Background

		Effective Tax Rates

Effective tax rates on corporate income can be defined in a variety of  ways, each of which provides insights into a different issue. These rates  fall into two broad categories—average rates and marginal rates. An  average effective tax rate, computed as the ratio of taxes paid in a given  year over all of the income the corporation earned that year, is a good  summary of the corporation’s overall tax burden during that particular  period. In comparison, a marginal effective tax rate focuses on the tax  burden associated with a specific type of investment (usually over the full  life of that investment) and is a better measure of the effects that taxes  have on incentives to invest. There is likely to be some correlation  between average effective tax rates, marginal effective tax rates, and  statutory tax rates across countries. In the remainder of the report, unless  we specify otherwise, we use the term effective tax rate to mean an  average effective tax rate.
Important methodological decisions to make when computing effective  tax rates on corporate income are the scope of the corporate taxpayer to  study and what measures of taxes and income to use. These decisions are  ultimately driven by both conceptual considerations and data availability.  These considerations will be different, depending on whether one is  estimating separate effective tax rates on domestic income and foreign  income or simply a single effective tax rate on worldwide income. Our  various estimates and those of others that we present below are based on  the same fundamental definition of an average effective tax rate but reflect  variations in scope and data as appropriate for the different populations  being examined.

		The Nature of U.S. Multinational Corporations and How the Federal Government Taxes Their Income

Large U.S. corporate taxpayers are often complicated groups of separate  legal entities. A parent corporation may directly own (either wholly or  partially) multiple subsidiary corporations. In turn, these subsidiaries may  own other corporate subsidiaries, and any of these corporations may own  stakes in partnerships. A domestic parent corporation (one that is  organized under U.S. laws) may head a large group of affiliated businesses  that includes both domestic and foreign subsidiaries and partnerships. The  timing of when these various entities pay U.S. tax on their income and the  tax return on which their income and taxes are reported varies depending  on both the location of the entities and choices made by the parent  corporation. These timing and reporting differences, which are  summarized in table 1 and table 2, matter in the estimation of effective tax  rates. In particular, the fact that the income of a controlled foreign  corporation (CFC) is not reported or taxed on a U.S. return until it is  recognized under Subpart F or repatriated in the form of dividends means  that an effective tax rate estimate based solely on income reported for tax  purposes would not reflect the tax treatment of a significant component of  the income of MNCs. This limitation is one reason why prior analysts have  used income reported on financial statements, rather than tax-reportable  income, when computing effective tax rates.
Two aspects of the U.S. tax treatment of foreign income lead to much  lower U.S. tax burdens on foreign income than on domestic income, which  is one reason why it makes sense to look at these effective tax rates  separately. The first aspect is the aforementioned deferral of tax on the  income of CFCs generally until that income is repatriated. The second  aspect is the foreign tax credit, which is designed to prevent the double  taxation of foreign income (once by the government of the country in  which the income is earned and once by the United States). In effect, the  United States taxes the foreign income only to the extent that the U.S.  corporate tax rate exceeds the foreign rate of tax on that income. If the  foreign rate of tax is equal to or exceeds the U.S. rate, the United States  collects no tax on that income.
Department of the Treasury tax regulations generally effective since  January 1, 1997 have an important influence on some of the effective tax  rate estimates and data on business activity location that we present  below. These regulations, commonly known as check-the-box rules,  permit corporate groups to treat a wholly owned entity either as a separate  corporation or to “disregard” it as an unincorporated branch simply by  checking a box on a tax form. Taxpayers have used this flexibility to  create “hybrid entities,” which are business operations treated as  corporations by one country’s tax authority and as unincorporated branch  operations by another’s. Hybrid entities can be used in a variety of ways  for tax-planning purposes. In one example, a U.S. MNC can put substantial  equity into a finance subsidiary located in a low-tax country. That  subsidiary then can lend money to an affiliate in a high-tax country to  finance most of the latter’s operations. The high-tax affiliate makes tax- deductible interest payments to the finance subsidiary, which will pay a  low rate of tax on this interest income. Prior to the check-the-box rules the  interest income of the finance subsidiary would have been subject to U.S.  tax on a current basis under the subpart F rules. Now, however, the  taxpayer can, in certain circumstances, treat the high-tax affiliate as an  unincorporated branch of the low-tax subsidiary, so the interest payment  is not recognized as a transaction for U.S. tax purposes. Subject to  Subpart F, the United States only taxes that income if it is repatriated.
The American Jobs Creation Act of 2004 provided a temporary incentive  for U.S. MNCs to repatriate income from their CFCs. The act allowed  recipients to make a special, one-time election to deduct 85 percent of  “extraordinary” dividends received from CFCs during either the recipient’s  last tax year beginning before October 22, 2004, or its first tax year  beginning after that date, provided that the CFCs’ dividends were not  funded by money borrowed from their U.S. shareholders and provided that  the repatriated funds were used for allowable domestic investments.  Dividends were extraordinary to the extent that they exceeded the average  dividends that the shareholder received from its CFCs over the previous 5  years (disregarding the highest and lowest amounts out of those 5 years).  IRS tracked the amount of qualified dividends repatriated under this  provision and found that 843 corporate owners of CFCs reported the  receipt of $312.3 billion in qualified dividends from tax years 2004 through  2006. Only $9.1 billion of this total was repatriated during tax year 2004,  the year on which most of our data analyses are based. At various points  below we discuss how this tax provision may make some of our specific  results for 2004 differ from those of surrounding years.

		Income Reporting on Financial Statements

Publicly traded corporations are required to produce financial statements  according to guidelines established by the Financial Accounting Standards  Board. The income reporting in these financial statements (commonly  known as book income) differs in important ways from the income that  the corporations report on their federal tax returns. One key difference is  that book income will include a parent corporations’ share (in proportion  to its ownership share) of all of the income of all subsidiaries, both  domestic and foreign, in which it has at least a 20 percent ownership  stake. Other differences arise because income reported for tax purposes  reflects the effects of various incentives and disincentives embedded in  the tax code (such as accelerated depreciation to encourage investment  and limits on deductible compensation to discourage excessive payments).
In the early 1980s, the Joint Committee on Taxation developed an  approach for using book income and taxes to estimate effective tax rates  of foreign taxes on foreign-source income, U.S. taxes on domestic income,  and worldwide tax on worldwide income. A limitation of this approach  was that the book measures of taxes did not allow a distinction between  U.S. taxes paid on domestic income and the U.S. residual tax on foreign- source income. This limitation can be overcome by using data from  Schedule M-3 of the federal tax return, which just recently became  available to researchers.

		Information Available from Schedule M-3

Beginning with tax year 2004, U.S. domestic corporations with assets of  $10 million or more are required to include the Schedule M-3 in their tax  returns. This schedule requires taxpayers to provide a more detailed  reconciliation of their book income and their tax income than what was  required in earlier years. Data from the Schedule M-3 allow for the  computation of effective tax rates, with some limitations, that use book  measures of income and taxes actually reported on returns. As a result,  one can take advantage of the broader scope of foreign-source income  reported in financial statements and the more detailed information on  taxes paid, which permits a separation of U.S. taxes paid on domestic and  foreign income. However, some data limitations remain (these are  discussed in detail in app. I). The most significant limitation is that the  data do not permit a comprehensive measurement of foreign income  without some double counting of income. This limitation is best addressed  by estimating a range of effective tax rates for foreign income using  alternative measures of income. The most inclusive measure is likely to  contain some double counting and, therefore, cause an understatement of  the effective rate. The least inclusive measure avoids double counting but  will leave out some income that should be included, causing an  overstatement of the effective rate. The true effective tax rate should be  between the upper and lower bound of this range.

	Effective Rates of Tax on the Income of Large U.S. Corporations Vary Considerably Both in the United States and across Foreign Locations

The weighted average U.S. effective tax rate on the domestic income of  large corporations with positive domestic income in 2004 was 25.2  percent, while the median effective tax rate for this population of  corporations was 31.8 percent. However, as figure 1 shows, under these  two summary measures there was considerable variation in effective tax  rates across taxpayers. At one extreme, 32.9 percent of the taxpayers,  accounting for 37.5 percent of income, had average effective tax rates of  10 percent or less; at the other extreme, 25.6 percent of the taxpayers,  accounting for 14.8 percent of income, had effective tax rate over 50  percent. The average effective tax rates for the remainder of the  taxpayers were fairly evenly distributed between these two extremes.

		The Residual U.S. Average Effective Tax Rate on the Foreign Income of Large U.S. Corporations in 2004 Was Less Than 5 Percent

In order to address limitations in the available income data, we estimated  the residual U.S. average effective tax rate on foreign-source income using  three alternative income measures. Our estimates of the weighted average  effective tax rates for large taxpayers with positive foreign income ranged   from 3.9 percent to 4.2 percent, depending on which income measure we  used. The true weighted average should fall somewhere within this range.
The residual U.S. average effective tax rates on foreign income are very  low for a combination of reasons that make this measure conceptually  quite different from our effective tax rate on domestic income. First, in  cases where a U.S. MNC has paid foreign income taxes at a rate that is  close or equal to the U.S. tax rate, the U.S. foreign tax credit eliminates  most or all of the U.S. tax liability on that corporation’s foreign-source  income. Second, in many cases a substantial portion of the foreign-source  income earned by U.S. MNCs is not taxed until it is repatriated to the  United States. The denominator of our tax rate reflects all of the foreign  income that was earned in 2004, but the numerator includes only taxes  that were actually paid in 2004. Consequently, the numerator does not  include any tax on nonrepatriated 2004 income; however, it does include  tax on repatriated dividends paid out of income that CFCs earned prior to  2004. It is important to recognize that tax deferral does not necessarily  mean that the tax will never be paid.
Figure 2 presents estimates for the distribution of effective tax rates that  are based on our broadest income measure. The distributions of effective  tax rates based on our other income measures did not look dramatically  different. Approximately 80 percent of the large taxpayers with positive  foreign income, accounting for about 30 percent of that population’s total  foreign income, paid no federal income tax on that income. An additional  8.5 percent of this population, accounting for about 52 percent of the  foreign income, had positive average effective U.S. tax rates of 5 percent  or less. Less than 10 percent of this population had effective tax rates over  10 percent. The taxpayers with the higher effective rates may have had  relatively high ratios of repatriations over current-year income from their  CFCs, or the dividends that they repatriated may have been paid out of  income earned in relatively low-tax locations.
Due to the incentives under the American Jobs Creation Act of 2004, the  ratio of repatriations to CFC income may have been different in 2004 than  it was in surrounding years. Some U.S. MNCs may have delayed  repatriations in the year or two prior to the year in which the made a one- time “extraordinary” dividend payment, so that their repatriations first  were lower than normal, then became higher than normal. The timing of  this behavior could have varied across firms, depending on when their  management became sufficiently confident that the tax preference would  be enacted, the timing of their tax years, and other factors. The IRS data  on repatriated income presented earlier suggest that the 2004 ratio of  repatriations is likely to be lower than the ratio for 2005 and, perhaps,  2006. The effects of these differences on the average effective rates of tax  on foreign-source income in all of those years are uncertain. On the one  hand, a higher rate of repatriation would mean that more of the CFCs’  income would become subject to U.S. taxation in that year; on the other  hand, the temporary deduction would effectively exclude 85 percent of the  repatriations from U.S. taxable income.

		Tax Credits Have a Relatively Small Effect on U.S. Average Effective Tax Rates

We estimated the effect of federal income tax credits (other than the  foreign tax credit) on U.S. average effective tax rates by computing rates  before and after the inclusion of the credits. We found that these credits  reduced the precredit tax liabilities on domestic income by a weighted  average 1.7 percentage points (from 26.9 percent to 25.2 percent). We also  found that tax credits reduced the precredit tax liabilities on foreign- source income by a weighted average 0.8 percentage points. These  estimates indicate the extent to which tax preferences in the form of tax  credits reduce corporate tax burdens. We have no way to precisely  measure the effects of other forms of tax preferences, such as exemptions  or accelerated depreciation. These other forms of preferences explain  some of the differences between the precredit effective tax rates shown in  figure 1 and the 35 percent statutory rate; however, there are differences  between book and tax income that are not tax preferences that also  explain some of the differences.

		Average Effective Tax Rates on the Worldwide Income of U.S. Controlled Foreign Corporations Vary Widely by Principal Place of Business

The U.S. average effective tax rates that we presented above do not reflect  the taxes that U.S. businesses pay on their foreign-source income to  foreign governments. The effective rates of foreign tax are likely to be one  of several factors that influence the specific location of U.S. business  activity abroad. Economists have used different approaches to estimate  these effective foreign taxes. Each of these approaches has limitations;  however, when used in combination, these approaches provide broadly  consistent effective tax rate rankings for many important locations of U.S.  business activity.

			Effective Tax Rates on All CFCs with Positive Income in 2004

One estimation approach used by researchers with access to IRS tax data  has been to compute effective rates of tax paid by U.S. CFCs as the ratio of  the total income taxes that a CFC pays on its worldwide income, divided  by that worldwide income. The income from CFCs represents a significant  component of U.S. businesses’ foreign-source income. We used IRS data  on CFCs for 2004 to estimate that the average combined (U.S. and foreign)  effective tax rate on the worldwide income of CFCs (excluding those that  had negative income) was 16.1 percent. One limitation of this estimation  approach is that when aggregated, the CFC income data double counts  income earned by lower-tier CFCs that is distributed to higher-tier CFCs in  the form of dividends. We computed a separate effective tax rate for  manufacturing CFCs only, which exclude holding companies that may be  used to accumulate income from lower-tier CFCs. We found that the rate  for manufacturing CFCs, at 15.4 percent, was actually lower than the rate  for all CFCs. One possible explanation for this result is that, if U.S. MNCs  do route substantial amounts of dividends to holding company CFCs, the  dividend-paying businesses may be hybrid entities that are disregarded for  U.S. tax-reporting purposes rather than CFCs themselves. That practice  would make sense from a tax-planning standpoint. Under such an  arrangement, the income of the hybrid entities would not be reported  separately in the IRS data we used; it would be counted only once, as part  of the income of a higher-tier CFC.
Our estimate for the effective rate of tax on manufacturing CFCs is  significantly lower than the 21 percent effective rate that Altshuler and  Grubert estimated for manufacturing CFCs for tax year 2001. Those  authors noted that the effective tax rate has declined steadily from 33  percent in 1980. Our estimate suggests that effective rates may have  continued to drop since 2001. This decline predominantly represents a  reduction in the amount of tax paid to foreign governments, not to the  United States. Altshuler and Grubert conclude that a significant portion of  the effective tax rate reduction may be attributable to the increased tax- planning flexibility that U.S. MNCs have enjoyed since the introduction of  the check-the-box rules. Oosterhuis (2006) points to Altshuler and  Grubert’s recent estimates as evidence of how the check-the-box rules  have enabled U.S. MNCs to reduce their payments of foreign taxes.  Oosterhuis notes that, although a reduction in foreign taxes may make U.S.  MNCs more competitive overseas against foreign MNCs, it also makes  foreign investment by U.S. MNCs more attractive relative to investment in  the United States.
Another approach for estimating the effective tax rate on the foreign- source income of U.S. businesses is to use BEA’s data on the operations of  U.S. MNCs, which includes the amount of net income earned and foreign  taxes paid by foreign affiliates of these MNCs. In the case of U.S.  majority-owned foreign affiliates, the BEA data permit one to compute net  income with and without equity income. The latter measure of income  eliminates some important forms of double counting (discussed below).  An unavoidable limitation of BEA’s foreign affiliate income measure for  the purposes of estimating effective tax rates is that it includes negative  values for affiliates that incur losses. As a consequence, when the income  data are aggregated at the country level or for the full population, the net  value will be lower than the aggregate income of just those businesses that  are profitable. In the absence of any offsetting factors, effective tax rates  that have this income measure as the denominator will overstate the rates  that profitable businesses pay. Using data from BEA’s 2004 benchmark  survey, we estimate that the average effective tax rate on foreign affiliates  was 28.7 percent, significantly higher than our estimate based on CFC  data.

			Effective Tax Rates by Principal Place of Business

Although the CFC data may be preferable to the BEA data for estimating  an overall average effective tax rate for the foreign operations of U.S.  MNCs, the former data provide an imperfect basis for estimating average  effective tax rates for specific countries. Although the CFC data can be  aggregated by principal place of business, the allocation of income and  taxes paid by principal place of business is not perfectly correlated with  where the income and taxes of the CFCs are actually earned and paid  because some CFCs earn income and pay taxes in multiple locations. The  growing use of hybrid entities has likely reduced this correlation,  particularly for CFCs located in countries that are favored locations for  accumulating income. Some hybrids may formerly have been CFCs with  separate U.S. tax filing requirements that indicated where their principal  operations were located. Now, as hybrids, their income and tax data  would not be separated from that of the CFCs into which they have  become absorbed for U.S. tax-reporting purposes. Consequently, the data  for those hybrids are now associated with the country where the CFC has  its principal operations, rather than where the hybrid has its own  operations. In contrast, the BEA data treat the disregarded hybrid entities  as separate affiliates, and their data are associated with the countries  where their physical assets are located or where their primary activities  are carried out. An important exception to this general treatment applies  in the case of holding companies. When a corporation has physical assets  or operations in multiple foreign countries, it is classified as a holding  company and the assets assigned to its country of incorporation include  the equity that it holds in the operations in the other countries. Those  outside operations are reported as separate foreign affiliates, so when the  BEA data are aggregated there is some double counting of assets.
Figure 3 compares the three effective tax rates we estimated for 17 of the  most important foreign locations of U.S. MNC operations, based on their  shares of various measures of U.S. business activity. In most cases the  effective tax rates based on BEA data are higher than those based on  either set of CFC data. Despite the variation in results from the three  different measures, one subset of countries (shown in the top panel) can  be identified as having relatively low effective rates of tax on the U.S.  business operations located there. Similarly, a subset of countries (shown  in the middle panel) has relatively high rates (over 18 percent) by any of  the three measures. Of the remaining four countries, Australia is near the  boundary between high and low effective rates by all three measures, the  Netherlands and the United Kingdom are shown to have low effective tax  rates according to the CFC data but high rates according to the BEA data,  and Luxembourg appears to have very low overall effective tax rates, but  not for manufacturing CFCs. Later in the report we show how the  distribution of activity by foreign affiliates of U.S. MNCs differs across  these three groups of countries.

		The Repatriated Foreign- Source Income of U.S. Corporate Taxpayers Is Composed of Various Types of Income

We were not able to disaggregate the worldwide income of U.S. corporate  taxpayers by character of income with the data that were available.  However, we were able to present such a disaggregation for an important  form of income: the foreign-source income that was subject to the federal  income tax (prior to the application of foreign tax credits) in 2004. Figure  4 shows that no single form of income predominates. “Grossed-up”  dividend income, the largest type of income, accounted for 24.6 percent of  this foreign-source income. The next most important type of income (that  could be broken out separately) was that from foreign branch operations  (direct foreign operations of U.S.-based corporations that were not  established as separate legal entities) with a 20.2 percent share, followed  by rents, royalties, and license fees with a 16.5 percent share.

		Estimates from Other Studies of Effective Tax Rates on Corporations Based in Foreign Countries Are Consistent with Our Estimates for Some Countries but Not for Others

The various estimates of effective rates of tax that we have presented up  to this point have covered only U.S. businesses (those that are  incorporated in the United States or whose parent corporations are). We  reviewed the relevant economic literature to determine what information  is available about effective tax rates imposed on all corporations based in  specific foreign countries. We identified four studies that used  corporations’ financial statement information to compare the average  effective tax rates corporations pay across multiple foreign countries. The  studies we identified estimated rates of total worldwide taxes paid on total  worldwide income for corporations based in countries in the European  Union and in Canada, the United States, Japan, and Australia. The two  studies that covered corporations based in the European Union during the  1990s reported similar rankings of countries by average effective tax rates,  although exact estimates varied across alternative measures using  different measures of income (see fig. 8 in app. IV). Ireland and Austria  had the lowest rates at around 20 percent or less, while Italy and Germany,  with rates over 35 percent, had the highest. The two other studies, which  covered limited selections of countries, suggested that effective tax rates  in the United States, the United Kingdom, Germany, France and Australia  were within 5 percentage points of each other, while Canada had a  significantly lower rate and Japan a significantly higher rate. A  comparison of the country rankings based on these estimated effective tax  rates for all corporations and the rankings based on our estimates of  effective rates for U.S. CFCs and other foreign affiliates of U.S. MNCs  reveals both consistencies (low rates for Ireland and high rates for Italy  and Japan) and inconsistencies (in the cases of Netherlands and the  United Kingdom).

	A Growing Share of U.S. Businesses’ Activity Is Located Abroad, and the Sourcing of Income Appears to Be Influenced by Foreign Country Tax Rates

Business activity can be measured in a variety of ways and the location of  these activities can be influenced by numerous factors, with certain  factors having greater influence on some activities than on others. For  example, taxes, wage rates, the availability of skilled labor, and proximity  to natural resources or to final product markets can all influence where  businesses decide to locate production facilities; however, wage rates are  likely to be particularly important for the location of low-skilled, labor- intensive operations, while access to a highly educated workforce may  have greater influence on the location of scientific research activities. Tax  regimes—both those of the United States and of foreign countries—will  have some influence over where business activity is actually located;  however, they also provide some incentive for businesses to report net  income as coming from locations other than where factors of production,  such as labor and physical capital, actually generated the income. This  shifting of income may be reflected in income data BEA and other  agencies gather from businesses as well as in data on related items, such  as sales and value added. In contrast, measures such as physical assets,  employment, and compensation are less likely to be debatably sourced  because of tax considerations. These practices make it difficult to  determine the extent to which the distribution of some of the business  activities that we present below reflects the actual, as opposed to just the  reported, location of the activities.

		Most of the Activity of U.S. MNCs Remains Located in the United States, but the Share of Activity Located Abroad Has Increased

Figure 5 shows the trends across the last four BEA benchmark studies of  U.S. MNC operations (1989–2004) for six key measures of business  activity: value added, sales, physical assets, compensation of employees,  number of employees, and pretax income excluding income from equity  investments. Each bar in the graph shows how the aggregate amount of a  particular activity was divided between operations of U.S. parent  corporations (including any of their domestic subsidiaries) and the  operations of the majority-owned foreign affiliates of those parent  corporations. Business activity by all measures increased in absolute  terms both domestically and abroad during this period, but the relative  share of activity that was based in foreign affiliates increased.  Nevertheless, as of 2004, over 60 percent of the activity (by all six  measures) of U.S. MNCs remained located in the United States.

		The Extent to Which Activity Is Located Abroad Varies by Industry

Figure 6 compares the division of activity between U.S. and foreign  operations across the three largest industries—manufacturing, finance and  insurance (excluding depository institutions), and wholesale trade. The  height of each bar in the figure represents the industry’s share of total  worldwide activity of U.S. MNCs. The division of each bar indicates how  that particular measure for the industry is divided between U.S. and  foreign operations. Manufacturing accounts for the largest share of all six  measures of activity. Among these three industries finance and insurance  has the lowest share of its activity (by all measures) located abroad, while  wholesale trade generally has the largest share (except for physical  assets). For example, only 19 percent of employment in finance and  insurance was located abroad in 2004, while 36.2 percent of manufacturing  employment and 42.9 percent of wholesale employment was located in  foreign operations that year.
We can track activity by industry consistently back to 1999 only (due to a  change in industrial classifications prior to 1999). The most significant  difference between these three industries’ shares of overall activity in 1999  and what is shown for 2004 is that manufacturing’s share of total value  added, physical assets, and pretax net income (excluding income from  equity) all declined by 4 to 5 percentage points during that interval. At the  same time, the proportions of manufacturing’s value added, physical  assets, and pretax net income that were located abroad increased from an  average of about 25 percent to an average of about 30 percent. There were  no significant changes in the shares of the finance and insurance industry.  The only significant change in the wholesale trade industry is that its share  of total pretax net income (excluding income from equity) increased by 6  percentage points from 1999 to 2004.

		Tax Rates Appear to Have Some Influence over the International Location of Income

Figure 7 clearly reveals a relationship between effective tax rates and the  size of a country’s income shares relative to its shares of the other  measures of business activity. The figure shows the share of the various  measures of U.S. multinational business activity in 2004 for the 17  important foreign locations that we presented in figure 3. The measures  include the five nonincome statistics from the previous figures (shown by  the darker bars) plus three measures of net income (shown by the lighter  bars). The first two income measures are pretax net income from the BEA  data, excluding and including income from equity investments. The third  income measure is net earnings and profits from the CFC data. With the  exception of China, all of the countries with relatively low effective rates  of tax have income shares that are significantly larger than their share of  the three measures least likely to be affected by income-shifting practices:  physical assets, compensation, and employment. This relationship holds  for all three income measures. In contrast, all of the countries with  relatively high effective tax rates, except for Japan, have income shares  that are smaller than their shares of physical assets, compensation, and  employment. Of the four countries with a mix of both high and low  estimated effective tax rates, the United Kingdom bears a similarity to the  high-tax pattern and Luxembourg to the low-tax pattern, while Australia is  balanced across all eight measures. The Netherlands has a balanced  pattern when income is measured in terms of the BEA data without equity  income; however, it has an extremely large proportion of equity income  relative to other types of net income. Luxembourg, the United Kingdom  Caribbean Islands (and, to a lesser extent, Bermuda and Switzerland) also  have significant shares of income from equity investments. IRS data on  dividends repatriated by U.S. MNCs claiming the temporary dividend  deduction indicates that the Netherlands, Switzerland, and Bermuda were  the three largest sources of such repatriations. Luxembourg and the  Cayman Islands were also among the top eight sources (along with  Ireland, Canada, and the United Kingdom). Income from equity  investments was not prominent in any of the 17 countries in 1989 (see app.  III). The growth in this category of income from 1989 through 2004 is  consistent with observations made by others that the 1997 check-the-box  rules have significantly affected the tax planning of U.S. MNCs. Data are  not yet available to show whether this accumulation of equity income in  certain countries was largely a temporary phenomenon, leading up to  repatriations made from 2004 through 2006.
The United Kingdom and Canada dominate all of the measures of activity,  except for income. Germany also has at least a 5 percent share of all of the  nonincome measures. Mexico, China, and Brazil have employment shares  that are disproportionate to their shares of the other activity measures.  This fact is not surprising, given that these are the three countries with the  lowest wage rates out of the 17 (which is apparent from the relative sizes  of their compensation and employment shares). Compared to 1989, the  share of U.S. business activity, particularly physical capital, that is located  in Canada has declined noticeably. This is also true, to a lesser extent, for  Germany.
Research and development is one more measure of business activity (not  included in figs. 5 through 7 because it is more narrowly focused than the  other measures) that is significant. The United Kingdom, which accounted  for 20.7 percent of all research and development performed by foreign  affiliates of U.S. MNCs, was the primary location for this activity in 2004,  followed by Germany (16.2 percent share) and Canada (10.6 percent  share). Japan’s share of this research and development activity fell from  12.6 percent in 1989 to 6.3 percent by 2004. Among the countries whose  shares increased the most over that period were Sweden (from 0.4 percent  to 5.6 percent) and Israel (from 0.4 percent to 3.4 percent).

	Agency Comments

We provided a draft of this report in July 2008 to the Secretary of Treasury  for review and comments. Officials from the Department of the Treasury’s  Office of Tax Policy provided technical comments, which we incorporated  as appropriate.
As we agreed with your offices, unless you publicly announce the contents  of this report earlier, we plan no further distribution of it until 30 days  from the date of this letter. We will then send copies to others who are  interested and make copies available to others who request them. This  report is available at no charge on GAO’s web site at http://www.gao.gov.  If you or your staff have any questions on this report, please call me at  (202) 512-9110 or whitej@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix V.

Appendix I: Details of the Methodology for Estimating Effective Tax Rates

	Average Effective Tax Rates of Schedule M-3 Filers

		Data Consistency Checks

Tax year 2004 was the first year for which corporations had to file the new  Schedule M-3. Consequently, there was likely to be a higher rate of  taxpayer error in filling out the form than there is for most forms that have  been in use for many years. We ran a number of internal consistency  checks and, to the extent possible, corrected common errors, guided by  the findings of previous researchers. We dropped all cases that had  uncorrectable errors in the data elements that were key to our analysis.  These exclusions reduced our population of corporations that filed  nonblank Schedule M-3s from 34,154 to 28,820. This final population of  corporations accounted for 95 percent of the book income of the  population of all Schedule M-3 filers.

		Calculating Domestic Income

To calculate domestic income we began with the book value of income of  the tax includible group and subtracted foreign-source income that is  includible. Specifically, our Schedule M-3 domestic income = book income  (Schedule M-3, Part I, line 11) –foreign equity method income (Schedule  M-3, Part II, line 1) – gross foreign dividends (Schedule M-3, Part II, line 2)  – gross foreign distributions (Schedule M-3, Part II, line 5) – domestic  equity method (Schedule M-3, Part II, line 6) – minority interest reduction  (Schedule M-3, Part II, line 8) – foreign partnership income (Schedule M-3,  Part II, line 10). This measure is designed to be closer to a tax consolidated  group measure by removing the less than 80 percent owned domestic  subsidiaries. It includes the total income of domestic tax consolidated  subsidiaries, excludes the income of nonincludible domestic subsidiaries  (ownership less than 80 percent), but includes the dividends of  nonincludible domestic subsidiaries and partnership income.
There are some limitations to this measure of income. While foreign  income is excluded through the conversion from the financial  consolidated group to the tax consolidated group and the removal of  foreign dividends, adjustments made in line 8 in Part I of the Schedule M-3  could result in the improper inclusion of foreign royalties and other  foreign payments. In addition, the 2004 Schedule M-3 did not require  taxpayers to fill in all of the columns in Part II. Line 10, foreign partnership  income and lines 2 and 5, foreign dividends and distributions, are reported  both under financial and tax rules but are not listed separately on the  Form 1120. We perform a sensitivity analysis by excluding observations  that did not complete all columns. (We do the same for our measures of  foreign-source income, described below.)

		Calculating Foreign Income

The data from the Schedule M-3 does not allow us to derive a  comprehensive measure of foreign-source income without double  counting certain types of income. For this reason, we provide estimates  based on three alternative measures of foreign income. Our estimates  based on one of these measures likely overstate the effective tax rate,  while estimates based on an alternative measure likely understate the  rates. Consequently, our range of estimates represents an upper and lower  bound for the true rate.
Our broadest measure of foreign income includes the book income of  majority owned foreign subsidiaries (reported on lines 5a and 5b in Part I  of the Schedule M-3), plus equity-method income from foreign subsidiaries  (reported on line 1 in Part II of the Schedule M-3), plus dividends and  distributions from foreign subsidiaries (reported on lines 2 and 5 in Part II  of the Schedule M-3). The problem with this broad measure is that it likely  double counts some income in the aggregate. Lines 5a/b list 100 percent of  the income of majority owned foreign subsidiaries, even if the taxpayer  filing the Schedule M-3 owns less than 100 percent of the subsidiary. Thus,  5a/b overstates the consolidated group’s share of the income or loss of  majority owned foreign subsidiaries. This reporting limitation, by itself,  would not be a problem for our aggregate measure of the foreign income  of Schedule M-3 filers, except to the extent to which the minority owners  of the less-than-100-percent-owned subsidiaries are not Schedule M-3 filers  themselves. However, a larger potential overstatement problem arises  when we include equity-method income and dividends and distributions in  our measure. For example, if a foreign subsidiary is owned 75 percent by  one U.S. parent and 25 percent by a second U.S. parent, line 5a/b would  provide 100 percent of the income of the foreign subsidiary and line 1 in  Part II of the Schedule M-3 providing the equity method income of foreign  subsidiaries would add another 25 percent of the income of that  subsidiary. Similarly, including the dividends and distributions in lines 2  and 5 in Part II of the Schedule M-3 would double count that income in  cases where it is already counted on another Schedule M-3 filer’s line 5a/b  or line 1 in Part II of the Schedule M-3.
Our second measure of foreign income starts with our broadest measure  and then excludes equity-method income. Our third measure excludes  both equity-method income and dividends and distributions. In contrast to  our broadest measure, our third measure is likely to understate foreign- source income in cases where Schedule M-3 filers share ownership of their  less-than-100-percent-owned foreign subsidiaries with majority  shareholders other than Schedule M-3 filers. For example, if U.S. Parent A  owns 70 percent of foreign subsidiary 1 and U.S. Parent B owns 30 percent  of foreign subsidiary 1 and 25 percent of foreign subsidiary 2 and a foreign  parent owns 75 percent of foreign subsidiary 2, line 5a/b would provide  100 percent of the income of foreign subsidiary 1, but none of the income  of foreign subsidiary 2. In addition, excluding dividends and distributions  would exclude any income from less-than-20-percent-owned foreign  subsidiaries if those subsidiaries are majority owned by a shareholder  other than a Schedule M-3 filer.
We compute our various effective rate estimates only for those taxpayers  that had positive domestic income, foreign income, or both. Table 3 shows  how many taxpayers had positive, negative, or zero values for domestic  and foreign income and the aggregate value of that income for our  broadest and narrowest measures of income.
We computed effective tax rates before credits, after credits, and after  credits and other taxes. The tax code does not specify that tax credits  (other than the foreign tax credit) be allocated in any particular manner  between U.S. tax on domestic income and U.S. tax on foreign-source  income. We simply assume that these credits are allocated against U.S.  taxes on domestic income and U.S. residual taxes on foreign-source  income in proportion to each of those taxes’ share of total U.S. tax.
To calculate U.S. taxes on domestic income, we began with regular tax  liability and removed the foreign tax credit limit because the latter  represents the initial U.S. tax due on foreign-source income before any  credits are given for foreign taxes paid. Specifically, U.S. tax on domestic  income before credits is calculated as regular tax liability (Form 1120,  Schedule J, line 5) – the sum over each income type of foreign tax credit  limitation (Form 1118, Schedule B, line 10). Taxpayers are required to file  a separate Form 1118 for each category of income, so we added the  separate limits from these forms together to obtain the total foreign tax  credit limit on repatriated foreign income.
This calculation provides the U.S. tax on domestic income regardless of  whether the corporation had excess credits because the credit limit is  essentially the initial US tax (before foreign tax credit) on foreign-source  income. If the corporation has an excess of foreign tax credits, then there  is no residual U.S. tax on repatriated foreign income and the U.S. tax on  domestic income is found by removing the initial U.S. tax on repatriated  foreign income (the credit limit) from the US tax on worldwide income  (Form 1120 tax liability without foreign tax credit). If the corporation is  below the credit limit, then there is a residual US tax on repatriated  foreign income, which would be included separately in the U.S. taxes on  foreign-source income measure. In that case the U.S. tax on domestic  income is found by removing the initial U.S. tax on repatriated foreign  income (the credit limit) from the U.S. tax on worldwide income (Form  1120 tax liability without foreign tax credit). In both cases, the foreign tax  credit limit represents the potential tax due on foreign-source income, and  by removing it the remaining tax is on domestic income.
U.S. residual tax on foreign-source income was calculated as the  difference between the foreign tax credit limit and the foreign tax credit  (with any negative values treated as zeros). Specifically, it equals the  greater of: the sum over the income types of the foreign tax credit limit  (line 10 on Form 1118, Schedule B) – foreign tax credit (line 11 on Form  1118, Schedule B) or 0 for each type of income. The U.S. residual tax on  foreign-source income is zero if the corporation has paid substantial  foreign taxes such that its foreign tax credit limit is binding. For example,  if a corporation paid taxes in a single country with a tax rate of 40 percent,  the United States would not collect any residual tax on the repatriated  income because the taxes paid abroad would be greater than the taxes due  in the United States at the corporate rate of 35 percent. The residual tax is  positive as long as the corporation’s creditable foreign taxes paid are  below the foreign tax credit limit. For example, if a corporation paid taxes  abroad at a rate of 10 percent, the United States would tax that income at  35 percent and thus collect a residual tax over the credit for the tax paid  abroad.

		Allocating Credits

To compute estimates of the domestic effective tax rates on domestic and  foreign-source income after credits, we allocated credits according to the  income sources’ shares of total tax. Specifically, U.S. tax on domestic  income after credits equals the total U.S. domestic tax before credits  minus total other credits times the domestic tax share of total U.S. and  foreign tax liability before the application of credits. Total other credits  equal the total credits (line 7 on the Form 1120, Schedule J) minus the  foreign tax credit (line 6a on the Form 1120, Schedule J). Similarly, we  also estimated effective tax rates after credits and other taxes by the same  formula, substituting total credits and other taxes for total credits. Total  credits and other taxes equal regular tax minus final tax liability minus the  foreign tax credit (line 5 – line 11 – line 6a on Schedule J of the Form  1120). The credits and other taxes are applied to the final taxes, which  include both domestic tax on domestic income and residual domestic tax  of repatriated foreign income.

	Average Effective Tax Rates for CFCs

We followed the methodology used by Altshuler, Grubert, and Newlon  (1998) and Altshuler and Grubert (2006) to estimate average effective tax  rates using data from Internal Revenue Service’s Statistics of Income  Division’s Form 5471 study for 2004. SOI’s 2004 CFC study changed from a  defined population study (7,500 largest CFCS of the largest parent  corporations) to a sample of CFCs that included all Form 5471’s filed by all  corporations in the SOI corporate study. We restrict our sample to CFCs  associated with U.S. corporations sampled at 100 percent. The effective  rate was computed as the income taxes paid (line 8 on Form 5471,  Schedule E) divided by pretax earnings and profits. Pretax earnings and  profits were calculated as final earnings and profits on line 5d of Form  5471, Schedule H plus the total income taxes paid (line 8 on Form 5471,  Schedule E). We restricted our analysis to CFCs with positive pretax  earnings and profits and nonnegative foreign taxes paid. We computed the  effective tax rates by primary place of business, as reported by the CFCs,  by aggregating the taxes paid and positive earnings for all CFCs reporting  the same principal place of business and then taking the ratio.

Appendix II: BEA Data Used in This Report

Bureau of Economic Analysis (BEA) data provide a wide array of data  items on multinational corporations (MNC) cross-classified by country  and industry. The financial and operating data are collected by BEA in two  types of surveys—benchmark and annual, authorized by a law known as  the International Investment and Trade in Services Survey Act. On both  surveys, the data are collected at the enterprise, or company, level and are  classified according to the primary industry of the enterprise. The annual  survey estimates are a collection of sample data reported to BEA on U.S.  direct investment abroad in the annual survey and the estimates of  affiliates that were not in the sample. The sample is a cutoff sample, with  reporting thresholds significantly higher than those on the benchmark  surveys. To obtain universe estimates of the overall operations of parents  and affiliates for nonbenchmark years, data reported in the benchmark  surveys for nonsample companies are extrapolated forward, based on the  movement of the sample data in the annual surveys. We relied on the BEA  benchmark surveys, which are conducted every 5 fiscal years because the  universe in the benchmark surveys did not pose the sample limitations of  the annual surveys. Selected tables from the final 2004 benchmark survey  results, including the tables needed for the charts in this report, are  available on the BEA Web site under Operations of Multinational  Companies, U.S. Direct Investment Abroad, Financial and Operating Data,  Selected Tables, IID Product Guide, Revised 2004 Estimates. Final  benchmark survey data results are available for all previous years.
The benchmark surveys covered every U.S. person who had a foreign  affiliate—that is, who had direct or indirect ownership or control of 10  percent or more of the voting securities of an incorporated foreign  business enterprise or an equivalent interest in an unincorporated foreign  business enterprise—any time during its reporting fiscal year. A completed  benchmark survey form was required for affiliates that had total assets,  sales, or net income (or losses) greater than a minimum set value per  reporting year, so the trend data we present refer to information on U.S.  businesses that met the reporting requirement. Data on all of the  benchmark surveys were required to be reported as they would have been  for stockholders’ reports rather than for tax or other purposes. Thus, U.S.  generally accepted accounting principles were followed unless otherwise  indicated by the survey instructions.
The 1999 benchmark survey marks the first year that annual and  benchmark survey data on U.S. direct investment abroad have classified  industries using BEA’s International Survey Industry (ISI) classification  system that is based on the 1997 North American Industry Classification  System (NAICS). Therefore, trend analysis by industry is not comparable  before and after this change. Our ability to provide details of worldwide  activity by country and industry were limited by BEA’s suppression of  aggregate data when they represented a small number of corporations that  accounted for a relatively large portion of the aggregate total. Under the  International Investment and Trade in Services Survey Act, the direct  investment data collected by BEA are confidential.
We contacted BEA to ensure that the data collection encompassed the  universe of worldwide activity of U.S. companies and their foreign  affiliates. BEA’s methodology for benchmark survey results notes that  because of limited resources, BEA’s efforts to ensure compliance with  reporting requirements focused mainly on large parents and affiliates.  Some parents of small affiliates that were not aware of the reporting  requirements and were not on BEA’s mailing list may not have filed  reports. BEA believes that the omission of these parents and their affiliates  probably has not significantly affected the aggregate values of the various  data items collected but would have caused an unknown, but possibly  significant, understatement of the number of parents or affiliates.

Appendix III: Additional Data on the Location of Business Activity

Pretx income (no equity)

Appendix IV: Studies of Effective Tax Rates in Foreign Countries That Include Non-U.S. Businesses

We identified four studies that used corporations’ financial statements to  compare the average effective tax rates of corporations across multiple  foreign countries. All of these studies produced estimates for multiyear  periods during the 1990s. There is considerable overlap in the  methodologies across the four studies; however, there are some variations  in the measures of effective tax rate used, even within some of the studies.  Buijink, Janssen, and Schols (2000) and Gorter and de Mooij (2001) both  use consolidated financial statements from the Worldscope financial  statement database to estimate effective tax rates for countries in the  European Union. Buijink, et al. use two different measures: the first is a  simple ratio of income taxes paid over pretax book income (before equity  income, minority interest income, and extraordinary income); in their  second measure they adjust income taxes for the net change in deferred  taxes. Gorter and de Mooij’s effective tax rate measure is calculated as the  ratio of corporate income taxes paid over pretax corporate income. The  results from these two studies are summarized in figure 9.
Collins and Shackelford (2003) and Chennells and Griffith (1997) both use  Standard and Poor’s Compustat Global database to estimate effective tax  rates for small selections of major industrial nations (see figure 10). The  Compustat Global database is limited to information on foreign firms that  people have requested and, therefore, is likely not to be a representative  sample of companies, but weighted toward larger and more recognized  firms. While Collins and Shackelford provide estimates of effective tax  rates separately for multinational firms, the average effective tax rates  listed in figure 10 are for all companies. They use an effective tax rate  measure similar to the second measure used by Buijink, et al.; they also  compute an alternative estimate that uses a less comprehensive measure  of income, but one that has greater comparability across countries. The  authors address the outlier issue by excluding cases with negative tax  rates or rates over 70 percent. Chennells and Griffith’s effective tax rate  measure is similar to the first measures of Collins and Shackelford and  Buijink, et al., except that they do not make the adjustment for deferred  taxes.

Appendix V: GAO Contact and Staff Acknowledgments

	Acknowledgments

In addition to the contact named above, James Wozny, Assistant Director;  Susan Baker; Sylvia Bascope; Kathleen Easterbrook; Jennifer Gravelle; Ed  Nannenhorn; and Cheryl Peterson made key contributions to this report.

Summary:
Why GAO Did This Study

U.S. and foreign tax regimes influence decisions of U.S. multinational corporations (MNC) regarding how much to invest and how many workers to employ in particular activities and in particular locations. Tax rules also influence where corporations report earning income for tax purposes. The average effective tax rate, which equals the amount of income taxes a business pays divided by its pretax net income (measured according to accounting rules, not tax rules), is a useful measure of actual tax burdens. In response to a request from U.S. Senate Committee on Finance, this report provides information on the average effective tax rates that U.S.-based businesses pay on their domestic and foreign-source income and trends in the location of worldwide activity of U.S.-based businesses. GAO analyzed Internal Revenue Service (IRS) data on corporate taxpayers, including new data for 2004 and Bureau of Economic Analysis data on the domestic and foreign operations of U.S. MNCs. Data limitations are noted where relevant. GAO is not making any recommendations in this report.

What GAO Found

The average U.S. effective tax rate on the domestic income of large corporations with positive domestic income in 2004 was an estimated 25.2 percent. There was considerable variation in tax rates across these taxpayers. The average U.S. effective tax rate on the foreign-source income of these large corporations was around 4 percent, reflecting the effects of both the foreign tax credit and tax deferral on this type of income. Effective tax rates on the foreign operations of U.S. MNCs vary considerably by country. According to estimates for 2004, Bermuda, Ireland, Singapore, Switzerland, the United Kingdom (UK) Caribbean Islands, and China had relatively low rates among countries that hosted significant shares of U.S. business activity, while Italy, Japan, Germany, Brazil, and Mexico had relatively high rates. U.S. business activity (measured by sales, value added, employment, compensation, physical assets, and net income) increased in absolute terms both domestically and abroad from 1989 through 2004, but the relative share of activity that was based in foreign affiliates increased. Nevertheless, as of 2004, over 60 percent of the activity (by all six measures) of U.S. MNCs remained located in the United States. The U.K., Canada, and Germany are the leading foreign locations of U.S. businesses by all measures except income. Reporting of the geographic sources of income is susceptible to manipulation for tax planning purposes and appears to be influenced by differences in tax rates across countries. Most of the countries studied with relatively low effective tax rates have income shares significantly larger than their shares of the business measures least likely to be affected by income shifting practices: physical assets, compensation, and employment. The opposite relationship holds for most of the high tax countries studied.