Featured Articles
on March 10, 2008.
Corporate tax revenues dropped by $17.4 billion in 2004 because U.S. multinational corporations have enhanced their ability to shift profits out of the United States since 1999.
That finding indicates that the IRS is losing its battle to rein in aggressive transfer pricing abuse and gives quantitative support to a recent statement by the Joint Committee on Taxation chief of staff on transfer pricing enforcement efforts. "Transfer pricing is dead," Edward Kleinbard told participants at the International Fiscal Association's meeting in late February. "Despite everyone's efforts, we're not collecting tax. It's a global problem."
The results also suggest that there are large potential revenue gains if the United States were to tighten its current arm's-length transfer pricing rules or adopt an entirely new framework, such as formulary apportionment, which is used by U.S. states and is now under consideration by the European Commission.
Table 1. U.S. Multinational Corporations, 1999 and 2004
(dollar amounts in billions)
--------------------------------------------------------------------
1999
-----------------------------------
U.S. Foreign
Parents Affiliates All
--------------------------------------------------------------------
Assets $10,435.2 $4,081.6 $14,516.8
Property, plant, and equipment $2,029.9 $820.4 $2,850.3
Sales $5,975.5 $2,611.8 $8,587.3
Compensation $1,103.9 $295.3 $1,399.2
Research expenditure $126.3 $21.9 $148.2
Capital expenditure $369.7 $144.3 $514.0
Value added $1,914.3 $682.6 $2,596.9
Employees 23,006.8 9,220.2 32,227
Income tax $4,166.2 $52.8 $219.0
Before-tax profits $455.3 $165.9 $621.2
Effective tax rate 36.5% 31.8% 35.3%
--------------------------------------------------------------------
--------------------------------------------------------------------
2004
-----------------------------------
U.S. Foreign
Parents Affiliates All
--------------------------------------------------------------------
Assets $14,417.6 $7,128.5 $21,546.1
Property, plant, and equipment $2,280.2 $996.8 $3,277.0
Sales $7,059.0 $3,841.4 $10,900.4
Compensation $1,239.5 $378.6 $1,618.1
Research expenditure $164.2 $30.0 $194.2
Capital expenditure $310.3 $143.4 $453.7
Value added $2,173.5 $949.4 $3,122.9
Employees 21,176.5 10,068.4 31,245
Income tax $163.5 $81.5 $245.0
Before-tax profits $449.4 $284.8 $734.2
Effective tax rate 36.4% 28.6% 33.4%
--------------------------------------------------------------------
--------------------------------------------------------------------
Ratio of 2004 Value to
1999 Value
-----------------------------------
U.S. Foreign
Parents Affiliates All
--------------------------------------------------------------------
Assets 1.38 1.75 1.48
Property, plant, and equipment 1.12 1.22 1.15
Sales 1.18 1.47 1.27
Compensation 1.12 1.28 1.16
Research expenditure 1.30 1.37 1.31
Capital expenditure 0.84 0.99 0.88
Value added 1.14 1.39 1.20
Employees 0.92 1.09 0.97
Income tax 0.98 1.54 1.12
Before-tax profits 0.99 1.72 1.18
Effective tax rate
--------------------------------------------------------------------
Sources: Bureau of Economic Analysis of the U.S. Department of
Commerce and author's calculations. The effective tax rate is the
ratio of income tax to before-tax profits. See notes for details.
Context
Two weeks ago we showed that the average effective tax rate reported by America's largest corporations to shareholders dropped from 34.1 percent in 1997-1999 to 30 percent in 2004-2006 ("Reported Corporate Effective Tax Rates Down Since Late 1990s," Tax Notes, Feb. 25, 2008, p. 882, Doc 2008- 3456 , or 2008 TNT 38-6). Last week we presented estimates showing that almost three-quarters of the decline was attributable to the increasingly favorable effects of the taxation of foreign earnings ("Why Reported Effective Corporate Tax Rates Are Falling," Tax Notes, Mar. 3, 2008, p. 977, Doc 2008- 4060, or 2008 TNT 43-9 ). This week we will examine how the factors behind changing foreign taxes on foreign earnings have lowered the worldwide effective tax rate.
In brief, a combination of three factors affecting foreign taxes has helped reduce the worldwide effective tax rate. First, the average foreign effective tax rate has dropped from 31.8 percent to 28.6 percent. Second, U.S. multinationals have increased their foreign business activity -- as measured by a variety of indicators -- by 43 percent, far more than domestic growth. Third, the profits of foreign operations have increased beyond what might be expected given the shift in business activity. That last effect -- the disproportionate profit shifting -- has reduced taxable U.S. profits by an estimated $49.7 billion and accounts for the estimated $17.4 billion revenue loss.
Table 2. Decomposing the Effects of Foreign Profits and Taxes
(dollar amounts in billions; figures from Table 1 in boldface)
-----------------------------------------------------------------------------
Estimates
Actual Projected Actual of Profit
1999 2004 2004 Shift
[1] [2] [3] [4]
-----------------------------------------------------------------------------
A. Non-U.S. Profits and Taxes
-----------------------------------------------------------------------------
Non-U.S. profits $165.9 $237.0 $284.8
Non-U.S. taxes:
1999 rates (31.8%) $52.8 $75.5 $90.7
2004 rates (28.6%) $47.4 $67.8 $81.5
Profit shift from 1999 $47.9
to 2004 ([3]-[2])
Non-U.S. revenue change $13.7
from profit shift
([3]-[2])
-----------------------------------------------------------------------------
B. United States Profits and Taxes
-----------------------------------------------------------------------------
U.S. profits $455.3 $497.3 $449.4
U.S. taxes:
1999 rates (36.5%) $166.2 $181.5 $164.0
2004 rates (36.4%) $165.7 $181.0 $163.5
Profit shift from 1999 -$47.9
to 2004
U.S. revenue change -$17.4
from profit shift
-----------------------------------------------------------------------------
C. Worldwide Profits and Taxes
(sum of A and B above)
-----------------------------------------------------------------------------
Worldwide profits $621.2 $734.2 $734.2
Worldwide taxes:
1999 rates (U.S. 36.5%, $219.0 $257.0 $254.7
other 31.8%)
2004 rates (U.S. 36.4%, $213.1 $248.7 $245.0
other 28.6%)
-----------------------------------------------------------------------------
D. Worldwide Average Effective Tax Rate
(ratio of tax to profits from C above)
-----------------------------------------------------------------------------
1999 rates (U.S. 36.5%, 35.0% 34.7% 34.4%
other 31.5%)
2004 rates (U.S. 36.4%, 34.3% 33.8% 33.3%
other 28.5%)
Foreign Affiliates of U.S. Multinational Corporations,
1999-2004
The Results
Table 1 shows the data we used to make our calculations. Unlike the last two articles, in which we used information from corporate annual reports, this week's data are from the 1999 and 2004 Commerce Department comprehensive surveys of U.S.multinational corporations. The notes at the end of this article provide details about the data.
Table 2 summarizes the results of our calculations. Let's focus first on Panel A dealing with the taxes and profits of foreign affiliates of U.S. multinationals. Actual profits for 1999 are shown in column 1. Projected profits are estimated using a "real" growth rate -- that is, a growth rate that measures the growth in production and economic activity. Four variables were used as measures of real activity: assets; property, plant, and equipment (tangible capital); sales; and compensation. In the lingo of U.S. transfer pricing regulations, those four variables are our profit level indicators. Three of those measures -- tangible capital, sales, and compensation -- are commonly used by U.S. states to allocate profits.
Table A1. Data Sources
Entries in this table show the table numbers from the
BEA survey from which the relevant data were taken.
---------------------------------------------------------------------
1999 Survey 2004 Survey
-------------------- ---------------------
U.S. Foreign U.S. Foreign
Parents Affiliates Parents Affiliates
---------------------------------------------------------------------
Assets 2M1/2N1 2A1/2B1 2N1 3B1/2A1
Property, plant, 2M1 2A1 2N1 2A1
equipment
Sales 2M1 2A1 2P1 2A1
Compensation 2M1 2A1 2M1 2A1
Employees 2M1 2M1 2M1 2M1
Research 2M1 3J1 2M1 2A1
expenditure
Capital 2M1 2D6 2M1 2A1
expenditure
Value added 2M1 3A1 2M1 2A1
Income tax 2P1 2E1 2P1 2A1/3E1
Before-tax 2P1 2E1 2P1 2A1/3E1
profits
As shown in Figure 1, affiliate assets grew by about 75 percent, tangible capital grew by about 22 percent, sales grew by about 47 percent, and employee compensation grew by about 28 percent. The average growth of these four profit level indicators was 42.86 percent. So we estimate that before-tax profits of foreign affiliates should have grown by an average of 42.86 percent to $237 billion.
Also as shown in Figure 1, actual affiliate profits in 2004 grew by 72 percent from 1999 levels to $284.8 billion. The excess of actual over projected profits -- $47.9 billion -- is profit shifting out of the United States that is not commensurate with changes in real business activity. That is the basis of our estimate of the deterioration of the IRS's ability to prevent unjustified profit shifting out of the United States.
Panel A of Table 2 shows that, with the average foreign tax rate of 28.6 percent in 2004, the estimated $47.9 billion profits shift increased foreign taxes by $13.7 billion. Panel B shows that, with an estimated average U.S. tax rate of 36.4 percent in 2004 (including both state and federal corporate taxes), the $47.9 billion profits shift reduced U.S. taxes by $17.4 billion. In other words, the United States lost $17.4 billion in revenue compared with what it would have collected if the degree of profit shifting were the same as it was in 1999. Presumably, because there were already revenue losses from aggressive transfer pricing practices in 1999, the total annual revenue loss to the U.S. government due to inappropriate profit shifting is significantly greater than $17.4 billion.
Panel A also indicates that the average foreign tax rate declined from 31.1 percent in 1999 to 28.6 percent in 2004. As shown in column 3, foreign profits taxes would have been $90.7 billion in 2004 instead of the actual figure of $81.5 billion if foreign rates had not declined.
Impact on Effective Tax Rates
Panel D of Table 2 allows us to comment on the causes of the decline in the worldwide effective tax rate. In this data set, the average overall effective corporate tax rate declined from 35 percent in 1999 to 33.3 percent in 2004. These figures are in bold in Panel D. (Last week, using a different data set of 80 corporations for an overlapping but different time period, we found that the average effective tax rate declined from 34.1 percent to 30 percent.)
The effect of lower foreign tax rates can be seen by comparing the two values in column 1 of Panel D: Lower foreign rates lowered the worldwide effective tax rate of U.S. multinational corporations from 35 percent to 34.3 percent. The effect of the movement of real business activity out of the United States reduced the estimated 1999 effective tax rate another 0.5 percentage point -- from 34.3 percent (column 1) to 33.8 percent (column 2). The effect of the artificial movement of profits out of the United States reduced the actual 2004 effective tax rate another 0.5 percentage point -- from 33.8 percent (column 2) to 33.3 percent (column 3).
Notes on Data
The two sources for the data in this article are data sets described in the following publications:
- U.S. Department of Commerce, Bureau of Economic Analysis, "U.S. Direct Investment Abroad, Final Results of the 1999 Benchmark Survey," March 2004.
- U.S. Department of Commerce, Bureau of Economic Analysis, "U.S. Direct Investment Abroad, Final Results of the 2004 Benchmark Survey," undated.
The best starting point on the Web for working with those data are the files listed under "Comprehensive financial and operating data" at http://www.bea.gov/scb/account_articles/international/iidguide.htm#USDIA1.
The Commerce Department's Bureau of Economic Analysis (BEA) conducts comprehensive benchmark surveys of U.S. multinational corporations every five years. The years 1999 and 2004 were chosen for this study because the data available for those two years were the most comprehensive of recent years. (The latest data currently available are preliminary for 2005.)
Table A1 lists the source tables for the data shown in Table 1. Many of the tables in the 1999 survey have the same heading as those in the 2004 survey, so care should be taken not to confuse similar tables from the two different surveys. All the data in unshaded cells of the table are directly from the indicated tables. Shaded cells are adjusted as described in the following paragraphs.
Before-Tax Profits
Before-tax income is equal to net income minus income from equity investments plus income taxes. In Table A2, original data are in the unshaded cells. The computed data are in the shaded cells.
In each BEA survey, data are presented in five different "groups." Group II is "Nonbank affiliates of nonbank U.S. parents" and their parents. Group III is "Majority-owned nonbank affiliates of nonbank U.S. parents" and their parents. This study drew most of its data from Group II. In some instances, however, because of a lack of available Group II data, Group III was used and extrapolated upward using as scale factors ratios of available Group II data to available Group III data.
Table A2. Before-Tax Profits
---------------------------------------------------------------------
1999 Survey Data 2004 Survey Data
(in millions) (in millions)
-------------------- ---------------------
U.S. Foreign U.S. Foreign
Parents Affiliates Parents Affiliates
---------------------------------------------------------------------
Net income $394,515 $181,915 $497,052 $496,964
Income from 105,397 6,477 211,208 285,815
equity in
foreign
affiliates
Income from -- 4,107 -- 7,805
other equity
investments
Income taxes 166,191 52,815 163,544 81,660
(foreign,
U.S.)
Before-tax 455,309 224,146 449,388 285,004
profits
Table A3. Assets
---------------------------------------------------------------------
1999 Survey Data 2004 Survey Data
(in millions) (in millions)
-------------------- ---------------------
U.S. Foreign U.S. Foreign
Parents Affiliates Parents Affiliates
---------------------------------------------------------------------
Assets $11,688,359 $4,631,810 $16,141,530 $9,373,484
Equity in 938,158 550,173 1,353,767 2,245,026
foreign
affiliates
Equity in 315,035 -- 370,155 --
other
affiliates
Assets 10,435,166 4,081,637 14,417,608 1,128,458
(adjusted)
For 2004 the affiliate variables for "income from equity in foreign affiliates," "income from other equity investments," and "income taxes" are estimated for Group II by multiplying Group III values for each ($259,815, $7,079, and $74,068, respectively) by the ratio of Group II "net income" of foreign affiliates to Group III "net income" (that is, 1.1025 equals $496,964 divided by $450,760).
Assets
Asset totals are adjusted to exclude equity investments in affiliates. In Table A3, the original data are in the unshaded cells. The data used in this study are in the shaded cells.
For 2004 the affiliate variable for "equity in foreign affiliates" is estimated for Group II by multiplying Group II affiliates' assets ($9,373,484) by the ratio of Group III "equity investment in other foreign affiliates" to "total assets" (that is, 0.2395 equals $2,080,979 divided by $8,688,553).
Other Adjustments
In the 1999 survey (see Table A4), "research expenditure" and "value added" were adjusted upward using the average of: (a) the ratio of nonbank affiliate assets to majority-owned nonbank affiliate assets; (b) the ratio of nonbank affiliate tangible capital to majority-owned nonbank affiliate tangible capital; (c) the ratio of nonbank affiliate sales to majority-owned nonbank affiliate sales; and (d) the ratio of nonbank affiliate net income to majority-owned nonbank affiliate net income. Those calculations are detailed in the following table. The raw data are in the unshaded cells. The computed data are in the shaded cells.
Table A4. Other Adjustments, 1999 Survey
(dollar amounts in millions)
---------------------------------------------------------------------
All Majority-Owned
Affiliates Affiliates Ratio
---------------------------------------------------------------------
Assets $4,631,810 $4,056,424 1.1418
Property, plant, equipment 820,413 592,891 1.3838
Sales 2,611,764 2,218,945 1.1770
Net income 181,915 162,759 1.1177
Average of above -- -- 1.2051
Research expenditure 21,865 18,144 1.2051
Value added 682,553 566,396 1.2051
Similarly, in the 2004 survey (see Table A5), "research expenditure," "capital expenditure," and "value added" were adjusted upward as described in the table below. Again, the raw data are in the unshaded cells, and the computed data are in the shaded cells.
Table A5. Other Adjustments, 2004 Survey
(dollar amounts in millions)
---------------------------------------------------------------------
All Majority-Owned
Affiliates Affiliates Ratio
---------------------------------------------------------------------
Assets $9,373,484 $8,688,553 1.0788
Property, plant, equipment 996,810 766,865 1.2999
Sales 3,841,409 3,312,531 1.1597
Net income 496,964 450,760 1.1025
Average of above -- -- 1.1602
Research expenditure 29,980 25,840 1.1602
Capital expenditure 143,262 123,479 1.1602
Value added 949,350 818,256 1.1602
Notes on Calculations
The effective tax rate is the ratio of income tax to before-tax profits.
Projected 2004 foreign profit is actual 1999 profit multiplied by a ratio. The ratio is the average of four other ratios: (a) 2004 foreign assets divided by 1999 foreign assets; (b) 2004 foreign tangible capital divided by 1999 foreign tangible capital; (c) 2004 foreign sales divided by 1999 foreign sales; and (d) 2004 foreign compensation divided by 1999 foreign compensation.
U.S. projected income is total worldwide income minus projected foreign income.
About Tax Analysts
Tax Analysts is an influential provider of tax news and analysis for the global community. Over 150,000 tax professionals in law and accounting firms, corporations, and government agencies rely on Tax Analysts' federal, state, and international content daily. Key products include Tax Notes, Tax Notes Today, State Tax Notes, State Tax Today, Tax Notes International, and Worldwide Tax Daily. Founded in 1970 as a nonprofit organization, Tax Analysts has the industry's largest tax-dedicated correspondent staff, with more than 250 domestic and international correspondents. For more information, visit our home page.
For reprint permission or other information, contact communications@tax.org
