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Transfer pricing and tax havens

How a corporation can set up a tax haven and use it through transfer pricing. Created by Sal Khan.

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  • leaf green style avatar for user Ian
    If a company is sending massive amounts of pre-tax profits to offshore accounts, wouldn't this make its reported profits look lower than they actually are and have some adverse effect on its stock price? Maybe it doesn't matter once a company's profits are in the billions. Perhaps these companies just distribute "small" amounts (a few billion here or there) to various off shore tax havens, and still keep quite a large amount inside the US. Is anyone clear on this? Also, on a side note or two, I heard (on an NPR 'Planet Money' podcast) that to many other countries, the US also acts as a tax haven for their profits. I've also heard many American companies are incorporated in Delaware due to certain tax advantages (I guess this would be to avoid state taxes but not sure).
    (8 votes)
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    • blobby green style avatar for user Lloyd Waldo
      Profits remain the same. Reported profits (those that are included in investor reports), reflect the actual profits of the company, regardless of the reported income.

      There are some very interesting cases of this. I believe in one example, the film "My Big Fat Greek Wedding," reported a loss of some millions of dollars. This when its original budget was less than 3 million, and its theater take over 200 Million. In a classic case of hollywood accounting, the film was "not profitable," despite taking in an enormous income. The opposite of the usual corporate scheme.
      (1 vote)
  • blobby green style avatar for user Vaughn Jumpp
    In corporate tax haven video. Can both an c & s corporation have a tax haven in cayman islands?
    (8 votes)
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    • male robot hal style avatar for user Greg L
      Welcome to another problem with trying to set up a tax haven. C & S corporations are legal entities defined by US law. The Cayman Islands is not part of the United States, so you would have to set up your corporation according to their laws.
      It is my understanding that in all 50 states it is illegal for anyone who is not a licensed lawyer to dispense legal advice. To get an answer you need to consult a lawyer who specializes in international business law (i.e. this is going to pricey).
      (7 votes)
  • leaf green style avatar for user Sonny Saggar
    1. Can a corporation 'donate' money to a US-based non-profit, thereby eliminating it's gross profit, and then somehow get paid back by said non-profit, as a legal way to avoid taxes?

    2. How does the IRS treat a 'loan'? Is it income? What if someone was to be 'given' (as opposed to paid) a 'loan' by someone else, at a zero (or close to zero) % interest rate, for an ultra-long period of time (say 1,000 years)? Is such a 'loan' taxable? I know you're thinking that the 'lender' of said 'loan' will want to 'expense' such a loan to reduce his [the lender's] taxes, but not so, if said lender is above-mentioned non-profit.

    Am I onto something here, or is it just nonsense? Is it a valid loophole?
    (9 votes)
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    • leaf green style avatar for user Sonny Saggar
      Thanks for that. So, when does a loan get perceived as a gift? Is it really a matter of fair market terms with regard to lending? If so, then when interest rates are significantly lower than tax rates (i.e. now), it makes a lot of sense to simply 'loan' back and forth instead of spend/earn, as long as the 'lender' is an entity that has nothing to gain from missing out on tax-deductible expenses. Right?
      (2 votes)
  • sneak peak green style avatar for user Cybernetic Organism
    Since corporations are legal persons, they seem to enjoy many privileges and less responsibilities than normal people would. Normally a real person would pay their fair amount of tax on foreign sourced income. Doesn't it seem that corporations are enjoying so many privileges where a typical working class person would have to pay tax on his income earned in some other country?
    (5 votes)
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    • mr pants teal style avatar for user Anthony Natoli
      A "typical working class person", as you call him/her, can establish an official residence in another U.S. state for paying less state income tax (and even less insurance rates on their automobiles), or can establish residence in another country for paying less U.S. federal and state income tax. However, that residence has to be their primary residence for most of the year. It could work out for telecommuting workers, consultants, and international salespeople and executives. But it would NOT work out for the "typical working class person" who mostly works physically close to their residential address.
      (1 vote)
  • male robot hal style avatar for user Ben
    What is the transfer tax to get the cash back into the US?
    (5 votes)
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  • male robot donald style avatar for user Pedro Miguel Fernandes da Silva
    By which type of operation do the small corporations (in the video, based on the country island) make the repatriation of the money to their mother corporations, transfering it to the United States so they can use it as the normal capital? Does the moment of the repatration counts as an income to the mother corporation?
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      The simplest way would be to have the overseas entity pay a dividend to the parent company. That dividend is then taxable income for the parent.

      There are other ways, too. You can make intercompany loans, for example. Or you can do a transfer pricing trick in the other direction.
      (4 votes)
  • blobby green style avatar for user Emmett Armstrong
    At , why does the physical location of said island country make a difference or impact on parent corp? What would be the impact if sub corp was halfway around the world?
    (1 vote)
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    • hopper cool style avatar for user Ryan Logsdon
      The physical location makes no difference. All he meant was that the island is not an American territory. What matters is that it's under the control of another government's laws and tax codes. And for the argument to work well, he picks a place with a very low tax rate.
      (4 votes)
  • blobby green style avatar for user Nitya Das P
    Hi Sal, Could you please post or share the link(if already uploaded) for the topic that you mentioned in the end.
    (3 votes)
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  • winston default style avatar for user Chase Yang
    If I had a business and I had to pay taxes, how much do I have to pay if I made a few hundred dollars?
    (1 vote)
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  • mr pants teal style avatar for user F. Chris Oliver
    What are some ways a company can use the money transferred out of the US to avoid sending the money to the US and incurring tax?
    (1 vote)
    Default Khan Academy avatar avatar for user

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.