69�þ�Ʒ

Key Takeaways

• U.S. multinational corporations (MNCs) have been widely reported to use highly complex tax planning strategies, yet little remains known about the prevalence or impact of these strategies.
• New research shows IRS tax return data can be used to reconstruct MNCs’ foreign affiliate ownership networks and identify firms with “hybrid” tax planning structures, which leverage legal mismatches in the tax treatment of affiliates between countries.
• By 2016, 35 percent of all U.S. MNC foreign profits were routed through a hybrid tax planning structure in Ireland, Luxembourg, or the Netherlands.
• After adopting a hybrid structure, MNCs amplify behaviors linked to profit shifting, leading to sharp decreases in foreign effective tax rates.
• Hybrid tax planning MNCs also experience changes in real economic outcomes, including increased tangible assets, domestic payroll, and R&D.

Use of intricate tax planning strategies is a well-documented phenomenon among multinational corporations: By leveraging discrepancies in tax laws across countries, firms can greatly reduce or even entirely avoid both domestic and foreign tax burdens. Quantifying the importance of these strategies, however, remains extremely difficult. As a result, the overall prevalence of multinational tax planning is largely unknown, as are its associated economic impacts.

While the existence of particular strategies has been detailed by various document leaks, government reports, and media outlets,[1] the incentive for firms to withhold individual tax information presents challenges for measuring tax planning comprehensively. Consequently, estimates of the revenues forgone to multinational tax avoidance vary widely.[2] For example, Clausing (2016) estimates that the U.S. lost as much as $111 billion in tax revenue due to profit shifting between 1983 and 2012, whereas Blouin and Robinson (2020) revise this estimate to $10 billion.

A new Internal Revenue Service (IRS) working paper by Rosanne Altshuler, Lysle Boller, and Juan Carlos Suárez Serrato addresses these challenges by using entity-level IRS corporate tax return data to measure three specific forms of tax planning. A salient benefit of using tax returns is that they accurately represent a firm’s true tax position, uninfluenced by accounting or reporting quirks. Moreover, combining data from multiple IRS forms enables us to reconstruct the global affiliate ownership networks of U.S. multinational corporations (MNCs), revealing linkages between entities that may not be disclosed publicly.

A final advantage of these data is that they allow us to observe the entity type of each affiliate company within a firm’s network. We use these observations to identify MNCs with “hybrid” affiliates, or entities subject to different tax treatment from the U.S. and foreign perspectives. We examine the use of three hybrid tax planning (HTP) strategies over time, compare differences in outcomes between HTP-adopting and non-adopting firms, and tie changes in these outcomes to the timing of HTP adoption.

To properly set policy, governments and international organizations first need a detailed understanding of the extent to which tax planning strategies are used by multinational corporations. Without such knowledge, many recent policy efforts, such as the ongoing OECD (Organization for Economic Cooperation and Development) Base Erosion and Profit Shifting initiative, may be poorly targeted. By developing fundamental measurements of the growth and real economic impacts of tax planning strategies that generate opportunities for profit shifting, this research provides a first survey of the international tax planning landscape.

More broadly, we demonstrate how IRS corporate tax return data can be an exceptional tool for observing the real tax behavior of multinational firms. As governments continue to implement policy changes, these data present expansive opportunities to study and improve the design of the international tax system.

Growth of hybrid tax planning

Hybrid tax planning strategies were extremely rare among U.S. MNCs before the 1997 enactment of “Check the Box” regulations, discussed below. By 2016, however, more than 17.5 percent of MNCs adopted at least one of the three HTP structures we study in Ireland, the Netherlands, and Luxembourg.

Moreover, we find that adopting firms account for a large portion of U.S. foreign economic activity. Over 60 percent of all U.S. foreign profits in 2016 are attributable to HTP-adopting firms, and more than half of those profits (35 percent total) directly flowed through a hybrid entity.

Adopting firms also comprise a large portion of domestic U.S. economic activity. We find that MNCs with hybrid tax planning structures accounted for more than 20 percent of domestic wages and 15 percent of domestic investment of all U.S. C corporations—both domestic and multinational—in 2010.

Hybrid tax planning and economic outcomes

We compare HTP adopters and non-adopters over time and find that adopting MNCs experience dramatic increases in outcomes linked to profit shifting, such as foreign intangible asset holdings, foreign cash holdings, and loans between related foreign affiliates.

These behaviors contribute to a striking discrepancy in the foreign effective tax rates paid by adopting MNCs compared with non-adopters between 1997 and 2016. By the end of this period, the foreign effective tax rate of firms with hybrid tax planning structures was roughly 10 percent—nearly half that of non-adopters, and far less than the 35 percent statutory rate applicable during this time.

Figure 1: Comparison of Foreign Effective Tax Rates

Finally, we examine real economic outcomes associated with hybrid tax planning. Compared with non-adopters, we find that HTP MNCs increased their stock of domestic and foreign capital assets, domestic wages, and R&D. The adoption of a hybrid tax planning structure is thus associated not only with intensification of tax avoidance behaviors, but also with real and significant domestic and foreign firm growth.

Check the Box regulations and the rise of hybrid structures

During our period of analysis, the U.S. had a worldwide tax system that levied post-repatriation corporate tax on MNC foreign profits as well as immediate corporate tax on certain types of transactions between foreign affiliates.[3] Under the worldwide system, Check the Box regulations greatly incentivized the use of multinational tax planning strategies designed to shift profits between affiliates.

This 1997 policy made it much easier for U.S. firms to change the entity classification of their affiliates and to reclassify foreign entities as “disregarded” pass-through entities. The U.S. Treasury views an incorporated (i.e., non-disregarded) foreign affiliate and any foreign pass-throughs connected to it as a single consolidated corporation. Thus, any transactions between these entities are seen as intra-company and are not subject to immediate U.S. tax.

MNCs could use Check the Box to avoid U.S. tax on foreign income with simple arrangements involving as few as two affiliates. For example, consider an MNC that transfers intellectual property rights to Affiliate A, an incorporated subsidiary in a low-tax country. This allows Affiliate A to license the intellectual property to Affiliate B, a disregarded entity in a high-tax country, in exchange for royalty payments. The royalty payments shift foreign profits to the low-tax country, where, if held indefinitely, they are not subject to U.S. repatriation-based tax.

This type of inter-affiliate transaction would generally incur immediate U.S. tax. However, because the MNC parent company “checked the box” to disregard Affiliate B, the U.S. Treasury views both affiliates as a single corporation. The royalty payment transaction is ignored from this perspective, so no tax is levied. Consequently, both pieces of the MNC’s related U.S. tax burden have been neatly avoided.

Hybrid tax planning structures

Though this simple tax planning strategy eliminates tax liability from the U.S. perspective, the MNC may still be subject to foreign corporate tax, as well as any foreign withholding taxes levied on payments between countries. As a result, Check the Box arrangements promulgated widespread use of hybrid entities—affiliates viewed as incorporated from one country’s perspective and disregarded from another’s—that can be used to leverage mismatches between U.S. and foreign tax treatment.

Our analyses focus on three well-known HTP structures: the Double Irish and related variations, Reverse Hybrid Mismatches in the Netherlands, and Reverse Hybrid Mismatches in Luxembourg. Each of these structures addresses the two remaining foreign tax burdens faced by an MNC using Check the Box.

The Double Irish

The Double Irish employs the basic two-entity structure discussed above using two Irish affiliates, where Affiliate A is legally incorporated in Ireland but managed and controlled in a tax haven like Bermuda. From the U.S. perspective, Affiliate A is an Irish company and Affiliate B is a disregarded pass-through. From the Irish perspective, however, Affiliate B is the incorporated Irish company, and Affiliate A is a Bermudian company not subject to Irish tax. This mismatch allows the MNC to avoid its U.S. tax liabilities via Check the Box, without incurring Irish tax on profits shifted to Affiliate A.

To address Irish withholding taxes on the royalty payments from Affiliate B, an MNC can further expand the Double Irish by introducing a “Dutch Sandwich”: a third, conduit entity in the Netherlands that is also disregarded from the U.S. perspective. Under Dutch and European Union laws during this period, royalty payments between these three foreign affiliates were not subject to any withholding tax. We diagram this enhanced structure in Panel A of Figure 2.

Reverse Hybrid Mismatches

We also study two forms of Reverse Hybrid Mismatch, which respectively involve foreign affiliates in either the Netherlands or Luxembourg. In this system, the MNC establishes U.S. managing/silent partner affiliates that control an incorporated foreign affiliate (Affiliate A). This entity, however, is a “reverse hybrid”: it is viewed as a corporation from the U.S. perspective but is disregarded from the foreign perspective. Affiliate A also owns a traditional hybrid entity (Affiliate B), which is disregarded from the U.S. perspective but seen as incorporated from the Dutch or Luxembourgish perspective. We diagram a Dutch Reverse Hybrid Mismatch, also known as a “CV-BV” arrangement, in Panel B of Figure 2.[4]

As with the Double Irish, Reverse Hybrid Mismatch arrangements help adopting MNCs address three key tax issues. First, the firm avoids its U.S. foreign tax obligations via Check the Box, as discussed above. Second, because the foreign country views Affiliate A as a disregarded pass-through, it does not levy tax on the profits shifted to this affiliate via royalty payments. Finally, during our period of analysis, foreign tax laws did not subject payments between these two types of affiliates to withholding taxes.

Figure 2: Diagrams of Hybrid Tax Planning Structures

(A) Double Irish with Dutch Sandwich

(B) Reverse Hybrid Mismatch: Dutch CV-BV

Notes: Blue rectangles depict consolidated corporations as perceived by the IRS; squares denote corporations; and squares with circles inside denote hybrid entities. In Panel B, the triangle denotes a reverse hybrid: It is a partnership for Dutch purposes but a corporation for U.S. purposes.

As these specific tax structures show, MNCs have powerful incentives to design clever ways of minimizing their global tax obligations. This research demonstrates that careful use of tax data can uncover these strategies, which can dramatically impact the foreign effective tax rates faced by multinational corporations.

Though recent domestic and foreign tax policies have targeted many aspects of the specific tax planning structures we study,[5] examining the use of these structures before regulation underscores the readiness of MNCs to devote significant resources toward lowering their global tax bills. As firms and governments continue to respond to changes implemented by policies like the 2017 U.S. Tax Cuts and Jobs Act, this new understanding of the importance of tax planning strategies is crucial for evaluating the effects of this landmark legislation on the foreign and domestic activities of U.S. MNCs.

Footnote

[1] See, e.g., Drucker (2010), Duhigg and Kocieniewski (2012), Kleinbard (2013), Pegg (2018), and Guardian Staff (2019).

[2] Throughout this brief, we refer to the legal use of strategies that minimize tax obligations as “tax avoidance.”

[3] The Tax Cuts and Jobs Act of 2017 made significant changes to U.S. corporate taxation, including eliminating the worldwide tax system. However, certain types of transactions between foreign affiliates remain subject to the immediate “Subpart F” tax.

[4] The reverse hybrid entity is known as a “CV” in the Netherlands or an “SCS” in Luxembourg. The traditional hybrid entity is known as a “BV” in the Netherlands or a “SARL” in Luxembourg.

[5] See, e.g., Samarakoon (2022).

References

Altshuler, Rosanne, Lysle Boller, and Juan Carlos Suárez Serrato. 2024. Working Paper, IRS Statistics of Income.

Blouin, Jennifer L., and Leslie Robinson. 2020. SSRN.

Clausing, Kimberly A. 2016. Washington Center for Equitable Growth.

Drucker, Jesse. 2010. Bloomberg.

Duhigg, Charles, and David Kocieniewski. 2012. New York Times.

Guardian Staff. 2019. The Guardian.

Kleinbard, Edward D. 2013. “Through a Latte, Darkly: Starbucks’ Stateless Income Planning.” Tax Notes, 1515–1535.

Pegg, David. 2018. The Guardian.

Samarakoon, Navodhya. 2022. SSRN.