We cannot turn “a blind eye to the highly questionable tax strategies that corporations like Apple use to avoid paying taxes in America.” So said Republican Sen. John McCain at a Senate hearing in 2013. He was referring to income shifting by U.S. multinationals: the use of foreign subsidiaries to siphon profits out of the U.S. and into countries with lower tax rates.
Since then, researchers, journalists, and policymakers have indeed taken a hard look at these strategies. And some scholars have suggested that, in the glare of the spotlight, it may be more difficult for firms to dodge taxation today. After all, the Internal Revenue Service can easily spot the signs of aggressive tax avoidance and initiate an audit.
“These arrangements are subject to an incredible amount of scrutiny now,” says Stanford Graduate School of Business accounting professor Lisa De Simone, a leading expert on income shifting. “So we wanted to see, are companies still getting away with it?”
To find out, she, along with Lillian Mills of the University of Texas at Austin and Bridget Stomberg of the University of Georgia, analyzed more than 11,000 corporate tax returns. What they learned, as reported in a new paper, is that firms that engage in income shifting do fare worse under audit than other multinationals, losing a larger share of their claimed tax benefits. But because they claim so much tax savings, they still end up paying less tax.
The takeaway? Apparently it pays to push the line on tax avoidance. “Corporations respond to incentives,” De Simone says. “If a firm is thinking of moving more profit off its domestic books, they view it as a business decision, balancing the tax savings against the risk of reversals and penalties. But we find that even if the IRS challenges them, they still come out ahead, so there’s not much downside.”
Spotting the Shifters
Not all companies can take advantage of these tax strategies. The Senate investigation targeted the country’s tech giants, who have a big advantage: Their key assets are intangibles like software and patents, which — unlike factories or coal mines — can easily be relocated to, say, Bermuda, enabling the parent company to claim that its income was earned there.
The other common method of income shifting is to set up a global supply chain that involves buying from or selling to subsidiaries in low-tax nations. Then, by pricing the goods or services to favor those affiliates, firms can shrink profit margins at home and inflate them abroad — essentially piggybacking tax avoidance on business operations.
Now, by law, these “transfer prices” are supposed to be set at a level that an independent supplier would charge. But if the product is unique, De Simone says, it’s very difficult for the IRS to second-guess the price — there’s no basis for comparison.
So for the study, the first step was to identify firms that are able to shift income. To pick out those with intangible assets (which are not well captured on balance sheets), the researchers looked at R&D spending and advertising. As a proxy for uniqueness, they considered gross margins and membership in an industry, such as pharmaceuticals, where innovation is important.
The researchers combined those factors into a single measure of income mobility. Then, running some preliminary analysis, they found that income-mobile companies do indeed channel more of their earnings out of the U.S. and claim larger tax benefits on their returns. In other words, firms with greater ability to shift income were taking advantage of the opportunity.
But the question remained: Do those claimed tax savings withstand IRS scrutiny? Despite the hand-wringing in Congress, academics have tended to doubt that companies can get away with it — and some prior studies support that view. But those findings are suspect, De Simone says, because they rely on financial statement data, which doesn’t reflect actual tax outcomes.
For this paper, she and her coauthors had rare access to IRS databases, including not just actual tax returns but also complete audit records extending through final case settlement. With a sample covering 2,202 U.S.-based multinationals between 1999 and 2014, it was an unprecedented opportunity to see what really happens to firms that engage in income shifting.
Playing a Numbers Game
What they found is that these firms do indeed fare worse under audit than other multinationals. While they were audited at about the same rate (large corporations are audited fairly routinely), they were more likely to have their claimed tax savings challenged, and the challenge hit a larger share of their claimed tax savings.
In dollar terms, the average tax deficiency proposed by the IRS for an income-mobile firm, $9.4 million, was twice that of other multinationals. In total, the IRS held that income-mobile firms in the sample underpaid on U.S. taxes by $16 billion. And those firms were no more successful in defending their positions; after appeals, they lost a larger share of claimed tax benefits.
That $16 billion, which the IRS proposed to recover, sounds like a hefty assessment. But putting it in context of total claimed tax savings by these companies — $235 billion — paints a different picture. In fact, because income-mobile firms shelter so much of their income, they still end up paying less U.S. tax. At the end of the audit process, De Simone says, the average effective tax rate for income-mobile firms was 1.8 percentage points lower than that paid by other multinationals. For a big company with $5 billion in pretax earnings, that’s an extra tax advantage of $90 million.
“The IRS can see what’s going on,” De Simone says. “They know who these income-shifting companies are, and they do challenge them.” In fact, the agency spends more time on audits of income-mobile firms — 165 agent-days more per audit, on average. “But there’s so much tax avoidance going on, only a fraction of it is getting called back in audit.”
Thriving in Murky Waters
The problem for tax authorities, she explains, isn’t detecting income shifting; the problem is that it’s hard to fight. “Auditors can go in and ask to see a company’s transfer pricing documentation. But then they have to sift through thousands of pages to figure out which transactions are the most tax-aggressive and which they have the best chance of prevailing on. It takes time.”
And they’re working at a disadvantage: The company almost always has better information about how much its products and assets are worth. “Intellectual property, especially, is hard to value,” De Simone says, “and the burden is on the auditors to prove their estimate is better. Some of these disputes go to court, and the IRS has been losing those cases.”
The fact is, the agency is outmatched. It’s well aware of the “questionable tax strategies” McCain spoke of, and it has focused intently on this issue for at least the past 15 years. But given the magnitude of income shifting today and the agency’s limited resources, it can’t hope to make up much of the revenue loss through audits — at least under current law.
And maybe that’s the game for income-mobile firms, De Simone suggests: “You’re willing to give up these adjustments to the IRS, because you have so much more that they haven’t even brought to the table. The more tax savings you claim, the more you end up with.”