Tuesday, December 6, 2016

The Auerbach Tax: Trade Distortion and Transfer Pricing

Alan Auerbach may be pulling a bait and switch here:
Unlike tariffs on imports or subsidies for exports, border adjustments are not trade policy. Instead, they are paired and equal adjustments that create a level tax playing field for domestic and overseas competition; Border adjustments do not distort trade, as exchange rates should react immediately to offset the initial impact of these adjustments. As a corollary, border adjustments do not distort the pattern of domestic sales and purchases
He is saying this in context of his Destination Based (DB) Cash Flow Tax (CFT). His claim on transfer pricing are getting some attention from the international tax law crowd:
Border adjustments eliminate the incentive to manipulate transfer prices in order to shift profits to lower-tax jurisdictions; and Border adjustments eliminate the incentive to shift profitable production activities abroad simply to take advantage of lower foreign tax rates.
I was bothered with this claim as was a November 18, 2016 discussion in BNA’s International Tax Monitor:
The new destination-based cash flow tax would likely change transfer pricing overnight, as incentives to shift high-cost intangibles overseas would be heavily negated. They would require a new look at U.S. tax treaties with permanent establishment clauses, and would cast new light on the OECD’s project to combat tax base erosion and profit shifting, as one of its key participants moves away from the arm’s-length principle and toward a system similar—though hardly identical—to formulary apportionment. The hybrid nature of the proposed tax has left many wondering if it will run afoul of World Trade Organization rules against border adjustments for income taxes—an issue the blueprint itself addresses, claiming that as a cash flow-through tax it wouldn’t apply... The simplicity of taxing income based on the location of sales is one reason why many critics of the current system look to the proposal with some wary optimism.
I think the real issue here is that this proposal smooshes together two very different ideas sort of like how shimmer was a floor wax and a dessert topping. Auerbach has been pushing a tax on economic profits instead of accounting profits for a long time. But typically profits taxes are sourced based not residence based. Now it is true that developing nations don’t like the idea of paying royalties to developed nations so they have favored residence based approaches but the OECD has favored sourced based approach to taxing income. Then again, a company like Apple neither declares its foreign based income in the US or in China but in places like Bermuda, which is why they make like Auerbach’s idea, which was my point here:
The House GOP proposal would effectively say we do not get to tax these profits. And yes I know that Apple has found a way to get all these profits sourced to Bermuda anyway. But this was the whole point of Senate hearings on May 21, 2013.
Sales taxes on the other hand are often DB although there may be exceptions. Excise taxes such as those on tobacco or medical devices are DB. And as I noted there may be transfer prices depending on how the excise tax is precisely administered. Auerbach can claim DB sales taxes do not distort trade but this does not hold for DB profits taxation. Permit me to expand upon this discussion:
Let’s take the Tax Foundation’s first example: “So if a business purchases $100 million in goods from a supplier overseas, the cost of those goods would not be deductible against the corporate income tax.” The foreign profits on those goods would be taxable so how do the proponents of this idea address the prospect of double taxation? Of course a Canadian manufacturer would be tempted to price their goods at production cost so as to have no Canadian taxable income. That would eliminate the double taxation but no sane person would think the Canadian Revenue Agency would accept this non-arm’s length transfer pricing.
Let’s do so by considering Trump Toaster Ovens (TTO) which are a hit in Michigan and are sold by Detroit Distributors but are manufactured in Canada by Windsor Warehouses –both of which are owned by a Toronto based holding company run by Tiffany Trump. TTOs sell for $125 a piece with the cost of production being $80. They are shipped across the Ambassador Bridge to Detroit Distributors which incurs $20 in operating expenses. Total profits are $25 per oven with 80% going to the Canadian affiliate if the intercompany price is $100. US tax rates are now 35% and Canadian tax rates are close to 25% so with no repatriation tax involved (Canada is a territorial system), the effective tax rate is 27%. While currently Tiffany might want to raise the intercompany price – she knows the IRS could object. Of course Auerbach’s DBCFT would change her incentives as she might want to lower this price to only $80 to eliminate the Canadian income tax – assuming the Canadian Revenue Agency does not object. What’s going on here? Auerbach admits:
System is equivalent to the combination of 1. A broad-based consumption tax (e.g. a retail sales tax or a VAT) 2. An equal rate subsidy to payroll
In effect, we would repeal the corporate profits tax for multinationals but then give them a payroll subsidy. Whether this violates current WTO rules, it certainly is a distortion facing sourcing production in Detroit over Windsor. Maybe Trump might like this idea but this is precisely because he wants to use tax policy to shift production away from foreign sources and back to places like Michigan.


hiyamaya said...

I think you have mixed up 'source' and 'residence' in the middle here. i.e. source = taxation where a company is doing business - where the factory is etc... residence = taxation where the company is tax resident - where the HQ is.

You say "Now it is true that developing nations don’t like the idea of paying royalties to developed nations so they have favored residence based approaches but the OECD has favored sourced based approach to taxing income."

It is the other way around developing countries tend to prefer source based taxation, whereas the OECD model tax treaty approach allows for more residence based taxation (i.e. by reducing witholding taxes on royalties)

ProGrowthLiberal said...

hiyamasa - to be honest, I'm no lawyer so I had to struggle with the odd wording these lawyers use. I hope my delving into their weird world did not get the simple points hopelessly lost. I will say Auerbach is abusing these confusiing terms to confuse his readers which is why I cite SNL who do a marvelous job of mocking all of us.

Owen Paine said...

Bravo pgl
You show some self awareness in your reply to h