Multinationals and Taxation

Via Michael Perelman comes an interesting discussion of the role of the multinational by Michael Mandel, which includes:

Moving operations overseas gives a multinational an almost infinite number of legal and quasi-legal strategies for reducing U.S. corporate taxes. It can borrow in high-tax countries to take maximum advantage of interest-rate deductions; it can transfer intellectual property to low-tax countries, in exchange for below-market royalty payments; and when it ships goods to its foreign affiliates, it can charge low prices to shift profits to low-tax jurisdictions. The result is that collections of U.S. corporate income taxes have been dropping significantly as a share of total global profits for U.S. companies. “Companies have taken advantage of these favorable cost-shifting agreements,” says Jack Mutti, an economist at Iowa’s Grinnell College and an international tax expert. “The law gets so complicated that very few people can understand what the trade-offs are.” To encourage multinational expansion in the U.S., it may be necessary to revise the corporate tax system, a step for which there is surprising support from Democrats and Republicans alike. One proposal—with the arcane name “formulary apportionment”—would tax the earnings of multinationals based on the proportion of their customer base in the U.S.

When I read these calls for formulary apportionment, my usual response is simply: why not enforce the section 1.482 regulations which declare that intercompany payments should be consistent with the arm’s length standard. If a US parent transfers intellectual property for below-market royalty payments, the IRS has the right to adjust upwards the taxable income of the US parent to reflect the market royalty rate. Of course, I’m assuming that the IRS is properly staffed to evaluate these issues and is otherwise not hamstringed by the system. I’m not saying Mandel is incorrect to assume that intercompany royalty rates are set at below market value as I often wonder if the IRS is really doing its job properly.