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International Tax
Evasion: What Can Be
Done?
Multinationals save hundreds of billions of dollars by oshoring income
and manipulating their booksand it's perfectly legal.

By Reuven Avi-Yonah

May 26, 2016

This article ran in the Spring 2016 issue ofThe American Prospectmagazine.
Subscribe here.

am Wyly is a rich Texas businessman. In 2006, Forbes estimated his

S net worth as $1.1 billion. He and his brother Charles made their
money in computers, a steakhouse chain, and Michaels Arts and
Crafts, which they bought in 1982 and sold in 2006 to a group of private equity
firms, including Bain Capital, for $6 billion. Sam is a major philanthropist: A
$10 million gift resulted in the naming of Sam Wyly Hall at the University of
Michigan Ross School of Business. He is also an avid Republican. In 2004, Sam
Wyly helped finance the Swift Boat ad campaign that scuttled John Kerrys
bid for the presidency.

But Sam Wyly is now bankrupt. In 2006, a hearing of the U.S. Senate
Permanent Subcommittee on Investigations (PSI) revealed that he had been
evading U.S. tax laws by hiding his money in trusts in the Isle of Man, a
notorious tax haven. He began by transferring stock options from his various
companies to the trusts, which were managed by Isle of Man trustees. The

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nominal trust beneficiaries were two foreign charities, but the six Wyly
children were contingent beneficiaries, and the trustees understood that at
Sams death the children would become the true beneficiaries and collect the
funds.

In the meantime, the trusts were free to exercise the stock options and use the
stock for investments, with the understanding that ten years down the road
they would have to make annuity payments to Sam. Sam obtained an opinion
from a law firm that this arrangement worked to defer taxes on the income
gained from exercising the options until he began receiving annuity payments
years later. But the linchpin of the legal opinion was that the offshore trusts
were independent actors when, in fact, Sam exercised total control over the
trust assets, secretly using the investment profits to operate businesses and
buy real estate, jewelry, and artworks in the United States. The Wylys secret
control over their offshore funds was revealed in the PSI hearing.

In 2010, the SEC charged Sam and Charles Wyly with securities fraud based on
Sams hidden control of the offshore trusts. In 2014, a jury found him liable. To
avoid paying a $300 million judgment, he filed for bankruptcy, which
triggered a tax assessment for his failing to pay any taxes on hundreds of
millions of dollars in offshore income since 1992. He is currently battling the
IRS in bankruptcy court over a tax assessment totaling more than $2 billion.

How many Wylys are hiding their money from the IRS, with no PSI hearing to
bring their misdeeds to light? We will probably never know. A recent estimate
of the global costs of illegal tax evasion by the economist Gabriel Zucman was
$200 billion, but this is probably too low since estimates for the U.S. alone
range from $20 billion to $70 billion. Every time a Swiss banker talks, many
billions in U.S. tax evasion are revealed. The IRS Offshore Voluntary
Disclosure Program has netted over $6 billion and counting.

And this is only for illegal tax evasion by individual taxpayers. Because the
evasion hides taxable income, its hard to quantify with any precision.

Corporations are another story, because what they are doing is legal tax
avoidancemanipulating their books to avoid taxationand therefore the
magnitudes can be better quantified. As of the end of 2015, U.S. multinationals
had more than $2 trillion in offshore profits in low-tax jurisdictions. This
amount, which translates to about $700 billion in U.S. taxes avoided, is mostly

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income that was economically earned in the U.S. and shifted offshore to
jurisdictions like Singapore, Ireland, or Luxembourg, which have effective tax
rates in the single digits.

The Corporate Tax Dodge

How do the multinationals do it? A couple of examples can suffice. Apple Inc.
is the worlds largest company by market capitalization. Most of its billions in
profits relate to intellectual property developed at its headquarters in
Cupertino, California. But for tax purposes, most of the profit is booked in its
Irish subsidiarieslets call them Apple Ireland.

Importantly, none of the actual work is done by

Apple Ireland. Apple just gives Apple Ireland the
money and Apple Ireland pays it back as its
contribution to the research costs.

Some of the profit-shifting is achieved through a cost sharing agreement.

Cost sharing is a concept developed in IRS regulations in the 1980s, but it
became more significant due to the increasing importance of intellectual
property. The idea behind cost sharing is this: When a U.S. multinational
begins a new research project (for example, a search for a drug to treat a
certain disease), it can agree to share the costs of development with its
offshore subsidiaries. Then, if the project is successful, the parties share the
profits in the same proportions. For example, if Apple Ireland contributed 80
percent of the costs of developing the iPhone 6, it would get 80 percent of the
profit. Importantly, none of the actual work is done by Apple Ireland. Apple
just gives Apple Ireland the money and Apple Ireland pays it back as its
contribution to the research costs.

Why would the IRS regulations permit this? Because if the research failed,
then the taxpayer would lose its ability to deduct the costs sent offshore. The
more of the cost sent offshore, the more deductions would be at risk. So the
IRS thought there was a natural limit to taxpayer willingness to share costs
with offshore affiliates.

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That analysis may have been true for Big Pharma, which usually waits to enter
into cost sharing with an offshore affiliate until a drug has passed its initial
trials and is well on its way to a patent, and then battles the IRS over valuation
issues at the time the cost-sharing agreement was executed. But the same
analysis makes no sense for Apple, since if there is anything certain in
business, it is that a new version of the iPhone will sell.

There is another trick involved in Apple Irelands profitability. Another

portion of its profits derive from countries where Apple sells the iPhones.
Apple Ireland licenses the right to use Apples brand and intellectual property
to Apple affiliates in other countries. Those affiliates in turn pay Apple Ireland
hefty royalties, which operate to shift the sales profits gained in those
countries to Ireland.

Before 1997, such a scheme would not have worked, because the royalties
received by Apple Ireland would have triggered a tax in the U.S. under so-
called Subpart F, which was designed to prevent foreign corporations from
taking advantage of inconsistencies between U.S. and foreign tax law. But in
1997, the Clinton administration adopted a rule called check the box. Under
check the box, Apple Ireland can, for U.S. tax purposes, treat all of its foreign
affiliates as if they did not exist as separate entities, and treat the money they
paid to Apple Ireland as income earned in Ireland. The result is that, for U.S.
tax purposes, there are no royalties and no U.S. tax triggered by them, because
Apple Ireland treats the money as its own sales income.

The Obama administration came in promising to repeal check the box; this
was the biggest international revenue raiser in the first Obama budget. But by
its next budget in 2010, the administration recanted under pressure from the
multinationals. Recently, Obama signed into law a five-year extension of a
provision (first enacted by a Republican Congress as a temporary measure in
2006) that enshrines check the box in the tax law.

Finally, the Senate hearing revealed two Irish-specific tricks used by Apple.
Ireland has a tax rate of 12.5 percent, far below the U.S. rate of 35 percent. But
Apple did not want to pay even 12.5 percent. Its solution was ingenious: For
U.S. tax purposes, Apple Ireland is treated as an Irish company because it is
incorporated in Ireland, so it is not taxed by the U.S. But for Irish tax purposes,
Apple Ireland was treated as an American company because it is managed
and controlled from California. As a result, Apple Ireland claimed it was a tax
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resident nowhere. On top of that, it negotiated a sweetheart tax deal with

Ireland for its Irish income, which resulted in its paying a tax rate of less than
2 percent.

THESE TYPES OF TRICKS are used by most U.S. multinationals. If the primary
driver of value of a U.S. multinational is intellectual property developed in the
U.S., the Apple scheme can simply be replicated.

But what if the value derives from more traditional, tangible items? Some U.S.
multinationals do pay higher taxes (e.g., the car companies). But others try to
avoid tax nevertheless. Caterpillar Inc. is a good example.

Caterpillar does not make a lot of money on the heavy equipment it

manufactures. But it makes a bundle on replacement parts, because once you
buy a Caterpillar bulldozer, you will need parts, which you can obtain only
from Caterpillar at a huge markup. Caterpillar prides itself on its ability to
deliver parts within 24 hours anywhere in the world, including the Arctic
tundra (where its equipment is used in mineral extraction).

Before 1999, Caterpillar bought the parts from unrelated manufacturers and
stored them at its warehouse in Morton, Illinois. When a dealer requested a
part for a customer overseas, Caterpillar sold (but did not actually ship) the
part to a Swiss subsidiary, which in turn sold the part to the unrelated dealer.

The problem, according to accounting firm PricewaterhouseCoopers, was that

Caterpillars sale of the part to its Swiss subsidiary triggered U.S. taxes. Much
better, PwC said, would be if the parts were sold by the manufacturer directly
to the Swiss subsidiary, which could then sell them to the dealer.

The result was that Caterpillar continued to run

its parts business from the U.S., but declared 85
percent or more of the parts prots in
Switzerland.

Fine, said Caterpillar, but we do not want to change our operations. So in

exchange for more than $55 million in fees, PwC came up with a way to lower
Caterpillars U.S. tax without changing its operations. PwCs solution was for
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the manufacturers to bill the Swiss subsidiary for the parts but continue to
ship them to the Illinois warehouse, which continued to transport them to
Caterpillars foreign customers. If the parts were shipped overseas, they were
deemed to have been owned by the Swiss subsidiary, and PwC devised a
virtual inventory to track them, even though the parts were indistinguishably
commingled in the warehouse. The result was that Caterpillar continued to
run its parts business from the U.S., but declared 85 percent or more of the
parts profits in Switzerland.

The IRS has now challenged this billing arrangement, which resulted in
shifting some $2.4 billion in Caterpillar profits from the United States to
Switzerland. A grand jury has issued subpoenas under a criminal
investigation for tax fraud.

But the disturbing fact is that the whole story would not have come to light but
for a whistleblower, who alerted both PSI and the IRS. And while Caterpillar is
facing a court challenge, in most cases of corporate tax avoidance, like Apple,
the IRSs hands are tied, because what Apple did may have been legal under
the U.S. tax code.

Addressing Tax Evasion

What might be done to reform this massive loss of revenue? Consider first
outright tax evasion. In the case of tax evasion like Sam Wylys, Congress has
acted decisively. In 2010, it enacted the Foreign Account Tax Compliance Act
(FATCA). Under FATCA, any foreign bank or other financial institution has to
report to the IRS accounts held by American citizens and residents. The
penalty for failure to comply is a hefty 30 percent tax on the foreign banks
U.S. income.

FATCA has real teeth, as the chorus of complaints by foreign banks and their
governments shows. It also led to real developments. The Offshore Voluntary
Disclosure Program, which has netted more than $6 billion in taxes, is a child
of FATCA. So are more than 100 intergovernmental agreements (IGAs) that
the U.S. Treasury has negotiated with various countries. Under the IGAs, the
foreign banks can disclose the information about U.S. account holders to their
government, which can turn it over to the IRS. This avoids legal problems

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from the banks dealing directly with the IRS, which is illegal in most countries.
Even Switzerland has signed an IGA.

In addition, more than 80 countries (including the U.S.) have signed a

Multilateral Agreement on Administrative Assistance in Tax Matters (MAATM),
which envisages automatic exchange of tax information among the
signatories, using a common reporting standard developed under FATCA.

But problems remain. First, FATCA itself is vulnerable because it can be

avoided by using a foreign bank with no U.S. exposure. In addition, its
disclosure obligations apply only to larger accounts and can be avoided by tax
cheats opening smaller accounts at multiple banks. So secret offshore
accounts are still possible, although the cost of tax evasion and the risk of
discovery have increased. Second, these agreements depend on compliance by
long-standing tax havens, an outcome that is far from certain. In addition, the
IGAs require reciprocity from the U.S., and while U.S. regulations that require
U.S. banks to collect the information for reciprocal exchanges have prevailed
in initial court proceedings, they are still subject to vigorous judicial
challenges.

Third, the U.S. has signed, but not ratified, MAATM, and it seems unlikely that
it can be ratified in a Republican-controlled Senate.

Finally, the entire edifice rests on an uncertain foundation. For exchange of

information to work, every single tax haven needs to cooperate, because
otherwise the funds will flow to the non-cooperating havens. Total tax haven
cooperation seems unlikely, to say the least, absent stiff sanctions that go
beyond the U.S. 30 percent FATCA tax, such as a mechanism to cut off an
offending tax havens banks from the international wire-transfer system. In
the past, world leaders have threatened sanctions against uncooperative tax
havens, but never actually imposed them. Economists like to imagine
universal solutions to the tax-evasion problem (such as the global tax on
wealth proposed by Thomas Piketty, or the universal registry of financial
assets advocated by Gabriel Zucman), but in the world we have, such solutions
are utopian. Automatic universal exchange of information is likewise a nice
ideal that may be implausible in practice.

There is an easier solution. The key observation is that funds cannot be

invested in tax havens because they are too small (even Switzerland is a small

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economy if one ignores the banking sector). And they must be invested in the
U.S., the EU, or Japan to avoid undue risk since most portfolio investors do not
invest directly in emerging markets because of the political and economic risk.

Therefore, if the U.S., the European Union, and Japan were to agree to impose
a tax on income flows to tax havens, the tax-evasion problem would largely be
solved without the need for cooperation from the havens. Using a 30 percent
tax (the U.S. rate under FATCA) will do the trick. Investors will be faced with
the choice of paying 30 percent on their gross interest, dividends, or capital
gains, or declaring the income to their home jurisdictions and paying a net tax
at that jurisdictions rates.

What prevents this obvious solution from

happening is that the U.S. is willing to aid and
abet tax evasion by Europeans, while the EU is
willing to aid and abet tax evasion by Americans.
This reects the political power of corporations
on both sides of the Atlantic.

What prevents this obvious solution from happening is that the U.S. is willing
to aid and abet tax evasion by Europeans, while the EU is willing to aid and
abet tax evasion by Americans. This reflects the political power of
corporations on both sides of the Atlantic. (In contrast, Japan already imposes
such a tax, demonstrating its feasibility.) What may change the status quo is
that both sides have come to realize that U.S. residents can pretend to be
Europeans, and EU residents can pretend to be Americans, widening the
incidence of tax evasion in both countries. To stop the tax cheating, the EU is
willing to impose anonymous withholding taxes on foreign account-holders;
even Switzerland entered into such an agreement with the U.K. The U.S.
should go along. Importantly, given likely Republican control of Congress, no
change in law is necessary: The U.S. code already provides that withholding
taxes can be imposed on payments to countries that do not have effective
exchange of information. The Obama administration could apply this
provision tomorrow if it had the political courage to do something about tax
evasion.

Battling Tax Avoidance

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Battling Tax Avoidance

Ideally, the solution to tax avoidance by multinationals is for each country to
tax the value that was economically generated by them in their locale. Many
such proposals have been advanced. Most call for some type of unitary
taxation in which the global profit of the multinational is allocated by
formula, like the way American states allocate profit among themselves for
corporate tax purposes, based on where sales are generated and where
property and personnel are located. The most recent proposal along those
lines is from the European Commission.

The problem is that such unitary-tax/formulary-apportionment proposals face

fierce opposition. The recent Base Erosion and Profit Shifting (BEPS) project of
the G20 and the Organisation for Economic Co-operation and Development
has summarily rejected the idea of unitary tax solutions. Moreover, unitary
tax would require rewriting more than 2,500 tax treaties that are based on
treating each company in a corporate group as a separate taxpayer.

This is a tall order. Some progress along these lines can be made under BEPS,
such as the new requirement that multinationals reveal to tax administrations
(but not to the public) how much profit they made in each jurisdiction they
operate in. But it will take many years to develop a workable unitary tax
proposal. The EU proposal is only for operations within the European Union.
While unitary taxation is technically feasible and may be the best long-term
solution to taxing multinationals, the fierce political opposition means that it
is not likely to happen in the near term.

What can be done in the meantime about the $2 trillion that U.S.
multinationals report in low-tax jurisdictions? The multinationals themselves
are clear: They want to be able to bring this money back to the U.S. without
paying taxes on it. This is the point of recent bipartisan proposals, like the one
developed by Senators Chuck Schumer and Rob Portman, for a territorial tax
system.

But this makes no sense. Even if the U.S. should care primarily about the
competitiveness of its multinationals, competitiveness clearly is not affected
when the U.S. taxes income that has already been earned. The U.S. can and
should tax the $2 trillion in full. $700 billion is a lot of revenue, even in
Washington.

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For the future, the best solution is for the U.S. to cut its corporate tax rate but
apply it to all the earnings of its multinationals currently. Abolishing
deferral, as the ability to delay tax on offshore earnings is called, can enable
a revenue-neutral corporate tax reduction from the current nominal rate of 35
percent to about 30 percent. If we also abolish other useless tax expenditures,
like accelerated depreciation and the credit for domestic manufacturing, the
rate can be brought down to 28 percent, which is about average for the G20.

This proposal has bipartisan support as well. But the multinationals are
predictably opposed, arguing that taxing them currently would harm their
ability to compete and lead more of them to expatriate to places like Ireland
Pfizer recently announced its plans to do so by merging with Allergan, a
formerly U.S.-based multinational that expatriated to Dublin.

In my opinion, the economic threat of such expatriations, or inversions, is a

red herringif Congress will only act to prevent the tax losses. Most of these
inversions involve mergers with other U.S. corporations. In reality, nothing
much changes in these transactions, because the corporate headquarters and
the jobs that go with it remain in the U.S. So I do not think the threat of
inversions is something the U.S. should really care about, although the U.S.
could prevent revenue loss by, for example, defining any corporation whose
headquarters is in the U.S. as a U.S. resident for tax purposes. (This would also
prevent the Apple Ireland tax nowhere residency trick.)

Moreover, reducing the corporate rate and even adopting territoriality will
not stop inversions, because there will always be lower rates somewhere. The
main reason to invert is to shift profits from the U.S. to the new residency
jurisdiction. Even if the U.S. rate is 25 percent and we have territoriality, as the
Republicans have proposed, a U.S. multinational can still cut its tax bill in half
by inverting to Ireland and shifting profits there.

If the oshore income were taxed currently,

then they could bring it home at any time
without further tax consequences.

The advantage of imposing a lower U.S. corporate tax rate on all the profits of
U.S. multinationals is that it would solve the lock-out problem, in which the
$2 trillion is trapped offshore because the multinationals will not pay the 35
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percent tax on bringing the money home. If the offshore income were taxed
currently, then they could bring it home at any time without further tax
consequences.

Taxing U.S. multinationals at 28 percent on worldwide income is unlikely to

put them at a competitive disadvantage, for two reasons. First, the effective
tax rate on worldwide income of their main competitors from the EU and
Japan is similar, because these countries have tougher rules about profit-
shifting than the U.S. They do not have check the box, and, in general, they
tax currently any subsidiary that does not have real operations in its country
of residence and that is subject to a low effective tax rate there. Apple Ireland
or Caterpillar Switzerland would have been taxed in full had they been owned
by parent corporations from France, Germany, or Japan.

Second, the Japanese already apply this rule to all their subsidiaries, and the
European Commission has proposed it for all subsidiaries of EU-based
multinationals. Under the EU proposal, any subsidiary would be taxed
currently in full on income that derives from investments or from sales to
related parties if it is subject to an effective tax rate below 40 percent of the
home-country tax rate.

Therefore, if the U.S. taxed its multinationals currently at 28 percent on

worldwide income, the other G20 nations (none of which have a corporate tax
rate below 20 percent) are likely to go along. No competitive disadvantage
would result.

A useful analogy is the prohibition on overseas bribes. Prior to 1977, there

were no domestic limits on multinationals paying bribes overseas to obtain
contracts from corrupt government officials. In 1977, following several
scandals, the United States enacted the Foreign Corrupt Practices Act, which
imposed criminal sanctions on such bribes by U.S.-based multinationals and
their executives. Predictably, U.S. multinationals complained that this ban put
them at a competitive disadvantage, especially when other countries like
Germany permitted foreign bribes to be deducted for domestic tax purposes.

Somewhat surprisingly, the outcome was not relaxation of the U.S. law.
Instead, the Clinton administration successfully pushed the OECD to adopt the
same provisions as part of a binding, multilateral treaty, which eliminated the

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competitive disadvantage issue. A similar coordinated move in the tax area

would solve the tax-avoidance problem once and for all.

If nothing is done about these two problems, the rich will continue to evade
the progressive income tax, and multinationals will avoid the corporate tax. If
that happens, ordinary middle-class Americans will be reluctant to pay their
taxes. Our tax system is built around voluntary cooperation; if most
Americans refused to cooperate, the IRS could not force them to do so. As the
Greek experience has recently demonstrated, once a tax culture of non-
payment is established, it is very hard to change. We need to do something
about both evasion and avoidance before it is too late.

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