Dan Bucks served as Montana director of revenue from 2005 to 2013, the longest tenure in the state's history, and also as the executive director of the Multistate Tax Commission from 1988 to 2005. He is now a public policy and management consultant.
In this article, Bucks criticizes corporate income shifting and suggests ways for states to determine what constitutes a tax haven.
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In a previous State Fare column, I outlined the serious economic, social, and governmental damage that corporate income shifting to tax havens has on society (State Tax Notes, Mar. 24, 2014, p. 701 ). Income shifting shreds the integrity of state tax systems.
Morally, corporate income shifting constitutes the theft by some corporations of the value of public services. Economically, it rewards income-shifting corporations at the expense of honorable businesses, increases inequality, and reduces growth. Governmentally, it surrenders the power to tax to corporations, violates standards of equal treatment, and undermines democratic governance. Socially, it alienates citizens from their leadership and undermines the sense of community and trust necessary for a vital, democratic society.
In that column, I also concluded that egregious and intentional corporate income shifting would constitute tax evasion in states that require income to be reported to fairly represent the extent of the taxpayer's business activity in the state and that have provided sufficient notice to taxpayers regarding what income-shifting behavior will constitute evasion.
Effective State Legislation
The best cure for income shifting to tax havens or anywhere else is worldwide unitary combined reporting. Recently, tax experts have paid more attention to worldwide apportionment, especially as it relates to reforming the mess the U.S. government has made of international tax issues. However, the corporate corruption of the political process at all levels makes the revival of worldwide unitary reporting a political long shot. That is an unfortunate state of affairs.
U.S. Supreme Court decisions have affirmed the constitutionality of worldwide unitary combined reporting because it is fair, equitable, and nondiscriminatory. Yet with unabashed hypocrisy, corporate lobbying groups claiming to support constitutional methods of state taxation have vigorously opposed the most constitutional method of all. State enactment of worldwide unitary reporting would require elected officials to have a level of independence from corporate political influence rarely seen these days.
Worldwide unitary reporting has one misperception working against it: It sounds both abstract and expansive in the sense of reaching beyond a state's boundaries, when in fact the opposite is the case. The method seeks only to minimize taxpayer manipulation and determine fully and equitably the income earned within a state -- nothing more, nothing less. It really ought to be renamed the "equitable [insert name of state] income method." A name like that would match the perception with the reality of worldwide reporting.
Because worldwide reporting may not be politically attainable, extending combined reporting to include unitary affiliates in tax havens is gaining support as a reasonable, if partial, alternative. The tax haven approach has the appeal of getting to the point: Corporations should not be able to hide income in tax havens to avoid paying a fair share of taxes in states where the income was earned. After all, the states where the business activities occur fund the public services the corporations use.
Corporations should be prevented from using creative accounting, stuffing income into tax havens, and paying little or no tax to states where they do business. Owners of small businesses who know what they pay in taxes to support state and local services especially resent the accounting games played by multinational companies. Further, almost everyone understands the negative role that secret Swiss and Caribbean bank accounts and the like play in undermining the fairness and integrity of tax systems.
Business groups have been critical of the naming of tax havens, likening it to "blacklisting" those nations. That criticism is without any analytical foundation and is an empty lobbying ploy using an emotional term to distract attention from corporate tax abuses.
When a state designates a nation as a tax haven, it prevents corporations from using the laws of that country to avoid or evade taxes in the state. The designation effectively requires corporations to use the laws of that state to calculate their taxable income, just as most other businesses must do -- and that is all it does. States can use the designation to reclaim proper authority over corporations operating within their borders and apply their laws equally to all taxpayers. Those states are legitimately protecting their tax bases from the harmful effects of corporations using the laws of tax havens to underreport income.
What lobbyists are saying when they cry blacklisting is that they want their unnamed corporate clients to use the laws of the Bahamas, the Cayman Islands, Singapore, Switzerland, or other tax haven nations instead of a state's laws to determine the income they will report to that state.
In some sense, one can understand why corporate agents are reduced to alarmist hyperbole. Imagine what would happen if they stood before a legislative committee and told the truth: "We want our corporate clients to be able to use the laws of Vanuatu, Belize, Panama, or any other nation they choose to calculate the income they report to your state." There would be laughter from those lawmakers beyond the lobbyists' influence and embarrassed dissembling by those safely under their sway. If not laughter and embarrassment, then at least disregard ought to greet any use of the term "blacklisting" as an argument against tax haven legislation.
There also are arguments that applying formulary apportionment with either tax haven or worldwide combined reporting disrupts international trade. Once again, the truth is the opposite. What could be more disruptive to trade than to have -- in the form of misallocating capital and avoiding responsibility to pay for public services enjoyed -- income artificially shifted to a nameplate in Bermuda or to an earnings-stripping shell corporation in Luxembourg? The truth is that dividing income by formula among national and state jurisdictions in proportion to the location of a multinational's business activities (and presumptive use of public services) is less disruptive to trade and easier to administer than any method yet devised.
There has also been some confused muttering about the WTO. There is no evidence that the WTO is considering combined reporting. If the organization ever addressed a combination case, it would confront the legal reality that the Supreme Court has thoroughly vetted state use of combined reporting internationally in Container, Barclays, and Colgate-Palmolive. The Court applied every commerce clause test of equal treatment, fair apportionment, and nondiscrimination, and gave those state practices its seal of approval.
It would take enormous chutzpah for a WTO dispute panel to pretend to know better. Politically, it would be a surprise for the organization to take on the issue, given that leaders of the G-8 countries, G-20 countries, and European Union are all abuzz over issues of improper corporate income shifting to tax havens, with even the OECD now wringing its hands over base erosion.
One question in applying the tax haven approach is what criteria to use in defining and identifying havens. It turns out that the question is not all that difficult to resolve and is closely related to the central policy in the Uniform Division of Income for Tax Purposes Act that income should be reported so that it fairly represents the extent of the taxpayer's business activities in a state. Identifying tax havens based on a long-standing state policy in corporate tax law provides a solid, credible foundation for that process.
States could determine what constitutes a tax haven using three criteria, with meeting two of the three sufficient for designation:
- Disproportionate income reporting results. Do corporations overreport income to a potential tax haven when compared with the corporate share of business activities in the jurisdiction? For example, do corporations, on a multiyear average, report to a jurisdiction a share of income that is X percent greater than the corporate share of property, payroll, and sales in that jurisdiction?
- Legal framework for disproportionate income shifting. Does the potential tax haven provide a legal and administrative framework (general or specific tax rate features, secrecy provisions, selective exemptions, discretionary rulings, etc.) that enables corporations to disproportionately assign income to the jurisdiction or to move income through it on its way to another tax haven? Is any disproportionate assignment or movement of income traceable to the laws and practices of the jurisdiction individually or in conjunction with those of other jurisdictions (for example, the interrelated corporate use of laws and practices in Ireland and the Netherlands)?
- Recognition, marketing, and institutional infrastructure of a tax haven. Do independent tax practitioners or advisers identify the jurisdiction as a tax haven? Do they develop tax shelter methods and marketing that rely on the laws and administrative practices of the jurisdiction? Is there an infrastructure of local financial institutions and professionals that facilitates disproportionate income shifting to or through the jurisdiction?
The first criterion measures whether income is being reported in a manner that fairly represents the extent of business activities conducted in a state or country. For example, using U.S. Commerce Department data, Martin A. Sullivan in 2009 calculated that the share of U.S. multinational profits reported in 2006 in Ireland, Bermuda, Switzerland, the Cayman Islands, and Singapore was on average 178 percent more than the share of payroll, property, and sales reported in those jurisdictions.1 Surely, disproportionate income reporting that exceeds even 50 percent of the share of property, payroll, and sales in a jurisdiction should be grounds for being considered a tax haven. The type of data and analysis developed by Sullivan and others should be the first step in determining which jurisdictions are tax havens.
If information is unavailable to test the first criterion, states may use tax return and audit data to determine if any multinational corporations filing in their state are disproportionately shifting income to some jurisdictions. The available data may not always be suitable to making tax haven determinations. For example, the Netherlands is a full participant in facilitating the "double Irish Dutch sandwich" tax shelter that shifts income out of the United States and into tax haven destinations. However, the income flows through a Dutch subsidiary at one stage to take advantage of business registration in the Netherlands and the exemption from cross-border withholding on royalty payments. The income apparently does not come to rest there, thus failing to be reflected in Commerce Department data. However, analysis under the second and third criteria supports the conclusion that the Netherlands is a conduit tax haven.
Overall, the three criteria rely primarily on independent and objective information that can be readily understood by tax administrators, public officials, and affected taxpayers.
States could use the criteria for determining tax havens in several ways. They might enact and update state legislation that lists tax havens, as Montana and Oregon have done. Tax agencies to which legislatures have delegated tax haven determinations, such as those in the District of Columbia and West Virginia, could use the criteria for rulemaking or other administrative action.
While the examples thus far have used nations, states could also use the criteria to designate other states that act as tax havens. Legislatures in separate-entity states that are unprepared to enact full combined reporting might consider it for entities incorporated in tax haven states. Further, tax agencies could consider the use of tax evasion findings as a way to correct cases of abusive income shifting to tax haven states.
A second question regarding tax haven combined reporting is whether income might be included in the combined report without corresponding representation of factors that gave rise to the income. For example, could income from business activities in a foreign nation get shifted to a tax haven and then later apportioned to a state without the inclusion of factors from the country of origin in the denominator? That is hypothetically possible.
If that happened to any degreee, two remedies would typically be available. First, the taxpayer could elect worldwide combined reporting that includes all unitary income and associated factors. Second, the taxpayer could request alternative apportionment that brings in the factors from the country of origin if the income arose from business activities there. As in any other standardized process, adjustments can always be made to the results of the apportionment.
Tax Evasion Findings
Determining the circumstances under which income shifting constitutes tax evasion falls primarily to tax administrators. If egregious and intentional violation of the income reporting standard of UDITPA section 18 is potentially tax evasion, the taxpayer is entitled to prospective notice of what it must do to prevent being sanctioned. In an earlier column, I outlined regulations for an objective, quantifiable standard that taxpayers could meet to avoid underreporting penalties.2 In brief, those regulations provided that no underreporting penalties would be assessed if a corporation reported a percentage of its worldwide unitary income to a state that was within 95 to 100 percent of the percentage of its real business activities in the state calculated on the same basis.
Those regulations can be extended to provide notice to taxpayers of what cross-border income-shifting behavior would constitute tax evasion. They should begin with a finding that the egregious and intentional failure by a corporation to report income in a manner that fairly represents the extent of its business activities in the state is a violation of that state's laws and potentially subject to treatment as tax evasion. The regulations would specify that the underreporting must be determined to have been both egregious and intentional for a finding of evasion and would list the periods to which they apply.
Egregious underreporting could be determined using a single- or multiyear pattern. The underreporting would be determined by comparing the taxpayer's percentage of worldwide unitary income reported to the state with the percentage of its real business activities (property, payroll, and sales) in the state. For example, the single-year evasion standard could be set so that the taxpayer's percentage of income reported to the state was no more than 60 percent of the percentage of its real business activities in the state. Why that level? Because evasion is highly likely if an individual hid 40 percent of his income, and corporations should be held to the same standard.
On a multiyear basis, the egregious underreporting standard should be more strenuous because the taxpayer is engaging in a continuous pattern of unacceptable behavior. For example, the multiyear standard might be any cumulative three-year period in which the taxpayer's average percentage of reported income was less than 75 percent of the average percentage of its real business activities in the state.
The second condition for a finding of tax evasion would be a determination that the underreporting was intentional. Intentionality would exist if one of two conditions was met:
- the majority of the corporation's underreporting resulted from using a tax shelter method that assigned income otherwise attributable to the state to one or more tax havens; or
- the corporation used the secrecy provisions of another jurisdiction to conceal income otherwise attributable to the state.
The rules would need to define the terms "tax shelter method," "tax havens," and "secrecy provisions." If the state's law does not define and identify tax havens, the tax agency's rule must do so to implement the regulations. The tax haven criteria suggested earlier could be used for that purpose.
A few states have adopted abusive tax shelter legislation patterned after federal law to discourage both unacceptable taxpayer behavior and the marketing of abusive shelters by tax practitioners. Those states might implement their laws by using the type of rules suggested here for treating income shifting as tax evasion, with different degrees of underreporting subject to different levels of sanctions. States without abusive tax shelter legislation should consider it to deal with the rapid increase in corporate income shifting.
Several state constitutions include anti-surrender clauses prohibiting legislatures from surrendering sovereign taxing powers to private corporations or other governments. Those clauses may come into play when states do not have adequate statutory language to correct corporate income shifting.3 Concerned citizens and organizations in anti-surrender states should bring lawsuits challenging the statutes that allow multinational corporations to substitute the laws of other nations for the corporate tax laws of those states. In that way, the public may be able to participate directly in curbing illegitimate corporate income shifting and restoring their state's sovereign taxing power over multinational corporations.
Corporations and their tax planners engaging in extensive and lucrative income-shifting schemes may have difficulty understanding why their activities might constitute tax evasion or abusive tax shelters. Historically, those who live in or serve the world of concentrated wealth and power rarely see how their activities constitute an abuse of the public interest.
The view of what constitutes the public good from outside the regions of privilege and power -- Wall Street and Washington in particular -- is different from the view inside. The public has begun to perceive that middle-income America is disappearing rapidly, and the tolerance for the excesses of the elite is growing thin. It has little regard for the leadership class of this nation. Increasing alienation is spreading across the land. What direction that alienation may take -- toward a passive depression of the spirit or an angry response to the powers that be -- is unclear. If it is the latter, the measures suggested here will be considered only the most modest of reforms.
1 Sullivan, "Obama Launches International Reform: The Battle Begins," Tax Notes, May 11, 2009, p. 646.
2 Bucks, "One Small Step for States, One Giant Leap for Tax Equality," State Tax Notes, Dec. 2, 2013, p. 547.
3 For example, a few states with the water's-edge election have statutory language that may shield a corporation's activities outside the scope of the water's-edge unitary group from being subject to UDITPA section 18. In those cases, the state tax agency may be prohibited from challenging that weakness in state law on state constitutional grounds.
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