Targeting Multinational Corporations’ Tax Avoidance

Many developed countries around the globe face sever fiscal problems as a result of aging populations and sluggish economic growth.  In light of these fiscal problems, politicians have put tax increases on the table for discussion.  In fact, the United States just raised taxes on high-income taxpayers as a result of the “fiscal cliff” legislation in early January 2013.  In addition, spending cuts- or at least reductions in the rate at which government spending is increasing- are seen as necessary by many commentators.

Multinational corporations are a ripe target in any reform of the U.S. tax system.  Many of these large companies pay a surprisingly low tax rate on their substantial foreign earnings despite the 35 percent tax rate that corporations are subject to under the Internal Revenue Code.  For example, Google paid only a 3.2 percent tax rate on its foreign earnings in 2011.  Although the United States taxes U.S.-based corporations on their worldwide income, the tax code provides a key exception to this rule: foreign earnings from an active business are not subject to U.S. tax until those earnings are repatriated to the United States.  A multinational corporation can benefit greatly from this exception.  For example, it can set up a subsidiary in a low-tax jurisdiction such as Bermuda and assign intangible property such as patents to this subsidiary.  The multinational’s operating subsidiaries in other countries use these patents and pay interest and royalties to the subsidiary in the low-tax jurisdiction.  This has the effect of decreasing the operating subsidiaries’ income subject to tax while routing the multinational’s profits to the low-tax jurisdiction.  These profits are then held in the low-tax jurisdiction to avoid the U.S. tax that would be due on repatriation.

Some corporations defend their tax breaks as the result of responding to incentives that foreign governments offered them.  For example, Ireland’s low corporate tax rates attracted various international companies, which contributed to the pre-2008 “Celtic Tiger” period when Ireland’s economy grew rapidly.  As Google’s Eric Schmidt unapologetically said in 2012 when addressing his company’s low effective tax rate in England: “I am very proud of the structure that we set up. We did it based on the incentives that the governments offered us to operate. . . . It’s called capitalism.”

With growing income inequality in the United States, there is a good chance that multinational corporations will soon be viewed as the corporate version of the “1 percent.”  Many tax experts agree that the nominal corporate tax rate of 35 percent is too high and makes the U.S. less competitive.  But any reduction in the corporate tax rate is likely to be accompanied by a “broadening” of the tax base and reform of the lenient tax rules governing multinationals’ foreign earnings.