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March 11, 2008
U.S. Multinationals Shifting Profits Out of the United States
by Martin A. Sullivan

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
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%)

Figure 1. Growth of Profits and Profit Level Indicators
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.

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