States enacted the Foreign Corrupt Practices Act, which imposed criminal sanctions on such bribes by U.S.-based multinationals and their executives. Predictably, U.S. multinationals complained that this ban put them at a competitive disadvantage, especially when other countries like Germany permitted foreign bribes to be deducted for domestic tax purposes. Somewhat surprisingly, the outcome was not relaxation of the U.S. law. Instead, the Clinton administration successfully pushed the OECD to adopt the same provisions as part of a binding, multilateral treaty, which eliminated the competitive disadvantage issue. A similar coordinated move in the tax area would solve the tax-avoidance problem once and for all. If nothing is done about these two problems, the rich will continue to evade the progressive income tax, and multinationals will avoid the corporate tax. If that happens, ordinary middle-class Americans will be reluctant to pay their taxes. Our tax system is built around voluntary cooperation; if most Americans refused to cooperate, the IRS could not force them to do so. As the Greek experience has recently demonstrated, once a tax culture of non-payment is established, it is very hard to change. We need to do something about both evasion and avoidance before it is too late. Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law and director of the International Tax LL.M. Program at the University of Michigan.