Taxing Multinationals: The Donnybrook Ahead

The U.S. international code badly needs fixing. But reforming the system will be bloody

Tax systems are never pretty. But even by the usual low standards of revenue codes, the way the U.S. taxes exporters and multinationals is especially ugly.

America's system imposes reams of incomprehensible rules on companies and forces them to spend a small fortune on lawyers and accountants. Because of a patchwork of special-interest laws, it generates huge subsidies for some companies yet punishes thousands of others. It encourages massive amounts of sheltering--paper transactions aimed at nothing more than reducing tax bills. And at the end of the day, the Treasury collects stunningly little revenue, perhaps just $5 billion a year. "The U.S. is probably rich enough to get away with stupid taxes," says University of Michigan tax economist James R. Hines Jr. "But it doesn't mean we should have them."

Now, change may be on the way. A World Trade Organization decision to prohibit one big U.S. export subsidy has kicked off a major effort in Washington to rethink the way foreign income is taxed. And the direction reform takes will inevitably create big winners--and big losers--in Corporate America. The billion-dollar question: Will Washington just replace its now-banned subsidies with new corporate tax cuts, or will it reform the way it taxes foreign profits?

With U.S. companies selling more than $150 billion worth of goods overseas each year, and with one-third of all sales of American multinationals coming from their foreign affiliates, the lobbying battle will be fierce. Hanging in the balance will be billions of dollars in profits that escape taxation.

If nothing else, there is broad agreement that the system needs fixing. To avoid taxes, U.S. companies are shifting increasing amounts of assets to low-tax countries. The Cayman Islands, for example, is home to 50 banks, making it the world's fifth-largest banking center. In 1994, the last year of available data, such tax havens accounted for just 3% of the world's gross domestic product but 26% of the assets and 31% of the net profits of U.S. multinationals.

Since then, the problem has gotten worse, despite aggressive efforts by the European Union, the Organization for Economic Cooperation & Development, and the U.N. to curb tax havens. Says Peter Merrill, a partner at accountants PricewaterhouseCoopers LLP: "The mobility of capital is unbelievable. Competitive pressures are going to keep forcing down corporate tax rates."

At the same time, American companies are becoming attractive targets for overseas takeovers--in part because they'll pay lower taxes as foreign-owned businesses. And the rise of the borderless Internet is raising still other questions about the sustainability of an international tax system based on a company's location.

To fight these trends, Washington created a $4 billion-a-year subsidy for exporting corporations. The arrangement allows companies to get a special tax break by creating a Foreign Sales Corporation (FSC), a third-country affiliate through which it can export goods. Most benefits go to a handful of companies. In 2001, for instance, Boeing Corp. (BA ) received $222 million in breaks through its FSC.

But the scheme has been declared illegal by the WTO. And U.S. businesses are desperate to replace it with new tax breaks, which, they insist, are essential to staying competitive in the global marketplace. Foreign governments, they note, heavily subsidize their own companies, through tax laws, trade barriers, and direct aid. "Whether we are financing exports or pure financial services, we are essentially competing on price," says Richard D'Avino, a senior vice-president at GE Capital. "A slight difference in cost will determine whether the deal goes to a competitor or to us." And, he adds, taxes can increase GE's costs by 20%.

Critics, however, call the system a giveaway to U.S. companies, largely because multinationals have become so artful at avoiding taxes. They do it two ways: They shift as much income as possible from the U.S. to low-tax nations such as the Caymans or Ireland. And they shuffle tax-deductible expenses from those low-tax countries back to the U.S. The now-infamous practice of reincorporating in Bermuda is "just the tip of the iceberg," says Robert McIntyre, director of Citizens for Tax Justice, a labor-funded tax group. "Bermuda makes it real easy, but it is not the only way to do it."

Although the corporate tax rate in America is 35%, one study found that in 1996 the taxman collected barely 3% on foreign earnings of U.S.-based companies. And tax collections have likely fallen even more as companies get better at shuffling income and costs. Harvard University economist Mihir Desai estimates that big companies slash their taxable income by $84 billion just by reinvesting foreign earnings overseas. Outright sheltering keeps billions more from the tax collector. "We've created a huge amount of complexity, and we collect very little revenue," says Rutgers University economist Rosanne Altshuler.

Some GOP lawmakers, including House Ways & Means Committee Chairman Bill Thomas (R-Calif.), would love to scrap the whole mess. "When people realize how much the U.S. system is out of sync with the rest of the world, we'll have a wholesale reexamination of the tax regime," he says.

Many Democrats, fearful that reform would simply turn into a bigger giveaway, are wary of more than modest changes. Even some business groups worry about getting into a game that will create winners and losers. The National Foreign Trade Council, which represents big multinationals, thinks Congress would be better off repairing the current system rather than replacing it. The tax vice-president at a major U.S.-based bank adds: "Any time you get involved in wholesale changes, you're asking for trouble. The current system is fine for us."

Perhaps, but it is also rife with problems. One reason: The world taxes foreign income two different ways. Much of Europe and the developing world use a territorial system where a country taxes goods and services sold on its soil--no matter where they were produced or where the seller is headquartered.

By contrast, the U.S., along with Britain and Japan, taxes its exporting companies on their worldwide income. To prevent business from being taxed twice, the U.S. gives companies a credit to offset the levies they pay to other countries on the same revenue.

Multinationals get another key benefit. They defer paying taxes on worldwide income until the money is returned to the U.S. Thus, a business can avoid taxes by reinvesting foreign income overseas and manipulating the timing of its decision to return the funds to the U.S.

Less than half of the foreign earnings of U.S. companies are returned to the U.S. parent in any given year. And of profits generated in low-tax countries, just 7% comes back to the U.S.

Companies have also invented creative ways to shift income to low-tax countries. One practice, known as earnings stripping, lets them shuffle patents and other intellectual property to, say, Ireland. The U.S. parent will pay as much as possible in royalties to its Irish subsidiary and deduct those costs against its U.S. taxes. Or a U.S. parent can borrow from a Caribbean affiliate, taking big interest deductions at home. The Internal Revenue Service tries to prevent companies from abusing these practices by limiting the deductions. But companies just find ways around them.

The most lucrative practice is known as transfer pricing. An American manufacturer buys parts from a subsidiary in, say, Singapore. To reduce its U.S. taxes, the company pays the highest possible prices to its overseas affiliates, thus maximizing deductions here and paying relatively low taxes there.

Sometimes, companies get even more aggressive. The most extreme recent example is the Bermuda shuffle, where companies move their paper headquarters to Bermuda--which has no business income tax--even though management remains in the U.S. The new company can not only shelter foreign income but also cut taxes on U.S. revenues. In recent years, companies such as Tyco International, Ingersoll-Rand, and the consulting firm Accenture have set up headquarters in Bermuda.

But these tax savings come at a price. Companies are diverted from the business of selling products and instead focus time and money on cutting taxes. University of Michigan tax economist Joel B. Slemrod estimates that the nation's 500 biggest companies spend more than $1 billion a year complying with the tax laws. And perhaps half of that cost is linked to international tax rules.

The effort to trim can also be disastrous for a company's image. New Britain (Conn.) toolmaker Stanley Works tried the Bermuda shift earlier this year. But following a firestorm of criticism from Congress, shareholders, and unions, Stanley dropped the effort.

Why did Stanley do it? Said CEO John Trani at the time: "Tax rates in other countries are much lower. It's not a choice. If you don't deal with [it], you get extinguished."

Stanley is a straightforward outfit that sells hammers and other tools. But think of the coming struggle over how companies that sell downloadable software or music will be taxed. Sorting out where such products are made and who taxes them will be a nightmare.

Already, the European Union is demanding the right to tax Internet transactions, most of which are generated by U.S. companies. America is trying to persuade other nations to go slow--with little success so far. "The [Europeans] are taking a very hard line," says University of Chicago economist Austan Goolsbee, an Internet tax expert. "They are going to try to impose taxes not just on physical goods but on digitally delivered goods."

Is there a solution to this mess? One possibility is for the U.S. to adopt a variation of the European-style territorial system. Called a dividend exemption regime, it would allow companies to avoid tax on all foreign income--except for passive investments. But it would also bar them from loading up on artificially inflated deductions generated by their foreign subsidiaries.

Today's U.S. system is so inefficient, say economists John Mutti and Harry Grubert, that exempting overseas income from taxes would actually generate $7 billion more for the Treasury than the current regime, which is supposed to be taxing it.

Here's another solution: Limit businesses' ability to defer the taxes they pay on foreign sales. Companies would pay tax on those revenues in the year they are earned, rather than when they repatriate the money back to the U.S. In return, they would get a tax-rate reduction. The plan would end a lot of gaming of the system, simplify the rules, and help investors figure out how much tax companies really pay. But it would also be a cash-flow nightmare for businesses.

A third alternative: Scrap the income tax and replace it with a consumption levy, such as a flat tax. That may seem extreme, but many economists are convinced that today's tax code is breaking down. Says PwC's Merrill: "You're really going to have a difficult time maintaining the income tax in a competitive, fluid, capital market."

In the short run, Congress is likely to go for a much more modest fix. It will drop the now-illegal FSC subsidy and in return, give U.S. business $4 billion in new tax breaks--some aimed at exporters, others aimed at all companies.

But such a solution will only buy time. In the end, Washington is going to have to find a way to modernize its tax code. Or else it can expect to see more and more U.S. companies shipping out.

By Howard Gleckman in Washington

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