Policy Measures and Countermeasures

Multinational corporate taxation is a long-standing game of cat and mouse. Laws are enacted, corporations react by shifting operations and residency (not to mention engaging in creative accounting), and governments take countermeasures. This back-and-forth process is illustrated by two examples: IRS Subpart F rules designed to limit tax avoidance through income shifting and IRS rules designed to discourage corporate "inversions" in which U.S.-based firms shift their residency abroad to avoid the global component of the U.S. corporate tax.

Many countries with territorial tax systems use controlled foreign corporation (CFC) rules to limit the ability of their resident multinationals to shift income to their foreign affiliates. In the United States, CFC rules take the form of the IRS's Subpart F rules, which were first enacted in 1962. These rules bar U.S. multinationals from deferring repatriation of certain types of income from their CFCs, including passive income on investments (such as interest on foreign securities) and royalty income.

But what one part of the tax code gave away, another part gave back. IRS "check the box" regulations allow U.S. multinationals to choose whether their foreign subsidiaries are treated as CFCs or as foreign disregarded entities (FDEs). The details are rather technical, but by merely switching the designation of certain foreign affiliates from CFC to FDE, a U.S. multinational can sidestep Subpart F rules and continue to shift royalty income to low-tax havens. Another limitation of the rules is that they only limit the income shifting of U.S.-based multinationals. They have no effect on the ability of foreign-based multinationals to shift income from their U.S.-based affiliates to their non-U.S.-based affiliates.

The IRS has taken substantial moves over the years to curtail corporate inversions. The first corporate inversions occurred during the 1980s, and the process accelerated in the 1990s. In 2004, the American Jobs Creation Act changed IRS rules to bar firms from inverting when the original U.S. shareholders still held 80 percent of the reorganized firm. Firms seeking to invert were also required to have substantive operations in their new host countries. These changes temporarily dampened the inversion wave, but firms eventually began to exploit other tax loopholes, and a second wave of inversions took place between 2009 and 2014. A subsequent series of regulations during 2014-2016 closed many of the loopholes. At the same time, the IRS moved against strategies — known as "hopscotch loans" and "earnings stripping" — that used loans among affiliated companies to shift income abroad.