Let’s say I run a company based in the United States. This is my company, and it makes a million dollars in pre-tax profits. At the time, the corporate tax rate is 35%.
It’s straightforward to calculate taxes, I would pay 35% of one million dollars, or $350,000, leaving me with $650,000 in profit.
Using Offshore Subsidiaries to Reduce Taxes
Now, let’s say my company wants to get creative about saving on taxes. It realizes there’s an island nearby with a much lower corporate tax rate, say 5%.
To take advantage of this, the company sets up a subsidiary in that island nation. This subsidiary is owned and controlled by the parent company. Often, the parent transfers intellectual property—patents, trademarks, copyrights—to the subsidiary.
Now, instead of reporting a million-dollar pre-tax profit, the U.S. company pays $800,000 in royalties to the subsidiary to license the intellectual property. This practice, called transfer pricing, is difficult to regulate since intellectual property is unique, making it hard to determine a fair market rate.
Tax Savings and the Repatriation Challenge
After paying the $800,000, the U.S. company’s pre-tax profit drops to $200,000. With a 35% tax rate, it pays $70,000 in taxes instead of $350,000. That leaves $130,000 in post-tax profit.
Meanwhile, the offshore subsidiary receives $800,000 in revenue. Assuming minimal costs, this amount is its pre-tax profit. With a 5% tax rate, it pays $40,000 in taxes, leaving $760,000 in net profit.
In total, the company pays $70,000 in U.S. taxes and $40,000 in offshore taxes, totaling $110,000—far less than the $350,000 it would have paid if it hadn’t shifted profits.
You might wonder why companies don’t transfer the full million dollars. If the transfer pricing is too extreme, it invites scrutiny. If there’s a market for the intellectual property, or if the company licenses it to others, that influences the pricing as well.
However, there’s a catch. The offshore profit remains trapped unless repatriated to the U.S., which would trigger additional taxes. This repatriation tax exists to prevent companies from indefinitely shifting profits abroad.