The Hidden Perils of Offshore Tax Havens

Yes, setting up shop overseas cuts Uncle Sam's take. But it also invites a backlash by once-bitten investors wary of unethical behavior

By Diane Brady

Stanley Works, the Connecticut toolmaker, has cast its recent decision not to move its base to Bermuda as a noble effort to support Congressional tax reform. Forget the fact that it expects third-quarter earnings to jump almost 18% over that period in 2001, or that it managed to stay in business for 157 years without having an island paradise to fall back on. CEO John Trani says he still feels his outfit's "ability to compete is undermined by the U.S. tax code" and warns that failure to lower corporate taxes "can only accelerate the trend of fewer U.S.-headquartered companies."

Not, of course, if Congress succeeds in refusing tax breaks to U.S. companies that are based offshore and denying them government contracts. Along with demanding pay that, in some cases, is more than 400 times what average hourly workers make, it seems chief executives feel their businesses should be above the mundane responsibility of paying their fair share of U.S. taxes. Of course, looking greedy has a high cost these days. Sensing a public-relations debacle with already skittish investors, not to mention the prospect of less revenue, corporations are rightly moving away from flight as a tax-management option.


  Veteran shareholder activists like Bob Monks see the Bermuda backlash as a symptom of real change in how people judge corporate behavior. For too long, he says, U.S. companies have taken a literal approach to issues like taxes and governance. "The definition of what's right is what's legal," says Monks. In his view, that perspective has encouraged execs to bully accountants and lawyers into pushing the limits of what was acceptable. But increased public hostility and disgust over corporate behavior is promoting a more cautious climate, one in which business leaders really do want to be above reproach.

The furor over offshore tax havens disguises the fact that U.S. companies already have plenty of ways to make their tax bills much lower than they should be. The Internal Revenue Service doesn't tax foreign profits kept offshore, so less-than-scrupulous businesses have long known the benefits of moving income abroad. That can mean anything from paying too much to a tax-haven subsidiary for products to funneling domestic sales through foreign offices.

The popularity of Delaware as a place to incorporate is no secret, either. Along with state's corporate governance laws that favor management and a famously efficient court system, Delaware doesn't tax royalty income. That could give companies an incentive to transfer the ownership of patents to their Delaware headquarters, thus avoiding some state taxes. "There are a whole bunch of scams," says Robert S. McIntyre, director of Citizens for Tax Justice, which tracks corporate taxes.


  The bulk of those maneuvers are perfectly legal, of course. But anyone who compares the accounting used to calculate earnings for quarterly reports vs. what's used in filing to the IRS can see that profits have a habit of expanding or contracting to fit the situation. Despite the grumbling of Stanley Works and other large players, U.S. public companies actually pay significantly less tax than their foreign rivals, according to the Organization for International Investment.

Ironically, relocating abroad is hardly the panacea that companies might believe it to be. After all, having a Bermuda base certainly couldn't keep players like Tyco International or Global Crossing thriving. And the lack of a Bermuda abode doesn't seem to have hindered the competitive advantage of companies like General Electric.

If anything, the instinct to set up shop outside the country in which a corporation is really based could send a signal to investors that there might be greater problems. Such a move smells fishy, and the public-relations implications alone can be more toxic than any tax advantages, especially in the current environment. Howard Schilit of the Center for Financial Research & Analysis puts it this way: "This is probably the worst time to look like you're operating in a devious fashion."


  Tell that to companies like Stanley Works, which maintains that its decision to stay put could change, despite the risk of additional wrath from shareholders, workers, and politicians. "At this time, we're going to support Congress and efforts to fix the tax system," says company spokesman Peter Duda. "If there's no reform, the company will always take a look at the situation and decide what steps are appropriate to remain competitive."

An even better way to stay competitive these days -- not to mention in the good graces of shareholders -- is to behave like a good corporate citizen. That means operating within the spirit, and not just the letter, of tax law to pay a fair share of what's owed. Refusing to relocate offshore merely to dodge taxes is just a first step. Investors want to see corporate leaders stop complaining and get ahead of the curve when it comes to doing what's in the best interests of everyone. Anything less could have painful consequences in a market that's already unforgiving.

Brady is associate editor of corporations for BusinessWeek in New York

Edited by Beth Belton

Before it's here, it's on the Bloomberg Terminal.