Ways & Means examines income shifting through U.S. transfer pricing system

The U.S. Treasury has found evidence of substantial income shifting through transfer pricing, said Deputy Assistant Secretary Stephen Shay at a July 22 House Ways and Means Committee hearing. Shay appeared before the panel to discuss U.S. transfer pricing issues and also outlined several Obama administration proposals to curtail excessive income shifting.

For their part, Ways and Means Committee Chairman Sander Levin, D-Mich., and several other House taxwriters expressed concern regarding the ability of U.S. multinational corporations to utilize the transfer pricing rules to shift profits overseas to avoid paying U.S. taxes. That concern was shared by several other witnesses from outside the government, although the panelists differed in their approaches to reform.

On the other hand, Ways and Means ranking Republican Dave Camp of Michigan advocated the careful consideration of the “economic implications of altering the current rules,” and expressed concern about the role the comparatively high U.S. corporate tax rate plays in incentivizing the movement of income offshore.

Administration proposals

Shay cited two proposals in the Obama administration’s FY2011 budget to prevent what it believed to be improper income shifting to low-tax jurisdictions. These proposals would:

Reduce inappropriate shifting of income outside the United States by clarifying the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill, and going concern value; clarify that where multiple properties are transferred, the valuation of intangible property on an aggregate basis is permitted where that achieves a more reliable result; and clarify the valuation of intangible property taking into account the prices or profits that a controlled taxpayer could have realized through realistically available alternative transactions.
Provide that where a U.S. person transfers an intangible from the United States to a related controlled foreign corporation that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting, then an amount equal to the excessive return will be treated as subpart F income in a separate foreign tax credit limitation basket.

Significantly, however, Levin assured the panel that the hearing was not convened to discuss any specific proposals, and Shay did not request any immediate legislative action on these, or any other, proposals.

Congressional proposals

Ways and Means member Lloyd Doggett, D-Texas, spoke out in favor of legislation (H.R. 5328) he introduced in May of this year that would amend the Internal Revenue Code to:

Treat foreign corporations that are managed, directly or indirectly, within the United States as domestic corporations for U.S. tax purposes;
Make certain royalty income and income from intangibles received from a controlled foreign corporation subject to U.S. taxation;
Repeal tax rules exempting foreign-source income attributable to the active conduct of a foreign trade or business from withholding of tax requirements; and
Revise the tax treatment of property other than stock (i.e., boot) received in connection with a corporate reorganization to provide that such property shall be treated as a taxable dividend.

Doggett argued that “some multinationals avoid taxes and shift the burden of paying for our national security, our homeland security, and other public services on to the small businesses and family taxpayers who play by the rules,” and that Congress must take steps to stop such “international shenanigans.”

House Democratic leadership has not weighed in on Doggett’s bill and there are no plans for action at this time.

Arm’s length standard

Several witnesses expressed the belief that the arm’s length standard is unworkable in the context of the transfer of high-value intangibles between related parties. Shay indicated that the administration believes that both of their proposals are consistent with the arm’s-length standard, while James R. Hines of the University of the Michigan Law School took the view that the excess return proposal is inconsistent with the current transfer pricing guidelines.

Formulary apportionment, according to economist Martin Sullivan of Tax Analysts, is a system under which “the worldwide profits of a multinational business are allocated in proportion to some combination of observable factors like sales, employment, and tangible property.” Shay countered that unless there is strong international cooperation including parallel systems in other countries, there is a risk of double- or over-taxation. The arm’s length standard, Shay said, is worth “enforcing, enhancing, and defending.”

U.S.-based research and development

Levin and other committee members expressed a number of concerns related to the interaction between the R&D credit and current transfer pricing rules. In particular, members expressed concern that the current U.S. tax rules do not properly balance the R&D credit incentive for U.S.-based research with the ability to defer earnings derived by foreign affiliates from operations that use intellectual property created from such research.

Other committee members and witnesses expressed concern regarding the potential impact that any transfer pricing reform may have in the migration of U.S.-based R&D activities outside the United States. After repeated questioning regarding this potential impact, Shay stated it was his belief that the U.S. has “world-class R&D capabilities,” and that any change to the U.S. tax rules would not impact multinational corporations’ choice of location for R&D activities.

Corporate tax rate

Committee members John Yarmuth, D-Ky., and Wally Herger, R-Calif., repeatedly pressed Shay for the administration’s stance on the corporate tax rate. Ranking member Camp asserted that the “real problem” is that the U.S. rate is too high, which, he said “discourages investment and job creation” and forces companies to “struggle to stay competitive.”

Shay hesitated to state an administration position on the current corporate tax rate, but did express that the current tax deductions available to multinational corporations make the effective marginal tax rate much lower.

— Kathy Loden
Tax Policy Group
Deloitte Tax LLP

The information contained is for general purposes only. The views expressed in this article are those of the author and do not constitute tax advice from or reflect the view of Deloitte & Touche LLP. Deloitte & Touche LLP assumes no responsibility with respect to assessing and/or advising the reader as to the respective tax consequences arising from circumstances relating to the reader's particular tax situation. It is recommended that the reader consult with their own tax advisor with regard to the application of the tax laws and resulting tax consequences relating to the reader's particular situation.