Profit-Shifting Structures: Making Ethical Judgments Objectively, Part 1

Abstract

MNCs and their advisors have seemingly taken ethics out of the mix when considering the profit-shifting tax structures they have so prolifically and enthusiastically implemented over the past several decades. There may be a variety of reasons for this. First, U.S. tax law is a self-assessment system, meaning that in most cases taxpayers compute and pay tax without advance approval of their tax positions from the IRS. No third party technical test or propriety standard has to be passed on the front end for any tax strategy or structure. Second, direct personal benefits accrue to management and advisors from implementing such structures, often measured, either, directly or indirectly, by a structure’s short-term success. Stock options and stock issued under performance share plans become more valuable more quickly, bonuses are higher, promotions may be faster, and professional advisors earn more fees and enhance their reputations and client relationships. With no up-front objective test to determine if the planning will survive later scrutiny and the fact that everyone else is doing it, there’s an easy inference that it represents good business practice. Third, some Congressional actions have encouraged and enabled such questionable and problematic tax strategies.

MNC boards of directors, senior management, and professional advisors need an objective ethical benchmark to test the appropriateness of their profit-shifting structures and any new strategies they might consider. Given the strong motivation to implement such structures, a counterweight is needed to balance the unfettered acceptance and adoption of profit-shifting strategies based solely on the mere possibility that they might pass technical tax scrutiny by the government. Greater thought needs to be given to whether these plans are consistent with and serve the long term objectives of the MNC and its many global stakeholders. Stating this proposition more directly, it is time to ask if all of these stakeholders would accept the efficacy of these structures if they were made fully aware of and understood the technical basis, the strained interpretations, the hidden arrangements, the meaningless intercompany agreements, the inconsistent positions, and the lack of change in the business model for the schemes proposed or already implemented.

This article presents an objective ethical benchmark to test the acceptability of certain profit shifting structures. In addition, the benchmark is defined solely from a U.S. perspective, though it is applicable to all MNCs that conduct U.S.-centric businesses. Thus, it applies to non-U.S.-based MNCs that have inverted or that have acquired U.S. MNCs. The concept behind this benchmark could also be applied in other countries in which global businesses are headquartered and conducted.

In brief, this ethical benchmark requires an examination of the factual situation for each of an MNC’s low or zero taxed foreign group members regarding three factors, which are: (a) identification and location of critical value-drivers, (b) location of actual control and decision-making of the foreign group member’s business and operations, and (c) the existence or lack thereof of capable offshore management personnel and a CEO located at an office of the foreign group member outside the U.S. who has the background and expertise to manage, and does in fact manage, the entity’s business.

Through this examination, it should be possible to determine whether a foreign group member is recording income that is economically earned through business decisions and activities conducted in the jurisdiction in which it claims to be doing business. Where, however, the facts indicate that a portion or all of the business of the foreign group member is done substantially in the U.S. by U.S. based affiliates, the Congressional intent is clear. And that clear intent is to directly tax such income through the effectively connected income rules of the Internal Revenue Code.

This benchmark should be used by MNCs with the active participation of board and management members. An MNC could also use this approach to proactively respond to critics or to demonstrate its tax bona-fides.

This article concludes by suggesting a number of steps to be considered by MNC Boards, professional tax advisors, and the Congress, Treasury and the IRS, with a view to improving the quality and outcomes of tax strategies, corporate governance, and the equitable collection of taxes. The suggestions include actions that could be instituted by Treasury and the IRS without the need for any Congressional action.

Part 2 of this article is available at: http://ssrn.com/abstract=2811280

Keywords: Profit shifting, international taxation, corporate governance, effectively connected income, ECI, Apple, Caterpillar, Microsoft, subpart F, transfer pricing, check-the-box

JEL Classification: H21, H25, K34, E62