The Real Effects of US Tax Arbitrage by Foreign Multinational Firms

45 Pages·2017·0.54 MB·English

The Real Effects of U.S. Tax Arbitrage
by Foreign Multinational Firms∗
James F. Albertus†
February 2017
Abstract
Controlled foreign corporation (CFC) laws are designed to restrict the tax arbitrage activities
of multinational firms. Using confidential microdata, I estimate a difference-in-differences spec-
ification to study how these laws relate to the profitability and real economic activity of foreign
owned U.S. subsidiaries. I find that when a U.S. subsidiary’s foreign parent is subject to a
CFClaw,thesubsidiary’sreturnonassetsincreases5percentagepoints,suggestingarestricted
ability to shift U.S. income to lower tax foreign jurisdictions. The laws are also associated with
lower employment and investment in the U.S., as well as a lower likelihood of a foreign firm
establishing U.S. operations.
∗The latest version of this paper is available at www.jamesfalbertus.com. For valuable comments I thank Viral
Acharya, Andrew Bird, Alexander Ljungqvist, Holger Mueller, Philipp Schnabl, Michael Smolyansky, and William
Zeile. IgratefullyacknowledgefinancialsupportfromtheNYUSternCenterforGlobalEconomyandBusiness. This
paperwaspreviouslytitled“U.S.TaxArbitragebyForeignMultinationalFirmsandItsRealEffects.”Thestatistical
analysis of firm-level data on multinational companies was conducted at the Bureau of Economic Analysis, U.S.
DepartmentofCommerceunderarrangementsthatmaintainlegalconfidentialityrequirements. Theviewsexpressed
are those of the author and do not reflect official positions of the Department of Commerce.
†Email: [email protected].
The purpose of this paper is to evaluate the impact of tax avoidance by foreign multinational firms
on real economic activity in the United States. To do so, I focus on the effect of controlled foreign
corporation (CFC) laws on foreign multinationals’ global allocation of U.S.-generated income. I
also examine how these laws relate to the employment and investment policies of these firms’ U.S.
subsidiaries.
Foreign multinationals face strong tax incentives to shift U.S.-generated income out of the
U.S.1 The U.S. corporate income tax rate, at 35 percent, is perhaps the most important aspect
of U.S. federal tax policy that generates these incentives. The corresponding tax rates of other
countries are generally lower. In recent years, the gap between the U.S. statutory tax rate and the
average foreign statutory tax rate has grown to about 10 percentage points, as seen in Figure 1.
CFC laws are intended to restrict the tax arbitrage activities of multinational firms. Coun-
tries that implement the laws often cite the objective of avoiding the erosion of their domestic
business tax base.2 The laws also mitigate the tax incentives multinationals face to shift income
among their subsidiaries located abroad.
The mechanism by which CFC laws operate can be illustrated with a simple example.
Consider a hypothetical multinational firm based in Australia with subsidiaries in the U.S. and
Bermuda, depicted schematically in Figure 2. Suppose the U.S. subsidiary is profitable and Aus-
tralia’s 1990 CFC law has not yet been implemented. Since Australia operates a territorial tax
system, the income of its U.S. subsidiary would be subject to taxation in the U.S., but not Aus-
tralia. The firm, seeking to maximize its consolidated after-tax income, has an incentive to shift
the income generated by its U.S. subsidiary to its Bermudian subsidiary.3 In doing so, it reduces
its tax obligation on the shifted income from the U.S. rate, 35 percent, to the Bermudian rate, 0
percent. This also reduces the apparent profitability of the firm’s U.S. subsidiary.4
NowsupposeinsteadthatAustralia’sCFClawisineffect. ThelawappliestoallAustralian
1The large literature on profit shifting by U.S. multinational firms emphasizes the same incentives, although in
the context of different parent firms.
2The Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting initiative
(OECD, 2013) includes an action plan on strengthening countries’ CFC laws (OECD, 2015).
3This shifting may occur through transfer pricing, for example, as discussed in Collins, Kemsley, and Shackelford
(1997).
4Through their impact on the profitability of foreign direct investment in the U.S., CFC laws play a role in the
income puzzle. The income puzzle is the counterintuitive empirical regularity that while the U.S. net international
investment position is negative, its net investment income is positive. A full discussion of this point is beyond the
scope of this paper. Further information can be found, for example, in Curcuru and Thomas (2015).
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based firms. It provides penalties payable to the Australian tax authority if Australian multina-
tionalsengageinprohibitedtaxavoidanceactivities. Followingtheexample, thelawstipulatesthat
the U.S.-generated income shifted to Bermuda would be immediately taxed at the Australian rate,
30 percent, not the Bermudian rate. This reduces the tax incentive the firm faces to shift income
to Bermuda.
If the U.S.-generated income remains in the U.S., there may be consequences for the firm’s
realU.S.operationsaswell. Inthescenariodescribedabove,incomefromthefirm’sU.S.operations
would change from not being taxed at all (or rather, taxed at the 0% Bermudian rate) to being
taxed at the 35% U.S. rate. In orther words, the after tax return on the firm’s U.S. operations
would fall 35 percent. In effect, operating in the U.S. would become less profitable. Facing these
new incentives due to the CFC law, the firm may scale back its real economic activity in the U.S.
(Romer and Romer, 2010).
Research on the profit shifting activities of foreign multinationals’ U.S. subsidiaries is ide-
ally conducted using unconsolidated financial information. These data are not publicly available,
presenting a challenge to researchers interested in investigating these issues empirically. I address
this challenge by using a confidential subsidiary-level panel on the U.S. operations of foreign-based
multinational firms collected by the Bureau of Economic Analysis (BEA), an agency of the U.S.
Department of Commerce. The data include detailed information on the U.S. subsidiaries’ balance
sheets and income statements. Confidentiality requirements, non-compliance penalties, and a sys-
tem of verification procedures ensure the surveys accurately capture data on virtually all foreign
direct investment in the U.S. These data allow me to evaluate whether the U.S. subsidiaries of
foreign multinational firms subject to a CFC law changed how they reported income and operated
in the United States.
Before turning to the profitability and real operations of foreign owned U.S. subsidiaries, I
consider the determinants of CFC implementation. In addition to being of interest from a policy
analysis perspective, this step is important because it helps identify the controls that may be useful
in ruling out the influence of omitted variables in the analysis that follows. I find, for example, that
countrieswithhightaxratestendtoimplementCFClaws. Thisapparentselectionisconsistentwith
the laws’ function. Companies in a country with a high tax rate face an incentive to shift income
to lower tax jurisdictions, and hence the country in turn has an incentive to implement a CFC law.
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When removing aggregate annual variation and time invariant country variation however (that is,
using year and country fixed effects), I find that local policies and macroeconomic conditions are
not systematically related to CFC implementation. This finding lends credence to the notion that,
after accounting for likely sources of selection, the implementation of CFC laws may be viewed as
plausibly exogenous. I discuss these issues further in section 2.3.
I use a standard difference-in-differences specification to estimate the association between
CFC laws and foreign-owned U.S. subsidiaries’ profits. “Treated” subsidiaries are those with a
foreign parent subject to a CFC law. “Control”subsidiaries are those whose foreign parent is based
in a country that has not implemented CFC legislation. The difference-in-differences approach
helps rule out potentially confounding variation in profits across subsidiaries and across years. The
baseline profit shifting estimate suggests that, on average, the implementation of a CFC law is
associated with a 5 percentage point increase in the return on assets at U.S. subsidiaries owned by
foreign based multinationals subject to a CFC law.
Of course, not all foreign CFC laws are the same. I explore whether certain features of CFC
laws increase or decrease their effectiveness. Specifically, I consider CFC laws that are triggered
only if tainted income exceeds a certain percentage of a subsidiary’s sales or profits. Generally
speaking, tainted income is passive income, such as that from interest payments or royalty receipts,
although the precise definition is contained in the text of the CFC law itself. I find that both
features weaken the effectiveness of a CFC law, although the weakening is statistically significant
only in the case of a tainted income to profits condition.
Next I consider how a change in the effective tax obligation generated by a foreign firm’s
U.S. subsidiary relates to the subsidiary’s real operations. I find that when a parent company
is subject to a CFC law, the U.S. subsidiary reduces the number of workers it employs by 16%.
The corresponding reduction in the subsidiary’s wage bill is 11%. The reduction in investment, as
measured by net property, plant, and equipment, is 12%. All of these estimates are statistically
significant.
Foreign multinationals may also modify their U.S. operations on the extensive margin in
response to CFC laws. Specifically, they may dissolve their existing operations or establish new
operations. I find the implementation of a CFC law is associated with a 3% reduction in the
probability that a foreign firm establishes a U.S. subsidiary.
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Thefindingsinformseveralstrandsofexistingresearch. First, theresultsaddtoarelatively
young literature on CFC laws. Voget (2011) considers the relationship between CFC laws (as
well as corporate taxation more generally) and instances of multinational firms relocating their
headquarters. He finds the association is positive, consistent with the notion that some firms act
to escape CFC laws by moving to a different country. The results indicate that CFC laws indeed
meaningfully alter the incentives multinational firms face. My findings are complementary, but
instead focus on profitability, employment, and investment in the U.S.
Bohm, Karkinsky, Knoll, and Riedel (2015), meanwhile, studies the role of taxes and CFC
laws in where multinational firms locate their intellectual property. The results indicate tax in-
centives lead firms to attribute the ownership of valuable patents to tax haven subsidiaries. The
firms are thus positioned to realize intellectual property-derived income in these low tax jurisdic-
tions. The relationship substantially weakens, however, if a multinational is based in country with
a CFC law. This result is again complementary with my findings in the sense that it demonstrates
that CFC laws weaken the tax incentives multinationals face to shift profits to countries with low
business income tax rates. My findings are distinct, however, in that they speak to income more
broadly (not only that associated with intellectual property), as well as multinational firms’ real
economic activity.
Finally, the paper arguably most similar to this one is Egger and Wamser (2011), which
relates CFC policy to changes in firms’ fixed assets. However, this paper differs from Egger and
Wamser (2011) in several important respects. While Egger and Wamser (2011) considers a single
CFC policy change, this paper considers the implementation of 17 geographically and temporally
dispersed CFC laws, allowing for cleaner identification of the main results. In addition, this paper
is the first to consider changes in employment, investment measured in accordance with GAAP, as
well as subsidiary formation and dissolution.
Second, the findings contribute more broadly to the substantial literature on international
business taxation. One branch of this research addresses the role of competition in countries’
decisions regarding their business tax rates Wilson (1986, 1991, 1999); Devereux, Griffith, and
Klemm (2002); Devereux, Lockwood, and Redoano (2008). These papers highlight the role of
competition in the secular downward trend in corporate tax rates over time, evidenced in Figure
1. CFC legislation, in turn, may be viewed as a policy response to curb the effects of this trend on
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domestically based multinational firms’ business decisions.
Another branch of the literature on international business taxation focuses on the ineffi-
ciencies induced by international tax policy. For example, Hanlon, Lester, and Verdi (2015) studies
the consequences of the worldwide tax system used by the U.S. and finds that U.S. multinational
firms with large amounts of locked out cash are more likely to make foreign acquisitions and that
these acquisitions tend to be less well received by investors, as reflected by market reactions at the
acquisition announcements. Duchin, Gilbert, Harford, and Hrdlicka (2016) also considers locked
out cash due to the U.S. worldwide tax system. The authors find that equity market participants
value firms’ financial assets held abroad at a discount, suggesting investor concern regarding the
dissipation of value due to agency conflicts. A CFC law may be viewed as a policy effort to reduce
the incentives firms face to reorganize their operations in potentially inefficient ways to exploit
variation in tax rates across countries.
Third, the results highlight the potential for policy decisions in one jurisdiction to spill over
and impact economic activity in a separate jurisdiction. This is true in two respects in the present
setting. Countries implement CFC laws that subject domestically-based multinational firms to
penalties that alter their behavior elsewhere. In addition, and perhaps more closely analogous
to the literature on spillovers, penalties for activity in one country (for example, profit shifting to
Bermuda)impactactivityinanothercountry(forexample,employmentintheUnitedStates). Case,
Rosen, and Hines (1993) provides evidence for spillovers in the context of fiscal policy, showing that
when one state government increases spending, neighboring states also choose to increase spending.
Bruno and Shin (2015) studies monetary policy spillovers and finds that contractionary shocks to
U.S. monetary policy reduce international lending. Albertus, Bird, Karolyi, and Ruchti (2017)
shows that looser constraints on short selling in the U.S. improves the allocation of resources across
U.S. multinational firms’ foreign operations. In a broadly similar way, this paper shows that policy
changes in one jurisdiction (i.e. the implementation of a CFC law by a foreign country) spill over
to impact economic activity in another jurisdiction (i.e. employment in the U.S.).
Finally, the results speak to the potential consequences of recently proposed federal tax
policy changes in the United States. Foreign-owned companies play a large role in aggregate U.S.
business activity. In 2007, the majority-owned nonbank U.S. subsidiaries of foreign firms had
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assets of roughly $7.6 trillion.5 Debt plays a sizable role in these companies’ financing, amounting
to $4.6 trillion.6 Of this, roughly 31% is provided by the companies’ foreign parents.7 These
statisticsconfirmthatforeign-ownedcompaniesplayasizeableroleintheU.S.economyandreceive
a significant fraction of their debt financing from their foreign parents. Policy changes pertinent to
this type of funding may have significant consequences for economic activity in the U.S.
Against this backdrop, the U.S. Treasury has long been concerned that“earnings stripping”
is a primary technique foreign multinationals employ to shift income out of the United States,
therebyreducingtheirU.S.taxpayments. Infact,thisisthoughttobeoneoftheprimarystrategies
used by firms that move their tax domicile out of the U.S. through corporate inversions. Policy
proposalshaveconsideredeliminatingtheexpensingofinterestpaymentsondebt. Theserestrictions
may be effective in reducing income shifting out of the United States, but, given the results in this
paper, potentially entail a loss of real economic activity in the U.S. Given the magnitude of foreign-
owned U.S. business activity, the real economic consequences may be substantial.8
The paper proceeds as follows. Section 1 outlines key elements of foreign international
taxation, including a discussion of CFC laws, and presents a detailed hypothetical example to
illustrate the laws’ consequences. In section 2 I explore the determinants of CFC implementation.
Section3providesadescriptionofBEA’sdataontheoperationsofforeign-ownedU.S.subsidiaries,
discusses sample selection, and presents summary statistics. Sections 4 and 5 present the results
on profitability and real economic activity. Section 6 concludes.
1 Foreign International Taxation
This section first covers the elements of foreign international taxation relevant to this study.
It then discusses the controlled foreign corporation laws. Finally it presents a hypothetical example
to illustrate the laws’ practical implications.
5See Table III.A 1 in Bureau of Economic Analysis (2011). The figure for all affiliates is approximately $13.0
trillion and is contained in Table I.A 1 of the same publication.
6This figure corresponds to current liabilities and long term debt.
7More precisely, this figure represents the percentage of a foreign-owned U.S. subsidiary’s current liabilities and
long term debt provided by the subsidiary’s foreign parent group.
8In April 2016 the U.S. Treasury proposed regulatory changes to effectively eliminate the tax benefits of debt
financing between foreign-owned companies in the U.S. and their foreign parents (United States Treasury, 2016).
Ultimately these changes were significantly weakened.
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1.1 Taxation of Foreign Owned U.S. Subsidiaries
Virtuallyallcountriesoperateaterritorialtaxsystem.9 Thismeanstheytaxincomerealized
within their borders, but not income realized elsewhere. Foreign multinational firms’ foreign source
income is only taxed locally (for example, a German multinational firm’s French income is only
taxed in France). In particular, the income of foreign multinational firms’ U.S. subsidiaries is
generally taxed only in the U.S.
This approach to taxation has the potential to induce significant tax avoidance activities.
Firms may arrange to realize income offshore in lower tax countries, reducing their home countries’
tax revenue. Perhaps more importantly, they may also move real activity, such as employment,
overseas. Controlled foreign corporation laws are intended to limit this activity by reducing the tax
incentive to realize income in low tax countries.
The higher the U.S. tax rate relative to those in other countries, the stronger the incentive
to record U.S.-generated income in other countries. Figure 1 depicts the U.S. and average foreign
business income tax rates over the sample period. The average foreign rate is weighted by the
assets of U.S. subsidiaries owned by parents in each foreign country in each year. As the plot makes
clear, the U.S. tax rate has been relatively high over the sample period. Of course, a limitation of
this comparison is that it does not capture the full set of options available to foreign multinationals
considering allocating U.S.-generated income elsewhere. It compares the U.S. rate with the average
foreign parent rate, not the rates faced by foreign multinationals’ non-U.S. subsidiaries. Hypothet-
ically, if a foreign parent has foreign subsidiaries in both the U.S. and Bermuda, the foreign parent
may allocate the U.S.-generated income not to the parent’s operations, but to the Bermudian sub-
sidiary, where business income is not taxed. Hence, Figure 1 likely understates the tax incentive
foreign multinationals face to shift U.S.-generated income out of the U.S.
1.2 Controlled Foreign Corporation Laws and Their Common Features
A country’s controlled foreign corporation law applies to the global operations of multina-
tional firms based there. It stipulates the conditions under which the country may also tax the
9The U.S., which operates a worldwide tax system, is the exception to this rule. Although use of these terms is
common, in practice tax systems occupy the gray area between the conceptual territorial and worldwide poles. In
fact,foreigncountries’CFClawsincludepenaltiesthatallowthetaxationofforeignsourceincome. Asaresult,these
countries arguably do not operate true territorial tax systems.
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income realized by these multinationals’ foreign subsidiaries. To the extent multinationals are tax
sensitive in their income allocation activities, CFC laws reduce multinationals’ discretion in allo-
cating income across their global operations.10 In broad terms, when a multinational is subject to
a CFC law, more income generated in relatively high tax countries is likely to remain there.
A commonly cited objective of CFC laws is to prevent the erosion of the country’s domestic
tax base (OECD, 2015). A CFC law accomplishes this by preventing the tax rate on domestically-
based multinationals’ foreign income from falling below the domestic tax rate. This eliminates
firms’ incentives to move domestically-generated income abroad for tax purposes. To the extent
firms move real economic activity, such as employment and capital investment, along with income,
it also helps retain this activity domestically.
Table 1 lists the countries that implemented CFC laws during the sample period.11 One
notablefeaturehighlightedbythetableisthecountries’considerablegeographicdispersion, asseen
in Figure 5. All 6 inhabited continents are represented. This dispersion strengthens the notion that
the CFC laws are plausibly exogenous by restricting the set of omitted variables that may enter
into the analysis. Specifically, an omitted variable that relates both to CFC implementation and
the performance of foreign-owned U.S. subsidiaries must not be region specific.
CFC laws also vary across countries. Two common features of CFC laws pertain to“tainted
income”and are presented in Table 7. The definition of tainted income is contained in the CFC
law itself. In general however, tainted income is income realized by a subsidiary which did not
contribute to its generation through any economically substantive activity. Interest income is a
common example of tainted income. Some countries’ CFC laws are triggered when the ratio of a
subsidiary’s tainted income to total profits rises above a specified threshold. Argentina serves as
an example. When the tainted income of a foreign subsidiary of an Argentinian multinational rises
above 50 percent of the subsidiary’s total profits, Argentina’s CFC law is triggered, subjecting the
subsidiary to Argentinian taxation. Alternatively, the tainted income threshold can be measured
relative to sales, as in Australia.
Figure 4 highlights the staggered nature of the CFC laws’ implementation by countries
10MihirDesaihighlightedthepotentialimportanceoftheserulesinaninterviewwiththeTaxFoundation.“[W]hy
andhow[isit]thatforeignmultinationalfirmsmayhavea[n]... abilitytotransferpriceprofitsoutoftheU.S.[?] [A]
set of investigations about CFC rules and how they work... would be very interesting.”Desai (May 12, 2015).
11The information in Tables 1 and 7 is drawn from Voget (2011).
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across time over the sample period. The first and last implementations span 21 of the sample’s
27 years. Six of the 17 laws were implemented in isolation. At the other extreme, the highest
frequencyocurredin1995,when5lawswereimplemented. Asdiscussedinsection4.2,thestaggered
implementationofCFClawslendscredencetothenotionthatthemainresultsrepresentthecausal
relationship between CFC implementation and, for example, the profitability of foreign-owned U.S.
subsidiaries.
1.3 Hypothetical Illustration of CFC Laws
The practical consequences of the rules outlined above are illustrated in the following hypo-
theticalexample, presentedschematicallyinFigure2. Consideramultinationalfirmheadquartered
in Australia with subsidiaries in the U.S. and Bermuda. Ordinarily, Australia does not tax income
realized by the U.S. or Bermudian subsidiaries since Australia operates a territorial tax system.
However, once it implements a CFC law, the subsidiaries’ income may be taxed by Australia.
First consider the allocation of income before Australia implemented a CFC law. Suppose
theU.S.subsidiarygeneratesincome. Themultinationalhasanincentivetoincreaseitsconsolidated
after tax profits by shifting this income from the U.S., where the business income tax rate is
relatively high, to Bermuda, where the business income tax rate is relatively low. Suppose this
allocation occurs through the use of debt. The Bermudian subsidiary would make a loan to the
U.S. subsidiary. The U.S. subsidiary would make the interest payments, recording them as an
expense, thereby lowering its taxable income in the U.S. The Bermudian subsidiary would record
theinterestreceiptsasincome, makingthemsubjecttotaxationinBermuda(althoughinthiscase,
since the Bermudian tax rate on business income is 0%, they would not be taxed at all).
NowconsidertheallocationofincomeafterAustraliaimplementedaCFClaw. TheBermu-
dian receipt of interest payments would be classified as passive income. Australia’s CFC law would
stipulate that this interest income be taxed at the Australian business income tax rate, reducing
the multinational’s incentive to shift income from the U.S. to Bermuda. U.S.-generated income
may more often remain in the U.S. Moreover, U.S. income would in effect be subject to increased
taxation. ThismayinducetheU.S.subsidiarytolayoffworkersorreduceinvestment,ordiscourage
the Australian parent from establishing additional U.S. subsidiaries.
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