No Tax Holiday for Multinational Corporations

If you think that “double Irish” and “Dutch sandwich” are schoolyard jump rope games girls play, think again. These are the nefarious, but legal, games that hundreds of multinationals play to avoid paying their fair share of taxes. According to a report by Bloomberg, Google used these techniques to cut its tax rate to 2.4 percent and its taxes by $3.1 billion over the three years from 2007 through 2009. The company's top two markets by revenue are the US, with a 35 percent corporate income tax rate, and the UK, with a 28 percent rate, yet Google – using practices widely employed by global companies – dramatically reduced its tax rate.

At the heart of this strategy is the transfer of rights to intellectual property developed in the US – often, as in Google's case, with early research funded by US taxpayers through the National Science Foundation – to a subsidiary in a low-tax country. Foreign earnings based on the technology are then attributed to the subsidiary. Google transferred its search and advertising technology for much of the world to its Irish subsidiary at a price sanctioned in 2006 by the IRS. But even the much-vaunted low Irish taxes were not low enough for Google. That's where the “double Irish” and the “Dutch sandwich” come in.

Here's how it works. In the “double Irish,” Google establishes two subsidiaries in Ireland. Google Ireland Holdings, managed from Bermuda, licenses intellectual property rights to Google Ireland Limited, which sells advertising rights in Europe, Africa and the Middle East and collects the advertising revenue. Google Ireland Limited keeps a fraction of these revenues and, ultimately, pays the balance in royalties to Google Ireland Holdings which, under Irish law, is a Bermuda company. No taxes are paid on these royalties because Bermuda has no corporate tax.

Ireland does have a 20 percent withholding tax that it would collect if royalties were paid to Google Ireland Holdings directly. That's where the “Dutch sandwich” comes into play. A Dutch subsidiary, Google Netherlands Holdings, is “sandwiched” between the two Irish subsidiaries. Google Ireland Limited actually pays the royalties to the Dutch subsidiary, which then pays the royalties to Google Ireland Holdings. Irish law exempts this type of royalty payment to companies in other EU countries from the withholding tax.

Google is not alone. Hundreds of multinationals – including Microsoft, Oracle and Eli Lilly – use these ploys, with a foreign tax haven as the ultimate repository for the firms' overseas profits. This kind of income shifting – known as transfer pricing – can significantly increase a company's earnings and share price.

Companies continue to owe taxes to the US government on these overseas earnings – technically, the taxes have only been deferred. But the taxes don't come due until the profits are brought back to the US – that is, repatriated. And companies do want to repatriate these profits.

A dozen large multinationals have joined the “Win America Campaign” to lobby for a tax holiday, so US companies can bring foreign profits home. In 2004, when Congress last declared a tax holiday, much of the $900 billion that corporations held abroad was repatriated at a reduced tax rate of just 5 percent. Today, US corporations hold roughly $1.43 trillion overseas. The demand for a tax holiday clearly indicates that parking profits overseas is a tax-avoidance strategy, not a business necessity.

The push for a tax holiday has bipartisan support in Congress. However, the Treasury opposes a tax holiday as a stand-alone measure although it might consider it as part of a broader tax reform package.

How should the rules governing taxes on overseas profits be reformed?

House Speaker John Boehner has proposed a system of territorial taxation, in which overseas profits of US corporations would not be taxed in the US. This would only increase incentives for US companies to offshore operations and increase the use of transfer pricing. Ultimately, it would mean a race to the bottom in which no country could tax corporate profits, since companies would threaten to move operations to a lower-tax country unless the home country reduced its tax rate.

Here's a better idea: replace the rules for transfer pricing with rules that allocate a company's profits among its subsidiaries based on metrics such as the number of employees or the sales revenue generated in each jurisdiction. Currently, about half of US states with corporate income taxes use this method for companies that operate in multiple states. It would not be difficult to apply the same rules to multinational companies.