How Multinationals Avoid Taxes: Common Strategies
Global companies and their advisors have devised a range of techniques to minimize taxes across countries. Some of the most widely used strategies include:
- Tax Havens and Offshore Shell Companies: Establishing subsidiaries or shell companies in tax havens – jurisdictions with very low or zero corporate tax rates (like Bermuda, the Cayman Islands, or Luxembourg) – is a cornerstone of many tax avoidance plans. A multinational can shift a portion of its profits to these entities on paper, so that the income is booked in a place where it faces minimal taxation. Often, these subsidiaries are little more than mailing addresses or holding companies with few employees. By routing profits through a web of such offshore companies, firms effectively shield income from higher-tax jurisdictions. For example, a company might sell its products in Country A but have the profits from those sales recorded by a subsidiary in Country B (a tax haven), thereby paying far less tax than if the profit were taxed where the sales occurred.
- Transfer Pricing and Profit Shifting: Multinational firms frequently transact with their own subsidiaries – selling goods, providing services, or licensing intellectual property internally. The prices they set for these intercompany transactions (“transfer prices”) can dramatically affect how much profit appears in each country. By adjusting prices, a company can allocate more profit to low-tax jurisdictions and less to high-tax ones. For instance, a subsidiary in a low-tax country might charge an artificially high price for components or services it provides to an affiliate in a high-tax country. The high-tax affiliate’s expenses (and thus its taxable profits) are inflated, while the low-tax affiliate reports greater profit (taxed minimally). This practice, often called profit shifting, exploits the difficulty tax authorities face in establishing the “correct” market price for unique goods or intangibles exchanged within a corporate group. While tax laws require that transfer prices reflect arm’s-length market values, the complexity and uniqueness of many transactions give companies considerable leeway.
- Intellectual Property and Royalty Schemes: Intangible assets like patents, trademarks, software, and other intellectual property (IP) are another avenue for shifting profits. Many technology and pharmaceutical companies, for example, assign ownership of valuable IP to subsidiaries in low-tax countries. Those subsidiaries then charge royalties or licensing fees to the company’s units in higher-tax countries for the right to use the IP. These royalty payments count as expenses in the high-tax jurisdictions (eroding taxable income there) and become revenue in the low-tax location (often taxed lightly or not at all). This technique was at the heart of the famed “Double Irish with a Dutch Sandwich” structure that companies like Google and Apple employed for years. In that scheme, profits from sales in Europe were paid as royalties to an Irish subsidiary, routed through a Dutch company, and ultimately collected by a second Irish entity that was managed from a tax haven like Bermuda – resulting in minuscule tax on those earnings. By moving paper ownership of IP to tax havens and charging affiliates steep fees to use it, multinationals can make profits effectively vanish from high-tax countries.
- Intercompany Loans and Earnings Stripping: Financing transactions within a multinational group can also be used to shift income. A common tactic is to have a subsidiary in a high-tax country borrow money from an affiliate in a low-tax country, then make large interest payments on that loan. The interest paid is tax-deductible in the high-tax jurisdiction, reducing that unit’s taxable profits, while the interest income is received in the low-tax jurisdiction, often subject to little or no tax. This strategy, known as earnings stripping, can significantly erode the tax base of high-tax countries while keeping the money within the corporate family. By loading subsidiaries in places like the U.S., Germany, or Japan with intercompany debt, multinationals can “strip” out earnings that would have been heavily taxed and shift them to tax havens under the guise of interest payments. In response, many countries have implemented rules to limit excessive interest deductions (so-called thin capitalization rules), but creative corporate financiers often find ways around these limits.
- Treaty Shopping and Hybrid Mismatches: Companies also exploit gaps between different countries’ tax rules. They might route transactions through third countries to take advantage of favorable tax treaties – a practice called treaty shopping. For example, if royalties sent directly from Country X to Country Y would incur a high withholding tax, the company might channel them through Country Z which has a tax treaty reducing or eliminating that tax. Additionally, firms leverage “hybrid” arrangements where an entity or financial instrument is treated differently by two tax systems (debt in one country, equity in another, for instance), allowing income to escape taxation or be deducted twice. By carefully structuring holding companies and financing chains, multinationals can ensure that certain streams of income pass through a jurisdiction in a way that incurs minimal tax. These cross-border arbitrage strategies are highly complex but can result in income that effectively slips through the cracks of two or more tax systems.
- Corporate Inversions (Relocating Headquarters): As discussed, a corporate inversion is essentially a relocation of a company’s legal residence for tax purposes. By merging with a foreign company and reincorporating in a low-tax country, a multinational can escape the higher taxes of its original home country on future earnings. During the 2000s and early 2010s, several U.S. companies pursued inversions – for instance, moving their headquarters-on-paper to Ireland or the Cayman Islands – to permanently shield foreign earnings from U.S. tax and sometimes to reduce domestic tax through post-inversion strategies. Inversions typically didn’t change the day-to-day operations of a company; they were largely about changing tax domicile. While this maneuver has been largely curtailed by recent laws, it stands as a stark illustration of how far companies have been willing to go in re-engineering themselves to cut taxes.