HOW U.S. TAX REFORM REWARDS COMPANIES THAT SHIFT PROFIT TO TAX HAVENS

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HOW U.S. TAX REFORM REWARDS COMPANIES THAT SHIFT PROFIT TO TAX HAVENS

Posted by Kim Chen on June 25th, 2018

Michael Erman, Tom Bergin, Reuters
As reported by Reuters, the corporate tax cut enacted in the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017) was in part designed to help dissuade U.S. companies from moving profits overseas, but may instead make the practice a lot more rewarding.
Under pre-TCJA law, companies which shifted profits linked to U.S. sales, research or production previously had to pay U.S. taxes on the money at the rate of 35% when they brought those profits home.
The TCJA cuts the overall corporate tax rate to 21%, and allows income from overseas to be taxed at about half that rate – as low as 10%. For more details on the TCJA provisions relating to businesses, see “2017 Tax Reform: Checkpoint Special Study on Business Tax Changes in the ‘Tax Cuts and Jobs Act'” (12/28/2017); and for more details on the foreign tax changes in the TCJA, see “2017 Tax Reform: Checkpoint Special Study on foreign income, foreign persons tax changes in the ‘Tax Cuts and Jobs Act'” (12/28/2017).
AbbVie Inc. is a case in point.
Its Chief Executive, Richard Gonzalez, told investors earlier this year that because of the change to a territorial system, whereby only profits reported by domestic subsidiaries face U.S. tax, the U.S. drugmaker expects its tax rate to fall to 9% this year from around 22% in recent years.
That ranks among the lowest of the companies in the S&P 500 that have announced estimates for their tax rate, which average around 22%, according to Credit Suisse.
The company has historically reported its income in lower tax jurisdictions, which is possible in part because AbbVie parks the majority of the patents for its top-selling drug, Humira, in Bermuda—a country that has a zero tax rate on corporate profits.
Despite recording over half its $28.2 billion in 2017 sales in the U.S. and basing most of its research facilities there, the suburban Chicago company has never reported a profit in its home country, its annual reports show.
In 2017, AbbVie reported foreign earnings before income tax of $10.4 billion on international revenue of only $9.97 billion.
Yet, between 2013 and 2016 AbbVie had to pay around $1 billion a year of taxes in the U.S., when it took the profits reported by foreign subsidiaries home to help cover expenses from its U.S. operations.
In the future, it will not have to pay such taxes under the TCJA. The authors of the tax legislation, including Senator John Thune (R-SD) of the Senate Finance Committee, said their bill would discourage the shifting of profits earned in the U.S.
But the principal anti-tax avoidance measures introduced still allow companies to benefit strongly from profit shifting.
AbbVie does not address the patent locations on earnings conference calls or in its SEC filings, and declined to discuss its accounting practices or its annual U.S. losses.
“If the guardrails in the new territorial system were meant to prevent companies from avoiding all taxes, AbbVie’s (tax rate) is a pretty clear signal that these guardrails may not be effective”, said Matthew Gardner, senior fellow with the Institute of Taxation and Economic Policy.
AbbVie is not the only U.S. company with big operations at home but which reports relatively few profits. Pfizer Inc, Expedia Group Inc, Boston Scientific Corp, Synopsys Inc, and Microsoft Corp also do the same and are set to be big winners from the shift in territorial system, executives have said and earnings for the most recent quarter show.
Microsoft and Synopsys declined to say if their 8-year runs of reporting around half their sales in the U.S. but less than a quarter of their profits domestically reflected a tax reduction strategy. Expedia and Boston Scientific did not respond to requests for comment.
Pfizer said its 10 years of U.S. losses reflected operational matters rather than tax planning.
“Because of our U.S. domicile, we have significant domestic funding needs, such as paying for R&D, corporate functions, interest on our debt, to name a few. As a result, our U.S. operations can be less profitable than other jurisdictions”, the company said in a statement.
Democrats in Congress are examining how the new tax law incentivizes companies to use patents to shift profits overseas, and Oregon Senator Ron Wyden plans to issue a report dealing in part with the issue later this summer.
“The U.S. shouldn’t get suckered into a race to the bottom with a bunch of no-tax, resort-lined islands to please the tax avoidance industry and their lobbyists”, said Wyden, the Senate Finance Committee Ranking Member.
The U.S. move away from worldwide taxation represents an adoption of modern tax orthodoxy. All the biggest western economies operate a territorial tax system, but, conscious of the risk of profit shifting, they also have rules to tackle this risk. Typically, these rules allow governments to tax income reported in tax havens as though it arose in the home country.
Congress attached such a provision to the TCJA. Under the new Global Intangible Low Tax Income (GILTI) provision, if a company generates untaxed profits in a tax haven, it will be liable to have that profit taxed as though it arose in the U.S.
However, the effective tax rate that will apply is half the U.S. corporate tax rate of 21%, or 10.5%. And if a company reports a loss in the U.S., this can reduce the tax liability further.
Senate Finance Committee spokeswoman Julia Lawless did not respond to a question about whether the panel’s Republican members would consider raising the GILTI rate. But she said current discussions around the TCJA centered on its implementation rather than redrafting it.
“The international title of the tax overhaul included significant anti-base erosion provisions”, she said.
Reuters reviewed close to 90 patents on Humira, most of which were cited by AbbVie in lawsuits as protecting intellectual property. Around two-thirds of those patents were assigned to the Bermuda subsidiary, AbbVie Biotechnology Ltd. Most of those patents were developed by teams of researchers entirely or somewhat based in the U.S., according to details in patent filings.
“This is the blueprint”, said Reuven Avi-Yonah, director of the International Tax LLM Program at the University of Michigan Law School. “The illusion that you would see more patents kept in the U.S. (under the new tax law) is unreal as long as there are places you can keep them off shore where you pay 0.”
The exact mechanisms AbbVie uses to report such a low a tax rate are not public. However, analysts and academics say corporate filings often show that drug companies frequently reduce their taxes by parking patents in a low-tax haven, as AbbVie does, and then have their affiliates—which manufacture or market the drug—pay the tax haven subsidiary royalty fees for the right to use the patent.
This arrangement sees a drug sold into a target market, like the U.S., at a high price, with the U.S. distribution arm getting a sales margin as low as 5%.
Sometimes the U.S. distribution profit is not enough to cover group costs incurred in the U.S. For example, many of AbbVie’s biggest costs—including $1 billion a year in interest charges and over $50 million in compensation for its top 5 executives—are covered by AbbVie’s U.S. entities, contributing to the U.S. loss, filings show.
That is why AbbVie can forecast a tax rate below the 10.5% GILTI rate, which some commentators have described as a new minimum tax rate.
“There is an incentive to profit-shift”, said Daniel Shaviro, a Professor of tax law at New York University.