Wanted: A Tax Code for the Digital AgeBy and
Anyone who wants a Nintendo Wii console or the latest John Grisham novel can pick it up at the nearest Target (TGT) store or log on to Amazon.com (AMZN) and have it delivered. The similarities between the two retailers aren't as apparent when it comes to taxes. Amazon's effective rate—the total it pays in federal, state, local, and international income taxes after deductions, along with its sales and property levies—has been more than 10 percentage points lower than Target's for the past four years. Target's effective tax rate in 2010 was 35.1 percent, compared with Amazon's 23.5 percent. Amazon in 2010 owed $352 million in income taxes worldwide on income of $1.5 billion, according to its SEC filings, while Target owed $1.58 billion on income of $4.5 billion. Amazon, the world's largest online retailer, has successfully resisted efforts from politicians to make it collect state and local taxes that brick-and-mortar rivals must charge. Tax laws "absolutely" put Target at a disadvantage, says Brian Sozzi, an analyst with Wall Street Strategies in New York. "It's one of the reasons why Amazon has been so successful."
These companies represent just one example of how the U.S. corporate tax code favors global companies over domestic ones, high-tech businesses over old-line manufacturers, and drugmakers over oil companies. The U.S. federal corporate tax rate of 35 percent is the highest in the developed world. Still, the Treasury Dept. says the federal government bleeds $1.2 trillion a decade as battalions of lobbyists, accountants, and lawyers create and promote more ways to avoid taxes.
This state of affairs has grown out of a political process where companies and their trade associations steer campaign money to lawmakers who write into laws special tax breaks for favored industries. "A tangle" is what George K. Yin, a former chief of staff for Congress's Joint Committee on Taxation and now a law professor at the University of Virginia, calls the tax code. "It is a very complicated society and economy that we live in. You add to that the fact that we don't have all politicians with pure hearts and minds. And then you have all the different interest groups." Put it all together and what do you get? A 5,000-page document that in printed form weighs around nine pounds—as much as a large newborn baby.
The U.S. tax code was written at a time when American companies dominated the world economy and the Internet hadn't entered the imaginations of Defense Dept. scientists. The last major rewrite a quarter century ago didn't alter that basic structure, which taxes companies on worldwide income only when they bring home profits earned overseas. "We have lots and lots of tax preferences that reduce the effective rate," says Ed Kleinbard, a tax law professor at the University of Southern California and a former chief of staff of the Joint Committee on Taxation. Those preferences "distort decisions and are imperfectly distributed throughout the corporate sector."
The effect of the tax code on business behavior is clear when comparing Target and Amazon. Amazon, based in Seattle and founded in 1995, has made a series of moves to cut its tax bill since it became profitable in 2005. That year it established a European headquarters in Luxembourg, where the corporate income tax rate is 21 percent. The following year the company paid an effective tax rate of 49.6 percent as a result of selling assets to its Luxembourg subsidiary, according to its Securities and Exchange Commission filings. Since 2007, Amazon's effective tax rate has ranged from 27.9 percent to 21.9 percent. Executives at Amazon declined to be interviewed.
By moving intangible assets such as patents and intellectual property to low-tax countries, Amazon could then pay its subsidiaries in those countries for the use of the assets, cutting its income in high-tax jurisdictions. The practice, known as transfer pricing, is a common strategy global companies employ to reduce taxes. Those techniques "are not readily available to purely domestic firms," says Sullivan.
Amazon didn't disclose in its corporate filings exactly what assets it moved to other locations. However, the company holds 253 U.S. patents and 39 U.S. registered trademarks, according to the U.S. Patent and Trademark Office's online database. The patents include several for its Kindle electronic reader and for its recommendation system.
Amazon generates about 46 percent of its sales outside the U.S. Yet the tax benefit it derives from its foreign operations far exceeds the proportion of its international sales, says Robert Willens, a corporate tax specialist in New York. For the past three years, Amazon's tax rate on international income averaged 4.2 percent, according to its annual report.
Target, by contrast, makes all of its sales in the U.S. More than half its $44 billion in assets are land and buildings—hundreds of giant big-box stores that can't be transported to Luxembourg by signing a few documents. All of the company's trademarks, patents, and other intellectual property are owned by Target Brands, a subsidiary that is also based in the U.S., says spokeswoman Molly Koenst.
Target's tax disadvantage is compounded by the state and local sales taxes it is required to collect, which can add as much as 10 percent to the customer's final bill. Amazon, on the other hand, has fought for years to avoid having to do the same. It currently collects sales tax in only five states where it has a physical presence.
The online retailer last month severed ties with all its affiliates in Illinois after legislators in Springfield approved a law requiring online companies that have affiliates in the state to collect state sales tax. A month earlier, Amazon said it would close an Irving (Tex.) distribution center after that state's comptroller sent the Web retailer a bill for $269 million in uncollected sales taxes.
Rachelle Bernstein, tax counsel to the National Retail Federation, a trade group representing brick-and-mortar retailers including Target, says retailers are burdened by the highest effective rates of any industry in the U.S. "Our members have for many years been supportive of tax reform that would lower the rate and broaden the base," she says.
More than half the companies in the Standard & Poor's 500-stock index had an effective tax rate of less than 30 percent. Carnival (CCL), the world's biggest cruise line company, which is incorporated in Panama, paid an effective tax rate of 1.4 percent, on average, from 2005 through 2010, according to Bloomberg calculations based on data from public filings. The rate for Agilent Technologies (A) was 10.7 percent over the same period and 17.7 percent for pharmaceutical giant Pfizer (PFE). General Electric (GE), the global conglomerate with a famously creative tax department, had a six-year average effective rate of 11 percent—in 2010 it was only 7.4 percent.
Oil giants ExxonMobil (XOM) and Chevron (CVX), by contrast, have effective rates of more than 40 percent, in part because of the hefty fees they pay to countries where they lease oil rights. Other companies that don't fare so well are Goldman Sachs Group (GS), with an effective rate of 32.7 percent from 2005 to 2010, and motorcycle maker Harley-Davidson (HOG), whose average rate was 36.2 percent.
The U.S. is among a handful of countries that tax profits earned in other countries, though only when the money is repatriated. This gives multinationals a decided advantage, says Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities, a Washington research group. "Companies can operate in tax havens and leave money offshore, where a purely domestic firm would not have that."
Many U.S. multinationals would rather bring their cash home, where it can be reinvested into core operations. Ray Stata, chairman of Analog Devices (ADI), a Norwood (Mass.) electronics manufacturer, who also heads the Semiconductor Industry Assn., says the industry has "gobs of money" sitting overseas. He spent two days in March lobbying members of Congress to shift the U.S. to a territorial tax system, where only profits earned domestically are taxed.
Some multinational companies have banded together to press lawmakers for a temporary repatriation holiday to allow them to bring their profits home at a lower rate. A tax holiday would give global companies, including Amazon, another advantage over domestic counterparts such as Target. Some Republicans in Congress, led by House Majority Leader Eric Cantor (R-Va.), support the idea. The Administration says it will consider a tax holiday only if it's part of an overall corporate tax overhaul.
President Barack Obama in his fiscal 2012 budget proposal called for lowering the corporate tax rate while eliminating deductions and exemptions so the Treasury can collect the same amount of revenue. Cantor and House Ways and Means Committee Chairman Dave Camp (R-Mich.) have said they'd like to see the rate fall to 25 percent, yet they have not stressed the need to make up for lost revenue. "The high corporate tax rate is a big problem because the statutory rate, the 35 percent rate, is what motivates behavior," says Martin A. Sullivan, an economist at Tax Analysts in Falls Church, Va. "If I want to do some tax sheltering, if I want to do some borrowing, all of that is based off of the corporate rate."
Even with a high top rate, U.S. corporate tax revenue as a share of the economy has declined since the 1950s. It then made up 4.7 percent of gross domestic product, according to an analysis by the Center on Budget and Policy Priorities. From 2000 to 2009, corporate tax revenue averaged just 1.9 percent of GDP. Corporate taxes accounted for 11 percent of federal revenue in the last decade, down from 30 percent in the 1950s.
One reason is that many owners are able to organize their businesses as "small business corporations" and pay taxes under the individual income tax code. These so-called S corporations—and other entities including partnerships and limited-liability companies—are not subject to corporate taxes. Profits at S corporation are taxed once, at an individual rate, when the cash flows to the owners. The strategy helps avoid what economists say is the double taxation of traditionally structured corporations, or C corporations. These businesses pay taxes on their profits at the corporate rate and then the owners or shareholders pay tax again on those profits when they are distributed as dividends.
Obama's call to lower the 35 percent top tax rate won't benefit all businesses equally. Unlike multinationals and other C corporations, S corporations, which pay taxes at the individual rate, would be unaffected by the cut. They may even wind up paying more if, as Obama has suggested, the cost of the reduction is offset by eliminating deductions for expenses, such as interest costs, available to all businesses, including S corporations.
Economists and Administration officials say the tax laws encourage companies to make decisions based on reducing their tax burden rather than on what's best for their business. Obama, in his Jan. 25 State of the Union address, said he wants "the market to decide which businesses grow, not the community of tax lobbyists and tax planners."
The bipartisan panel appointed by Obama to come up with a plan to reduce the federal deficit and debt—the National Commission on Fiscal Responsibility and Reform—has proposed dropping the corporate rate to 28 percent. Each percentage-point reduction in the 35 percent corporate rate, however, could cost $8 billion or more a year in forgone revenue to the Treasury, according to the Joint Committee on Taxation. On that basis, the panel recommended eliminating almost all business tax breaks to ensure the lower rate doesn't increase the deficit.
To say that would be difficult is a colossal understatement. Many companies are deeply attached to their special tax benefits. Analog Devices' Stata says cutting the rate shouldn't depend on raising the same amount of money by eliminating deductions. "The scary part of this is the revenue-neutral part," he says. "We're trying to figure out how not to end up worse off."
Senator Ron Wyden (D-Ore.), a member of the tax-writing Finance Committee, last year introduced legislation to lower the top corporate tax rate to 24 percent in exchange for eliminating special preferences—especially those that encourage businesses to go offshore. He says he's "upbeat" about prospects for a tax-code overhaul, in large part because it can create jobs. "If you look at the two years after the last major tax reform bill in 1986, our country created 6.3 million nonfarm jobs," he says.
Wyden says he's working to build support among Democrats and Republicans "so that when all the interest groups mobilize and say, 'You take away my tax break and Western civilization is going to end,' you've got a bipartisan coalition with strength to hang in there and beat them."
After all, unlike the health-care overhaul Congress passed last year, it's not as if the U.S. hasn't done this before. Says Wyden: "No senator is going to face a town hall meeting where people say, 'Keep your cotton-picking hands off the tax code I love.' "
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