Don’t Judge The Tax Cuts And Jobs Act’s Anti-Profit-Shifting Measures Yet

Despite U.S. lawmakers’ eagerness to pass final judgment on the 2017 Tax Cuts and Jobs Act’s signature anti-base-eroding measures, it will be some time before the law’s legacy becomes clear.

The Senate Finance Committee’s May 11 hearing, which the majority had planned to devote to the aggressive tax planning practices of U.S.-based pharmaceutical manufacturers, produced a fountain of contradictions from everyone concerned. The hearing largely devolved into an exchange of denunciations about the TCJA and the global agreement on an OECD-brokered minimum tax regime under pillar 2.

Endorsing one and condemning the other, as members of each party did during the hearing, seems odd considering the relationship between the TCJA’s international tax provisions and the pillar 2 rules they helped inspire. There are obviously major differences between the U.S. global intangible low-taxed income regime and base erosion and antiabuse tax and the elements of pillar 2. What drew the most attention from lawmakers who were opposed to pillar 2 was the disparate treatment of nonrefundable credits compared with the GILTI rules enacted as part of the TCJA.

There’s still a certain irony in the devotion of one party’s senators to an ongoing TCJA marketing campaign and denunciation by those same senators of the TCJA-inspired pillar 2 measures that Treasury negotiated when their party held the presidency. And there’s an equal but opposite irony in the other party’s vilification of the TCJA and their embrace of a pillar 2 agreement that their political rivals negotiated based on the very law they now vilify.

Another oddity in the hearing was that much of the vitriol directed at the TCJA consisted of blaming the law for the same tax planning arrangements that the law’s international provisions were clearly intended to deter. According to some senators, the effective tax rates of U.S. pharmaceutical companies prove that multinational enterprises accepted the TCJA’s invitation to intensify their aggressive profit-shifting practices. The result was the kind of overly politicized and misleading exchange that frustrates and disheartens tax practitioners and experts of all political persuasions.

Forgetting Something?

Seemingly lost amid a great deal of grandstanding about the Senate’s hallowed constitutional prerogatives by some legislators — and, surprisingly, some of the experts who testified — is the stark reality that doing U.S. MNEs the favor of sparing them from pillar 2 in the United States would not actually do them any favor. As Treasury officials in both Republican and Democratic administrations have recognized and repeatedly explained, repudiating pillar 2 to oblige U.S. MNEs would be self-defeating. This is because the UTPR, formerly known as the undertaxed payments rule or undertaxed profits rule, will pry away any benefit that an overly accommodating jurisdiction could hope to offer its MNEs by not adopting pillar 2.

Analogous to the defensive mechanism built into the OECD-endorsed hybrid mismatch rules, pillar 2 will allow jurisdictions to impose the UTPR on MNEs that escape domestic top-up tax or an income inclusion. Application of the UTPR by constituent entity jurisdictions should, in principle, lead to a similar result as a top-up tax or income inclusion in the ultimate parent entity’s jurisdiction. However, the compliance costs and double taxation risks associated with triggering the UTPR in multiple jurisdictions, which may or may not interpret or apply the UTPR as uniformly as the OECD intends, would almost certainly dwarf those caused by a single jurisdiction’s imposition of a top-up tax or income inclusion rule. This is doubly true for U.S. MNEs, which would still have to comply with the GILTI rules that served as the partial inspiration for pillar 2.

The compliance costs and double taxation risks give the UTPR an almost punitive effect, whether deliberate or not, that resembles the local filing rules for country-by-country reporting. Although an MNE’s ultimate parent entity generally has exclusive responsibility for filing a CbC report under action 13 of the base erosion and profit-shifting project, any constituent entity could be subject to local CbC reporting if the ultimate parent entity’s jurisdiction fails to adopt and implement action 13. Because action 13 called for countries to require CbC reporting before the regulations implemented by the United States could take effect, U.S. MNEs faced the risk of triggering local filing rules in multiple foreign jurisdictions for 2016.

Similar to the May 11 hearing, hostile legislators bristled at the prospect of handing CbC reports filed by U.S. MNEs to foreign tax administrations through automatic exchange. However, the risk of facing local filing obligations abroad was evidently distressing enough for U.S. MNEs — many of which had been erstwhile opponents of CbC reporting — to clamor for the option to file CbC reports in the United States before U.S. law required it. Current U.S. lawmakers may be wise to consider this episode — which featured a paltry compliance nuisance, compared with potential UTPR liability, and only affected a single year — when they assess the wisdom of reneging on the United States’ agreement to pillar 2.

Seen in this light, adoption of pillar 2 in the United States isn’t a matter of capitulating to the will of other countries, or of some Stasi-like transnational tax police. It’s a matter of claiming for the United States what other jurisdictions will almost certainly take anyway, in a way that will be decidedly less convenient for the very U.S.-based MNEs that a pillar 2 boycott would ostensibly be intended to help. There’s a reason why low-tax countries (like Switzerland) and state-sponsored tax haven island jurisdictions (like Jersey and Guernsey) are adopting pillar 2, and it’s not because of a sudden change of heart.

The EU, Japan, and Korea have all adopted legislation implementing pillar 2, and other jurisdictions have begun the process to do the same. It’s telling that the only country to abstain on the EU pillar 2 directive was Hungary, and even it eventually relented in its effort to block the directive’s approval. U.S. lawmakers who believe that the United States has the power to compel or browbeat the rest of the world into repealing or abandoning such legislation have probably been watching too many D-Day documentaries on the History Channel.

TCJA Boogeyman

The hearing was a truly bipartisan display of confusion, and one faction’s puzzling failure to grasp the existence of the UTPR was counterbalanced by the other’s misdirected outrage at the TCJA. Other than defending the TCJA-inspired pillar 2 agreement and harping on the seemingly distinct problem of high U.S. drug prices, lawmakers who weren’t busy ignoring the UTPR (or pretending to) were focused on blaming the TCJA for decades-old profit-shifting practices.

As Senate Finance Committee Chair Ron Wyden, D-Ore., declared at the outset of the hearing, the target of the investigation and the intended subject of the hearing was “byzantine, intricate tax schemes of some of the largest U.S. pharmaceutical companies and the immense handouts that these companies got from the 2017 Republican tax law.” The link between the two, according to Wyden, is that “the 2017 Republican tax bill essentially greenlighted the kind of tax gaming that the biggest drug companies pursue day in and day out.” A press release issued ahead of the hearing identified the specific tax games that Wyden had in mind:

The ongoing Senate Finance Committee Democratic staff investigation of Big Pharma’s tax practices pulls the curtain back on an industry that excels at shifting profits offshore to avoid tax. Through offshoring intellectual property (IP), aggressive transfer pricing, foreign manufacturing, and other techniques, Big Pharma is able to put most of its income — and sometimes every single dollar of profit — into offshore subsidiaries.

To illustrate the extent of the problem, senators unfavorably disposed toward the TCJA emphasized the disconnect between the jurisdictions in which U.S. pharmaceutical MNEs report their taxable profit and the jurisdictions in which they maintain their headquarters and derived their revenue. Drawing on the data presented in a May 9 Joint Committee on Taxation report, a staff memorandum attached to Wyden’s press release noted that 75 percent of U.S. pharmaceutical companies’ income was reported offshore in 2019.

The memorandum reinforced this assessment with a review of five major U.S. pharmaceutical companies: AbbVie Inc., Abbot Laboratories, Amgen Inc., Bristol Myers Squibb Co., and Merck & Co. Inc. Although each company’s sales to U.S. patients accounted for somewhere between 36 percent (Abbot) and 74 percent (Amgen) of total global revenue, four of the five reported between 0 percent (AbbVie) and 17 percent (Bristol Myers Squibb) of their income in the United States. Although Amgen reported 40 percent of its global income in the United States, this percentage was still considerably less than the 74 percent share that sales-based apportionment would require.

Hostile senators tried in a few ways to draw a link between the TCJA and this perceived imbalance, but the connection was principally based on the timing of the sharp post-TCJA drop in the U.S. pharmaceutical industry’s average ETR as reported by the JCT. According to the JCT report, the average ETR for U.S.-based pharmaceutical companies with at least $100 million in assets in 2016 fell from 19.6 percent for 2014 through 2016 to 11.6 percent for 2019 and 2020. Wyden’s staff memorandum, like the testimony of anti-TCJA senators, supplemented this tacit post hoc ergo propter hoc argument by reciting the flaws in the GILTI regime:

Under the [GILTI] regime Republicans created in 2017, these offshore profits can access a special low tax rate and take advantage of “global blending” of foreign income to minimize any additional tax. These provisions significantly cut pharmaceutical companies’ tax rate, sometimes into just single-digits, creating a huge incentive to put profit, investments, and jobs offshore. The industry’s average effective tax rate is an astonishingly low 11.6 percent — a 40 percent decrease from years prior to the 2017 Republican tax law. [Emphasis in original.]

Although it would be perfectly reasonable to regard these results as signs of a problem, definitively laying the blame at the feet of the TCJA is another matter. The JCT report that provided the ammunition for these criticisms of the TCJA noted that “there is no causal research on how the deduction for foreign-derived intangible income and GILTI affects U.S. pharmaceutical companies.” And the report framed the TCJA measures as a deterrent, albeit an incomplete one, to “tax gaming” through profit shifting:

Changes in the 2017 legislation generally reduced the incentive to book profits abroad, including (1) the decrease in the U.S. corporate rate from 35 percent to 21 percent, (2) taxation of GILTI, and (3) the taxation of base erosion payments to foreign affiliates. . . . The incentive to keep profits out of the United States while reduced, was not eliminated.

This assessment was based on a company-by-company review by Tax Analysts’ chief economist Martin Sullivan. Sullivan found that the weighted average ratio of foreign profits to total profits for 15 large U.S. pharmaceutical companies fell slightly after the TCJA, from 73.5 percent in 2014 through 2017 to 73.2 percent in 2018 through 2022. This, along with significant unrelated year-to-ear variation, strongly suggests that the TCJA’s alleged greenlighting of offshore profit-shifting is not the culprit behind the observed drop in the post-TCJA ETRs of U.S. pharmaceutical companies.

This really shouldn’t be surprising, considering the TCJA’s relevant provisions. The law subjected far more low-taxed foreign income to current taxation, introduced a blunt punitive mechanism for offshore related-party payments, and adopted a preferential rate for income tied to intangibles held in the United States.

It’s certainly reasonable to argue that the reduced 10.5 percent tax rate for GILTI and FDII is too low, especially compared with the adoption of a 15 percent minimum rate under pillar 2. But the 10.5 percent GILTI rate materially exceeds zero, which is more than can be said for the pre-TCJA tax rate on unrepatriated earnings. The FDII rate simply establishes rough tax parity between the income generated by intangibles held onshore and the income attributed to foreign intangibles under GILTI.

It would also be fair to note, as some senators did during the hearing, that GILTI’s 10 percent qualified business asset investment exception encourages offshore employment and investment. But the offshoring of real operations, undesirable as it may be for the United States, is not an artificial profit-shifting technique: The principle that taxable income should follow real economic activity is generally not considered especially controversial. Nor is it tax gaming or aggressive tax planning to simply be subject to a lower headline corporate tax rate.

Nothing New

It’s also hard to see how the TCJA could be to blame for profit-shifting practices that clearly began long before the law’s 2018 effective date. Wyden’s staff memorandum subjects Amgen, along with Merck, to particularly harsh scrutiny. The criticisms of Amgen stem largely from the company’s ongoing Tax Court litigation contesting $10.7 billion in deficiencies and penalties for 2010 through 2015. According to the IRS in Amgen Inc. v. Commissioner, Docket No. 16017-21, Amgen’s transfer pricing arrangements improperly shifted $24 billion of income from the United States to an offshore subsidiary with manufacturing operations in Puerto Rico.

If claims that a large U.S. MNE in the medical industry allocated excessive profit to a subsidiary that physically makes products developed, designed, and marketed in the United States sound familiar, there’s a very good reason. This was also the situation in Medtronic v. Commissioner, T.C. Memo. 2022-84, the Tax Court’s second opinion in the case after an Eighth Circuit remand (Medtronic, 900 F.3d 610 (8th Cir. 2018), vacating T.C. Memo. 2016-112). Although there is reason to expect the case to be appealed again, the Tax Court’s two opinions aptly illustrate how questionable judicial precedent — not flawed legislation — is responsible for the success of IP offshoring and aggressive transfer pricing practices. Whether either of the Tax Court’s two Medtronic opinions properly interpreted the law or not, they clearly legitimize and insulate the kinds of arrangements wrongly attributed to the TCJA at the hearing.

It’s especially strange to suggest that the TCJA greenlighted profit shifting through aggressive IP planning in light of the law’s amendments to section 482 and former section 936(h)(3)(B), now section 367(d)(4). For reasons that remain somewhat murky, the TCJA adopted a legislative proposal by the preceding administration for the express purpose of preventing the offshoring of income from U.S.-developed intangibles. The law broadened the definition of intangible property applicable for section 367(d) purposes, thereby confirming that the commensurate with income standard applies to controlled transfers involving goodwill, going concern value, and workforce in place. The TCJA also codified the aggregation and realistic alternatives principles, two regulatory concepts that the IRS invoked to no avail in Amazon.com v. Commissioner, 148 T.C. No. 8 (2017), aff’d 934 F.3d 976 (9th Cir. 2019); and Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009).

Case law applying the post-TCJA statute is still many years off. In the meantime, assessing the success of the amendments will be premature. Considering the history of section 482 litigation and the less-than-ideal drafting of the statute, a healthy degree of skepticism is warranted. Regardless, it’s hard to see how the TCJA amendments could possibly have greenlighted the very same objectionable transfer pricing arrangements that they were clearly meant to counteract.