The question is: what is the difference between tax arbitrage and legal profit shifting strategies? The difference is as fundamental as the question itself. Both involve international taxation, but their methods are different. Tax arbitrage strategies are the use of different structures to avoid taxes in one jurisdiction and to generate profits in another. The use of tax arbitrage allows businesses to maximize their profits in one jurisdiction and avoid paying taxes in another. This is a legal strategy that is widely used by multinational corporations to reduce their tax burdens in the United States.
The best strategy involves paying royalties to other group companies and shifting profits from one jurisdiction to another to increase profits available to group shareholders. These payments, called “transfer pricing,” are deducted from the company’s pre-tax profits. Additionally, some countries have lower tax rates on royalties, making them attractive to profit shifting. However, the process can create some legal challenges. Regardless of the complexities, these strategies are effective.
Countries are faced with a difficult dilemma when determining their domestic international tax policies. While they want to maximize revenue by taxing cross-border income, they also want to clamp down on perceived avoidance activities. By cutting tax rates, they compete with one another, but in doing so they erode their own tax bases and facilitate the erosion of other countries’ tax bases. They often make this decision without considering the impact it will have on their own tax base.
There are many ways to measure the effectiveness of profit shifting. Some academic accountants have calculated the impact of profit shifting on corporate tax receipts using different methods. For instance, economist Kimberly Clausing has used Bureau of Economic Analysis data to estimate the costs of profit shifting in 2012. However, her 2016 study suggests that profit shifting costs the United States between $77 billion and $111 billion in corporate tax revenues in 2012, while total corporate tax receipts stood at $242 billion.
One major issue with legal profit shifting strategies is the possibility of profits being transferred to jurisdictions with low tax rates. Often, these strategies involve the use of affiliates in low-tax countries to license IP, make loans to other affiliates, and assume business risks. This means that profit can be transferred to low-tax countries without generating any real activity. Nevertheless, because of this fundamental approach, preventing profit shifting to low-tax jurisdictions is difficult.
Another problem with legal profit-shifting strategies is the loss of value. Without a transparent tax system, the value of projects would diminish and society would suffer. The best way to address this problem is to develop a tax system that is fair to all stakeholders. Ideally, tax arbitrage and legal profit shifting strategies will be aimed at achieving these goals. In this way, we can maximize our tax-saving potential.