A new paper by economics professor Rishi Sharma examines how corporations skirt paying taxes on intellectual property — and how they might be held accountable.
If you recently took a ride in an Uber anywhere in the world, a portion of your fee went to the driver, a portion went to the local Uber affiliate, and a portion went to … Bermuda. That’s where — until recently — the intellectual property (IP) for the company had its home. And thankfully for Uber headquarters in San Francisco, the company paid no taxes on those earnings. “A lot of tax avoidance from companies involves IP in some way,” says Rishi Sharma, Colgate associate professor of economics, “usually finding creative ways of locating IP in countries where the income generated is going to be untaxed or taxed at exceedingly low rates.”
Sharma explores the phenomenon in a paper published in the Journal of Public Economics, detailing how companies are able to get away with these maneuvers and what might be done to keep them accountable. “There really hasn’t been any systematic analysis of these types of incentives, and we were motivated by that gap,” says Sharma, who wrote the paper with Joel Slemrod of University of Michigan and Michael Stimmelmayr of University of Bath and ETH Zurich.
Technically, there are rules in place to ensure that companies pay taxes on intangible assets in their countries of origin, Sharma explains. Even if they transfer the IP to a subsidiary in a country with a lower tax rate, such as Bermuda, they are supposed to pay a so-called arm’s length price — that is, a reasonable value for the property as determined by an independent third party — at the time of the transfer.
Some companies, however, transfer the IP early on in development, at a time when its value cannot be determined by an outside observer. “Before the IP has been fully used and scaled all over the world, the value of the IP is really only known to the company that develops it,” Sharma says. “There’s no way for anyone else to verify it.” That asymmetry of information means that companies can game the system to transfer at an opportune time to reduce the taxes they will pay.
In the case of Uber, for example, the company transferred the IP to Bermuda right before undergoing a major round of venture capital funding. “They used the lower valuation, which was the only publicly available valuation of the time,” Sharma says. “The tax authorities don’t really have any information to dispute that.” In their paper, Sharma and his colleagues use a theoretical model to show how companies have incentive to maximize their tax savings by transferring IP early on in the development process. At the same time, however, they are able to mask such transfers by moving numerous IP assets at once.
“With early stage IP, a lot of projects don’t work out,” Sharma says. “So they are in a position to argue that they transferred 100 IP assets, and 95 of them were valued fairly, given the profits they eventually made on them — in fact, they might have been overvalued.” In this way, companies have “plausible deniability” that keeps governments from being able to accuse corporations of transferring valuable IP at a time after they knew its potential but before it technically generated profits.
Because of that, the researchers argue, foreign tax authorities are unable to adequately tax the small percentage of IP that generates the lion’s share of profit. Thankfully, increased scrutiny from the EU and reputational concerns have recently prompted Uber to move its IP from Bermuda to the Netherlands, where it will be taxed at a higher rate. But many companies still have their IP in low- or no-tax countries.
“Even if tax authorities can get the right valuation on average — which itself is optimistic — it’s not sufficient to stop this kind of tax avoidance,” Sharma says. “Even if you tighten or reform a bit, it’s implausible to think you’d make a significant dent in this.”
In the paper, the authors consider a type of minimum tax imposed by the Trump Administration’s Tax Cuts and Jobs Act of 2017, called global intangible low-taxed income. The measure was intended to de-incentivize companies from moving their IP assets overseas, using a complex formula taxing some of companies’ foreign profits in low-tax countries, ending up somewhere around 10–13%.
While that is still less than the U.S. corporate tax of 21%, Sharma says it could have some impact on holding firms accountable. “Right now, it’s too soon to tell,” Sharma says. “Often firms can find loopholes, though it takes some time for them to figure out which ones are legally sustainable.”
A potentially more promising solution, Sharma says, is the recently proposed Global Minimum Tax, which has been pushed by the Biden administration, to apply a 15% minimum corporate tax on earnings of any company anywhere in the world, no matter where they are located. In cases where that percentage is higher than the tax of a particular country, the difference would go to a combination of the headquarters’ country and where sales occurred.
“We would expect this to reduce the incentive to place IP in a tax haven,” Sharma says. “It’s still lower than the corporate tax rate in the U.S. and other large economies, but the gap is much narrower — 0 versus 20% is quite different than 15 versus 21%.”
Ironically, even though the Biden administration pushed the Global Minimum Tax through the Organisation for Economic Co-operation and Development, Congress has yet to approve it for the U.S. Meanwhile, 140 countries have signed on to the agreement, meaning that the U.S. may lose out on potential income from the tax if it does not approve it by the time it goes into effect worldwide.
Sharma hopes that his paper provides additional support for deeper reforms of the international tax system such as the Global Minimum Tax by showing that existing forms of enforcement are wholly inadequate for making corporations pay their fair share of taxes from IP. “Relying on reform of the existing arm’s length system by making things stricter is not likely to address these issues,” he says. Only by countries working together across the world, he says, can companies be held accountable, and the loopholes they might use to deprive taxpayers be stopped.