The Use of Tax Havens of American Multinational Corporations and Its Implication to the US Domestic Tax Base and Economic Development of Host Countries
The research primarily focuses on Tax Havens and its effect on both US domestic tax base and the respective economy of the host countries involved. The study aims to identify if the movement of businesses of American multinational corporations to (MNCs) to tax havens would strengthen or weaken the US domestic tax base. In relation to this, the disposition of tax haven countries will also be significantly studied in relation to the entries of MNCs and the effects that it bring forth in relation to more favorable taxation policies bestowed upon them.
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In this proposal, the research have employed the qualitative tradition of research using secondary data collection wherein the researcher used scholarly journals and articles, magazines, and theses, and trusted websites such as those of the United States government.
The research found out that tax havens provides both overall positive outcomes for the United States and to its host countries as well.
Statement of the Problem
Multinational Corporations (MNCs) and their strategic plans primarily reflect the aforementioned’s pursuit for after-tax profits. One significant response to the rising local and international competitiveness in the international market is the capability of American firms to have some of their operations moved to foreign countries, or tax havens; tax havens are countries that offer relatively low tax rates. However, a number of critics claimed that the use of tax havens could eventually weaken the US domestic tax base, since MNCs would opt to have most of their operations offshore. Certain studies also suggest that tax havens have flourished since the entry of MNCs. As such, the mutual relationship of MNCs and Tax havens would be the focus of the study.
The first sub-problem focuses on the identification of the effects of low foreign rates on US tax revenue.
The second sub-problem focuses on the evaluation of the attractiveness of low tax rates for the governments of tax havens and possible tax havens.
The United States government primarily collects more tax revenues when American firms earn in foreign countries, since foreign tax credits are usually available on profits made from tax havens, in comparison with the ones earned from high-taxing countries. Also, the capability of American based MNCs to present their reported profits in juxtaposition to local taxes could also enhance US tax revenues since US forms often have certain incentives to report in certain counties wherein they earn the fewest foreign tax credits.
The total revenue figures based on the study of Hines and Rice in 1994 are reported to be $56.6 billion way back in 1982 and aggregate foreign tax credits of $18.1 billion the same year. Consequently, 16 largest tax havens where US firms are off-shored generated a total of $7.8billion in income and $0.6 billion on foreign tax credits (Hines and Rice, 1994). These figures then imply that low foreign rates applied to MNCs in tax havens have positive effects in terms of US tax revenues.
Most MNCs in tax haven countries provide tax revenue, employment, and other valuable spillovers, as such oftentimes enticing developing countries to tailor their tax policies to attract foreign investors. It is often the case MNCs investing in tax haven countries often end up maximizing their tax revenues through the act of choosing certain tax rates at which their tax bases are unit elastic in relation to tax rates.
The study of Hines and Rice (1994) claimed that revenue maximizing tax rates are low in certain tax havens. However Hines and Rice (1994) also suggests that if a significant number of tax havens would be able to collaborate, their revenue maximizing tax rates are likely to improve. The investment of MNCs in tax havens also paves the way for a relatively higher pay for employees. Study of Hines and Rice (1994) shows that the median US employee compensation is abut 1% of GDP in industrialized countries and 0.4 percent of GDP in developing countries; consequently, the compensation in havens was 2.5% of the GDP in the Big-7 tax havens.
The study of Hines (2004) on the other hand presented that development of tax haven dispositions since 1982. Tax havens, due to its capability to attract foreign investment not only of MNCs, but of other capabilities as well, paved the way to the growth of their economy relatively faster compared to countries which have higher tax rates; also tax havens and the incentives provided to foreign investors allowed the aforementioned to improve government finances.
Definition of Terms
Blocker Companies are companies which accumulate profits gained somewhere else in the world only in order to shelter them from the avid hands of the heavily taxed production countries.
Multinational Corporations (MNCs) are corporations or enterprises which operate their production or services in at least two counties.
Tax Havens are the place to move profits to, as they have either no taxation on profits or very low taxation.
During the 1990’s competition for inbound investment has led to the increase of number of countries which offer reductions and effective tax rates or tax holidays for foreign investors. In effect of this, the abovementioned countries, or so-called production tax havens enable MNCs to earn huge income from foreign countries which re free of host-country taxation (Avi-Yonah, 2000). Albeit, in certain instances, MNCs are also fortunate enough to escape home country taxation, like for instance the case of the United States; wherein the aforementioned does not impose current taxation on foreign sourced businesses income of resident MNCs, due to the underlying fear of diminishing MNCs’ capability to compete against MNCs of foreign counties. Hence it is with this respect that tax havens provide MNCs huge income due to the free host-taxation and in some cases free home-country taxation as well.
Importance of the Study
The study is relevant in order to review benefits to both MNC and the US government of investing to tax haven countries. This is vital in order to provide significant scholarly study in terms of the issue in terms of tax haven countries’ tendency to divert economic activity away from developed countries which have relatively higher tax rates. In addition to this, the erosion of tax bases is another issue that entices some critics to view tax havens on a negative light.
Effects of host countries which offer tax exceptions or relatively low tax rates to foreign countries are also important as the entry of MNCs to most developing countries are criticized to elicit a boomerang effect that claims to cause reduction on tax collections that could be used to fund various government projects and initiatives. However, other studies did emphasized that such criticisms in terms of negative effects of MNCs to tax haven countries are very unlikely to happen as MNCs are expected to provide better economic outcomes and greater investment opportunities to host countries that are still in the process of developing its economies.
The study is limited based on the data made available to the public by multinational corporations. Consequently, since there are time constraints, the study is only limited to certain multinational companies in which directly caters to answering the research problem and its sub problems. The analysis of the economic and other financial data of host countries is also limited to the data made available in public by the government and specific host governments.
Other issues in terms of MNCs that are not directly related to the problem and sub-problems of the study are also not discussed in the research.
Review of Related Literature
The review of related literature presents the background of the study, and review of scholarly studies on multinational corporations and tax havens.
Background of the Study
The mobility of capital in the age of globalization has paved the way for international tax competition in which sovereign countries focus upon in order to attract portfolio and direct investment through the act of lowering the income taxes earned by multinational companies (Avi-Yonah, 2000). The intense competition on taxes eventually allowed countries to undermine individual and corporate income taxes which are initially earn the highest revenue. Instead, tax burden for multinational corporations are shifted from capital to labor hence reducing the social safety net of a particular country and paves the way to fiscal crises for countries that aims to provide social insurance. In addition, such also creates increased income inequality, job insecurity and income volatility (Avi-Yonah, 2000).
Two recent changes in the international taxing policies that significantly augmented the way individuals and MNCs are taxed: the end of withholding taxation in developed countries and rise of tax havens in developing countries. When the United States abolished its withholding tax paid to foreigners in 1984, other countries have followed the aforementioned due to the fear of driving their mobile capital elsewhere or in some cases, increase the cost of capital for domestic borrowers, including the government. In effect of this, such a move paved the way for individuals to earn investment income that are free of hosting taxation. On the other hand, tax havens which have strong bank secrecy laws have made it difficult to developing countries with relatively weak tax administrators to collect tax on foreign income of individual residents in instances wherein there are no withholding taxes in certain host counties (Schecter, 1998). However, a number of critics claimed that the widespread use of tax havens could in the long cause the weakening to the US domestic tax base since MNCs might end up shifting their US- source income to tax havens, hence a number of criticisms arise in terms of the overall financial utility that tax havens can provide (Hines and Rice, 1994).
The Nature of Multinational Corporations (MNCs)
Part of the nature of multinational corporations is the formulation of various strategic plans not only for profitability but also for market reach expansion. The frequent shift of locations or in some cases, expanding to various countries with relatively lower costs for operations are viewed as major determinants of MNCs’ shift of location; in some cases, decisions are also dependent on “hot-spot” clusters or certain locations wherein there is notable growing investment opportunity (Stopford, 1999). However, it should be noted that immobile resources of MNCs in one way or another also hinders them to uproot their operations on a particular country. For instance, skills that could only be seen in specific host countries could not be easily left behind by MNCs even if for instance there are sudden changes of tax policies, due to certain vital factors that determine the success and profitability of their global operations such as specialized skills of local workers. For instance, Volkswagen’s Resende plant in Brazil is known for its expertise in assembly process. Although Brazil’s tax policies could be relatively costly compared to other host countries, Volkswagen simply cannot leave the country on virtue on tax considerations alone due to its valuable human resource (Stopford, 1999).
It should also be noted that it is not often the case that MNCs are huge corporations. Recent studies reveal that on a closer perspective, MNC newcomers are relatively small. For instance, a number of estimated 45,000 firms reveal that most of them only have 250 people. In addition, there are certain instances, that service MNCs employs less than 100 employees in more than 15 countries. As such, this data implies that MNC investment is not always necessarily related to increased job opportunities and availability for host countries (Stopford, 1999).
The rise of MNCs in the international market could not also be strictly tagged on certain industries. At present, a number of firms most especially in the service sector are also growing global such as office cleaning in Denmark: the International Service Systems; dialysis centers in Germany: the Fresenius; and fresh-food retailing in the United Kingdom: Sainsbnurys. Multinational corporations could also be seen in real estate, law, transportation such as taxis, and hairdressing (Stopford, 1999).
Certain issues in terms of the inherent exploitative nature of MNCs to its host countries due to tax exceptions and low operation costs to be the primary reason for investment should also not be taken into close study. For instance, the North American Free Trade Agreement and presidential candidate Ross Petrot’s issue of US-MNCs going to Mexico and relocation in Haiti for the sake of reduced operation costs is only a part of the total strategic plan. Stopford (1999) noted that it is often the case that MNCs provide salaries that are relatively above the standard wage or the host country, and provide superior and quality training to all of their employees. Although intentions of MNCs could be viewed as well, the aforementioned sometimes end up suffering credibility issues when for instance implicit commitment of providing economic security through good employment is not fully achieved.
Bermuda Invasion and Offshoring
The Bermuda Inversion is one of the most popular tax havens used by American MNCs in order to increase their profitability and cost effectiveness. The process of investment in Bermuda normally includes relocating the corporate headquarters of a particular MNC in the country or another tax heaven in order to avoid double taxation (Cafferry, 2003).
As the Bermuda inversion process is very simple and without heavy costs, it is able to attract huge corporations. The US shareholders transfer their stocks to Bermuda companies, and in exchange, they get shares of the Bermuda based companies. The controlled foreign corporations (CFCs) become subsidiaries of a mother company registered in Bermuda and not in the US, and therefore their profits are not taxable anymore in the US (Cafferry, 2003).
But this scheme has been quite impaired by the anti-inversion regulations issued by US tax administration and some studies have shown that the tax benefits can be less than expected due to the re-incorporating costs. Therefore, companies that would not get most of their income from foreign subsidiaries would not consider Bermuda Inversion to be financially sound (Cafferry, 2003). In an article dated February 2006, Jack Cummings described how anti-inversion regulation was over-reaching. He explained that IRS Sec.7874, though issued in 2004 in order to fight against abuse of inversions of US corporation into foreign corporation, had been drafted in such a broad way that even ordinary restructuring operations which had no specific tax evasion purposes would be generating significant adverse US corporate tax effects (The Wall Street Joural Online, 2005).
Besides the Bermuda invasion, offshoring is also used in order to create cost effectiveness and tax exceptions through establishing affiliates in host countries and afterwards organizing its sales or service processes. It is often the case that the offshore company purchases the products to the affiliates at production costs and sells them at a market value; it is with this respect that the profits stay in the offshore company, while the affiliate creates no profits at all. The offshore company at times purchases goods at very low market price, and resells them at very high value to the group affiliates which have heavy costs to deduce when using the goods in their production process, therefore lowering their taxable profits (Jacobs and Dukes, 2006).
These techniques which aim to avoid US taxation of foreign income are called “blocker” companies (Martin, 2007). The logic behind the emergence of blocker companies lies behind the idea that if it is not possible to avoid US taxation then it might be possible to avoid foreign country’s taxation. As such, it is with this respect that foreign subsidiaries and US parent companies usually conducts a management fees agreement in a manner in which the foreign subsidiary agrees to pay a certain amount of fees to the US parent company in order to pay for global services from which it benefits. These services go from brand and marketing management to accounting services or research and development. US government issued regulations (Jacobs and Dukes, 2006).
According to latest Internal Revenue Service (IRS) regulation’s amendment, blocker companies will be studied using passive incomes such as interests, dividends and rents. Blocker companies will only be exempted on virtue of their capacity to meet two criteria: first, the blocker corporation has to be in the same country as the one where the service was performed; and second, the assistance granted has to be substantial. Examples of substantial assistance are when blocker’s personnel or guarantee is needed in order to secure execution of a job or conclusion of a contract. According to IRS, a service is substantial only if its cost value is at least worth 50% of the paid value. The IRS also sometimes considers royalties in case of patent licensing, if the patent is owned by the parent company (Schmidt and Lady, 2007). Rowe and Cummings (2007) significantly noted the “arm’s length” theory which is according to them, the governing the valuation of the royalties to be paid by subsidiaries. Rowe and Cummings (2007) emphasized that this valuation should be commensurate with income, which means that it should be evaluated by taking into consideration the profits which the use of this patent could produce. The problems generated by the hindsight bias of evaluating benefits of something which will be used in the future have been recently addressed by the government (International Revenue Service, 2007). These cross border inter related-parties transfers are generally deductible from the foreign subsidiary’s income, which enables them to be taxed only once in the United States. These management fees sometimes take the form of royalties from the use of trademarks, or sometimes, the management fees are not repatriated to the United States but only to a holding company set in a tax heaven.
The Tax Havens
Tax havens are defined as any jurisdiction that imposes a lower tax on a corporate income compared to the jurisdiction where the foreign investment originates (Conklin and Robertson, 1999; Hines and Rice, 1994).
Tax havens allow corporations to reduce their taxes that they pay on the returns to capital that they invest outside their country. The process of tax reduction normally involves the purchase of equity in a tax haven entity which eventually leads to an interest bearing basis to a third-country investment entity (Conklin and Robertson, 1999). The returns to capital in the third country could partially escape tax by having their returns transferred to the tax haven as tax-deducible interest. In order to identify the total tax impact, the company must be able to consider both income taxes and withholding taxes. These net returns are eventually made available for reinvestment as loans by the tax haven entity. Returns to capital that are accumulated in the tax haven can be distributed to the country of the company’s main operation as dividends (Conklin and Robertson, 1999).
Hines and Rice in 1994 have identified 41 countries and regions as tax havens for US businesses. The combined operations of these firms amount to 30 million dollars. The table below shows some of the characters of tax haven economies.
Table 1: Tax Havens in the World Economy
Source: Hines and Rice (1994, p. 152)
The table shows that tax havens are responsible for a quarter of the worldwide international operations of US-MNCs. The revenues produced by these tax havens are more than United State’s investment in all of non-haven countries in Europe. The table also shows that the net income of tax haven affiliates is larger compared to their asset share of $11.1 billion, as the total revenue of the MNCs amounts to $360 billion (Hines and Rice, 1994).
The relatively low tax rates of tax haven countries largely influence the behavior of American companies due to the elimination of tax liability on their specific host countries. In addition, firms which have tax-haven profits can earn interest on their residual US tax liability for as long as they defer repatriation of those profits. US companies with excess foreign tax credits can reduce its total tax liability of it can attribute to a haven certain affiliate profits that were gained in a high tax country. In effect of this, the total taxes of a particular MNC could decline by an amount equal to the difference between the two tax rates (Hines and Rice, 1994).
MNCs can also profit if haven subsidiaries would invest their profits outside their country; and instead invest it in the global capital market, hence allowing a significant rate of return (Hines and Rice, 1994).
In order to significantly contribute to the existing scholarly literatures in terms of knowing the utility that MNCs and tax haven countries derive from their relationship, the use of the qualitative tradition of research using secondary data from legal history, constitutional theory, case law interpretation, statutory interpretation, regulatory interpretation, logic and policy analysis is viewed as very relevant.
According to Creswell (1994) secondary data collection is primarily done through desk or library research. Secondary data collection normally includes data that were collected by another researcher or writer. It is often the case that they are lifted from books of recent publications, journals, magazines, newspapers and even trusted websites such as those of private organizations, non-government organizations, government organizations and the likes. In terms of studying the effectiveness of using tax havens for multinational corporations in the United States and also the effects of MNCs in terms of the economic development of host countries. The research used scholarly journals and articles, books and magazines specifically focusing on the benefits of MNC and the US government in terms of investing in tax haven countries. At the same time, tax haven countries are analyzed in relation to their tax policies and its implication to their overall financial and economic development. The scholarly literatures are primarily taken from EBSCO Host, JSTOR and Questia Media America, an exclusive on-line library.
The study revealed that both American based Multinational Corporations, and the United States domestic tax base; and tax haven countries are both benefited in their relationship. Both MNCs and the US domestic tax base will be able to collect more tax revenues when American firms earn in foreign tax haven countries since foreign tax credits are available on profits made from tax havens in comparison with the ones earned from high-taxing countries. On the other hand, MNCs in tax haven countries provide tax revenue, employment, and other valuable spillovers hence making the host country benefit as well on the relationship.
Although there are various criticisms that could be pointed out in terms of these claims, such as tax haven countries’ tendency to divert economic activity away from developed countries which have relatively higher tax rates and the reduction on tax collections of host countries that could be used to fund various government projects and initiatives; other details that could prove the leverage of utilities that these two industries could provide to one another is evident.
The nature of multinational corporations in the 21st century clarifies certain underlying notions that MNCs only invest in tax havens for the sake of their own financial gain. On the other hand, this literature is balanced by various secondary data emphasizing various tax evasion attempts of various MNCs such as the Bermuda invasion and offshoring. The nature of tax havens is also presented and how they can significantly help MNCs to improve its profits and revenues.
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