Base erosion and profit shifting

Based on Wikipedia: Base erosion and profit shifting

In 2015, Apple executed the largest tax maneuver in corporate history. The company restructured its Irish operations in a way that caused Ireland's gross domestic product to jump by 26 percent in a single quarter—an economic absurdity that economists nicknamed "leprechaun economics." No factories were built. No jobs were created. On paper, hundreds of billions of dollars simply appeared in Ireland, having vanished from the tax bases of other countries.

This wasn't illegal. It was a perfectly orchestrated example of base erosion and profit shifting, a category of tax avoidance strategies that costs governments somewhere between one hundred and two hundred forty billion dollars every year.

The Mechanics of Making Profits Disappear

The name itself tells the story. "Base" refers to the tax base—the pool of income that a government can actually tax. "Erosion" is what happens when that pool shrinks. "Profit shifting" is the mechanism: moving money from places with high taxes to places with low or no taxes, even when little actual business happens in those low-tax locations.

Consider a simplified example. A technology company develops software in the United States, where corporate taxes are substantial. It sells that software worldwide, generating billions in revenue. In a straightforward world, those profits would be taxed where the work was done and where the sales occurred.

But corporations don't operate in a straightforward world. They operate in a world of intricate legal structures and bilateral tax treaties.

The company creates a subsidiary in Ireland. It transfers ownership of its intellectual property—the patents, the code, the brand—to that Irish entity. Now when customers in Germany, Japan, or Brazil buy the software, the profits don't flow to the United States. They flow to Ireland, because Ireland "owns" the intellectual property. The American parent company might even pay royalties to its own Irish subsidiary for the right to use technology that American engineers created.

Ireland's corporate tax rate is already low. But the story doesn't end there.

Why Intellectual Property Is the Perfect Vehicle

Patents and copyrights have a peculiar quality that makes them ideal for tax avoidance: they're valuable, but they have no physical form. A factory cannot be teleported to the Cayman Islands. A patent can be transferred with paperwork.

This matters enormously because the global economy has shifted. The most valuable companies in the world—Apple, Google, Microsoft, Pfizer, Merck—derive much of their worth not from physical assets but from ideas. The formula for a drug. The algorithm behind a search engine. The design of a smartphone interface.

These intangible assets are easy to identify, relatively easy to value, and remarkably easy to relocate. They aren't geographically bound in any meaningful sense. A pharmaceutical company's patent works the same whether it's legally domiciled in New Jersey or the Netherlands.

Tax scholars describe intellectual property as the raw material of tax avoidance. The largest flows of shifted profits globally involve IP-based structures. Companies establish licensing and patent-holding entities in offshore locations, then have their foreign subsidiaries pay royalties to those entities. The profits land in a jurisdiction where taxes barely exist, while the countries where actual research, manufacturing, and sales occur are left with diminished revenues.

The Other Great Tool: Debts That Exist Only on Paper

Intellectual property gets the most attention, but there's another mechanism that's even simpler. Intra-group debts—loans between different parts of the same corporation—can be created, as the United Nations delicately put it, "with the wave of a pen or keystroke."

Here's how it works. A multinational corporation has a subsidiary in a high-tax country that's generating substantial profits. The parent company creates a financing subsidiary in a low-tax jurisdiction. That financing subsidiary then "lends" money to the profitable subsidiary. Now the profitable subsidiary has to pay interest on this loan, and interest payments are tax-deductible expenses in most countries.

The beauty of this arrangement, from a tax avoidance perspective, is its invisibility. These intra-group debts don't appear on consolidated financial statements. They don't require moving any employees, factories, or real assets. They don't involve third parties who might ask inconvenient questions. The Organisation for Economic Co-operation and Development, known as the OECD, has identified the risks from these debt arrangements as "the main tax policy concerns surrounding interest deductions."

The American Anomaly

For decades, the United States operated under a "worldwide" tax system, one of only eight countries to do so. This meant that American corporations technically owed U.S. taxes on their global profits, not just their domestic ones. Most countries use a "territorial" system, where they only tax profits earned within their borders.

You might think a worldwide system would reduce tax avoidance. After all, there's no escaping American taxes by moving profits abroad if the IRS can tax those foreign profits anyway.

In practice, the opposite happened.

American companies could defer paying U.S. taxes on foreign profits indefinitely, as long as they never brought that money home. This created an enormous incentive to shift profits overseas and leave them there. By some estimates, half of all the profits shifted to tax havens globally came from American multinationals—far more than any other country's corporations.

The numbers are staggering. American companies booked more profits in Ireland than in China, Japan, Germany, France, and Mexico combined. The effective tax rate they paid in Ireland was around 5.7 percent, far below Ireland's official rate of 12.5 percent.

The Tax Cuts and Jobs Act of 2017 partially addressed this by moving the United States toward a territorial system and imposing a one-time tax on accumulated offshore profits. But by then, American multinationals had accumulated over two trillion dollars in untaxed foreign earnings, much of it sitting in tax havens.

The Geography of Shifted Profits

Where does all this money go? Research by Gabriel Zucman and his colleagues has mapped the terrain. Ireland emerges as the world's largest profit-shifting hub, bigger than the entire Caribbean tax haven system excluding Bermuda. The Netherlands, Luxembourg, Singapore, and Switzerland round out the top destinations.

These aren't the palm-fringed islands of popular imagination. They're sophisticated financial centers with advanced legal systems, extensive networks of tax treaties, and professional services firms that specialize in structuring these arrangements. Tax researchers draw a distinction between two types of jurisdictions: "conduit" locations like Ireland and the Netherlands, which serve as waypoints for money moving toward its final destination, and "sink" locations like the Cayman Islands, where profits ultimately come to rest.

The conduit jurisdictions have something crucial that pure tax havens lack: legitimacy. They've signed dozens or even hundreds of bilateral tax treaties with other countries. The United Kingdom has over 122 such treaties; the Netherlands has more than 100. These treaties mean that other countries' tax authorities will recognize and accept the profit-shifting structures these conduits facilitate.

No major economy would sign a comprehensive tax treaty with an obvious tax haven. But Ireland, the Netherlands, and Singapore are OECD members in good standing. Their structures are technically compliant with international rules, even if the result is that multinationals pay almost nothing.

The Double Irish and Its Successors

For years, the most famous profit-shifting structure was known as the "Double Irish." The name came from its use of two Irish-registered companies. One was managed from Ireland and therefore subject to Irish tax law. The other was Irish on paper but managed from Bermuda, which meant it was technically a Bermuda company for tax purposes—and Bermuda has no corporate income tax.

Intellectual property would be licensed from the Bermuda-managed Irish company to the Ireland-managed Irish company, which would then sublicense it to operating subsidiaries around the world. Profits from those subsidiaries would flow up through this structure, landing eventually in a Bermuda-taxed entity.

Google, Facebook, and countless other technology companies used variations of this arrangement. By 2015, the European Union and OECD pressured Ireland to close it to new users. But companies already using the Double Irish were given five years to transition, and by then Ireland had developed replacements.

One successor is known as the "Single Malt"—a nod to Irish whiskey. It uses Ireland's tax treaties with countries like Malta to achieve similar results. Another is the "Green Jersey," formally called Capital Allowances for Intangible Assets, which Apple used in its 2015 restructuring. These tools haven't been banned by international bodies. They continue to operate.

The Contradictions at the Heart of American Policy

There's a peculiar twist to this story that rarely gets discussed. Some economists argue that American multinationals' use of tax havens actually increased revenue to the U.S. Treasury, at the expense of other countries.

The logic works like this. When American companies paid low foreign taxes, they accumulated cash overseas. Eventually, that money would come home, either through repatriation or the kind of forced payment that happened in 2017. When it did, American companies owed tax on it. But if those same companies had paid higher taxes to Germany, France, or Japan, they would have received foreign tax credits that would have offset their U.S. liability.

In other words, every dollar paid to a foreign government is a dollar that can be deducted from what's owed to the IRS. Low foreign taxes mean higher eventual American taxes. From a narrow Treasury perspective, tax havens might actually work in America's favor.

This helps explain why the United States was one of the only major developed nations not to sign the OECD's 2016 Multilateral Instrument designed to curtail profit shifting. It also explains why American lobbying groups have worked to water down international reform efforts. In January 2017, the law firm Baker McKenzie, representing 24 multinational software companies including Microsoft, lobbied Ireland's finance minister to resist OECD proposals.

The Cost to Everyone Else

The burden of corporate tax avoidance doesn't fall equally. Developing countries are hit hardest.

Wealthy nations have diverse tax bases. They collect substantial revenue from personal income taxes, payroll taxes, property taxes, and consumption taxes. Corporate income tax is important but not dominant. Developing economies rely more heavily on taxing corporations, often because their administrative capacity to collect other taxes is weaker and because multinational corporations are among the most visible and valuable enterprises operating within their borders.

When those corporations shift their profits to Ireland or Luxembourg, developing countries lose revenue they desperately need to build infrastructure, fund education, and provide healthcare. The OECD estimates that the proportional impact on developing economies is larger than on developed ones.

There's also a fairness problem that operates within wealthy countries. Domestic businesses—the local manufacturer, the regional retailer—can't use these structures. They compete against multinationals that effectively pay far lower tax rates. This isn't about abstract numbers on government balance sheets. It's about whether Main Street businesses can survive against rivals with structural advantages built into the tax code.

Captured States and the Taxonomy of Havens

Tax researchers use a pointed term for jurisdictions that build their economies around facilitating avoidance: "captured states." The implication is that the normal functions of government—protecting citizens, providing services, maintaining the rule of law—have been subordinated to the interests of the tax avoidance industry.

This captures something real about how these jurisdictions operate. The structures multinationals use require sophisticated legislation, drafted in coordination with major accounting and law firms. The 2017 Nature study that distinguished between conduit and sink jurisdictions noted that the five major conduits—Ireland, the Netherlands, the United Kingdom, Singapore, and Switzerland—all rank in the top ten globally for intellectual property protection.

This isn't coincidence. To attract the most valuable profit-shifting structures, a jurisdiction needs strong legal infrastructure. Patents and copyrights are only valuable if they can be enforced. Financial structures are only useful if they're legally robust. The best conduit jurisdictions offer sophisticated courts, predictable legal systems, and professional services firms that can structure deals worth billions.

They also offer discretion. Financial secrecy laws, resistance to country-by-country reporting, and the absence of public filing requirements all help obscure what's actually happening. Ireland and the Netherlands don't call themselves tax havens. They prefer "knowledge economies."

The Long Road Toward Reform

The G20 began seriously addressing profit shifting in 2012, tasking the OECD with developing an action plan. Three years later, the OECD released 15 recommendations covering everything from transfer pricing to disclosure requirements. In 2016, countries began signing a Multilateral Instrument to implement these changes through existing tax treaties.

Over 78 jurisdictions have signed on. The instrument entered into force in 2018.

Progress has been real but uneven. Many tax havens opted out of specific provisions, particularly Action 12, which required disclosure of aggressive tax planning. The most sophisticated conduit jurisdictions have generally found ways to comply technically while maintaining their attractiveness to multinationals. New structures emerge to replace old ones as they're closed off.

The fundamental problem is that profit shifting exploits gaps and mismatches between different countries' tax rules. Each country is sovereign, free to set its own rates and define its own tax base. When 193 countries each make independent decisions, the result is a patchwork with countless seams. Sophisticated advisors find those seams and stitch together structures that no single country's rules anticipated.

Closing one gap often just redirects flows to another. The Double Irish gave way to the Single Malt and the Green Jersey. Tomorrow's structures haven't been named yet, but they're being drafted in law offices right now.

The Deeper Questions

Underneath the technical details lie profound questions about how economies should work and who should pay for government services.

Corporations use public infrastructure—roads, courts, educated workers, stable currencies. They benefit from the rule of law and the security that governments provide. Should they be able to structure their affairs so that the profits generated from those benefits are taxed nowhere meaningful?

Defenders of aggressive tax planning note that corporations have a fiduciary duty to shareholders to minimize costs, including taxes. What's legal is permissible. If societies don't like the results, they should change the laws.

Critics respond that the line between legal tax avoidance and illegal tax evasion has become so blurred as to be meaningless. When companies pay effective tax rates of 2 or 3 percent despite official rates of 20 or 30 percent, something has gone wrong with the concept of corporate taxation itself.

There are also questions about what happens to public trust when ordinary citizens see headlines about massive corporate tax avoidance. Why should an individual pay their income taxes honestly if multinational corporations—often their employers—are paying almost nothing? The OECD explicitly worries about this, noting that visible avoidance by multinationals "lessens deliberate compliance" by everyone else.

Where Things Stand

Profit shifting remains a defining feature of the global economy. The absolute amounts involved are difficult to measure precisely—that's partly the point—but the best estimates suggest something like $200 billion in annual lost tax revenue worldwide. The structures have grown more sophisticated even as reform efforts have intensified.

American technology and pharmaceutical companies remain the heaviest users, though their competitive advantage in this arena has narrowed somewhat as other countries' multinationals have caught up. Ireland remains the single largest hub, handling more shifted profits than the entire Caribbean. The gap between headline tax rates and effective rates paid continues to be wide in every major conduit jurisdiction.

For developing countries, the stakes are highest. They need revenue to build the infrastructure and institutions that might eventually allow them to compete with wealthy nations. Profit shifting drains that revenue to jurisdictions that need it least.

The story of base erosion and profit shifting is, ultimately, a story about the gap between the way we imagine capitalism working and the way it actually works. In textbooks, corporations compete on efficiency and innovation. In practice, tax engineering has become a source of competitive advantage as significant as any new product or process. The companies that do it best aren't just making things—they're making profits disappear.