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International Taxation: What are the consequences of the U.S. international tax system?

The current U.S. system of international taxation encourages U.S. multinational firms to earn and report profits in low-tax foreign countries, primarily by allowing them to defer U.S. tax on their foreign-source income until profits are repatriated. This and other incentives also encourage firms to locate physical assets, production, and jobs in such countries.

  • Differences in taxation between countries give multinationals an incentive to alter their transfer prices from what a nonaffiliated customer would be charged. For example, by underpricing sales to their affiliates in low-tax countries and overpricing purchases from them, firms can shift reported profits to those countries, thus reducing their tax.
  • To deal with this practice, for tax reporting purposes most governments require firms to use an "arm’s length" standard, setting transfer prices equal to the prices that would prevail if the transaction were between independent entities. Yet ample room remains for firms to manipulate transfer prices, because arm’s-length prices are often difficult to establish for many intermediate goods and services, including intangibles, such as patents, that are unique to the firm.
  • Other provisions of U.S. tax law also encourage firms to shift profits to low-tax countries. For example, cross-crediting allows firms to use excess tax credits from operations in high-tax countries to offset tax due on repatriated profits from income earned in low-tax countries. In addition, the American Jobs Creation Act recently enacted a temporary tax break on repatriations of foreign income from low-tax countries.
  • Multinational firms can shift income among their affiliates in different countries in other ways. For example, by borrowing money in high-tax countries to finance their overall operations, they can claim larger interest deductions in those countries and so report more profits in low-tax countries. The tax incentive to book profits in low-tax jurisdictions also affects decisions on the location of intangible property, the payment of royalties, and the timing of profit repatriation.
  • U.S. multinational firms appear to book a disproportionate share of profits in low-tax locations. Seven of the ten countries with the largest shares of non-U.S. profits earned by U.S. multinationals in 2003 had effective tax rates under 10 percent (see figure 1). Studies have confirmed that the financial decisions of multinational firms are sensitive to international differences in corporate tax rates.

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  • Most of the advanced industrial countries have lowered their corporate income tax rates in recent years, while U.S. rates have changed little. The increasing discrepancy between U.S. and foreign rates has strengthened incentives to shift income and has reduced U.S. tax revenue. One study found that income shifting reduced U.S. corporate income tax revenue by approximately 35 percent in 2002.
  • Despite evidence that firms shift the location of real investment in response to tax rate differences among countries, a substantial share of U.S. multinational activity remains in high-tax countries. These tend to be large economies with close economic ties to the United States (figure 2) whose effective corporate tax rates are, on average, quite similar to the U.S. rate.
  • The current U.S. system treats multinational enterprises whose parent company is incorporated in the United States differently from those headquartered elsewhere. The former, but not the latter, are subject to U.S. corporate tax rules, including limitations on the foreign tax credit and deferral. This different treatment has led some U.S.-based multinationals to shift the formal incorporation of their parent company offshore without changing the location of any of their real business activities-a practice called inversion.

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The formal residence of a corporation may be losing significance in an increasingly global economy where capital flows freely and a firm’s R&D, production, and sales are often spread worldwide. The location of investment, jobs, R&D, and tax revenue matter more than the site of a multinational firm’s headquarters

 
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