Inversions, Earnings Stripping and Transfer Pricing, the triumvirate of U.S. companies avoiding U.S. taxation.

As previously noted on this blog, the American public is now aware of U.S. companies inverting to a foreign jurisdiction to reduce or eliminate its U.S. income tax liabilities.  The publicity (see here for outrage over Pfizer’s inversion attempt in 2014 and response by the President and the Treasury’s new Regulations attempting to curtail inversions here) that inversions have received fail to paint a complete picture of the ability of U.S. corporations and former U.S. corporation from avoiding U.S. taxation.

As found here, Professor Steven Davidoff Solomon, outlines in his N.Y. Times article the next step to maximize the inversion by the former U.S. corporation is to strip the earnings from its now U.S. subsidiary.  As noted by Professor Solomon, the process starts by having the inverted offshore parent company make loans to its now U.S. subsidiary to pay for its operations in the U.S.  The loans would generate interest payments to the offshore parent company, which can be deducted by the U.S. subsidiary to offset the earnings (otherwise taxable) in the U.S. 

Professor Solomon also references the studies of inverted companies and their earnings stripping efforts in 2004 (See National Tax Journal 2004 Article, “Effective Tax Rate Changes and Earnings Stripping Following Corporate Inversion”) and the Treasury’s 2007 article regarding the same.  Professor Solomon also notes that while Treasury has attempted to minimize the inversions, there is little being done to stop earnings stripping.  Finally Professor Solomon suggests that the Treasury and Congress adopt a radical approach to prevent earnings stripping, namely Professor Stephen Shay’s article, which would convert the interest payments to the foreign parent to taxable dividends instead of interest income.

While these articles address the effect of inversions and continued expansion of the Tax Gap (See IRS’s website describing the Tax Gap at $2 trillion annually) the current focus on inversions and earnings stripping fail to address how U.S. companies are currently reducing their tax liabilities through transfer pricing.  For a brief description of transfer pricing, see Bloomberg articles here and here.

As documented by the Senate Permanent Subcommittee on Investigations (“PSI”) (See Part 1 (Microsoft and HP) of the PSI hearing on Offshore Profit Shifting and U.S. Code; or Part 2 (Apple), U.S. Multi-National Corporations (“MNC”) have aggressively taken advantage of Transfer Pricing (Section 482) and Subpart F to shift profits to its low tax offshore subsidiaries.  PSI recommends the following changes to address Transfer Pricing abuses including the following: 1. Revise Sections 482 and 956; 2. Revise APB 23 to minimize MNC’s ability to manipulate the earnings reports to enable transfer pricing; and 3. Have IRS utilize its anti-abuse powers to stop transfer pricing.  See PSI’s recommendations.

Despite these recommendations, Congress and the IRS have yet to successfully limit or prohibit U.S. MNC from stripping the earnings from U.S. companies by shifting the profits offshore through transfer pricing.  However, IRS has aggressively pursued MNC on transfer pricing issues regarding cost sharing arrangements between the parent and subsidiary corporations of the MNCs.  See International Tax Review’s summaries of IRS transfer pricing cases.  For example, see the following active IRS cases on transfer pricing issues:

1. Microsoft: IRS is challenging Microsoft’s cost sharing buy-in payment arrangement between Microsoft and its Bermudian Affiliate and its Puerto Rican Affiliate (see Microsoft Corporation vs. Internal Revenue Service, 15-cv-00850, U.S. District Court, Western District of Washington);
2. Amazon: IRS is challenging Amazon’s cost sharing agreement between Amazon and its Luxembourg subsidiary (see Amazon.com, Inc. v. Comm’r, T.C. Docket 31197-12);
3. Zimmer: IRS is making 482 adjustments between Zimmer and its Dutch subsidiary (see Zimmer Holdings, Inc. v. Comm’r, T.C. Docket 19073-14); and
4. Medtronic: IRS is challenging Medtronic’s value of intangibles transferred between Medtronic and its Puerto Rican subsidiary (See Medtronic v. Comm’r, T.C. Docket 6944-11)

If you feel strongly about the injustice of transfer pricing and have specific/credible information about corporations avoiding the payment of tax through transfer pricing, you can get involved in preventing/limiting the tax avoidance by filing an IRS tax whistleblower claim.  The IRS pays an award between 15% to 30% of the tax collected to a whistleblower with specific and credible information about a corporate taxpayer’s avoidance of tax (through transfer pricing, or other methods).   Contact us if you want to file a tax whistleblower claim.