How to Improve the Base Erosion and Anti-Abuse Tax

One significant international provision of the 2017 TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
Cuts and Jobs Act (TCJA) was the base erosion and anti-abuse tax (BEAT), so named because it attempts to combat a tax problem known as base erosion. Base erosion is the loss of corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.
revenues from global companies due to profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens.
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BEAT is intended to address a legitimate problem, and there are virtues to BEAT’s overall strategic approach; however, its execution leaves room for improvement.

Base Erosion: How Cross-Border Transactions Can Lead to Revenue Loss

BEAT concerns the tax treatment of cross-border tax payments made by a multinational enterprise (MNE) to related companies abroad. Now, since the companies are related—that is, they have the same ownership—it does not change the total income of the group. A loss for one part of the MNE is a gain for another. But it does have tax implications: cross-border payments create a deductible expense in one country and income in another, reducing taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
in the first country and increasing it in the second. The practice of accounting for cross-border transactions is known as transfer pricing.

While transfer pricing is a necessary part of doing business, and deductibility is a normal feature of traditional income tax systems, MNEs have an incentive to use transfer pricing to create deductions in the U.S. and income in the low-tax jurisdiction. This functionally shifts the profits to that low-tax jurisdiction, reducing the overall tax burden for the company and “eroding” the U.S. tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
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An MNE cannot simply arbitrarily shift profits around with any payment it desires. Regulations for transfer pricing require that cross-border payments follow an “arm’s length principle”—that is, they must be priced as if the two related parties were independent and negotiating based on their own interests, hopefully resulting in accounting that reflects economic substance.

In practice, though, certain categories of transactions are quite subjective, leaving MNEs some wiggle room to shift profits. For example, payments for commodities are relatively objective, while royalties—payments for unique intellectual property—are much less objective, allowing the wiggle room to shift profits. As a result, base erosion is associated with certain categories of expense far more often than others.

Statistical Discrimination as Tax Policy

BEAT is an attempt to slow this practice down. It creates a category for base erosion payments—expenses paid to related corporations abroad in categories often associated with profit shifting, such as services, interest, rents, and royalties—and taxes MNEs with too many of these base erosion payments.

While BEAT is intended to address abuse of cross-border transactions in general, BEAT should not be thought of as a system for adjudicating guilt; a BEAT liability is not by itself evidence that an MNE has engaged in transfer mispricing. However, a BEAT liability does indicate that the MNE’s overall tax profile, as measured by an aggregate accounting metric, is statistically more consistent with transfer mispricing than an average company’s tax profile might be. As a result, the MNE is instructed to pay more taxes.

Statistical discrimination is a useful concept frequently applied in other areas of business. For example, consider loan interest rates. Lenders offer lower interest rates when they predict—based on what they know of the borrower—that they are likely to get their money back. And they demand higher interest rates when they predict that the borrower is more likely to fail to pay. They do not know for sure—some loans with low interest rates end up in delinquency, and some loans with high interest rates end up repaid—but lenders make the best call they can with the information they can readily access and legally use.

Imperfections in these systems are a fact of life. Of course, policymakers should prefer that BEAT’s formula accurately identifies transfer mispricers (as creditors would prefer to identify the borrowers most likely to repay), but acquiring information to improve the model is costly. It takes resources to prove transfer mispricing, and those resources earn diminishing marginal returns. Eventually, the benefits of further improvements to the model do not justify the costs.

BEAT’s virtue is that it takes a realist approach to solving thorny problems. Its design is a recognition that transfer pricing issues cannot be resolved with perfect clarity, fairness, and efficiency. Instead, it carves out a rough compromise. MNEs whose tax profile contains circumstantial evidence of transfer mispricing simply pay some tax, a bit like a legal settlement without wrongdoing, and move on.

False Positives and False Negatives

While accepting imperfections in statistical discrimination (as BEAT does) is sometimes most efficient, policymakers should still try to improve the system where possible and reasonably cheap. A system like BEAT can make two major errors: the false positive, where an MNE not engaged in profit shifting nonetheless triggers BEAT liability, and the false negative, where an MNE successfully engages in profit shifting and avoids triggering BEAT liability.

BEAT certainly makes both types of errors. And in the years since 2017, its most consistent failure modes have become apparent.

One false positive error is that large and valuable foreign MNEs whose intellectual property is genuinely a product of work done abroad will often trigger BEAT liability, even though their royalty payments likely reflect economic substance in a location outside the United States. For example, a Paris-based MNE in the cosmetics industry might bottle and sell haircare products in the U.S. but credit much of its value chain to valuable brands developed in and marketed from France. Transfer pricing reflecting that reality is not a profit-shifting activity—and indeed, not even beneficial to the MNE, as the corporate income tax rates in France are higher than the U.S. rate. Taxing investment by these foreign MNEs may discourage foreign direct investment, worsening the U.S. economy.

Another false positive error is the inclusion of income that is ultimately taxable under U.S. law anyway. Consider the following arrangement: a U.S.-headquartered MNE makes royalty payments to a related corporation abroad. However, those royalties ultimately end up included in the U.S. income tax calculation through a provision known as Subpart F. Subpart F, a form of controlled foreign corporation (CFC) rule, predates BEAT and requires some income from CFCs to be included in U.S. income for tax purposes. Given the similar aims of BEAT and Subpart F, it is unsurprising that these provisions overlap. But the policy justification for BEAT does not make sense in this case: an MNE paying taxes on Subpart F income is not eroding the U.S. tax base.

Simultaneously, there is solid evidence that BEAT misses many of the MNE behaviors it was intended to curb. Accounting scholars have shown that firms can and do recategorize some base erosion payments as cost of goods sold, which does not factor into BEAT calculations. This behavior may be hard to regulate; over the long run, MNEs could even structure themselves such that many of their base erosion payments are made by an intermediary not subject to BEAT.

In a recent report, Tax Foundation noted that BEAT revenues are relatively low, at less than $2 billion a year. While BEAT may also raise revenue indirectly—through firms giving up certain deductions they otherwise would have taken, increasing their ordinary corporate income tax liability—it seems likely that BEAT is failing to capture many of the profit-shifting behaviors it was intended to capture.

Potential Reforms

BEAT’s top-level strategic approach of statistical discrimination is a valid framework for tax policy: do not spend too many resources on litigating details, and instead, look at the big picture. If this approach is imperfect, that can be accepted, because speedy and efficient resolution is more important than perfection.

However, BEAT has significant failures in execution. There are at least two classes of MNEs that can be reasonably easily identified as false positives. Policymakers should consider excluding from BEAT those deductions that return to the U.S. tax base in the form of Subpart F income.

They should also consider finding means to avoid the over-application of BEAT to inbound foreign direct investment. One idea might be to provide safe harbor for payments to some countries—especially large countries with high corporate income tax rates. These are much more likely to reflect real economic substance, not profit shifting. However, such a policy would have costs: in practice, determining which countries have acceptable tax regimes, and which countries are low-tax attractors of profit shifting, can be subjective and difficult.

Handling BEAT’s many false negatives may be even trickier. It may be subject to Goodhart’s Law—the observation that once a measure becomes used as a target, it may no longer be as good a measure as before. If BEAT’s revenue impact ends up being minimal because it is too easily circumvented, then BEAT may not be worth continuing at all; it would be better to free up the resources MNEs spend on circumventing BEAT so that talented people can instead devote their time to more economically productive tasks.

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