Pricing schemes reduce corporate taxes by billions

Multinational corporations, including some of the icons of American business, routinely cut tax liability through pricing schemes. By dropping the cost of goods sold to subsidiaries and inflating the price of goods that come back to the U.S., multinationals transfer profits — and tax liability — to tax-friendly nations. Experts estimate that corporations shift $62 to $87 billion of pre-tax income out of the U.S. each year resulting in substantial tax revenue losses. Legislation pending in Congress could help plug corporate tax-haven loopholes.

"Buy low, sell high" may be the winning strategy on Wall Street, but it's not necessarily the way you want to go if you're a multinational corporation looking to shift profits — and tax liability — to low- or no-tax jurisdictions. Often, companies with subsidiaries in tax havens gain by artificially dropping the cost of goods sold to the subsidiary, thereby boosting the tax-haven entity's profits. On the flip side, the corporations inflate the cost of goods returned to the United States or other high-tax jurisdiction, where the puffed-up prices reduce profits and corporate tax burdens.

Called transfer pricing, the prices on goods transferred between parts of the company can be manipulated to help multinational corporations dodge their rightful corporate tax bills. The practice is not illegal when prices represent fair market value for goods transferred, however, abuses do occur. And experts agree: Questionable practices in transfer pricing cost the U.S. Treasury tens of billions of dollars each year.

Shifty business

How much corporate income escapes U.S. tax collectors because of questionable transfer pricing? Estimates vary. It all depends on how you ferret out the numbers. Charles Christian, director of the School of Accountancy at the W. P. Carey School of Business, recently teamed with Thomas Schultz of Case Western Reserve University in conducting research commissioned by the Internal Revenue Service.

According to Christian and Schultz, multinational corporations are shifting $87 billion of pre-tax income out of the U.S. each year, and that number is net of income shifted into the country. Uncovering income shifting is tricky. Christian and Schultz came to their conclusions by comparing the effective tax rates and the returns on assets for 6,212 multinational corporations. Although Christian admits it is possible for companies to legitimately shift income abroad by moving productive assets such as factories into a tax haven and earning income there, that is not what he sees occurring.

"We observed how much companies were earning in a foreign jurisdiction relative to their assets there," Christian says. "Then we observed the same thing domestically and made the assumption that if companies hadn't manipulated transfer prices, after-tax return on assets would have been equal between a parent company and the foreign subsidiary."

That's how things should work according to theoretical models. However, research demonstrated that return on assets was much higher in tax havens than in domestic operations. Among 686 firms shifting income out of the U.S., for instance, Christian and Schultz found that, on average, foreign return on assets was 11.3 percent compared to domestic return on assets of 2.4 percent. For those same companies, average foreign effective tax rates were 22.2 percent compared to U.S. tax rates of 32.9 percent.

After looking closely at data from those 686 companies, Christian and Schultz concluded, "$62 billion of pre-tax income was shifted abroad." Details of this study appear in a paper soon to be published by the IRS Research Bulletin entitled "ROA Based Estimates of Income Shifting by U.S. Multinational Corporations."

Dwindling tax collections

Tax Economist Martin Sullivan used U.S. Commerce Department data to come to his conclusion that U.S. corporations have shifted approximately $75 billion a year to foreign subsidiaries. "Over the last 12 years, foreign profits have more than tripled — from $89 billion in 1993 to $298 billion" in 2004, Sullivan writes in an article from Tax Notes, a nonprofit tax journal.

To reach that conclusion, Sullivan compared foreign profits against domestic profits and found that "the domestic share of profits has declined significantly — from 83.6 percent in 1993 to 74.4 percent in June" of 2004. Noting that U.S. corporations generated annualized profits of $1.166 trillion, Sullivan applies that 6.6 percent drop in domestic U.S. profits and comes up with an income-shifting estimate of $75 billion.

What does that mean for U.S. tax collections? The title of Sullivan's Tax Notes article says it all: "Shifting of Profits Offshore Costs U.S. Treasury $10 Billion or More." Another study conducted by Simon Pak of Pennsylvania State University and John Zdanowicz of Florida International University determined that multinational corporations used transfer pricing to avoid $53.1 billion in taxes during 2001.

Pak and Zdanowicz studied U.S. import and export data produced by the U.S. Department of Commerce and contained in the U.S. merchandise trade database, the same data used to determine the U.S. balance of trade. Among the more astonishing import prices they uncovered were tweezers priced at $4,896 per unit, toilet tissue that cost some foreign subsidiary $4,121.81 per kilogram and plastic buckets priced at $972 each.

Prices on goods exported from U.S. companies to their foreign subsidiaries weren't much different. Researchers found missile launchers that cost $52.03 and prefabricated buildings priced at $1.20 per unit. What's more, data from earlier Pak and Zdanowicz studies indicate the problem is growing worse. The IRS lost an estimated $44.6 billion in 2000, which was up from $42.7 billion in 1999 and $35.7 billion in 1998.

Payback holdups

Estimating how much tax revenue is lost to shady income shifting is one thing. Uncovering specific cases and collecting back taxes is quite another. "The law is well developed but difficult to enforce," Christian says. Christian explains that under Section 482 of the Internal Revenue Code, transfer prices are supposed to represent fair market value of the goods being transferred, but that sometimes it's hard to determine fair market value because in the case of patented technology or knowledge, the item being transferred is unique.

And even when IRS audits uncover transfer-pricing violations, getting the tax monies back can take years, particularly if a company appeals IRS findings. "Five to 10 years is typical for this type of litigation," Christian says.

A little piece of haven

It doesn't take much for multinationals to get in on the income-shifting game. There is no need to set up offices, hire staff or build factories in the tax havens, which may be why little Luxembourg, a nation with a population of around 437,000 and an effective corporate tax rate of 1 percent, saw profits from subsidiaries of U.S. corporations skyrocket from $4 billion in 1999 to $18.4 billion in 2002, according to Sullivan's research.

"The ownership of a trade name like Coca-Cola can be anywhere," says Robert McIntyre, director of Citizens for Tax Justice. "You assign your valuable trade name or patents on drugs or other knowledge to the offshore entity, and then you have that entity charge the U.S. company a big royalty to use it."

This may be why a modest five-story building on Church Street in the Cayman Islands capital of George Town is the "official address of 12,748 companies," writes David Evans in the June 21, 2004 issue of Bloomberg Markets magazine. This site and "other office buildings in George Town are home to subsidiaries of more than 150 U.S. corporations, including Coca-Cola Co., Intel Corp. and 10 more of the 30 companies in the Dow Jones Industrial Average," Evans reports.

Multinational corporations can easily set up handy offshore subsidiaries. "Purely domestic companies can't," McIntyre says. "It's hard to compete with people who aren't paying taxes." U.S. Sen. Byron Dorgan, D-N.D., has expressed similar sentiments. He commissioned a study by the Government Accountability Office (GAO), the investigative arm of Congress.

According to GAO's 2004 report, "59 out of the 100 largest publicly-traded federal contractors in 2001, with tens of billions of dollars in federal contracts in 2001, had established hundreds of subsidiaries in offshore tax havens," Dorgan says. In other words, companies are making money off Uncle Sam but not necessarily paying back what they owe in taxes.

Dorgan quoted GAO findings when he introduced S.B. 779 on the Senate floor last April. "Exxon-Mobil Corporation, the 21st largest publicly traded federal contractor in 2001, has some 11 tax-haven subsidiaries in the Bahamas," Dorgan said. "Halliburton Company reportedly has 17 tax-haven subsidiaries, including 13 in the Cayman Islands, a country that has never imposed a corporate income tax. And the now infamous Enron Corporation had 1,300 different foreign entities, including some 441 located in the Cayman Islands."

His legislation will amend the Internal Revenue Code of 1986 to treat controlled foreign corporations established in tax havens as domestic corporations for tax purposes. It even lists the tax havens targeted. "This legislation is carefully drafted," says Barry Piatt, communications director for Sen. Dorgan.

"It will not adversely impact U.S. controlled corporations that are doing legitimate and substantial business in tax-haven countries." Piatt notes that the bill also empowers the IRS to add or remove countries from the bill's list of tax havens, and it does not go into effect until December 31, 2007, "which will give affected businesses ample time to restructure their tax-haven operations if they so choose."

For now, S.B. 779 is under study by the Senate Finance Committee. "It needs a bit of tweaking but, overall, it would make a big difference in cracking down on offshore tax avoidance or evasion," McIntyre says. "As for its chances in this Congress — well, because it would make a big difference, I don't see much hope," he adds.