Tax evasion is not the only charge being levied — the American corporation is under extreme scrutiny from all corners. An article about Corporate tax in the USA for American corporations.
U.S. SENATOR Chuck Grassley’s remarks represent a trend toward drawing public attention to corporate tax dodgers and the “lost revenue” they represent. But do the politicians have it right? Is corporate tax avoidance, particularly the use of tax shelters, a “disgusting deeply unpatriotic act especially during wartime?”
Tax evasion is not the only charge being levied — the American corporation is under extreme scrutiny from all corners. Because of intense competitive pressures in an increasingly globalized marketplace, corporations must maximize shareholder returns by any means necessary. Social responsibility is the catchphrase of the moment, as stakeholders from community organizations and even retirement funds ask companies to consider how their business practices affect the world around them.
And in the wake of the Enron and Worldcom scandals, the Sarbanes-Oxley Act of 2002 prescribes significant individual liability (including possible criminal penalties) to any director or officer not engaging in proper oversight of business processes.
In light of these conflicting pressures, are corporations that use tax shelters unpatriotic? Or are they doing what corporations do: maximizing profits by minimizing legitimate costs? The answer lies somewhere in the middle: while blatant violations of clearly defined tax statutes are wrong, corporations that minimize taxes while engaging in legitimate business transactions act in the best interests of their shareholders and consumers.
Assumption One: All tax shelters are illegal
Simply put, a tax shelter is any investment strategy that enables a taxpayer to decrease or avoid taxation, and allows homeowners to deduct their mortgage interest from their tax liability, which provides an incentive to reduce taxes by owning rather than renting.
Why does the U.S. government allow certain tax shelters and not others?
The government can influence taxpayer behavior by manipulating taxes. Roth IRAs encourage retirement savings, and mortgage interest deductions promote increased homeownership. These tax shelters and other legally-sanctioned strategies tend to reflect the current values of the U.S. government and the larger society, both in terms of ideology (e.g. the intrinsic value of owning a home) and analysis of long-term economic health (e.g. weighing the long-term benefits of a working population with significant retirement savings against the current cost of the tax shelter).
Assumption Two: Corporations that move their money offshore do so to avoid paying taxes
For domestic corporations, the United States uses a “worldwide” tax system which provides that all of a domestic corporation’s income is subject to U.S. taxation, regardless of whether the income is earned at home or abroad. The tax code further dictates that the income earned by a domestic parent corporation from operations conducted by a foreign subsidiary is not taxed in the United States unless and until the foreign subsidiary distributes the income there are multiple legal and government-sanctioned tax shelters. For example, a Roth IRA is a tax shelter because investment proceeds are generally protected from taxation. The purchase of a home might also be considered a tax shelter — the U.S. government to the domestic parent corporation as a dividend.
Congress enacted the “Subpart F” anti-deferral provisions to prevent corporations from avoiding taxation by keeping income out of the U.S. These provisions allow the domestic parent corporation to be taxed immediately on the income earned by the foreign subsidiary if it is considered a “controlled foreign corporation” (i.e. the parent owns above a certain threshold percentage of shares in the subsidiary). Income earned solely within the subsidiary’s country of origin is not subject to this taxation.
It should be acknowledged that because of confidentiality provisions in countries like the Cayman Islands, it is possible that corporations may misstate their actual earnings and assets in an effort to avoid the payment of U.S. income taxes, though this is illegal behavior and not a sanctioned practice.
The tangled web of tax shelter law & policy
Two questions logically follow: First, how do you define an abusive, or illegal, tax shelter? Second, what is the extent of the problem in the U.S.? The answers to these questions require examination of a century of jurisprudence, and include a great deal of uncertainty.
Currently, the United States defines illegal tax shelters in several sections of the IRS code. In general, an abusive tax shelter is “any entity, plan, arrangement, or transaction, a significant purpose of the structure of which is the avoidance or evasion of Federal income tax [emphasis added].”4 The courts have often intervened by interpreting whether specific transactions constitute violations of the tax code. The primary method of assessing whether a transaction amounts to an abusive tax shelter originated in the Supreme Court case of Gregory v. Helvering5 and has resulted in a long line of common law decisions on the “economic substance doctrine.” A transaction with economic substance must (1) produce a meaningful change in the taxpayer’s economic position, and
(2) have a tax-independent business purpose. The courts can “…[balance] the transaction’s risk and return potential in order to determine whether the transaction had any purpose beyond reducing or avoiding tax liability.”
However, the outcome of jurisprudence on tax shelters has been mixed, and courts are divided in their decision- making. For instance, in 2001, two strikingly similar cases had markedly different results. Both transactions involved the purchase and sale of American Depository Receipts, one by Compaq Computer Corporation and the other by IES Industries; both companies subsequently claimed a foreign tax credit and a capital loss to the IRS. The Eighth Circuit Court of Appeals held that the IES Industries’ transaction had economic substance, but the Tax Court found that the Compaq transaction did not have business purpose and was a sham transaction.
These differing outcomes reveal how unpredictable courts can be in defining the parameters of abusive tax shelter behavior. Whether and how to codify the economic substance doctrine in significant dent in U.S. tax revenue. However, given that there is such uncertainty about what behavior is abusive, it is incredibly difficult to quantify the issue. The U.S. Treasury Department tried to do that, claiming that approximately $10 billion a year is lost to abusive tax shelters. But there is little or no information available about their methodology in arriving at that figure.
Perhaps the IRS has a better understanding of the extent of the problem. Unfortunately, even Internal parameters of abusive tax shelter behavior. Whether and how to codify the economic substance doctrine in order to more clearly define abusive tax shelters and impose appropriate penalties has been heavily debated by a variety of stakeholders, including Congressional leaders.
Penalizing abusive tax shelter behavior would be particularly important if the scope of the problem put a Revenue Service Commissioner Mark W. Everson acknowledges that “Estimates vary on the size of this problem it is very difficult to make a precise determination based on the many different interpretations and definitions of abusive tax shelters.”
Given that the U.S. still has not definitively characterized abusive tax shelters, and has little idea what the impact of the problem is, to what extent are politicians and pundits who single out “unpatriotic corporations” justified?
“Devotion to the welfare of one’s country”
Consider a hypothetical corporation that engages in absolutely no behavior that might be considered ‘unpatriotic’ or tax dodging, one that has not hired any tax planning personnel, and uses no external tax planning promoters. As a result, the company is taxed at the maximum rates at the local, state, federal, and foreign levels, and often taxed by multiple levels of government on the same income. Would such a corporation have any profits? At this rate, would it stay in business?
This is an extreme example, but illustrates an important point. Why does the government allow corporations to have tax planning professionals at all? Why not ban all complex corporate structures? Wouldn’t it be easier to spot illegitimate transactions by requiring that all transactions be completely transparent and perfectly simple? To some extent, the government recognizes the right of the corporation to structure its business activities in an advantageous fashion for its consumers, shareholders and employees.
Consumer happiness and investor confidence are primary contributors to a robust economy
Because consumer happiness and investor confidence are primary contributors to a robust economy and the overall welfare of the nation, and because patriotism is fundamentally a devotion to improving the nation’s welfare, corporations that rationally act to improve the well-being of consumers and investors do not behave unpatriotically. Legitimate business transactions that are structured to minimize the corporate tax burden are rational responses to the pressures corporations face.
And in a globally competitive environment, all companies are playing by the same rules.
Tax planning professionals generally view the payment of taxes as a legitimate cost of doing business.
Tax departments are increasingly viewed by corporations as profit centers for the corporation, and face pressure to put business deals together in the most cost-effective way. If a company has a choice between several methods of structuring transactions, the firm will choose the option that maximizes its profits. Though discussions of tax shelter behavior often point to the complexity or abnormality of arrangements as evidence of tax sheltering, the unusual or complex transaction should be no less legitimate. Avoiding tax liability is not the same thing as failing to pay owed taxes. Should it be illegal to sell stock on January 1st rather than December 31st to reduce tax liability? That it is customary to sell on December 31st should not matter; the transaction is legitimate, and the choice is a rational decision designed to minimize cost.
Corporations also act rationally when they minimize tax payments in the ordinary course of business
Corporations also act rationally when they minimize tax payments in the ordinary course of business. First, greater opportunities exist today for corporations to increase their market competitiveness by using tax shelters. In connection with the movement toward free trade, certain countries make it very attractive for corporations to create tax-advantaged situations. And because both consumers and shareholders demand that companies bring “good deals” to the marketplace, the need for lower product prices and higher stock values drives the American corporation to minimize costs in every way possible.
Second, the IRS code is an ambiguous and complex regulatory framework for corporations to follow, and agency and judicial enforcement of tax shelter statutes has been contradictory. Labeling a corporation a “tax dodger” relies on individual discretion to an incredible extent. For example, in the previously mentioned Compaq and IES cases, IES met the “business purpose” requirement by “[meeting] twice about the transactions and [consulting] outside accountants and securities counsel for reassurance on the legality of the transactions and their tax consequences”.
But in the Compaq case, the Tax Court concluded that the expected tax benefits of the transactions were what motivated the company.
In addition, the IRS response to abusive shelters is necessarily reactionary. Current enforcement of tax shelter law is based on the disclosure of a list of tax shelter transactions by corporations, individuals, and promoters of tax shelters that is amended from time to time.
But this logic is circular: (1) the IRS audits corporate tax returns, (2) finds and penalizes transactions it believes to be abusive by levying fines, and (3) adds those transactions to the list for disclosure and possible penalties. Corporations that subsequently enter into similar transactions are subject to penalties for blatant violations of the law. There is significant uncertainty surrounding whether a new transaction will be judged abusive, but once that transaction is added to the regulations, corporations would not likely attempt it.
A marked difference exists between engaging in forbidden behavior and acknowledging uncertainty in the tax code to achieve the primary goal of profit maximization. That difference is the main reason that corporations that minimize taxes as a legitimate business cost should not automatically be labeled unpatriotic. Rhetoric about patriotism conveniently ignores that corporations act in the best interests of their consumers, employees and shareholders by minimizing costs, and obfuscates the fact that well- performing American corporations do help to improve the welfare of the nation.
Rhetoric about corporate patriotism: why should we care?
Rhetoric alone is simply free speech; rhetoric accompanied by legislation may have negative consequences. In an attempt to better define abusive tax shelters and provide guidance and increased enforcement, Congress has proposed multiple legislative prescriptions, including the codification of the economic substance doctrine.15 As previously discussed, abusive tax shelters are difficult to define and assess. If Congress is overly broad in its definition, many legitimate business transactions may either be labeled as abusive shelters, or Congressional action could have a “chilling effect” on corporate transactional behavior.
Given the competitive global environment, the increasing scrutiny corporations receive from various stakeholders on their governance practices
Given the competitive global environment, the increasing scrutiny corporations receive from various stakeholders on their governance practices, and current controversies over corporate outsourcing and expatriation of capital, is the American corporation the appropriate target for blame about revenue loss? Corporations might hesitate to enter into potentially lucrative transactions for their shareholders, consumers and the U.S. economy. We may also risk the prospect of some corporations balking at doing business in the U.S. altogether.
The government plays a key role in promoting certain types of taxpayer behavior. Just as the Roth IRA constitutes a tax shelter that encourages people to save for retirement, corporations should be allowed to structure legitimate business transactions in the best interests of their consumers and shareholders, who demand low prices and high share values. The economic welfare of the nation, as measured by numerous indicators, is improved with healthy corporate profits and increased corporate transactions. Why alienate corporations by engaging in critical and unfounded rhetoric, backed up by potentially damaging legislation? We should be rethinking our assumptions about what constitutes patriotism.
FROM THE EDITOR:
Ms. Shepherd defends the American corporation’s right to maximize the advantage of tax shelters, claiming that they are just rational actors trying to get the most out of the government’s complex tax structure. What right do we have to question the profit-maximizing behavior, she posits, if we have deemed tax shelters a legitimate transaction? She claims that tax shelters are in fact a reflection of the government’s and larger society’s values. Excuse me, but I believe
American corporate tax law is a reflection of the power of the corporation’s purse
American corporate tax law is a reflection of the power of the corporation’s purse. Sure, they may be playing by the rules, but they have had undue influence in creating those rules, wending them to fit their desires regardless of the larger social context of their actions. Corporations buy and sell influence, pay minimally for a favorable tax structure, and use our “nation’s welfare” as a tool for improving their own.
Author: Denise Shepherd