The Cayman Islands and other offshore financial services centres are sophisticated business locales, well situated to serve as the domiciles for cross-border trusts, securitisation vehicles, investment funds and insurance firms.
Another important role played by offshore financial services centres, however, is as the domicile of internal holding companies within multinational groups.
These internal holding companies often serve as the receptacles for what I call “stateless income” – income that is derived for tax purposes by a multinational group from business activities in a country other than the group’s “home country” domicile, but that is subject to tax only in a jurisdiction that is neither the source of the production factors through which it was derived nor the domicile of the group’s parent company.
Stateless income tax planning thus involves foreign-to-foreign intragroup income shifting. It is a complement to the more widely analysed problem of firms shifting income from their home countries via aggressive transfer pricing and the like. Google Inc.’s ‘‘Double Irish Dutch Sandwich’’ structure, which has been extensively discussed in the US press, is one example of stateless income tax planning in operation.
Multinational firms get at least two bites at the stateless income apple. First, they can situate in an offshore financial services centre the ownership of intangibles (or the provision of unique high-value services), and thereby capture in that offshore centre income generated by returns from sales to customers in high-tax foreign countries and the like.
These first-stage strategies rely on the norms of freedom of contract within the group, the purportedly arm’s-length nature of arrangements reached by a parent company and its wholly owned subsidiary (freshly capitalised by the parent), and ambiguities in the international consensus rules surrounding the source of returns to intangible assets.
Second, relying on many of the same norms, multinational firms can use intragroup earnings-stripping strategies to move income originally earned by a subsidiary doing business in a jurisdiction with the most plausible claim as the source of that income to an offshore financial services centre.
Firms typically do so through the creation of an item of intragroup deduction/income inclusion (for example, intercompany interest, rents, or royalties), where the ultimate recipient of the intragroup income is domiciled in an offshore financial services centre. That second-stage earnings-stripping strategy need not have any nexus to the generation of the income.
US multinationals in particular have become masters of the tax technologies necessary to generate stateless income and to bring that income to rest in offshore financial services centres without generating subpart F income (ie, income immediately taxed back to the US parent).
As a result, sophisticated US multinational firms today face effective tax rates on their international income that are far lower than the nominal US statutory rate – or, for that matter, the weighted effective tax rate in the jurisdictions in which they do business.
Stateless income is not the result of outright tax evasion or the like, although firms might fairly be accused of often taking very aggressive transfer pricing positions on their tax returns, on the theory that the tax return is a sort of opening negotiating position vis-à-vis the relevant tax authorities.
Although perfectly lawful (at least after the transfer pricing audit is completed), stateless income nonetheless raises important issues for tax policy.
Business people and legislators alike often misapprehend why stateless income tax tactics should be viewed as problematic. A US chief executive or member of Congress might argue, for example, that if a US multinational lawfully minimises its tax bills in France, Germany and the UK, where its overseas customers and factors of production are located, and brings that income to rest instead in an offshore financial services centre, it is to be congratulated, not condemned.
What is more, the argument continues, under US law offshore income ultimately is subject to US tax once repatriated, subject to foreign tax credit; as a result, lower foreign tax bills on that foreign income mean more US tax when that income ultimately is repatriated.
But these sorts of arguments fail to recognise how stateless income planning fundamentally vitiates the economic theories underlying international corporate tax systems.
In thinking about international corporate tax design, economists begin with the premise that multinational firms operate primarily in open economies with access to liquid cross-border capital markets.
In these economies, risk-adjusted after-tax marginal returns on capital can be expected to converge around the world. If after-tax returns do not converge, then firms and investors will move capital from countries where returns are too low to countries where returns are higher, until equilibrium is achieved.
Every sensible country that is the domicile of significant multinational enterprises worries that its international corporate tax system might bias its multinational firms to prefer investing outside the home country.
In theory, however, a simple “territorial” tax system along the lines adopted by most countries, along with the invisible hand of the markets, which assures convergence around the world in risk-adjusted after-tax returns from business investments, are sufficient to by themselves to address the concern.
(Although the United States nominally operates a “worldwide” tax system, in actuality the US corporate tax on foreign operations of US firms operates as an ersatz variant on territorial tax systems, and the analysis presented below with respect to territorial tax systems applies with equal force to the United States.)
If after-tax returns in fact perform as the model predicts, then there will be no tax advantage to moving genuine business operations to a low-tax country, because risk-adjusted after-tax returns from real business operations in the source country will converge with after-tax returns in the multinational firm’s country of domicile. (Passive investments, particularly in debt instruments, are a different story, because cross-border interest income typically is not taxed in the source country; for this reason, most territorial tax systems do not extend their tax exemption to passive income.)
As a result, firms will move businesses offshore for business rather than tax reasons.
Returning to the fundamental premise, corporate tax rates do vary quite significantly around the world. If one accepts the premise that after-tax rates of returns on capital converge, the phenomenon of differential tax rates means that pre-tax marginal investment returns on business capital must diverge around the world.
And it is here that stateless income tax planning undermines the entire foundation of international corporate tax policy. In brief, when firms engage in stateless income tax planning, they move high-tax foreign jurisdiction pre-tax rates of return to very low tax environments, thereby capturing higher than market after-tax returns on investment.
I call this tax-advantaged income “tax rents”. And this ability in turn is an attribute enjoyed only by the largest and most sophisticated multinationals, and not by domestic firms, which means that it will not be reflected in prevailing pre-tax rates of return.
The availability of stateless income tax planning means that firms have in fact a strong reason to prefer making offshore investments to domestic ones, and ironically to making real business investments in high-tax jurisdictions; the prevailing high-tax country pre-tax returns then serve as the raw feedstock to be processed into tax rents, when the pre-tax income comes to rest in an offshore financial services centre.
Another way of saying this is that territorial tax systems rely entirely on the geographic source of business income as the basis for assigning the rights of jurisdictions to tax that income; stateless income tax planning in turn strips the concept of “source” of any meaning.
What is more, and particularly in the case of the United States (where thin capitalisation rules are extremely weak), the returns from stateless income tax planning can be turbocharged by locating all of a group’s external borrowings in the jurisdiction of the parent company.
By doing so, domestic income in the home country can be sheltered from tax with interest deductions, while the group captures tax rents in an intragroup offshore financial services centre subsidiary.
In brief, then, stateless income tax planning vitiates the premise on which much international corporate tax policy rests. Policymakers should care about foreign-to-foreign income shifting where that income comes to rest in an offshore financial services centre, because these strategies enable firms first to capture tax rents, and second to turbo-charge those returns by using group external interest expense to shelter domestic home country operating income.
Pure “territorial” tax systems and the United States alike are at risk of seeing their domestic corporate tax bases eroded and systematic biases favouring offshore investments over domestic ones institutionalised. In a world where the geographic “source” of income has become largely meaningless, policymakers will need to revisit the fundamental designs of their international corporate tax regimes.
- Stateless Income, 11 Florida Tax Review 699 (2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1791769
- Stateless Income’s Challenge to Tax Policy, 132 Tax Notes 1021 (Sept. 5 2011)
- The Lessons of Stateless Income, forthcoming, Tax Law Review. A working version of this paper is available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1791783