Tuesday, March 29, 2011

Tax Dodging Corporations Are Now Demanding a Tax Holiday

Did you ever hear of a “Double Irish?” If that conjures up an image of a frothy beverage and congenial but boisterous companions, you are about to be disappointed. The Double Irish is the name those in the know give to a tax dodge that allows U.S. corporations to transfer many billions of dollars overseas where the IRS cannot touch it. Businessweek describes how this works using Forest Laboratories, a pharmaceutical company as the example.

“With a swipe of his debit card in a Phoenix pharmacy, Tyler Hurst bought a $99 bottle of Lexapro and kicked off a 9,400-mile odyssey of international corporate tax avoidance. Each stop along the way—an industrial park in Dublin, a skyscraper in Amsterdam, a palm-shaded law office in Bermuda—helps the medicine's maker, Forest Laboratories, cut its income tax bill. Although all of Forest's Lexapro sales are in the U.S., the company moves profits generated by the world's third-best-selling antidepressant from subsidiary to subsidiary overseas, exploiting tax advantages in multiple countries. The technique, known as transfer pricing, reduced Forest's net U.S. tax bill by more than a third in 2009, according to the company's annual report.”
Forest sets up an office in Bermuda and licenses it to produce and sell Lexapro. There is no corporate tax in Bermuda. Another subsidiary is set up in Ireland to actually manufacture the drug, under license of the Bermuda office. The Irish company sells the drug to Forest in the U.S. at some unknown, but probably large price. At this point the profits could be taxed at Ireland’s low rate rather than at the U.S’s higher rate. This is the “first Irish.” Since the Irish company is licensed by the Bermuda company, an arbitrarily large fraction of the funds could be transferred to Bermuda to avoid even the low Irish corporate tax. However, Ireland imposes a separate tax on funds transferred out of the country unless they are transferred to another E.U. country. That is where Amsterdam and the “second Irish” comes in. Another subsidiary is established in Amsterdam whose function is to accept the funds from Ireland and forward them to Bermuda. This is also referred to as the “Dutch Sandwich.”

This is all perfectly legal if performed in good faith. The IRS is aware of this process and has made it a rule that if Forest wants to license production of a drug to an overseas subsidiary, it must treat that subsidiary as if it were a third party. In that case, manufacturing is cheap and Forest would demand a high fee for the manufacturing rights. Most of the profits would go to Forest in the U.S.  Forest can ignore this requirement and provide the license to its Bermuda outfit at very little cost. Forest in the U.S. ends up paying a high price for the Irish pills, selling them domestically at a small markup, and funnels nearly all the profit overseas with a net tax rate close to zero.

Businessweek investigated and was unable to find any evidence of actual Forest employees in either Amsterdam or Bermuda. The address of the Bermuda subsidiary is a lawyer’s office.
“Thousands of other companies, from Oracle to Eli Lilly to Pfizer, also legally avoid some income taxes by using transfer pricing, typically converting sales in one country to paper profits in another, often a place where they have few employees or actual sales. GlaxoSmithKline, the U.K.'s largest drugmaker, settled a transfer-pricing case with the U.S. in 2006 for $3.4 billion. Since December, the IRS and the Justice Dept. have lost two such cases against Silicon Valley companies: a $24.3 million dispute with chipmaker Xilinx and a $545 million battle with software maker Symantec.”
Another Businessweek article lets us know that these corporate “patriots” wish to do the country a favor by bringing home some of these profits—estimated at around $1 trillion—provided they are allowed to do it without paying any significant tax. What they are asking for is a tax holiday on these repatriated profits.
“All they want in return is a temporary tax break that wouldn't cost the U.S. Treasury anything, since it's money that would otherwise be kept abroad and not taxed at all. The tax break would actually raise billions of dollars from applying the reduced tax rate to the money that's been repatriated. “

“What's not to like? John T. Chambers, Cisco's chief executive officer, told securities analysts in February that ‘you're now seeing political leaders at all levels understand"’ the case for a tax holiday on repatriated foreign profits. ‘I think this one has well over a 60 percent probability of being resolved in a positive way,’ he said. Although a lobbying campaign is just getting under way, Representative Brian P. Bilbray (R-Calif.) has already introduced a bill that would let companies bring home money tax-free if they used it for research and development or facilities expansion.”
This gambit succeeded in 2005 and repatriation was encouraged with a generous tax reduction.
“The temporary holiday....allowed companies to repatriate profits attributed to their foreign operations at a 5.25 percent tax rate instead of the usual 35 percent. (Companies get a credit for foreign tax already paid.) According to the IRS, $362 billion came back to the U.S., of which $312 billion was eligible for the reduced tax rate. The amount repatriated was 45 percent of the total held abroad at the end of 2004.”

“In the long run, though, the holiday was rife with unintended consequences. Research by Northwestern's Brennan indicates companies rationally concluded that if they were granted one special one-time tax break, they might very well be granted another. That gave them the incentive to attribute even more of their profits to foreign operations, like a shopper waiting for an end-of-season sale. By the end of 2006 the total ‘permanently’ reinvested abroad had exceeded the 2004 peak. It has continued to grow since.”
And what of the supposed benefits of bringing that money home at that low tax rate? What was the benefit to the economy?
“The 2005 repatriation ‘did not increase domestic investment, employment, or R&D,’ but did boost share buybacks, concludes a forthcoming Journal of Finance article by Illinois' Dharmapala, C. Fritz Foley at Harvard Business School, and Kristin J. Forbes at the MIT Sloan School of Management.”
The fear is that the same thing will happen again. Most companies are already hoarding a large amount of assets.
“Some economists say a holiday today might be even less effective because cash isn't a constraint in 2011—it's bountiful, thanks to the Federal Reserve's loose-money policy. U.S. nonfinancial corporations have $1.9 trillion in liquid assets, the Fed says. No more than half of that—probably significantly less—is offshore. (An unknown portion of the $1 trillion-plus in foreign-held profits isn't cash. It's tied up in foreign factories, offices, and the like and can't easily be repatriated.)”
The position of the Administration and the Fed seems to be that there will be no tax break without it being coupled to tax reform. With this much money involved the lobbyists will have a lot of weight to throw around. Hopefully Congress will hold its ground until the problem is finally fixed.

It seems fair to tax domestic profits by U.S. law, and tax non-domestic profits by the rules of the country in question, but it is ridiculous to allow corporations to extract funds from our economy, transfer them overseas and define them to be international profits. Apparently a company can defraud the government of billions of tax dollars and receive a slap on the wrist. How big does a financial crime have to be before it becomes a felony? Putting a few CEOs in jail could be a very effective deterrent.

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