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Outsourcing Jobs and Taxes

How US Corporations Avoid Paying US Income Taxes

We're all aware that US corporations outsource jobs to countries such as India and the Philippines to lower costs and increase profits. A major concern is another practice sanctioned in the U.S. Tax Code that allows companies to avoid paying US income taxes on profits earned by foreign subsidiaries until and unless such amounts are repatriated to the US parent. The technique used to defer taxes payable to the US government on profits earned abroad is known as transfer pricing. It has been estimated that the deferral of tax payments may be costing the US Treasury $100 billion or more each year. This has become a politically hot topic as we begin the 2012 election year cycle.

Here's how it works. Say you have a US company and it sets up a subsidiary in Ireland. Let's assume the US company ships raw materials or semi-finished (even finished) goods to Ireland. The subsidiary operates as a separate entity so a price has to be established for the shipment. Ireland has one of the lowest income tax rates on corporations in the world (12.5%) whereas the maximum rate is 35.0% in the US. The goal of the US parent company is to minimize worldwide taxes thereby maximizing global profits. Let's assume the raw materials cost $1 million. The US company charges the Irish subsidiary $1.1 million even though it could sell the materials for as much as $2 million in the US had the raw materials or semi-finished product been kept at home. The US company earns $100,000 in profit, pays the US government $35,000 in taxes ($100,000 x .35), and nets $65,000.  Now, the Irish subsidiary sells the product it received from the US company at a cost of $1.1 million, to customers in Ireland and elsewhere for what the product is really worth -- $2 million. The subsidiary earns $900,000 in profit, pays the Irish government $112,500 in taxes ($900,000 x.125), and nets $787,500. The total worldwide profits are $852,500 ($65,000 + $787,500).

However, had the US company not set up the Irish subsidiary and simply made and sold the product in the US, its profits would have been $1 million ($2m-$1m) and paid $350,000 taxes to the US government ($1 million x .35) thereby netting $650,000 or $202,500 less than in the transfer situation ($852,500-$650,000). The US government is "cheated" out of $315,000 in taxes: $350,000 it should have received less the $35,000 it did receive. If we add some zeroes to the total value of such transferred goods in our hypothetical company and add to it the same effect that is occurring in hundreds of US companies, then we have our estimated $100 billion in tax revenue lost by the US Treasury. Let me summarize the data.

                    US Profit w/o Transfer     US Profit w/Transfer  &   Irish Sub Profit    

Sales                     $2,000,000                      $1,100,000                        $2,000,000               

Cost                       (1,000,000)                      (1,000,000)                       (1,100,000)   

Profit                    $1,000,000                     $    100,000                        $   900,000

Taxes            (.35)  $350,000          (.35)  $       35,000             (.125)   $  112,500

                                                                                                                  (paid to Irish gov't)

  Lost Tax Revenue to US Treasury $315,000

I previously blogged about the fact that G.E. reported worldwide profits for 2010 of $14.2 billion of which only $5.1 billion came from US operations. The company not only paid no US tax but it claimed a tax benefit of $3.2 (  About 30% of GE's business and 46% of its employees were overseas in 2000. Today it is 60% and 54%, respectively.

A similar income-shifting result occurs in a different transaction when a pharmaceutical or technology company -- Google for example -- sells or licenses the foreign rights to intellectual property developed in the US to a subsidiary in a low-tax country. The result is foreign profits based on the technology get attributed to the offshore unit, not the US parent.

In the US, Section 482 of the Internal Revenue Code governs transfer-pricing rules. The Code permits the IRS to redistribute the profits between the US company and its foreign subsidiary if it believes tax evasion is occurring. The IRS prefers that all transfers among related entities take place at "arm's-length" prices, which are defined as prices that would be obtained between unrelated entities.  The problem, of course, is how to determine what an arm's-length price is. Disputes between the IRS and a company can take years to resolve. In fact, on September 11, 2006 , the IRS announced it had successfully resolved a transfer pricing dispute with GlaxoSmithKline. The case represents the largest tax dispute in the history of the IRS. Under the settlement agreement, GSK paid $3.4 billion to resolve the parties' long-running transfer pricing dispute for the tax years 1989 through 2005.

Transfer pricing is at the core of the current debate about whether US corporations pay their fair share of taxes to the US  Treasury. There are arguments on both sides of the issue. Those who defend the deferral practices believe:

  • US corporate tax rates are among the highest in the world and promote offshore activities and discourage the repatriation of profits
  • US companies locate overseas to better serve growing markets such as in Brazil, China and India and to remain globally competitive not for tax advantages
  • US companies need to be competitive with foreign multinationals many of which operate in countries with a "territorial" tax treatment of foreign earnings that largely exempt these active earnings from home country taxation

Those who criticize US multinationals for using transfer pricing practices point out they shift income and tax payments outside the country thereby denying the Treasury of needed tax revenues and those practices negatively affect the economic recovery and future growth. Also, income-shifting techniques promote outsourcing of jobs, capital, and even know-how.

What is the answer to the dilemma? One suggestion is to lower the tax rate to 25% or less. Bear in mind corporate tax rates in the US range from 15-35% so the 25% would be the upper limit. Supporters point to low tax corporate federal tax rates in countries such as Canada (11-16.5%), Germany (15%) and the UK (20-26%) . China's corporate tax rate is 25% however in some cases it can be lowered to 15%, if the enterprise is in an industry promoted by the Chinese government (High technology/New technology companies, for example). China's policies raise questions whether the US can remain competitive when the governments in some countries subsidize business practices? That's a subject for another blog.

One implication of lowering the US corporate income tax rate to 25% or less is the earlier repatriation of profits and encouraging companies to set up operations and hire workers in the US. The result could be to increase net tax revenues to the Treasury even though the rates go down. I believe this matter should be given the highest priority by Congress because doing nothing, our usual approach to complicated, politically controversial issues, will lead us down the road of falling further behind countries like China. We need to find a way to: create new jobs in the US and not overseas; create an environment for sustaininable economic growth; and get to the point where we can start to pay down our enormous debt.

Blog by Steven Mintz, aka Ethics Sage, April 21, 2011