Corporations Use $20 Billion Legal Tax Loophole

As the economy threatens to fall into a recession and an increasing number of Americans are struggling to make ends meet, many corporations are drastically reducing their tax liability to the federal government through a perfectly legal practice known as transfer pricing, costing the Treasury more than $20 billion a year.

"Large corporations don't hide income, but they might engage in very sophisticated transactions that reduce their tax liability in ways that aren't appropriate," said Eric Toder, a senior fellow at the Urban Institute who focuses on taxes and retirement.

One such loophole that corporations are likely exploiting, says Toder, is transfer pricing, or prices charged for items or services within groups of the same company. Multinational companies commonly sell assets to overseas subsidiaries in low-tax countries to reduce taxable profits in the United States and increase them in the countries with lower tax rates. For tax purposes, these groups are all treated as separate companies.

"If a U.S. firm is purchasing a product from their foreign subsidiary, then they've moved potential U.S. profit to their offshore subsidiary," said Mike Brostek of the Government Accountability Office.

The GAO released a report just last week revealing that three percent of large US corporations – defined as having more than $50 million in gross receipts or $250 million in assets – paid no tax to the federal government for all eight years analyzed, raising, but not answering questions on how these corporations are legally evading Uncle Sam. While the report briefly alluded to a transfer pricing problem existing, it did not elaborate on the subject or specify which firms might be engaging in the practice.

Firms often overpay for products to hold more income off-shore and deduct the expenses on their U.S. tax returns.

Since there is no market test for what goods or services should cost, it is nearly impossible to assess how much money is being moved off-shore, and therefore how much taxable income is ending up somewhere other than the Treasury.

"It's so hard to determine what these prices should be," said Martin Sullivan, a former economist with the Treasury Department.

"You can argue that the price of something should be $200 instead of $100 and there's nobody who can say with absolute certainty what the price should be," he said.

The issue has become more complex over the last decade, as corporations are increasingly trading technology, patents, and copyrights that lack a tangible or comparable value to overseas subsidiaries. Companies pay royalty fees for rights to these intangible assets, but without comparable goods on the market, "there's a lot of scope for manipulation," said Toder.

In a prominent example, the Wall Street Journal reported in 2005 that Microsoft Corporation set up a subsidiary in a small law office in Ireland to shrink its tax liability by $500 million. Microsoft responded the Wall Street Journal by saying it was "fully compliant with the tax laws of the United States and all other countries."

In May, the Treasury Inspector General for Tax Administration (TIGTA), which provides independent oversight of IRS activities, according to its website, released a report stating that the IRS "is not routinely making mandatory referrals of corporate tax returns containing international features."

The report states that over $72 billion was lost between 2002 and 2006 due to transfer pricing.

TIGTA Inspector General J. Russell George was unavailable for comment.

"The IRS doesn't have the resources to adequately examine even corporate returns they have identified as having problems," said Martin Lobel, a tax attorney and Chairman of Tax Analysts, which publishes Tax Notes.

"Given the resources the IRS has, policing transfer pricing is like policing the New Jersey Turnpike on a bicycle," said Lobel.

Yet not all of the corporations examined by the GAO paid little or no tax due to the use of transfer pricing. A large number of corporations pay no taxes because they are what's known as "shell" corporations, or companies established as legal entities but do little if any actual business.

Without a significant business operation these entities might have zero tax liability yet are still counted among the 66 percent of corporations that pay no taxes, as the report stipulates.

According to Sullivan, many corporations avoid paying taxes because they are simply not profitable. Airline and automotive industries, for example, have struggled significantly during the eight-year span the GAO studied. Large corporations like General Motors, Ford, and Chrysler have millions in assets, yet their federal income tax liability would be zero if they did not turn profits in a given year.

"There can be perfectly legitimate reasons why corporations aren't paying taxes," adds Brostek. "There can also be less legitimate ones. We're unable, from the work that we did, to actually comment on those."

Still, the fact that corporations with millions in assets -- whose CEOs earn tens of millions in annual salaries -- pays nothing in federal income tax does not sit well with some. "It's not fair," said Lobel, calling the dichotomy "outrageous."

"The competetive market has not held down CEO salaries while it's held down employee salaries," he said. Not only is it unfair to taxpayers, he added, "it's unfair to the shareholders, too."

And while two-thirds of corporations are not paying taxes, profitable corporations, Sullivan argued, fall into the one-third of corporations that do pay.

"This report isn't saying that Exxon/Mobil or any Fortune 500 company isn't paying tax. You can't infer that," said Sullivan.

That does not mean, however, that these corporations who are paying contribute their fair share. Corporations should pay tax on 36 percent of their profits, but Lobel believes the effective rate holds near nine percent because of tax subsidies and transfer pricing abuse. "[Thirty-six] is the rate in the code, but nobody pays it. If they do, they've got to fire their accountants," he said.

Michelle Dubert is a freelance writer based in New York. Her work has appeared on, and in New York magazine.

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