Attacking the Cash Box

A colleague of mine yesterday highlighted comments made recently by Robert Stack, deputy assistant secretary for international tax affairs at the US Treasury Department: “We are determined to put a big dent in the ‘cash box’ because countries cannot afford large piles of untaxed income.”

4871276_sBut what is a “cash box”, anyway?  The concept is pretty simple: it’s a company within a multinational group located in a low-tax jurisdiction that owns some sort of valuable asset. That company may not even have any employees, but since it owns the asset it is legally entitled to the profits that are generated by the asset, thereby ensuring that a portion of the multinational group’s income gets taxed at a very low tax rate.

But for tax authorities, restricting the use of such arrangements is trickier than it might seem. Let’s use an example to illustrate. Imagine there’s a company called SuperTech USA that develops a fantastic new product. SuperTech USA sets up a subsidiary on a lovely tropical island that happens to have a corporate tax rate of zero, and then has SuperTech Island Co purchase the designs and technology underlying that product. SuperTech Island Co hires a contract manufacturing company in China to make the product, and contracts other SuperTech affiliates around the world, possibly including SuperTech USA, to essentially act as local sales agents.  From that time onward, whenever SuperTech products are sold to consumers the local sales affiliates get some sort of arm’s length compensation for their services (maybe a sales commission), but SuperTech Island Co gets the rest of the revenue. If it’s really a good product with fat profit margins then it’s likely that the bulk of the group’s profits will actually belong to SuperTech Island Co and be subject to zero corporate income tax.

If you are interested in stopping this type of arrangement, how would you go about it? Perhaps you might consider blocking the initial purchase of the asset by SuperTech Island Co. But companies buy and sell assets all the time for perfectly reasonable business reasons, so any sort of simple rule prohibiting that won’t work. What about requiring all of SuperTech’s sales revenue to belong to the local sales affiliates rather than to SuperTech Island Co?  Allowing the owner of an asset to claim the income generated by that asset is a basic element of our notion of property rights, so we can’t easily tamper with that.

The OECD seems inclined to address the issue in a different way: require SuperTech Island Co to pay much more compensation to SuperTech’s local sales affiliates. That’s a transfer pricing issue, and would depend on making the argument that SuperTech Island Co is paying its sales affiliates less than what it would have to pay to unrelated sales agents. Given the abundance of sales people in this world eager to have a good product to sell, it seems likely that would be a difficult argument to make. Trying to tweak existing transfer pricing rules to address this particular situation would likely open an entirely new can of worms.

Instead, Stack indicated that the US government thinks a better approach would be for an international agreement to allow countries to tax income earned by companies domiciled outside their jurisdiction. In other words, Treasury would like to get other countries to agree to allow the US to tax the profits of SuperTech Island Co even though that company is not located in the US. Needless to say, however, reaching such an international agreement could be extremely difficult.

But the economist in me wonders if the root cause of this sort of arrangement is really something else: incorrect initial valuations of the asset.  If the price that SuperTech Island Co had to pay to acquire ownership of the asset fully reflected the future stream of income that could be expected from that asset, then it seems likely that there would not be much of an incentive to move the asset in the first place. With the transaction described above SuperTech USA would record a large amount of income in the year of the asset sale – on which it would pay US tax rates – in exchange for a stream of tax savings in future years.  It strikes me that a correct initial valuation of the asset should take this into account. And if it did, then perhaps the cash box problem would not be so much of a problem after all.

5 comments

  1. santcugat says:

    The cash box only works to the extent that the payments to SuperTech Island Co are a deductible expense for the local sales affiliate. This is why Ireland, Luxembourg and the Netherlands are such a big deal, since they have tax treaties that allow deductions for payments from their foreign subs, but on the other hand allow the money to escape to the Cayman Island without being taxed.

    Countries with large markets are really in a good position to dictate what they will allow. For example, a country could require that a company provides a global consolidated accounting across all its affiliate prior to being allowed any deductions. The country could then apply a formula to apportion the global income based on revenue, number of local employees, etc.

    Countries could even do this as a group to get more leverage, and to simplify the life of multinationals somewhat. Although it’s hard to have too much mercy on complicated corporate structures.

  2. Mike Beadle says:

    I wondered the same thing – the initial valuation of the asset should reflect not just a cost+ but also the option value that owning that asset would bring, specifically the ability to make large sales of licences etc.

    Presumably the next step would be to transfer the ownership of the IP at an earlier stage, before it could be argued that there is much likelihood of high future sales. However, I think there is a very credible argument that the very act of transferring IP suggests that there is an expectation of high future returns. And if there is a requirement to further ‘develop’ the IP through marketing or further R&D, then this should result in revenues receivable in the US.

    If through luck (and not marketing / IP) there is a material increase in value of the asset, the US authorities should be careful to capture the capital gain on the asset when it is ultimately realised (or indeed the dividends / cashflows remitted from Supertech Island). Exemptions for entrepreneurs are not appropriate when tax has been avoided.

  3. Harold McClure says:

    “But the economist in me wonders if the root cause of this sort of arrangement is really something else: incorrect initial valuations of the asset.” This may be part of the issue but there is a more fundamental question that needs to be addressed first. What do we mean by the intangible asset. This was a key issue in Veritas and it will also be so in Amazon. The taxpayer in both wanted the Court to view the intangible strictly as current production applications or the specific software (as in lines of code) at the time of the transfer. In Amazon, the lines of code were likely worth just over $200 million. The IRS wants the question to be what is the value of the entire bundle of intangible assets, which they claim were worth $3.6 billion. An economist cannot do a reliable estimate of the value of something until that something in clearly defined.

  4. MadNumismatist says:

    “If the price that SuperTech Island Co had to pay to acquire ownership of the asset fully reflected the future stream of income that could be expected from that asset”

    Surely this will mean that all R&D would take place outside country of domicile to start with; giving tropical islands/ mountain hideouts all the high paying jobs.

  5. ThomasH says:

    A better way would be to impute the business income to the owners and tax the imputed income (not just dividends). If Super Tech Co’s owners are the same as Super Tech, it does not matter. Why should “business” income be taxed at all?

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