Jesse Drucker of Bloomberg recently published an article discussing a cross-border tax strategy known as the “Double Irish.” Under this structure, large U.S.-based multinational corporations set up manufacturing operations in Ireland, but record most of their profits in Bermuda.
According to the article, the profits of the Irish/Bermuda subsidiary are subject to an effective tax rate of 2.4%. The Irish subsidiary profits are often attributable to products sold in the U.S. With U.S. federal and state corporate income tax rates in the range of 40%, these multinationals substantially reduce their effective tax rates by shifting profits (and often jobs) outside the U.S.
With such a tax rate differential, multinationals put forth significant efforts into substantiating why their Irish/Bermuda operations should be so profitable. The profits are shifted to Ireland in related party transactions. The multinationals must apply the “arms-length” standard for transactions between related parties.
The arm’s length standard requires a hypothetical analysis --- “How would the related parties have acted if they were not related?” Of course, the parties are related. Therefore, they will structure their operations in a way that provides them the most benefit when the hypothetical analysis is performed. The hypothetical analysis is very fact intensive and the multinationals have the best access to the facts and they can even manipulate the facts to their best advantage.
Typically, an arm’s length “range” is determined and as long as the related party transactions are within that range, the transactions are respected. The I.R.S. often determines that the related party transactions are not within the proper range, but the multinationals seem to have the upper hand. Some penalties already exist in this area. However, they do not seem to be effective.
Congress recently enacted penalties in the tax shelter area where taxpayers are found to lack economic substance. An interesting aspect of these new penalties is that there is no “reasonable cause” exception. If there is no economic substance, the penalty applies. Commentators have noted that this new “strict liability” penalty will likely deter aggressive tax shelter planning.
Should a new strict liability penalty be created for related party transactions? Perhaps the penalty would apply only if the transactions are "materially" outside of the arm’s length range or if the profits were outside the range and were ultimately shifted to a low tax jurisdiction. Such a penalty might deter aggressive tax planning for multinational related party transactions. In fact, it might even discourage (rather than encourage) the transfer of jobs overseas.