This article shows how US corporations use foreign subsidiaries in low-tax jurisdictions to minimize tax on their global income. The subsidiaries hold their profits overseas indefinitely without being taxed in the US as repatriated income. US parent companies abuse this legal “grey area” when they organize buy-backs, acquisitions and deployment of their working capital. To avoid taxes, corporations are deliberately organizing their finances in a complex, wasteful and abusive way, which seriously decreases oversight and transparency as well as emptying the national treasury.
By Victor Fleischer
More than a trillion dollars in cash and short-term investments sits in offshore holding companies, awaiting a repatriation tax holiday. In the meantime, tax professionals spin out ways to manipulate the system.
The tax code provides multinationals based in the United States with many incentives to shift income to foreign low-tax jurisdictions. In theory, American corporations are taxed at 35 percent on their worldwide income. But income earned by an active controlled foreign corporation is not usually taxed until the cash is repatriated to the parent company in the United States as a dividend.
From a policy perspective, the problem is not so much that tax on foreign income is deferred, but rather that United States income is being masqueraded as foreign income.
Many multinationals use transfer pricing (the pricing of goods and services sold between affiliates of a parent company) to minimize their global tax rate. After transferring intellectual property to low-tax jurisdictions like Puerto Rico, Ireland and Singapore, companies manipulate licensing and cost-sharing arrangements to avoid or reduce United States taxes. Cash from global operations is then parked offshore until the tax professionals can figure out how to get it home tax-free.
Microsoft, for example, now holds more than $50 billion in foreign cash, cash equivalents and short-term investments. Apple holds more than $100 billion in foreign cash and investments - an amount roughly equivalent to the gross domestic product of Vietnam.
Accounting rules make the situation worse. Based on a presumption that the earnings of a foreign subsidiary will eventually be distributed to the United States parent company, the promise of a future 35 percent tax on repatriated income often creates a deferred tax liability on the consolidated balance sheet. There is an exception, however, for "permanently reinvested earnings" - that is, earnings the parent company does not need and is indefinitely or permanently reinvesting overseas. If a company can convince its accountants that the cash will be reinvested overseas and is not needed at home, the company can avoid recognizing a tax liability on its balance sheet.
Congress is largely to blame. In 2004, the United States temporarily reduced the tax rate on repatriations to roughly 5 percent. The problem was not just the lost revenue orthe false promise of a flood of new domestic investment. The tax holiday also raised expectations for future tax holidays, and companies have changed their behavior accordingly by hoarding cash offshore.
Many companies now find themselves holding a particularly awkward pose - simultaneously accessing cash for stock buybacks, acquisitions and working capital needs while maintaining the false financial-reporting premise that the cash is indefinitely reinvested overseas.
A recent hearing by the Senate Permanent Subcommittee on Investigations highlighted one technique. According to the subcommittee report, Hewlett-Packard used a loan program employing overseas cash to de facto repatriate billions of dollars each year to finance most of H.P.'s American operations without paying the repatriation tax.
H.P. used alternating loans from two offshore entities, one in Belgium and another in the Cayman Islands, during 45-day windows to technically meet an exception for "short term" loans. The subcommittee report explains that a pattern of "continuous lending appeared to be occurring for most of the period between 2008 through 2011."
The legality of this loan program is questionable. In similar cases, the Internal Revenue Service has successfully argued that a series of short-term loans should be recast as what it is in substance: a single long-term loan that would be treated as a cash repatriation under Section 956 of the tax code. In an e-mail attached as an exhibit to the subcommittee report, an Ernst & Young adviser warned that with respect to the H.P. loan program, "the I.R.S. may seek to apply the substance over form [doctrine] to transactions that it views as abusive."
A conservative adviser might have stopped there and advised against the scheme. Instead, Ernst & Young sprinkled holy water on the transaction, explaining: "We do believe that we can get comfortable with a 'should' level of opinion, assuming H.P. avoids behavior that could be interpreted as abusive."
Should-level opinions and getting comfortable are, increasingly, telltale signs of aggressive tax behavior, as is a warning not to write down the goal of the transactions. "Documents and/or workpapers that indicate an intention to circumvent or otherwise abuse the spirit of section 956," the e-mail warns, "could prove particularly troublesome and thus should be avoided."
No one will be surprised when, after a new tax holiday, companies bring back "permanently" reinvested cash to conduct stock buybacks. As another Ernst & Young adviser wrote: "An assertion of indefinite or permanent investment until Congress changes the law allowing cheaper repatriation again doesn't sound permanent."
Hoarding cash in tax havens is evidence of the implicit cost of international tax deferral, as companies engage in wasteful tax planning techniques and fail to allocate economic resources in an efficient manner.
There is reason to be equally concerned about companies that respect the accounting rules and, in order to avoid the repatriation tax, actually reinvest overseas. Evidence suggests that accounting-motivated foreign direct investments achieve a lower rate of return than investments in the United States. As economic theory would predict, corporate managers are willing to accept a lower pretax rate of return and create jobs overseas rather than paying the repatriation tax and create jobs at home.
The tax system that creates these incentives is in need of attention. A territorial tax system with better policing of transfer pricing is one option. A worldwide consolidation system without tax deferral is a better one. And a lower corporate tax rate would help.
Until then, we can expect further scrutiny of tax professionals struggling to navigate a system that begs for gamesmanship.
