Sacha Wunsch-Vincent of the World Intellectual Property Organization (WIPO) and I have a forthcoming chapter in a World Trade Organization (WTO) book which extends our analysis of tax distortions in the location of intellectual property. Not surprisingly, low tax rates have encouraged the assignment of intangible income by multinational enterprises to countries with low effective tax rates. The bad news is that tax-motivated profit shifting has distorted reduced governmental revenues and distorted national statistics. The good news is that such distortions will be reduced in the future due to collaborative governmental policies.
The OECD/G20 BEPS project addressed the disconnect between the location of taxable income and the location of value creation. The project instituted standards to prevent harmful tax competition, updated standards for tax treaties and transfer pricing, and instituted new country-by-country reporting of MNEs for improved transfer pricing administration, among other changes.
Information from the World Development Indicators on cross-border charges for the use of intellectual property (CUIP) has not previously been used to assess profit shifting from transfer mispricing and the strategic location of IP, which have been estimated to be the main channels of base erosion and profit shifting. Cross-border IP receipts should be strongly related to prior R&D expenditures.
A simple analysis examines whether corporate tax rates, including tax rates for certain intangible income, affects the relationship of cross-border IP receipts and prior year R&D expenditures across countries. The figure above shows a high ratio for several countries with low tax rates or tax regimes providing low effective taxation of IP. Luxembourg, Netherlands and Ireland have ratios exceeding 175% while Japan, Germany and the U.S. have ratios below 25%. Profit shifting, not real economic activity, explains the vast differences.
Regression analysis of CUIP, R&D, outbound FDI and tax rate data for 29 OECD countries from 2005 to 2016 finds that a one percentage point lower tax rate on IP income increases the ratio of IP income to lagged R&D expenditures by 5-7 percent. This is consistent with other empirical findings showing greater transfer mispricing in R&D intensive sectors and the strategic location of IP in countries with low tax rates. Non-tax explanations can not fully account for the consistent pattern of higher IP receipts relative to prior year R&D expenditures recorded in countries with lower tax rates. Future research could use this type of data to determine if the OECD/G20 BEPS project and implementation of anti-avoidance rules by countries since 2014 are reducing tax-motivated distortions in the IP flows and national statistics.
Regression results of excess cross-border CUIP receipts to tax rates
The regression finds the general corporate tax rate to be statistically significant, but with a larger effect when the intangible tax rate is used. The differential between the general and intangible tax rate has a larger effect than the intangible (favorable “patent box”) tax rate by itself. The ratio of countries’ outbound foreign direct investment (FDI) to GDP is positive and statistically significant. High relative outbound FDI is expected to be associated with greater cross-border activity, but also reflects countries with significant Special Purpose Entities (SPEs), which often facilitate tax planning.
A number of alternative specifications were tested. The last column shows when CUIP as a percent of GDP is an absolute rather than a ratio to lagged R&D expenditures, with a slightly larger tax differential effect. Time fixed effects don’t affect the size of the coefficients. The coefficient on the tax rate differential variable declines with country fixed effects, suggesting most of the effect occurs across countries rather than within individual countries.
Reductions in a country’s tax rate on IP income increases the amount of cross-border IP income relative to its lagged R&D expenditures. Most likely that effect is driven by tax-motivated profit shifting across countries than increasing total returns to global IP investments. Lower general corporate tax rates and non-harmful competition tax rates on IP income in countries with real R&D activity, such as the 2017 U.S. tax reform, should reduce the current shifting of IP and IP income out of the those countries.
Tom Neubig