Just as water flows downhill, so do the profits of multinational corporations travel toward the countries with the lowest tax rates. That's a fact of life in an era of global markets and businesses; there will always be countries that set unusually low corporate tax rates in the hope of attracting investment and economic growth. The challenge for the rest of the world's nations is to make sure corporations follow the rules designed to distinguish legitimate tax minimization from illegal tax evasion. The European Commission took a welcome step in that direction last week when it announced an investigation into how three of its members treated Apple, Starbucks and Fiat. Yet the EU's probe won't touch some of the most controversial profit-shifting techniques, highlighting the need for a global crackdown on corporate shell games.
Each European Union country applies its corporate income tax only to the revenue a business makes within its borders. A multinational based in Germany, for example, would pay German taxes on its headquarters' profits, but its French subsidiary's profits would be taxed in France.
Things get tricky, though, when multinationals shift assets from one country to another in search of lower tax rates. If there were no rules governing such maneuvers, a manufacturer in France could transfer its products — not physically, just on paper — to an Irish subsidiary at an artificially low price that just covers its costs. It could then record sales of those products on the Irish company's books, shifting the profits from its French ledgers (tax rate: 33%) to its Irish ones (tax rate: 12.5%). To stop such accounting legerdemain, numerous countries require multinationals to assign a fair price to their internal asset transfers.
The European Commission's investigation will examine whether Ireland, the Netherlands and Luxembourg allowed Apple, Starbucks and Fiat, respectively, to transfer assets at artificial prices in order to cut their tax bills, amounting to an impermissible state subsidy. Fiat and Apple have denied any impropriety, and Starbucks has said it is moving its European headquarters out of the Netherlands. The decisions by the targeted countries, however, are at least as much a focus for investigators as actions by the three companies. If tax officials contorted the transfer pricing rules to attract or keep the companies' business, they did more than reduce the tax revenue collected by other EU states. They put their fingers on the scales of competition and distorted the markets for the companies' goods.
Sadly, the commission's probe will ignore some of the most notorious techniques used by multinationals to launder profits between subsidiaries in tax havens, such as the "Double Irish" and "Dutch sandwich" maneuvers Google and other tech-centric companies have used to shield foreign earnings even from Ireland's low tax rate. Such dodges are legal, if unseemly, efforts to stuff global earnings into the gaps left by different countries' tax laws. The more markets become global, and the more companies derive their income from assets that can move easily from country to country, the more widespread these practices will be.
The United States taxes the profits that American corporations make through their foreign subsidiaries as soon as they bring the money back into this country, theoretically eliminating the incentive for transfer-pricing and tax-haven chicanery. But the U.S. system encourages multinationals to move their headquarters offshore or to reinvest profits overseas instead of expanding here, which are problems in their own right. And it does not discourage companies from playing shell games with the income earned by foreign subsidiaries. According to one study, U.S. multinationals attributed nearly 60% of the income these subsidiaries earned to 16 tax havens where they had little sales, employment or other business activity.
Although the commission's investigation will shed more light on the tax practices of multinationals, what's needed is an international effort to standardize transfer pricing and eliminate the loopholes created by the inconsistencies among countries' tax codes. The corporate impulse to avoid taxes is understandable. But as governments vie for corporate investments, they shouldn't be distorting markets and depressing other countries' tax revenue by helping multinationals hide their profits.