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The Global Tax Avoidance Dance

Tax collectors in the U.S. and in high-tax foreign countries are the direct victims of tax avoidance, but we all suffer from the resulting budget deficits.
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America's most successful multinationals make great products and offer superior services. But they have another, less enviable quality in common -- they have become world leaders in tax avoidance.

General Electric's global effective tax rate for 2010 was 7.4%. Pfizer's was 11.9%; Cisco came in at 17.5%. The nominal U.S. corporate tax rate is 35%.

Each company has its own tax story, but all -- like other multinationals -- have for years relied heavily on low-taxed foreign income to drive down their worldwide tax obligations, including those of their U.S. businesses.

American multinationals claim they are taxed on their worldwide income, but in reality the "active" income they earn through foreign subsidiaries is not taxed in this country until the cash is repatriated. In addition, financial accounting practices (the lens through which we view these firms because their tax returns are not public) permit a company not to book any U.S. tax liability on foreign earnings if the firm states that the income is "indefinitely invested" abroad.

General Electric has $94 billion in indefinitely reinvested earnings. The total for corporate America is more than $1 trillion.

If the story was simply that U.S. firms have successfully expanded into international markets and are paying taxes abroad at lower rates, one could argue that there is no U.S. tax mischief afoot. But these are not the facts.

Tax collectors in the U.S. and in high-tax foreign countries are the direct victims of the tax avoidance, but we all suffer from the resulting budget deficits and distorted investment decisions that firms make as a result of their ability to generate what I call "stateless income" -- income derived from selling goods and services in a high-tax country but that, through internal tax legerdemain, surfaces in a low-taxed affiliate.

What's going on is a highly choreographed six-step dance.

Step 1: U.S. firms rely on aggressive "transfer pricing" to sell, at bargain prices, high-profit U.S. assets or business opportunities to their low-taxed foreign subsidiaries in countries like Ireland. It cannot be simply the luck of the Irish that explains the extraordinary profitability of the Irish subsidiaries of U.S. firms relative to their European sister companies.

Step 2: U.S. multinationals move income from higher-tax foreign countries, where their customers actually are located, to lower-taxed ones not only through transfer pricing but also through "earnings stripping." For example, a corporation funds its German subsidiary with loans secured in Ireland, so the interest is deductible in Germany.

Step 3: Not satisfied with low corporate tax rates in Ireland (12.5%) or in other countries, U.S. firms set up exotic internal funding structures -- with such names as "Double Irish Dutch Sandwich" -- to shift income from these countries to zero-tax havens like Bermuda.

Step 4: Firms arbitrage what remains of their U.S. tax base by parking their global external-debt financing here, which creates interest deductions to shield their U.S. income. They then overstuff their low-taxed foreign subsidiaries with equity capital.

Step 5: Having put their stateless-income generating machines in motion, U.S. firms let their ultra-low-taxed foreign income accumulate abroad. Microsoft, for example, has accumulated $29.5 billion in offshore indefinitely reinvested earnings. Its financial statements suggest that its effective foreign tax rate from selling its products and services to customers located primarily in populous and relatively high-tax countries is in the neighborhood of 4%.

Step 6: With more than $1 trillion in low-taxed earnings offshore, the firms complain to Congress that U.S. tax law impedes their ability to reinvest their foreign earnings back home because they have not yet paid U.S. taxes on them. They demand a special tax holiday from Congress so they can complete the circle and repatriate all those earnings at nominal cost.

All this tax engineering has yielded tax burdens that bear no relationship to tax rates in the United States or in the populous foreign countries where the firms actually have personnel, real investment and customers.

It's true that the U.S. corporate tax rate, at 35%, is too high relative to its economic peers, about 28% on average. (Click here for data on the 31 member states of the OECD; the 28% figure is an unweighted average of the larger OECD members. Click here for the "BRICs" and other non-OECD countries.) But the solution is not to reward U.S. multinationals for concocting and implementing worldwide tax-minimization schemes.

The only feasible solution is to lower the U.S. rate to a level comparable with global norms and to pay for the reduction in part by introducing worldwide tax consolidation for U.S. firms, just as they today consolidate their worldwide operations for financial accounting purposes.

Edward D. Kleinbard, a professor of law at the University of Southern California Gould School of Law, is former chief of staff of the U.S. Congress' Joint Committee on Taxation. The facts and arguments in this piece are abstracted from two recent papers authored by Prof. Kleinbard: Stateless Income and The Lessons of Stateless Income.

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