Valparaiso University Law Review
Volume 47
Number 1 pp.313-355
Fall 2012
Closing International Loopholes: Changing the
Corporate Tax Base to Effectively Combat Tax
Avoidance
John T. VanDenburgh
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Recommended Citation
John T. VanDenburgh, Closing International Loopholes: Changing the Corporate Tax Base to Effectively Combat Tax Avoidance, 47 Val. U.
L. Rev. 313 (2012).
Available at: http://scholar.valpo.edu/vulr/vol47/iss1/8
313
CLOSING INTERNATIONAL LOOPHOLES:
CHANGING THE CORPORATE TAX BASE TO
EFFECTIVELY COMBAT TAX AVOIDANCE
I. INTRODUCTION
NoTax is a publicly traded technology corporation that deals
primarily with internet-based services and products. NoTax is
headquartered in California, incorporated in Delaware, and does the
majority of its business within the United States. In 2010, NoTax
reported three hundred and fifty million dollars in worldwide revenue
to its shareholders and reported a net income of one hundred million
dollars to the IRS. NoTax paid the standard 35% federal tax rate, or
thirty-five million dollars, to the IRS. Subsequently, NoTax’s president
and board of directors decided to hire a group of tax consultants and
attorneys to see if there was a way to reduce their corporate tax. In 2011,
NoTax reported approximately the same level of revenue and business
to its shareholders but reported a much lower net income and only paid
around two million dollars to the IRS. NoTax did not physically move
its headquarters, change its products, or cut any employees. How was it
able to cut its corporate taxes by nearly thirty-three million dollars?
NoTax employed a complex scheme of tax planning strategies to
manipulate its financial records, take advantage of international tax
loopholes, and avoid paying U.S. taxes. Even more remarkable, NoTax
was able to do this primarily with paper transactions that are completely
legal.1
Many U.S. corporations have started using similar tax avoidance
strategies to reduce their corporate tax.2 These strategies have become a
problem in the last few decades because of the globalization of the world
economy, improvements in technology, and increased tax competition.3
1 NoTax is a fictional company. The author of this Note created this hypothetical to
explain the concept of international tax avoidance.
2 “Tax avoidance” refers to the legal strategies corporations employ to get around
paying taxes, as opposed to “tax evasion,” which refers to the avoidance of tax obligations
through illegal means. See JANE G. GRAVELLE, MAJOR TAX ISSUES IN THE 111TH CONGRESS,
CONG. RESEARCH SERV. 13 (May 6, 2009), http://royce.house.gov/uploadedfiles/
major_tax_issues_in_the_111th_congress.pdf (explaining the major differences between tax
evasion and tax avoidance techniques); see also Michelle Hirsch, Tax Havens: Offshore
Operations Cost U.S. Billions, FISCAL TIMES, Sept. 7, 2010, http://hsgac.senate.gov/public/_
files/071708PSIReport.pd (noting that eighty-three out of the largest one hundred publicly
traded U.S. companies have subsidiaries in countries with lower corporate tax rates than
the United States).
3 See Reuven S. Avi-Yonah, Globalization, Tax Competition, and the Fiscal Crisis of the
Welfare State, 113 HARV. L. REV. 1573, 1575–76 (2000) (discussing the increased mobility of
capital from technology advances, which has led to international tax competition because
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314 VALPARAISO UNIVERSITY LAW REVIEW [Vol. 47
Most of these methods involve setting up a shell corporation—a
corporation with no operations or assets—as a subsidiary in a lower tax
jurisdiction and then manipulating the parent corporation’s financial
records to show that the income was earned by the shell subsidiary
outside of the United States.4 What these corporations are doing is
technically legal, but only because of the difficulty of applying U.S. tax
law to other sovereign countries.5 There have been many attempts to try
to fix this current tax avoidance problem while keeping the same tax
base, but these have all proved to be ineffective, which is evident from
the alarming number of corporations that are employing tax avoidance
schemes.6 Tax avoidance strategies are causing the United States to lose
companies can easily shift capital to low-tax jurisdictions). Tax competition in this context
refers to countries lowering their tax rates to make it more desirable for corporations to do
business in their country. Id. See also Jason Bordoff & Jason Furman, General Essay,
Progressive Tax Reform in the Era of Globalization: Building Consensus for More Broadly Shared
Prosperity, 2 HARV. L. & POL’Y REV. 327, 328 (2008) (explaining that tax reform might be
necessary with recent changes in the economy); Timothy V. Addison, Shooting Blanks: The
War on Tax Havens, 16 IND. J. GLOBAL LEGAL STUD. 703, 711 (2009) (discussing several
reasons for why tax havens exist); Diane Ring, Who is Making International Tax Policy?:
International Organizations as Power Players in a High Stakes World, 33 FORDHAM INT’L L.J.
649, 702 (2010) (explaining why some countries lower their tax rates).
4 See Press Release, The White House, Executive Office of the President, Leveling the
Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs
Overseas, May 4, 2009, available at http://www.whitehouse.gov/the_press_office/
LEVELING-THE-PLAYING-FIELD-CURBING-TAX-HAVENS-AND-REMOVING-TAXINCENTIVES-
FOR-SHIFTING-JOBS-OVERSEAS/ [hereinafter Press Release] (providing
examples of several problems that exist under current U.S. law and describing proposals to
fix each problem).
5 See Ilan Benshalom, The Quest to Tax Financial Income in a Global Economy: Emerging to
an Allocation Phase, 28 VA. TAX REV. 165, 166 (2008) (noting how the corporate structure has
changed because of changes in the global economy); Diane M. Ring, What’s at Stake in the
Sovereignty Debate?: International Tax and the Nation-State, 49 VA. J. INT’L L. 155, 156–57
(2008) (explaining the link between sovereignty and international tax laws). Countries are
not able to enforce their tax laws in other sovereign states because those sovereign states
represent the supreme source of the law on internal matters, such as corporate taxation. Id.
at 160. See also David R. Tillinghast, Issues of International Tax Enforcement, in THE CRISIS IN
TAX ADMINISTRATION 38, 38–42 (Henry J. Aaron & Joel Slemrod eds., 2004) (discussing a
number of challenges facing the IRS in enforcing U.S. tax laws in foreign jurisdictions, as
well as the complexity of the Tax Code and the difficulty in obtaining financial
information). See generally Nancy Birdsall, Asymmetric Globalization: Global Markets Require
Good Global Politics, (Ctr. for Global Dev., Working Paper No. 12, 2002), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1106282 (explaining how the global
economy has made it more difficult to enforce tax laws).
6 See Ilan Benshalom, Sourcing the “Unsourceable”: The Cost Sharing Regulations and the
Sourcing of Affiliated Intangible-Related Transactions, 26 VA. TAX REV. 631, 642–44 (2007)
(explaining the Arm’s Length Standard as one attempt to prevent corporate tax avoidance
through the use of subsidiaries); see also Tracy A. Kaye, The Regulation of Corporate Tax
Shelters in the United States, 58 AM. J. COMP. L. 585, 588–92 (2010) (describing the judiciary’s
development of different common law doctrines to combat tax avoidance, such as
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billions of annual tax dollars that could be used to pay off the current
budget deficit.7 Allowing corporations to escape paying U.S. taxes when
they actively derive benefits from the U.S. market is unacceptable.8 The
attempts and proposals to fix this problem through legislation have
focused on creating laws to force corporations to stop manipulating their
net income; however, the more effective method to combat this issue
might be changing the tax base altogether.9 This Note proposes that the
United States needs to change the current tax base so that corporations
no longer have the incentive to manipulate their financial information.10
First, Part II of this Note briefly provides a historical context of the
U.S. corporate tax, presenting relevant background information, theories
for and against taxation, and popular techniques used by corporations to
avoid tax.11 Next, Part III offers an analysis of the current tax base and
“substance over form,” “step-transaction,” “business purpose,” and “economic
substance”); Abrahm W. Smith, Tax Dodgers Beware: New Foreign Account Tax Compliance
Legislation, 84 FLA. B.J., July–Aug. 2010, at 52–53 (explaining legislative attempts by the
Obama Administration to correct the tax avoidance problem); Anthony D. Todero, Note,
The Stop Haven Abuse Act: A Unilateral Solution to a Multilateral Problem, 19 MINN. J. INTL. L.
241, 258–60 (2010) (examining the Stop Tax Haven Abuse Act (STHAA), which was another
attempt to prevent corporations from establishing tax havens).
7 See Frederick J. Tansill, Asset Protection Trusts (APTS): Non-Tax Issues, ST012 A.L.I.-
A.B.A., in INT’L TRUST & EST. PLAN. 293, 309 (2011) (noting how President Obama’s
administration had clear plans to crack down on tax avoidance to pay for the U.S. deficit);
see also Lilian V. Faulhaber, Sovereignty, Integration and Tax Avoidance in the European Union:
Striking the Proper Balance, 48 COLUM. J. TRANSNAT’L L. 177, 179 (2010) (explaining that tax
avoidance is a problem, not only in the United States, but also in the European Union);
Hirsch, supra note 2 (explaining that U.S. multinational corporations are collectively
avoiding anywhere between $10 billion and $60 billion a year in taxes by shifting their
earnings on paper to overseas subsidiaries); Anup Shah, Tax Havens; Undermining
Democracy, GLOBAL ISSUES, http://www.globalissues.org/article/54/tax-havensundermining-
democracy (last updated July 12, 2009) (explaining some effects that tax
havens are having on the U.S. economy).
8 See infra Part II (discussing the benefits theory of taxation). The U.S. companies that
are using these tax avoidance strategies are taking advantage of the benefits that the U.S.
market provides. Id. See also Jennifer Barton, Comment, Running from the United States
Treasury: The Need to Reform the Taxation of Multinational Corporations, 43 J. MARSHALL L.
REV. 1041, 1051 (2010) (noting the need for reform in the corporate tax structure because of
tax avoidance issues).
9 See I.R.C. § 11 (2006) (containing the current tax base for corporations—net income);
Rachelle Y. Holmes, Deconstructing the Rules of Corporate Tax, 25 AKRON TAX J. 1, 2 (2010)
(noting that most proposed solutions to the tax problem are structural, including statutory
changes to stop companies from using loopholes); see also infra Part IV (proposing a change
in the tax base, thus altering the way that companies are taxed altogether, rather than
adding new laws to the already complicated Tax Code).
10 See infra Part IV (explaining how changing the tax base to corporate revenue will
decrease the incentive to shift income abroad and avoid paying U.S. taxes).
11 See infra Part II (providing relevant background information on U.S. corporate
taxation, as well as describing popular tax avoidance methods and previous legislation).
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its weaknesses.12 Further, Part III illustrates the potential effects of
failing to change the tax base in the near future.13 Finally, Part IV
proposes a change of the tax base that will take away corporations’
incentives to manipulate their financial records and that will fairly tax
corporations based on the benefits they derive from the U.S. market,
which will lead to a much more efficient and profitable U.S. economy.14
II. BACKGROUND
Despite recent legislative changes aimed at stopping U.S. corporate
tax avoidance and President Obama’s full commitment to reforming the
corporate tax system, many corporations continue to use aggressive tax
planning to circumvent much of their corporate tax obligations.15 There
is difficulty in making effective legislative changes, because there are
many problems with the U.S. corporate tax base—or general pool of
wealth to which tax liability is imposed.16 Currently, the U.S. corporate
tax base consists of net income, which is calculated by taking revenues
and adjusting for (subtracting) expenses, interest, depreciation, taxes,
and amortization. Corporations are presently able to manipulate their
12 See infra Part III (analyzing why the current tax base has led to corporate tax
avoidance).
13 See infra Part III (presenting the possible effects on the U.S. economy of continuing to
allow corporations to legally avoid paying taxes).
14 See infra Part IV (proposing a change to the current tax base that will eliminate the
corporate incentive to transfer income abroad in order to avoid paying U.S. taxes); see also
The World’s Largest Economies, ECONOMYWATCH.COM (June 30, 2010),
http://www.economywatch.com/economies-in-top/ (noting the profitability of top
economies in the world).
15 See Holmes, supra note 9, at 2 n.3 (explaining some recent prevalent recommendations
for changing the U.S. tax system); Kaye, supra note 6, at 594 (explaining the emergence of
the American Jobs Creation Act of 2004, which enacted new penalties, strengthened
disclosure requirements, and changed substantive law against tax shelters); David J. Lynch,
Does Tax Code Send U.S. Jobs Offshore?, USA TODAY, Mar. 21, 2008,
http://www.usatoday.com/money/perfi/taxes/2008-03-20-corporate-taxoffshoring_
N.htm (“‘Big businesses will always look for ways to skirt the tax code. An
Obama administration will close loopholes and will tighten (IRS) enforcement so
companies cannot go around tax regulations,’ says Bill Burton, a spokesman for the Obama
campaign.”).
16 See BLACK’S LAW DICTIONARY 1599 (9th ed. 2009) (defining the tax base as the “total
property, income, or wealth subject to taxation in a given jurisdiction; the aggregate value
of the property being taxed by a particular tax”); Melissa J. Morrow, Comment, Twenty-Five
Years of Debate: Is Acquisition-Value Property Taxation Constitutional? Is It Fair? Is It Good
Policy?, 53 EMORY L.J. 587, 591 (2004) (“The tax base is the ‘assessed value’ of the taxable
property.”).
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net income, because it is separately reported to the IRS, and there is no
incentive for them to keep this figure high.17
Before analyzing the benefits associated with changing the corporate
tax base, Part II.A of this Note provides the key history of the corporate
tax, highlighting the major theories supporting why corporations should
be taxed.18 Next, Part II.B lays out the basic framework of how
corporations are taxed in the United States.19 Part II.C then examines the
major tax avoidance techniques that corporations use, providing a more
in-depth context of these techniques by looking at what Google does to
reduce its taxes.20 Then, Part II.D briefly mentions four of the most
popular proposals to fix tax avoidance in the United States.21
A. The History of the Corporate Tax
The corporate tax was first enacted in 1909 on corporate income to
provide support for a general individual income tax on citizens.22 The
goals of this tax were: (1) to provide the government with knowledge
about profits in order to prevent the abuse of power; (2) to raise
additional revenue; (3) to supervise corporations; and (4) to discourage
excessive borrowing.23 Many corporations challenged the tax in court,
17 See infra Part III (analyzing the problems with the current tax base); see also MICHAEL
MAZEROV, STATE CORPORATE TAX SHELTERS AND THE NEED FOR “COMBINED REPORTING” 1
(CTR. ON BUDGET & POL’Y PRIORITIES 2007), available at http://www.cbpp.org/files/10-26-
07sfp.pdf (advocating for combined reporting); Michael J. McIntyre, Paull Mines & Richard
D. Pomp, Designing a Combined Reporting Regime for a State Corporate Income Tax: A Case
Study of Louisiana, 61 LA. L. REV. 699, 702–05 (2001) (examining the benefits of a combined
reporting regime for corporations at the state level).
18 See infra Part II.A (providing the key history of the corporate tax and highlighting the
major theories supporting why corporations should be taxed).
19 See infra Part II.B (laying out the basic framework of how corporations are taxed in the
United States).
20 See infra Part II.C (providing a more in-depth context of the major tax avoidance
techniques by specifically looking at what Google does to reduce its taxes).
21 See infra Part II.D (defining four of the most popular proposals to fix the U.S. tax
avoidance problem).
22 See Corporate Tax Act of 1909, Pub. L. No. 61-4, § 38, 36 Stat. 11, 112 (establishing the
corporate tax by creating an excise tax for corporations measured by corporate income); see
also Steven A. Bank, Entity Theory as Myth in the Origins of the Corporate Income Tax, 43 WM.
& MARY L. REV. 447, 464 (2001) (noting that there were several motivations for the first
corporate income tax); Jane G. Gravelle, The Corporate Income Tax: A Persistent Policy
Challenge, 11 FLA. TAX REV. 75, 78 (2011) (explaining that there was support for the income
tax because it taxed the wealthy, reduced the concentration of power, and provided for a
flexible revenue source).
23 See W. ELLIOT BROWNLEE, FEDERAL TAXATION IN AMERICA: A SHORT HISTORY 50–52
(1996) (highlighting how corporations originally fit into the U.S. tax policy); SIDNEY
RATNER, TAXATION AND DEMOCRACY IN AMERICA 280–83 (1980) (providing a detailed
account of the congressional deliberations that lead up to the Corporate Tax Act of 1909).
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because they thought the government was overstepping its boundaries,
discouraging the corporate form, and killing the profit motive.24 The
Supreme Court upheld the tax, reasoning that it was an appropriate tax
on the privilege of doing business in the corporate capacity.25
Then, in 1918, the taxation of international income began with the
Revenue Act of 1918, which allowed a credit against U.S. income for
taxes paid by a U.S. corporation to any foreign government on income
earned outside the United States.26 In 1928, the League of Nations
created the first model bilateral treaty agreement, giving a corporation
relief from being taxed twice on income earned abroad.27 Subsequently,
in 1934, the Supreme Court decided, in Helvering v. Gregory, that a
corporation could not simply “reorganize” for tax purposes and that
24 See Gravelle, supra note 22, at 78–79 (noting some general reasons why many people
opposed the 1909 corporate income tax); Marjorie E. Kornhauser, Corporate Regulation and
the Origins of the Corporate Income Tax, 66 IND. L.J. 53, 125 (1990) (illustrating some of the
objections to the corporate income tax in 1909).
25 See Flint v. Stone Tracy Co., 220 U.S. 107, 176 (1911) (upholding the corporate excise
tax in its entirety); see also Kornhauser, supra note 24, at 118 (explaining that the Corporate
Tax Act of 1909 was challenged immediately after it was enacted, but a decision by the
Supreme Court was not rendered until 1911).
26 See Revenue Act of 1918, ch. 18 §§ 222(a)(1), 238(a), 240(c), 40 Stat. 1057, 1073, 1080–82
(1919) (providing a foreign tax credit for individuals and a similar credit for domestic
corporations and describing creditable taxes). The Revenue Act of 1921 limited this foreign
tax credit so that it could not exceed the amount of the U.S. tax liability on the taxpayer’s
foreign source income. Revenue Act of 1921, ch. 136 §§ 222(a)(5), 238(a), 42 Stat. 227, 249,
258 (1923). This limitation was intended to ensure that U.S. companies and individuals
could not use foreign taxes to reduce or eliminate U.S. taxes on U.S. source income. Id.
27 See Michael J. Graetz & Michael M. O’Hear, The “Original Intent” of U.S. International
Taxation, 46 DUKE L.J. 1021, 1023 (1997) (explaining the importance of the League of
Nations’ 1928 model bilateral income tax treaties); C. John Taylor, Twilight of the
Neanderthals, or Are Bilateral Double Taxation Treaty Networks Sustainable?, 34 MELB. U. L.
REV. 268, 270–71 (2010) (providing a brief history of bilateral tax treaties as a model to
relieve corporations from double taxation). Double taxation refers to instances where
income is taxed by one jurisdiction and then taxed again by another jurisdiction. Id. For
example, if country A taxes a corporation at a rate of 35% on income because the income
was earned in its county, and then country B taxes the same income by that corporation at a
rate of 30% because that corporation is a resident of country B, then the corporation is
forced to pay an astronomically high total effective tax rate of 65% on that net income. See
infra part II.B (explaining in more depth source income and residence income). One way
that countries eliminate double taxation is by cooperating with each other through bilateral
tax treaties. See also Sunita Jogarajan, Prelude to the International Tax Treaty Network:
1815–1914 Early Tax Treaties and the Conditions for Action, 31 OXFORD J. LEGAL STUD. 679, 680
(2011) (noting that there are over three thousand bilateral tax treaties in the world
currently). The common bilateral tax treaties account for double taxation by making it so
that one country agrees unilaterally not to impose tax on income earned in another
country, reducing the amount of tax payable in their country for any tax paid in another
country on the same income, or by allocating taxation rights from different types of
incomes between the different countries. Id. at 683.
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there must be a business purpose for the corporate reorganization
outside of saving on corporate taxes.28 This decision was particularly
important because it was the first decision addressing corporate
techniques to avoid paying taxes.29 The international income tax regime
has remained reasonably intact, despite the growth of the economy,
increases in technology, and the globalization of business.30
Throughout history, the U.S corporate income tax has been based on
the benefit theory of taxation, which indicates that corporations should
be taxed because they take advantage of the benefits that the state
provides.31 The United States taxes corporations under this theory in
28 Gregory v. Helvering, 293 U.S. 465, 469 (1935) (holding that the transfer of the original
corporation’s assets to the shareholder did not qualify as reorganization because it was a
“mere device which put on the form of a corporate reorganization as a disguise for
concealing its real character”). The Court further held that there had to be a business
purpose for the reorganization and not just the benefit of saving on taxes. Id.
29 Id. Though it was not a decision regarding corporations using international law to
avoid taxes, the decision represented the Court’s stance that business decisions should not
be made for the sole reason of avoiding taxes. Id. These types of decisions affect the
business market and make it less efficient. See Donald C. Lubick, Remarks to the Tax
Executives Institute, reprinted in FOUNDATIONS OF INTERNATIONAL INCOME TAXATION 19–21
(Michael J. Graetz ed., 2003) (explaining different policy goals in the area of international
taxation). The goals of having an efficient market, market neutrality, and a competitive
market sometimes conflict, and the goal is to find to what extent taxation can be reduced to
stay competitive internationally while not distorting business decisions based on this
reduced taxation. Id. The author then explains the two major types of efficiency norms
that exist in the market: (1) capital import neutrality (CIN) and (2) capital export neutrality
(CEN). Id. at 21. See also William B. Barker, International Tax Reform Should Begin at Home:
Replace the Corporate Income Tax with a Territorial Expenditure Tax, 30 NW. J. INT’L L. & BUS.
647, 654 (2010) (explaining that an efficient tax is a neutral tax, which does not change the
relative price of goods or services).
30 See Avi-Yonah, supra note 3, at 1575–76 (explaining how technological advances have
led to a much more global economy); see also MICHAEL J. GRAETZ, FOUNDATIONS OF
INTERNATIONAL INCOME TAXATION 4 (2003) (noting that the basic framework of the
international structure remains the same as it did in the early 1920s). The author explains
that the basic international tax structure has not changed, because it has never proved to be
a barrier to the international flow of goods, services, or capital. Id. See generally Holmes,
supra note 9, at 3 (noting that the only two major changes in international tax law came in
the form of the Revenue Act of 1962 and the Tax Reform Act of 1986).
31 See Reuven S. Avi-Yonah, International Taxation of Electronic Commerce, 52. TAX L. REV.
507, 521 (1997) (explaining the Benefits Principle, which gives the right to tax active
business income primarily to the source jurisdiction, while the right to tax passive
investment income is assigned primarily to the residence jurisdiction); Jeffrey M. Colón,
Changing U.S. Tax Jurisdiction: Expatriates, Immigrants, and the Need for a Coherent Tax Policy,
34 SAN DIEGO L. REV. 1, 11 (1997) (“The theoretical basis for source and trade or business
taxation is that the United States has provided the benefits that generated the income.”);
Steven A. Dean, More Cooperation, Less Uniformity: Tax Deharmonization and the Future of the
International Tax Regime, 84 TUL. L. REV. 125, 144 n.79 (2009) (explaining that source income,
or income earned in one country, is based on the notion that the government has the right
to collect tax revenues by providing the services that make the creation of that underlying
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two different ways: (1) on the benefits resulting from being incorporated
in the United States, or residence based tax; and (2) on the benefits that
corporations receive from using the U.S. market to derive their income,
or source based tax.32 Examples of some of the benefits that U.S.
corporations receive include the: transportation facilities, infrastructure,
education system, labor force, financial institutions, customer base, and
stock markets.33 The basic framework of the U.S. tax system follows this
theory and taxes corporations based on their residence and whether their
income is derived within the United States.34
income possible); Edward A. Zelinsky, Citizenship and Worldwide Taxation: Citizenship as an
Administrable Proxy for Domicile, 96 IOWA L. REV. 1289, 1293–94 (2011) (maintaining that
source based taxation reflects the notion that a certain tax jurisdiction provides benefits that
protect income and assets maintained in that jurisdiction); see also Peggy B. Musgrave,
Interjurisdictional Equity in Company Taxation: Principles and Applications to the European
Union (2000), reprinted in FOUNDATIONS OF INTERNATIONAL INCOME TAXATION 6 (Michael J.
Graetz ed., 2003) (explaining that a jurisdiction should be able to charge a tax to pay for the
services that it renders).
32 See Deborah A. Geier, Letter to the Editor, Time to Bring Back the “Benefit” Norm?, 102
TAX NOTES 1155, 1157 (2004) (advocating the benefits theory of taxation because of the
exploitation of the U.S. economic system); Majorie E. Kornhauser, Choosing a Tax Rate
Structure in the Face of Disagreement, 52 UCLA L. REV. 1697, 1708 (2005) (“[B]enefit taxation
underlies international tax principles that allow both the country of residence and the
source country to tax income.”); Herwig J. Schlunk, Double Taxation: The Unappreciated
Ideal, 102 TAX NOTES 893, 895 (2004) (explaining the two types of taxation and analyzing
them under the benefits theory); see also infra Part II.B (explaining the framework of U.S. tax
policy, specifically residence and source based taxation).
33 See Ruth Mason, Tax Expenditures and Global Labor Mobility, 84 N.Y.U. L. REV. 1540,
1553–54 (2009) (explaining some of the benefits conferred on corporations associated with
source based taxation, including human resources, natural resources, infrastructure, and
markets); see also Musgrave, supra note 31, at 6 (explaining the more complicated benefits
that come from source and residence based income). A company may also benefit by
having a lower intermediate goods cost, which in turn lowers the total cost of production.
Id. Benefits also arise when the government contributes capital to the capital of the
corporation in order to generate a profit. Id. But see Nancy H. Kaufman, Fairness and the
Taxation of International Income, 29 LAW & POL’Y INT’L BUS. 145, 184–85 (1998) (comparing
principles of source based taxation to those of benefit theory taxation).
34 See GRAETZ, supra note 30, at 5 (2003) (distinguishing between residence and source
taxation). There is much difficulty in defining residence and source, which creates
problems in international taxation. Id. See also Stephen E. Shay, J. Clifton Fleming, Jr. &
Robert J. Peroni, “What’s Source Got to do With It?” Source Rules and U.S. International
Taxation, 56 TAX L. REV. 81, 90–92 (2002) (explaining that source based taxation represents
the price paid for access to state markets, while residence based taxation represents the
benefits associated with being a citizen of that state).
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B. Basic Corporate Taxation Framework
There are two major types of taxation systems for international
corporations: (1) the territorial system and (2) the worldwide system.35
The territorial system, also known as the source system, taxes income
that is derived within a particular country.36 This means that a
corporation is taxed by a country if the corporation earns its income
within the country’s borders, irrespective of the corporation’s
residency.37
In a worldwide system, a corporation is taxed on its worldwide
income based on its “residence,” regardless of where the income is
actually earned.38 Accordingly, a corporation is taxed only if it is a
“resident” of a particular country.39 Some countries deem a corporation
a resident based on where its headquarters are located; however, most
35 See RESTATEMENT (THIRD) OF FOREIGN RELATIONS LAW OF THE UNITED STATES § 411
(1987) [hereinafter RESTATEMENT (THIRD)] (explaining the main ways that people and
corporations are subject to tax in the United States); id. § 412(1)(a) (stating that no matter
the source of the income, the United States has authority to tax based on residence);
GRAETZ, supra note 30, at 12–13 (outlining the basics of a pure territorial tax system and a
pure worldwide tax system).
36 See HUGH J. AULT & BRIAN J. ARNOLD, COMPARATIVE INCOME TAXATION: A
STRUCTURAL ANALYSIS 347–49 (2d ed. 2004) (discussing the positives and negatives of both
the source and residence tax systems); GRAETZ, supra note 30, at 12–17 (discussing different
rationales for worldwide and territorial tax systems); Barker, supra note 29, at 664–65
(highlighting some factors that connect a nation’s tax base to the taxing jurisdiction).
37 See GRAETZ, supra note 30, at 12–13 (explaining the importance of the source income
concept in international taxation). The principal right to tax usually lies with the source
country, and the burden of preventing the corporation from being taxed twice on the
income—from the source country and the residence country—is on the resident country.
Id. at 13. See also J. Clifton Fleming, Jr., Robert J. Peroni & Stephen E. Shay, Fairness in
International Taxation: The Ability-to-Pay Case for Taxing Worldwide Income, 5 FLA. TAX REV.
299, 303 (2001) (illustrating that source based taxation does not take into account the
residence of the corporation); Timothy Hisao Shapiro, Tax First, Ask Questions Later:
Problems Predicting the Effect of President Obama’s International Tax Reforms, 16 STAN. J.L. BUS.
& FIN. 141, 149–50 (2010) (explaining the basics of both worldwide and territorial taxation).
38 See Daniel Shaviro, The Case Against Foreign Tax Credits, 3 J. LEGAL ANALYSIS 65, 66
(2011) (maintaining that in a worldwide system, the United States taxes the income of
residents no matter where it arose); see also Reuven S. Avi-Yonah, The Structure of
International Taxation: A Proposal for Simplification, 74 TEX. L. REV. 1301, 1311–14 (1996)
(providing several reasons for preferring residency-based taxation over source based
taxation).
39 See I.R.C. § 7701(a)(30)(C) (2006) (defining the term “United States Person” as “a
domestic corporation”); Daniel Shaviro, The Rising Tax-Electivity of U.S. Corporate Residence,
64 TAX L. REV. 377, 383 (2011) (“A corporation is a U.S. resident if and only if it is ‘created
or organized in the United States or under the law of the United States or of any State.’”).
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countries, including the United States, use place of incorporation as the
test for corporate residence.40
Like most other industrialized countries, the United States employs a
system of taxation that combines both the territorial and the worldwide
tax systems.41 The United States taxes corporations if they are
incorporated in the United States and also taxes foreign corporations if
the income is earned within the United States.42 Thus, the only way that
a corporation will not incur any U.S. tax is if the company is a foreign
40 See Shaviro, supra note 39, at 413 (“A number of countries base corporate residence on
some version of an inquiry into the location of a given company’s headquarters, or its place
of central management and control.”).
41 See GRAETZ, supra note 30, at 13 (explaining that the United States tax system is
referred to by most as a worldwide system, because the United States taxes foreign source
income even though it is not quite a pure system). The author explains:
Sometimes analysts distinguish systems that tax foreign-source income
from those that do not. They often call the former “worldwide
systems” and the latter “territorial systems.” No country, however
employs a pure “worldwide system” or a pure “territorial system.”
International tax regimes throughout the world are hybrid or “mixed”
systems.
Id.
42 See I.R.C. §§ 881(a), 882(a) (2010) (imposing tax on foreign corporations that generate
or derive their income within the United States); id. § 63 (2010) (imposing tax on U.S.
corporations); see also Reuven S. Avi-Yonah, Kimberly A. Clausing & Michael C. Durst,
Allocating Business Profits for Tax Purposes: A Proposal to Adopt a Formulary Profit Split, 9 FLA.
TAX REV. 497, 499–500 (2009) (examining some specifics in the U.S. tax system). An
example is provided:
The U.S. government taxes U.S. multinational firms on a
residence basis, and thus U.S. resident firms incur taxation on income
earned abroad as well as income earned in the United States. U.S.
taxation is imposed only when income is repatriated by a foreign
subsidiary to the U.S. parent via a dividend. Thus, a subsidiary’s
income can grow free of U.S. tax prior to repatriation, a process known
as deferral. Deferral provides strong incentives to earn income in lowtax
countries.
As an example, consider a U.S. based multinational firm that
operates a subsidiary in Ireland. Assume that the U.S. corporate
income tax rate is 35% while the Irish corporate income tax rate is
12.5%. The Irish subsidiary earns 800 and decides to repatriate 70 of
the profits to the United States. (Assume, for ease of computation
only, a 1:1 exchange rate.) First, the Irish affiliate pays 100 to the Irish
government on profits of 800. It then repatriates $70 to the United
States, using the remaining profit (630) to reinvest in its Irish
operations. The firm must pay U.S. tax on the repatriated income, but
it is generally eligible for a tax credit of $100 (taxes paid) times 70/700
(the ratio of dividends to after-tax profits), or $10. Owing to deferral,
the remaining profits (630) can grow abroad tax-free prior to
repatriation.
Id. (footnotes omitted).
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corporation and has not earned any income in the United States.43 If the
parent corporation is based in the United States and has foreign
subsidiaries, then the income earned by these subsidiaries is not taxed
until it is repatriated to the U.S. parent via dividends or some other
financial alternative.44 Therefore, the current tax base for U.S.
corporations is net income, and the tax base for foreign corporations is
income earned within the United States—both of which are separately
reported to the IRS, which means that the only reason to report is to
determine tax liability.45 These current tax bases represent the general
pools of wealth that are subject to taxation—those numbers are then
subject to thousands of pages of complex tax code and Treasury
Regulations, which attempt to resolve a seemingly never-ending amount
of issues, including: regulating certain actors, monitoring specific
transactions, and reconciling U.S. law with other international taxing
jurisdictions by issuing credits.46
43 See GRAETZ, supra note 30, at 40 (explaining how the United States generally does not
have taxing authority over foreign based residents with foreign source income).
44 See I.R.C. § 881 (2010) (providing for taxation of foreign corporations that repatriate
their income to a U.S. parent corporation); Avi-Yonah et al., supra note 42, at 499
(examining some specifics in the U.S. tax system). The process of companies keeping funds
in their overseas subsidiaries and not repatriating until they need capital is known as
deferral. Id. The reasoning behind this is that the money earned by the subsidiary is
attributed to a foreign corporation until it is repatriated to the U.S. parent. Id. See also
William B. Barker, An International Tax System for Emerging Economies, Tax Sparing, and
Development: It is All About Source!, 29 U. PA. J. INT’L L. 349, 353–54 (2007) (“Under a
residence-based system like the one used in the United States, as long as home country
[corporations] use the form of foreign corporations to carry out their activities, income is
deferred until repatriated and, upon repatriation of the profits, the enterprise is still
entitled to a credit for foreign taxes previously paid.”); Shapiro, supra note 37, at 150
(noting that U.S. corporations are able to defer recognition of their foreign-source income,
lowering their effective tax rate); supra note 42 (giving an example of repatriation and the
foreign tax credit).
45 See Noël B. Cunningham, The Taxation of Capital Income and the Choice of Tax Base, 52
TAX L. REV. 17, 17–18 (1996) (explaining the difference between having an income or
consumption tax base); Edward D. Kleinbard, Stateless Income, 11 FLA. TAX REV. 699, 717
(2011) (describing the current U.S. corporate tax base of net income as worldwide, except
for income earned by U.S. subsidiaries and not repatriated); Edward J. McCaffery & James
R. Hines Jr., The Last Best Hope for Progressivity in Tax, 83 S. CAL. L. REV. 1031, 1041 (2010)
(explaining that having a certain tax base affects the particular tax rate a jurisdiction sets);
Robert J. Peroni, Back to the Future: A Path to Progressive Reform of the U.S. International
Income Tax Rules, 51 U. MIAMI L. REV. 975, 976 (1997) (supporting the U.S. tax base of net
income for the foreseeable future); Holmes, supra note 9, at 4 (explaining that the shifting of
income out of the United States has eroded the corporate tax base because it has removed a
large part of potential tax revenue to other countries with lower tax rates); see also Barker,
supra note 29, at 651–52 (explaining the three different aspects of the tax base and how they
are all inter-related).
46 See Reuven S. Avi-Yonah & Kimberly A. Clausing, Reforming Corporate Taxation in a
Global Economy: A Proposal to Adopt Formulary Apportionment 5 (Brookings Inst., Discussion
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To prevent double taxation, the United States gives a foreign tax
credit to U.S. corporations if they earn income abroad.47 For example, if
a U.S. corporation earns income in a foreign country and that country
imposes a territorial tax (as most countries do), then that corporation will
receive a credit for the taxes paid.48 The U.S. corporation would only
owe the United States the difference between the U.S. rate and the
foreign territorial taxes paid, unless the foreign rate was higher, at which
point the corporation would not be subject to any U.S. tax.49 The main
Paper, 2007), available at http://www.brookings.edu/~/media/Research/Files/Papers/
2007/6/corporatetaxes%20clausing/200706clausing_aviyonah.PDF (“The U.S. system is
also notoriously complex: observers are nearly unanimous in lamenting the heavy
compliance burdens and the impracticality of coherent enforcement.”); Holmes, supra note
9, at 6–7 (describing the complexity of the U.S. Tax Code as many bright line rules aimed at
various goals that lack uniformity); see also David A. Weisbach, Formalism in the Tax Law, 66
U. CHI. L. REV. 860, 871 (1999) (explaining that the more tax laws there are, the more
transactional costs there are to ensure that those laws work together and that they do not
allow for any loopholes).
47 See I.R.C. §§ 901–08 (2010) (providing the rules governing the foreign tax credit for
U.S. corporations); see also Zelinsky, supra note 31, at 1297 (providing a simplified example
of the foreign tax credit system). That example is provided below:
To see the operation of the foreign income tax credit, suppose a
highly simplified example in which A, a U.S. citizen, is in a 30% federal
income tax bracket and earns $100 from renting his condominium in
Country X. If X has no income tax, A, on her federal return, reports
this rental income as part of her worldwide income and pays $30 of
such income to the federal fisc. If, on the other hand, X also imposes
income taxes on A at a 30% bracket, A pays a $30 income tax to X, the
source jurisdiction, and then credits that $30 paid against the tax A
would otherwise owe to the United States. The result is no net
payment by A to the U.S. Treasury. If, in contrast, X imposes income
taxes on A at a 20% bracket, A pays a $20 tax to X, takes a credit on her
federal tax return for that $20 income tax payment, and thereby pays a
net tax to the United States of $10 on her rental income from her
condominium located in X. The conventional view is that the credit for
foreign income taxes prevents double taxation by giving the source
jurisdiction the priority to tax.
Id. (footnote omitted).
48 See J. Clifton Fleming, Jr., Robert J. Peroni & Stephen E. Shay, Worse than Exemption, 59
EMORY L.J. 79, 81 (2009) (explaining the fundamentals of the foreign tax credit system).
Under the foreign tax credit system, the residence country subtracts
the source-country tax on a resident’s foreign income from the
residence-country tax on the resident’s foreign income and collects a
so-called residual tax to the extent that the residence-country tax
exceeds the source-country tax. Where a resident’s source-country tax
exceeds the residence-country tax, however, the residence country
does not refund the excess to the resident.
Id.
49 Id.; see Jane G. Gravelle, International Corporate Income Tax Reform: Issues and Proposals,
9 FLA. TAX REV. 469, 473 (2009) (“[I]f foreign taxes exceed the U.S. tax that would be due,
the excess foreign taxes cannot be credited.”).
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policy reasons behind creating the foreign tax credit were to encourage
corporations to continue to form and operate in the United States and to
attract foreign investment in these corporations by eliminating the
negative effect of double taxation.50 However, corporations have found
ways to manipulate their tax credits, shielding their income and paying a
lower overall effective tax rate.51 The foreign tax credit system also
depends, in large part, on accurately identifying the source of the
income—which has proved to be difficult with the globalization of the
economy.52
As the global economy has evolved, most tax rules have become
more complicated and harder to implement.53 The residence rules have
become much easier to manipulate because of how simple it is to
incorporate in another country.54 Even if a corporation decides not to
50 See Raquel Alexander, Stephen W. Mazza & Susan Scholz, Measuring Rates of Return on
Lobbying Expenditures: An Empirical Case Study of Tax Breaks for Multinational Corporations,
25 J.L. & POL’Y 401, 411 (2009) (describing how corporations are able to defer U.S. tax on
income derived by a foreign subsidiary until the parent corporation repatriates the
income). See generally Michael S. Kirsch, The Role of Physical Presence in the Taxation of Cross-
Border Personal Services, 51 B.C. L. REV. 993, 1025 (2010) (providing a very broad description
of the foreign tax credit system).
51 See Steven A. Dean, Philosopher Kings and International Tax: A New Approach to Tax
Havens, Tax Flight, and International Tax Cooperation, 58 HASTINGS L.J. 911, 924–25 (2007)
(explaining the process of using foreign tax credits to shield income). The shielding
process involves racking up a high amount of foreign tax credits in a low-tax jurisdiction to
shield that income from being taxed at a higher rate in another jurisdiction. Id.
52 See I.R.C. §§ 861, 862, 863, 865 (2006) (providing the statutory rules governing how the
United States determines the source of income); INT’L BUREAU FISCAL DOCUMENTATION,
INTERNATIONAL TAX GLOSSARY 277 (3d ed. 1996) (providing that a source of income is the
“country or countries from which the company derived its profits”); Reuven S. Avi-Yonah,
International Tax as International Law, 57 TAX L. REV. 483, 490 (2004) (“The special problem of
territoriality in the tax area is that the source of income is very difficult to define.”).
53 See Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 DUKE L.J. 557, 559–
60 (1992) (examining the differences between tax standards and tax laws). The problem
with tax laws is that their ideal content is not immediately apparent, and they are
promulgated after the fact. Id. at 569. See also Kenneth W. Gideon, Cutler & Pickering
Wilmer, Tax Law Works Best when the Rules are Clear, 81 TAX NOTES 999, 1001 (1998) (arguing
that tax law problems need to be confronted and solved before they occur so the laws do
not continue to get more complex).
54 See I.R.C. §§ 7701(a)(4)–(5) (2006) (explaining that the term “domestic,” when applied
to a corporation, means created or organized under the laws of the United States and the
term “foreign,” when applied to corporations, means one that is not domestic); William M.
Funk, On and over the Horizon: Emerging Issues in U.S. Taxation of Investments, 10 HOUS. BUS.
& TAX L.J. 1, 30–31 (2010) (noting that the United States corporate residence test is unusual
because it is based on form rather than substance, which encourages tax avoidance); David
R. Tillinghast, A Matter of Definition: “Foreign” and “Domestic” Taxpayers, 2 INT’L TAX & BUS.
LAW. 239, 259–60 (1984) (explaining the positives and negatives of the United States using
the place of incorporation to determine a corporation’s residence). The one advantage of
the place of incorporation test is that it is very easy to apply. Id. It is applied by referring
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change its country of incorporation, it could set up a foreign subsidiary,
incorporate in that foreign jurisdiction, and transfer its income through
financial record manipulation.55
The source rules have been criticized for containing inherent
problems in their application.56 In order to determine the source of the
income, the IRS has developed bright line rules that apply to different
types of income, different parties depending on their residence, and
exemptions. However, these rules are easily manipulated.57 Also, issues
to the jurisdiction in which the charter is filed and by the laws governing the shareholders.
Id. at 260. The major drawback of the place of incorporation test is that it is by nature
androgynous and creates progeny. Id. Once a decision to incorporate in the United States
is made, tax restraints discourage a company from incorporating abroad, but there are not
restraints hindering the subsidiary of a U.S. corporation from incorporating abroad. Id.
55 See Edward Kofi Osei, Transfer Pricing in Comparative Perspective and the Need for
Reforms in Ghana, 19 TRANSNAT’L L. & CONTEMP. PROBS. 599, 603 (2010) (identifying a few
major U.S. corporations that set up subsidiaries in lower tax jurisdictions); Jon M. Truby,
Towards Overcoming the Conflict Between Environmental Tax Leakage and Border Tax
Adjustment Concessions for Developing Countries, 12 VT. J. ENVTL. L. 149, 165–67 (2010)
(providing four examples of different ways that corporations set up subsidiaries in lower
tax jurisdictions); Jesse Drucker, Forest Laboratories’ Globe-Trotting Profits, BLOOMBERG
BUSINESSWEEK (May 13, 2010), http://www.businessweek/magazine/content/10_21/
b4179062992003.htm (explaining that thousands of U.S. companies are using subsidiaries in
other countries and describing some of the techniques that they are using).
56 See I.R.C. §§ 861–63, 865 (2006) (providing the U.S. source rules); GRAETZ, supra note
30, at 41 (explaining problems associated with the U.S. source rules). An example is
provided:
Suppose a company manufactures and sells bicycles. Its owners
live in Japan; its factory is in Mexico; its main offices are in Canada; its
principle sales office is in the U.S., where most of its bicycles are sold;
and it is incorporated in Bermuda. The geographical source of income
from its bicycle sales is far from clear. On one hand, the Japanese
owners supplied the capital to create the company, and the U.S.
provides its principal market. But Mexico provides the bulk of its
labor, Canada is the locus of its management, and Bermuda provides
the legal arrangements enabling the company to exist.
Id. See also Fred B. Brown, An Equity-Based, Multilateral Approach for Sourcing Income Among
Nations, 11 FLA. TAX REV. 565, 579–83 (2011) (pointing out that the two major problems with
the current U.S. source rules are that they lack coherence to achieve a consistent tax policy,
and there is such a variation between the U.S. rules and the rules of other developed
countries).
57 See GRAETZ, supra note 30, at 55–56 (explaining source rule manipulation). “Two
prevalent types of source rule manipulation are the shifting of source within a particular
category of income and the recharacterization of income into a different source category
altogether.” Id. An example of the former is shifting income between passive and active
because they are taxed differently. Id. An example of the latter is shifting income to capital
gains. Id. See also Avi-Yonah, supra note 38, at 1331 (“[T]he current [source] rules place an
immense premium on [how] payments are characterized . . . . [T]hese distinctions require
constant policing, and much of the complexity of the inbound rules of the Code stems from
this problem.”); Charles I. Kingson, Taxing the Future, 51 TAX L. REV. 641, 642 (1996)
(explaining how income is sometimes characterized as royalties, service, sales, or interest).
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with determining the source have grown even more with technology, ecommerce,
and intellectual property.58 Difficulties arise when attributing
the source of an Internet transaction and when determining the source of
income produced by an algorithm or some other type of intellectual
property.59 The U.S. corporate tax structure has opened up loopholes for
a few popular tax avoidance methods that corporations like to exploit.60
This Note explains the fundamentals of each popular strategy by using
Google as a structural example.61 Although there are many corporations
that utilize these tax avoidance techniques, each has its own specific
version.62 Google’s tax avoidance process illuminates the basics of
several different methods employed to take advantage of multiple
international tax loopholes simultaneously.63
58 See Avi-Yonah, supra note 31, at 527 (explaining how easy it is for corporations to
establish their business and income in tax havens); Yariv Brauner, An International Tax
Regime in Crystallization, 56 TAX L. REV. 259, 312 (2003) (explaining that the source and
resident rules are “fairly easy to exploit in the e-commerce context”); Thomas C. Pearson,
Proposed International Legal Reforms for Reducing Transfer Pricing Manipulation of Intellectual
Property, 40 N.Y.U. J. INT’L L. & POL. 541, 562–63 (2008) (describing the problem with
intellectual property and abusing tax avoidance); Kyrie E. Thorpe, Comment, International
Taxation of Electronic Commerce: Is the Internet Age Rendering the Concept of Permanent
Establishment Obsolete?, 11 EMORY INT’L L. REV. 633, 639–40 (1997) (describing how
corporations earning money through e-commerce transactions can avoid source taxes by
locating their servers in countries with a lower tax rate); see also 26 C.F.R. § 1.482-4(b)(1) (as
amended in 2006) (providing the regulations governing the transfer of intellectual
property, such as inventions, formula, processes, designs, and patterns).
59 See Susan C. Morse, Revisiting Global Formulary Apportionment, 29 VA. TAX REV. 593,
599 (2010) (“Common transfer pricing strategies include the location of valuable intellectual
property in low-tax offshore corporations . . . .”). The I.R.S. has tried to fix this problem by
changing regulations to require the sharing of a larger pool of costs and to attribute a
higher value to intellectual property originating with the parent company. Id. at 627.
There have also been proposals to tax U.S. corporations on excess returns from intangibles
placed in low-tax jurisdictions. Id. The problem with this proposal is that it is very hard to
put a value on intellectual property to properly determine what is in excess. Id.
60 See Colin P. Marks, Jiminy Cricket for the Corporation: Understanding the Corporate
“Conscience”, 42 VAL. U. L. REV. 1129, 1154–55 (2008) (stating that the use of loopholes
allows corporations to comply with the letter, but not necessarily the spirit, of a law, which
in turn gives them the ability to manipulate and exploit the legal system); see also infra Part
II.C (explaining four major tax avoidance techniques used by corporations); Gary Clyde
Hufbauer & Jisun Kim, U.S. Taxation of Multinational Corporations: What Makes Sense, What
Doesn’t 4 (Peterson Inst. Int’l Econ., Policy Brief No. PB09-7, 2009), available at
http://www.iie.com/publications/interstitial.cfm?ResearchID=1152 (noting the loopholes
in the U.S. tax system).
61 See infra Part II.C (using Google as the example in each section to provide an example
of the type of tax avoidance structures that corporations employ).
62 See, e.g., Kleinbard, supra note 45, at 763 (explaining Cisco’s strategies for tax
avoidance).
63 See Gravelle, supra note 22, at 76 (discussing why Google uses so many different types
of loopholes in its tax avoidance scheme).
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C. Major Tax Avoidance Techniques
Recent technological innovations, as well as a movement towards a
global economy, have enabled corporations to take advantage of the U.S.
tax system, avoiding taxation.64 Part II.C.1 explains the use of shell
companies; Part II.C.2 examines the earnings stripping technique; Part
II.C.3 provides details about transfer pricing; and Part II.C.4 combines
the three strategies to show how Google is manipulating the U.S. tax
system.65
1. Shell Companies
One major technique being used by U.S. corporations occurs when a
company sets up shell companies, companies with little or no assets, as
subsidiaries in tax shelters or countries with low tax rates.66 This usually
involves establishing an office or even just a mailbox in a low-tax
country and then either incorporating in that country or claiming that its
office in that country is its central place of management.67 Corporations
64 See supra note 3 (describing how technology has made it easier for corporations to get
around tax laws); see also Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial
Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L.
REV. 215, 467 (2002) (explaining how technological improvements made it easier for
corporations to get around financial services requirements).
65 See infra Part II.C.1 (discussing the use of shell companies); infra Part II.C.2 (explaining
the use of earnings stripping); infra Part II.C.3 (examining the practice of transfer pricing);
infra Part II.C.4 (defining and explaining the “Double Dutch Irish Sandwich”).
66 See 17 C.F.R. § 240.12b-2(3)(iv) (2010) (providing a definition of a shell company);
Simone M. Haug, The United States Policy of Stringent Anti-Treaty-Shopping Provisions: A
Comparative Analysis, 29 VAND. J. TRANSNAT’L L. 191, 250 (1996) (maintaining that shell
corporations follow the sham doctrine in which no real business or activity is going on in
them); Piroska Soos, Self-Employed Evasion and Tax Withholding: A Comparative Study and
Analysis of the Issues, 24 U.C. DAVIS L. REV. 107, 160 (1990) (explaining the basic strategy of
filtering money through a shell company); Press Release, supra note 4 (noting that shell
companies are created for the sole reason of saving money on taxes); see also John Hasnas,
Between Scylla and Charybdis: Ethical Dilemmas of Corporate Counsel in the World of the Holder
Memorandum, 44 VAL. U. L. REV. 1199, 1211–12 (2010) (explaining that tax shelters are
designed to allow wealthy investors to avoid paying taxes); David E. Spencer & Jason C.
Sharman, OECD Proposals on Harmful Tax Practices, 13 N.Z. J. TAX’N L. & POL’Y 129, 148
(2007) (giving details on how criminals use shell companies to house funds derived from
criminal activity).
67 See 60 minutes Special Report: A Look at the World’s New Corporate Tax Havens,
CBSNEWS.COM (Mar. 25, 2011), http://www.cbsnews.com/stories/2011/03/25/
60minutes/main20046867.shtml?tag=contentMain;contentBody (describing certain
companies that employ these techniques in Switzerland). Central place of management is
another test that countries use for establishing whether a corporation is a resident for tax
purposes. See Aldo Forgione, Weaving the Continental Web: Exploring Free trade, Taxation,
and the Internet, 9 L. & BUS. REV. AM. 513, 534 (2003) (exploring the different ways countries
define a corporation). Forgione provides a brief summary:
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do this because they can take advantage of the lower tax rates,
repatriating just enough money in order to keep their U.S. parent
companies running.68 For example, Google, Inc., a U.S. based
corporation, created a subsidiary in the Netherlands, Google
Netherlands Holdings, which has no employees or assets but filters
through 99.8% of Google’s income for tax reasons.69
One preventive measure that the IRS employed to stop this type of
behavior was the subpart F rules, or the Controlled Foreign Corporations
(“CFC”) regulations, as part of the 1962 Tax Revenue Act.70 These
regulations identified corporate forms that were more prone to tax
avoidance and specified several categories of income that would be
subject to U.S. income tax, because certain types of income could easily
While many nations define a resident corporation, for tax purposes, as
a company incorporated in the state, a significant number of countries
have also enacted laws that purport to deem a corporation to be a
resident of the country if the company’s place of central management
is located domestically or, more rarely, if the corporation’s principal
economic activities are conducted locally.
Id. The central place of management test looks more to the substance rather than the form
of the corporation. See Avi-Yonah, supra note 52, at 486 (explaining the advantages and
disadvantages of the central place of management test used in the United Kingdom).
68 See Andrew Brady Spalding, The Irony of International Business Law: U.S. Progressivism
and China’s New Laissez-Faire, 59 UCLA L. REV. 354, 386 (2011) (“When a foreign-chartered
corporation is owned by a U.S. corporation, the result is that profits attributable to U.S.
shareholders escape U.S. tax as long as they are reinvested in foreign tax jurisdictions;
hence the frequent establishment of subsidiaries in low-tax foreign jurisdictions.”); Avi-
Yonah et al., supra note 42, at 499–500 (examining some specifics in the U.S. tax system and
noting how the U.S. system creates an incentive for corporations to earn profits in countries
with lower tax rates). The process of companies keeping funds in their overseas
subsidiaries and not repatriating them until they need capital is known as deferral. Id.
Companies employ this tactic because the money earned by the subsidiary is deemed to be
of a foreign corporation until it is attributed to the U.S. parent. Id.
69 See Gravelle, supra note 22, at 76 (describing the scheme that Google uses, which is
commonly referred to as the “Double Irish” with a “Dutch Sandwich”); Jesse Drucker, The
Tax Haven That’s Saving Google Billions, BLOOMBERG BUSINESSWEEK (Oct. 21, 2010),
http://www.businessweek.com/magazine/content/10_44/b4201043146825.htm
(explaining the entire process that Google goes through in order to cut their effective
corporate tax rate from 35% to 2.4%).
70 Revenue Act of 1962, Pub. L. No. 87-834, § 956(d), 76 Stat. 960 (codified as amended in
scattered sections of 26 I.R.C.); see I.R.C. § 957 (2006) (defining a controlled foreign
corporation in the Tax Code); GRAETZ, supra note 30, at 218 (defining a “controlled foreign
corporation” or “CFC” as a “foreign corporation that is majority owned by U.S. individuals
or corporations, counting only those U.S. shareholders who hold 10% or more of the
stock”); Keith Engel, Tax Neutrality to the Left, International Competitiveness to the Right, Stuck
in the Middle with Subpart F, 79 TEX. L. REV. 1525, 1538–40 (2001) (explaining the history of
subpart F and how President Kennedy’s administration worked to enact it); Adam H.
Rosenzweig, Why Are There Tax Havens?, 52 WM. & MARY L. REV. 923, 974–76 (2010)
(examining the history of the subpart F regulations and why they were enacted).
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be shifted to low-tax jurisdictions.71 Under these rules, specific U.S.
corporations are taxed to the extent that their foreign subsidiaries
received disfavored forms of income, which were most likely aimed at
shifting income.72 Corporations, such as Google, are still finding ways to
manipulate their form, circumventing the controlled foreign corporation
label.73 These rules are objective, mechanical, and designed to isolate
income typically associated with tax avoidance.74 This has led to layers
upon layers of technical rules aimed at retroactively fixing a specific
problem; however, these rules simultaneously create another loophole.75
2. Earnings Stripping
Earnings Stripping is a tax avoidance technique in which a U.S.
corporation sets up a subsidiary in a low-tax country, and then the U.S.
corporation uses its U.S. earnings and makes deductible payments to the
71 See Charles E. McLure Jr., Legislative, Judicial, Soft Law, and Cooperative Approaches to
Harmonizing Corporate Income Taxes in the U.S. and the E.U., 14 COLUM. J. EUR. L. 377, 389
(2008) (explaining how CFC regulations target certain corporations that are prone to shift
their income); GRAETZ, supra note 30, at 218 (noting that most controlled foreign
corporations were formed for the sole reason of moving their passive income); see also
I.R.C. § 954(c)(1)–(2) (2006) (codifying the different types of income that the subpart F
regulations apply to); Engel, supra note 70, at 1542–48 (examining the major categories of
income targeted under Subpart F including: passive income, diversionary sales income,
diversionary services income, and miscellaneous provisions). The biggest category that
companies abuse is passive income, which includes dividends, interest, rents, royalties,
stocks, and securities. Id. at 1542.
72 See GRAETZ, supra note 30, at 220 (maintaining that the disfavored forms of business
income include income involving structures that shift income outside a foreign subsidiary’s
place of incorporation with little or no economic cost); see also supra note 71 (naming types
of income to which controlled foreign corporation regulations are aimed).
73 See I.R.C. § 957 (2006) (providing that a corporation is considered a “controlled foreign
corporation” when a certain percentage of stock is owned by U.S. shareholders). If
subsidiaries are owned by means other than stock, then these controlled foreign
corporation regulations can be avoided. Id. See also GRAETZ, supra note 30, at 236
(explaining a few other ways that controlled foreign corporation regulations can be
avoided). Corporations avoid these regulations by becoming a hybrid entity and
transferring income inter-branch. Id. Another way to avoid these regulations is contracting
out the actual processing or manufacturing into a low-tax jurisdiction. Id. at 236–37.
74 See sources cited supra note 50 (explaining why tax laws in the United States appear to
be so complicated); see also Ilya A. Lipin, Uncertain Tax Positions and the New Tax Policy of
Disclosure Through the Schedule UTP, 30 VA. TAX REV. 663, 665–67 (2011) (explaining that
U.S. tax laws contain ambiguities, obscurities, and perplexities, which make their
interaction and application to specific situations incoherent and complex).
75 See Lipin, supra note 74, at 665–67 (explaining that there are over seventy thousand
pages of tax code that have been changed over fifteen thousand times, with each new
change creating an opportunity for exploitation); see also sources cited supra note 50
(providing an explanation for why the U.S. Tax Code is so difficult to apply).
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subsidiary in the form of interest, royalties, or fees. 76 This “strips” the
earnings from the U.S. corporation and transfers the majority of the
income to the country with the low tax rate.77 For example, the foreign
subsidiary could make a loan to the U.S. parent, and in return the parent
would make extremely high interest payments back to the subsidiary.78
In 2006, Google, Inc. (U.S.) implemented a form of earnings stripping
when it licensed the rights of its intellectual property to its subsidiary in
Bermuda for “undisclosed” fees.79 These fees are ongoing and are set
very low in order to capture as much profit as possible in Bermuda,
which does not have a corporate income tax.80
76 See Press Release, supra note 4 (describing the process that corporations go through in
order to shift their income to subsidiaries in countries with lower tax rates). Traditionally,
if a U.S. company sets up a foreign subsidiary in a tax haven and one in another country,
income shifted between the two subsidiaries—for example, through interest on loans—
would be considered “passive income” for the U.S. company and subject to U.S. tax. Id.
Over the last decade, it has become easier for U.S. firms to make these subsidiaries
disappear for U.S. tax purposes. Id. With the separate subsidiaries disregarded, the firm
can shift income among them without reporting any passive income or paying any U.S. tax.
Id. As a result, U.S. firms that invest overseas are able to shift their income to tax havens.
Id. “It is clear that this loophole, while legal, has become a reason to shift billions of dollars
in investments from the United States to other counties.” Id. See also Ilan Benshalom,
Taxing the Financial Income of Multinational Enterprises by Employing a Hybrid Formulary and
Arm’s Length Allocation Method, 28 VA. TAX REV. 619, 641–42 (2009) (acknowledging that the
traditional earnings stripping technique involved debt, but also maintaining that it could
be replicated using other types of related transactions); Robert E. Culbertson & Jaime E.
King, U.S. Rules on Earnings Stripping: Background, Structure, and Treaty Interaction, 29 TAX
NOTES INT’L 1161, 1161–62, 1166–68 (2003) (explaining the background of earnings
stripping); Kleinbard, supra note 45, at 703 (defining earnings stripping as “the extraction of
pretax earnings from a source country through tax-deductible payments to offshore
affiliates”).
77 See Culbertson & King, supra note 76, at 1161–68 (explaining that foreign investors can
take advantage of debt structuring to strip their earnings to a low-tax jurisdiction);
Kleinbard, supra note 45, at 706 (noting that earnings stripping is a type of leveraging
technique that strips countries of attributable tax revenue).
78 See Ilan Benshalom, How to Live with a Tax Code with Which You Disagree: Doctrine,
Optimal Tax, Common Sense, and the Debt-Equity Distinction, 88 N.C. L. REV. 1217, 1218 (2010)
(“Remarkably, the current rules are ineffective even in preventing tax revenue loss because
they fail to recognize the weakest link in terms of tax erosion—interest payments made to
foreign investors.”); Kleinbard, supra note 45, at 705 (explaining that earnings stripping
usually occurs through the creation of an item of income inclusion, such as intercompany
interest, rents, or royalties).
79 See Drucker, supra note 69 (explaining Google’s entire tax avoidance strategy); see
Gravelle, supra note 22, at 76 (giving a brief summary of Google’s tax avoidance process);
Kleinbard, supra note 45, at 711–12 (explaining that the earnings stripping step in Google’s
tax avoidance process is the last step after which most of its income comes to rest in
Bermuda).
80 Drucker, supra note 69. Drucker goes on to explain:
The subsidiary is supposed to pay an “arm’s length” price for the
rights, or the same amount an unrelated company would. Yet because
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One way that Congress tried to stop this type of behavior was by
passing the Revenue Reconciliation Act of 1989, which codified the
earnings stripping rule as section 163(j) of the Tax Code.81 Under this
regulation, certain rules applied to corporations with debt/equity ratios
greater than 1.5 to 1.82 In other words, if the company was structured so
that it paid out more than half of its cash flow as interest expenses, then
the interest payments would be treated as excess interest and not interest
income for taxing purposes.83 Corporations are still able to manipulate
and restructure to make their ratios appear lower than they actually
are.84 This rule is also aimed specifically at earnings stripping involving
debt and does not consider earnings stripping involving other forms of
intercompany payments, such as Google’s use of fees.85
3. Transfer Pricing
Transfer pricing is probably the most used tax avoidance strategy,
which involves the setting of prices in transactions between related
entities.86 A common example occurs when a U.S. parent corporation
licensing fees from the Irish subsidiary generate income that is taxed at
35 percent, one of the highest corporate rates in the world, Google has
an incentive to set the licensing price as low as possible.
Id.
81 Revenue Reconciliation Act of 1989, Pub. L. No. 101–239, § 7210(a), 103 Stat. 2106,
2339; I.R.C. § 163(j)(2)(A)–(C) (2006) (describing the earnings stripping rules for
corporations); Julie A. Roin, Adding Insult to Injury: The “Enhancement” of S 163(J) and the
Tax Treatment of Foreign Investors in the United States, 49 TAX L. REV. 269, 270 (1994)
(commenting that section 163(J) is known as the “earnings stripping rule” because it
prevents shareholders from using interest payments to strip corporations of their earnings).
82 See I.R.C. § 163(j)(2)(A)–(C) (2006) (providing the statutory rules designed to prevent
corporations from abusing the debt to equity form in order to avoid paying taxes).
83 See Culbertson & King, supra note 76, at 1167–68 (explaining section 163(J) represents
the principle that a corporation should not be able to filter its income through interest or
any other kind of intra-company payments to reduce its tax liability).
84 See Claire A. Hill, Why Financial Appearances Might Matter: An Explanation for “Dirty
Pooling” and Some Other Types of Financial Cosmetics, 22 DEL. J. CORP. L. 141, 168–70 (1997)
(explaining that companies use debt/equity swaps and other transactions to manipulate
their ratio for a purely cosmetic effect). Not only will the company be able to bypass the
earnings stripping rules, but it also will look more attractive to future investors. Id.
85 See I.R.C. § 163(j)(2)(A)–(C) (giving the rules associated with stopping earnings
stripping). These rules do not contain any regulations for fees, rents, or royalties and only
relate to earnings stripping by debt. Id. See also Benshalom, supra note 76, at 641
(mentioning how earnings stripping could also be accomplished by manipulating a variety
of different financial transactions).
86 See GRAETZ, supra note 30, at 400 (explaining that the common transfer pricing strategy
involves income that is earned by a high tax rate entity being somehow realized by a
subsidiary that pays tax at a lower rate). Corporations that own subsidiaries in low-tax
jurisdictions usually engage in transfer pricing to shift income through the manufacturing
process without lowering the overall economic profit per transaction. Id. at 401. See About
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interacts with a foreign subsidiary, and that subsidiary sells either goods
or services abroad.87 The U.S. corporation can then “sell,” on paper, the
product to its foreign subsidiary for a minimum price so that most of the
profit is captured in the foreign country with the lower tax rate.88
Transfer pricing is a problem because there is not one globally
recognized tax code, and corporations are always searching for ways to
maximize profit.89 Google, Inc. (U.S.) also employs a form of transfer
pricing, in which it licenses its search and advertising technology to
Google Ireland in return for licensing payments.90 The licensing
Transfer Pricing, OECD CTR. TAX POL’Y & ADMIN. (last updated July 2010),
http://www.oecd.org/ctp/transferpricing/abouttransferpricing.htm (explaining the
process of transfer pricing generally); see also Eduardo Baistrocchi, The Transfer Pricing
Problem: A Global Proposal for Simplification, 59 TAX LAW. 941, 949 (2006) (defining transfer
price as “the unit price assigned to goods and services between the parent company and
subsidiaries or between divisions within the same firm”).
87 See John Sokatch, Transfer-Pricing with Software Allows for Effective Circumvention of Sub-
Part F Income: Google’s “Sandwich” Costs Taxpayers Millions, 45 INT’L LAW. 725, 739 (2011)
(“Transfer-pricing is the practice of making payments from one business entity to another
affiliated business entity for the receipt of goods or services.”).
88 See GRAETZ, supra note 30, at 400 (explaining transfer pricing and the allocation of
income among related parties). An example is provided:
Suppose that Company A, a U.S. corporation, manufactures
contact lenses. Most of Company A’s product is sold abroad through a
wholly owned subsidiary, Company B. Each lens costs $5 to
manufacture and is sold to the public abroad for $9 by Company B.
Suppose that Company B is a wholly-owned subsidiary of Company
A, then Company A may, by controlling the sales price of the lenses, be
able to choose in which jurisdiction its taxable income is realized.
Company A may attempt to realize the bulk of its income in the
foreign jurisdiction by selling contact lenses to Company B for say,
$5.25, resulting in a token profit of $0.25 per lens in the U.S. Company
B will realize profit of $3.75 per lens ($9.00 minus the $5.25 it paid for
each lens from Company A). Absent a challenge by the IRS, for the
purpose of allocating income from the sales of each lens for
determining income tax owed, the profit will be split between
Companies A and B, with only 25 cents of profit realized in the U.S.
and $3.75 in Company B’s low-tax jurisdiction for each lens produced
and sold.
Id.
89 See Miguel González Marcos, Seclusion in (Fiscal) Paradise is Not an Option: The OECD
Harmful Tax Practices Initiative and Offshore Financial Centers, 24 N.Y. INT’L L. REV. 1, 22–23
(2011) (explaining that tax policies are efficient if they minimize tax considerations in
corporations’ decision making); Sokatch, supra note 87, at 739 (noting that corporations and
consumers always search for ways to “re-capture” profits that would normally be
attributed to taxes); see also Ian B. Lee, Corporate Law, Profit Maximization, and the
“Responsible” Shareholder, 10 STAN. J.L. BUS. & FIN. 31, 31–32 (2005) (explaining the main
goals of a corporation).
90 See Kleinbard, supra note 45, at 707 (noting that Google Ireland Holdings operated
with five total employees in 2003); Sokatch, supra note 87, at 740 (explaining that Google
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agreement allows Google to attribute its overseas profits to its Irish
operations, instead of the United States where most of the technology
was developed.91
One way that the IRS tried to combat transfer pricing was through
the Arm’s Length Standard.92 This standard states that “in determining
the true taxable income of a controlled taxpayer, the standard to be
applied in every case is that of a taxpayer dealing at arm’s length with an
uncontrolled taxpayer.”93 This standard is met if uncontrolled taxpayers
would have engaged in the same transactions under the same
circumstances.94 However, this standard creates uncertainty because
neither the taxpayer nor the market can predict in advance what a
reasonable outcome should be in a transfer pricing case, especially for
unique goods.95
4. Putting It All Together—Google’s “Double Irish Dutch Sandwich”
These three techniques all involve methods of manipulating financial
statements to lower income, but Google has combined these three
methods, creating what has become known as the “Double Irish Dutch
Ireland Holdings is in control of Google’s “search engine software, advertising banners,
and the Android platform”).
91 See Drucker, supra note 69 (explaining that although Google’s money filters through
its Irish subsidiary, the money still has another step in Google’s tax avoidance scheme); see
supra note 55 (explaining the problem that arises with attributing the source of e-commerce,
intellectual property, formulas, and designs).
92 See I.R.C. § 482 (2006) (codifying the Arm’s Length Standard); see also supra note 80
(explaining the meaning of the Arm’s Length Standard).
93 Treas. Reg. § 1.482(b)(1) (1994); see REUVEN S. AVI-YONAH, INTERNATIONAL TAX AS
INTERNATIONAL LAW: AN ANALYSIS OF THE INTERNATIONAL TAX REGIME 6–7 (2007)
(maintaining that one is only engaged in the Arm’s Length Standard as long as he or she is
looking for comparable prices); see also GRAETZ, supra note 30, at 407 (explaining that the
Arm’s Length Standard requires that parties to a transaction not only calculate their
respective profits separately, but also that related parties treat transactions as if unrelated
parties had entered into them).
94 See Yehonatan Givati, Resolving Legal Uncertainty: The Unfulfilled Promise of Advance
Tax Ruling, 29 VA. TAX REV. 137, 170 n.113 (2009) (explaining that the applicable standard in
every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer).
95 See Reuven S. Avi-Yonah, The Rise and Fall of Arm’s Length: A Study in the Evolution of
U.S. International Taxation, 15 VA. TAX REV. 89, 137 (1995) (explaining that the Arm’s Length
Standard leads to uncertainty because “neither the taxpayer nor the IRS can know in
advance the likely revenue outcome in a transfer pricing case”); Wayne M. Gazur, An Arm’s
Length Solution to the Shareholder Loan Tax Puzzle, 40 SETON HALL L. REV. 407, 428–29 (2010)
(establishing that an Arm’s Length Standard might be hard to prove in the majority of
markets); see also Benshalom, supra note 76, at 621 (noting that another flaw in the Arm’s
Length Standard is that it requires unrealistic levels of government monitoring and can be
easily abused).
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Sandwich.”96 Google has created four separate subsidiaries and has used
conflicting tax codes, as well as bilateral tax agreements to avoid paying
almost any U.S. taxes.97 Google licenses to Google Ireland Holdings, a
shell company with only two thousand employees, the offshore rights to
its intellectual property for undisclosed fees so that the United States has
an incentive to set a very low price.98 Next, while Google Ireland
Holdings is an Irish company, it reports that its place of management
(Irish residence rule) is centered in Bermuda, exempting it from Irish
taxes.99 Google Ireland Holdings gets credit for about 88% of the
company’s overseas sales, yet reported a pre-tax profit of less than 1% of
sales in 2008, in large part because of the $5.4 billion in royalties it paid,
indirectly, to the Bermuda managed company.100 Finally, the royalty
payments from Google Ireland Holdings in Dublin take a quick detour to
the Netherlands to avoid triggering an Irish withholding tax.101 In
Amsterdam, Google Netherlands Holdings BV paid out 99.8% of the $5.4
billion it received from Dublin to the unit managed in Bermuda.102 The
Dutch company has no employees, meeting the definition of a shell
corporation.103 Other corporations have now engaged in similar
practices, which costs the United States billions of dollars in tax revenue
annually.104 Now that this Note has described the tax avoidance
problem, it will define a few popular proposals to fix this problem.105
D. Popular Proposals
The four most popular proposals to fix the corporate tax avoidance
problem in the United States include: (1) lowering the corporate tax rate,
96 See Sokatch, supra note 87, at 741 (explaining how this scheme received its name).
97 See id. at 740 (explaining how Google developed its tax avoidance scheme).
98 See id. at 740–42 (describing the first step of Google’s process); Drucker, supra note 69
(explaining how Google uses the strategy of earnings stripping in the Netherlands).
99 See Drucker, supra note 69 (explaining how Google manipulates the residence rules
and filters their income through a complicated system of shell companies); see also supra
Part II.B (providing a background for the U.S. corporate residence rules).
100 See Jesse Drucker, Google 2.4% Rate Shows How $60 Billion Lost to Tax Loopholes,
BLOOMBERG BUSINESSWEEK (Oct. 21, 2010), http://www.bloomberg.com/news/2010-10-
21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes.html
(explaining how Google uses the transfer pricing method of tax avoidance).
101 Id. (explaining the final step in Google’s tax avoidance scheme).
102 Id. (describing Google’s use of Bermuda’s tax haven).
103 See Sokatch, supra note 87, at 742 (evaluating the final numbers after Google has
utilized several tax avoidance techniques.)
104 See id. (explaining how other corporations are using the same type of techniques); see
also supra note 7 (describing the widespread use of tax avoidance techniques by
corporations all over the world).
105 See infra Part II.D (defining a few popular proposals to fix the tax avoidance problem
in the United States); infra Part IV (proposing a change to the tax base).
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(2) shifting the U.S. tax system to a pure territorial tax, (3) continuing to
add provisions to the Tax Code to address specific problems, and (4)
using a formulary apportionment to tax corporations.106 Lowering the
corporate rate refers to lowering the 35% corporate rate to a rate
comparable to tax havens and other low-tax jurisdictions.107 This has
become especially popular since President Obama made a proposal to
lower the standard corporate tax rate from 35% to 28%.108 This plan
focuses on attracting investment to the United States while reducing one
of the highest tax rates in the world.109 Shifting to a pure territorial tax
implies that the United States would no longer tax U.S. corporations on
the basis of residency, taxing corporations based only on their U.S.
source income.110 This is the way that most industrialized countries
currently tax corporations.111 There has been much support for this
106 See infra text accompanying notes 106–18 (explaining generally these four proposals).
107 See Kathryn J. Kennedy, The IRS’s Recent Uncertain Tax Positions Initiative: A Tangle of
Accounting, Tax and Privilege Issues, 9 DEPAUL BUS. & COM. L.J. 401, 406 (2011)
(acknowledging that lower tax rates could cause businesses to stay in the United States);
Robert T. Kudrle & Lorraine Eden, The Campaign Against Tax Havens: Will it Last? Will it
Work?, 9 STAN. J.L. BUS. & FIN. 37, 41 (2003) (mentioning that firms invest in countries with
low tax rates to give them a tax advantage); Richard T. Page, The International and
Comparative Tax War: A Strategic Tax Cut Recommendation for the Obama Administration, 18
TUL. J. INT’L & COMP. L. 287, 289–90 (2009) (listing other countries that have recently
lowered their corporate tax); Meg Shreve, Sessions Open to Paying for Corporate Tax Cut, 130
TAX NOTES 632, 632 (2011) (arguing for lowering the corporate tax rate in the United
States); Martin Feldstein, Want to Boost the Economy? Lower Corporate Tax Rates, WALL ST. J.,
Feb. 15, 2011, http://online.wsj.com/article/SB1000142405274870358480457614413153907
2472.html (explaining how lowering a country’s tax rate can attract investors). But see
Robert A. Green, The Future of Source-Based Taxation of the Income of Multinational Enterprises,
79 CORNELL L. REV. 18, 21 (1993) (asserting that a corporate tax rate war would threaten the
U.S. economy).
108 See Zachary A. Goldfarb, Obama Proposes Lowering Corporate Tax Rate to 28 Percent,
WASH. POST, Feb. 22, 2012, http://www.washingtonpost.com/business/economy/obamato-
propose-lowering-corporate-tax-rate-to-28-percent/2012/02/22/gIQA1sjdSR_story.html
(explaining Obama’s proposal to cut the corporate tax to 28% in order to be competitive
with other countries).
109 Id.
110 See David L. Cameron & Phillip F. Postlewaite, Incremental International Tax Reform: A
Review of Selected Proposals, 30 NW. J. INT’L L. & BUS. 565, 566–79 (2010) (describing a few
proposals to fix the international tax avoidance problem in the United States); Michael S.
Knoll, The Corporate Income Tax and the Competitiveness of U.S. Industries, 63 TAX L. REV. 771,
772 (2010) (evaluating the advantages and disadvantages of the United States moving to a
territorial tax); Gravelle, supra note 49, at 491–92 (analyzing the territorial and worldwide
tax systems). But see Alex Khachaturian, Reforming the United States Export Tax Policy: An
Alternative to the American Trade War with the European Union, 14 U.C. DAVIS J. INT’L L. &
POL’Y 185, 195–97 (2008) (supporting the idea of a territorial tax in the United States).
111 See GRAETZ, supra note 30, at 12–13 (explaining how most European nations have
territorial systems and do not have a residence tax).
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proposal because of its relative success in European countries.112 The
third proposal—adding specific provisions to the Tax Code—is how the
United States currently handles tax issues.113 When a problem arises, a
provision is added to the Tax Code to retroactively address it.114
Keeping the corporate tax system this way is the least popular of the
current proposals because of its well documented failures in the past.115
Formulary apportionment is a rather new proposal that suggests using a
formula and basing a corporation’s income on a variety of factors.116
This proposal is more modern in that it recognizes the abuse that results
from corporations reporting their own income to the IRS.117 These
proposals have advantages and disadvantages that can be best
understood by first analyzing why these tax avoidance problems are
occurring in the United States.118
III. ANALYSIS
The IRS has struggled in its attempts to create regulations that
prevent U.S. corporations from using tax avoidance techniques.119 Part
III of this Note discusses the various reasons why the IRS has struggled
to combat tax avoidance techniques and the continued effects that
corporate tax avoidance is having on the U.S. economy as a whole.120
More specifically, Part III.A explains the inherent problems contained
within the current U.S. tax base, which make it difficult for the IRS to
112 Id.
113 See, e.g., Stop Tax Haven Abuse Act, § 681, 111th Cong. § 7492, Subchapter F (as
introduced by Senator Levin, Mar. 2, 2009) (providing an example of retroactive rules
proposed to the Tax Code); see also Gravelle, supra note 49, at 488–89 (explaining some
specific provisions that could be added to the Tax Code); supra note 52 (discussing the
complexity of tax code rules).
114 See Holmes, supra note 9, at 23–26 (highlighting the complexities of the Tax Code,
which explains why making tax laws after the fact do not work).
115 See Bordoff & Furman, supra note 3, at 353–54 (illustrating the brokenness of the U.S.
corporate tax system).
116 See Avi-Yonah et al., supra note 42, at 498 (advocating for the United States to switch
its tax system to formulary apportionment); Morse, supra note 59, at 599–600 (examining
the benefits of formulary apportionment). But see Edward D. Kleinbard, The Lessons of
Stateless Income, 65 TAX L. REV. 99, 149 (2011) (explaining formulary apportionment of
income methodology as “the mechanism for allocating a multinational enterprise’s global
income to source countries”).
117 See Avi-Yonah et al., supra note 42, at 498–99 (explaining some benefits of formulary
apportionment).
118 See infra Part III.A (analyzing why these loopholes in the U.S. Tax Code exist).
119 See supra note 7 (noting how much revenue the United States is losing because of tax
avoidance).
120 See infra Part III (discussing various reasons why tax avoidance is a problem in U.S.
tax law).
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create regulations that effectively combat tax avoidance strategies.121
Part III.B examines the continued negative effects that corporate tax
avoidance has on the U.S. economy and some public policy reasons that
support changing the Tax Code to better eliminate these tax loopholes.122
Part III.C evaluates the shortcomings of some popular proposals that
have been offered as solutions to the corporate tax avoidance problem.123
Ultimately, Part III concludes that the existing regulations designed to
address tax avoidance strategies fail to resolve this problem adequately
because of the current structure of the U.S. tax base and that the best
solution to this problem is to change the tax base altogether.124
A. Inherent Problems with Current U.S. Tax Base
“More effective taxation internationally is primarily a question of the
tax base.”125 One inherent problem with the current tax base for
corporations is that it promotes manipulation.126 One way it does this is
exemplified in the fact that corporations separately report their income
to the IRS.127 This means that corporations have the added incentive to
report their income as low as possible, pay as little taxes as possible, and
121 See infra Part III.A (explaining the problems that the United States faces from using net
income as the corporate tax base).
122 See infra Part III.B (examining the negative effects that tax avoidance is having on the
U.S. economy).
123 See infra Part III.C (evaluating the advantages and disadvantages of some popular
proposals to fix the tax avoidance problem).
124 See infra Part IV (proposing to fix the corporate tax avoidance problem by changing
the tax base).
125 See Barker, supra note 29, at 651 (explaining generally the importance of having a good
tax base); McCaffery & Hines, supra note 45, at 1041 (stating that the tax structure and rate
depend on the tax base).
126 See Holmes, supra note 9, at 10 (examining some of the shortcomings of the United
States’ prescriptive corporate tax regime). Holmes explains:
[T]he U.S corporate tax system represents the worst of both worlds: (i)
a high statutory tax rate with relatively low, declining effective rates
(and thus corporate tax revenue); and (ii) complex rules that fail to
protect the corporate tax base, but can be manipulated, with significant
social costs, by sophisticated MNCs to lower their effective rates.
Id.
127 See McIntyre et al., supra note 17, at 706–07 (explaining that separate reporting opens
up the opportunity for corporations to employ tax minimization strategies). The article
explains transfer pricing and asserts that combined reporting “directly blocks these
techniques and other similar tax-minimization strategies.” Id. See Mazerov, supra note 17,
at 4 (“In combined-reporting states, however, corporate manipulation of transfer prices
does not affect state corporate tax revenues. Since the profits of a corporation’s
components are added together to determine the corporation’s taxable base, the allocation
of those profits within the corporation is irrelevant.”).
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thus maximize their after tax profits.128 Because there is a lack of
cooperation between countries on how high or low to set the tax rate for
corporations, countries tend to undercut one another with lower tax
rates so they can attract foreign investment.129 If corporations can
manipulate their income so that it looks as though it was earned in a
low-tax jurisdiction, then they can lower their tax liability.130 Former IRS
Commissioner Mark Everson noted that large multinational corporations
will “utilize every available resource to explore opportunities to reduce
their tax liability by using the most intricate and complicated Code
provisions . . . .”131 Corporations do not have an incentive to keep the
income figure that they report to the IRS high, and the IRS cannot make
laws forcing them to pay because of state sovereignty.132
Since these rules were enacted, the U.S. economy has changed
dramatically.133 Increases in technology have led to globalization, which
has made it easier for capital and resources to be shifted
internationally.134 The current tax base was created without this new
128 See McIntyre et al., supra note 17, at 708 (explaining that when income is separately
reported, there is a higher likelihood of tax avoidance); see also Holmes, supra note 9, at 8
(asserting that taxes tend to be a very critical part in a large corporation’s decision making
processes because it is focused on maximizing its after-tax profits); Marcos, supra note 89, at
22–23 (explaining the goals of efficient tax policies).
129 See Rosenzweig, supra note 70, at 955 (explaining that tax havens exist because
countries that cannot compete in a competitive market can attract investors by offering a
minimal tax rate); Ring, supra note 5, at 184 (explaining that countries lower their tax rates
to attract business); Addison, supra note 3, at 711 (“A state becomes a tax haven for one
undeniable reason: to attract capital to help promote growth in its financial industry.”).
130 See, e.g., GRAETZ, supra note 30, at 400 (providing one method whereby corporations
can shift the origin of their earned income); Kleinbard, supra note 45, at 735 (identifying
cost sharing agreements as another popular way that corporations like to shift their
profits).
131 Senate Committee on Homeland Security and Governmental Affairs’ Permanent
Subcommittee on Investigations Hearing on Offshore Abuses: The Enablers, the Tools and Offshore
Secrecy, 109th Cong. 2 (2006) (statement of Mark Everson, Comm’r, Internal Revenue),
available at www.hsgac.senate.gov/download/stmt-8-1-06-everson-mark-irs. See Weisbach,
supra note 46, at 867 (explaining that nations assert tax sovereignty because they want to
control revenue and fiscal policy); Kaplow, supra note 53, at 571–72 (explaining the
complexity of tax rules compared to that of tax standards).
132 See Ring, supra note 5, at 160, 170 (explaining that countries are the supreme source of
control over their respective tax laws); supra note 44 and accompanying text (explaining
that the United States cannot enforce a tax regulation on a foreign corporation that derived
its income outside of the United States).
133 See Bordoff & Furman, supra note 3, at 341 (“The U.S. economy has become
increasingly integrated with the rest of the world over the past twenty years, due to
advances in technology and transportation. The result has been greater flows across
borders of goods, services, capital, people, and ideas.”).
134 See Benshalom, supra note 5, at 166 (noting the change in the corporate structure due
to globalization); Holmes, supra note 9, at 7 (“Globalization has both magnified the
competitive pressures that MNCs feel from their foreign competitors and increased the
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technology in mind, and the United States cannot easily account for this
change because the problem extends internationally.135 The IRS is not
able to hold these corporations liable for their tax avoidance, because
their behavior is completely legal in the United States.136
Another problem with the current tax base is that it was enacted, for
the most part, in 1962 and 1986.137 As technology and the U.S. economy
changed, the IRS addressed the changing needs of the corporate tax
system by adding patchwork rules to the framework, instead of
reviewing and reformulating the tax base as a whole.138 This created a
very complex set of rules to compensate for the outdated tax base.139
Corporations have found ways around most of these rules, because the
rules lack coherence and uniformity, often working to counteract each
other.140
ability of jurisdictions around the world to effectively compete for their resources.”). See
generally Birdsall, supra note 5 (describing the globalization of the last few decades).
135 See Avi-Yonah, supra note 3, at 1575–76 (discussing how the increased mobility of
capital due to technological advances has led to international tax competition, because
companies can easily shift capital to low-tax jurisdictions).
136 See Tillinghast, supra note 5, at 38–39 (explaining how the IRS has certain powers in
enforcing tax laws within the United States that it lacks in other jurisdictions). The IRS
does not have a practical way to enforce U.S. tax liabilities on foreign corporations. Id. See
also supra note 5 (explaining the limits on the U.S. taxing authority).
137 Revenue Act of 1962, Pub. L. No. 87-834, § 12(a), 76 Stat. 1009 (codified as amended at
26 U.S.C. § 954 (2006)). The most significant changes to the international tax system since
the 1960s occurred in the Tax Reform Act of 1986, which adopted changes to the income
source, expense allocation, and foreign tax credit rules; however, these changes did not
alter the fundamental system. See generally Peter H. Blessing et al., Report of the Task Force
on International Tax Reform, 59 TAX LAW. 649 (2006).
138 See Holmes, supra note 9, at 11–12 (summarizing the American Bar Association’s
findings regarding the U.S. tax system). Holmes provides the following conclusions:
As a result, the United States has gone “from a complex to a supercomplex
regime . . . .” Indeed, the American Bar Association, in its
recent report evaluating various tax reform proposals, recognized that
the “accretion of tax rules without periodic thorough reviews of the
needs of the system” is a key source of complexity in the corporate tax
regime.
Id. (footnotes omitted). The enormous complexity of the tax system creates efficiency,
administrative, and equity problems. Id. This includes the increased compliance costs to
taxpayers, challenging administrative enforcement, and proliferation of high cost tax
planning. Id. See also note 46 (noting the complexity of the U.S. Tax Code).
139 See Barker, supra note 29, at 649–50 (noting that Congress adds patches to the existing
system to close loopholes and raise additional revenue); see also Holmes, supra note 9, at 11
(recommending a fundamental review of the outdated tax system); Weisbach, supra note
46, at 882 (explaining the downfalls of putting rules on top of rules); supra note 46
(explaining the intricacies and complexities of U.S. tax laws).
140 See Barton, supra note 8, at 1050 (“The IRS attempts to close the loopholes that allow
MNCs to avoid paying taxes on money that the U.S. Treasury should be entitled to tax. Yet
these practices have essentially created a game of cat and mouse, and companies always
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B. Negative Effects
These tax avoidance strategies are continuing to have negative
effects on the U.S. economy by unfairly draining significant tax revenue
away from the U.S. government.141 This is harmful because the U.S.
government then has to raise revenue in other ways (like raising taxes on
individuals) to make up for the large U.S. deficit, instead of using these
corporate funds.142 The first function of taxation is to raise revenue to
pay for the benefits associated with being a U.S. citizen or business.143 If
the larger corporations are not paying their corporate income tax, then
they are, in effect, passing these costs onto someone else while still
utilizing the same U.S. economy, infrastructure, and other benefits that
the United States provides.144
Another negative effect that these tax avoidance strategies have on
the United States is the long-term loss of jobs and capital to other
countries.145 U.S. corporations that employ these tax avoidance
strategies end up attributing most of their money to these low-tax
jurisdictions in order to pay less.146 The money is not taxed until it is
brought back, or repatriated, to the United States.147 This creates the fear
that the United States will permanently lose jobs, assets, and production
seem one step ahead of the government.”); see also Lynch, supra note 15 (explaining that big
corporations will always try to find ways to save money on taxes).
141 See Hirsch, supra note 2 (explaining that U.S. multinational corporations are
collectively avoiding anywhere between $10 billion and $60 billion a year in taxes by
shifting their earnings on paper to overseas subsidiaries); Bill McGuire, U.S. Debt Tops $15
Trillion Mark Today, ABC NEWS (Nov. 16, 2011), http://abcnews.go.com/blogs/
business/2011/11/u-s-debt-will-top-15-trillion-mark-today/ (noting the record breaking
debt in the United States); see also Tansill, supra note 7, at 294 (describing how President
Obama’s administration planned to make laws stopping tax avoidance techniques so that
money could be put towards the U.S. deficit).
142 See Sokatch, supra note 87, at 747 (explaining that the United States will try to find
ways to stop tax avoidance so it can pay for its historically high national deficit); Shah,
supra note 7 (explaining that most governments tax the population to compensate for the
lost revenue from corporate tax avoidance).
143 See sources cited supra note 32 (providing a variety of sources that explain the benefits
theory of taxation).
144 See Hirsch, supra note 2 (providing a study of the largest U.S. corporations); see also
Shah, supra note 7 (explaining that individual taxes are raised as a result of corporate tax
avoidance).
145 See Press Release, supra note 4 (explaining how the United States has lost jobs to
foreign countries because these countries offer tax incentives, encouraging corporations to
move their operations overseas); Rosenzweig, supra note 70, at 956 (describing how low-tax
jurisdictions attract investment).
146 See supra Part II.C (stating that the goal of avoidance techniques is to make the IRS
attribute earnings to a country with lower taxes).
147 See supra notes 42, 44–45, 50 (analyzing tax deferral and explaining that corporations
are not taxed until they repatriate the money back into the United States).
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to foreign jurisdictions, because it is much cheaper for corporations to
operate abroad.148 On the other hand, the United States arguably has the
most attractive market when it comes to investment and, no matter how
cheap investment is in other jurisdictions, corporations will still invest in
the United States because of the how much it imports.149
The policy arguments heavily favor the need to change the corporate
tax system to account for these tax avoidance strategies.150 The United
States never intended for these corporations to avoid paying corporate
income tax.151 According to the benefit theory of taxation and other
equity theories, these corporations should be required to pay their
corporate taxes even if they have the resources to find loopholes in the
system.152 The question is not whether it should be done, but rather
what is the most effective way to remedy the problem.153 Next, this Note
analyzes some common proposals to fix this problem before ultimately
concluding that, instead of adding another regulation to the current
complex Tax Code, the United States should change its tax base
altogether.154
C. Popular Proposals
As the tax avoidance problem has persisted, the public has opposed
the corporate use of tax avoidance techniques and supported corporate
148 See Hufbauer & Kim, supra note 60, at 2 n.6 (discussing the United States’ downward
trend in the world economy and how the United States is losing its competitive advantage
against the emerging economies of Brazil, Russia, India, China, and Korea).
149 See The World’s Largest Economies, supra note 14 (identifying the top economies in the
world). The U.S. is the largest economy in the world, thus the largest consumer of goods
and services in the world. Id.
150 See Gravelle, supra note 22, at 89–90 (explaining some policy arguments for the need
for corporate tax reform in the United States). See generally JOINT REP. WHITE HOUSE &
DEP’T TREASURY, THE PRESIDENT’S FRAMEWORK FOR BUSINESS TAX REFORM (Feb. 2012),
http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-
Framework-for-Business-Tax-Reform-02-22-2012.pdf (explaining the push towards closing
loopholes, broadening the tax base, and cutting corporate tax rates).
151 See GRAVELLE, supra note 2, at 13 (explaining the definition of tax avoidance). There
are a variety of factors that give corporations the ability to avoid taxes, none of which are
because the United States wanted it. See generally Part II (explaining the background of the
U.S. tax structure and how tax avoidance came to be).
152 See supra note 32 (describing the benefit theory of taxation); see also Holmes, supra note
9, at 13 (explaining that when corporations spend dollars on tax planning it creates an
extraordinary amount of social waste and can result in lower profits, higher prices for
goods and services for customers, and decreased capital available for domestic and foreign
investment).
153 See THE PRESIDENT’S FRAMEWORK FOR BUSINESS TAX REFORM, supra note 150, at 1
(noting that America’s system of business taxation is in need of reform).
154 See infra Part III.C (examining the disadvantages of some popular proposals to fix the
tax avoidance problem).
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tax reform.155 Part III.C.1 evaluates what would happen if the United
States tried lowering its tax rate; Part III.C.2 examines the possibility of
shifting to a territorial tax; Part III.C.3 looks at the option of continuing
with the same strategy; and Part III.C.4 assesses the option of formulary
apportionment.156
1. Lowering the Corporate Tax Rate
One common proposal is for the United States to lower its corporate
tax rate to be more competitive with other countries.157 In theory, this
would solve the tax avoidance problem because if the United States
lowers the rate, there will no longer be an incentive for corporations to
shift their income abroad.158 Some positives of this approach are that it
would attract more foreign investment and keep domestic corporations
from shifting their earnings abroad.159 The major reason why this would
not work is that corporations are greedy and even if the United States
lowers its corporate rate, there will always be lower tax jurisdictions to
which corporations will try to shift their earnings.160 For example, if
President Obama’s proposal to cut corporate tax rates to 28% passes,
corporations, such as Google, that use tax avoidance strategies to cut
their effective tax rate to around 3% will still be saving a substantial
amount of money by using these strategies.161 The fact that the rate is
lower will not matter because another country will probably have a
lower rate.162
2. Shifting to a Pure Territorial Tax
Another common proposal is to stop taxing corporations based on
incorporation and only tax them based on where income is earned, like
155 See Faulhaber, supra note 7, at 178–79 (explaining that public opposition grew on a
global scale as the issue of tax avoidance become more well-known).
156 See infra Part III.C.1 (discussing the possibility of lowering the tax rate); infra Part
III.C.2 (describing the territorial tax); infra Part III.C.3 (listing specific provisions of the
current Tax Code); infra Part III.C.4 (evaluating formulary apportionment).
157 See Kennedy, supra note 107, at 406 (discussing lowering the corporate tax rate as a
means of competing with low-tax jurisdictions).
158 Id.; see also supra Part II.C (explaining four popular tax avoidance techniques and
noting that the goal is for corporations to filter their money into a country with a lower tax
rate).
159 See supra note 107 (describing how countries with lower tax rates attract investment
because it costs less to do business there).
160 See Lynch, supra note 15 (explaining that no matter how low the tax rate is,
corporations will try to find new ways around them).
161 Id.
162 Id.
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most other developed countries.163 There would no longer be a foreign
tax credit, which would lead to a more efficient and a more simplified
system.164 This approach would also ensure that the United States
remains an attractive location for multinational corporation
headquarters.165 This proposal is likely to fail, because it would still
incentivize corporations to manipulate their income.166 Corporations
could continue to transfer income into jurisdictions with a lower source
tax rate; thus, unless the United States had the lowest tax rate in the
world, there would still be the incentive to shift income.167 Although this
approach would simplify the tax system, the same worries about income
manipulation would exist as they do now.168
3. Specific Provisions to Address Tax Avoidance
Another popular proposal is to keep the U.S. tax system as is and
continue adding provisions to the Tax Code when specific problems
163 See Rosenzweig, supra note 70, at 964–66 (explaining how a country would go about
imposing a territorial tax); see also Barker, supra note 29, at 715 (advocating a territorial
approach to corporate taxation); Gravelle, supra note 49, at 491 (offering analyses of these
proposals and indicating that switching to a territorial tax would raise tax revenues in the
United States by $10 billion); Kleinbard, supra note 45, at 701 (noting that there is pressure
on the United States to change to a territorial tax system); Shaviro, supra note 39, at 378
(explaining that all of the other world industrial powers use a territorial tax system). See
generally supra Part II (explaining the territorial tax system).
164 See Brown, supra note 56, at 589–90 (explaining that countries using a foreign tax credit
give primary taxing authority to the source country); see also Fleming, Jr. et al., supra note
48, at 82 (discussing the complexity and heavy administrative costs of the foreign tax credit
system); supra Part II (laying out the basics of the territorial tax system).
165 See Knoll, supra note 110, at 782–83 (noting that if the United States adopted a
territorial tax, it would remove the unduly tax burden of being a U.S. corporation and
attract more investors); Rosenzweig, supra note 70, at 965 (explaining that a territorial tax
leads to tax competition among countries); Shaviro, supra note 39, at 378 (asserting that as
long as the territorial tax rate is comparable to other industrialized countries, corporations
will not shy away from investing in the United States).
166 See Rosenzweig, supra note 70, at 965 (noting that manipulation can still occur under a
pure territorial tax system).
167 Gravelle, supra note 49, at 492. Outlining several criticisms with the territorial tax, the
author explains:
The main reservation with an explicit territorial approach is that it
increases the pressure to shift profits into active business enterprises in
low-tax jurisdictions. The increased pressures on transfer pricing,
including shifting of intangibles and the income from those intangibles
into low-tax jurisdictions, were cited by the Joint Committee on
Taxation and others as a problem with a territorial approach.
Id.
168 Id.
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arise.169 These new provisions would be narrow and technical,
addressing very specific problems and attempting to cut down tax
avoidance strategies.170 An example of this might be an alteration that
changes the Arms Length Standard or cracks down on specific tax
havens.171 Provisions like this are beneficial because they are goal
oriented and are not as difficult to implement, as they are only minor
changes.172 The reason why these types of regulations have failed is that
they add more complexity to the Tax Code and do not act with
uniformity. Regulations like this are also known to address certain
problems with the effect of creating new problems.173 Since the main
formulation of the Tax Code, all the changes have been small regulations
that build on one another.174
4. Formulary Apportionment
Under formulary apportionment, a corporation’s worldwide income
is calculated using a mathematical formula that reflects the distribution
of economic activity and divides the income of the business among the
jurisdictions in which it operates.175 The formula treats a parent and a
subsidiary as the same unit and uses factors such as sales, assets, or
payroll to determine the tax rate in a certain jurisdiction.176 Essentially, a
169 See id. at 487–88 (providing some examples of provisions that could be added to the
Tax Code).
170 See Holmes, supra note 9, at 20–21 (describing the current prescriptive rules that the
United States has in its Tax Code); Kaplow, supra note 53, at 588–89 (assessing the
complexity of U.S. Tax Code while analyzing the alternatives to tax standards).
171 See, e.g., I.R.C. § 482 (2006) (defining and codifying the Arm’s Length Standard); see
also Lipin, supra note 74, at 665–67 (explaining that there are thousands of pages in the Tax
Code that have been changed numerous times).
172 See Barker, supra note 29, at 649–50 (explaining how the government sometimes adds
patchwork rules).
173 See Holmes, supra note 9, at 12–13 (explaining that the enormous complexity of the tax
system creates inefficiency, as well as administrative and equity problems). This includes
the increased compliance costs to taxpayers, challenges to administrative enforcement, and
proliferation of high cost tax planning. Id.
174 See Lipin, supra note 74, at 666–67 (explaining how each rule adds to the depth and
makes matters worse instead of better).
175 See Morse, supra note 59, at 601–02 (providing a general explanation of formulary
apportionment).
Under formulary apportionment, the existence of an
apportionment factor such as sales into the jurisdiction—rather than
residence or source—could constitute taxing nexus. Accordingly,
formulary apportionment would have no need for the current rules
determining corporate residence or corporate income source. It is a
wholly different way of allocating jurisdiction to tax.
Id. (footnotes omitted).
176 Id. at 600.
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corporation would only pay U.S. taxes on the share of worldwide income
that was apportioned to the United States using the formula.177 A major
strength of formulary apportionment is that it would eliminate most of a
corporation’s incentive to shift its earnings into a low-tax jurisdiction,
because it would base a corporation’s tax liability on measures of its real
economic activity as established by the formula, rather than its legal
residence or form.178 Another strength of this system is that it simplifies
the tax system for corporations into one formula.179 However, formulary
apportionment is likely to fail, because it would require the cooperation
of foreign countries in order to properly implement the system.180 This
would be extremely difficult as most countries have existing tax treaties
or are trying to attract investment by offering a lower tax rate.181
Although there are some strengths associated with the common
proposals, none of them adequately address the corporate tax avoidance
problem. Thus, this Note proposes to fix the problem by changing the
U.S. corporate tax base to either (1) revenue reported to a U.S. public
stock exchange or (2) revenue reported to a U.S bank to obtain a loan.182
IV. CONTRIBUTION
The current tax base allows many corporations to use international
loopholes to take advantage of the U.S. tax system, costing the United
States billions annually in lost tax revenue.183 Society’s ever increasing
obsession with maximizing profits has encouraged corporations to cheat
the United States out of tax revenue, even though the United States has
provided these corporations with many resources that contribute to their
177 See, e.g., Avi-Yonah et al., supra note 42, at 498 (proposing a particular formulary
apportionment in which the fraction of that corporation’s worldwide income would be “the
sum of (1) a fixed return on their expenses in the United States and (2) the share of their
worldwide sales that occur in the United States”).
178 See id. at 510–16 (examining the advantages and disadvantages of formulary
apportionment). Formulary apportionment removes the incentive for companies to use
accounting devices to shift income on paper because it does not matter where the income is
attributed. Id. The formula takes a percentage of the corporation’s worldwide income. Id.
179 Id.
180 See Kleinbard, supra note 116, at 150–51 (explaining that formulary apportionment can
bring about its own harm). There would still be an incentive for smaller countries to
remain as tax havens and not cooperate. Id. Unless cooperation is full among the
international community, corporations will just flee to the countries that are not
participating and that still have very little or no corporate tax. Id.
181 Id.
182 See infra Part IV (proposing a change to the tax base as a solution to the corporate tax
avoidance problem).
183 See supra Part II.B (explaining the current U.S. tax structure); supra Part II.C
(examining some popular tax avoidance techniques that corporations use).
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success.184 The current outdated tax structure has proved that it is
impossible to reconcile this tax problem by making new laws that fit into
the structure.185 Every new law opens up another loophole in the system
and makes it more complicated.186 However, tax avoidance creates such
great harm to the economy that something must be done to capture this
tax revenue.187 Unlike all other unsuccessful attempts, this proposal
attempts to fix the problem by changing the initial tax base, instead of
merely adding another law to an already complicated tax structure.188
First, Part IV.A proposes a new tax base in statutory form and
explains why it is a superior method of taxing corporations.189 More
specifically, Part IV.A.1 explains the first part of the new tax base—
taxing corporations on revenue reported to a U.S. public stock
exchange.190 Then, Part IV.A.2 examines the second part of the new tax
base—taxing corporations on revenue reported to a U.S. bank to obtain a
loan.191 Lastly, Part IV.B examines the potential problems associated
with such a big change in the tax structure.192
A. Proposed Tax Base
To address tax avoidance strategies, the tax base for publicly traded
corporations and corporations that apply for a bank loan should be
changed to revenue. Accordingly, a corporation would be taxed on its
revenue if that corporation (1) is traded publicly on a U.S. public stock
exchange, or (2) applies for a loan from a U.S. bank. If a corporation
does not do either of these things, then its tax base will not change, and it
will continue to pay tax on its net income reported to the IRS. The
proposed amendment appears as follows:
184 See supra note 32 and accompanying text (explaining the theory that corporations
should pay taxes if they take advantage of the benefits a country provides).
185 See supra Part III.A (discussing the problems with the current tax base, which make it
difficult for the United States to prevent tax avoidance); see also supra notes 3, 7 (discussing
the prevalence of corporations using tax avoidance methods).
186 See supra notes 113–18 and accompanying text (explaining how the complexity and
lack of uniformity of the Tax Code leads to loopholes, which corporations are able to
exploit).
187 See supra Part III.B (discussing the continued negative effects that tax avoidance is
having on the U.S. economy).
188 See supra Part II.B (identifying and explaining some of the failed reform measures); see
also Part III.C (examining some popular proposals to fix the U.S. tax avoidance problem).
189 See infra IV.A (proposing an amended tax base that decreases incentives for
corporations to manipulate financial records).
190 See infra Part IV.A.1 (explaining how a corporation would be taxed on a percentage of
its total revenue reported to a U.S. public stock exchange).
191 See infra Part IV.A.2 (discussing how a corporation would be taxed on a percentage of
its total revenue reported to a U.S. bank).
192 See infra Part IV.B (noting the potential problems in implementing this new tax base).
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348 VALPARAISO UNIVERSITY LAW REVIEW [Vol. 47
Proposed Amendment to I.R.C. § 11(a)(1)(2)193
(a) Corporations in General—A tax is hereby imposed for each
taxable year on the total revenue of a corporation—U.S. resident or
not—if:
(1) The corporation is publicly traded on a U.S. public stock exchange;
or
(2) The corporation applied for a bank loan from a U.S. bank.
(b) If a corporation does not fall into § 11(a)(1) or § 11(a)(2), then a tax is
hereby imposed on the taxable income reported by that corporation to
the IRS.
(c) If a corporation operates at a loss, then it will not be subject to any tax
on its revenue.
(d) Revenue will be determined by:
(1) The total revenue the corporation reports to the public stock
exchange in § 11(a)(1) on its Form 10-k or equivalent reporting
procedure; or
(2) By the total revenue the corporation reports to the U.S. bank in
§ 11(a)(2).
(3) If a corporation falls into both § 11(a)(1) and § 11(a)(2), the
revenue figure used will be the higher of the two reported.
(e) Definitions
(1) U.S. public stock exchange—any stock exchange registered as a
U.S public exchange with the Securities and Exchange
Commission. This includes but is not limited to: Arizona Stock
Exchange (AZX), BATS Exchange, Chicago Board Options
Exchange (CBOE), Chicago Board of Trade (CBOT), Chicago
Mercantile Exchange (CME), Chicago Stock Exchange (CHX),
Direct Edge, International Securities Exchange (ISE), NASDAQ
Stock Market, National Stock Exchange (NSE), and the New York
Stock Exchange (NYSE).
(2) U.S. bank—any bank registered under the laws of the United
States.
Commentary
The above provisions change the corporate tax base for publicly
traded corporations and corporations that apply for a bank loan from
income reported to the IRS to total revenue reported to a U.S. public
stock exchange or U.S. bank. If a corporation is not traded on a U.S.
193 The proposals are the contribution of the author. Specifically, proposed additions are
italicized while the unitalicized portions are taken from I.R.C. § 11(a)–(b). See generally
I.R.C. § 11(a)–(b) (2006).
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2012] Closing International Loopholes 349
public stock exchange and it does not obtain a loan from a U.S. bank,
then its tax base does not change, and it is taxed the same way that
corporations are currently taxed. This means that the tax base for small,
private corporations will not change, and the tax base for corporations
who apply for loans through foreign banks will also remain the same.
The two main reasons why this proposal does not focus on private
corporations are (1) because the majority of the U.S. corporate tax
revenue comes from publicly traded corporations, and (2) because most
private corporations do not have the resources to shift their income into
countries with lower tax rates. This proposal does not change the tax
base for corporations that apply for loans through foreign banks because
that information would not be easily obtained.
To continue, this proposal treats corporations that operate at a loss as
they are currently treated—not making them pay any taxes, because
corporations should not have to pay taxes on what they do not have.
This proposal also does not deal with any other specific provisions—
such as the exact rate that corporations would be taxed—just the initial
corporate tax base. Addressing these specific provisions in a tax code
that is over 70,000 pages long would be overly complicated and
ultimately outside the scope of this Note, especially since it is evident
that changing the tax base in this manner would greatly reduce
corporate tax avoidance and significantly increase U.S. tax revenue.
Most corporate tax rules, like the foreign tax credit system, are focused
on fairly taxing corporations while at the same time keeping businesses
from moving abroad. However, corporations have found ways to
manipulate these rules to their benefit to pay a lesser tax rate. Since this
was not the original purpose or design of most U.S. international tax
laws, the tax base should be changed to account for the fact that certain
laws, like the foreign tax credit, might be subject to manipulation.
Making the tax base a higher revenue figure will help ensure that the
total tax revenue does not decrease. Part IV.A.1 examines the first part
of the proposed statute and Part IV.A.2 analyzes the second part.194
1. Revenue Reported to a U.S. Stock Exchange
This section of the proposed tax suggests that corporations be taxed
if they are publicly traded on a U.S. stock exchange. Corporations are
taxed on revenue previously reported to a stock exchange on their Form
194 See infra Part IV.A.1 (explaining why taxing total revenue reported to a public stock
exchange is a good alternative tax base); infra Part IV.A.2 (discussing why taxing total
revenue reported to banks is superior to taxing income).
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350 VALPARAISO UNIVERSITY LAW REVIEW [Vol. 47
10-k.195 The Form 10-k is an annual report that each publicly traded
corporation must file with the SEC giving a comprehensive summary of
the corporation’s performance. This ensures that the tax base is not a
separately reported figure to the IRS and takes away corporations’
incentive to report the lowest possible figure so that their taxes are
lower.196 Additionally, there is no longer an incentive for a corporation
to manipulate financial records for tax purposes because there is already
the motivation to keep the figure as high as possible.197 When a
corporation is traded on a U.S. public stock exchange, like NASDAQ,
NYSE, or AMEX, the corporation’s main goal is to maximize shareholder
value by either increasing the stock price or paying out dividends to
shareholders.198 The best way to maximize shareholder value is by
attracting investors so that the stock price of that company will
increase.199 One of the main components of determining shareholder
value is the corporation’s total revenue.200 Therefore, a corporation will
want to report a high revenue figure so that it can increase its
shareholder value and thus attract investors.
Although the ultimate goal of a corporation is to maximize income, a
corporation’s revenue is often a good determinate of its growth. Taxing
corporations on their reported revenue is also more effective than taxing
corporations on their reported income because net income can be
distorted by manipulating expenses, interest, taxes, depreciation, and
amortization, all of which are subtracted from revenue. Also, as
mentioned above, using a higher tax base figure, such as revenue, takes
into account the fact that there are some U.S. tax laws, like the foreign tax
credit system, that will always be subject to manipulation. Therefore, by
using revenue, the tax base will be larger, a more true representation of a
corporation’s tax liability, and immune from manipulation. The United
States does not need any extra cooperation with other nations to impose
this tax base because the reported revenue comes straight from the U.S.
stock exchange.201 Also, this provision is easily applied to U.S. public
195 See supra Part II.C (noting the dilemma created when companies must report their tax
base separately, as illustrated by Google).
196 See supra note 17 and accompanying text (discussing the benefits of combined
reporting).
197 See supra Part II.C (describing some popular tax avoidance techniques and notiing
how corporations have an incentive to manipulate financial records in all of them).
198 See supra note 89 (explaining how the main goal of corporations is to maximize profit).
199 See Lee, supra note 89, at 36–37 (explaining how stock price is a direct reflection of
shareholder value).
200 Id. at 35.
201 See supra Part III.C.4 (determining that formulary apportionment would be too
difficult to implement because it would call for a great deal of international cooperation
between countries).
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2012] Closing International Loopholes 351
stock exchanges and does not contain any intricate provisions that could
open up loopholes.202
2. Revenue Reported to a U.S. Bank
In the second section of the proposed tax base, a corporation is taxed
when it applies for a loan at a U.S. bank. When a corporation applies for
a loan with a bank, it presents financial data to the bank so that it can
evaluate the merits of the corporation’s ability to pay the loan back.203
Like in the first section, this takes away the separate reporting aspect
because the total revenue number comes from the bank.204 This also
eliminates the incentive to manipulate records and lower total revenue,
because one of the main components that banks look at when evaluating
corporate loans is revenue. The higher the revenue figure, the more
likely the corporation will be able to pay back the loan, and thus the
higher loan amount that the corporation can obtain. Inherent, then, is
the notion that a corporation will not distort this revenue amount but
will keep it as high as possible so it is able to secure a larger loan. In
addition, there would not be any international cooperation needed—
only cooperation with U.S. banks—and the concept is fairly
straightforward with a limited set of rules.205
Instead of merely adding another law to an already complicated tax
structure that combats tax avoidance and attempts to reconcile an
outdated tax base, the proposed solution updates the tax base to
eliminate the incentive for corporations to manipulate financial
figures.206 Of course, as with any change to the tax structure of this
magnitude, there are potential problems that must be analyzed.207
202 See supra note 46 (detailing the complexity of the tax and how every new intricacy
opens up another loophole); see also supra Part III.C.4 (explaining the difficulty in
implementing a tax structure like formulary apportionment).
203 See Wilmarth, supra note 64, at 230–31 (listing the requirements for obtaining a loan
since 1975).
204 See supra note 127 (asserting that manipulation becomes an issue when things are
separately reported); supra note 17 (describing how combined reporting eliminates the
incentive to manipulate).
205 See supra Part III.C.4 (noting how international cooperation is not an easy thing in this
economy); see also supra note 47 (explaining how complexity negatively affects the Tax
Code).
206 See supra Part III.A (explaining that one of the problems with the tax base is that it
does not account for the changes in technology and the global economy).
207 See infra Part IV.B (analyzing the possible problems that could occur when
implementing this new tax base).
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352 VALPARAISO UNIVERSITY LAW REVIEW [Vol. 47
B. Potential Problems
Since changing the tax base would be a complete revamp of the
current tax structure, there are possible problems that could arise.208
First, because the proposed tax base is calculated from a corporation’s
total revenue, there are potential issues in determining an applicable rate
because not all of the money was earned in the United States.209 Most
likely, the rate would have to take into account the fact that not all of the
revenue was produced in the United States and would have to be much
lower than the current tax rate of 35%. Second, there could be issues
with double taxation.210 The rate would have to be low enough to
account for the fact that corporations might be taxed in other countries
on the same revenue.211
Third, this type of tax could cause corporations to invest in public
stock exchanges overseas or obtain loans overseas, causing the United
States to lose businesses and jobs permanently.212 Considering the size
and dominance of the U.S. stock exchanges, this would probably not be a
smart option for many of the larger corporations that are currently using
tax avoidance strategies. The advantages of being a member of a U.S.
stock exchange, being able to obtain loans from U.S. banks, and being in
the U.S. market are so great that most corporations would not be willing
to pass up the U.S. market permanently.
Fourth, there could be execution problems if the U.S. banks or stock
exchanges are not able to report this information efficiently.213 However,
the proposed process should be simple enough to avoid significant
barriers. Last, because corporations will continue to avoid taxation if
they operate at a loss, there could be a potential issue with corporations
manipulating their financial statements to show a loss. This problem
could easily be solved by additional legislation monitoring whether a
corporation reported income on their Form 10-k. Although these
potential problems exist, the advantages of having a tax base that
208 See Holmes, supra note 9, at 3 (discussing how there have been only two major
structural changes in the U.S. Tax Code); see also supra Part II.A (explaining how the
fundamental tax structure from the 1920’s remains today).
209 See supra Part II.B (comparing territorial taxation and worldwide taxation); see also
supra note 113 (asserting that some countries base their rate on competitiveness
internationally).
210 See supra note 27 (exploring the issue of double taxation).
211 See supra Part II.A (noting the benefits theory of taxation). Following this theory, if
income is earned in more than one country, then both countries have the right to tax. Id.
212 See supra note 107 (asserting that countries lower their rates so that they can attract
investment).
213 See supra Part III.C (examining the implementation problems contained within these
four popular proposals).
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2012] Closing International Loopholes 353
eliminates the incentive for tax avoidance greatly outweighs these
potential problems.
V. CONCLUSION
The United States, along with most industrialized nations, follows
the benefit theory of taxation.214 As a result, the United States enforces a
tax because of the benefits that corporations receive from the U.S. market
and economy.215 Since the establishment of the corporate tax,
corporations have been taxed on the basis of the income that they
reported separately to the IRS.216 The income is then subjected to many
rules, regulations, and provisions designed to ensure that companies are
paying their share of taxes.217 For example, there are laws establishing
that a corporation owes tax if it earns the income in the United States, or
if it is a U.S. resident corporation.218
As the global economy has progressed over time, it has become
much easier for corporations to circumvent the rules and manipulate the
income they report through financial records.219 This allows
corporations to escape tax liability by reporting that income was earned
in other countries with lower tax rates.220 It is difficult for the United
States to enforce its tax laws because of national sovereignty.221 Today,
large corporations, such as Google, employ a wide variety of tax
avoidance techniques to avoid billions in taxes annually.222
Most proposals to fix the U.S tax avoidance problem contain new
regulations, which are designed to ensure that companies pay a fair
amount of taxes.223 However, every time a new law is passed to fix a
part of the Tax Code, corporations discover new loopholes. This has
resulted in a very complicated U.S. Tax Code that does not effectively
combat the tax avoidance problem.224
214 See supra Part II.A (detailing the history of the U.S. corporate tax).
215 Id.
216 Id.
217 See supra Part II.B (explaining the basic U.S. tax structure); supra note 47 (noting the
complexity of the U.S. Tax Code).
218 See supra Part II.B (discussing the basic tax framework and establishing when the
United States has tax jurisdiction).
219 See supra Part II.C (exploring a few major tax avoidance techniques that corporations
use to bypass tax law).
220 Id.
221 See supra note 5 and accompanying text (explaining why sovereignty prevents the
United States from enforcing its tax laws in other countries).
222 See supra Part II.C.4 (outlining the entire tax avoidance process that Google uses).
223 See supra Part III.C (analyzing some of the popular proposals to fix the tax avoidance
problem).
224 See supra note 46 (explaining the intricacies of the U.S. Tax Code).
VanDenburgh: Closing International Loopholes: Changing the Corporate Tax Base
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354 VALPARAISO UNIVERSITY LAW REVIEW [Vol. 47
This Note’s proposed solution is to change the U.S. tax base,
imposing taxes on a corporation if it (1) is traded publicly on a U.S.
public stock exchange or (2) applies for a loan from a U.S. bank.225 The
new tax base would tax a corporation’s total income as reported to either
the stock exchange or bank. Altering the tax base in this way would
eliminate the incentive for corporations to manipulate their financial
records.226 The corporate tax would be based on something that has
already been reported and that corporations have an incentive to keep
high.227 Corporations have an incentive to keep their revenue figure
high when reporting to the public stock exchange so that they maximize
shareholder wealth. Likewise, they have the incentive to keep their
revenue figure high when obtaining a bank loan so that they can obtain a
larger loan. The proposed tax base is also beneficial because it lacks
complexity, requires very minimal international cooperation, and is
fairly easy to implement.
However, with any tax structure change of this magnitude, there
might be problems in the execution.228 Nevertheless, the advantages of
the new tax base greatly outweigh any potential problems. The change
will reduce tax avoidance, increase tax revenue, and eliminate many
harmful effects that tax avoidance is having on the United States.
Therefore, enacting this proposed solution would not only restore equity
back to the corporate tax but also give rise to a much more stable
economy.
Using this new tax base would change the situation for NoTax.
Instead of owing taxes on its relatively small net income reported to the
IRS, NoTax would owe tax on the three hundred and fifty million dollars
of worldwide revenue. The fact that NoTax reduced its reported net
income to the IRS by thirty-three million dollars is irrelevant because
NoTax would pay corporate tax as a percentage of its worldwide
income. Since NoTax reported around the same worldwide revenue to
225 See supra Part IV (proposing a change in the tax base to combat the tax avoidance
problem in the United States).
226 Id.
227 Id.
228 See supra Part IV.B (discussing the possible problems with implementing a new tax
base).
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2012] Closing International Loopholes 355
its shareholders, it would not be able to escape tax liability by
manipulating its net income, thus rendering its tax avoidance methods
ineffective.
John T. VanDenburgh*
* J.D. Candidate, Valparaiso University Law School (2013); B.S., Accounting,
Management, Purdue University (2009). I would like to thank Professor David Herzig and
Executive Editor of Student Writing (2011–2012) Jessica Levitt for their comments and
advice on prior drafts of this Note. Also, I sincerely thank my parents for their constant
support and guidance. I would also like to thank my siblings, Mark and Lisa, for
encouraging me to pursue a legal career and for providing me with the realization that we
will need a lawyer in the family. A special thanks to Taryn Baker who believes in me and
has been there for me every step of the way throughout our law school career. Lastly, I
would like to thank my friends and family who not only encourage me but have made my
law school journey bearable.
VanDenburgh: Closing International Loopholes: Changing the Corporate Tax Base
Produced by The Berkeley Electronic Press, 2012
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