Europe is taking a closer look.

Photographer: Michael Gottschalk/Photothek via Getty Images

Avoiding Taxes Can Be Really Expensive

Justin Fox is a Bloomberg View columnist. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of “The Myth of the Rational Market.”
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You’ve probably seen this Learned Hand quote about tax avoidance:

Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.

Less often discussed is the rest of the 1934 appeals court ruling in which the most influential judge never to serve on the Supreme Court wrote those words, Helvering v. Gregory. In it, Judge Hand actually ruled against a company owner (Evelyn Gregory) who had used a temporary corporate reorganization to reduce her tax bill and in favor of the Commissioner of the Internal Revenue Service (Guy Helvering). In the same paragraph as the famous quote, Hand concluded:

To dodge the shareholders' taxes is not one of the transactions contemplated as corporate "reorganizations."

There may not be a patriotic duty to pay taxes, Hand’s reasoning went, but neither do you get to avoid them unless Congress meant for you to. Or something like that -- I’ve read a couple of law review articles on Hand’s tax jurisprudence and they don't depict it as especially consistent or comprehensible. That’s mainly because what Hand was trying to do was hard. He thought companies should be free to make business decisions, including business decisions that reduced their tax burdens. He just didn’t want them organizing and reorganizing themselves purely to avoid taxes.

Tax Inversion

This is of course quite the topical issue. In the U.S. the talk is all about “inversions,” in which American companies use mergers to move their legal domiciles overseas (even if their headquarters and the most of their business stays in the U.S.), thus reducing their tax bills. Past Congresses surely didn’t intend for companies to do what they’ve been doing lately, but the current Congress won’t stop them because many lawmakers think U.S. corporate tax rates are too high and the U.S. practice of taxing corporations on their worldwide income unfair. The Obama Treasury Department announced some rule changes last fall that seem to have slowed the flow, but don't underestimate the inventiveness of our nation’s tax lawyers. Also, while we’re on this subject, you have to read Zachary Mider’s BloombergBusinessweek profile of the late inventor of the corporate inversion, and watch the accompanying video of the operetta written in his honor. That’s an order.

The even bigger drama, though, may be in Europe, where American firms have for years been exploiting the combination of a single market and multiple tax jurisdictions to generate what University of Southern California law professor Ed Kleinbard calls “stateless income” -- profits that are routed from the country where they are generated to one where they almost entirely escape taxation. The classic case is probably Google’s “Double Irish” plus “Dutch Sandwich,” which as described in a much-cited 2010 article by Bloomberg News reporter Jesse Drucker involved a stop in Bermuda, too, and kept the tax rate on the company’s overseas profits in the low single digits. Drucker reported last month, based on the work of economist Gabriel Zucman, that “the share of U.S. companies’ foreign profits attributed to a handful of tax-friendly locales -- including Luxembourg, the Netherlands, Switzerland, Ireland and Grand Cayman -- has more than doubled over 20 years, from 25 percent in 1993 to 56 percent in 2013.”

Google has probably caught more flak for this than any company. Chairman Eric Schmidt’s standard response has been that he and his fellow executives had "a fiduciary responsibility to our shareholders" to pay as little in taxes as the law allows. That’s in keeping with Hand’s assurance that “any one may so arrange his affairs that his taxes shall be as low as possible.”

What about the second part of Hand’s argument, though? Did lawmakers in the countries where Google makes its profits intend for it to get away with paying almost no taxes on them? Well, it depends which lawmakers. The Irish definitely did mean to give Google and other companies a big tax break in order to bring jobs to the country. Authorities in the big European markets where Google and other U.S. companies actually make their money, though, didn't set out to exempt them from income taxes. And now they’re kind of ticked off.

It can’t be a coincidence that in recent years European authorities have turned increasingly hostile to Google, targeting it with antitrust investigations, punitive laws and possibly a continent-wide Internet tax. They have also been cracking down on other companies’ tax strategies. The latest is Amazon.com, which gets tax breaks in Luxembourg that the European Commission, in a letter made public Jan. 16, described as impermissible “state aid.” The Organization for Economic Cooperation and Development, the club of the world’s wealthy nations, is also at work on a "Base Erosion and Profit Shifting" initiative aimed at cutting down on such behavior.

Now, maybe the giant tax savings will prove to be worth all the ensuing hassle and bad publicity. It isn't inconceivable, though, that executives at Google and elsewhere will discover over the coming years that they would have served their shareholders better by listening to both halves of Learned Hand’s argument instead of just the first.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Justin Fox at justinfox@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net