Inversions and Transfer Pricing Will Hurt the US Economy
By Trevir Nath AAA |
Inversions and Transfer Pricing Will Hurt the US Economy
With liberal trade restrictions and globalization, companies and economies around the world have become more financially intertwined. For the most part, this has stimulated economic growth around the world, creating more affordable goods and services for consumers. That being said, there is a big loophole in the tax system between countries in the global economy. Many multinationals like Apple, have moved their most profitable subsidiaries overseas to reap the tax advantage unavailable in the United States. As this continues to occur, the United States continues to have the world’s highest corporate taxes of 35%. If you factor in state taxes, this can be closer to 40%. To put this in perspective, the average tax rate of countries belonging to the Organization for Economic Cooperation and Development (OECD) is 24%. This may even seem high compared to tax havens such as Ireland, which boasts corporate tax rates of 12.5%. Most multinationals do not operate or generate revenue in these tax-friendly countries, yet through corporate inversion and transfer pricing, financial statements could lead you to believe otherwise. For a company like Apple (APPL), valued almost at $1 trillion, this can save the organization multiple billions of dollars in annual tax payments.
What is Corporate Inversion?
For many multinationals, a key piece of financial planning is taking advantage of the tax structures around the world. Since corporate taxes are high in the U.S., many firms elect to invert operations overseas to reduce their tax burdens. By definition, corporate inversion is a strategy of reincorporating a company overseas to reduce the tax burden on income earned abroad. Traditionally, inversion was used by companies that generate revenue overseas, since that income is subject to taxes domestically and abroad. The undertaking of this strategy can be done by legally restructuring your corporate headquarters overseas or through the acquisition of a previously established company. Inversions are particularly attractive for companies that own a lot of intangible assets, including patents, trademarks, brand names or intellectual property. As a result, technology and pharmaceutical companies have been particularly drawn to corporate inversion. However, corporate inversion does not work in all industries and for firms with many tangible assets, it is almost infeasible. For example, a car manufacturer in the United States produces, sells and holds many of its assets through brick and mortar stores and cannot function overseas.
While corporate inversion is frequently used, accounting for this practice can often be difficult. In accounting, transfer pricing is used to record transactions conducted between divisions of a large corporate entity. Sound accounting treats corporations as a single entity, no matter how many different operations exist around the world; however, federal tax laws treat corporate subsidiaries as separate economic actors. According to American tax laws, a company’s profits are only subject to U.S. taxes only when cash is repatriated. As a result, multinational corporations record massive shifts in profits to countries with minimal tax burdens.
Apple has taken advantage of tax inversion for more than 30 years. In 1980, Apple established its international headquarters in Ireland, thanks to friendly corporate tax rates. Despite Ireland’s already low tax rates, Apple continues to pay less than 2% in taxes because of a preexisting agreement with the Irish government. On top of that, Ireland’s tax structure promotes R&D with 25% tax breaks. Apple has taken advantage of this strategy by shifting R&D costs to Ireland, resulting in even further tax breaks. That being said, 90% of Apple’s cash holdings remain overseas. It is estimated that $180 billion of Apple’s $200 billion in cash holdings remain abroad, theoretically to avoid incurring U.S. taxes.
By the Numbers
With the advances in technology and globalization, operating a business overseas and domestically has never been so easy. As a result, many multinationals have flocked to low tax havens to avoid incurring high tax rates from the United States. Since 1980, the share of American firm profits booked overseas has more than doubled. Amongst the United States largest companies, it is estimated $2 trillion in profits remain offshore.
Impact on the U.S. Economy
Despite the negative connotations corporate inversion receives, there are benefits to the U.S. economy. Tax inversions can result in a greater flow of income into the United States and as a result, expand operations at a lower cost than its competitors. Since many of the largest firms pursue tax inversions, their success can influence future employment. Supposing a company has more cash on hand, then they are more likely to expand operations and create jobs. Likewise, when a company’s profits increase, shareholders wealth does as well because stock prices are determined by expected and actual earnings.
While corporate inversions can be beneficial for stimulating economic growth, there are much better ways to stimulate the economy and often inversions can be detrimental. In particular, when companies avoid U.S. taxes, the government forgoes billions of dollars in tax revenue used to build the economy. For example, if Apple were to repatriate their foreign cash holdings, they would be subject to a tax bill close to $60 billion. Yet many multinationals continue to avoid exorbitant tax burdens even though the U.S. government invests heavily into supporting these industries. For the most part, small businesses and consumers end up making up the difference in forgone taxes. This trend threatens to undermine our federal tax base and is projected to cost the United States, $34 billion over the next ten years.
The Bottom Line
Despite being an age old concept, corporate has become a buzzword as globalization progresses. Many multinationals use this strategy to avoid the higher tax rates the U.S. imposes on corporations. While its legality is unquestioned, the government often deems the act unpatriotic and detrimental to the economy. Despite the monetary benefits, companies, such as Walgreens, have forgone their inversion plans due to the negative publicity the company received. As tax inversion continues to proliferate, the government must be put in place reforms to preserve federal tax revenue while also not crippling the profits of multinational corporations.
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