Unintentional tax humor at Forbes

David Cay Johnston emailed me that there were errors in Forbes contributor Tim Worstall’s recent criticisms of the linked article. Indeed there are, but the biggest one (or at least the funniest one) isn’t the one Johnston pointed me to.

Worstall writes that AbbVie’s pending inversion will not, by itself, reduce the taxes the company owes on its U.S. operations, though it could be a preparatory move to drain profits from the United States. I’ll come back to that point, but Worstall then gives the example of how AbbVie might sell its patents to a foreign subsidiary and pay royalties to that unit, thereby draining U.S.-generated profits to a tax haven subsidiary, for instance Bermuda (though Ireland is more germane in the real world for intellectual property). But then comes the zinger:

However, do note something else that has to happen with that tactic. That Bermudan company must pay full market value for those patents when they are transferred. Meaning that the US part of the company would make a large profit of course: thus accelerating their payment of tax to Uncle Sam. This tax dodging stuff is rather harder than it sometimes looks: if you’re going to place IP offshore you can do that, certainly, but you’ve got to do it before it becomes valuable, not afterwards. [link in original]

“Must pay full market value”? I’m falling off my chair! It’s like Worstall doesn’t think transfer pricing abuse exists. If patent, copyright, and other intellectual property transfers had to be made at full market value, they would never happen. As I explain in the linked post, academic research has shown that transfer pricing abuses, in this case underpricing the intellectual property transferred from the United States to Bermuda (again, really Ireland), are quite common when no arm’s-length market exists for a good. Since companies aren’t going to sell their crown jewels to strangers, how can a tax authority know what will be a fair price for a Microsoft patent going from the U.S., where it was derived, to its Irish subsidiary?

Let’s be a bit more precise. What would it take for Apple to buy all of Microsoft’s patents? In return for whatever lump sum Apple paid, it would need the equivalent back in terms of the present value of all Microsoft’s future royalty payments. But if Microsoft sold its patents to its Irish subsidiary at that price, Worstall would be right that there would be no tax benefit. And it’s not like it’s cost-free to organize such a transaction. Not only would Microsoft incur the costs of drawing up the contract and so forth, but nowadays companies are taking reputational hits as a result of their tax shenanigans: Ask Starbucks, Google, and Amazon. So if the transaction created no true savings, yet hurt a company’s reputation, we know that it wouldn’t make the transaction. The fact that multinationals are flocking to sell their intellectual property to Irish subsidiaries where the royalties are tax free tells us that the transfer price is not the “full market value” Worstall claims.

Moreover, contra Worstall, it isn’t a question of transferring the intellectual property before it’s valuable. If you’re a multinational drug company, you can make estimates of FDA approval, how much you think a drug will earn, and so forth. And you’ve got inside information! To take the simplest possible example, let’s say AbbVie has two drugs it thinks are each 50% likely to generate revenues with a present value of $500 million each. If you believe Worstall, it will sell one of the patents to its Bermudan subsidiary for only $250 million. But it will sell its other patent for another $250 million, so the supposed cost will still be $500 million and the subsidiary will expect to earn revenues equal to a present value of $500 million off whichever drug turns out to be successful. It’s inescapable that there is no point for a multinational company to sell the patent to its subsidiary at a fair price. There would be no tax benefit, and we wouldn’t be seeing Microsoft with $76.4 billion offshore or Apple with $54.4 billion offshore in 2013. Or a total of $1.95 trillion for 307 companies. Heck, even AbbVie has $21 billion permanently reinvested offshore, according to its 2013 Annual Report (downloadable here), p. 93. “Full market value,” indeed.

Finally, a note on Johnston’s and Worstall’s main dispute. Worstall argued that an inversion does not reduce the tax that a U.S. subsidiary would owe to the United States, noting that you can drain profits (except, as we saw, he doesn’t really believe you can drain profits) from the American subsidiary as long as you have a tax haven subsidiary, i.e., you don’t need inversion for that.

From a very narrow point of view, this is correct. But what Worstall overlooks is that, for the U.S., worldwide taxation substitutes for a general anti-avoidance rule making avoidance itself illegal, which is the approach most other industrialized countries take. Inversions make it impossible to police avoidance, so they indeed threaten tax collections from U.S. subsidiaries. But one might argue that deferral has almost completely neutered the benefit from worldwide taxation already. The bottom line is that the United States needs an end to deferrals at least until it adopts strong anti-avoidance rules, at which point it would only then be possible to discuss ending worldwide taxation.

But all of that will be for naught if we allow ourselves to be seduced by silly claims about how transfer prices have to be the same as “full market value.”

Cross-posted from Middle Class Political Economist.

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