Tax authorities around the world are in an increasingly contentious battle over how to tax the income of multinational corporations. In 2017, the US moved toward a territorial tax system but also adopted a global minimum tax. Over the past year, several European countries have moved unilaterally to impose a new digital tax on (mostly) US tech companies, an initiative strongly opposed by the Trump Administration.
Now a group of leading economists and lawyers has proposed replacing the current rules for taxing multinational firms with a modified form of destination-based income tax they call a Residential Profit Allocation by Income (RPAI) system. Instead of taxing multinational firms on where they undertake business activities (the source country) or where their parent company is chartered or managed (the residence country), they argue that firms should be taxed on where they sell their products (the destination country). The authors do a good job identifying flaws in the current system, but their alternative may not be much of an improvement.
The current systems used by most countries tax foreign affiliates of a multinational corporation as if they were separate entities, even if the affiliates have common ownership. Each affiliate pays corporate income tax to the source country where it produces goods and services on the income generated by those activities.
Rules to determine the source of profits work reasonably well when those profits mainly reflect returns to tangible assets such as land, buildings, and machines. But they are ineffective in determining the location and source of returns to intellectual property (IP) assets such as patents, organizational knowhow, and brand name recognition. Both US and foreign-resident companies substantially lower the tax they pay on such so-called “residual profits” by moving the legal ownership of their IP assets to affiliates in low-tax countries.
Today, most countries, including the United States, have a modified source-based system that taxes multinational firms on profits earned within their borders, but exempts most foreign-source income of their resident companies.
To limit profit shifting that erodes their corporate tax bases, most major economies tax on a current basis income from so-called “passive” assets (mostly interest and dividends of the foreign affiliates of their resident companies). The Tax Cuts and Jobs Act of 2017 (TCJA), went a step further and introduced a new minimum tax on residual profits (profits above a 10 percent return on tangible capital), which TCJA calls Global Intangible Low Tax Income, or GILTI. This new minimum tax limits the ability of US companies to shift income from intangible assets. But because the GILTI provision only applies to US-resident companies, it may place some of them at a disadvantage with foreign-resident competitors that may not pay any tax on their active foreign-source income.
An alternative approach would assign taxing rights to destination countries because consumers are much less mobile than the location of either corporate residence or reported profits. In this way of thinking, corporations could not avoid a destination-based tax without forgoing valuable markets for their goods and services.
The House Republican 2016 tax reform plan included a destination-based cash flow tax (DBCFT) that would have allowed companies to deduct all investment costs immediately, eliminated interest deductions, exempted export income from tax, and denied a deduction for the cost of imports.
The DBCFT would have taxed residual profits, but exempted normal returns by allowing companies to deduct immediately the cost of both tangible and intangible investments. And it would have effectively shifted the tax burden to profits earned in destination countries. However, Congress rejected the DBCFT in part because such a radical change would have created many winners and losers.
The RPAI is less ambitious. Thus, its creators believe it might be easier for lawmakers to enact. Countries would continue to tax normal returns – the returns that are easiest to assign by location – on a source basis. But the RPAI would allocate residual profits to the country where the company’s goods were sold. An OECD Consultative Document has endorsed this approach as its “Pillar 1” of international tax reform.
In contrast to the DBCFT, the RPAI maintains the basic features of an income tax (depreciation over time of capital investments and interest deductibility) and the current territorial system for allocating normal returns to investments among countries based on the physical location of the corporate taxpayer. But by shifting to a destination-basis for residual profits, it tries to better allocate the profits of multinational companies among countries where they operate.
The RPAI, however, has its own serious defects.
When multinational corporations sell into a high-tax country, some amount of corporate tax would fall on its consumers. But it would fall unevenly among goods and services consumed, depending on the residual return’s share of each product’s value.
The RPAI, unlike the DBCFT, would also create new profit-shifting opportunities. Under RPAI, the destination country would tax only the portion of sales that represent residual profits, and so multinationals could minimize reported profits in high-tax countries by selling to independent retailers in tax havens, thereby still diverting much of their profit to low-tax jurisdictions. The destination country would tax only the (much smaller) profit margin of the retailers.
More generally, the RPAI would encourage firms to shift the later stages of production to low-tax countries to increase the share of profits reported in these “destinations.” The designers of the RPAI acknowledge these problems, but have not found convincing solutions.
Modifying the existing system for taxing multinational firms based on their source of income and corporate residence may be a better alternative. The OECD approach in Pillar Two could encourage other countries to follow the new US model for taxing foreign-source income of their resident multinational companies – fully taxing passive foreign-source income, taxing residual profits at a reduced rate, and exempting normal returns from tax. This could be combined with tougher rules to prevent profit shifting of inbound investments (e.g., foreign owners of firms located in the US).
No system for taxing corporate income in our complex global economy will be perfect, though keeping tax rates low can minimize the flaws in any system. The least bad approach may well be to rely on reduced tax rates on multiple tax bases – some combination of source, residence, and destination-based taxes at the business level and worldwide taxation of capital income at the individual level.
Individual countries and international bodies will necessarily continue to try to modernize a century-old system of international taxation to make taxation of multinational companies more compatible with an integrated world economy where intangible assets generate a greater share of corporate profits.
