Corporate Taxation, or the Lack Thereof
(Part II of our series Cracking the Internal Revenue Code: How the tax system rewards the rich. Part I was Capital Games.)
President Bush and Republicans in Congress have proclaimed for months that the health of the American economy depends on significant tax cuts for American businesses. By their logic, American corporations suffer from crippling tax rates. In reality, large corporations pay modest amounts of their net income in federal taxes.
Normally, the press pays little attention to corporate tax strategy. But when Citizens for Tax Justice revealed in Janaury that Enron received net rebates of $381 million from 1996 through 2000 but had profits before taxes of $1,785 million, the press started to take notice. How Enron cut its corporate taxes to less than nothing is hardly novel. Enron was just particularly good at the practice.
In fiscal year 2000, the IRS took in just over $1.9 trillion in taxes. Of this amount, $978 billion came from individual income taxes and $205 billion came from corporate income taxes. Between 1996 and 2000, net corporate income tax receipts declined from 20.72% of all income taxes to 17.34% of all income taxes. (Forty years ago, corporate income taxes were roughly one-third of all income taxes.) When corporate income taxes decline, other taxpayers pay a disproportionate burden.
In 2000, Citizens for Tax Justice and the Institute on Taxation and Economic Policy sifter through the financial reports of 250 large American corporations to determine how much they paid in corporate income taxes in 1996, 1997, and 1998. In each of these years, the statutory rate for large corporations was 35 percent. The CTJ-ITEP study found that the companies in its sample paid taxes at an effective rate of 20.1 percent in 1998. Fully two-fifths of the aggregate pre-tax income of these companies was sheltered from taxation,one way or the other.
Some of the tax breaks that the CTJ-ITEP study outlines are significant but explicitly included in the Internal Revenue Code. Companies can write off the cost of most equipment and machinery, for example, far quicker than those assets deteriorate in real life. On their financial statements, which determine net income for the stock markets, those companies reflect the actual decrease in value for that equipment. The difference reflects an indirect but very real subsidy for manufacturers.
Other tax breaks include tax credits designed to reward certain kinds of business activity. (Disclaimer: I work for a company that matches companies with investments in low-income housing and historic rehabilitation tax credits.) Among the most important credits for large corporation is the research and experimentation credit, designed to reward businesses for engaging in research that the market might not otherwise favor. As Robert McIntyre has noted in The American Prospect, many companies have claimed the research credit for work of dubious scientific merit. When the Treaury Department in 1997 proposed regulations to require that "research" for the research credit actually involve expanding scientific knowledge, large corporations and their accountants had large farm animals. The Clinton administration promulgated final regulations along those lines just before it left office. But the Bush adminsitration not only suspended those regulations, but also issued regulations of its own that reversed the new test.
Just outside of Fitchburg, Massachusetts, along Route 2, the major road in the area, sits an office building for Tyco Industries, the conglomerate that makes everything from surgical equipment to burglar alarms to plastic coat hangers. Along its façade lies a huge American flag that represents the pride and patriotism of its employees. That same flag cannot speak for Tyco the company, for although all of Tyco's officers work out its Nashua, New Hampshire, offices, its official headquarters are in Hamilton, Bermuda. Out of 180,000 worldwide employees, it employs only 19 Bermudans.
Tyco was in fact a company based in New Hampshire until it bought ADT, the burglar alarm company, in 1997. Officially, ADT bought Tyco (even though Tyco was the larger company), then changed its name to Tyco. This stunt allowed Tyco to save hundreds of millions of dollars each year in income taxes, because it pays only token taxes to Bermuda for its foreign income. Plus, while it still pays income taxes on its American income, having an overseas headquarters allows all sorts of opportunities to shift expenses to the American subsidiary and income to the Bermuda hub.
Tyco is not an abberration. As articles in the New York Times and The American Prospect have shown, the number of expatriate corporations has grown in the past three years. Seagate, the manufacturer of disk drives, now claims the Cayman Islands as its home. Stanley Tools, dissatisfied with merely shutting down all of its American manufacturing plants, will move its headquarters to Bermuda. Ingersoll-Rand, which was eager to sell its explosive detectors to the federal government to use in airports, will also move to Bermuda. None of these companies will change the location of its real corporate headquarters. But each will save millions of dollars in taxes each year.
The only impediment to moving to a tax haven for most companies is that an when an American company expatriates itself, its American shareholders have to treat the transaction as a sale and could be liable for capital gains taxes. For companies with depressed stock prices, however, this requirement is not an onerous one.
It was only a matter of time before manufacturing firms tried to establish themselves in tax havens. Corporations involved in international finance have long understood the benefit of incorporation in a country or territory with no corporate income tax. Several American insurance companies have reincorporated themselves in Bermuda. Accenture, the former Anderson Consulting, is officially a Bermuda corporation. Enron esatblished over 800 overseas entities, many of them in the Cayman Islands. Although Rupert Murdoch does most of his business in the United States, Australia, and Great Britain (which have tax rates of 35%, 36%, and 30%), his News Corporation paid taxes at a 6% rate from 1994 through 1997.
The fundamental method to save on taxes is to have the offshore entity loan money to the domestic entity. The interest on the loan is income to the tax-free offshore entity, but a valuable deduction to the domestic entity. All of this is perfectly legal, of course. But it is also perfectly artificial, and Congress has ignored this loophole for years.
For tax purposes, the value of stock options count as deductions for the companies that issue them. When employees exercise the options, they recognize income on their gains and the corporations recognize a corresponding loss. The tax treatment of options actually makes sense: most compensation to employees, whether in cash or in stock options, gets the same treatment.
To the financial markets, however, stock options do not affect a corporation's profits or losses whatsoever. Corporations must figure the effect of recognizing losses from options, but need only report them in a footnote to the financial statement. Corporations that can choose between paying executives large amounts in cash or in stock options have an easy choice, courtesy of the bizarre world of accounting. Cash payments create tax losses (good) but also book losses (bad). Stock options create tax losses (good) but no not affect book income (good). Between 1996 and 1998, Microsoft saved over $2.7 billion in taxes by issuing stock options instead of paying equivalent cash bonuses. The other 249 companies in the CTJ-ITEP study followed suit, to lesser extents: they saved just over $23.1 billion in those years.
The coming weeks and months will certainly bring with them calls for a stimulus package with tax cuts designed to help businesses. Both major parties in America like to present themselves as the party of the small businessperson of the entrepreneur. Cutting corporate taxes, or accelerating depreciation, or expanding business tax credits all have effects beyond any short-term stimulus to the economy. They would represent a potentially massive subsidy to some of the largest corporations in the world, corporations that are doing just fine with the subsidies that they currently have. They do not need any more.
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