Benjamin Franklin said that in this world nothing is certain but death and taxes. President Barack Obama is making this even more true with his recent proposal to raise approximately $190 billion over the next 10 years by outlawing a tax avoidance strategy used by some U.S.-based multinational corporations. These companies have legally used offshore locations, such as the Cayman Islands, that impose no corporate income tax on businesses incorporated within their jurisdiction, to avoid paying U.S. corporate income tax.
The concept of every taxpayer paying their fair share breaks down when it comes to the differences between individual and corporate taxpayers. U.S. citizens who live and work abroad generally can exclude a part of their annual foreign wages from U.S. income taxes (up to $91,400 for the 2009 tax year), but these individuals pay taxes at the rate that would apply to their income without the exclusion. Therefore, the tax rates for most expatriates start at 25%, rather than 10%. And if individuals don't pay U.S. taxes, they can be prosecuted for criminal tax evasion.
It's no wonder that many individual taxpayers who pay their fair share are fed up with corporations abusing transfer-pricing rules.
Some businesses, however, pay little or no taxes depending upon the jurisdiction of their incorporation and a practice called transfer pricing. This practice allows corporations to trade goods and services with their offshore subsidiaries and establish arbitrary prices for those transactions. A company may execute a tax-avoidance strategy by establishing artificially high prices for goods imported into the United States and artificially low prices for goods exported out of the United States. The fictitious import prices allow a business to fraudulently report higher expenses for tax purposes, while the significantly understated export prices reduce the company's revenue for IRS reporting.
As a result, U.S.-based multinational corporations can avoid paying U.S. taxes on profits earned from “sales” by their offshore subsidiaries unless the money is brought back into the United States, and a loophole in our current laws allows it. It's no wonder that many individual taxpayers who pay their fair share to support our nation's policies are fed up with corporations abusing transfer-pricing rules and shifting profits overseas as a tax avoidance measure.
Tax Avoidance and Fairness
According to a December 2008 Government Accountability Office (GAO) Report, “Eighty-three of the 100 largest publicly traded U.S. corporations in terms of 2007 revenue reported having subsidiaries in jurisdictions listed as tax havens or financial privacy jurisdictions.” Furthermore, only public corporations are required by the SEC to report significant subsidiaries, therefore the numbers cited in the GAO report are likely understated. The report acknowledges that there isn't an agreed-upon definition for a tax haven, but some common characteristics include: a zero or nominal tax rate; a lack of effective information exchange with foreign tax authorities; and a lack of transparency in legislative, legal, or administrative provisions.
Admittedly, there could be various business reasons, not related to tax avoidance, for companies to set up subsidiaries in listed jurisdictions. One reason might be to place assets in a strategic geographic location for efficient distribution. Nevertheless, the majority of companies would be hard-pressed to convince American taxpayers that the tax implications were not a significant consideration in their decision to establish a subsidiary in a jurisdiction promoted as an offshore tax haven.
These tax schemes shift a disproportionate burden of the costs of our society's needs, such as public education, healthcare, and national security, to honest taxpayers who don't abuse the tax laws. Basic issues of fairness and integrity are at stake.
But aside from the ethical implications that might argue against companies using tax havens to reduce or eliminate their tax burden, there also may be good business reasons to stay away from them. In our current economic environment, savvy investors are looking for companies that follow conservative business strategies for improving the bottom line, not tax loopholes or gimmicks. If President Obama's proposal eliminates those loopholes, perhaps businesses will refocus on improving their core operations.
As always, I welcome your comments.
Mary-Jo Kranacher, MBA, CPA, CFE. Editor-in-Chief.