The Decline in U.S. Corporate Taxes and the Rise in Offshore Tax Haven Abuses
Although the statutory corporate income tax rate is 35 percent, corporate income taxes relative to corporate profits have dropped precipitously since the 1960s. (See Box 4-2 of the CBO's budget and revenue outlook). Through the 1990s, the effective tax burden for all U.S. companies, public and private, was around 30%. But from the fourth-quarter of 2001 onward, companies have paid out just 20% of their profits in taxes. The tax burdens of publicly traded companies (versus privately owned corporations) and multinationals (versus domestic only corporations) are even lower.
The sharp decline in corporate taxes in recent years can be measured in a variety of ways. According to the Congressional Budget Office, between 2007 and 2009 overall corporate income taxes collected by the federal government declined slightly from $370 billion to $356 billion (Table 1-3).
Historically, corporate tax rates have also dropped precipitously in comparison to the size of the economy (i.e. as a percentage of GDP). According to the Congressional Budget Office’s Historical Budget Data, corporate income taxes declined from 4.2 percent of the GDP in 1967 to 2.7 percent in 2007, and were expected to decline to below 2.0 percent within five years.
Many large multinational corporations pay no taxes at all. According to the GAO more than 60% of U.S. controlled corporations with at least $250 million in assets (representing 93 percent of all corporate assets reported to the IRS) reported no federal tax liability each year between 1996 and 2000, while the economy boomed and corporate profits soared. 71% of foreign-based firms operating in the U.S. during that same period paid no U.S. income taxes. According to Citizens for Tax Justice, 82 of 275 top U.S. corporations paid zero taxes between 2001 and 2003, although they earned $102 billion in pre-tax profits. 46 companies with a combined profit of $42.6 billion paid no federal income taxes in 2003 alone. Instead they received rebates totaling $5.4 billion.
Offshore Shelter Abuses
The rise of corporate tax haven abuses has contributed significantly to the precipitous decline of corporate taxes raised by the U.S. government in recent years particularly when it comes to U.S. multinationals who are able to shift their pretax income offshore. Martin Sullivan, editor of Tax Notes, reports that U.S. Corporations shifted $75 billion of their taxable profits into tax havens in 2003, depriving the IRS of between $10 billion and $20 billion in expected tax revenues. Sullivan says “the figures provide just one more indication that the U.S. system of taxing international income is nearing a breakdown.” Sullivan, a former Treasury Department economist, based his study on Commerce Department data. (See “Economic Analysis: Profit Shift Out of U.S. Grows, Costing Treasury $10 Billion or More,” Tax Analysts, September 28, 2004)
Corporate Inversions: Moving the Headquarters Offshore
One of the simplest ways some corporations have reduced their taxes is by relocating their headquarters offshore on paper (a relatively simple transaction known as “corporate inversions”). This scam is expected to cost the U.S. $5 billion over the next decade, according to the Joint Committee on Taxation. By paying just $30,000 to establish a simple postal drop, for instance, Ingersoll-Rand expects to save $40 million per year by declaring itself headquartered in Bermuda. Dozens of companies have undergone corporate inversions to reduce their taxes while continuing to enjoy U.S. protections.
Corporate inversions are just one way that companies have used offshore jurisdictions to reduce their taxes without significantly changing their operations. Much more money is lost through other, often complex forms of offshore tax haven abuses that are difficult for the IRS to detect and measure, including:
1) Transfer pricing. Considered a form of fake billing, transfer pricing is an accounting shell game used by companies to structure internal transactions so that profits are reported in offshore jurisdictions that have lower corporate tax rates. A study conducted by two tax experts from the University of Florida estimates that the U.S. lost $53 billion in corporate taxes in 2001 from this type of abnormal trade pricing. Most of this money ends up in offshore accounts. Profits of the U.S. Multinationals’ subsidiaries in no-tax Bermuda, for example, rose from $8.5 billion to $25.2 billion. As former Treasury International Tax Counsel Stephen E. Shay (now with Ropes & Gray in Boston) put it, “the reality is that the IRS is unable to meaningfully audit transfer prices.” (Tax Notes, 9/13/04; also see related NYTimes story.)
Update: Charles Christian and Thomas Schultz recently estimated in a study commissioned by the IRS that multinational corporations are shifting $87 billion of pre-tax income out of the U.S. each year.
2) Income Stripping. In this scheme, money is "lent" by the offshore subsidiary to the U.S. parent company or another U.S. subsidiary and paid back to the offshore company at higher interest rates. That interest payment is then deducted from the U.S. company's federal taxes. One example of this occurred at Tyco, which set up a Luxembourg-based subsidiary to finance most of the company's debt. The Luxembourg subsidiary made loans to Tyco units in the U.S. and elsewhere, which then deducted the interest payments from their taxable income in the U.S.
3) Parking Intellectual Property ("Intangibles") Offshore. Another way corporations reduce their taxes is by relocating intellectual property offshore and charging the U.S. headquarters or other divisions of the company royalty payments. This scheme is common among corporate sectors like the pharmaceutical industry and computers and software, who have established dozens of subsidiaries in Bermuda in recent years. As two tax practitioners recently (2/15/05) explained in Tax Notes, “U.S. income tax may be eliminated entirely if the intangible property is located in a foreign jurisdiction that has concluded with the United States an income tax treaty that eliminates withholding tax on source-country royalty payments.” (In a similar manner, companies reduce their state-level taxes by parking their trademarks and other intellectual property in states like Delaware that do not tax such property.) The offshore subsidiary company charges a licensing fee for the use of trademarks, patents, etc. – which allows the corporation to lower their taxes in the jurisdiction with higher rates. The practice of holding intellectual property offshore began to grow significantly in the early 1990s and is now widespread.
4) Hybrid corporations are also used in an ownership chain to reduce taxes. A company can eliminate or significantly reduce income and withholding taxes in the U.S., the tax haven, and the country in which the foreign operating company resides by restructuring its form in this manner. (For more details, see Martin Sullivan, Tax Notes, 10/13/04).
5) Special Purpose Entities and Derivatives. Some tax shelter deals involve the use of special purpose entities (SPEs -- made famous by Enron) and structural financial instruments such as derivatives – so that profits not only can be moved overseas to a lower tax jurisdiction, but also from one income accounting category to another (e.g. capital gains). They can even be used to move money across time – to a reporting period where the tax rate may be lower. These deals are also used to hide the identity of the ultimate beneficiary. Tax haven expert Jack Blum estimates that there are 3 million SPEs in existence globally. The Enron and AIG cases demonstrate how SPE’s have also been used by corporate insiders to loot the company. The Powers Report to Enron's Board makes it clear that the company’s own directors did not understand the complicated deals constructed by CFO Andy Fastow to hide the company’s debt and pay himself at the same time. Often these deals are the invention of bankers, accountants and lawyers (see below). A Senate investigation revealed that Enron's complicated SPE deals were not simply the invention of a lone CFO, but rather were pitched to the company by its own outside bankers, who also pitched them to other companies. As Senator Carl Levin, D-MI, testified in a Senate panel hearing he led on the banks’ role in the collapse of Enron, “Citigroup and Chase … not only assisted Enron, they developed the deceptive pre-pays as a financial product and sold it to other companies as so-called balance sheet-friendly financing, earning millions of fees for themselves in the process.”
Handcuffing the IRS.
The IRS has had a hard time keeping up with the complex schemes that corporations use to avoid paying taxes. For example, the IRS did nothing to uncover the corporate scandals that erupted in the late 1990s, even though in cases like Enron, offshore sheltering was used to hide debt offshore. According to IRS commissioner Mark Everson,“we were not even near the year these returns were filed, which is inexcusable.”
Cutbacks in IRS staff and enforcement have forced it to forgo complex investigations involving key business sectors that have incorporated more than the average number of offshore subsidiaries. An analysis of IRS enforcement trends released by Syracus University's Transaction Records Access Clearinghouse in April concluded that “when it comes to audits, large corporations providing the American people with investment advice, various kinds of banking and credit services and insurance are subject to a lot less IRS scrutiny than corporations in other businesses.” Insurance companies and big commercial banks are two businesses that have conduct much of their business offshore.
Observers say that unless there are significant changes in policy and enforcement mandates coupled with budgetary increases, things are unlikely to change. The IRS will have a hard time replacing season professionals with top professional talent able to keep up with the consultants who counsel corporations and individuals on tax avoidance schemes.(See below.)
In 2003 the IRS announced that it would shift its approach to auditing business tax returns, by using a fast-track method that critics say is likely to miss certain complex types of fraud. The Washington Post reported (12/29/03) that before the IRS’s new fast-track policy just 4 percent of 148,000 mid-sized corporations were audited – a portion substantially lower, even, than the 12 percent of annual financial reports that the SEC had reviewed in 2001 before the massive epidemic of accounting fraud was revealed. The Senate Committee on Government Affairs concluded that the SEC’s failure to review a substantial portion of annual financial reports was a clear example of the lack of significant regulatory oversight and enforcement, and a major reason why Enron’s fraud went undetected.
Justice Department and court data document that criminal tax fraud prosecutions also continue to slide. The data show the actual performance of the IRS in regard to businesses differs in significant ways from some Bush Administration claims when it comes to cracking down on corporate scofflaws.
In the words of two tax law professors, “for every suspect shelter picked up by the IRS on audit or exposed on the front page of The Wall Street Journal or The New York Times, dozens (perhaps hundreds) remained unknown – hidden from the prying eyes of the IRS agents by multi-tiered partnership structures, grantor trusts, and Cayman Island LLCs.”
Accountants, Lawyers and Bankers: Aiders and Abetters of Tax Avoidance
A series of hearings and investigations by the Senate Committee on Governmental Affairs into the role of tax consulting professionals in pitching certain shelters have revealed the important role that accountants, lawyers and bankers play in the corporate tax dodge game. These professional consultants have created a large tax consulting industry over the past decade, and they are far ahead of the IRS’ ability to catch them.
The extent of corporate abuses of offshore shelters is difficult to measure. Using data compiled by Standard & Poor’s on public corporations and Internal Revenue Service data on tax shelters, GAO determined that over five years (1998 to 2003), 207 of the Fortune 500 companies, or 40%, purchased tax shelter services from a third party. 114 of the 207 obtained them from an accounting firm, 61 from their own auditor. GAO also found that at 57 Fortune 500 companies one or more of the company’s officers or directors also obtained tax shelter services, 17 from the company’s own auditor. GAO estimated that total tax revenue losses to the U.S. Treasury during the five years from these 207 Fortune 500 companies and 10,300 individuals from tax shelter transactions amounted to nearly $129 billion.
Part of the reason for the boom in tax consulting is that absence of effective penalties. Existing penalties for tax shelter promoters are often treated as a minor cost of doing business. E.g. KPMG partner Gregg Richie wrote an internal e-mail that was revealed by the Senate Subcommittee on Investigations of the Senate Committee on Governmental Affairs in November 2003. Comparing the cost of penalties with the revenue to be made peddling the firm’s “OPIS” shelter, “we conclude that the penalties would be no greater than $14,000 per $100,000 in KPMG fees…” (See Senator Carl Levin’s related release on Tax Shelter Services by Accounting Firms.)
A report on the role of professional firms in the U.S. tax shelter industry released by the Senate Permanent Subcommittee on Investigations in 2005 documents how accounting firms such as Enrst & Young, KPMG and PwCC, banks such as Deustche Bank and Wachovia Bank, and law firms such as Sidley Austin Brown & Wood “developed, implemented and mass-marketed cookie-cutter tax shelters used to rip off the Treasury,” as Senator Norm Coleman (R-MN), the committee’s chair, put it.
The problem of auditors providing tax consulting services to their clients is a clear conflict of interest that was not adequately addressed by the Sarbanes-Oxley Act of 2002. The law exempts certain types of tax consulting for auditors. Prompted by the GAO's report that said 61 Fortune 500 companies had bought tax shelters from their outside auditors, resulting in $3.4 billion in federal revenue losses, the Public Company Accounting Oversight Board, which was created by Sarbanes-Oxley as an independent body responsible for developing accounting regulations, announced in late 2004 it would begin to write a new rule that would restrict the accounting firms’ ability to sell aggressive tax shelters to audit clients.
Recommendations: General Tax Policy Suggestions:
1) Corporate tax dodgers should be barred from government contracts. States that have adopted legislation to bar companies from state contracts include California, Montana and North Carolina. (Similar laws have been introduced in MA, MN, PA, IL and TX).
2) Close the loopholes that allow companies to deduct any fines, penalties or other settlements associated with relation to any violations of law. (Under U.S.C. Title 26, section 162 (f) "No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law." The proposal by Senator Baucus would elevate this regulation into the statute." Although the law clarly prohibits tax deductions for certain fines and penalties, certain other settlements remain outside the reach of this provision. Legislation has been proposed to further clarify the law on this matter. See, e.g., S. 936, "Government Settlement Transparency Act of 2003," introduced by Senator Baucus in 2003.).
3) The IRS should deny tax refunds to companies that restate their income after admitting to accounting fraud. It’s ridiculous that WorldCom was able to collect nearly $300 million in tax refunds after admitting that it had fraudulently inflated its earnings by $11 billion. Enron, Qwest and HealthSouth also reportedly considered filing refund claims. When companies deliberately overstate their income, they should not be refunded any taxes already paid to the IRS.
4) Impose an entity-level tax on all business enterprises, whatever their form. New hybrid business forms (e.g. the Limited Liability Corporation or LLC) are increasingly being used to avoid taxes while retaining the advantages of the corporate form (e.g. limited liability). All for-profit businesses should be treated as taxable forms.
5) The IRS should enforce the “economic substance doctrine” and stop treating offshore shell corporations as if they have rights. No credence should be given to offshore companies when they are incorporated for purposes besides legitimate economic activity, and have no employees or physical place of operations. A genuine economic purpose test should be applied.
6) Public pension funds and other investment funds should avoid investing in companies that have moved offshore. These fiduciaries have an obligation to protect their clients from the relatively weaker investor protection provisions that countries like Bermuda maintain, which undermine their clients' ability to hold company management accountable through derivative lawsuits. Bermuda, for example, does not codify its law in books. There are no lawyers who specialize in plaintiff actions, in large part because it bars contingency fee cases. Bermuda also doesn’t require shareholder approval before all or parts of a company’s assets are disposed (e.g. in event of mergers), and allows up to $250 million to be spent w/o board approval (Tyco’s Kozlowski used this in his own defense for abuses of shareholder money). In addition to these weaknesses, it is difficult to enforce U.S. court judgments in Bermuda.
7) Stop allowing U.S. banks to be used as a haven. The IRS should increase disclosure of foreign deposits in U.S. bank accounts. There is no reason dictators, drug dealers, money launderers and others that have looted their own countries should be allowed to use U.S. banks as a haven. This kind of secrecy also makes it easier for terrorists to move their money around the world. Offshore companies that do not disclose their ultimate owners to U.S. regulators or which can demonstrate no substantial economic purpose should be banned from opening up accounts at U.S. securities firms.
Also see the recommendations section of this Report of Senate Permanent Subcommittee on Investigations.
Groups That Work Against Corporate Tax Abuses:
Outside the U.S./International Groups
Reports and Articles:
“Sacrifice is for Suckers” by Charlie Cray
and Lee Drutman, Citizen Works
State Corporate Tax information