Profit shifting

What Is Profit Shifting?

Profit shifting is a strategy employed by multinational corporations to legally move profits from higher-tax jurisdictions to lower-tax jurisdictions or tax havens. This practice, a component of broader international taxation strategies, aims to reduce a company's overall corporate tax liability. Profit shifting typically involves transactions between related entities, such as a parent company and its subsidiaries, often leveraging disparities in tax laws across different countries. One of the most common methods involves manipulating transfer pricing, which refers to the pricing of goods, services, and intangible assets transferred between related entities.

History and Origin

The concept of profit shifting is as old as multinational commerce itself, but it gained significant global attention in the early 21st century due to increased globalization and digitalization. As companies expanded across borders, the inconsistencies and loopholes in various national tax systems became more apparent, allowing for sophisticated profit shifting schemes. Governments and international organizations began to recognize the substantial revenue losses attributable to these practices. In response, the Organisation for Economic Co-operation and Development (OECD) and G20 countries launched the Base Erosion and Profit Shifting (BEPS) project in 2013. The BEPS project aimed to create a more uniform and coordinated international tax system to prevent multinational enterprises from shifting profits to low-tax jurisdictions and reduce their overall tax liabilities.,¹² This initiative released final reports in 2015, outlining 15 action plans to combat BEPS, which included measures to address issues such as treaty abuse, harmful tax practices, and transfer pricing guidelines.¹¹,¹⁰ The project sought to ensure that profits are taxed where economic activities generating them are performed and where value is created.

Key Takeaways

• Profit shifting involves multinational corporations strategically reallocating taxable income to lower-tax jurisdictions to reduce their global tax burden.
• Common methods include manipulating transfer prices, intellectual property relocation, and intercompany financing arrangements.
• International efforts, such as the OECD's BEPS project, aim to counter profit shifting through enhanced transparency and aligned global tax rules.
• While often legal, profit shifting is contentious due to its impact on government revenues and perceived fairness in the global tax system.
• Regulations like the arm's length principle and Controlled Foreign Corporation (CFC) rules are key tools used by tax authorities to combat aggressive profit shifting.

Interpreting Profit Shifting

Profit shifting is interpreted in the context of international tax planning. When a company engages in profit shifting, it is typically aiming to minimize its effective tax rate globally. This often involves intricate legal structures and transactions designed to move value, particularly in the form of intellectual property or financing arrangements, to jurisdictions with lower tax rates. The scale of profit shifting can vary widely among companies and industries. High-value, easily mobile assets like intangible assets are often central to profit shifting strategies, as their fair market value can be difficult to determine, providing latitude for aggressive transfer pricing.

Hypothetical Example

Consider a multinational technology company, "GlobalTech Inc.," headquartered in Country A, which has a corporate tax rate of 25%. GlobalTech has a subsidiary, "IP Holdings Ltd.," located in Country B, a jurisdiction with a 5% corporate tax rate.

1. Creation of Value: GlobalTech's research and development (R&D) team in Country A develops a groundbreaking new software.
2. IP Transfer: GlobalTech then "sells" or licenses the rights to this software's intellectual property to IP Holdings Ltd. in Country B for a relatively low price, or through an arrangement where IP Holdings receives the majority of the future royalties generated by the software.
3. Revenue Generation: The software is marketed and sold globally by various GlobalTech subsidiaries. All revenues from these sales are technically directed to IP Holdings Ltd. in Country B as royalty payments for the use of the intellectual property.
4. Expense Shifting: Additionally, GlobalTech Inc. in Country A might take out large intercompany loans from IP Holdings Ltd. in Country B, accruing significant interest expenses in Country A. These interest payments are tax-deductible in high-tax Country A, further reducing GlobalTech's taxable income there.
5. Tax Outcome: The bulk of the profits from the software sales are now legally recognized in low-tax Country B, subject to only a 5% tax rate, while the taxable income in high-tax Country A is significantly reduced by deductible expenses. This results in a much lower overall global tax payment for GlobalTech Inc. than if all profits were taxed in Country A.

Practical Applications

Profit shifting manifests in various aspects of corporate finance and international tax planning. It is primarily observed in how multinational corporations structure their global operations and intercompany transactions.

One primary application area is the use of transfer pricing for tangible goods, services, and particularly intangible assets. Companies might set prices for internal transactions to shift profits from high-tax regions to low-tax ones. For example, a manufacturing subsidiary in a high-tax country might sell goods to a distribution subsidiary in a low-tax country at a low price, thereby recognizing less profit in the manufacturing country. Tax authorities, such as the U.S. Internal Revenue Service (IRS), provide guidance on transfer pricing, expecting intercompany transactions to adhere to the arm's length principle, meaning prices should be comparable to those between unrelated parties.⁹,⁸ The IRS publishes regulations and offers programs like the Advance Pricing and Mutual Agreement program to resolve complex international transfer pricing cases.⁷

Another key application involves the strategic location of intellectual property. Companies often centralize valuable patents, trademarks, and copyrights in subsidiaries located in jurisdictions with favorable tax regimes for royalties and intellectual property income. These subsidiaries then "charge" other group entities for the use of these assets, leading to deductible expenses in higher-tax countries and taxable income in lower-tax ones.

Furthermore, intercompany financing, such as intercompany loans, can be used to shift profits. A subsidiary in a high-tax country might pay interest on a loan from a related entity in a low-tax country, thereby reducing its taxable income. Regulations like Controlled Foreign Corporations (CFC) rules aim to prevent the deferral of taxation on certain income earned by foreign subsidiaries. The European Union's Anti-Tax Avoidance Directive (ATAD) includes measures like interest limitation rules and CFC rules to counter aggressive tax planning within the EU.⁶,⁵

Limitations and Criticisms

While profit shifting can offer significant tax savings for multinational corporations, it faces substantial limitations and criticisms, primarily from governments and the public. A major criticism is the erosion of national tax bases, which can deprive countries of crucial revenue needed for public services and infrastructure. The OECD estimates that the worldwide annual loss of potential tax revenue due to BEPS practices is significant.⁴

One key limitation arises from the increasing scrutiny and regulatory efforts by international bodies and national tax authorities. The OECD's BEPS project, for instance, has led to widespread changes in international tax laws, making aggressive profit shifting more difficult and riskier. Tax administrations are enhancing their capabilities to audit complex cross-border transactions and challenge structures that lack economic substance. For example, the International Monetary Fund (IMF) has acknowledged that stronger anti-avoidance measures can impact investment decisions and lead to increased corporate tax revenue.³,²

Companies engaging in profit shifting also face reputational risks and public backlash. High-profile cases have led to negative media attention and calls for stricter regulations, potentially damaging brand image and consumer trust. There is also the risk of double taxation if different countries dispute the allocation of profits and a consensus cannot be reached through mutual agreement procedures.

Moreover, the effectiveness of profit shifting can be limited by anti-abuse rules, such as General Anti-Abuse Rules (GAARs), which allow tax authorities to disregard transactions primarily motivated by tax avoidance. Compliance with evolving international tax standards, including detailed financial statements and country-by-country reporting requirements, adds significant administrative burden and cost. An IMF blog post discusses the global efforts towards a minimum corporate tax, which aims to further limit profit shifting by putting a floor on rates.¹

Profit Shifting vs. Tax Avoidance

While often used interchangeably or relatedly, "profit shifting" is a specific tactic within the broader concept of "tax avoidance".

Profit Shifting refers to the strategic movement of taxable income from one jurisdiction to another, typically from a high-tax country to a low-tax one, within a multinational corporate structure. It focuses on the internal reallocation of profits across related entities using methods like transfer pricing manipulation, intercompany loans, and intellectual property transfers. Profit shifting specifically describes how a company legally reduces its tax base in one jurisdiction by moving profits elsewhere.

Tax Avoidance is the legal act of minimizing tax liability by taking advantage of loopholes, deductions, credits, and other legitimate tax planning strategies permitted by tax law. It encompasses a wide range of actions, from individuals claiming eligible deductions to corporations structuring their operations to benefit from favorable tax treaties or incentives. Profit shifting is a form of corporate tax avoidance, but tax avoidance itself can also include domestic strategies not involving cross-border profit reallocation, such as accelerated depreciation or utilizing tax credits for research and development. The key distinction is that profit shifting is a mechanism or technique of tax avoidance that specifically leverages international differences in tax rates and rules among related entities.

FAQs

What is the main goal of profit shifting?

The main goal of profit shifting is to reduce a multinational corporation's overall global corporate tax burden by legally reallocating taxable income to jurisdictions with lower tax rates.

Is profit shifting illegal?

Profit shifting generally operates within the bounds of existing tax laws and treaties, making it distinct from illegal tax evasion. However, tax authorities are increasingly scrutinizing aggressive profit shifting practices, often challenging them if they are deemed to lack economic substance or violate the arm's length principle.

How do companies shift profits?

Companies often shift profits through methods like adjusting prices for goods and services exchanged between their subsidiaries (transfer pricing), moving intangible assets like patents to low-tax jurisdictions and then charging high royalties for their use, or arranging intercompany loans that generate deductible interest expenses in high-tax countries.

How does profit shifting impact a country's economy?

Profit shifting can reduce the amount of revenue a country collects in corporate tax, potentially impacting public services and infrastructure. It can also create an uneven playing field for domestic companies that do not have the same opportunities to shift expenses or net income across borders.

What is being done to combat profit shifting?

International efforts, most notably the OECD's Base Erosion and Profit Shifting (BEPS) project, aim to counter profit shifting. These initiatives involve developing common standards and recommendations for countries to update their tax laws, increase transparency, and ensure that multinational corporations pay taxes where economic activity occurs and value is created. This includes new rules on transfer pricing documentation and proposals for a global minimum corporate tax.