Biggest Tax Avoiders Win Most Gaming $1 Trillion U.S. Tax Break

Cisco Systems Inc. (CSCO) has cut its income taxes by $7 billion since 2005 by booking roughly half its worldwide profits at a subsidiary at the foot of the Swiss Alps that employs about 100 people.

Now Cisco, the largest maker of networking equipment, wants to save even more -- by asking Congress to waive most federal taxes due when multinationals bring such offshore earnings home. Chief Executive Officer John T. Chambers has led the charge for the tax holiday, which would be the second since 2004. He says it would encourage companies to “repatriate” as much as $1 trillion held abroad, spur domestic investment and create jobs.

Cisco’s techniques cut the effective tax rate on its reported international income to about 5 percent since 2008 by moving profits from roughly $20 billion in annual global sales through the Netherlands, Switzerland and Bermuda, according to its records in four countries. The maneuvers, permitted by tax law, show how companies that use such strategies most aggressively would get the biggest benefit from the holiday, said Edward D. Kleinbard, a law professor at the University of Southern California in Los Angeles.

“Why should we reward firms for successfully gaming the tax system when we in turn are called on to make up the missing tax revenues?” said Kleinbard, a former corporate tax attorney at Cleary Gottlieb Steen & Hamilton LLP. “Much of these earnings overseas are reaped from an enormous shell game: Firms move their taxable income from the U.S. and other major economies -- where their customers and key employees are in reality located -- to tax havens.”

Photographer: Charles Crowell/Bloomberg

John Chambers, chief executive officer of Cisco Systems Inc., speaks at the Global Competitiveness Forum in Riyadh, Saudi Arabia. Close

John Chambers, chief executive officer of Cisco Systems Inc., speaks at the Global... Read More

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Photographer: Charles Crowell/Bloomberg

John Chambers, chief executive officer of Cisco Systems Inc., speaks at the Global Competitiveness Forum in Riyadh, Saudi Arabia.

Complying With Laws

“Cisco complies with all global tax laws,” said John Earnhardt, a spokesman for the San Jose, California-based company, which makes switches, routers and other products, in an e-mailed statement. “In the past three years alone, Cisco (which has over 35,000 U.S. employees) has paid approximately $4.4 billion in U.S. federal corporate income taxes.” The company reported an effective tax rate last year of 17.5 percent, half the U.S. statutory rate.

Companies including Google Inc. (GOOG), Apple Inc. (AAPL) and Pfizer Inc. (PFE) are also pushing the proposed tax holiday, which would allow profits to return to the U.S. at a discounted 5.25 percent rate. Under current law, American companies can defer federal income taxes on most overseas earnings indefinitely. When they do return to the U.S., they’re taxed at the corporate rate of 35 percent -- with credits for foreign income taxes paid. Thus, companies paying little overseas face higher U.S. tax bills upon repatriation, and would get more benefit from the discount.

Photographer: Gianluca Colla/Bloomberg

Cisco’s international earnings have been taxed at about 5 percent since 2008, records show. Close

Cisco’s international earnings have been taxed at about 5 percent since 2008, records show.

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Photographer: Gianluca Colla/Bloomberg

Cisco’s international earnings have been taxed at about 5 percent since 2008, records show.

Competitors’ Rates

“Cisco would like to bring its after-tax foreign earnings back to spend in the U.S., but cannot with the U.S. corporate tax rate at 35 percent,” Earnhardt said. “Our foreign competitors are allowed to repatriate foreign earnings at rates of 0 to 2 percent.” The tax-holiday push comes as the company faces shareholder pressure to add to its cash outlays by paying higher dividends to boost its stock price. It closed at $15.05 yesterday, down 25.6 percent this year.

One way multinationals avoid taxes is through “transfer pricing,” transactions among subsidiaries that allow for allocating expenses to high-tax countries and profits to tax havens.

As governments worldwide grapple with budget deficits -- $1.4 trillion projected for the U.S. and 597 billion euros for the European Union -- such income-shifting by multinationals cost the U.S. Treasury about $90 billion in revenue in 2008 alone, according to a March article by Kimberly A. Clausing, an economics professor at Reed College in Portland, Oregon.

‘Round-Tripping’

Cisco transfers a portion of the patent rights to technology developed in the U.S. to a Dutch unit, which sells some of the resulting products back to its parent for eventual distribution in the U.S., according to annual reports filed by the Amsterdam subsidiary. That means Cisco credits about $5 billion in U.S. sales annually to the Netherlands.

While that sort of structure allows for shifting income from U.S. sales to offshore subsidiaries -- a maneuver known as “round-tripping” -- Cisco pays all U.S. taxes on its profit from U.S. sales, said Earnhardt, the spokesman.

The company’s overseas units move at least some of the income back to their American parent via payments for the use of intellectual property and other services. Cisco does not disclose whether any earnings from U.S. sales remain permanently offshore.

At the same time, most of the income from sales in countries like Germany, France and Japan, where statutory income tax rates average more than 30 percent, is ultimately transferred to Switzerland, meaning the other nations lose potential tax revenue. The result: Cisco’s international earnings have been taxed at about 5 percent since 2008, records show.

Cost of Holiday

Chambers, 61, declined to be interviewed for this article. Over the past year, he has campaigned for a repatriation tax holiday, which the nonpartisan congressional Joint Committee on Taxation says would cost the U.S. Treasury $78.7 billion over the next decade. That’s about how much the federal government will spend on cancer research over that time, based on current budgets.

On earnings calls, in speeches and in national media, Chambers has made the case for the tax break, saying it would help overcome a corporate tax system he calls “a dinosaur” and “put more than two million Americans back to work.”

It’s unclear whether any jobs would come from Cisco, which announced plans in May to shed an unspecified number of workers. Earnhardt, the spokesman, declined to comment on hiring plans for the company, whose customers include Verizon Communications Inc. (VZ) and AT&T Inc. (T)

Cash Overseas

All told, Cisco has accumulated $31.6 billion in overseas earnings on which it has paid no U.S. income taxes yet, records show -- part of more than $1 trillion in U.S. companies’ offshore profits, according to data compiled by Bloomberg. In total, almost 90 percent of Cisco’s cash sits overseas.

“I create jobs overseas,” Chambers told interviewer Lesley Stahl on the CBS News program “60 Minutes” in March. “I build plants overseas and I badly want to bring that money back.”

The company needs that cash to prop up its share price -- which explains its support for the tax break, said Sandeep Shyamsukha, a communications analyst at Auriga USA LLC in San Francisco. Since 2006, Cisco has spent $43.5 billion on stock buy-backs. In April, it paid its first shareholder dividend. Consumer advocate Ralph Nader, who owns Cisco stock, this month called for doubling the payout, as first reported in the Wall Street Journal.

‘Tremendous Pressure’

“The stock is struggling, the company has reached a mature phase and investors are demanding more returns,” said Shyamsukha, who has a “hold” recommendation on Cisco shares. “There’s tremendous pressure on the management to give out dividends and higher buybacks and that’s probably what’s pushing them in this direction.”

U.S. companies used $312 billion they repatriated under a 2004 tax holiday largely for stock repurchases, while doing little direct hiring or domestic investment, according to a paper in the current issue of the Journal of Finance by professors at the University of Illinois, Harvard University, and the Massachusetts Institute of Technology. It was the latest in a series of studies that reached similar conclusions.

While Treasury Secretary Timothy F. Geithner has expressed skepticism about a new repatriation break, Representative Kevin Brady, a Texas Republican, introduced a bill on May 11 that, like the 2004 measure, would not require companies to use their cash for hiring.

Lower the Gate

Brady declined to address why his measure does not include a hiring requirement. “With millions of Americans seeking work it makes good economic sense to temporarily lower the tax gate and allow up to a trillion dollars of stranded American profits to flow back into our economy,” he said in a statement.

The idea gained momentum last week after Senator Charles Schumer, a New York Democrat, said his party’s caucus was discussing whether short-term revenue from the holiday could fund an “infrastructure bank” to create jobs. Senator John Kerry, a Massachusetts Democrat, has also signaled that he may reconsider his previous opposition.

Cisco, Oracle Corp. (ORCL), Microsoft Corp. (MSFT) and others formed a coalition called WIN America Campaign that plans to spend several million dollars pushing the issue. The group is being advised by SKDKnickerbocker, a Washington-based political consulting firm for which Anita Dunn, President Obama’s former communications director, is a managing director.

“We simply don’t think it’s a good idea to do nothing while a trillion dollars sits overseas,” said Doug Thornell, a vice president for the firm who is advising the campaign.

Terra Cotta Hub

Cisco’s overseas hub, in a terra cotta-faced office on the outskirts of Amsterdam, coordinates manufacturing, distribution and sales to Europe, Asia and other markets. Cisco Systems International BV employs about 2 percent of the company’s global workforce of roughly 70,000. It gets credit for more than half of Cisco’s worldwide sales, including part of the U.S. business, according to Dutch and U.S. filings.

Beginning in 1996, the Netherlands subsidiary began paying for part of Cisco’s ongoing research in the U.S. under a cost- sharing agreement, according to corporate records. Like other U.S. technology companies, Cisco qualifies for U.S. tax benefits by doing most of its research and development domestically. By paying for some of it, the overseas unit can remove a chunk of any subsequent profits from the U.S. and claim them offshore.

Buy-in Payments

Cisco’s foreign operations also made so-called buy-in payments to the U.S. parent, acquiring an interest in some existing intellectual property -- and a claim on future profits from it.

The company hasn’t disclosed the amounts paid in those transactions since 2002. The U.S. Treasury Department requires that foreign subsidiaries pay an “arm’s length” price, or the amount that would be paid by an unrelated party.

As a result of these arrangements, Cisco must buy from its own Dutch subsidiary some of the products it then sells to U.S. customers, even for equipment based on patents developed in the U.S. In 2008, for example, the Amsterdam unit reported $6.1 billion in sales to the U.S. and Canada -- equaling about 30 percent of Cisco’s total sales in those two countries.

The Dutch unit reported just a 1 percent profit margin on its total revenue of $22.1 billion in 2008. That’s because most of Cisco’s overseas earnings flow from the Netherlands to a separate subsidiary in Switzerland under a sublicensing agreement for intellectual property.

Dutch Rules

Dutch tax rules make it cheaper for companies to route payments to their units in tax havens like Bermuda through the Netherlands instead of sending them there directly, said Richard Murphy, director of UK-based Tax Research LLP.

In Rolle, about 25 miles north of Geneva, a subsidiary called Cisco Systems International Sarl collects billions of dollars a year from its Dutch cousin. The town, which features sweeping views of the Alps and Lake Geneva, is home to units of several U.S. multinationals, lured by tax advantages. Rolle’s main pedestrian drag, Grand Rue, is lined by boulangeries and real estate offices listing homes for millions of Swiss francs.

A short walk from 13th century buildings is Cisco’s Swiss subsidiary, housed in a five-story structure with horizontal metal blinds that resembles a giant air conditioner.

Although Cisco does not disclose precise amounts paid to the Swiss company, the Dutch unit reported paying $9.6 billion to other Cisco subsidiaries in 2008, including “royalty payments for the license of intellectual property.” The Swiss unit’s tax rate has been less than 5 percent in recent years.

Other Countries’ Rates

That beats the income-tax rates in many countries where Cisco has sales: Germany’s combined national-local rate is 30.2 percent; France’s 34.4 percent; Japan’s 39.5 percent and the U.K.’s 26 percent, according to figures from the Organization for Economic Cooperation and Development.

While Switzerland’s average combined statutory corporate income tax rate is about 21 percent, some companies receive significant exemptions at both the federal level and the canton, the Swiss equivalent of the state. A spokesman for the Swiss Federal Tax Administration declined to comment.

The unit in Rolle, which has roughly 100 workers, is owned by yet another Cisco subsidiary, registered at the offices of Conyers Dill & Pearman, a law firm in Hamilton, Bermuda. For U.S. tax purposes, profits from the Swiss and Dutch units flow to this shell company, one of hundreds the law firm handles on Bermuda, which has no corporate income tax.

Also Serving Google

One of the three directors listed for Cisco’s Bermuda subsidiary, a manager at Conyers Dill, is also a director for a pair of units that helps cut the tax bills of another U.S. technology company: Google. The search engine giant used subsidiaries in Bermuda, the Netherlands and Ireland to cut $3.1 billion from its worldwide tax bill over three years, Bloomberg News reported in October.

The benefits from Cisco’s foreign profits lopped 19.3 percentage points off its total tax rate last year. Bloomberg calculated Cisco’s $7 billion tax savings since 2005 by applying each year’s foreign tax benefit to pretax earnings as disclosed in U.S. filings. Results were combined for all years after the company restructured its overseas operations for tax reasons in 2004.

While tax strategies have boosted Cisco’s earnings, they mean less revenue for governments in countries where the company operates, a trend that may affect Cisco as well. The company is seeing slowdowns in its business with cash-strapped governments, Chambers said during a May 11 earnings call.

Historically, the public sector has made up 20 percent of Cisco’s sales, Chambers said -- that’d be about $8 billion in taxpayer-funded sales last year. “We do not underestimate the transition in front of us,” he said.

To contact the reporter on this story: Jesse Drucker in New York at jdrucker4@bloomberg.net

To contact the editor responsible for this story: Gary Putka at gputka@bloomberg.net.

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