Tax overhaul: big numbers, hidden stories

Multinationals have ways to avoid taxes not available to domestic companies, and momentum is building in both parties to fix a flawed system. A few journalists are taking note.

How big corporations pay—or don’t pay—their taxes isn’t a subject that gets a lot of quality explanatory coverage, though it should. And with momentum quietly building in the House, the Senate, and the White House to fix a clearly flawed system, now would be a good time to start. Fortunately, some publications are digging in.

We begin with The Wall Street Journal, which explained on Monday that—as the two top tax writers in Congress try to rush through comprehensive corporate tax reform before the end of the year—not all big corporations want the same outcomes. That makes balancing the interests of different powerful corporations a bit tricky for politicians.

As Journal reporters Damian Paletta and Kate Linebaugh explain,

The stakes are particularly high for multinational companies because the White House and Congress are considering changes that would dramatically alter the way foreign income is treated.

Democrats and Republicans have taken aim at the corporate practice of shifting profits abroad to places that impose little or no tax. How to address this issue is dividing large businesses that would be affected differently by various proposed tax-code changes.

One big split: Companies that pay hefty royalties to offshore subsidiaries for their intellectual property—patents, manufacturing processes, chemical formulas and even corporate logos—do not necessarily want the same tax rules as companies eager to expand manufacturing operations abroad. Think Microsoft vs. General Electric.

And, Paletta and Linebaugh note, “some multinationals want Congress to end the U.S. practice of taxing their income earned abroad altogether.” Some corporations already have arranged their books to profit off taxes by building up untaxed profits offshore and investing the money, as I showed here, using Apple as the example.

The Journal piece tees off of the announcements Friday and Saturday from Moscow, where the G-20 finance ministers said they would work together to keep multinational companies from gaming the system. This is the only indication that tax avoidance is not a uniquely American problem, but one common to all advanced economies. The reporters could have given us more on that.

The Journal piece also falls short in not quoting any critics of the varied multinational corporate arguments, instead relying on vague counterpoints such as “the companies defend the practice….” But it’s a good start.

Meanwhile, Fortune’s Lynnley Browning took aim on Monday at another issue central to any overhaul of corporate taxes, one that has gotten little attention outside of tax journals. People typically think of income taxes as objective. You fill in the boxes on tax forms and the software computes the same number for everyone. But as Browing explained, for big multinational corporations, taxes can be largely negotiable.

Multinationals privately negotiate agreements with the IRS that largely determine their taxes, by establishing how much they charge themselves for goods and services made in one country but sold in another.

The pacts, known as advance pricing agreements, effectively lock the IRS into agreeing with a company’s tax planning over many years, both future and past. Despite costing companies up to millions of dollars in fees to prepare and taking up to four years to seal, the agreements are nonetheless worth it to an elite group of big corporations that have them, including Google (GOOG), Apple (AAPL), and Amazon (AMZN).

To understand this, imagine you build widgets in a low tax country, say Vietnam. Your cost when the widgets are loaded onto a ship in Hanoi is $1 per widget including shipping to the Port of Los Angeles. While the widgets cross the Pacific, your Vietnam manufacturing arm sells the widgets to a sister “sales company” in the Cayman Islands for $40, which then resells them to your US marketing subsidiary for $45, which in turn sells them for $50 to retailers (who charge consumers $100).

Ignoring shipping costs, your company made a $49 gross profit ($50 sale to retailers minus $1 in costs), but took $44 of that profit tax-free in the Caymans ($45-$1)—and thus in the US reported only $5 profit ($50-$45). Only the $5 in the U.S. is currently taxable. Meawhile, though, the $44 profit in the Cayman Islands can be loaned to your US parent for limited periods of time, and becomes taxable profit only if permanently moved to America.

Browning (disclosure: she was a colleague at two news organizations) explains that these deals “effectively lock the IRS into agreeing with a company’s tax planning over many years, both future and past” and then observes that:

some experts wonder if advance pricing agreements, perfectly legal under U.S. law and growing in number, sometimes play a major role in helping to shift some of those profits and drive down corporate tax bills. “There’s a lot of confidential information in these deals, because it’s where companies make their profits,” said Patricia Lewis, a tax lawyer at Caplin & Drysdale who helps companies negotiate the pacts.

Ending these secret and company-specific agreements has, so far, not shown up as part of tax overhaul being promoted by Senator Max Baucus, the retiring Montana Democrat who chairs the Senate Finance Committee, and Representative Dave Camp, the Michigan Republican who chairs the House Ways and Means Committee.

Meanwhile, Baucus and Camp call their largely unknown plans “reform”—a word that journalists should be careful to use only with attribution to advocates. (Paletta and Linebaugh demonstrated such care in their their Monday WSJ piece, referring in the lede to “the congressional effort to overhaul the tax code,” rather than tax code “reform.”)

In the coming weeks and months, journalists should expect to get a lot of spin from lobbyists and flacks for companies that hope tax reform will ease their burdens. An initial primer on the flak we can expect from flacks appeared Monday in the Tax Analysts blog of Martin Sullivan, a former Treasury economist. (Disclosure: I am a Tax Analysts columnist).

Sullivan offered six initial examples of arguments likely to confuse the debate over corporate tax overhaul. Many of these arguments relate to the advance pricing agreements that Browning wrote about, because they have to do with corporations making contracts between parent company and offshore subsidiaries—essentially between sibling subsidiaries.

The prime motivation is to enjoy the benefits of being in a market like the US or Europe without bearing the burden of the taxes that the support the systems that make these markets valuable.

Also good to remember: Any tax overhaul proposals will likely have little to no affect on the vast majority of corporations, at least based on the limited and often vague information Baucus and Camp have made available so far. Here are some telling details, pulled from the 2010 IRS Statistics of Income report on corporate taxes—Corporate Tax Table 4 if you want to look it up—to keep in mind when you are writing about efforts to revise tax policy via Congress, where major corporations hold the most sway through lobbying and donations:

• Two thirds of the 5.8 million corporations in America have between a dollar and $500,000 of assets; another 17.2 percent have no assets.
• More than 99 percent have less than $25 million in assets.
• Just 0.048 percent—one in 2,100 corporations—has more than $2.5 billion in assets; they average $23.4 billion.
• These 2,772 biggest corporations own 81 percent of corporate assets, and they paid an average tax rate of 16.7 percent.

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David Cay Johnston covers fiscal and budget matters for CJR’s United States Project. He is a reporter with 46 years of experience, including 13 at The New York Times; a columnist for Tax Analysts; teaches tax and regulatory law at Syracuse University Law School; and is president of Investigative Reporters & Editors (IRE). Follow him on Twitter @DavidCayJ. Tags: , , , , ,