One of the ideas floating in diplomatic circles and in Congress is the concept of minimum corporate income taxes.  To understand what is being discussed, it is important to understand some basics of corporate law and income tax law as it applies to businesses.

Corporations come in all shapes and sizes.  They range from small charities to your local independent grocery store to big multi-nationals.  What they all share in common derives from the basic concept of the corporate structure — that the corporation is an independent legal person.  This basic concept allows people to become “owners” of the corporation — either shareholders who make money from the profits in a for-profit organization or as members who merely support and have a vote in electing the governing body in not-for-profit organizations.  The key thing for both is that, unless you participate in the management and do something that makes you personally liable, a person suing the corporation for corporate acts can only recover from the assets of the corporation and may not collect any judgment from the owners of the corporation.  This differs from a partnership (an unincorporated business with multiple owners) in which a claimant can go after the personal property of all of the partners or a sole proprietorship (an unincorporated business with only one owner) in which a claimant can go after the personal property of the sole owner.

One key thing about corporations is that they can have a single owner or multiple owners.   Thus, it is possible to have a parent company which is the sole owner of separate “subsidiaries.”  Putting it in a little more benign situation, think of a regional grocery company.   The regional company is the parent company.  But each of the grocery stores is its own corporation wholly owned by the regional company.  That way, if problems occur at one store, it does not bring down the entire chain of stores.

Moving from these general concepts to corporate income tax.  While businesses pay sales taxes on revenue (i.e. the price charged for whatever goods or service is provided by that business), income tax is not paid on revenue.  Instead, it is paid on the income’s profits (revenue minus expenses).  Now there are certain rules that bump up business expenses for tax purposes that results in businesses having two sets of books (one calculating expenses and therefore income based on tax rules and the other calculating income, assets, and liabilities based on generally accepted accounting principles), but that is not the big issue that is currently being discussed.

The big issue comes from the fact that a subsidiary is not necessarily located in the same country as the parent company.  The existence of subsidiaries does not matter for our hypothetical Southwest County Grocery Company.  All of the subsidiaries are located in the United States.  Thus, it does not matter which one is making $100,000.00 per year and which is making $1,000,000.00 per year.  The full $50,000,000.00 is U.S. income and is fully taxable.

But a hypothetical Make America Great Again Corporation is different.  MAGA Corp makes a multitude of consumer products, and has several subsidiaries.  MAGA Research Company is its laboratory company.  It is based in California and is where most of the revolutionary new materials come from.  MAGA Design Company is the wing responsible for developing new products or improving existing products.  It is based in Connecticut near the headquarters for MAGA Corp.  MAGA Corp. itself is based in New York City and makes the final decisions on what products to make and sell as well as doing the marketing work to promote those products.  MAGA Production actually makes the product and has various locations around the world with most factories being in the country in which the product will be sold.  MAGA Distribution is responsible for delivering the product to the wholesalers who purchase it and works in multiple countries.  Finally, there is MAGA Intellectual Properties.  MAGA Intellectual Properties holds the patents and copyrights on all of MAGA’s products.  MAGA Intellectual Properties is based in the Cayman Islands and has a handful of employees in that location.

This corporate structure is what permits companies to play games with corporate income taxes.  Ultimately, the income of the company comes from the sale of the product to wholesalers.  For the typical product, expenses might break down like the following:

MAGA Distribution (Transportation Expenses, Salesmen, and overhead) — 5%

MAGA Production (Purchase of Raw Materials or component parts, labor, and overhead) — 65%

MAGA Corp(Advertising and Overhead) — 2%

MAGA Research — 7.5%

MAGA Design — 7%

MAGA Intellectual Property — 0.5%

That means that 87% of each product sold represents expenses leaving about 13% of revenue as income.

Now if each of these companies was independent, each would make a reasonable profit at each step of the process.  And one potential fair system would require the parent company to attribute income based on the proportional sale of each product.  So, if you sold, 25% of your product in the U.S., you would pay taxes on 25% of your income in the U.S.  Alternatively, you could look at the total expenses of the parent company and allocate revenue and income based on expenses.

But the problem with this is that each country has different laws for calculating revenue, expenses, and income.   And companies take advantage of this in the way that they allocate that 13% of revenue that ends up as income.

Continuing with our MAGA example, if each of the subsidiaries was an independent company, each would be selling their part of the production to the next level at market price.  But with each being part of the parent corporation, that is not what is happening.

The key part of this scenario is MAGA Intellectual Property.  This part of the company is very tiny and can be based anywhere in the world.  It does not need to have to be at the location whether the intellectual property is being created nor does it have to be at the location where the product is being made.  It can purchase the intellection property from MAGA Research and MAGA Design at a low price that results in those two subsidiaries having very little income.  Likewise, MAGA Intellectual Property can sell the license to use those patents and trademarks to MAGA Production at high price such that neither MAGA Production nor MAGA Distribution make any significant income when they sell the ultimate product to wholesalers. Instead, almost all of that income ends up on the books of MAGA Intellectual Property.  And shock of shocks, MAGA Intellectual Property is located in a low tax country.

Contrary to any argument put out by conservatives about corporate income tax, this type of scheme has no impact on where products are made or the income of employees or the dividends paid to stockholders.  Instead, it is merely shell games for tax avoidance purposes.  And the willingness of multinationals to play these shell games is not a reason to excuse domestic corporations from paying an appropriate level of income tax.  Instead, what is needed, and what is being discusses is a set of international tax rules that will figure out a way for the major economies to allocate a multinational corporations income between different countries and eliminate the ability to avoid taxes by shifting nominal income from one country to another.  And part of this concept is having some uniform floor to eliminate tax havens.

Now whether this will work and how it will work will depend on the details, but the current system is broken, and the way to fix it is not to reduce corporate taxes and shift the tax burden to private individuals.