Profit Shifting and "Aggressive" Tax Planning by Multinational Firms: Issues and Options for Reform

Google, Apple and other highly profitable multinationals are able to drastically reduce their tax burden on worldwide income by shifting profits from high- to low-tax countries. Reports on these tax avoidance strategies have triggered an intense public debate, which has brought the issue to the top of the international policy agenda. Both the OECD and the EU Commission are currently working on measures to fight tax avoidance and profit shifting by multinational firms and have already published first recommendations.

This paper contributes to the current debate in two ways: First, we provide background information for a better understanding of the issue. Second, we discuss different policy options to address tax avoidance and profit shifting by multinationals and derive recommendations for policy makers. As most companies currently accused of avoiding taxes use intra-group licensing to shift profits, we focus on IP-based profit shifting but do also elaborate on profit shifting in general.

Based on a detailed description of typical tax planning strategies of multinational firms, we reveal central flaws and loopholes in tax law. Moreover, we show that there is solid empirical evidence demonstrating that profit shifting is indeed taking place but little is known about the tax revenue consequences of profit shifting.

With respect to the policy options, we differentiate between four general approaches for tackling profit shifting and tax avoidance by multinational firms:

1. Extension of residence taxation
2. Extension of source taxation
3. Fundamental reforms of corporate income taxation
4. Stricter reporting and transparency requirements

We argue that strengthening residence taxation, for example by tightening CFC rules, is an effective reform option but has the disadvantage that some countries benefit from a weak residence taxation and, hence, might be reluctant to move in this direction. Enforcing source taxation, on the other hand, is more promising. In the short run, we especially recommend extending withholding taxes in an internationally coordinated way. This measure effectively tackles profit shifting without causing double taxation. Unilateral measures for strengthening source taxation, like for example deduction restriction rules for interest and license payments or a general anti-avoidance measures, are not recommended because the first are economically harmful and the second are presumably ineffective. For the longer perspective, we recommend the more fundamental reform options, like formula apportionment or a destination-based tax, to be further promoted. Stricter reporting and transparency requirements, like country-by-country reporting, do face serious legal constraints and it is questionable whether the benefit of such rules justifies the corresponding high effort and costs.

Fuest, Clemens, Christoph Spengel, Katharina Nicolay, Jost Henrich Heckemeyer and Hannah Nusser (2013), Profit Shifting and "Aggressive" Tax Planning by Multinational Firms: Issues and Options for Reform, ZEW Discussion Paper No. 13-044, Mannheim.