If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:6:47

Video transcript

- Let's say that I run a company that is based inside of the United States. So this right over here is my company. Maybe I have some smokestacks of some kind. So that is my company, and it makes a million dollars in pre-tax profits. One million dollars, and this is before tax. So, pre-tax profits. And let's say that the country that I'm in, and the way I've drawn it, this is the United States, let's say at the time that I make those pre-tax profits the corporate tax rate is 35%, 35% tax rate. So, it's pretty straightforward to think about how much taxes I would have to pay. I would pay 35% on this one million dollars, or essentially I would pay $350,000 in taxes. Three-hundred and fifty thousand dollars in taxes, and I would have 650,000 left in profit. So, 650,000 left in profit. Now what I want to think about, let's say my company wants to get a little bit more creative about how it might save on taxes. So what it does is, it realizes that there's an island not too far off the U.S. Coast, and there are actually several of them, that has a substantively lower tax rate. And I'm just picking it arbitrarily, but let's say it has a 5% corporate tax rate, 5% tax rate. So how can this company, which is physically or for the most part based in this country, somehow benefit from this lower tax rate that is happening offshore? Well, what they'll typically do is set up another subsidiary, one that this company owns and controls, but it is set up in this little island nation. So let's set it up right over here. So that's the other company. And what it'll do is, it'll tend to give it maybe often times it'll give it some intellectual property, maybe patents, trademarks, things like this. So it gets all of the intellectual property of the parent company. So, given the intellectual property. And then, what it can say is-- And this is owned by the parent entity, so I'll draw a little dotted line here. It's owned and controlled by this company that's based in the U.S., and what they'll say is, look, we don't have a million dollar pre-tax profit anymore, because we had to essentially license the use of this intellectual property, whether it's trademarks, copyrights, patents, we've got to pay this entity right over here some amount of money to use that intellectual property. So let's say that they say, we're going to pay them, I don't know, $800,000, and this is essentially transfer pricing. In theory, there should be a way of deciding what is the fair rate for that intellectual property, but often times that intellectual property is fairly unique, so it's hard to determine a market rate, which really just leaves this company to decide it for itself. So let's go into that reality, where instead of this reality, this company, before it had a million in pre-tax profits, but now it's paying 800,000 in royalties and licensing to this entity right over here. So out of that one million, you have 800,000 going offshore. You have 800,000 goes offshore. And so, the real pre-tax profit for this company now, based on accounting for it this way, based on paying this subsidiary that's offshore for use of the intellectual property, the company now has 200K in pre-tax profits, 200K. So that was before the licensing. Now this is after the licensing. This is the new pre-tax number. This is the new pre-tax number. And so in the U.S., it would only pay 35% of the $200,000. Instead of paying $350,000 in taxes, it would now pay-- So it's no longer 350 in taxes. Thirty-five percent of 200K is 70K in taxes, 70K in taxes, and the U.S., I guess you could say parent company, would show a profit of 200K minus the 70K of $130,000. So, 130,000, I would call it net profit, or we could say post-tax profit. And then, this character right over here, let's say it has very minimal costs. Let's say it has no costs, for simplification. It would have some, to do some paperwork. All of this would essentially be profit. Maybe have a few thousand dollars in costs, but we'll ignore that for now. So all of this would be its pre-tax profit. It would have to pay 5% of it. Five percent in taxes to this country right over here. So 5% of 800,000 is $40,000. So it would pay 40,000 in taxes to the government of this island right over here, and then it would be left with the remainder, $760,000. So, it would have 760,000. I guess you could call that it's net profit, after paying taxes, net profit. So you can see here the company saved substantially on taxes. It paid 70,000 in the U.S. and 40,000 abroad. So it paid a total of 110,000 in taxes versus the 350,000 it would have had to pay if it was based purely, purely in the United States. So you might say, hey, this is a great thing. Companies, why even have an 800,000 transfer price? Why not do a million? And, obviously, if you do it a little bit too ridiculously, it'll get more and more scrutiny. So there's some balancing influence there, and obviously if there is a market for this intellectual property or that type of intellectual property, or if you are licensing to other people, that might dictate what this is, but you might say, why not do this night and day? Well, the question is, you now have this profit, and it might be in the form of cash. We go into other videos in more depth when it might not be. But you have essentially this profit, but you won't be able to get it back into the United States without paying a tax on it. So if you want to get it back in the United States, and that's actually the check. The reason why we do tax repatriation of funds is so that companies can't do this night and day, essentially transfer profits abroad and then bring the cash back in. In order to close this loophole, that's why the repatriation of these funds are actually taxed. And I'll let you think about, and it obviously depends on what the transfer prices are and things like that, but essentially what this tax rate would have to be in order for a company to come out neutral. And there's other ways of getting around it, and I'll do other videos later, of ways that this cash can be put to use, and it still is not actually taxed.