As noted yesterday, the US does not tax foreign income of foreign corporations, even when the foreign corporation is a wholly-owned subsidiary of a US corporation. Under this regime, a US parent corporation with a subsidiary in a low-tax (tax haven) jurisdiction has an incentive to park income in the tax haven by (i) paying the subsidiary too much for goods and services and (ii) charging the subsidiary too little for goods and services. The US polices this with two mechanisms: First, some very mobile income, like royalties, of a controlled foreign corporation is taxed to US shareholders as earned by the foreign corporation. Second, there are rules that attempt to insure that parent/subsidiary transactions are priced at “arm's length.” The arm's-length rules don't work, which calls the entire regime into question.
The arm's-length standard fails both in theory and in practice. The theoretical problem probably doesn't seem all that compelling (except to a hand full of theorists), but it helps understand the practical problems. Here is the idea: Income is a measure of individual wellbeing. It is not earned in any place or by a legal entity. This was illustrated in the Sue hypothetical. She performed her surgeries offshore. But, in the abstract, the earning process began the day that she was born. To try to figure out what she earned offshore — to try to break a seamless earning process into artificial pieces — seems doomed to failure.
And fail it does. To figure out an arm's-length price, one needs a comparable transaction between unrelated parties. In every interesting case, there is no useful comparable. Economists are beginning to figure out why. Multinational corporations are more complicated than initially thought. They are more than the sum of their parts. (Like The Beatles, I like to say.) This violates traditional economic theory, but the empirical work bears out that there is extra value in multinationals. Thus, comparables may not exist, as multinational groups can do things that a collection of independent local companies cannot. Also, a multinational has extra profit from being a multinational, which is not attributable to any local piece, and which is missed in traditional arm's-length pricing. (But yes, tax jocks, is dealt with toward the end of the 1994 regs somewhat.)
Tomorrow: Formulary apportionment