International Taxation: Tax Haven Companies Were More Likely to
Have a Tax Cost Advantage in Federal Contracting (30-JUN-04,
GAO-04-856).
The federal government was involved in about 8.6 million contract
actions, including new contract awards, worth over $250 billion
in fiscal year 2002. Some of these contracts were awarded to tax
haven contractors, that is, U.S. subsidiaries of corporate
parents located in tax haven countries. Concerns have been raised
that these contractors may have an unfair cost advantage when
competing for federal contracts because they are better able to
lower their U.S. tax liability by shifting income to the tax
haven parent. GAO's objectives in this study were to (1)
determine the conditions under which companies with tax haven
parents have a tax cost advantage when competing for federal
contracts and (2) estimate the number of companies that could
have such an advantage. GAO matched federal contractor data with
tax and location data for all large corporations, those with at
least $10 million in assets, in 2000 and 2001, in order to
identify those companies that could have an advantage.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-04-856
ACCNO: A10710
TITLE: International Taxation: Tax Haven Companies Were More
Likely to Have a Tax Cost Advantage in Federal Contracting
DATE: 06/30/2004
SUBJECT: Contractors
Federal taxes
Government contracts
Corporations
Tax administration
Tax evasion
Competition
GSA Federal Procurement Data System
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GAO-04-856
United States General Accounting Office
GAO Report to the Chairman, Committee on Governmental Affairs, U.S. Senate
June 2004
INTERNATIONAL TAXATION
Tax Haven Companies Were More Likely to Have a Tax Cost Advantage in Federal
Contracting
a
GAO-04-856
Highlights of GAO-04-856, a report to the Chairman, Committee on
Governmental Affairs, U.S. Senate
The federal government was involved in about 8.6 million contract actions,
including new contract awards, worth over $250 billion in fiscal year
2002. Some of these contracts were awarded to tax haven contractors, that
is, U.S. subsidiaries of corporate parents located in tax haven countries.
Concerns have been raised that these contractors may have an unfair cost
advantage when competing for federal contracts because they are better
able to lower their U.S. tax liability by shifting income to the tax haven
parent.
GAO's objectives in this study were to (1) determine the conditions under
which companies with tax haven parents have a tax cost advantage when
competing for federal contracts and (2) estimate the number of companies
that could have such an advantage. GAO matched federal contractor data
with tax and location data for all large corporations, those with at least
$10 million in assets, in 2000 and 2001, in order to identify those
companies that could have an advantage.
June 2004
INTERNATIONAL TAXATION
Tax Haven Companies Were More Likely to Have a Tax Cost Advantage in Federal
Contracting
There are conditions under which a tax haven contractor may have a tax
cost advantage (lower tax on additional income from a contract) when
competing for a federal contract. The extent of the advantage depends on
the relative tax liabilities of the tax haven contractor and its
competitors. One way for a contractor to gain a tax cost advantage is by
reducing its U.S. taxable income from other sources to less than zero and
by using its losses to offset some or all of the additional income from a
contract, resulting in less tax on the contract income. A company would
thereby gain an advantage relative to those competitors with positive
income from other sources and may be able to offer a lower price or cost
for the contract. While some domestic corporations may also have a tax
cost advantage, tax haven contractors may be better able to reduce U.S.
taxable income to less than zero because of opportunities to shift income
to their tax haven parents. Whether a contractor has a tax cost advantage
in competing for a particular contract depends on the tax liabilities of
other competitors. Also, the contractors with a tax cost advantage are not
necessarily the successful competitors because the tax cost savings may
not be reflected in actual prices, and prices may be only one of several
factors involved in awarding contracts.
Using tax liability as an indicator of ability to offset contract income,
GAO found that large tax haven contractors in both 2000 and 2001 were more
likely to have a tax cost advantage than large domestic contractors. In
2000, 56 percent of the 39 large tax haven contractors reported no tax
liability, while 34 percent of the 3,253 large domestic contractors
reported no tax liability. In 2001, 66 percent of large tax haven
contractors and 46 percent of large domestic contractors reported no tax
liability.
Tax Status of Large Tax Haven and Domestic Contractors in 2000 and 2001
Contractors with tax liability Contractors without tax liability
U.S. federal Number of Percentage of Number of Percentage of contractors
companies companies companies companies
2000
Tax haven 17 44 22 56
Domestic 2,132 66 1,121 34
2001
Tax haven 17 34 33 66
Domestic 1,888 54 1,636 46
Source: GAO analysis of IRS data.
www.gao.gov/cgi-bin/getrpt?GAO-04-856.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact James White at (202)
512-9110 or whitej@gao.gov.
Contents
Letter
Results in Brief
Background
Scope and Methodology
There Are Conditions under Which Tax Haven Contractors May
Have a Tax Cost Advantage Tax Haven Contractors Were More Likely to Have a
Tax Cost
Advantage Than Domestic Contractors Concluding Observations Agency
Comments and Our Evaluation
1 3 3 5
7
13 15 15
Appendixes
A Simple Qualitative Model for Assessing
Appendix I: Potential
Contracting Advantages 17
Additional Information about Contractors in 20
Appendix II: 2000
Information on Large Contractors in 2000 20
Appendix III: Staff Acknowledgments 21
Table 1: Tax Liabilities and Interest Expenses
Tables of Large Contractors
and Noncontractors in 2001 12
Table 2: Tax Status of Large Tax Haven and
Domestic Contractors
in 2000 and 2001 14
Table 3: Tax Cost Advantage of Corporations
with Headquarters in
a Tax Haven Country 18
Table 4: Tax Liabilities and Interest Expenses
of Large Contractors
and Noncontractors in 2000 20
Contents
Abbreviations
FPDS Federal Procurement Data System
GSA General Services Administration
I.R.C. Internal Revenue Code
IRS Internal Revenue Service
OECD Organisation for Economic Co-operation and Development
SOI Statistics of Income
This is a work of the U.S. government and is not subject to copyright
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separately.
A
United States General Accounting Office Washington, D.C. 20548
June 30, 2004
The Honorable Susan M. Collins Chairman Committee on Governmental Affairs
United States Senate
Dear Chairman Collins:
The federal government was involved in about 8.6 million contract actions,
including new contract awards, worth over $250 billion in fiscal year
2002. Some of the companies that were awarded these contracts were U.S.
subsidiaries of corporate parents located in tax haven countries.1 In this
report, we will refer to such contractors as "tax haven contractors." We
reported in October 2002 that four of the top 100 federal contractors that
were publicly traded corporations in fiscal year 2001 were tax haven
contractors and that three of these were originally U.S.-headquartered
corporations that had reincorporated in tax haven countries through
corporate inversions.2
Because tax haven contractors may have opportunities to shift income
between the U.S. subsidiary and the corporate parent in ways that reduce
U.S. tax, you have raised concerns that tax haven contractors may have an
unfair cost advantage over U.S.-headquartered contractors when competing
for federal contracts. Because of the concerns, you asked us to determine
the extent, if any, to which tax haven contractors have an advantage when
competing for federal contracts.
1 In such cases, the U.S. subsidiary is a U.S. corporation, incorporated
in the United States, but is owned by a parent company incorporated in a
tax haven country. The term tax haven is used by the Organisation for
Economic Co-operation and Development (OECD) to refer to a country that
has no or nominal taxes on corporate income and also meets other criteria
related to the transparency of its legal and accounting systems and to its
openness to the exchange of tax information with other countries.
2 See U.S. General Accounting Office, Information on Federal Contractors
That Are Incorporated Offshore, GAO-03-194R (Washington, D.C.: Oct. 1,
2002). An inverted company is a U.S. subsidiary of a foreign parent where
ownership of the U.S. subsidiary had been transferred to the foreign
parent. The term "inversion" is used to describe a broad category of
transactions through which a U.S.-based multinational company restructures
its corporate group so that after the transaction the ultimate parent of
the corporate group is a foreign corporation. See U.S. Department of the
Treasury, Office of Tax Policy, Corporate Inversion Transactions: Tax
Policy Implications (Washington, D.C.: May 17, 2002).
After reviewing the relevant literature, determining what data were
available, and meeting with your staff, we decided to (1) determine the
conditions under which corporations with parents in tax havens have a tax
cost advantage when competing for federal contracts and (2) to the extent
possible, estimate the number of companies that have characteristics
consistent with having such an advantage. We did not try to determine the
size of any tax cost advantage or whether the tax cost advantage had an
effect on the competition for specific contracts.
To address our objectives, we collected and analyzed information on
government contracting practices and business decision-making processes.
Using this information, we built a simple qualitative model to explain the
conditions under which a corporation may gain a tax cost advantage in
competing for federal contracts over other competitors whose headquarters
are not located in tax haven countries. We matched contractor data from
the General Services Administration's (GSA) Federal Procurement Data
System (FPDS) to tax and location data of corporations from the Internal
Revenue Service's (IRS) Statistics of Income (SOI) division to estimate
the number of companies with characteristics that the qualitative model
identifies as consistent with a tax advantage. For our analysis of
contractors in 2000, we selected the 3,924 corporations that appeared in
both FPDS and SOI in that year that had total assets of at least $10
million. For our 2001 analysis, we selected the 4,264 corporations in both
databases that had total assets of at least $10 million. In this report,
we refer to corporations with at least $10 million in assets as large
corporations.3 The SOI sample includes the universe of such large
corporations in 2000 and 2001. Because it is the universe, there is no
sampling error for the information that we report about these
corporations.
Some companies may have reasons to locate in tax haven countries that are
unrelated to tax advantages. For example, some companies may locate their
operations in tax haven countries because of business conditions in the
tax haven related to costs and profitability. Location in a tax haven
country does not by itself establish that a company has adopted a
taxminimizing strategy.
We requested comments on this draft from the Commissioner of Internal
Revenue and the Secretary of the Treasury. We conducted our review from
3 The designation large corporation, as used in this report, is not
related to the business size standards used in determining small business
status for federal government contracts.
July 2003 through June 2004 in accordance with generally accepted
government auditing standards.
Results in Brief There are conditions under which contractors, including
tax haven contractors, may have a tax cost advantage when competing for
contracts, including federal government contracts. The extent of the tax
cost advantage depends on the relative tax liabilities of a contractor and
its competitors. The tax cost of the contract is the tax liability on the
additional income derived from the contract. One way for a contractor to
gain a tax advantage is by reducing its U.S. taxable income from other
sources to less than zero and by using its losses to offset some or all of
the additional income from a contract, resulting in less tax on this
income. A company would thereby gain an advantage relative to companies
with positive income from other sources and may be able to offer a lower
price or cost for the contract. While some domestic corporations may also
have a tax cost advantage, tax haven contractors may be more likely to
have such an advantage because of opportunities to shift income to their
tax haven parents. Whether a contractor has a tax cost advantage in
competing for a particular contract depends on the tax liabilities of
other competitors. Also, the contractors with a tax cost advantage are not
necessarily the successful competitors because the tax cost savings may
not be reflected in actual prices, and prices may be only one of several
factors involved in awarding contracts.
Using tax liability as an indicator of ability to offset income from the
contract, we determined that in both 2000 and 2001, large tax haven
contractors were more likely to have a tax cost advantage than large
domestic contractors. In 2000, 56 percent of the 39 tax haven contractors
reported no tax liability, while 34 percent of the 3,253 domestic
contractors reported no tax liability. In 2001, 66 percent of tax haven
contractors and 46 percent of domestic contractors reported no tax
liability. While in 2000 and 2001 tax haven contractors were more likely
to have zero tax liability, companies may have low or zero tax liabilities
for a variety of reasons, such as overall business conditions, industry or
company-specific performance issues, or the use of income shifting.
Background Corporations can be located in tax haven countries through a
variety of means, including corporate inversions, acquisition, or initial
incorporation abroad. Location in a tax haven country can change a
company's tax
liability because the United States taxes domestic corporations
differently than it taxes foreign corporations.
U.S. Tax Treatment of a Domestic Corporation
The United States taxes the worldwide income of domestic corporations,
regardless of where the income is earned; gives credits for foreign income
taxes paid; and defers taxation of foreign subsidiaries until their
profits are repatriated in the form of dividends or other income. However,
a U.S. parent corporation is subject to current U.S. tax on certain income
earned by a foreign subsidiary, without regard to whether such income is
distributed to the U.S. corporation.
Through "deferral," U.S. parent corporations are allowed to postpone
current taxation on the net income or economic gain accrued by their
subsidiaries. These subsidiaries are separately incorporated foreign
subsidiaries of U.S. corporations. Because they are not considered U.S.
residents, their profits are not taxable as long as the earnings are
retained and reinvested outside the United States in active lines of
business. That is, U.S. tax on such income is generally deferred until the
income is repatriated to the U.S. parent.
The U.S. system also contains certain anti-deferral features that tax on a
current basis certain categories of passive income earned by a domestic
corporation's foreign subsidiaries, regardless of whether the income has
been distributed as a dividend to the domestic parent corporation. Passive
income includes royalties, interest and dividends. According to the
Internal Revenue Code (I.R.C.), passive income is "deemed distributed" to
the U.S. parent corporation and thus denied deferral. The rules defining
the application and limits of this antideferral regime are known as the
Subpart F rules.
In order to avoid double taxation of income, the United States permits a
taxpayer to offset, in whole or in part, the U.S. tax owed on this
foreignsource income. Foreign tax credits are applied against a
corporation's U.S. tax liability. The availability of foreign tax credits
is limited to the U.S. tax imposed on foreign-source income. To ensure
that the credit does not reduce tax on domestic income, the credit cannot
exceed the tax liability that would have been due had the income been
generated domestically. Firms with credits above that amount in a given
year have "excess" foreign tax credits, which can be applied against their
foreign source income for the previous 2 years or the subsequent 5 years.
This system of taxation of U.S. multinational corporations has been the
subject of ongoing debate. Specific issues in international taxation
include whether to reform the U.S. system by moving from worldwide
taxation to a territorial system that exempts foreign-source income from
U.S. tax. These issues have become more prominent with the increasing
openness of the U.S. economy to trade and investment.
U.S. Tax Treatment of a Foreign Corporation
The United States taxes foreign corporations on income generated from
their active business operations in the United States. Such income may be
generated by a subsidiary operating in the United States or by a branch of
the foreign parent corporation. It is generally taxed in the same manner
and at the same rates as the income of a U.S. corporation. In addition, if
a foreign corporation is engaged in a trade or business in the United
States and receives investment income from U.S. sources, it will generally
be subject to a withholding tax of 30 percent on interest, dividends,
royalties, and certain types of income derived from U.S. sources, subject
to certain exceptions. This tax may be reduced or eliminated under an
applicable tax treaty.
Scope and Methodology
For objective 1, we collected and analyzed information on government
contracting practices and business decision-making processes. We also
reviewed the economics literature and reports of the Department of the
Treasury and the Joint Committee on Taxation to determine how differences
in the tax treatment of corporations can contribute to a tax cost
advantage. Using the information we obtained, we built a simple
qualitative model to explain the conditions under which a tax haven
company may have a tax cost advantage in competing for federal contracts
relative to other companies whose headquarters are not located in tax
haven countries. For a description of the model, see appendix I.
For objective 2, we used the qualitative model to identify companies that
had characteristics consistent with having a tax cost advantage. We
matched contractor data (name and taxpayer identification numbers) from
the GSA's FPDS for 2000 and 2001 to tax and location data from the IRS's
SOI corporation file. In this matched database, we analyzed information
about large corporations, those with at least $10 million in assets.4 We
identified the large corporations with characteristics consistent with a
tax cost advantage compared to other large corporations and counted the
number of these advantaged and disadvantaged corporations. We divided the
SOI data into categories that differentiated between federal contractors
(domestically owned and foreign owned) and noncontractors (domestically
owned and foreign owned). We further divided the foreignowned corporation
data by those headquartered in tax haven countries from those not
headquartered in tax haven countries.5
Data Limitations and Reliability
SOI is a data set widely used for research purposes. SOI corporation files
are representative samples of the population of all corporations that
filed tax returns. Generally, SOI data can be used to project tax return
information to the universe of all filers. However, the total corporations
that matched in both the SOI and FPDS databases could not be used to
project the results of our analysis to the universe of all corporations.
Because SOI's sampling rate for smaller corporations is very low, our
matched database contained very few smaller corporations and would not
lead to reliable estimates of the properties of the universe of smaller
corporations. Therefore, the results of our analysis cannot be projected
to the universe of all corporate filers. However, our results do represent
the universe of large tax haven contractors. SOI samples corporations with
at least $10 million in assets at a 100 percent rate so that the SOI
sample
4 We did not include in our analysis corporations that were real estate
investment trusts, regulated investment companies, or subchapter S
corporations because these pass-through entities are treated differently
for tax purposes than ordinary corporations.
5 As of December 2003, OECD had identified 39 countries or jurisdictions
that they consider to be tax havens. In this report, we refer to these
countries and jurisdictions as tax haven countries. They are Andorra,
Anguilla, Antigua and Barbuda, Aruba, Bahamas, Bahrain, Barbados, Belize,
Bermuda, British Virgin Islands, Cayman Islands, Cook Islands, Cyprus,
Dominica, Gibraltar, Grenada, Guernsey, Isle of Man, Jersey, Liberia, The
Principality of Liechtenstein, Malta, The Republic of the Marshall
Islands, Mauritius, The Principality of Monaco, Montserrat, The Republic
of Nauru, Netherlands Antilles, Niue, Panama, St. Christopher (St. Kitts)
and Nevis, St. Lucia, St. Vincent and the Grenadines, Samoa, San Marino,
Seychelles, Turks & Caicos, U.S. Virgin Islands, and Vanuatu.
includes the universe of these larger corporations. For this reason, we
report the results of our analysis without sampling error.
IRS performs a number of quality control steps to verify the internal
consistency of SOI sample data. For example, it performs computerized
tests to verify the relationships between values on the returns selected
as part of the SOI sample and manually edits data items to correct for
problems, such as missing items. We conducted several reliability tests to
ensure that the data excerpts we used for this report were complete and
accurate. For example, we electronically tested the data and used
published data as a comparison to ensure that the data set was complete.
To ensure accuracy, we reviewed related documentation and electronically
tested for obvious errors. We concluded that the data were sufficiently
reliable for the purposes of this report.
We have previously reported that there are limitations to the accuracy of
the data in FPDS.6 The data accuracy issues we reported on involved
contract amounts and classification of contract characteristics. For this
report, the only FPDS data we used were the contractors' names and
taxpayer identification numbers. Our previous report did not address the
accuracy of these data elements. Therefore, our match of the FPDS and SOI
data may contain some nonsampling error; that is, due to inaccurate
identification numbers, we may fail, in some cases, to correctly identify
large corporations in SOI that were also federal contractors. However, we
expect this nonsampling error to be small, and we concluded that the data
were sufficiently reliable for the purposes of this report.
There Are Conditions under Which Tax Haven Contractors May Have a Tax Cost
Advantage
Contractors, including tax haven contractors, that have a lower marginal
tax rate on the income from a contract than other contractors would have a
tax cost advantage when competing for a contract. Furthermore, there is
some evidence that a tax haven contractor may be able to shift income
between the U.S. subsidiary and its tax haven parent in order to reduce
U.S. taxable income.
6 U.S. General Accounting Office, Reliability of Federal Procurement Data,
GAO-04-295R (Washington, D.C.: Dec. 30, 2003).
Contractors with Lower Marginal Tax Rates May Have a Tax Cost Advantage
There are conditions under which a contractor could have a tax cost
advantage when competing for a contract. The tax cost of the contract is
the tax paid on the additional income derived from the contract. A
contractor that pays less tax on additional income from a contract gains a
tax cost advantage compared to companies that pay higher tax. One way to
gain a tax cost advantage is by offsetting income earned on the contract
with losses from other activities. The contractors with a tax cost
advantage are not necessarily the successful competitors because the tax
cost savings may not be reflected in actual bid prices or price proposals,
and prices or costs are only one of several factors involved in awarding
contracts. This reasoning holds for all contractors, including tax haven
contractors, and all contracts, including federal contracts.
The appropriate measure of the tax cost of the contract is the
corporation's marginal tax rate. The marginal tax rate is the rate that
applies to an increment of income. As such, the marginal tax rate would be
the rate that applies to the additional income that would arise from the
federal contract. For example, if a contractor in a 34 percent tax bracket
earns $1 million of additional income from the contract, it would owe
$340,000 in additional tax. The 34 percent statutory tax rate is this
contractor's marginal rate.
A lower marginal tax rate may confer a tax cost advantage when companies
are bidding on contracts because it indicates a higher after-tax rate of
return on the contact. All other things being equal, a lower marginal
effective tax rate is equivalent to a reduction in cost, that is, a
reduction in either the tax rate or cost would produce a higher after-tax
return. For example, a contractor with a 30 percent marginal tax rate on a
contract producing $1 million of income pays $300,000 in taxes and
receives $700,000 in additional after-tax income. On the other hand, a
contractor with a 34 percent marginal tax rate on the same contract
producing $1 million of income pays $340,000 in taxes and receives
$660,000 in additional after-tax income. The $40,000 difference in
after-tax income due to the difference in marginal tax rates is the tax
cost advantage. In this example, the contractor with the tax cost
advantage can, in theory, underbid the competitor by as much as $40,000
and earn an after-tax income at least as large as the competitor. In this
sense, the competitor with the lower marginal tax rate would have a tax
cost advantage over a competitor with a higher marginal tax rate.
A contractor gains a tax cost advantage if it has a lower marginal tax
rate compared to other companies that are competing for the contract.
However, the available data are not sufficient to measure marginal rates
accurately. In order to compute marginal rates, detailed information is
required about the tax status of the contractors and types of spending by
the contractors associated with the contracts.
Although the marginal tax rates are not available, conditions under which
the marginal rates may be lower for some companies than others can be
inferred from their current taxable income. Specifically, a company that
has positive taxable income may be more likely to have a positive tax
liability on the incremental income from the contract than companies with
zero or negative taxable income. Therefore, a company with zero taxable
income may have a lower marginal tax rate relative to companies with
positive taxable income.7 Tax losses in the United States on other
activities could absorb incremental income generated from a contract. All
other things being equal, a company competing for a federal contract that
reported taxable income in the United States would face a higher tax cost
than a competitor without taxable income.
While a zero tax liability provides an indicator of a tax cost advantage,
it does not necessarily mean that the advantage exists. Whether a
contractor with zero tax liability has a tax cost advantage when competing
for a particular contract depends on the tax liabilities of the other
competitors. The contractor with zero tax liability would have no tax cost
advantage if all the other competitors also had no tax liability.
Even if a contractor can be shown to have a tax cost advantage when
competing for a federal contract, this advantage does not imply that the
contractor's bid or proposal will be successful. A tax cost advantage may
not be reflected in the contractor's bid or price proposal, the content of
which depends on the business judgment of the contractor. For example, in
order to include more profit, a contractor may decide not to use any tax
cost advantage to reduce its price. Even if the tax advantage is reflected
in the bid or price proposal, other price or cost factors that affect
whether the bid or proposal is successful may not be equal across the
companies competing for the contract. For example, a bidder may have a tax
cost
7 Besides depending on taxable income and potential availability of tax
losses to offset income, the likelihood of a zero marginal rate also
depends on the availability of accumulated tax credits, which can directly
offset tax liabilities. We emphasize taxable income here because the
availability of tax losses is more directly connected to the income
shifting discussed in the next section. Our estimate of the number of
contractors with an advantage is based on whether they have positive or
zero tax liability, which includes the effects of both loss and credit
carryforwards.
advantage over other bidders, but if its costs of labor and material are
higher, its tax cost advantage may be offset by its higher costs for those
other elements of its bid. Further, where price or cost is not the only
evaluation factor for award of the contract, any tax cost advantage may be
offset by the relative importance of other factors such as technical
merit, management approach, and past performance. Generally, the
contractor's tax cost advantage would become a competitive advantage where
other contractors would have to reduce their prices (or costs) and/or
improve the nonprice (or noncost) elements of their proposals to offset
the tax cost advantage.
Tax Haven Contractors May Be Able to Shift Income to Reduce U.S. Taxable
Income
Tax haven contractors may be more likely to have lower tax costs than
other contractors because they may be able to shift U.S. source income to
their tax haven parents, reducing U.S. taxable income. Some, but not all,
domestic contractors - those that have overseas affiliates -may also be
able to shift income. Any income earned by the U.S. subsidiary from a
contract for services performed in the United States would be U.S. taxable
income. Such income would be taxed in the United States unless it is
shifted outside the United States through such techniques as transfer
pricing abuse.
Location in a tax haven country can confer tax advantages that are not
related to income shifting and do not give a company an advantage when
competing for federal contracts. When a parent locates in a tax haven
country, taxes on foreign income can be reduced by eliminating U.S.
corporate-level taxation of foreign operations. However, these tax savings
are unrelated to the taxes paid on income derived from the contract for
services performed in the United States and have no effect on the tax cost
of the contract.8 The tax haven contractor potentially gains an advantage
with respect to contract competition because of the increased scope for
income shifting to reduce U.S. taxable income below zero.
8 For a more detailed description of the potential tax advantages, see
app. I.
A tax haven contractor may be able to shift income outside of the United
States by increasing payments to foreign members of the corporate group.
The contractor may engage in transfer pricing abuse, whereby related
parties price their transactions artificially high or low to shift taxable
income out of the United States. For example, the tax haven parent can
charge excessive prices for goods and services rendered (for example,
$1000 instead of $500). This raises the subsidiary's expenses (by $500),
lowers its profits (by $500), and shifts the income ($500) to the lower
tax jurisdiction outside the United States. Transfer pricing abuse can
also occur when the foreign parent charges excessive interest on loans to
its U.S. subsidiary. 9 Interest deductions can also be used to shift
income outside the United States through a technique called "earnings
stripping." Using this technique, the foreign parent loads the U.S.
subsidiary with a disproportionate amount of debt, merely by issuing an
intercompany note, thereby generating interest payments to the parent and
interest deductions against U.S. income for the subsidiary. However, the
U.S. subsidiaries would still be subject to the I.R.C. rules that limit
the deductibility of interest to 50 percent of adjusted taxable income
whenever the U.S. subsidiary's debt-equity ratio exceeds 1.5 to 1.
Determining whether companies shift income to obtain a tax cost advantage
is difficult because differences among companies that may indicate
shifting can also be explained by other factors affecting costs and
profitability. For example, while differences in average tax rates and
interest expenses may be consistent with income shifting, they do not
prove that such activities are occurring. The differences might be
explained by other factors, such as the age of the company.
As table 1 shows, tax haven contractors in 2001 had greater interest
expense and lower tax liabilities relative to gross receipts than domestic
or all foreign contractors. The greater interest expense associated with
lower tax liabilities may indicate that the tax haven contractors have
used techniques like earnings stripping to shift taxable income outside
the United States. The pattern of tax liabilities and interest expense in
2000 is the same as in 2001 in all respects except one: the ratio of
interest expense
9 There are various provisions in the I.R.C. designed to limit income
shifting. The limits include the requirement (Section 482) that
transactions between related parties use arm's length prices, that is, the
prices that unrelated parties would or should use for the transactions.
to gross receipts for tax haven noncontractors is lower than the ratio for
domestic or all foreign contractors in 2000. (For details, see app. II.)
Table 1: Tax Liabilities and Interest Expenses of Large Contractors and
Noncontractors in 2001 Contractors Noncontractors
Tax liability as a Interest expense Tax liability as a Interest expense
Number of percentage of as a percentage Number of percentage of as a
percentage companies gross receipts of gross receipts companies gross
receipts of gross receipts
All foreign 740 0.89 6.55 7,093 1.01
Tax haven 50 0.75 8.33 787 0.91 16.32
Domestic 3,524 1.18 7.12 33,293 1.76 12.90
Total 4,264 1.14 7.04 40,386 1.59 11.92
Source: GAO analysis of IRS data.
Notes: Large contractors and noncontractors are companies with total
assets greater than or equal to $10 million. The number of companies does
not sum to the total because tax haven contractors are included among all
foreign contractors.
This pattern of interest expenses and tax liabilities is largely
consistent with tax haven contractors inflating interest costs to shift
taxable income outside of the United States but does not prove that this
has occurred. The differences may be due to such factors as the age and
industry of the companies, their history of mergers or acquisitions, and
other details of their financial structure and the markets for their
products. Furthermore, low or zero tax liability is not necessarily an
indicator of noncompliance. Companies may have low or zero tax liabilities
for a variety of reasons, such as overall business conditions, industry-or
company-specific performance issues, and the use of income shifting.
The evidence on the extent to which income shifting is occurring is not
precise. Studies that compare profitability of foreign-controlled and
domestically controlled companies show that much of the difference can be
explained by factors other than income shifting.10 However, the range of
estimates can be wide, contributing to uncertainty about the precise
effect, and the studies do not focus on income shifting to parents in tax
haven countries. The 1997 study by Harry Grubert showed that more than 50
percent, and perhaps as much as 75 percent, of the income differences
could be explained by factors other than income shifting. A Treasury
report on corporate inversions did discuss income shifting to parents in
tax haven countries but did not provide any quantitative estimates of the
extent of such shifting. According to the report, the tax savings from
income shifting are greatest in the case of a foreign parent corporation
located in a no-tax jurisdiction.11 The Treasury report cites increased
benefits from income shifting among other tax benefits as a reason for
recent corporate inversion activity and increased foreign acquisitions of
U.S. multinationals.
Tax Haven Contractors Were More Likely to Have a Tax Cost Advantage Than
Domestic Contractors
Using tax liability as an indicator of ability to offset contract income,
we determined that large tax haven contractors were more likely to have a
tax cost advantage than large domestic contractors in both 2000 and 2001.
In both years, tax haven contractors were about one and a half times more
likely to have no tax liability as domestic contractors.12 As table 2
shows, in 2000, 56 percent of the 39 tax haven contractors reported no tax
liability, while 34 percent of the 3,253 domestic contractors reported no
tax liability. In 2001, 66 percent of the 50 tax haven contractors and 46
percent of the 3,524 domestic contractors reported no tax liability.
10 See, for example, Harry Grubert, "Another Look at the Low Taxable
Income of Foreign-Controlled Companies in the United States," Tax Notes
International (Arlington, Va.: Dec. 8, 1997), 1,873-97, and David S.
Laster and Robert N. McCauley," Making Sense of the Profits of Foreign
Firms in the United States," Federal Reserve Bank of New York Quarterly
Review (New York: Summer-Fall 1994).
11 U.S. Department of the Treasury, Office of Tax Policy, Corporate
Inversion Transactions: Tax Policy Implications.
12 The relative probability of contractors having no tax liability can be
computed by comparing relative frequencies (percentages) of tax haven and
domestic contractors with no tax liability. In 2000 and 2001, the relative
frequencies were 1.65 (.56 divided by .34) and 1.43 (.66 divided by .46),
respectively.
Table 2: Tax Status of Large Tax Haven and Domestic Contractors in 2000 and 2001
Contractors with tax liability Contractors without tax liability
U.S. federal Number of Percentage of Number of Percentage of contractors
companies companies companies companies 2000
Tax haven 17 44 22
Domestic 2,132 66 1,121
2001
Tax haven 17 34 33
Domestic 1,888 54 1,636
Source: GAO analysis of IRS data.
Under the conditions of our model, contractors with no tax liability would
have a tax cost advantage compared to the contractors that did have tax
liabilities in these years. Consequently, in 2000, the tax haven
contractors without tax liabilities were likely to have a tax cost
advantage compared to the 17 other tax haven contractors and 2,132
domestic contractors that had tax liabilities. The 1,121 domestic
contractors without tax liabilities were also likely to have a tax cost
advantage compared to these same companies. In 2001, the tax haven
contractors with zero tax liability were likely to have a tax cost
advantage compared to the 17 other tax haven contractors and 1,888
domestic contractors that had tax liabilities. Because they reported no
tax liability, 1,636 domestic contractors were also likely to have a tax
cost advantage with compared to these same companies.
This analysis of possible tax advantages does not show that income
shifting is the only potential cause of the advantage. As mentioned above,
the tax losses that confer the advantage may be due to income shifting,
but may also be due to other factors such as overall business conditions,
industry and age of the company, or company-specific performance issues.13
In addition, the analysis does not show the size of the advantage in terms
of
13 In a prior report, we found that the ratios of tax liability and
interest expense to gross receipts varied by industry. However, after
controlling for the age and industry of the corporations, we found that
U.S. subsidiaries of foreign parent corporations were more likely to have
zero tax liability than domestic corporations from 1996 through 2000. See
U.S. General Accounting Office, Tax Administration: Comparison of the
Reported Tax Liabilities of Foreign-and U.S.-Controlled Corporations,
1996-2000, GAO-04-358 (Washington, D.C.: Feb. 27, 2004).
tax dollars saved. The amount saved depends, in part, on the amount of
additional income from the contract. If the contractor with no tax
liability has insufficient losses to offset the additional income, it
would pay taxes on at least part of the income, reducing the potential
advantage. Lastly, the analysis identifies tax haven contractors that meet
the conditions for having a tax cost advantage with respect to income from
the contract in 2000 and 2001. The data do not indicate whether they have
an overall tax cost advantage on a contract that produces income in other
years. Furthermore, to the extent that losses are used to offset income in
the current year, they cannot be used to offset income in other years.
These smaller loss carryovers would reduce the overall tax cost advantage.
Concluding Observations
The existence of a tax cost advantage for some tax haven contractors
matters to American taxpayers. First, the advantage could, but does not
necessarily, affect which company wins a contract. A contractor with a tax
cost advantage could offer a price that wins a contract based more on tax
considerations than on factors such as the quality and cost of producing
goods and services. Second, the potential tax cost advantage may
contribute, along with other tax considerations, to the incentives for
companies to move to tax haven countries, reducing the U.S. corporate tax
base.
The issue of tax cost advantages for tax haven contractors is related to
the larger issue of how companies headquartered or operating in the United
States should be taxed. For example, the questions about how the worldwide
income of U.S. multinational corporations should be taxed are part of a
larger debate and beyond the scope of this report. Because of these larger
policy issues, we are not making recommendations in this report.
Agency Comments and Our Evaluation
In a letter dated June 22, 2004, the IRS Commissioner stated that because
IRS's only role in our report was to provide us with certain tax data,
IRS's review of a draft of this report would be limited to evaluating how
well we described the tax data it provided. The Commissioner stated that
IRS believes that the report fairly describes these data. On June 28,
officials from the Department of the Treasury's Office of Tax Policy
provided oral comments on several technical issues, which we incorporated
into the report where appropriate.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its date. At that time, we will send copies to the Secretary of the
Treasury, the Commissioner of Internal Revenue and other interested
parties. We will also make copies available to others on request. In
addition, this report will be available at no charge on GAO's Web site at
http://www.gao.gov.
If you have any questions concerning this report, please contact me at
(202) 512-9110 or whitej@gao.gov or Kevin Daly at (202) 512-9040 or
dalyke@gao.gov. Key contributors to this report are listed in appendix
III.
Sincerely yours,
James R. White Director, Tax Issues
Appendix I
A Simple Qualitative Model for Assessing Potential Contracting Advantages
A parent corporation that locates in a tax haven country may reduce U.S.
tax on corporate income by shielding subsidiaries from U.S. taxation and
by providing opportunities for shifting of U.S. source income to lower tax
jurisdictions. Such a corporation could have an advantage because it is
able to have a lower marginal tax rate on U.S. contract income than its
domestic competitors or other foreign competitors. The simple qualitative
model in this appendix specifies a set of conditions under which
corporations with a tax haven parent may have a lower marginal U.S. tax
rate.
The principal means by which a parent corporation that locates in a tax
haven country may have lower U.S. tax liabilities are as follows.
o The corporation pays no U.S. tax on what would have been its foreign
source income if it were located in the United States. To the extent that
foreign subsidiaries are owned by a foreign parent, the U.S.
corporatelevel taxation of foreign operations is eliminated. Tax savings
would come from not having to pay tax on the corporate group's foreign
income.
o The corporation may be able to shift income outside of the United
States by increasing payments to foreign members of the group. The
corporation may engage in transfer pricing abuse, whereby related parties
price their transactions artificially high or low to shift taxable income
out of the United States.1 Transfer pricing abuse can also occur when the
foreign parent charges excessive interest on loans to its U.S. subsidiary.
Interest deductions can also be used to shift income outside the United
States through a technique called earnings stripping. Using this
technique, the foreign parent loads the U.S. subsidiary with a
disproportionate amount of debt, merely by issuing an intercompany note,
thereby generating interest payments to the parent and interest deductions
against U.S. income for the subsidiary. The subsidiaries would still be
subject to the thin capitalization rules (I.R.C. section 163 (j)) that
limit the deductibility of interest to 50 percent of adjusted taxable
income whenever the U.S. subsidiary's debt-equity ratio exceeds 1.5 to 1.
1 There are various provisions in the I.R.C. designed to limit income
shifting. The limits include the requirement (Section 482) that
transactions between related parties use arm's length prices, that is, the
prices that unrelated parties would use for the transactions.
Appendix IA Simple Qualitative Model for AssessingPotential Contracting
Advantages
When a parent corporation locates in a tax haven country, the elimination
of U.S. corporate-level taxation of foreign operations can reduce taxes on
foreign income. However, these tax savings are unrelated to the taxes paid
on income derived from the contract and have no effect on the tax cost of
the contract. Any income earned by the U.S. subsidiary from a contract for
services performed in the U.S. would be U.S. taxable income. Therefore,
the elimination of the corporate-level taxation of foreign operations
provides no competitive advantage to a corporation that is competing for a
U.S. government contract.
A corporation has a U.S. tax advantage in competing for a government
contract when it would pay a lower marginal U.S. tax rate on the income
from that contract than would the other companies competing for that same
contract. The available data are not sufficient to measure marginal rates
accurately. However, the likelihood that the rates are lower for some
companies than others can be inferred from their current tax liabilities.
The manipulation of interest payments and other transfer pricing can
reduce U.S. taxable income. We can infer that the corporation may have a
lower marginal tax rate on its U.S. contract income if the manipulation
allows a corporation that would otherwise have positive taxable income to
reduce its taxable income (excluding the net income from the contract) to
a negative amount. Table 3 shows a set of situations, or cases, in which a
corporation may and may not have a cost advantage when bidding on a
contract.
Table 3: Tax Cost Advantage of Corporations with Headquarters in a Tax
Haven Country
U.S. income of a U.S. income of a company Company has a tax cost company
in the with its parent located in a advantage with parent in
Case United States tax haven country tax haven country
+ -Yes
2++ No
3--No
Source: GAO qualitative model of tax cost advantage.
In order to use this model to identify corporations with a tax cost
advantage, we make two assumptions: (1) corporations with positive U.S.
taxable income pay tax at the same rate based on the schedule of corporate
tax rates (that is, their income before the contract income puts them in
the same tax bracket) and (2) corporations with negative income have
Appendix IA Simple Qualitative Model for AssessingPotential Contracting
Advantages
sufficient losses to offset income from the contract. With these
assumptions, we can draw inferences about relative marginal tax rates for
the three cases. A U.S. corporation that has positive U.S. taxable income
(before taking the income from the contract into account) and has a parent
located in a tax haven country does not have a competitive advantage
compared to a U.S. corporation with positive income (Case 2). Because they
have positive income and pay the same rate of tax, neither has a lower
marginal tax rate than the other. Likewise, a corporation with a tax haven
parent that has U.S. tax losses and zero tax liability would not have an
advantage compared to another corporation with tax losses (Case 3).
Because the marginal tax rate is zero for both these corporations and they
have sufficient losses to offset the contract income, neither has a tax
cost advantage.
However, a corporation that has a tax haven parent and U.S. tax losses
would have an advantage when compared to a corporation with positive
income (Case 1). In this case, the corporation with losses has a zero
marginal rate, which provides a tax cost advantage compared to a
corporation with taxable income and a positive marginal rate. The
assumption that a corporation with zero tax liability has sufficient
losses to offset contract income may not be true in particular instances.
For example, a corporation may obtain more than one contract (in the
public or private sector) and the marginal tax rate on income from a
particular contract will depend on how the losses are allocated across
income from all the contracts. However, a corporation with zero tax
liability is more likely to be able to offset the additional income than a
corporation with positive tax liability. In this sense, tax liability is
an indicator of the ability to offset income from the contract.
The qualitative model does not identify the causes of the advantage. The
tax losses that confer the advantage may be due to income shifting, but
may also be due to other factors. In addition, the model does not show the
size of the advantage in terms of tax dollars saved. The amount saved
depends, in part, on the amount of additional income from the contract. If
the contractor with no tax liability has insufficient losses to offset the
additional income, it would pay taxes on at least part of the income,
reducing the potential advantage compared to contractors that have
positive tax liabilities. Lastly, the model is used to identify tax haven
contractors that meet the conditions for having a competitive advantage
with respect to income from the contract in 2000 and 2001. The data do not
indicate whether they have an overall tax advantage on a contract that
produces income in other years.
Appendix II
Additional Information about Contractors in 2000
The additional table of tax liabilities and interest expense for 2000 is
provided for comparison with the data reported in the letter. It shows
substantially the same pattern.
Information on Large Contractors in 2000
Table 4 shows that in 2000, tax haven contractors had greater interest
expense and lower tax liabilities relative to gross receipts than domestic
or all foreign contractors. The pattern of tax liabilities and interest
expense in 2000 is the same as in 2001 in all respects except one: the
ratio of interest expense to gross receipts for tax haven noncontractors
is lower than the ratio for domestic or all foreign contractors in 2000.
The greater interest expense associated with lower tax liabilities may
indicate, but does not prove, that the tax haven contractors have used
techniques like earnings stripping to shift taxable income outside the
United States.
Table 4: Tax Liabilities and Interest Expenses of Large Contractors and
Noncontractors in 2000 Contractors Noncontractors
Tax liability as a Interest expense Tax liability as
a Interest expense as
Number of percentage of as a percentage Number of percentage
of a percentage of
companies gross receipts of gross receipts companies gross
receipts gross receipts
All foreign 671 1.25 5.01 7,173 1.27 11.62
Tax haven 39 0.31 9.92 787 1.10
Domestic 3,253 1.55 7.13 35,433 1.90 13.01
Total 3,924 1.50 6.81 42,606 1.76 12.71
Source: GAO analysis of IRS data.
Notes: Large contractors and noncontractors are
those with total assets greater than or equal to
$10 million. The number of companies does not sum to
the total because tax haven contractors are
included among all foreign contractors.
Appendix III
Staff Acknowledgments
Amy Friedheim, Donald Marples, Samuel Scrutchins, James Ungvarsky, and
James Wozny made key contributions to this report.
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