CTJ Reports

Proposals to Resolve the Crisis of Corporate Inversions

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Several proposals have been offered to address the crisis of American corporations “inverting.” These companies reincorporate as offshore companies to avoid U.S. taxes even as they continue to operate and be managed in the U.S. and benefit from the public investments that American taxpayers support. This report describes these proposals and explains why some are much stronger and more effective than others.

The Basics
The Inversion Crisis Consists of Three Problems which Require Separate Solutions

The inversion crisis actually consists of three related problems which each call for specific solutions. First, loopholes in our tax law allow American corporations to pretend they are based abroad. Second, those corporations claiming to be based abroad (and corporations that really are based abroad) are able to use “earnings stripping” techniques to make profits earned in the U.S. appear to be earned in countries where they will be taxed more lightly or not at all. Third, the profits that American corporations earn offshore are supposed to be taxed by the U.S. when they are brought to the U.S., but after inverting corporations are able to use accounting tricks to escape that rule.

The first problem is simply the absurdity that American corporations can pretend to be foreign corporations, while the second and third problems are the benefits they obtain by doing so. As Edward Kleinbard, former director of the Joint Committee on Taxation (JCT) argues, these benefits, rather than any attempt to enhance “competitiveness,” are the true goals of inversions.[1]

A powerful response would be to address all three problems by taxing “inverted” corporations as American corporations and removing the ability of such companies to earnings strip or access their previously accumulated offshore profits without triggering U.S. taxes.

It is possible that Congress will only address the first problem, by enacting the anti-inversion proposal from President Barack Obama’s recent budget plan and introduced as legislation by Rep. Sander Levin and Senator Carl Levin to tighten the rules around which corporations are treated as American for tax purposes.[2] Or, Congress could instead enact legislation that would address the other two problems — i.e., addressing the motivation for most inversions. The most obvious way to accomplish this would be the enactment of the new legislation that Rep. Sander Levin is reportedly working on to address these problems.

Yet another possibility is that Congress will fail to act and the Obama administration will act on its own to issue regulations authorized under existing law. There is no obvious way that a regulatory change could address the first problem (the loopholes allowing American corporations to pretend to be foreign) but former Treasury official Stephen Shay argues that the administration does have authority to issue regulations that would partially address the other two problems (the motivations for many inversions) which would alleviate the crisis to a large extent.[3] [4]

Loopholes allowing inversions must be closed.

The first problem is that loopholes in our tax law simply allow American corporations to invert. That is, loopholes allow American corporations to pretend, for tax purposes, that they have restructured themselves as foreign companies even though this restructuring exists only on paper. Before 2004, an American corporation might set up a shell corporation in a tax haven like Bermuda and then, as a technical matter, become a subsidiary of that tax haven corporation. Bipartisan legislation enacted in 2004 treats such a company as an American corporation for tax purposes if the former shareholders of the American corporation own more then 80 percent of the newly merged company and there is no substantial business activity in the foreign country.[5]

But American corporations have recently responded by merging with real foreign corporations — albeit smaller ones — to provide the sheen of legitimacy that the 2004 rules require. The arrangements still do not include any actual move of managers or other personnel or any significant change in the business operations, but result in corporations that can pretend to be foreign for tax purposes. The straightforward solution is to treat the company that results from this arrangement as American if the majority of it is owned by the former shareholders of the American company, and to treat is as American if it is managed in the U.S. This is what the Obama-Levin-Levin proposal would do.

Earnings stripping must be stopped.

The second problem is that once a corporation has inverted, it has opportunities to use “earnings stripping” to make profits earned in the U.S. appear to be earned in other countries where they will be taxed more lightly or not at all. In theory, any profits earned in the U.S. are subject to U.S. taxes, whether they are earned by an American-owned company or a foreign-owned company (which an inverted corporation is, technically). But earnings are stripped out of the U.S. when a U.S. corporation (which after inversion is technically the subsidiary of a foreign parent corporation) borrows money from its foreign parent corporation, to which it makes large interest payments that wipe out U.S. income for tax purposes. The loan is really an accounting gimmick, since all the related corporations involved are really one company that is simply shifting money from one part to the other. The interest payments made by the American corporation in effect shift the profits that are really earned in the U.S. to the foreign country for tax purposes.

Restrictions on earnings stripping can take several forms, any of which can be weak or strong depending on how strict the limits are. One approach is to limit the amount of interest that can be deducted for tax purposes to some percentage of income or revenue. Another approach is to limit the deductions to the extent that the American subsidiary’s ratio of debt to equity (loans taken to stock issued) exceeds some set limit. The current (very weak) rule uses these approaches, and some reform proposals would simply lower the percentage of income or revenue that the deductable interest cannot exceed. Another approach would be to limit the interest deductions to the extent that the American subsidiary’s indebtedness is disproportionate relative to the rest of the corporate group (the group of corporations owned by the same foreign parent company). This is the approach taken in the earnings stripping proposal in President Obama’s most recent budget plan, which may be the strongest proposal to stop earnings stripping.

American corporations must not be allowed to avoid the U.S. tax normally due on offshore profits upon repatriation to the U.S.

The third problem is that the profits that American corporations earn offshore are supposed to be taxed by the U.S. when they are officially brought to the U.S. But after inverting, corporations are able to use accounting tricks to escape this rule.

The U.S. theoretically taxes all the profits of American corporations, including the profits earned by offshore subsidiaries. (The U.S. corporate income tax is reduced by whatever corporate income tax has been paid on these profits to foreign governments.) But U.S. corporations are allowed to defer paying U.S. tax until these profits are officially brought to the U.S., which may never happen. As a result, one of the key questions is what will become of the offshore profits that American corporations’ subsidiaries have accumulated offshore (at least officially, since these profits are often in the U.S. in a real economic sense).

In theory, if the U.S. corporation inverts and becomes the subsidiary of a foreign corporation, the profits accumulated by the offshore subsidiaries of the U.S. corporation are still subject to U.S. tax whenever they are repatriated (officially brought to the U.S.) But inverted corporations can easily get around this rule. Money is fungible. The subsidiaries of the U.S. company can loan the money they have accumulated offshore to the foreign company that ostensibly owns the U.S. corporation after inversion, or to another foreign company in the corporate group that is not a subsidiary of the U.S. company. That money can then be used to expand business in the U.S. or buy back stock from the shareholders of the U.S. company. If the offshore accumulated profits of the subsidiaries were directly used for these purposes, that would constitute a repatriation and would trigger U.S. tax. But the inversion allows for the use of loans (as an accounting gimmick) to move the money into the U.S. for that purpose while avoiding the tax.

Proposed solutions generally would enhance the effectiveness of section 956 of the tax code, which is designed to prevent corporations from avoiding the U.S. tax that is due upon repatriation of offshore profits. Before section 956 was enacted in the 1960s, an American corporation could get around the tax by having an offshore subsidiary make an investment in its American operations that was not actually a dividend payment to the American parent company, and thus not considered a taxable repatriation. Section 956 was enacted to treat such investments as repatriations, and to impose U.S. tax at that point. But section 956 applies to investments made by the offshore subsidiaries directly in related American companies. It does not apply when the offshore subsidiaries hopscotch over their American parent company, investing or lending the money to other foreign companies within the corporate group (foreign companies that are not subsidiaries of the American company), which can then use that money for the same purpose without triggering U.S. tax.

Proposals to address this loophole would make section 956 apply when such investments are made by the subsidiaries of the American corporation to other foreign companies in the corporate group in certain situations.

More Details
The Three Problems and Specific Proposals to Address Them

1. Corporations Using Paperwork to Claim to Be Foreign Companies

Problem: Corporations use restructuring that exists only on paper to claim “foreign” status to avoid U.S. taxes.

Solution: Amend the tax laws to refuse to recognize foreign status that exists only on paper.

Proposal: The basic anti-inversion proposal included in President Obama’s most recent budget and then incorporated into the Stop Corporate Inversions Act, provides this solution. The proposal would treat an entity that results from a U.S.-foreign corporate merger as an American corporation if the majority (as opposed to the current threshold of 80 percent) of voting stock is held by the shareholders of the former American corporation. It would also treat the entity resulting from the merger as an American corporation if it is managed and controlled in the U.S. and has significant business activities in the U.S. (Significant business is defined as 25 percent of the corporate group’s employees, payroll, assets or income.)

This proposal would raise $19.5 billion from 2014 through 2014 according to Congress’s official revenue estimator, the Joint Committee on Taxation (JCT). 

Some lawmakers have taken issue with the provision concerning inverted corporations managed in the U.S. They claim that this could encourage corporations to literally and physically move their headquarters, including management and supporting personnel, to a foreign country in order to reduce their tax bill. This seems extremely unlikely. So far there is no evidence of any inverting corporations moving managers offshore. In fact, Ireland, where many inverted corporations claim to be based, appears not to be benefiting from the inversion wave precisely because nothing real is actually moving to Ireland, which consequently does not enjoy any revenue or economic gain.[6] In other words, the danger that corporations might respond to a change in the law by moving management offshore is at best speculative, while the danger of corporate inversions causing a loss of revenue is very real and unfolding before our eyes.

Even if there was any reason to fear that some American corporations would do whatever necessary to be considered “foreign,” even if that means moving management abroad, the answer would be to enact additional provisions that remove the incentives a corporation currently obtains by virtue of being foreign (which are discussed in the following sections) and make these provisions apply to all corporations. Under this approach, even if an American corporation was willing to be acquired in a true, economic sense and was willing to move management offshore, there would be little or no incentive to do so because becoming “foreign” would no longer provide significant benefits.

2. Earnings Stripping by Inverted Corporations

Problem: American corporations that invert to claim foreign status often then engage in “earnings stripping,” the practice of multinational corporations earning profits in the United States reducing or eliminating their U.S. profits for tax purposes by making large interest payments to their foreign affiliates.

Solution: Enact tighter limits on debt taken on by the U.S. part of a multinational corporation (tighten restrictions against earnings stripping).

Proposals:

a) Obama’s fiscal 2015 budget plan

The strongest anti-earnings stripping proposal is the one included in President Obama’s most recent budget plan. It would, with good reason, apply to all corporations, not just those that have inverted. It would allow a multinational corporation doing business in the U.S. to take deductions for interest payments to its foreign affiliates only to the extent that the U.S. entity’s share of the interest expenses of the entire corporate group (the entire group of corporations owned by the same parent corporation) is proportionate to its share of the corporate group’s earnings (calculated by adding back interest deductions and certain other deductible items). A corporation doing business in the U.S. could choose instead to be subject to a different rule, limiting deductions for interest payments to ten percent of “adjusted taxable income” (which is taxable income plus several amounts that are usually deducted for tax purposes).

This proposal would raise $41 billion from 2015 through 2024 according to JCT.

b) Rep. Levin’s discussion draft legislation

A different approach is taken by a proposal in legislation being drafted by Rep. Sander Levin, the ranking member of the House Ways and Means Committee.

It would bar the American corporation (which is technically a subsidiary of a foreign company after an inversion) from taking deductions for interest payments to a foreign parent company in excess of 25 percent of its “adjusted taxable income,” which is defined as taxable income plus certain significant deductions that corporations are allowed to take. The current rule (under section 163(j) of the tax code) sets the limit at 50 percent of adjusted taxable income.

This proposal would eliminate the rule that waives that limit if the corporation’s debt does not exceed 150 percent of its equity.

This proposal would also repeal the rule allowing corporations to carry forward any excess limitation (the amount by which the limit on interest deduction exceeds the interest expenses deducted in a given year) to increase their limit in future years.

It would also bar corporations from carrying forward any disallowed interest deductions to more than five years into the future. (The current rules allow disallowed interest payments to be carried forward indefinitely, to be used in any year in which the company has income to deduct from and is not otherwise subject to the limits on interest deductions.)

There is not yet any estimate of the revenue that would be saved under this proposal. It therefore difficult to determine whether it is more effective or less effective than the earnings stripping proposal in the President’s most recent budget plan, which was described above.

c) President Obama’s previous budget plans

The earnings stripping proposal included in the President’s previous budget plans is the template for the proposed change to section 163(j) in Rep. Levin’s discussion draft (described above). But the proposal from the President’s previous budgets was much weaker because it would apply only to companies that are considered inverted under the existing rules, whereas Rep. Levin’s earnings stripping proposal would apply to all corporations.[7]

Limiting this proposal to inverted companies makes it much weaker, as demonstrated by its relatively small estimated revenue impact. This proposal would raise just 2.7 billion from 2014 through 2023 according to JCT, which suggests that it would have little effect.

This should be a warning to lawmakers. If, during the process of legislative negotiations, they are tempted to scale back Rep. Levin’s proposal so that it only applies to inverted corporations (as President Obama had earlier proposed) the policy will likely have very little impact.

d) Camp tax reform plan

The tax reform plan proposed by House Ways and Means chairman Dave Camp also includes an anti-earnings stripping proposal that would amend section 163(j) and is also based on the proposal in President Obama’s older budget plans. Rep. Camp’s proposal is broader in the sense that it would apply to all corporations (not just inverted corporations) but also narrower in the sense that the limits would not be as strict as those proposed by the President.

Rep. Camp’s proposal would bar an American subsidiary company from taking deductions for interest payments to a foreign parent company in excess of 40 percent of its “adjusted taxable income,” which is defined as taxable income plus certain significant deductions that corporations are allowed to take. (As explained, the current rule sets the limit at 50 percent of adjusted taxable income, while President Obama would set it at 25 percent for inverted companies.)

Another difference is that Rep. Camp’s proposal would not change the rule that waives the limit if the corporation’s debt does not exceed 150 percent of its equity.

Like Levin and Obama, Camp would also repeal the current rule allowing corporations to carry forward to future years any excess limitation. But, unlike the other two, Camp would not change the rule allowing disallowed interest payments to be carried forward to be deducted in future years.

In other words, Rep. Camp’s proposal is less strict in these ways, but also applies to all corporations. The result is that Camp’s proposal has roughly the same revenue impact as President Obama’s old proposal. Rep. Camp’s proposal would raise $2.9 billion from 2015 through 2024 according to JCT.

The revenue impact would be somewhat larger than that if this proposal was enacted on its own. The revenue estimate assumes that it is enacted as part of Rep. Camp’s larger tax reform plan, which also gradually reduces the corporate tax rate to 25 percent. Enacting this earnings stripping proposal on its own, without the reduction in the corporate tax rate, would raise somewhat more.

e) Possible administrative action

Former Treasury official Stephen Shay has proposed that if necessary, the Treasury Department could issue regulations under section 385 of the tax code that would limit earnings stripping for inverted corporations.[8] That section of the law essentially allows Treasury to issue regulations to determine whether an interest in a corporation is treated as debt or equity (stock). Regulations could, Shay explains, reclassify excessive debt taken on by an inverted American company from its (ostensible) foreign parent company as equity. This would mean that any interest payments made by the inverted American corporation would be reclassified as dividends paid on stock, which, unlike interest payments made on debt, are not deductable.

There are probably several ways that Treasury could define the excess indebtedness that would be reclassified as equity. Shay proposes that Treasury provide two calculations, and whichever amount is less would apply.

The first would be any debt that exceeds 110 percent of the debt that the inverted U.S. corporation would have if its debt-to-equity ratio was the same as that of the rest of the corporate group (the rest of the group of corporations owned by the same parent company). (This rule borrows from another provision of Camp’s tax reform plan.)

The second would be the amount of debt for which the interest would exceed 25 percent of the American corporation’s adjusted taxable income (again, income plus certain expenses usually deducted) averaged over the previous three years.

There is no estimate of how much revenue this proposal would save.

3. Inverted Corporations Avoiding the U.S. Tax Due on Accumulated Offshore Profits Upon Repatriation to the U.S.

Problem: Inverted corporations are able to avoid the rule that requires U.S. taxation when an American company repatriates (officially brings to the U.S.) profits of its offshore subsidiaries.

Solution: Strengthen section 956 of the tax code, the provision that is designed to prevent corporations from circumventing the rule that requires U.S. tax paid on offshore subsidiary profits when they are repatriated.

Proposals:

a) Rep. Levin’s discussion draft legislation

Rep. Levin’s discussion draft legislation would strengthen section 956 to impose U.S. tax on certain investments made by offshore subsidiaries of the American company to its ostensible foreign parent company or to other companies within the corporate group when such investments are really ways to indirectly move offshore profits into the U.S. without technically making a taxable repatriation.

Section 956 currently applies when the offshore subsidiaries of an American company invest directly in the U.S. company in some way that is really a repatriation of offshore profits by another name. For example, the offshore subsidiary could lend money to, or guarantee a loan to, its American parent company in a way that has the same effect as paying a dividend to the American parent company. Section 956 treats such investments as repatriation and imposes U.S. tax on them. The reform proposed by Levin would do the same when the investment is done indirectly, routed through a foreign parent company after an inversion or through one of the other companies that is owned by the foreign parent company.

There is currently no revenue estimate for this proposal.

The arcane nature of this reform belies the significance of the problem it addresses. American corporations officially hold, through their offshore subsidiaries, $2 trillion in foreign profits that they have declared to be “permanently reinvested” abroad. In many cases, these profits are really earned in the U.S. or another country with a normal tax system but manipulated through accounting gimmicks to appear to be earned in countries like Bermuda or the Cayman Islands that do not tax corporate profits. Almost none of these profits can be described as “earned,” in a real economic sense, in these tax haven countries, which do not provide nearly enough business opportunities to justify the amount of profits reported there.[9]

In fact, several corporations have acknowledged that if they repatriate these offshore profits, they would pay almost the full U.S. tax rate of 35 percent on them, which indicates that a large portion of these profits have not been taxed by any government, a clear sign that they are largely reported in tax havens.[10]

These corporations would like to access their offshore subsidiaries’ profits (to increase domestic investment or, more likely, to enrich shareholders with dividends or stock buybacks). This would be considered a repatriation of offshore profits, and U.S. taxes would come due — at or near the full 35 percent rate when tax haven profits are repatriated. Naturally, the corporations would like to avoid this tax. Allowing them to do so would essentially reward their offshore tax avoidance.

Section 956 as currently written blocks American corporations from getting around the U.S. tax that is due upon repatriation, but fails when these companies invert and become part of foreign-controlled corporate group. Rep. Levin’s proposal would address this problem.

b) Possible administrative action

Former Treasury official Stephen Shay has argued that this problem (along with earnings stripping) can be resolved through administrative action if Congress fails to act. He cites several sections of the tax code, including 956(e) which says the “Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this section, including regulations to prevent the avoidance of the provisions of this section through reorganizations or otherwise.” The mergers that corporations use in inversions to claim to be restructured as foreign companies would seem to be such “reorganizations.”

Another section of the law cited by Shay is even more straightforward in providing this authority to the President. Section 7701(1), provides that the “Secretary may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title.”

The techniques used by inverted companies to access their offshore cash (having their offshore subsidiaries lend to or guarantee loans to a foreign parent company or one of its foreign subsidiaries which then finances the American company) would seem to be the sort of “multiple-party financing transaction” mentioned in the provision quoted above.

There is currently no revenue estimate for this proposal.

Shay cites other provisions that seem to grant such authority, so that the question left is not a legal one but a political one. If Congress fails to act and the administration addresses the crisis with regulations, there is no doubt that some members of Congress will accuse it of overstepping its authority, even if that is factually not true. Does the administration have the will to act despite that inevitable backlash? A lot may depend on how that question is answered.

 

 


[1] Edward D. Kleinbard, “’Competitiveness’ Has Nothing to Do with It,” August 5, 2014. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2476453

[2] H.R. 4679, “Stop Corporate Inversions Act of 2014.” http://democrats.waysandmeans.house.gov/bill/hr4679-stop-corporate-inversions-act-2014

[3] Stephen E. Shay, “Mr. Secretary, Take the Tax Juice Out of Corporate Inversions,” Tax Notes, July 28, 2014.

[4] Other prominent tax law experts agree with Shay that current law allows the Treasury Department to do this. See Victor Fleischer, “How Obama Can Stop Corporate Expatriations, for Now,” New York Times, August 7, 2014. http://dealbook.nytimes.com/2014/08/07/how-obama-can-stop-corporate-expatriations-for-now/?_php=true&_type=blogs&_r=0; Steven Rosenthal, “Can Obama Slow Corporate Inversions? Yes He Can,” August 15, 2014. Tax Vox, Tax Policy Center. http://taxvox.taxpolicycenter.org/2014/08/15/can-obama-slow-corporate-inversions-yes-can/

[5] I.R.C. sec. 7874.

[6] Maureen Farrell, “Ireland: U.S. Tax Inversions Aren’t Helping Us Much Either,” Wall Street Journal, July 8, 2014. http://blogs.wsj.com/moneybeat/2014/07/08/ireland-u-s-tax-inversions-arent-helping-us-much-either/

[7] One additional difference is relatively minor: The proposal from the President’s previous budget plans would allow companies to carry forward disallowed interest expenses for ten years, as opposed to the five year limit proposed in Rep. Levin’s discussion draft.

[8] Stephen E. Shay, “Mr. Secretary, Take the Tax Juice Out of Corporate Inversions,” Tax Notes, July 28, 2014.

[9] Citizens for Tax Justice, “American Corporations Tell IRS the Majority of Their Offshore Profits Are in 12 Tax Havens,” May 27, 2014. http://ctj.org/ctjreports/2014/05/american_corporations_tell_irs_the_majority_of_their_offshore_profits_are_in_12_tax_havens.php

[10] Citizens for Tax Justice, “Dozens of Companies Admit Using Tax Havens,” May 19, 2014. http://ctj.org/ctjreports/2014/05/dozens_of_companies_admit_using_tax_havens.php

 

Statement: Despite Walgreens' Decision, Emergency Action Is Still Needed to Stop Corporate Inversions

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Following is a statement by Robert McIntyre, director of Citizens for Tax Justice, regarding emerging reports that Walgreen Co. will announce Wednesday that, although it still plans to buy Switzerland-based Alliance Boots, it will not use legal maneuvers to reincorporate as a Swiss company to avoid U.S. taxes.

“Reports are stating that Walgreen Co. has decided to set aside — for now — plans to avoid U.S. taxes by reincorporating as a foreign company. Only the proverbial fly on the boardroom wall truly knows what led the company to reach this decision. But a single company backing off plans to exploit loopholes in our tax code to dodge U.S. taxes does not fix the fundamental problem.

“Congress and the Obama Administration still need to act quickly because many other American corporations such as Medtronic, AbbVie and Mylan are still pursuing corporate inversions, while other major companies such as Pfizer have indicated that they may pursue inversion in the near future.

“Walgreens is a quintessentially American company and an easy scapegoat. But the company’s initial plans to dodge U.S. taxes were merely a symptom of a larger problem. The loopholes in our tax code are so gaping that corporations can simply fill out some papers and declare themselves foreign companies that are mostly not subject to U.S. taxes.

“Congress needs to, at very least, enact the legislation proposed by Sen. Carl Levin and Rep. Sander Levin that would disregard, for tax purposes, attempts by American corporations to claim a foreign status that only exists on paper.

“Refusing to address inversions except as part of comprehensive tax reform would be like refusing to put out a house fire until there is a detailed blueprint for rebuilding the house. Quick action is needed while there is still something to save.” 

State-by-State Figures on Two Child Tax Credit Proposals: President Obama vs. House GOP

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Read this report in PDF.

House Republicans have proposed to let an expansion of the child tax credit for low-income working families expire after 2017. Under their plan, the money that had previously gone to children in low-income families would in effect be used to fund bigger child tax credits for better-off families.

President Obama has proposed to make permanent the expansion for low-income working families. The President’s proposal and the House Republican proposal (H.R. 4935) are each estimated to cost about $11 billion a year. The national and state-by-state figures below illustrate how the benefits of the President’s proposal would mostly help families with incomes under $40,000 while the House Republican proposal would mostly help those with incomes above $100,000.

The child tax credit (CTC) provides families with a maximum tax break of $1,000 per child. It is partially refundable, mean­ing it can (within certain limits) benefit families who are too poor to have any federal income tax liability even before tax credits are taken into account. Under a provision enacted in 2009 and extended since then, the refundable part of the credit equals 15 percent of the portion of a family’s earnings that exceed $3,000, up to the $1,000 per-child limit. If this provision expires as scheduled at the end of 2017, the earnings threshold for the refundable part of the credit will revert from $3,000 to a much higher level ($14,750 in 2018).

The President has proposed, in each of his budget plans since 2009, to make permanent the $3,000 earnings threshold in order to maintain this expansion of the CTC for low-income working families. One argument for his proposal is that the refundable part of the CTC encourages work. Because it is calculated as a percentage of earnings, a family must have a working parent in order to qualify for it.

The House Republican bill, H.R. 4935, would expand the CTC in three ways that do not help the working poor. First, it would index the $1,000 per-child credit amount for inflation, which would not help those who earn too little to receive the full credit. Second, it would increase the income level at which the CTC starts to phase out from $110,000 to $150,000 for married couples. Third, that $150,000 level for married couples and the existing $75,000 income level for single parents would both be indexed for inflation thereafter.

The Internet Does Not Need Special Breaks

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On July 14, Citizens for Tax Justice sent a letter to members of the House of Representatives asking them to vote against the so called "Permanent Internet Tax Freedom Act," which would make permanent law banning state governments from taxing internet access the same way they tax other comparable services.

Read CTJ's letter.

The House approved the bill on July 15. Below is the post on the Tax Justice Blog about this bill.

The House Votes to Treat the Internet Like an Infant

Somehow, arguments that conservative lawmakers usually make about not interfering with the economy and respecting states’ rights have fallen silent as Congress rushes to pass a bill that provides special treatment for an industry that has grown very profitable and powerful.

On Tuesday the House of Representatives voted to make permanent a law banning state and local governments from taxing Internet access just as they tax other goods and services. First enacted as a temporary ban in 1998 (the Internet Tax Freedom Act) under the argument that the Internet was an “infant industry” needing special protection, the ban has been extended several times and is now scheduled to expire on Nov. 1.

As we have argued previously, the infant of 1998 now has the keys to the American economy, and yet Congress is still coddling it by shielding it from taxes that apply to other comparable services, such as cable television and cell phone service.

The pending bill is going one step further than previous extensions by stripping out the grandfather provision that allowed seven states that had enacted Internet taxes prior to 1998 to keep those laws in place. This move would cost those states half a billion dollars in revenue each year. And the remaining states would collectively forgo billions in revenue that they could otherwise raise each year if they chose to tax Internet access.

Members of Congress will take credit for shielding the Internet from taxes but the cost will be borne entirely by state and local governments. In other words, continuing the ban on taxing Internet access introduces distortions in the economy by favoring some industries over others and it interferes with state governments’ ability to raise revenue in the ways they find most sensible.

Addressing the Need for More Federal Revenue

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Read this report in PDF.

America is undertaxed, and the result is underfunding of public investments that would improve our economy and the overall welfare of Americans. Fortunately, Congress has several straightforward policy options to raise revenue, mostly by closing or limiting loopholes and special subsidies imbedded in the tax code that benefit wealthy individuals and profitable businesses.

Part I of this report explains why Congress needs to raise the overall amount of federal revenue collected. Contrary to many politicians’ claims, the United States is much less taxed than other countries, and wealthy individuals and corporations are particularly undertaxed. This means that lawmakers should eschew enacting laws that reduce revenue (including the temporary tax breaks that Congress extends every couple of years), and they should proactively enact new legislation that increases revenue available for public investments. Parts II, III, and IV of this report describe several policy options that would accomplish this. This information is summarized in the table to the right. 

Even when lawmakers agree that the tax code should be changed, they often disagree about how much change is necessary. Some lawmakers oppose altering one or two provisions in the tax code, advocating instead for Congress to enact such changes as part of a sweeping reform that overhauls the entire tax system. Others regard sweeping reform as too politically difficult and want Congress to instead look for small reforms that raise whatever revenue is necessary to fund given initiatives.

The table to the right illustrates options that are compatible with both approaches. Under each of the three categories of reforms, some provisions are significant, meaning they are likely to happen only as part of a comprehensive tax reform or another major piece of legislation. Others are less significant, would raise a relatively small amount of revenue, and could be enacted in isolation to offset the costs of increased investment in (for example) infrastructure, nutrition, health or education.

For example, in the category of reforms affecting high-income individuals, Congress could raise $613 billion over 10 years by eliminating an enormous break in the personal income tax for capital gains income. This tax break allows wealthy investors like Warren Buffett to pay taxes at lower effective rates than many middle-class people. Or Congress could raise just $17 billion by addressing a loophole that allows wealthy fund managers like Mitt Romney to characterize the “carried interest” they earn as “capital gains.” Or Congress could raise $25 billion over ten years by closing a loophole used by Newt Gingrich and John Edwards to characterize some of their earned income as unearned income to avoid payroll taxes.  

In the category of reforms affecting businesses, Congress could raise $428 billion by repealing accelerated depreciation. (This reform would also raise an additional $286 billion in the first decade, but this impact would be temporary.) Accelerated depreciation is the most significant break for domestic businesses and a major reason some companies can avoid paying taxes. Or Congress could take much less dramatic steps and repeal smaller breaks that benefits businesses, such as the domestic manufacturing deduction. Proponents of accelerated depreciation and the domestic manufacturing deduction claim that they encourage investment and job creation in the United States, but neither seems to be accomplishing this goal.

In the category of reforms affecting multinational corporations, Congress could raise $601 billion over 10 years by closing the huge loophole in the corporate income tax that allows U.S. corporations to indefinitely “defer” paying U.S. taxes on profits that they generate offshore or that appear to be generated offshore because of dodgy accounting methods. (This reform would also raise an additional $158 billion in the first decade, but this impact would be temporary.) Or Congress could raise smaller amounts of revenue by curbing the worst abuses of deferral. President Obama has put forward several proposals to do this by closing loopholes in the deferral rules, and several of these proposals have been introduced as legislation by members of Congress.  

These are just a few examples among many that are described in more detail in this report.

I. Why Congress Should Raise Revenue

America Is Not Overtaxed

The belief that Americans pay too much, rather than too little, in taxes has so permeated our society that Microsoft Word’s spellchecker recognizes the word “overtaxed” but not its obvious antonym, “undertaxed.” As a result, some anti-government activists and politicians insist that no tax loopholes should be closed unless tax rates are also reduced so that the net result is no increase in federal revenue. This approach is entirely unwarranted, because America is actually one of the least taxed countries in the developed world. According to the Organization for Economic Cooperation and Development (OECD), the Unites States collects less tax revenue as a percentage of gross domestic product than all but two other industrial countries (Chile and Mexico), as illustrated in the graph below.[1]

Wealthy Individuals Are Not Overtaxed

Another anti-tax argument is that the richest 1 percent or richest 5 percent of Americans are already paying more than their fair share of taxes, but this is also false. America’s tax system is just barely progressive, meaning it does very little to address the growing income ine­qual­ity our nation has experienced over the last several decades.[2] The share of total taxes paid by each income group is very similar to the share of total in­come received by each group.

For example, the share of total taxes (includ­ing federal, state and local taxes) paid by the richest 1 percent (23.7 percent) is not signifi­cantly different from the share of total in­come this group receives (21.6 percent). Similarly, the share of total taxes paid by the poorest fifth (2.1 percent) is only slightly lower than the share of total income this group receives (3.3 percent).

Corporations Are Not Overtaxed

Some corporate lobbyists complain that the 35 percent U.S. statutory cor­porate income tax rate is one of the highest in the word. They fail to mention that the effective corporate income tax rate, the percentage of profits that corporations actually pay, is far lower due to loopholes that reduce their taxes. In fact, some corporate profits are not taxed at all. A recent report from CTJ examined 288 corporations (most of the Fortune 500 corporations that were profitable each year from 2008 through 2012) and found that over that five-year period they collectively paid 19.4 percent of their profits in federal corporate income taxes, and 26 of these companies paid nothing at all over that period.[3]

Corporate CEOs and their lobbyists often argue that the federal corporate income tax makes the nation “uncompetitive” because it causes companies not to invest in the United States, but this claim is not borne out by evidence. The CTJ study found that of those corporations with significant offshore profits (meaning at least one-tenth of profits were reported to be earned offshore) about two-thirds paid higher effective corporate income tax rates in the other countries where they did business than they paid in the U.S.

 

 

Of course, corporate income taxes are ultimately borne by human beings — primarily the corporate share­holders and owners of business assets, who are concentrated among the wealthiest Americans. As already explained, the richest Americans are not overtaxed, even when you account for all of the taxes, including corporate income taxes, that they ultimately pay.

Some opponents of higher corporate taxes have recently argued that the corporate income tax actually is borne by workers because it chases investment out of the United States and leaves working people with fewer job opportunities and lower wages. But corporate investment is not perfectly mobile and as a result, Congress’s non-partisan Joint Committee on Taxation has concluded that 82 percent of the corporate income tax is paid by owners of corporate stocks and other business assets.[4]

II. Revenue Options Affecting High-Income Individuals

Eliminate the special low income tax rates for capital gains
10-year revenue gain: $613 billion[5]

The federal personal income tax currently taxes the income of people who live off their wealth at lower rates than the income of people who work. This is particularly problematic because income from wealth (investment income) is largely concentrated among the richest Americans.

The unfairness of the existing preference for capital gains can best be illustrated with an example. Imagine an heiress who owns so much stock and other assets that she does not have to work. When she sells assets (through her broker) for more than their original purchase price, she enjoys the profit, which is called a capital gain. (Most of these gains are long-term capital gains, which we often refer to as “capital gains” for simplicity.) On this income she pays tax rate of only 23.8 percent. (This includes the personal income tax at a rate of 20 percent and a tax enacted as part of health care reform at a rate of 3.8 percent.)

Now consider a receptionist who works at the brokerage firm that handles some of the heiress’s dealings. Let’s say this receptionist earns $50,000 a year. Unlike the heiress, his income comes in the form of wages, because, alas, he has to work for a living. His wages are taxed at progressive income tax rates, and a portion of his income is actually taxed at 25 percent. (In other words, he faces a marginal income tax rate of 25 percent, meaning each additional dollar he earns is taxed at that amount).

On top of that, he also pays the federal payroll tax of around 15 percent. (He pays only half of the payroll tax directly, while his employer directly pays the other half, but economists generally agree that the full tax is ultimately borne by the employee in the form of reduced compensation.) So he pays taxes on his income at a higher rate than the heiress who lives off her wealth.

What makes this situation even worse are the various loopholes that allow wealthy individuals to receive these tax breaks for income that is not really even capital gains. As Warren Buffett has explained, fund managers use the “carried interest” loophole to have their compensation treated as capital gains and taxed at the low 20 percent rate, while the “60/40 rule” benefits traders who “own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent [now 20 percent], as if they’d been long-term investors.”[6]

The tax reform signed into law by President Reagan in 1986 eliminated such preferences for investment income from the personal income tax and taxed all income at the same rates. During the administrations of George H.W. Bush and Bill Clinton, Congress raised rates on “ordinary” income (income that does not take the form of long-term capital gains) but reduced the rates for capital gains in 1997.

When George W. Bush took office, the top tax rate on long-term capital gains was 20 percent, and the tax changes he signed into law in 2003 reduced that top rate to 15 percent. At the start of 2013, Congress extended most of the Bush-era tax cuts but allowed the top 20 percent tax rate for capital gains to come back into effect for the richest Americans.

Congress should go much further and repeal the capital gains break that still exists. Under this proposal, capital gains would simply be taxed at ordinary income tax rates. This would raise at least $613 billion over a decade. The table on the previous page shows that the richest 1 percent of taxpayers would pay 72 percent of the tax increase resulting from eliminating the capital gains preference in 2015, and the richest 5 percent of taxpayers would pay 86 percent of the tax increase.

Some commentators, including The Wall Street Journal editorial board and many anti-tax activists, claim that if the income tax rate for capital gains reaches a certain point, investors will respond by selling assets less often and the revenue yield from the tax will be reduced as a result. They often claim that these behavioral responses are so strong that tax revenue will actually decrease if Congress raises the tax rate for capital gains, and revenue will actually increase if Congress reduces the tax rate.[7]

The Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) also assume that this behavioral response exists, to a lesser but still significant degree. It is likely that if JCT estimated the revenue impact of eliminating the income tax preferences for capital gains, they would assume that these behavioral responses limit the amount of revenue raised to a much smaller figure than we calculate.[8]

We agree with the conclusion of the Congressional Research Service that JCT likely overestimates these behavioral responses and therefore underestimates how much revenue will result from raising income tax rates on capital gains.[9] It seems that people with investments do respond to changes in capital gains rates mostly in the short-term, but JCT relies on research that seems to mistake much of the short-term responses for long-term changes in investment behavior.

A previous CTJ report explains this in detail and explains that we use JCT’s methodology to quantify the way investors respond to tax changes, but we assume smaller behavioral responses based on rigorous studies cited and analyzed by the Congressional Research Service.[10]

Eliminate the special low income tax rates for stock dividends
10-year revenue gain: $231 billion[11]

Corporate stock dividends are subject to the same special low rates as capital gains, which provide another unjustified break that mostly goes to the well-off. Lawmakers introduced this break as part of 2003 legislation enacted under President Bush, which taxed both capital gains and stock dividends at a top rate of 15 percent. The 2013 legislation that extended most, but not all, of the Bush-era tax cuts allowed the top rate for dividends and capital gains both to rise to 20 percent for the richest Americans.

The unfairness of the dividends tax preference is straightforward. The wealthy heiress in the example above who lives off her wealth would likely receive income in the form of stock dividends just as she receives income in the form of capital gains, and in both cases she is taxed much less than someone who works to earn the same (or a much lower) amount of income.

The table to the right shows that two-thirds of the tax increase resulting from taxing stock dividends as ordinary income would be paid by the richest 5 percent of taxpayers.

Some corporate lobbyists have argued that taxing stock dividends at higher rates (at the same rates as other types of income) would cause corporations to pay out less in dividends, which would harm all investors. The gaping hole in this logic is that two-thirds of stock dividends are not paid to individuals subject to the personal income tax but rather are paid to tax-exempt entities like pension funds.[12] There is no reason why stock prices would be affected by a tax that only applies to one-third of the dividends paid on them.

Limit certain deductions and exclusions for the wealthy (President Obama’s “28 Percent Rule”)
10-year revenue gain: $498 billion[13]

This proposal, often called the “28 percent rule,” would limit tax savings for high-income taxpayers from itemized deductions and certain other deductions and exclusions to 28 cents for each dollar deducted or excluded. If this reform was in effect in 2015, it would result in a tax increase for only 3.3 percent of Americans.

This proposal, which was offered in different forms over the past several years by President Obama, is a way of limiting tax expenditures for the wealthy. The term “tax expenditures” refers to provisions that are government subsidies provided through the tax code. As such, tax expenditures have the same effect as direct spending subsidies, because the Treasury ends up with less revenue and some individual or group receives money. But tax subsidies are sometimes not recognized as spending programs because they are implemented through the tax code.

Tax expenditures that take the form of deductions and exclusions are used to subsidize all sorts of activities. For example, deductions allowed for charitable contributions and mortgage interest payments subsidize philanthropy and home ownership. Exclusions for interest from state and local bonds subsidize lending to state and local governments.

Under current law, three income tax brackets have rates higher than 28 percent (the 33, 35, and 39.6 percent brackets). People in these tax brackets (and people who would be in these tax brackets if not for their deductions and exclusions) could therefore lose some tax breaks under the proposal.

Currently, a high-income person in the 39.6 percent income tax bracket saves almost 40 cents for each dollar of deductions or exclusions. An individual in the 35 percent income tax bracket saves 35 cents for each dollar of deductions or exclusions, and a person in the 33 percent bracket saves 33 cents. The lower tax rates are 28 percent or less. Many middle-income people are in the 15 percent tax bracket and therefore save only 15 cents for each dollar of deductions or exclusions.

This is an odd way to subsidize activities that Congress favors. If Congress provided such subsidies through direct spending, there would likely be a public outcry over the fact that rich people are subsidized at higher rates than low- and middle-income people. But because these subsidies are provided through the tax code, this fact has largely escaped the public’s attention.

President Obama initially presented his proposal to limit certain tax expenditures in his first budget plan in 2009, and included it in subsequent budget and deficit-reduction plans each year after. The original proposal applied only to itemized deductions. The President later expanded the proposal to limit the value of certain “above-the-line” deductions (which can be claimed by taxpayers who do not itemize), such as the deduction for health insurance for the self-employed and the deduction for contributions to individual retirement accounts (IRA).

More recently, the proposal was also expanded to include certain tax exclusions, such as the exclusion for interest on state and local bonds and the exclusion for employer-provided health care. Exclusions provide the same sort of benefit as deductions, the only difference being that they are not counted as part of a taxpayer’s income in the first place (and therefore do not need to be deducted).

Minimum 30 percent tax for millionaires to implement the “Buffett Rule”
10-year revenue gain: $70 billion[14]

The “Buffett Rule” began as a principle, proposed by President Obama, that the tax system should be reformed to reduce or eliminate situations in which millionaires pay lower effective tax rates than many middle-income people. This principle was inspired by billionaire investor Warren Buffett, who declared publicly that it was a travesty that his effective tax rate is lower than his secretary’s.

At the time, Citizens for Tax Justice argued that the most straightforward way to implement this principle would be to eliminate the special low personal income tax rate for capital gains and stock dividends (the main reason why wealthy investors like Mitt Romney and Warren Buffett can pay low effective tax rates) and tax all income at the same rates.[15]

The proposal offered by President Obama in his most recent budget plan and by Senate Democrats to fund a recent student loan proposal would implement the Buffett Rule in a more round-about way by applying a minimum tax of 30 percent to millionaires’ income. This would raise much less revenue than simply ending the break for capital gains and dividends, for several reasons.

First, taxing capital gains and dividends as ordinary income would subject them to a top income tax rate of 39.6 percent while the proposed minimum tax would have a rate of just 30 percent. Second, the proposed minimum income tax rate on capital gains and dividend income would effectively be less than 30 percent because it would take into account the 3.8 percent Medicare tax on investment income that was enacted as part of health care reform. Third, even though most capital gains and dividend income goes to the richest one percent of taxpayers, there is still a great deal that goes to taxpayers who are among the richest five percent or even one percent but are not millionaires and therefore not subject to the proposed minimum tax.

Other reasons for the lower revenue impact of this proposal (compared to repealing the preference for capital gains and dividends) have to do with how it is designed. For example, the minimum tax would be phased in for people with incomes between $1 million and $2 million. Otherwise, a person with adjusted gross income of $999,999 who has effective tax rate of 15 percent could make $2 more and see his effective tax rate shoot up to 30 percent. Tax rules are generally designed to avoid this kind of unreasonable result.

The legislation also accommodates those millionaires who give to charity by applying the minimum tax of 30 percent to adjusted gross income less charitable deductions.

Scale back the carried interest loophole
10-year revenue gain: $17 billion[16]

If Congress does not eliminate the tax preference for capital gains (as explained earlier) then it should at least eliminate the loopholes that allow the tax preference for income that is not truly capital gains. The most notorious of these loopholes is the one that allows “carried interest” to be taxed as capital gains.

Some businesses, primarily private equity, real estate and venture capital, use a technique called a “carried interest” to compensate their managers. Instead of receiving wages, the managers get a share of the profits from investments that they manage, without having to invest their own money. The tax effect of this arrangement is that the managers pay taxes on their compensation at the special, low rates for capital gains (up to 20 percent) instead of the ordinary income tax rates that normally apply to wages and other compensation (up to 39.6 percent). This arrangement also allows them to avoid payroll taxes, which apply to wages and salaries but not to capital gains.

Income in the form of carried interest can run into the hundreds of millions (or even in excess of a billion dollars) a year for individual fund managers. How do we know that “carried interest” is compensation, and not capital gain? There are several reasons:

The fund managers don’t invest their own money.  They get a share of the profits in exchange for their financial expertise. If the fund loses money, the managers can walk away without any cost.[17]

A “carried interest” is much like executive stock options. When corporate executives get stock options, it gives them the right to buy their company’s stock at a fixed price. If the stock goes up in value, the executives can cash in the options and pocket the difference. If the stock declines, then the executives get nothing. But they never have a loss. When corporate executives make money from their stock options, they pay both income taxes at the regular rates and payroll taxes on their earnings.

Private equity managers (sometimes) even admit that “carried interest” is compensation. In a filing with the Securities and Exchange Commission in connection with taking its management partnership public, the Blackstone Group, a leading private equity firm, had this to say in 2007 about its activities (to avoid regulation under the Investment Act of 1940):

“We believe that we are engaged primarily in the business of asset management and financial advisory services and not in the business of investing, reinvesting, or trading in securities.

We also believe that the primary source of income from each of our businesses is properly characterized as income earned in exchange for the provision of services.”

The President has proposed to close the carried interest loophole, but his version of this proposal would only raise $17 billion over a decade, less than the version of the proposal he offered in his first budget plan, which was estimated to raise $23 billion over a decade.[18] The President’s current proposal now clarifies that only “investment partnerships,” as opposed to any other partnerships that provide services, would be affected.[19]

Close payroll tax loophole for S corporation owners (close the “John Edwards/Newt Gingrich Loophole”)
10-year revenue gain: $25 billion

This option would close a loophole that allows many self-employed people, infamously including two former lawmakers, John Edwards and Newt Gingrich, to use “S corporations” to avoid payroll taxes. Payroll taxes are supposed to be paid on income from work. The Social Security payroll tax is paid on the first $117,000 in earnings (adjusted each year) and the Medicare payroll tax is paid on all earnings. These rules are supposed to apply both to wage-earners and self-employed people.

“S corporations” are essentially partnerships, except that they enjoy limited liability, like regular corporations. The owners of both types of businesses are subject to income tax on their share of the profits, and there is no corporate level tax. But the tax laws treat owners of S corporations quite differently from partners when it comes to Social Security and Medicare taxes. Partners are subject to these taxes on all of their “active” income, while active S corporation owners pay these taxes only on the part of their “active” income that they report as wages. In effect, S corporation owners are allowed to determine what salary they would pay themselves if they treated themselves as employees.

Naturally, many S corporation owners likely make up a salary for themselves that is much less than their true work income in order to avoid Social Security payroll taxes and especially Medicare payroll taxes.[20] 

Under this proposal, which was included in President Obama’s most recent budget plan, businesses providing professional services would be taxed the same way for payroll tax purposes regardless of whether they are structured as S corporations or partnerships.

Limit total savings in tax subsidized retirement plans
10-year revenue gain: $4 billion[21]

In 2013, Citizens for Tax Justice proposed that Congress limit the amount of savings that can accrue in individual retirement accounts (IRAs), which allow individuals to defer paying taxes on the income saved until retirement. [22] This was a response to reports that Mitt Romney had $87 million saved in an IRA, which was an obvious example of a tax subsidy meant to encourage retirement saving benefiting someone who did not need any such encouragement.

The budget plan released by the Obama administration later that year included this reform, as did the budget plan released this year.

Under current law, there are limits on how much an individual can contribute to tax-advantaged retirement savings vehicles like 401(k) plans or IRAs, but there is actually no limit on how much can be accumulated in such savings vehicles.

The contribution limit for IRAs is $5,500, adjusted each year, plus an additional $1,000 for people over age 50. It probably never occurred to many lawmakers that a buyout fund manager like Mitt Romney would somehow engineer a method to end up with tens of millions of dollars in his IRA.

The President proposes to essentially align the rules of 401(k)s and IRAs with the rules for “defined benefit” plans (traditional pensions). Under current law, in return for receiving tax advantages, defined benefit plans are subject to certain limits including a $210,000 annual limit on benefits paid out in retirement (adjusted each year). The President’s proposal would, very generally, limit contributions and accruals in all  401(k) plans and IRAs owned by an individual to whatever amount is necessary to pay out at that limit when the individual reaches retirement.

There seems to be great uncertainty over how exactly this proposal would work and how much revenue it would raise. This is not surprising given how difficult it is to predict how high-wealth individuals might manage to effectively transfer extremely undervalued assets into tax advantaged savings accounts, and how they might change their behavior in response to a legislative change. While the Joint Committee on Taxation estimates that the President’s proposal would raise $4 billion over a decade, the administration estimates that it would raise $28 billion over a decade.[23]

III. Revenue Options Affecting Businesses

Repeal accelerated depreciation
10-year revenue gain: $428 billion
(plus $286 billion temporary impact in the first decade)[24]

Businesses are allowed to deduct from their taxable income the expenses of running the business, so that what’s taxed is net profit. Businesses can also deduct the costs of purchases of machinery, software, buildings and so forth, but since these capital investments don’t lose value right away, these deductions are taken over time. The basic idea behind depreciation is that when a company makes a capital purchase of a piece of equipment, it can deduct the cost of that equipment over the period of time in which the equipment is thought to wear out.

Accelerated depreciation allows a company to take these deductions more quickly — sometimes far more quickly — than the equipment actually wears out. The deductions for the cost of the capital purchase are thus taken earlier, which makes them bigger and more valuable. Accelerated depreciation was first introduced in the 1950s, and then greatly expanded in the 1970s and 1980s. The rules were so generous that many large corporations were able to avoid taxes entirely. This resulted in a public outcry that led to the Tax Reform Act of 1986, which curtailed, but did not eliminate, special tax breaks for capital purchases.

Combined with rules allowing corporations to deduct interest expenses, accelerated depreciation can result in a very low, or even negative, tax rate on profits from particular investments. A corporation can borrow money to purchase equipment or a building, deduct the interest expenses on the debt and quickly deduct the cost of the equipment or building thanks to accelerated depreciation. The total deductions can then be more than the profits generated by the investment.

A report from the Congressional Research Service reviews efforts to quantify the impact of depreciation breaks and explains that “the studies concluded that accelerated depreciation in general is a relatively ineffective tool for stimulating the economy.”[25]

One might argue that some depreciation breaks are more effective than others. For example, the breaks studied most closely by CRS are temporary increases in depreciation breaks (“bonus depreciation”) because these temporary provisions make possible before-and-after comparisons. But CRS analysts have also concluded that the permanent depreciation breaks likely have even less of an impact on economic growth because there is no requirement that they be used before any particular deadline.[26]

Nonetheless, many members of Congress and even many tax analysts seem committed to the (false) idea that depreciation breaks are necessary to spur domestic investment.

Repealing accelerated depreciation would raise a total of $714 billion over a decade, but a portion of that would be a temporary revenue boost reflecting a shift in timing of tax payments. A recent report from the Center on Budget and Policy Priorities explains that revenue raised from repealing accelerated depreciation would be much larger in the first decade than in later decades because part of the revenue increase represents a change in timing of tax payments. (Ending accelerated depreciation would mean that businesses must write off the costs of equipment over the period of time it actually wears out, which is typically longer, meaning they must wait longer to take deductions for these investments.) [27] That report explains that ending accelerated depreciation would raise only about 60 percent as much in later decades as it would raise in the first decade after enactment. We therefore count only 60 percent of the revenue raised in the first decade from ending accelerated depreciation as permanent revenue.

If lawmakers wanted to take a more limited approach than repealing accelerated depreciation altogether, they could opt to curb the worst abuses by barring it for leveraged investments. This would end situations in which the combination of depreciation breaks and interest deductions provide a negative effective tax rate for a given investment. A strong corporate AMT, which was enacted as part of the Tax Reform Act of 1986 but rendered toothless during the 1990s, would also have the effect of limiting the most egregious uses of depreciation breaks.

Repeal deduction for domestic manufacturing
10-year revenue gain: $145 billion[28]

In 2002, the World Trade Organization (WTO) found that a U.S. tax break meant to encourage exports violated U.S. trade treaties with other countries. In the wake of this ruling, the European Union began imposing retaliatory sanctions against the United States in March of 2004. Congressional tax writers immediately moved to comply with the WTO ruling by repealing the illegal tax break. But lawmakers were wary of being seen as hiking taxes on manufacturers — even when the “tax hike” in question resulted from repealing an illegal tax break — and sought to enact new tax cuts that would offset the lost illegal subsidy for manufacturers. However, as the tax bill took shape, this provision was hijacked by legislators seeking to use the tax bill to provide new tax breaks for other favored corporations.

As finally enacted, the “manufacturing deduction” ballooned to apply to a wide variety of corporate activities that no ordinary person would recognize as “manufacturing,” the most egregious of which is oil drilling. The President has proposed to prohibit oil and gas companies from using the break, but Congress should go much farther and repeal the manufacturing deduction altogether. It provides no identifiable benefit to the economy and repealing it altogether could raise $145 billion over a decade.[29] 

Reduce the “Mark Zuckerberg loophole” for stock options
10-year revenue gain: $23 billion[30]

For several years, Senator Carl Levin has championed legislation to limit corporate tax deductions for stock options given to highly compensated employees to the amount of the stock option expense that companies report to their shareholders.

Stock options are rights to buy stock at a set price. Corporations sometimes compensate employees (particularly top executives) with these options. The employee can wait to exercise the option until the value of the stock has increased beyond that price, thus enjoying a substantial benefit.

Tax deductions for stock options were very controversial during the years when book rules (accounting rules regarding how companies report expenses to shareholders) conflicted entirely with tax rules (regarding how such expenses are deducted from a company’s income when calculating corporate income taxes). Book rules did not require companies to count stock options as an expense while tax rules did allow companies to count them as an expense to be deducted from their taxable income. Of course, corporations like to report the largest possible profits to shareholders and the lowest possible profits to the IRS for tax purposes, so this situation suited corporate executives.

In other words, corporations were allowed to tell their shareholders one thing and then tell the IRS something different about how stock options affected their profits. Congress made book rules and tax rules less divergent in 2006, but they still differ. Congress changed book rules so that corporations report an expense for stock options both to shareholders and to the IRS, but book write-offs often are still far less than tax write-offs.

Barring corporations from counting stock options as an expense for either book or tax purposes would make more sense. There is no cost to a corporation when it grants stock options, so there is no need for a deduction from taxable income. Corporations compensating employees with stock options are like airlines that compensate employees with free rides on flights that are not full. In both cases the employee receives a form of compensation, and in neither case does it cost the employer anything.[31] No deduction is allowed for the free flights, so none should be allowed for stock options.

Facebook announced in 2012 that it would take $7.5 billion in tax deductions for stock options paid to favored employees, mostly to co-founder Mark Zuckerberg. [32] The following year, Facebook confirmed what was already obvious, that these tax deductions wiped out its tax liability for 2012 and resulted in excess deductions that could be carried back against previous years’ taxes. Despite earning profits of $1 billion in the U.S. in 2012, the company actually received a refund of $429 million.[33] Facebook incurred no real cost but nonetheless wiped out its tax liability, probably for years.

A more modest reform would be to make the book write-offs for stock options identical to what corporations take as tax deductions. Currently, the oddly-designed book rules require the value of the stock options to be guessed at when the options are issued, while the tax deductions reflect the actual value when the options are exercised. Given the uncertainty of what the options will be worth when exercised and the fact that corporations have an incentive to guess on the low side (so they can report higher profits to shareholders), it’s no wonder that their guesses are always wrong, and typically too low.

The legislation introduced by Senator Levin would not bar companies from counting stock options as an expense for book or tax purposes. It would, however, bar companies from taking tax deductions for stock options that are larger than the expenses they booked for shareholder-reporting purposes. It would also remove the loophole that exempts compensation paid in stock options from the existing rule capping companies’ deductions for compensation at $1 million per executive.

Eliminate fossil fuel tax preferences
10-year revenue gain: $51 billion[34]

There are several tax breaks that subsidize the extraction and sale of oil, natural gas and coal, which President Obama has proposed to eliminate. Repealing these breaks can be justified as a way to help the environment by redirecting resources away from dirty fuels, and also simply because it does not make economic sense for the government to give tax subsidies to an industry that is already extremely profitable. Most of the revenue raised from ending tax breaks for fossil fuels would come from three proposals. 

One of these proposals would repeal the deduction for “intangible” costs of exploring and developing oil and gas sources. The “intangible” costs of exploration and development generally include wages, costs of using machinery for drilling and the costs of materials that get used up during the process of building wells. Most businesses must write off such expenses over the useful life of the property, but oil companies, thanks to their lobbying clout, get to write these expenses off immediately.

Another proposal would repeal “percentage depletion” for oil and gas properties. Most businesses must write off the actual costs of their property over its useful life (until it wears out). If oil companies had to do the same, they would write off the cost of oil fields until the oil was depleted. Instead, some oil companies get to simply deduct a flat percentage of gross revenues. The percentage depletion deductions can actually exceed costs and can zero out all federal taxes for oil and gas companies. The Energy Policy Act of 2005 actually expanded this provision to allow more companies to enjoy it.

The President also proposes to bar oil and gas companies from using the manufacturing tax deduction. The manufacturing tax deduction was added to the law in 2004 and allows companies to deduct 9 percent of their net income from domestic production. Some might wonder why oil and gas companies can use a deduction for “manufacturing” in the first place. But Congress specifically included “extraction” in the definition of manufacturing so that it included oil and gas production, obviously at the behest of the industry.

Reform like-kind exchange rules
10-year revenue gain: $11 billion[35]

Another reform proposed by President Obama would limit the taxes that can be deferred under existing rules for profits from “like-kind exchanges” to $1 million. This limit would be indexed to inflation.

Businesses can take tax deductions for depreciation on their pro­perties, and then sell these properties at an ap­preciated price while avoiding capital gains tax, through what is known as a “like-kind exchange.” The break was originally intended for situations in which two ranchers or two farmers decided to trade some land. Since neither had sold their land for cash and they were still using the land to make a living, it seemed reasonable at the time to waive the rules that would normally define this as a sale and tax any gains from it.

But the break has turned into a multi-billion-loophole that has been widely exploited by many giant companies, including General Electric, Cendant and Wells Fargo.[36] In fact, the “tax expenditure report” of the Joint Committee on Taxation (JCT) shows that most of the revenue lost as a result of this tax expenditure actually goes to corporations, not individuals.[37]

By limiting the tax deferral for like-kind exchanges to $1 million, the President’s proposal ensures that the break is less abused than it is today.

IV. Revenue Options Affecting Multinational Corporations

Repeal “deferral”
10-year revenue gain: 601 billion
(plus $158 billion temporary impact in the first decade)[38]

One of the very largest tax expenditures, one that only benefits corporations, is so-called “deferral.” This is the rule allowing American corporations to “defer” paying U.S. taxes on the profits of their offshore subsidiaries until those profits are officially “repatriated.” That’s another way of saying Americans corporations are allowed to delay paying U.S. taxes on their offshore profits until those offshore profits are officially brought to the U.S. A corporation can go years without paying U.S. taxes on those profits, and may never pay U.S. taxes on those profits.

This creates two terrible incentives for American corporations. First, in some situations it encourages them to shift their operations and jobs to a country with lower taxes. Second, it encourages them to use accounting gimmicks to disguise their U.S. profits as foreign profits generated by a subsidiary company in some other country that has much lower taxes or that doesn’t tax these profits at all.

The countries that have extremely low taxes or no taxes on profits are known as tax havens. And the subsidiary company in the tax haven that is claimed to make all these profits is often nothing more than a post office box.

The corporate income tax has rules that are supposed to limit this practice of artificially shifting profits (on paper) to offshore tax havens. For example, American corporations are not allowed to defer U.S. taxes on “passive income,” which refers to certain types of income that Congress considers too easy to shift around from one country to another. And there are “transfer pricing” rules, which require that a U.S. corporation and its offshore subsidiary (which are really two parts of the same company) deal with each other at “arm’s length” when there is a transaction of some sort between them. In other words, if a U.S. corporation is transferring, say, a patent to its offshore subsidiary, it’s supposed to pretend that the subsidiary is an unrelated company and charge it a fair market price for the patent. And if the subsidiary wants to allow the U.S. corporation to use the patent, it must charge royalties at a fair market price.

These rules are failing to prevent abuses of deferral. The IRS cannot easily identify a fair market price for (for example) a patent for a brand new invention, particularly when there is no similar transaction in the marketplace for the IRS to look to for comparison. American corporations are therefore able to transfer patents to subsidiaries in Bermuda or the Cayman Islands at very low prices and then pay inflated royalties to these subsidiaries for the use of those patents — and then claim to the IRS that they have no U.S. profits as a result. 

Recent data from the IRS confirm that this sort of corporate tax dodging involving offshore tax havens is happening on a massive scale. For example, the profits that American corporations report to the IRS that they earn through their subsidiaries in Bermuda totaled $94 billion in 2010. But Bermuda’s gross domestic product (GDP) in 2010 was just $6 billion. It is obviously impossible for American corporations to have profits in Bermuda that equal more than 16 times all the goods and services produced in that country. Similarly, American corporations reported to the IRS that their subsidiaries in the Cayman Islands earned $51 billion in 2010 even though that country’s GDP was just $3 billion, and they reported their subsidiaries earned $10 billion in the British Virgin Islands even though that country’s GDP was just $1 billion.[39]

It is clear that most of the profits reported to be earned in these countries were truly earned in the U.S. or other developed countries and manipulated through accounting gimmicks so that they appear to be earned in countries where they will be taxed lightly or not at all.  

The most straightforward solution is to repeal deferral. This would mean that all the profits of American corporations are subject to the U.S. corporate income tax whether they are domestic profits or foreign profits generated by offshore subsidiaries. There would be no incentive for an American corporation to move its operations offshore or to make its U.S. profits appear to be generated in an offshore tax haven.

American corporations would continue to receive a credit against their U.S. taxes for corporate taxes paid to any foreign government (the foreign tax credit), just as they do now, to prevent double-taxation. For example, imagine an American corporation has a subsidiary in another country and pays a corporate tax of 20 percent of the profits it earns there to that country’s government. Under the current rules, the American corporation can indefinitely defer paying any U.S. tax on those profits by keeping them in the foreign country. (And characterizing these profits as “offshore” may be largely an accounting matter.) When it does “repatriate” those profits (bring them to the U.S.) it receives a credit for the 20 percent it already paid to the foreign government and then pays the difference between the U.S. corporate income tax rate of 35 percent and the rate of 20 percent paid to the foreign government, which comes to a 15 percent rate paid to the U.S.

If Congress repeals deferral, the American corporation would still receive the foreign tax credit and still only pay 15 percent to the U.S. government. The only difference is that the company would be required to pay that tax the same year the profits are earned regardless of whether or not the profits are brought back to the U.S.

In other words, the total tax due the year the profits are earned would be the same, 35 percent, regardless of whether those profits were generated in the U.S. or in another country. There would therefore be no incentive for an American corporation to make its U.S. profits appear to be generated in an offshore tax haven.

Part of the revenue that would be raised during the first decade after deferral is repealed is really just a timing shift in tax payments. This is because some of the offshore profits for which U.S. taxes are deferred under current law would have eventually been brought to the U.S. and subject to U.S. taxes. But most of the revenue raised comes from U.S. taxes paid on profits that would not have been brought to the U.S. under the current rules and from shifting to a system that no longer provides incentives for corporations to shift profits or operations offshore.

Bar deduction for interest expense for offshore business until profits are taxed
10-year revenue gain: $51 billion[40]

One of President Obama’s proposals to limit the worst abuses of deferral would require that U.S. companies defer deductions for interest expenses related to earning income abroad until that income is subject to U.S. taxation (if ever).

U.S. multinational companies are allowed to “defer” U.S. taxes on income generated by their foreign subsidiaries until that income is officially brought to the U.S. (“repatriated”). There are numerous problems with deferral, but it’s particularly problematic when a U.S. company defers U.S. taxes on foreign income for years even while it deducts the expenses of earning that foreign income immediately to reduce its U.S. taxable profits. For example, an American corporation could borrow to buy stock in a foreign corporation and deduct the interest payments on that debt immediately even if it defers for years paying U.S. taxes on the profits from the investment in the foreign company. In this situation, the tax code effectively subsidizes American corporations for investing offshore rather than in the U.S.

Under the President’s proposal, the share of interest payments on debt used to invest abroad that could be deducted would be limited to the share of income from those offshore investments that is subject to U.S. taxes in a given year. The rest of the deductions for interest payments would be deferred, just as U.S. taxes on the rest of the offshore profits are deferred. 

The version of this proposal included in the President’s first budget was stronger because it would have required that U.S. companies defer deductions for all expenses (other than research and experimentation expenses) relating to earning income abroad until that income is subject to U.S. taxation. The current proposal only applies to interest expenses.

Calculate foreign tax credits on a “pooling” basis
10-year revenue gain: $59 billion[41]

This proposal, which is also included in the President’s budget, would require that the foreign tax credit be calculated on a consolidated basis, or “pooling basis,” in order to prevent corporations from taking the credit in excess of what is necessary to avoid double-taxation on their foreign profits.

The foreign tax credit allows American corporations to subtract whatever corporate income taxes they have paid to foreign governments from their U.S. tax bill. This makes sense in theory, because it prevents the offshore profits of American corporations from being double-taxed.

But, unfortunately, corporations sometimes get foreign tax credits that exceed the U.S. taxes that apply to such income, meaning that the U.S. corporations are using foreign tax credits to reduce their U.S. taxes on their U.S. profits, not just avoiding double taxation on their foreign income.

For example, say a U.S. corporation owns two foreign subsidiaries, one in a country where it actually does business and pays taxes, the other in a tax haven where it does no real business and pays no taxes. The U.S. corporation has accumulated profits in both foreign subsidiaries. If the U.S. company decides to officially bring some of its foreign profits back to the U.S., it can say that the profits it has “repatriated” all came from the taxable foreign corporation, thereby maximizing its foreign tax credit that it can use to reduce its U.S. tax on the repatriation.

Under the President’s proposal, the U.S. corporation would be required to compute the foreign tax credit as if the dividend was paid proportionately from each of its foreign subsidiaries. Since no foreign tax was paid on the profits in the tax haven, this approach will reduce the U.S. company’s foreign tax credit to the correct amount.

Restrict excessive interest deductions used for earnings stripping
10-year revenue gain: $41 billion[42]

The President also proposes a reform to restrict “earnings stripping,” the practice of multinational corporations earning profits in the United States reducing or eliminating their U.S. profits for tax purposes by making large interest payments to their foreign affiliates.

The President would allow a multinational corporation doing business in the U.S. to take deductions for interest payments to its foreign affiliates only to the extent that the U.S. entity’s share of the interest expenses of the entire corporate group (the entire group of corporations owned by the same parent corporation) is proportionate to its share of the corporate group’s earnings (calculated by adding back interest expenses and certain other deductible expenses). The corporation doing business in the U.S. could also choose instead to be subject to a different rule, limiting deductions for interest payment to ten percent of “adjusted taxable income” (which is taxable income plus several amounts that are usually deducted for tax purposes).

Most of the President’s international tax reform proposals address situations in which American corporations attempt to claim that their U.S. profits are actually earned by their affiliated corporations in other countries. This proposal is different in that it also addresses situations in which the American corporation is itself a subsidiary of a foreign corporation (at least on paper, since the foreign corporation can actually be a shell corporation in a tax haven).

In this situation, the American company is subject to U.S. corporate income taxes, but “earnings stripping” is used to make the American profits appear to be earned by the foreign corporation and thus not taxable in the U.S. To accomplish this, the U.S. company is loaded up with debt that is owed to the affiliated foreign company. The U.S. company then makes large interest payments (which reduce or wipe out its taxable income) to the foreign company.

Section 163(j) of the tax code was enacted in 1989 to prevent this practice, but it seems to be failing. It bars corporations from taking deductions for interest payments if their debt is more than one and a half times their equity (capital invested by stockholders) and the interest exceeds 50 percent of the company’s “adjusted taxable income” (taxable income plus several amounts that are usually deducted for tax purposes).

The problem is that an American corporation could have debt and interest payments that are below these thresholds but still high relative to the rest of the corporate group (the rest of the corporations all ultimately owned by the same parent corporation). For example, imagine a foreign corporation owns five subsidiary corporations, one in the U.S. and the other four in countries with much lower tax rates or no corporate income tax at all. If the American corporation tells the IRS that it generated a fifth of the revenue of the corporate group but also has half of the interest expense of the entire group, the IRS ought to be able to surmise that this has been arranged to artificially reduce U.S. profits to avoid U.S. taxes — even if the thresholds for the existing section 163(j) have not been breached. This is one of the problems that the President’s proposal would address.

Prevent American corporations from “inverting” (becoming foreign corporations for tax purposes)
10-year revenue gain: $19.5 billion[43]

A proposal in Congress would prevent American corporations from pretending to be “foreign” companies to avoid taxes even while they maintain most of their ownership, operations and management in the United States. This proposal is a slightly stronger version of a reform first proposed by President Obama in his budget plan.

The Stop Corporate Inversions Act requires the entity resulting from a U.S.-foreign merger to be treated as a U.S. corporation for tax purposes if it is majority owned by shareholders of the acquiring American company or if it is managed in the U.S. and has substantial business here. These are common sense rules and many people might be surprised to learn that they are not already part of our tax laws. In fact, the law on the books now (a law enacted in 2004) recognizes the inversion unless the merged company is more than 80 percent owned by the shareholders of the acquiring American corporation and does not have substantial business in the country where it is incorporated.

The current law therefore does prevent corporations from simply signing some papers and declaring itself to be reincorporated in, say, Bermuda. But it doesn’t address the situations in which an American corporation tries to add a dollop of legitimacy to the deal by obtaining a foreign company that is doing actual business in another country.

The management of Pfizer recently attempted to acquire the British drug maker AstraZeneca for this purpose.[44] A group of hedge funds that own stock in the drug store chain Walgreen have been pushing that company to increase its stake in the European company Alliance Boots for the same purpose.[45]

 

 

 


[1] During the most recent year for which OECD data are available, the United States collected lower taxes as a share of GDP than all but two OECD countries, Chile and Mexico. See Citizens for Tax Justice, “The U.S. Is One of the Least Taxed of the Developed Countries,” April 7, 2014. http://ctj.org/ctjreports/2014/04/the_us_is_one_of_the_least_taxed_of_the_developed_countries.php 

[2] The figures presented in the following paragraph and nearby graph first appeared in Citizens for Tax Justice, “Who Pays Taxes in America in 2014?,” April 7, 2014. http://ctj.org/ctjreports/2014/04/who_pays_taxes_in_america_in_2014.php

[3] Citizens for Tax Justice and the Institute on Taxation and Economic Policy, “The Sorry State of Corporate Taxes,” February 26, 2014. http://www.ctj.org/corporatetaxdodgers/

[4] Julie-Anne Cronin, Emily Y. Lin, Laura Power, and Michael Cooper, “Distributing the Corporate Income Tax: Revised U.S. Treasury Methodology,” Treasury Department, 2012. http://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/OTA-T2012-05-Distributing-the-Corporate-Income-Tax-Methodology-May-2012.pdf

[5] Institute on Taxation and Economic Policy (ITEP) microsimulation tax model, June, 2014. As explained in the main text, an official revenue estimate for this proposal from the Joint Committee on Taxation (JCT) would likely be quite different because JCT makes different assumptions about behavioral impacts. Our analysis adopts assumptions regarding behavioral impacts that have been argued to be more realistic by the Congressional Research Service.

[6] Warren E. Buffett, “Stop Coddling the Super-Rich,” New York Times op-ed, August 14, 2011. http://www.nytimes.com/2011/08/15/opinion/stop-coddling-the-super-rich.html?_r=1&scp=1

[7] These claims are easily refuted. Revenue collected from taxing capital gains was greater during the Clinton years when the rate was higher than in years after 2003 when the rate was reduced under President Bush. See Citizens for Tax Justice, “Ending the Capital Gains Tax Preference would Improve Fairness, Raise Revenue and Simplify the Tax Code,” September 20, 2012. http://ctj.org/ctjreports/2012/09/ending_the_capital_gains_tax_preference_would_improve_fairness_raise_revenue_and_simplify_the_tax_co.php Also, claims that the 1986 tax reform caused a drop-off in capital gains tax revenue fail to mention that there was an increase in capital gains tax revenue leading up to the reform going into effect, as individuals rushed to cash in assets before their tax preferences disappeared, and then afterwards such sales naturally dropped off from this artificial high point.

[8] CBO and JCT have not examined the option of totally eliminating the income tax preference for capital gains but have analyzed a very small reduction in the preference. Congressional Budget Office, “Options for Reducing the Deficit: 2014 to 2023,” November 2013, p. 111. http://www.cbo.gov/budget-options/2013/44687 The option studied by CBO would raise the capital gains rates by 2 percentage points and raise $53.4 billion from 2014 through 2023.

[9] Jane Gravelle, “Capital Gains Tax Options: Behavioral Responses and Revenue,” Congressional Research Service, August 10, 2010.

[10] Citizens for Tax Justice, “Policy Options to Raise Revenue,” March 9, 2012. http://ctj.org/ctjreports/2012/03/policy_options_to_raise_revenue.php

[11] Institute on Taxation and Economic Policy (ITEP) microsimulation tax model, June, 2014.

[12] Citizens for Tax Justice, “Fact Sheet: Why We Need the Corporate Income Tax,” June 10, 2013. http://ctj.org/ctjreports/2013/06/fact_sheet_why_we_need_the_corporate_income_tax.php

[13] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[14] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[15] Citizens for Tax Justice, “How to Implement the Buffett Rule,” October 19, 2011. http://ctj.org/ctjreports/2011/10/how_to_implement_the_buffett_rule.php

[16] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[17] Fund managers can invest their own money in the funds, but of course, tax treatment of any return on investments made with their own money would not be affected by the repeal of the carried interest loophole. (Profits from investments actually made by the managers themselves could still be taxed as capital gains).

[18] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2010 Budget Proposal,” JCX-36-14, June 11, 2009. https://www.jct.gov/publications.html?func=startdown&id=3618

[19] Department of the Treasury, “General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals,” March 2014, p. 177. http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2015.pdf

[20] Citizens for Tax Justice, “Payroll Tax Loophole Used by John Edwards and Newt Gingrich Remains Unaddressed by Congress,” September 6, 2013. http://www.ctj.org/taxjusticedigest/archive/2013/09/payroll_tax_loophole_used_by_j.php

[21] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[22] Citizens for Tax Justice, “Working Paper on Tax Reform Options,” revised February 4, 2013. http://ctj.org/ctjreports/2013/02/working_paper_on_tax_reform_options.php

[23] Department of the Treasury, “General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals,” March 2014. http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2015.pdf

[24] This estimate is based on the estimates provided by the Joint Committee on Taxation (JCT) of the impacts of Senator Ron Wyden’s Bipartisan Tax Fairness and Simplification Act of 2010, which includes repeal of accelerated depreciation. Joint Committee on Taxation, “Estimated Revenue Effects of S. 3018, the “Bipartisan Tax Fairness and Simplification Act of 2010,” November 2, 2010. http://www.wyden.senate.gov/download/joint-committee-on-taxation-estimated-score-of-the-bipartisan-tax-fairness-and-simplification-act-of-2010  JCT’s estimates separate the impacts of eliminating business tax expenditures, reducing the corporate income tax rate, and the interaction between the two. This allows us to calculate the revenue impact of enacting these provisions without a reduction in the corporate tax rate. We adjust the revenue estimates for each year based on more recent CBO revenue estimates to account for the later time period we examine (2015 through 2024) and to account for the greater corporate profits that JCT now predicts during the coming decade. We then draw on other research that suggests only about 60 percent of the revenue impact from ending accelerated depreciation would be a permanent impact sustained in the following decades. Chye-Ching Huang, Chuck Marr, and Nathaniel Frentz, “Timing Gimmicks Pose Threat to Fiscally Responsible Tax Reform,” Center on Budget and Policy Priorities, July 24, 2013. http://www.cbpp.org/cms/index.cfm?fa=view&id=3994

[25] Gary Guenther, “Section 179 and Bonus Depreciation Expensing Allowances: Current Law, Legislative Proposals in the 112th Congress, and Economic Effects,” Congressional Research Service, September 10, 2012. http://www.fas.org/sgp/crs/misc/RL31852.pdf

[26] Statement of Jane G. Gravelle, Senior Specialist in Economic Policy, Congressional Research Service, before the Committee on Finance, United States Senate, March 6, 2012, on Tax Reform Options: Incentives for Capital Investment and Manufacturing, pages 5-6. http://www.finance.senate.gov/imo/media/doc/Testimony%20of%20Jane%20Gravelle.pdf

[27] Chye-Ching Huang, Chuck Marr, and Nathaniel Frentz, “Timing Gimmicks Pose Threat to Fiscally Responsible Tax Reform,” Center on Budget and Policy Priorities, July 24, 2013. http://www.cbpp.org/cms/index.cfm?fa=view&id=3994

[28] The estimate is based on the revenue estimate provided by the Joint Committee on Taxation for the Rep. Dave Camp’s tax reform plan, which includes a proposal to repeal the domestic manufacturing deduction. The estimate is adjusted to reflect that this proposal would go into effect in 2015, whereas Rep. Camp’s plan would not fully repeal the deduction until 2017. Joint Committee on Taxation, Estimated Revenue Effects of the Tax Reform Act of 2014, February 26, 2014, JCX-20-14. http://waysandmeans.house.gov/uploadedfiles/jct_revenue_estimate__jcx_20_14__022614.pdf

[29] Repeal of the manufacturing deduction would also greatly help many state governments. This is because many states have corporate income taxes that are linked to the federal corporate income tax, so a deduction on the federal level applies on the state level as well. State lawmakers can enact legislation to “decouple” from the federal rules related to this deduction. But political and constitutional constraints in some states make it difficult to enact any sort of “tax increase,” even when it only consists of decoupling from federal rules allowing a deduction.  See Institute on Taxation and Economic Policy, “The QPAI Corporate Tax Break: How It Works and How States Can Respond,” October 2008. http://www.itepnet.org/pb33qpai.pdf 

[30] Statement of Senators Levin and McCain on Stock Option Tax Deductions, November 6, 2013. http://www.levin.senate.gov/newsroom/press/release/statement-of-senators-levin-and-mccain-on_stock-option-tax-deductions

[31] In theory, there could be some cost to existing shareholders when individuals are allowed to buy stock for less than it’s worth, but the same is true whenever a corporation issues new stock and this does not generate a tax deduction for the corporation.

[32] For a more detailed explanation, see Citizens for Tax Justice, “Putting a Face(book) on the Corporate Stock Option Tax Loophole,” February 7, 2012. http://www.ctj.org/pdf/FacebookReport.pdf

[33] Citizens for Tax Justice, “Facebook’s Multi-Billion Dollar Tax Break: Executive-Pay Tax Break Slashes Income Taxes on Facebook — and Other Fortune 500 Companies,” February 14, 2013. http://ctj.org/ctjreports/2013/02/facebooks_multi-billion_dollar_tax_break_executive-pay_tax_break_slashes_income_taxes_on_facebook--.php

[34] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[35] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[36] David Kocieniewski, “Major Companies Push the Limits of a Tax Break,” The New York Times, January 6, 2013. http://www.nytimes.com/2013/01/07/business/economy/companies-exploit-tax-break-for-asset-exchanges-trial-evidence-shows.html?pagewanted=all&_r=0

[37] Joint Committee on Taxation, “Estimates Of Federal Tax Expenditures For Fiscal Years 2012-2017,” JCS-1-13, February 01, 2013. https://www.jct.gov/publications.html?func=startdown&id=4503

[38] This estimate is based on the estimates provided by the Joint Committee on Taxation (JCT) of the impacts of Senator Ron Wyden’s 2010 tax reform plan, which includes repeal of deferral. See Joint Committee on Taxation, “Estimated Revenue Effects of S. 3018, the Bipartisan Tax Fairness and Simplification Act of 2010,” November 2, 2010. http://www.wyden.senate.gov/download/joint-committee-on-taxation-estimated-score-of-the-bipartisan-tax-fairness-and-simplification-act-of-2010  JCT’s estimates separate the impacts of eliminating business tax expenditures, reducing the corporate income tax rate, and the interaction between the two. This allows us to calculate the revenue impact of enacting these provisions without a reduction in the corporate tax rate. We adjust the revenue estimates for each year based on more recent CBO revenue estimates to account for the later time period we examine (2015 through 2024) and to account for the greater corporate profits that JCT now predicts during the coming decade.

[39] Citizens for Tax Justice, “American Corporations Tell IRS the Majority of Their Offshore Profits Are in 12 Tax Havens,” May 27, 2014. http://ctj.org/ctjreports/2014/05/american_corporations_tell_irs_the_majority_of_their_offshore_profits_are_in_12_tax_havens.php

[40] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[41] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[42] Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4585

[43] Letter from Joint Committee on Taxation to Karen McAfee, Ways and Means Committee Democratic staff, May 23, 2014. http://democrats.waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/113-0927%20JCT%20Revenue%20Estimate.pdf

[44] Citizens for Tax Justice, “Why Does Pfizer Want to Renounce Its Citizenship?” April 30, 2014. http://www.taxjusticeblog.org/archive/2014/04/pfizer_is_a_bad_corporate_citi.php

[45] Citizens for Tax Justice, “Walgreens May Become a ‘Foreign’ Company to Avoid Taxes — But an Obama Proposal Could Stop Them,” April 24, 2014. http://www.ctj.org/taxjusticedigest/archive/2014/04/walgreens_may_become_a_foreign.php

 

The Koch Brothers' Ugly Vision for Tax Deform

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The billionaire brothers Charles and David Koch are in the news once again as they step up their efforts to influence elections and the political process with a new super PAC called Freedom Partners Action Fund. It's worth thinking about how tax policy could be affected if they succeed.

Last year, the Koch-Brothers-funded Americans for Prosperity released a 37-page report laying out the group’s vision for what it calls “tax reform.”

The paper is vague or incoherent in its details, but the group’s ultimate goal is stated very clearly.

Here are a few quotes from the paper:

■“Taxes should not target individuals based on their ability to pay” (page 13).

■ “[P]rogressive taxation is bad policy from a moral perspective” (page 29).

■ “AFP believes that the tax code should not be used to demonstrate preference to individuals on the basis of their income status” (page 28).

In other words, AFP wants to cut taxes on the wealthy by huge amounts.

Some of the details of how AFP would achieve its goal include: a large, although unspecified  reduction in the top personal income tax rate, lower taxes on capital gains, and what amounts to the virtual elimination of the corporate income tax.

Having called for gigantic tax cuts for the wealthy, AFP also says that it wants its plan to raise the same amount of tax revenues as current tax law (page 1).

Under the laws of arithmetic, there is only one way to reconcile these two goals: AFP wants to increase taxes sharply on the middle- and low-income American families.

That’s the ugly vision that Americans for Prosperity and its wealthy backers are promoting.

 

 


 

Notes:

The paper: Americans for Prosperity, “Tax Reform: Restoring Economic Growth through Neutrality and Simplicity” (2013).

Corporate tax elimination: When corporations earn profits, there are essentially two things it can do with those profits. It can pay dividends to shareholders or it can reinvest the profits to increase future profits. Under the AFP plan, both of these uses of profits would be tax deductible. So corporations would have no taxable income. Close to half of the corporate tax is ultimately paid by the richest one percent of Americans.

Personal income tax rates: The AFP paper does not specify exactly what income tax rates it favors. But it suggests that a top income tax rate of 25 percent might be a good idea, and it highly praises a flat tax rate of 17 percent. The current top income tax rate, which applies only to the top one percent, is 39.6 percent.

Capital gains: AFP proposes to tax capital gains at lower rate than other income. It does not say how much lower. At one point, however, it endorses indexing the basis of capital assets for inflation, which would amount to a 30-40 percent exclusion for capital gains (on top of the lower capital gains tax rate). Under the 17 percent flat rate tax than AFP praises, capital gains would not be taxed at all. Two-thirds of all capital gains reported on tax returns go to the best-off one percent.

Offshore Shell Games 2014

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The Use of Offshore Tax Havens by Fortune 500 Companies

Read this report in PDF.

Download Dataset/Appendix (XLS)

Executive Summary

Introduction

Most of America’s Largest Corporations Maintain Subsidiaries in Offshore Tax Havens

Cash Booked Offshore for Tax Purposes by U.S. Multinationals Doubled between 2008 and 2013

Evidence Indicates Much of Offshore Profits are Booked to Tax Havens

Firms Reporting Fewer Tax Haven Subsidiaries Do Not Necessarily Dodge Fewer Taxes Offshore

Measures to Stop Abuse of Offshore Tax Havens

Methodology

End Notes

 

Executive Summary

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Many large U.S.-based multinational cor­porations avoid paying U.S. taxes by using accounting tricks to make profits made in America appear to be generated in offshore tax havens—countries with minimal or no taxes. By booking profits to subsidiaries registered in tax havens, multinational corporations are able to avoid an estimated $90 billion in fed­eral income taxes each year. These subsidiaries are often shell companies with few, if any em­ployees, and which engage in little to no real business activity.

Congress has left loopholes in our tax code that allow this tax avoidance, which forces ordinary Americans to make up the difference. Every dollar in taxes that corporations avoid by using tax havens must be balanced by higher taxes on individuals, cuts to public investments and public services, or increased federal debt.

This study examines the use of tax havens by Fortune 500 companies in 2013. It reveals that tax haven use is ubiquitous among America’s largest companies, but a narrow set of compa­nies benefit disproportionately.

Most of America’s largest corporations maintain subsidiaries in offshore tax ha­vens. At least 362 companies, making up 72 percent of the Fortune 500, operate subsid­iaries in tax haven jurisdictions as of 2013.

  • All told, these 362 companies maintain at least 7,827 tax haven subsidiaries.
  • The 30 companies with the most money officially booked offshore for tax purposes collectively operate 1,357 tax haven subsid­iaries.

Approximately 64 percent of the companies with any tax haven subsidiaries registered at least one in Bermuda or the Cayman Islands—two notorious tax havens. Fur­thermore, the profits that all American multi­nationals—not just Fortune 500 companies—collectively claim were earned in these island nations in 2010 totaled 1,643 percent and 1,600 percent of each country’s entire yearly economic output, respectively.

Six percent of Fortune 500 companies ac­count for over 60 percent of the profits re­ported offshore for tax purposes. These 30 companies with the most money offshore—out of the 287 that report offshore profits—collectively book $1.2 trillion overseas for tax purposes.

Only 55 Fortune 500 companies disclose what they would expect to pay in U.S. taxes if these profits were not officially booked offshore. All told, these 55 companies would collectively owe $147.5 billion in ad­ditional federal taxes. To put this enormous sum in context, it represents more than the en­tire state budgets of California, Virginia, and Indiana combined. Based on these 55 cor­porations’ public disclosures, the average tax rate that they have collectively paid to other countries on this income is just 6.7 percent, suggesting that a large portion of this offshore money is booked to tax havens. This list includes:

  • Apple: Apple has booked $111.3 billion offshore—more than any other company. It would owe $36.4 billion in U.S. taxes if these profits were not officially held off­shore for tax purposes. A 2013 Senate in­vestigation found that Apple has structured two Irish subsidiaries to be tax residents of neither the U.S.—where they are managed and controlled—nor Ireland—where they are incorporated. This arrangement en­sures that they pay no taxes to any govern­ment on the lion’s share of their offshore profits.
  • American Express: The credit card com­pany officially reports $9.6 billion offshore for tax purposes on which it would other­wise owe $3 billion in U.S. taxes. That im­plies that American Express currently pays only a 3.8 percent tax rate on its offshore profits to foreign governments, suggesting that most of the money is booked in tax ha­vens levying little to no tax. American Ex­press maintains 23 subsidiaries in offshore tax havens.
  • Nike: The sneaker giant officially holds $6.7 billion offshore for tax purposes, on which it would otherwise owe $2.2 billion in U.S. taxes. That implies Nike pays a mere 2.2 percent tax rate to foreign governments on those offshore profits, suggesting that nearly all of the money is officially held by subsidiaries in tax havens. Nike does this in part by licensing the trademarks for some of its products to 12 subsidiaries in Bermu­da to which it then pays royalties.

Some companies that report a significant amount of money offshore maintain hun­dreds of subsidiaries in tax havens, includ­ing the following:

  • Bank of America reports having 264 sub­sidiaries in offshore tax havens—more than any other company. The bank officially holds $17 billion offshore for tax purposes, on which it would otherwise owe $4.3 bil­lion in U.S. taxes. That means it currently pays a ten percent tax rate to foreign gov­ernments on the profits it has booked off­shore, implying much of those profits are booked to tax havens.
  • PepsiCo maintains 137 subsidiaries in off­shore tax havens. The soft drink maker re­ports holding $34.1 billion offshore for tax purposes, though it does not disclose what its estimated tax bill would be if it didn’t keep those profits booked offshore for tax purposes.
  • Pfizer, the world’s largest drug maker, oper­ates 128 subsidiaries in tax havens and offi­cially holds $69 billion in profits offshore for tax purposes, the third highest among the Fortune 500. Pfizer recently attempted the acquisition of a smaller foreign competitor so it could reincorporate on paper as a “for­eign company.” Pulling this off would have allowed the company a tax-free way to use its supposedly offshore profits in the U.S.

Corporations that disclose fewer tax haven subsidiaries do not necessarily dodge fewer taxes. Many companies have disclosed fewer tax haven subsidiaries, all the while increas­ing the amount of cash they keep offshore. For some companies, their actual number of tax haven subsidiaries may be substantially greater

than what they disclose in the official docu­ments used for this study. For others, it suggests that they are booking larger amounts of income to fewer tax haven subsidiaries.

Consider:

  • Citigroup reported operating 427 tax hav­en subsidiaries in 2008 but disclosed only 21 in 2013. Over that time period, Citigroup more than doubled the amount of cash it re­ported holding offshore. The company cur­rently pays an 8.3 percent tax rate offshore, implying that most of those profits have been booked to low- or no-tax jurisdictions.
  • Google reported operating 25 subsidiar­ies in tax havens in 2009, but since 2010 only discloses two, both in Ireland. During that period, it increased the amount of cash it reported offshore from $7.7 billion to $38.9 billion. An academic analysis found that as of 2012, the 23 no-longer-disclosed tax haven subsidiaries were still operating.
  • Microsoft, which reported operating 10 subsidiaries in tax havens in 2007, disclosed only five in 2013. During this same time period, the company increased the amount of money it reported holding offshore by more than 12 times. Microsoft currently pays a tax rate of just 3 percent to foreign governments on those profits, suggesting that most of the cash is booked to tax ha­vens.

Strong action to prevent corporations from using offshore tax havens will re­store basic fairness to the tax system, make it easier to avoid large budget deficits, and improve the functioning of markets.

There are clear policy solutions policy­makers can enact to crack down on tax haven abuse. Policymakers should end in­centives for companies to shift profits off­shore, close the most egregious offshore loopholes, and increase transparency.

Introduction

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Ugland House is a modest five-story office building in the Cayman Islands, yet it is the registered address for 18,857 companies.1 The Cayman Islands, like many other offshore tax havens, levies no income taxes on companies incorporated there. Simply by registering sub­sidiaries in the Cayman Islands, U.S. com­panies can use legal accounting gimmicks to make much of their U.S.-earned profits appear to be earned in the Caymans and pay no taxes on them.

The vast majority of subsidiaries registered at Ugland House have no physical presence in the Caymans other than a post office box. About half of these companies have their billing ad­dress in the U.S., even while they are officially registered in the Caymans.2 This unabashedly false corporate “presence” is one of the hall­marks of a tax haven subsidiary.

Companies can avoid paying taxes by booking profits to a tax haven because U.S. tax laws al­low them to defer paying U.S. taxes on profits they report are earned abroad until they ”repa­triate” the money to the United States. Cor­porations receive a dollar-for-dollar tax credit for the taxes they pay to foreign governments in order to avoid double taxation. Many U.S. companies game this system by using loop­holes that let them disguise profits legitimately made in the U.S. as “foreign” profits earned by a subsidiary in a tax haven.

Offshore accounting gimmicks by multina­tional corporations have created a disconnect between where companies locate their actual workforce and investments, on one hand, and where they claim to have earned profits, on the other. The Congressional Research Service found that in 2008, American multinational companies collectively reported 43 percent of their foreign earnings in five small tax haven countries: Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland. Yet these coun­tries accounted for only 4 percent of the com­panies’ foreign workforce and just 7 percent of their foreign investment. By contrast, American multinationals reported earning just 14 percent of their profits in major U.S. trading partners with higher taxes—Australia, Canada, the UK, Germany, and Mexico—which accounted for 40 percent of their foreign workforce and 34 percent of their foreign investment.5 The IRS released data this year showing that American multinationals collectively reported in 2010 that 54 percent of their foreign earnings were on the books in 12 notorious tax havens (see table 4 on pg. 14).6

What is a Tax Haven?
Tax havens are jurisdictions with very low 
or nonexistent taxes. This makes it attrac-
tive for U.S.-based multinational firms to 
report earnings there to avoid paying taxes 
in the United States. Most tax haven coun-
tries also have financial secrecy laws that 
can thwart international rules by limit
-ing disclosure about financial transactions 
made in their jurisdiction. These secrecy 
laws are used by wealthy individuals to 
avoid paying taxes by setting up offshore 
shell corporations or trusts. Many tax ha-
ven countries are small island nations, such 
as Bermuda, the British Virgin Islands, 
and the Cayman Islands.3
This study uses a list of 50 tax haven juris-
dictions, which each appear on at least one 
list of tax havens compiled by the Organi-
zation for Economic Cooperation and De-
velopment (OECD), the National Bureau 
of Economic Research, or as part of a U.S. 
District Court order listing tax havens. 
These lists were also used in a 2008 GAO 
report investigating tax haven subsidiaries.4

What is a Tax Haven?

Tax havens are jurisdictions with very low
or nonexistent taxes. This makes it attractive
for U.S.-based multinational firms to report
earnings there to avoid paying taxes in the
United States. Most tax haven countries also
have financial secrecy laws that can thwart
international rules by limiting disclosure about
financial transactions made in their jurisdiction.
These secrecy laws are used by wealthy
individuals to avoid paying taxes by setting up
offshore shell corporations or trusts. Many tax
haven countries are small island nations, such
as Bermuda, the British Virgin Islands, and
the Cayman Islands.3

This study uses a list of 50 tax haven
jurisdictions, which each appear on at least one
list of tax havens compiled by the Organization
for Economic Cooperation and Development
(OECD), the National Bureau of Economic
Research, or as part of a U.S. District Court
order listing tax havens. These lists were also
used in a 2008 GAO report investigating tax
haven subsidiaries.4

Profits booked “offshore” often remain on shore, invested in U.S. assets

Many of the profits kept “offshore” are actually housed in U.S. banks or invested in American assets, but registered in the name of foreign subsidiaries. A Senate investigation of 27 large multinationals with substantial amounts of cash supposedly “trapped” offshore found that more than half of the offshore funds were in­vested in U.S. banks, bonds, and other assets.7 For some companies the percentage is much higher. A Wall Street Journal investigation found that 93 percent of the money Microsoft has officially “offshore” was invested in U.S. assets.8 In theory, companies are barred from investing directly in their U.S. operations, pay­ing dividends to shareholders or repurchasing stock with money they declare to be “perma­nently invested offshore.” But even that re­striction is easily evaded because companies can use cash supposedly “trapped” offshore for those purposes by borrowing at negligible rates using their offshore holdings as collateral. Either way, American corporations can benefit from the stability of the U.S. financial system without paying taxes on the profits that are of­ficially booked “offshore” for tax purposes.9

Average Taxpayers Pick Up the Tab for Offshore Tax Dodging

Congress has left loopholes in our tax code that allow offshore tax avoidance, which forces ordinary Americans to make up the difference. The practice of shifting corporate income to tax haven subsidiaries reduces federal revenue by an estimated $90 billion annually.10 Ev­ery dollar in taxes companies avoid by using tax havens must be balanced by higher taxes paid by other Americans, cuts to government programs, or increased federal debt. If small business owners were to pick up the full tab for offshore tax avoidance by multinationals, they would each have had to pay an estimated $3,206 in additional taxes last year.11

It makes sense for profits earned in America to be subject to U.S. taxation. The profits earned by these companies generally depend on access to America’s largest-in-the-world consumer market, a well-educated workforce trained by our school systems, strong private property rights enforced by our court system, and American roads and rail to bring products to market.12 Multinational companies that de­pend on America’s economic and social infra­structure are shirking their obligation to pay for that infrastructure if they “shelter” the re­sulting profits overseas.

A Note On Misleading 
Terminology

“Offshore profits”

Using the term “offshore profits” without
any qualification is a misleading way to 
describe the profits U.S. multinationals 
hold in tax havens. The term implies 
that these profits were actually earned 
offshore, as a result of actual business 
activity. In reality, for many—if not most
—of the companies examined in this 
study, “offshore profits” mostly refers 
to U.S. profits that companies have 
disguised as foreign profits made in tax 
havens to avoid taxes. To capture this 
reality, this study describes “offshore 
profits” as profits booked offshore for 
tax purposes.

“Repatriation” or “bringing the money back”

Repatriation is the term used to describe 
what happens when a U.S. company 
“returns” offshore profits to the U.S. This 
term is misleading because it implies that 
profits companies have booked offshore 
for tax purposes are actually offshore in a 
real sense and that a company cannot 
make use of those profits in the U.S. 
without “bringing them back” and paying 
U.S. tax.The reality (as previously described) 
is that much of the profits reported “offshore” 
are actually already in the U.S., housed in 
U.S. banks or invested in U.S. assets like 
Treasury bonds. In theory, companies are 
restricted from using profits booked offshore 
to pay dividends to shareholders or make 
certain investments, but companies can get 
around these restrictions by using “offshore” 
profits as collateral to borrow money at low 
rates to use for those purposes.

Most of America’s Largest Corporations Maintain Subsidiaries in Offshore Tax Havens

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This study found that as of 2013, 362 Fortune 500 companies—over 72 percent—disclose subsidiaries in offshore tax havens, indicating how pervasive tax haven use is among large companies. All told, these 362 companies maintain at least 7,827 tax haven subsidiaries.13 The top 30 companies with the most money held offshore collectively disclose 1,357 tax ha­ven subsidiaries. Bank of America, Citigroup, JPMorgan-Chase, AIG, Goldman Sachs, Wells Fargo and Morgan Stanley—all large financial institutions that received taxpayer bailouts in 2008—disclose a combined 702 subsidiaries in tax havens.Cash Booked Offshore

Companies that rank high for both the number of tax haven subsidiaries and how much profit they book offshore for tax purposes include:

  • Bank of America, which reports having 264 subsidiaries in offshore tax havens. Kept afloat by taxpayers during the 2008 financial meltdown, the bank reports hold­ing $17 billion offshore, on which it would otherwise owe $4.3 billion in U.S. taxes.14 That implies that it currently pays a ten percent tax rate to foreign governments on the profits it has booked offshore, suggest­ing much of those profits are booked to tax havens.
  • PepsiCo maintains 137 subsidiaries in off­shore tax havens. The soft drink maker re­ports holding $34.1 billion offshore for tax purposes, though it does not disclose what its estimated tax bill would be if it didn’t keep those profits offshore.

  • Pfizer, the world’s largest drug maker, op­erates 128 subsidiaries in tax havens and of­ficially reports $69 billion in profits offshore for tax purposes, the third highest among the Fortune 500.15 The company made more than 40 percent of its sales in the U.S. between 2010 and 2012,16 but managed to report no federal taxable income six years in a row. This is because Pfizer uses account­ing techniques to shift the location of its taxable profits offshore. For example, the company can license patents for its drugs to a subsidiary in a low or no-tax country. Then, when the U.S. branch of Pfizer sells the drug in the U.S., it must pay its own offshore subsidiary high licensing fees that turn domestic profits into on-the-books losses and shifts profit overseas.

    Pfizer recently attempted a corporate “in­version” in which it would have acquired a smaller foreign competitor so it could rein­corporate on paper in the UK and no longer be an American company. A key reason Pfiz­er attemped this maneuver is that it would have allowed the company to more aggres­sively shift U.S. profits offshore and have full, unrestricted access to its offshore cash.

 

Cash Booked Offshore for Tax Purposes by U.S. Multinationals Doubled between 2008 and 2013

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In recent years, U.S. multinational companies have increased the amount of money they book to foreign subsidiaries. An April 2014 study by research firm Audit Analytics found that the Russell 1000 list of U.S. companies collective­ly reported having just over $2.1 trillion held offshore. That is nearly double the income re­ported offshore in 2008.17

For many companies, increasing profits held offshore does not mean building factories abroad, selling more products to foreign cus­tomers, or doing any additional real business activity in other countries. Instead, many com­panies use accounting tricks to disguise their profits as “foreign,” and book them to a subsid­iary in a tax haven to avoid taxes.

The practice of artificially shifting profits to tax havens has increased in recent years. In 1999, the profits American multinationals reported earning in Bermuda represented 260 percent of the country’s entire economy. In 2008, it was up to 1,000 percent.18 More offshore prof­it shifting means more U.S. taxes avoided by American multinationals. A 2007 study by tax expert Kimberly Clausing of Reed College es­timated that the revenue lost to the Treasury due to offshore tax haven abuse by corpora­tions totaled $60 billion annually. In 2011, she updated her estimate to $90 billion.19

The 287 Fortune 500 Companies that re­port offshore profits collectively hold $1.95 trillion offshore, with the top 30 companies accounting for 62 percent of the total

This report found that as of 2013, the 287 For­tune 500 companies that report holding off­shore cash had collectively accumulated close to $2 trillion that they declare to be “permanently reinvested” abroad. That means they claim to have no current plans to use the money to pay dividends to shareholders, make stock repur­chases, or make certain U.S. investments. While 72 percent of Fortune 500 companies report having income offshore, some companies shift profits offshore far more aggressively than oth­ers. The thirty companies with the most money offshore account for nearly $1.2 trillion. In oth­er words, six percent of Fortune 500 companies account for 62 percent of the offshore cash.

Not all companies report how much cash they have “permanently reinvested offshore,” so the finding that 287 companies report offshore profits does not factor in all cash booked off­shore. For example, Northrop Grumman re­ported in 2011 having $761 million offshore. But since 2012, the defense contractor has reported have that it continues to have per­manently reinvested earnings, but no longer specifies how much.

Evidence Indicates Much of Offshore Profits are Booked to Tax Havens

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Companies are not required to disclose pub­licly how much they earned—or booked on paper—in another country. Still, some compa­nies provide enough information in their an­nual SEC filings to deduce that much of their offshore cash is sitting in tax havens.

Only 55 Fortune 500 companies disclose what they would pay in taxes if they did not keep their profits booked offshore.

Companies are required to disclose this infor­mation in their annual 10-K filings unless the company determines it is “not practicable” to do so—a major loophole.20 Collectively, these 55 companies alone would owe more than $147.5 billion in additional federal taxes. To put this enormous sum in context, it represents more than the entire state budgets of Califor­nia, Virginia, and Indiana combined.21

More startling is that, as a group, the average tax rate these 55 companies have paid to for­eign governments on these profits booked off­shore seems to be a mere 6.7 percent.22 If these companies officially repatriated their “offshore” money to the U.S., they would pay the 35 per­cent statutory corporate tax rate, minus what they have already paid to foreign governments. This means that, for example, a corporation dis­closing that it would pay a U.S. tax rate of 30 percent upon repatriation must have paid about 5 percent to foreign governments on its offshore profits. Based on such calculations, these 55 cor­porations seem to have paid a 6.7 percent rate to foreign governments, which suggests that the bulk of this cash is booked to tax havens that levy minimal to no corporate tax.

Examples of large companies paying very low foreign tax rates on offshore cash include:

  • Apple: A recent Senate investigation found that Apple pays next to nothing in taxes on the profits it has booked offshore, which constitute the largest offshore cash stock­pile. Manipulating tax loopholes in the U.S. and other countries, Apple structured two subsidiaries to be tax residents of neither the U.S.—where they are managed and con­trolled—nor Ireland—where they are in­corporated. This arrangement ensures that they pay no taxes to any government on the lion’s share of their offshore profits. One of the subsidiaries has no employees.23
  • American Express: The company offi­cially reports $9.6 billion offshore for tax purposes, on which it would otherwise owe $3 billion in U.S. taxes. That implies it is currently paying a 3.8 percent tax rate on its offshore profits to foreign govern­ments, suggesting that most of the money is booked in tax havens levying little to no tax.24 American Express maintains 23 sub­sidiaries in offshore tax havens.
  • Nike: The sneaker giant officially holds $6.7 billion offshore for tax purposes, on which it would otherwise owe $2.2 billion in U.S. taxes. That implies Nike pays a mere 2.2 percent tax rate to foreign governments on those offshore profits, suggesting nearly all of the money is held by subsidiaries in tax havens. Nike does this in part by licensing the trademarks for some of its products to 12 subsidiaries in Bermuda. The American parent company must pay royalties to the Bermuda subsidiaries to use the trademarks in the U.S., thereby shifting its income offshore. Its Bermuda subsidiaries actually bear the names of their shoes like “Air Max Limited” and “Nike Flight.”25

New data shows that in 2010, more than half of the foreign profits reported by all multinationals for that year were booked to tax havens

In the aggregate, recently released data show that American multinationals collec­tively reported to the IRS 2010 earnings of $505 billion in 12 well known tax havens.

That is more than half (54%) of the total profits American companies reported earn­ing abroad that year. For the five tax havens where American companies booked the most profits, those reported earnings were greater than the size of those country’s entire econo­mies (as measured by GDP). This data indi­cates that there is little relationship between where American multinationals actually do business, and where they report that they made their profits for tax purposes.

Approximately 64 percent of the companies with tax haven subsidiaries registered at least one in Bermuda or the Cayman Islands—the two tax havens where profits from American multinationals accounted for the largest per­centage of the two counties’ GDP.

Maximizing the benefit of offshore tax havens by reincorporating as a “foreign” company: a new wave of corporate “inversions”

 Some American companies go as far as to change the address of their corporate head­quarters on paper so they can reincorporate in a foreign country, a maneuver called an ‘inversion,” which reflects how the scheme stands the reality of the corporate structure on its head. Inversion increases the reward for exploiting offshore loopholes. In theory, an American company must pay U.S. tax on profits it claims were made offshore if it wants to officially bring the money back to the U.S. to pay out dividends to shareholders or make certain U.S. investments. However, once a corporation reregisters as foreign, the profits it claims were earned for tax purposes outside the U.S. become fully exempt from U.S. tax.

Even though a “foreign” corporation still must pay U.S. tax on profits it reports were earned in the U.S., corporate inversions are often followed by “earnings-stripping,” in which the corporation makes its remaining U.S. profits appear to be earned in other countries in order to avoid paying U.S. taxes on them. A corporation can do this by load­ing the American part of the company with debt owed to the foreign part of the com­pany. The interest payments on the debt are tax deductible, officially reducing American profits, which are effectively shifted to the foreign part of the company.26  

In 2004, Congress passed bipartisan legisla­tion to crack down on inversions. The law now requires inverted companies that had at least 80 percent of the same shareholders as the pre-inversion parent to be treated as American companies for tax purposes, unless the company did “substantial business” in the country in which it was reincorporating.27 The Treasury’s definition of “substantial business” made this law difficult to game.28  

However, in recent years, companies have discovered a way to circumvent the biparti­san anti-inversion laws by acquiring a smaller foreign company so that shareholders of the foreign company own more than 20 percent of the newly merged company.29 Walgreens and Pfizer—two quintessentially American companies—made headlines when it was revealed that they were considering merg­ers that would allow them to reincorporate abroad. A Bloomberg investigation found that 15 publicly traded companies have rein­corporated abroad within the last few years, explaining that “most of their CEOs didn’t leave. Just the tax bills did.”30


 

Firms Reporting Fewer Tax Haven Subsidiaries Do Not Necessarily Dodge Fewer Taxes Offshore

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In 2008, the Government Accountability Of­fice conducted a study which revealed that 83 of the top 100 publically traded companies op­erated subsidiaries in offshore tax havens. To­day, some companies report fewer subsidiaries in tax haven countries than they did in 2008. Meanwhile, some of these same companies re­ported significant increases in how much cash they hold abroad, and pay such a low tax rate to foreign governments that it suggests the mon­ey is booked to tax havens.

One explanation for this phenomenon is that companies are choosing not to report certain subsidiaries that they previously disclosed. The SEC requires that companies report all “signif­icant” subsidiaries based on multiple measures of a subsidiary’s share of the company’s total assets. Furthermore, if the combined assets of all subsidiaries deemed “insignificant” collec­tively qualified as a significant subsidiary, then the company would have to disclose them. But a recent academic study found that the penal­ties for not disclosing subsidiaries are so light that a company might decide that disclosure isn’t worth the bad publicity. The researchers postulate that increased media attention on offshore tax dodging and/or IRS scrutiny could be a reason why some companies have stopped disclosing all subsidiaries. Examining the case of Google, the academics found that it was so improbable that the company could only have two significant foreign subsidiaries that Google “may have calculated that the SEC’s failure-to-disclose penalties are largely irrelevant and therefore may have determined that disclosure was not worth the potential costs associated with increases in either tax and/or negative publicity costs.”31 The researchers found that as of 2012, 23 no-longer-disclosed tax haven subsidiaries were still operating.

The other possibility is that companies are simply consolidating more income in fewer offshore subsidiaries, since having just one tax haven subsidiary is enough to dodge billions in taxes. For example, a 2013 Senate investiga­tion of Apple found that the tech giant primar­ily uses two Irish subsidiaries—which own the rights to certain intellectual property—to hold on to $102 billion in offshore cash. Manipulat­ing tax loopholes in the U.S. and other coun­tries, Apple has structured these subsidiaries so that they are not tax residents of either the U.S. or Ireland, ensuring that they pay no taxes to any government on the lion’s share of the money. One of the subsidiaries has no employ­ees. 32

Examples of large companies that have report­ed fewer tax haven subsidiaries in recent years while simultaneously shifting more profits off­shore include:

  • Citigroup reported operating 427 tax ha­ven subsidiaries in 2008 but disclosed only 21 in 2013. Over that time period, Citi­group increased the amount of cash it re­ported holding offshore from $21.1 billion to $43.8 billion, ranking the company 10th for the amount of cash booked offshore. The company estimates it would owe $11.6 billion in taxes had it not booked those profits offshore. The company currently pays an 8.3 percent tax rate offshore, im­plying that most of those profits have been booked to low- or no-tax jurisdictions.

  • Google reported operating 25 subsidiaries in tax havens in 2009, but since 2010 only discloses two, both in Ireland. During that period, it increased the amount of cash it had booked offshore from $7.7 billion to $38.9 billion. An academic analysis found that as of 2012, the 23 no-longer-disclosed tax haven subsidiaries were still operating.33 Google uses accounting techniques nick­named the “double Irish” and the “Dutch sandwich,” according to a Bloomberg in­vestigation. Using two Irish subsidiaries, one of which is headquartered in Bermuda, Google shifts profits through Ireland and the Netherlands to Bermuda, shrinking its tax bill by approximately $2 billion a year.34
  • Microsoft reported operating 10 subsidiar­ies in tax havens in 2007; in 2013, it disclosed only five. During this same time period, the company increased the amount of money it held offshore from $6.1 billion to $76.4 bil­lion, on which it would otherwise owe $19.4 billion in U.S. taxes. That implies that the company pays a tax rate of just 3 percent to foreign governments on those profits, suggesting that most of the cash is booked to tax havens. Microsoft ranks 4th for the amount of cash it reports offshore. A Wall Street Journal investigation found that over 90 percent of Microsoft “offshore” cash was actually invested by its offshore subsidiaries in U.S. assets like Treasuries, allowing for the company to benefit from the stability of the U.S. financial system without paying taxes on those profits.35

 

Measures to Stop Abuse of Offshore Tax Havens

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Strong action to prevent corporations from using offshore tax havens will not only restore basic fairness to the tax system, but will allevi­ate pressure on America’s budget deficit and improve the functioning of markets. Markets work best when companies thrive based on their innovation or productivity, rather than the ag­gressiveness of their tax accounting schemes.

Policymakers should reform the corporate tax code to end the incentives that encourage com­panies to use tax havens, close the most egre­gious loopholes, and increase transparency so that companies can’t use layers of shell compa­nies to shrink their tax burden.

End incentives to shift profits and jobs offshore.

  • The most comprehensive solution to end­ing tax haven abuse would be to no longer permit U.S. multinational corporations to indefinitely defer paying U.S. taxes on the profits they attribute to their foreign sub­sidiaries. Instead, they should pay U.S. taxes on them immediately. “Double taxation” is not a danger because the companies al­ready subtract any foreign taxes they’ve paid from their U.S. tax bill, and that would not change. Ending deferral would raise nearly $600 billion in tax revenue over ten years, according to the Joint Committee on Taxa­tion analysis of 2012 legislation.36

  • Reject a “territorial” tax system. Tax haven abuse would be worse under a system in which companies could temporarily shift profits to tax haven countries, pay minimal or no tax under those countries’ tax laws, and then freely use the profits in the Unit­ed States without paying any U.S. taxes. The Treasury Department estimates that switching to a territorial tax system could add $130 billion to the deficit over ten years.37

Close the most egregious offshore loopholes.

Policy makers can take some basic common-sense steps to curtail some of the most obvious and brazen ways that some companies abuse offshore tax havens.

  • Stop companies from licensing intellec­tual property (e.g. patents, trademarks, licenses) to shell companies in tax haven countries and then paying inflated fees to use them. This common practice allows companies to legally book profits that were earned in the U.S. to the tax haven sub­sidiary owning the patent. Proposals made by President Obama could save taxpayers $23.2 billion over ten years, according to the Joint Committee on Taxation.38
  • Treat the profits of publicly traded “for­eign” corporations that are managed and controlled in the United States as domestic corporations for income tax purposes.
  • Reform the so-called “check-the-box” rules to stop multinational companies from ma­nipulating how they define their corporate status to minimize their taxes. Right now, companies can make inconsistent claims to maximize their tax advantage, telling one country they are one type of corporate en­tity while telling another country the same entity is something else entirely.
  • Close the current loophole that allows U.S. companies that shift income to foreign subsidiaries to place that money in foreign branches of American financial institutions without it being considered repatriated, and thus taxable. This “foreign” U.S. in­come should be taxed when the money is deposited in U.S. financial institutions.
  • Stop companies from taking bigger tax credits than the law intends for the taxes they pay to foreign countries by reform­ing foreign tax credits. Proposals to “pool” foreign tax credits would save $58.6 bil­lion over ten years, according to the Joint Committee on Taxation.39
  • Stop companies from deducting interest expenses paid to their own offshore affili­ates, which put off paying taxes on that in­come. Right now, an offshore subsidiary of a U.S. company can defer paying taxes on interest income it collects from the U.S.-based parent, even while the U.S. parent claims those interest payments as a tax de­duction. This reform would save 51.4 bil­lion over ten years, according to the Joint Committee on Taxation.40

Increase transparency.

  • Require full and honest reporting to ex­pose tax haven abuse. Multinational cor­porations should report their profits on a country-by-country basis so they can’t mis­lead each nation about the share of their income that was taxed in the other coun­tries. An annual survey of CEOs around the globe done by PricewaterhouseCoo­pers found that nearly 60 percent of the CEOs support this reform.41

Methodology

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To calculate the number of tax haven subsid­iaries maintained by the Fortune 500 corpora­tions, we used the same methodology as a 2008 study by the Government Accountability Of­fice that used 2007 data (see endnote 4).

The list of 50 tax havens used is based on lists compiled by three sources using similar char­acteristics to define tax havens. These sources were the Organization for Economic Co-oper­ation and Development (OECD), the National Bureau of Economic Research, and a U.S. Dis­trict Court order. This court order gave the IRS the authority to issue a “John Doe” sum­mons, which included a list of tax havens and financial privacy jurisdictions.

The companies surveyed make up the 2013 Fortune 500, a list of which can be found here: http://money.cnn.com/magazines/fortune/fortune500/.

To figure out how many subsidiaries each company had in the 50 known tax havens, we looked at “Exhibit 21” of each company’s 2013 10-K report, which is filed annually with the Securities and Exchange Commission (SEC). Exhibit 21 lists out every reported subsidiary of the company and the country in which it is reg­istered. We used the SEC’s EDGAR database to find the 10-K filings.

We also used 10-K reports to find the amount of money each company reported it kept offshore in 2013. This information is typically found in the tax footnote of the 10-K. The companies disclose this information as the amount they keep “permanently reinvested” abroad.

As explained in this report, 55 of the compa­nies surveyed disclosed what their estimated tax bill would be if they repatriated the money they kept offshore. This information is also found in the tax footnote. To calculate the tax rate these companies paid abroad in 2013, we first divided the estimated tax bill by the total amount kept offshore. That number multiplied by 100 equals the U.S. tax rate the company would pay if they repatriated that foreign cash. Since companies receive dollar-for-dollar cred­its for taxes paid to foreign governments, the tax rate paid abroad is simply the difference be­tween 35%—the U.S. statutory corporate tax rate—and the tax rate paid upon repatriation.

 


End Notes

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1 Government Accountability Office, Business and Tax Ad­vantages Attract U.S. Persons and Enforcement Challenges Ex­ist, GAO-08-778, a report to the Chairman and Ranking Member, Committee on Finance, U.S. Senate, July 2008, http://www.gao.gov/highlights/d08778high.pdf.

2 Id.

3 Jane G. Gravelle, Congressional Research Service, Tax Ha­vens: International Tax Avoidance and Evasion, 4 June 2010.

4 Government Accountability Office, International Taxation; Large U.S. Corporations and Federal Contractors with Subsid­iaries in Jurisdictions Listed as Tax Havens or Financial Privacy Jurisdictions, December 2008.

5 Mark P. Keightley, Congressional Research Service, An Analysis of Where American Companies Report Profits: Indica­tions of Profit Shifting, 18 January, 2013.

6 Citizens for Tax Justice, American Corporations Report Over Half of Their Offshore Profits as Earned in 12 Tax Havens, 28 May 2014.

7 Offshore Funds Located On Shore, Majority Staff Report Ad­dendum, Senate Permanent Subcommittee on Investiga­tions, 14 December 2011, http://www.levin.senate.gov/newsroom/press/release/new-data-show-corporate-off­shore-funds-not-trapped-abroad-nearly-half-of-so-called-offshore-funds-already-in-the-united-states/.

8 Kate Linebaugh, “Firms Keep Stockpiles of ‘Foreign’ Cash in U.S.,” Wall Street Journal, 22 January 2013, http://on­line.wsj.com/article/SB10001424127887323284104578255663224471212.html.

9 Kitty Richards and John Craig, Offshore Corporate Prof­its: The Only Thing ‘Trapped’ Is Tax Revenue, Center for American Progress, 9 January, 2014, http://www.american­progress.org/issues/tax-reform/report/2014/01/09/81681/offshore-corporate-profits-the-only-thing-trapped-is-tax-revenue/.

10 Kimberly A. Clausing, “The Revenue Effects of Multina­tional Firm Income Shifting,” Tax Notes, 28 March 2011, 1560-1566.

11 Phineas Baxandall, Dan Smith, Tom Van Heeke, and Ben­jamin Davis. Picking up the Tab, U.S. PIRG, April 2014. http://uspirg.org/reports/usp/picking-tab-2014.

12 “China to Become World’s Second Largest Consumer Market”, Proactive Investors United Kingdom, 19 January, 2011 (Discussing a report released by Boston Consulting Group), http://www.proactiveinvestors.co.uk/columns/china-weekly-bulletin/4321/china-to-become-worlds-sec­ond-largest-consumer-market-4321.html.

13 The number of subsidiaries registered in tax havens is cal­culated by authors looking at exhibit 21 of the company’s 2013 10-K report filed annually with the Securities and Ex­change Commission. The list of tax havens comes from the Government Accountability Office report cited in note 5.

14 The amount of money that a company has booked offshore and the taxes the company would owe if they repatriated that income can also be found in the 10-K report; however, not all companies disclose the latter information.

15 See note 12.

16 Calculated by the authors based on revenue information from Pfizer’s 2012 10-K filing.

17 Audit Analytics, “Overseas Earnings of Russell 1000 Tops $2 Trillion in 2013,” 1 April 2014. http://www.audita­nalytics.com/blog/overseas-earnings-of-russell-1000-tops-2-trillion-in-2013/.

18 See note 6.

19 Kimberly A. Clausing, “Multinational Firm Tax Avoidance and Tax policy,” 62 Nat’l Tax J 703, December 2009; see note 10 for more recent study.

20 Citizens for Tax Justice, “Apple is not Alone” 2 June 2013, http://ctj.org/ctjreports/2013/06/apple_is_not_alone.php#.UeXKWm3FmH8.

21 Budget information comes from a database compiled by the National Association of State Budget Officers. California’s cur­rent budget is $97 billion http://www.ebudget.ca.gov/2013-14/pdf/Enacted/BudgetSummary/FullBudgetSummary.pdf; Vir­ginia’s current budget is $42 billion - https://solutions.virgin­ia.gov/pbreports/rdPage.aspx?rdReport=BDOC2014_Front­Page, Indiana’s current budget is $6.7 billion - http://www.in.gov/sba/files/AP_2013_0_0_2_Budget_Report.pdf. The three together add up to $145.7 billion.

22 See methodology for an explanation of how this was calculated.

23 Offshore Profit Shifting and the U.S. Tax Code—Part 2,Senate Permanent Subcommittee on Investigations, 21 May, 2013, http://www.hsgac.senate.gov/subcommittees/investigations/hearings/offshore-profit-shifting-and-the-us-tax-code_-part-2.

24 Companies get a credit for taxes paid to foreign govern­ments when they repatriate foreign earnings. Therefore, if companies disclose what their hypothetical tax bill would be if they repatriated “permanently reinvested” earnings, it is possible to deduce what they are currently paying to foreign governments. For example, if a company discloses that they would need to pay the full statutory 35% tax rate on its offshore cash, it implies that they are currently pay­ing no taxes to foreign governments, which would entitle them to a tax credit that would reduce the 35% rate. This method of calculating foreign tax rates was original used by Citizens for Tax Justice (see note 21).

25 Citizens for Tax Justice, “Nike’s Tax Haven Subsidiaries Are Named After Its Shoe Brands,” 25 July 2013, http://www.ctj.org/taxjusticedigest/archive/2013/07/nikes_tax_haven_subsidiaries_a.php#.U3y0Gijze2J.

26 Citizens for Tax Justice, “The Problem of Corporate In­versions: the Right and Wrong Approaches for Congress,” 14 May 2014, http://ctj.org/ctjreports/2014/05/the_prob­lem_of_corporate_inversions_the_right_and_wrong_ap­proaches_for_congress.php#.U3tavSjze2J.

27 Other consequences kick in for inversions involving 60‐79.9% of the same shareholders. This law is based on a 2002 bill introduced by Senator Charles Grassley (R-IA) and former Sen. Max Baucus (D-MT). See 26 U.S.C.§7874 (available at http://codes.lp.findlaw.com/uscode/26/F/80/C/7874/).

28 Treasury first defined “substantial business” in 2006 with a relatively loose bright line standard. That 2006 stan­dard was replaced in 2009 with a vague facts and cir­cumstances test and an intent to make inverting harder.Companies got comfortable with that approach too, how­ever, and resumed inverting. On June 7, 2012, Treasury issued new temporary rules creating a difficult-to-evade bright line test. Specifically, the new rules define substan­tial business as a minimum of 25 percent of an inverting company’s business. That is a hard threshold to meet if the main “business” in country is a post office box. But the rules go further by making the standard hard to game; the 25 percent has to be met in three different ways. Moreover, those measurements must be taken a year before the inver­sion, so the inversion process itself cannot be manipulated to meet the thresholds. For a more detailed discussion of the history of the interpretations, see Latham & Watkins Client Alert No. 1349, “IRS Tightens Rules on Corporate Expatriations—New Regulations Require High Threshold of Foreign Business Activity” June 12, 2012, http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=14&ved=0CFsQFjADOAo&url=http%3A%2F%2Fwww.lw.com%2FthoughtLeadership%2FIRSTightensRulesonCorporateExpatriations&ei=fPYmUIeDca36gG5q4GICg&usg=AFQjCNEMzRNjJYwoJtmyd4VJFDnap_hxA.

29 Citizens for Tax Justice, “The Problem of Corporate In­versions: the Right and Wrong Approaches for Congress,” 14 May 2014. http://ctj.org/ctjreports/2014/05/the_prob­lem_of_corporate_inversions_the_right_and_wrong_ap­proaches_for_congress.php#.U3tavSjze2J.

30 Zachary R. Mider, “Tax Break ‘Blarney’: U.S. Companies Beat the System with Irish Addresses,” Bloomberg News, 5 May 2014, http://www.bloomberg.com/news/2014-05-04/u-s-firms-with-irish-addresses-criticized-for-the-moves.html.

31 Jeffrey Gramlich and Janie Whiteaker-Poe, “Disappear­ing subsidiaries: The Cases of Google and Oracle,” March 2013, Working Paper available at SSRN, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2229576.

32 See note 25.

33 See note 27.

34 Jesse Drucker, “Google Joins Apple Avoiding Taxes with Stateless Income,” Bloomberg News, 22 May 2013, http://www.bloomberg.com/news/2013-05-22/google-joins-ap­ple-avoiding-taxes-with-stateless-income.html.

35 See note 14.

36 “Fact Sheet on the Sanders/Schakowsky Corporate Tax Fairness Act,” February 7, 2012, http://www.sanders.sen­ate.gov/imo/media/doc/CORPTA%20FAIRNESSFACT­SHEET.pdf.

37 The President’s Economic Recovery Board, The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation, August 2010, http://www.treasury.gov/resource-center/tax-policy/Documents/PERAB-Tax-Reform-Re­port-8-2010.pdf.

38 Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions Contained in the President’s Fiscal Year 2015 Budget Proposal,” April 15, 2015, https://www.jct.gov/publications.html?func=startdown&id=4585.

39 Id.

40 Id.

41 Cited in Tom Bergin, “CEOs back country-by-country tax reporting—survey,” Reuters, 23 April 2014. http://uk.reuters.com/article/2014/04/23/uk-taxcompanies-idUKBREA3M18I20140423.

 

 

American Corporations Tell IRS the Majority of Their Offshore Profits Are in 12 Tax Havens

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A few days after Americans filed their tax returns last month, the Internal Revenue Service released data on the offshore subsidiaries of U.S. corporations. The data demonstrate, in an indirect way, that these companies are not playing by the same rules as the rest of us.

The figures show how much profit American corporations tell the IRS that their subsidiaries have earned in each foreign country. Amazingly, American corporations reported to the IRS that the profits their subsidiaries earned in 2010 in Bermuda, the Cayman Islands, the British Virgin Islands, the Bahamas and Luxembourg were greater than the entire gross domestic product (GDP) of those nations in that year.

It is obviously impossible for American corporations to actually earn profits in a given country that exceed that country’s total output of goods and services. Clearly, American corporations are using various tax gimmicks to shift profits actually earned in the U.S. and other countries where they actually do business into their subsidiaries in these tiny countries. This is not surprising, given that these countries impose little or no tax on corporate profits.

Besides the five countries just mentioned, the data also indicate that other countries also serve as tax havens for American multinational corporations. For example, American corporations report to the IRS that the profits their subsidiaries earned in Switzerland were equal to 9 percent of Switzerland’s GDP. This is a much higher share of GDP than the profits reported in more significant European countries: about half a percent of GDP in Germany and France, and 3 percent in the United Kingdom. This suggests that American corporations are exaggerating how much of their profits are earned in Switzerland, which is not surprising given that some corporations are able to obtain very low tax rates in that country.

The dozen countries with the highest reported American offshore corporate profits as a percentage of their GDP in 2010 had only four percent of the total GDP for all the foreign countries included in the IRS figures. But American corporations report to the IRS that 54 percent of their offshore subsidiary profits were earned in these tax-haven countries. This is obviously impossible. The only plausible conclusion is that American corporations are engaging in various accounting gimmicks to make large amounts of their profits appear, for tax purposes, to be earned in these dozen tax-haven countries. 

These 12 countries have either zero tax rates or provide loopholes that allow corporate profits to go largely untaxed in many circumstances. The two columns on the right side of the table on page one show the amount of corporate income taxes paid on the subsidiary profits to the country where they were supposedly earned or any other foreign country. This is shown first as a dollar figure and then as a percentage of the profits supposedly earned in that country.

There are apparently foreign income taxes paid on some profits even in countries known to have a zero corporate tax rate like Bermuda or the Cayman Islands. This may often occur because the profits are shifted from a subsidiary in another foreign country that imposes some tax on profits when they are shifted to a tax haven country. Overall, however, these subsidiary corporations are able to avoid paying almost any taxes. The effective rate of foreign taxes paid on subsidiary profits in the dozen countries was only 7 percent.[1]

The U.S. allows its corporations to defer paying U.S. corporate income taxes on profits of their offshore subsidiaries until those profits are officially “repatriated” (officially brought to the U.S.). This creates an incentive for American corporations to engage in accounting gimmicks to make their U.S. profits appear to be earned in countries where they will not be taxed. These data demonstrate that this is happening on a large scale. In fact, American corporations reported that more than half a trillion dollars of their profits were earned, for tax purposes, in the 12 tax haven countries shown in the table.

Amazingly, some lawmakers are calling for even greater tax breaks for the offshore profits of American corporations. Some proposals would largely exempt previously accumulated offshore profits from U.S. taxes on an (allegedly) one-time basis (often called a “repatriation holiday”). Others would provide a permanent exemption (often called a “territorial tax system”). Perhaps these lawmakers do not realize that over half of the profits that American corporations claim their subsidiaries earn offshore — over half of the profits that could benefit from such new tax breaks — are reported by the companies to have been earned in 12 obvious tax havens.

Corporate profits that are genuinely earned through real business activities abroad are typically subject to taxes in the countries where they are earned, and if they are repatriated, the U.S. tax that is due is reduced by whatever amount of tax was paid to foreign governments. For this reason, the only offshore profits that are potentially subject to nearly the full 35 percent U.S. tax rate upon repatriation are those artificially shifted to tax havens. Companies engaging in these tax-avoidance games would therefore be the main beneficiaries of a repatriation holiday or territorial system.

Congress could end this corporate tax avoidance in a straightforward way by ending the rule allowing American corporations to defer paying U.S. taxes on their offshore subsidiary profits. They would still be allowed to reduce their U.S. income tax bill by whatever amount of tax was paid to foreign governments, in order to avoid double-taxation. But there would no longer be any reason to artificially shift profits into tax havens because all profits of American corporations, whether earned in the U.S. or in any other country, would be taxed at least at the U.S. corporate tax rate in the year they are earned.   

 


[1] The Tax Foundation recently issued a report stating that the “effective tax rate on foreign income was 27.2 percent in 2010, prior to paying additional taxes to the United States,” but that report only examines those offshore subsidiary profits actually repatriated to the U.S. Of course, the offshore profits most likely to be repatriated are those that were taxed at relatively high rates by foreign countries, because these profits generate the largest foreign tax credits that reduce the U.S. tax that would be due upon repatriation. For the same reason, tax haven profits, which generate little or no foreign tax credits, are not as likely to be repatriated. In other words, the Tax Foundation report simply excludes tax haven profits from its analysis of foreign taxes paid on subsidiary profits. See Kyle Pomerleau, “How Much Do U.S. Multinational Corporations Pay in Foreign Income Taxes?,” Tax Foundation, May 19, 2014.

Dozens of Companies Admit Using Tax Havens

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Hundreds More Likely Do the Same, Avoiding $550 Billion in U.S. Taxes

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American Fortune 500 corporations are likely saving about $550 billion by holding nearly $2 trillion of “permanently reinvested” profits offshore. Twenty-eight of these corporations reveal that they have paid an income tax rate of 10 percent or less to the governments of the countries where these profits are officially held, indicating that most of these profits are likely in offshore tax havens.

While congressional hearings over the past few years have focused attention on the tax avoidance strategies of technology corporations like Apple and Microsoft, this report shows that a diverse array of companies are using offshore tax havens, including U.S. Steel, the pharmaceutical giant Eli Lilly, the apparel manufacturer Nike, the supermarket chain Safeway, the financial firm American Express, and banking giants Bank of America and Wells Fargo.

How We Know When Multinationals’ Offshore Cash is Largely in Tax Havens

Some American multinational corporations complain to members of Congress that their offshore profits would be taxed at the U.S. corporate income tax rate of 35 percent if those profits were subject to U.S. taxes. However, this can only be true if those profits are mostly held in tax havens — countries in which they are subject to little or no corporate tax.

The general rule is that offshore profits that an American corporation “repatriates” (officially brings back to the United States) are subject to the U.S. tax rate of 35 percent minus a tax credit equal to whatever taxes were paid to foreign governments. Thus, if an American corporation says it would pay a U.S. tax rate of 25 percent or more on its offshore profits, that means it has paid foreign governments a tax rate of 10 percent or less.

Twenty-eight American corporations have acknowledged paying less than a 10 percent foreign tax rate on the $409 billion they collectively hold offshore. The table on the following page shows the disclosures made by these 28 corporations in their most recent annual financial reports.

It is almost always the case that profits reported by corporations to the IRS as earned in tax havens were actually earned in the United States or another country with a tax system similar to ours.  Most economically developed countries (most of the countries where there are real business opportunities for American corporations) have a corporate income tax rate of at least 20 percent and rates are typically higher than that. The countries that have no corporate income tax or a very low corporate tax — countries like Bermuda, the Cayman Islands, and the Bahamas — provide very little in the way of real business opportunities for American corporations like U.S. Steel, Safeway, and Microsoft. But large Americans corporations use accounting gimmicks (most of which are, unfortunately, allowed under current law) to make profits appear to be earned in tax haven countries.

Hundreds of Other Fortune 500 Corporations Don’t Disclose This Information

These 28 companies are not alone in shifting their profits to low-tax havens—they’re only alone in disclosing it. A total of 301 Fortune 500 corporations have disclosed, in their most recent financial reports, holding some of their income as “permanently reinvested” offshore profits. At the end of 2013, these permanently reinvested earnings totaled a whopping $1.95 trillion. (A full list of these 301 corporations is published as an appendix to this paper.) Yet the vast majority of these companies — 243 out of 301 —decline to disclose the U.S. tax rate they would pay if these offshore profits were repatriated. (58 corporations, including the 28 companies shown on this page, disclose this information. A full list of the 58 companies is published as an appendix to this paper.) The non-disclosing companies collectively hold $1.4 trillion in unrepatriated offshore profits at the end of 2013.

Accounting standards require publicly held companies to disclose the U.S. tax they would pay upon repatriation of their offshore profits — but these standards also provide a loophole allowing companies to assert that calculating this tax liability is “not practicable.”  Almost all of the 243 non-disclosing companies use this loophole to avoid disclosing their likely tax rates upon repatriation — even though these companies almost certainly have the capacity to estimate these liabilities.

20 of the Biggest “Non-Disclosing” Companies Hold $801 Billion Offshore

While hundreds of companies refuse to disclose the tax they likely owe on their offshore cash, just a handful of these companies account for the lion’s share of the permanently reinvested foreign profits in the Fortune 500. The nearby table shows the 20 non-disclosing companies with the biggest offshore stash at the end of the most recent fiscal year. These 20 companies held $801 billion in unrepatriated offshore income — more than half of the total income held by the 243 “non-disclosing” companies. Most of these companies also disclose, elsewhere in their financial reports, owning subsidiaries in known tax havens. For example:

General Electric disclosed holding $110 billion offshore at the end of 2013. GE has subsidiaries in the Bahamas, Bermuda, Ireland and Singapore, but won’t disclose how much of its offshore cash is in these low-tax destinations. [Some of it is clearly there; see text box below.]

Pfizer has subsidiaries in Bermuda, the Cayman Islands, Ireland, the Isle of Jersey, Luxembourg and Singapore, but does not disclose how much of its $69 billion in offshore profits are stashed in these tax havens.

Merck has12 subsidiaries in Bermuda alone. It’s unclear how much of its $57 billion in offshore profits are being stored (for tax purposes) in this tiny island.

Even “Non-Disclosers” Slip Up Sometimes
As noted above, General Electric does not disclose the U.S. tax it would owe if its $110 billion offshore stash was repatriated. But in its 2009 annual report, GE noted that it had reclassified $2 billion of previously earned foreign profits as “permanently reinvested” offshore, and said that this change resulted “in an income tax benefit of $700 million.” Since $700 million is 35 percent of $2 billion, this is an admission that the expected foreign tax rate on this $2 billion of offshore cash was exactly zero, which in turn strongly suggests that GE’s “permanent reinvestment” plan for this $2 billion involved assigning it to one of its tax haven subsidiaries.

Even “Non-Disclosers” Slip Up Sometimes

As noted above, General Electric does not disclose the U.S. tax it would owe if its $110 billion offshore stash was repatriated. But in its 2009 annual report, GE noted that it had reclassified $2 billion of previously earned foreign profits as “permanently reinvested” offshore, and said that this change resulted “in an income tax benefit of $700 million.” Since $700 million is 35 percent of $2 billion, this is an admission that the expected foreign tax rate on this $2 billion of offshore cash was exactly zero, which in turn strongly suggests that GE’s “permanent reinvestment” plan for this $2 billion involved assigning it to one of its tax haven subsidiaries.

Time is of the Essence

While the $2 trillion in offshore profits detailed in the appendix has grown gradually over the past decade, there are two reasons why it is vital that Congress act promptly to deal with this problem. First, a large number of the biggest corporations appear to be increasing their offshore cash significantly. 105 of the companies surveyed in this report increased their declared offshore cash by at least $500 million each in the last year alone. Eight particularly aggressive companies each increased their permanently reinvested foreign earnings by more than $5 billion in the past year. These include Apple, Microsoft, IBM, Google, and Cisco.

A second reason for concern is that there is some evidence companies are aggressively seeking to permanently shelter their offshore cash from U.S. taxation by engaging in corporate inversions, through which companies acquire smaller foreign companies and reincorporate in foreign countries, thus avoiding most or all U.S. tax on their profits. Drug giant Pfizer is currently attempting this move.

Hundreds of Billions in Tax Revenue at Stake

It’s impossible to know precisely how much income tax would be paid, under current tax rates, upon repatriation by the 243 Fortune 500 companies that have disclosed holding profits overseas but have failed to disclose how much U.S. tax would be due if the profits were repatriated. But if these companies paid the same 28 percent average tax rate as the 58 disclosing companies, the resulting one-time tax would total $403 billion for these 243 companies. Added to the $148 billion tax bill estimated by the 58 companies who did disclose, this means that taxing all “permanently reinvested” foreign income of the 301 companies at the current federal tax rate could result in more than $550 billion in added corporate tax revenue.

What Should Be Done?

Many large multinationals that fail to disclose whether their offshore profits are officially in tax havens are the same companies that have lobbied heavily for tax breaks on their offshore cash. These companies propose either to enact a temporary “tax holiday” for repatriation, under which companies officially bringing offshore profits back to the U.S. would pay a very low tax rate on the repatriated income, or a permanent exemption for offshore income in the form of a “territorial” tax system. Either of these proposals would actually increase the incentive for multinationals to shift their U.S. profits, on paper, into tax havens.

A far more sensible solution would be to simply end “deferral,” that is, repealing the rule that indefinitely exempts offshore profits from U.S. income tax until these profits are repatriated. Ending deferral would mean that all profits of U.S. corporations, whether they are generated in the U.S. or abroad, would be taxed by the United States in the year they are earned. Of course, American corporations would continue to receive a “foreign tax credit” against any taxes they pay to foreign governments, to ensure profits are not double-taxed. 

Conclusion

The limited disclosures made by Apple and a handful of other Fortune 500 corporations show that they have moved profits into tax havens — and that some have managed to avoid virtually all taxes on these profits. But the scope of this tax avoidance is likely much larger, since the vast majority of Fortune 500 companies with offshore cash refuse to disclose how much tax they would pay on repatriating their offshore profits.

Lawmakers should resist calls for tax changes, such as repatriation holidays or a territorial tax system, that would reward U.S. companies for shifting their profits to tax havens. If the Securities and Exchange Commission required more complete disclosure about multinationals’ offshore profits, it would become obvious that Congress should end deferral, thereby eliminating the incentive for multinationals to shift their profits offshore once and for all. 

Why the Senate's Tax Extenders Bill Is a Travesty, and How It Can Be Made Tolerable

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The Senate is likely to approve a bill often called the “tax extenders” because it would extend dozens of tax breaks, mostly benefiting corporations and other businesses, for two years. This bill would increase the deficit by $85 billion over the coming decade, but the number everyone should be concerned with is much bigger — over $700 billion. That’s the increase in the deficit that would result if Congress stays on its current course of extending these tax breaks every two years over the coming decade. The Senate has given every indication that this is the direction it’s headed in.

One problem is that lawmakers are willing to increase the deficit in order to hand out tax subsidies like the tax extenders to corporations and other businesses, even while they insist that any benefits for working families or the unemployed must be somehow paid for in order to avoid an increase in the deficit. Another problem is that most of the tax cuts that are part of the tax extenders are themselves bad policy. Both of these problems could be solved, or at least mitigated, by amending the legislation to include various loophole-closing provisions and reforms that are described in this report.

I. Congressional Hypocrisy in Insisting on Offsetting the Cost of Helping Working Families, but Increasing the Deficit to Help Corporations and Other Businesses

If lawmakers insist that the cost of any assistance for low- and middle-income working families must be offset to avoid an increase in the deficit, then it would be reasonable for lawmakers to offset the cost of any legislation providing business tax breaks by closing existing tax loopholes that businesses enjoy. Unfortunately, that’s not the approach Congress has taken. 

In the past several months, Congress made clear that it will not enact an extension of emergency unemployment benefits (which have never been allowed to expire while the unemployment rate was as high as today’s level) unless the costs are offset to prevent an increase in the budget deficit.[1] The bill approved by the Senate earlier this year to extend those benefits through May included provisions to offset the cost, which is $10 billion.

Congress has also, in the last several years, enacted automatic spending cuts of about $109 billion a year known as “sequestration” in order to address an alleged budget crisis. Even popular public investments like Head Start and medical research were slashed. The chairman of the House and Senate Budget Committees (Republican Paul Ryan and Democrat Patty Murray) struck a deal in December that undoes some of that damage but leaves in place most of the sequestration for 2014 and barely touches it in 2015.[2]

Meanwhile, lawmakers have expressed almost no concern that the “tax extenders” are enacted every two years without any provisions to offset the costs. According to figures from the Congressional Budget Office, if Congress continues to extend these breaks every couple years, they will reduce revenue more than $700 billion over a decade.[3]

II. The Tax Extenders Are Mostly Bad Policy

Often a lawmaker or a special interest group will argue that the tax extender legislation should be enacted because it includes some provision that seems well-intentioned but makes up only a tiny fraction of the cost of the overall package of tax breaks.

For example, some support the deduction for teachers who purchase classroom supplies out of their own pockets. Never mind that this provides a tiny benefit that hardly excuses the absurdity that teachers are forced to purchase school supplies with their own money. (A school teacher in the 15 percent income tax bracket saves less than $40 a year under this provision). The important point is that this break makes up just 0.3 percent of the cost of the tax extenders package. This meager provision that supposedly helps teachers cannot possibly be the justification for enacting over $700 billion worth of tax cuts that mostly go to corporations and businesses.

The same is true for other provisions included among the tax extenders that are often cited as important benefits for ordinary Americans. One provision often cited is the exclusion of mortgage debt forgiveness from taxable income. Regardless of what one thinks about this policy, it cannot possibly justify enacting the entire package of provisions, given that it makes up just two percent of the costs. 

The most costly three provisions among the tax extenders — bonus depreciation, the research credit, and the so-called “active financing exception” — make up 58 percent of the total cost of the package and yet do not seem to be designed to actually help the economy, as discussed below. The fourth most costly break, small business expensing, is unlikely to boost small businesses in the way that its proponents claim, although at least very large companies are restricted from using it. The fifth most costly provision is the deduction for state and local sales taxes, which supposedly is important to the nine states that do not have state income taxes, meaning their residents get no advantage from the existing federal deduction for state income taxes. But the reality is that most of the residents in those states do not benefit. Many of the other tax extenders are either poor policy or subsidies that could more sensibly be provided through direct spending.

It would be difficult for anyone (particularly a member of Congress) to understand all of the provisions, which number over 50. Below is a description of the most significant provisions which make up the vast majority of the cost of the legislation.

 

Bonus Depreciation
$296.4 billion

Bonus depreciation is a significant expansion of existing breaks for business investment. Unfortunately, Congress does not seem to understand that business people make decisions about investing and expanding their operations based on whether or not there are customers who want to buy whatever product or service they provide. A tax break subsidizing investment will benefit those businesses that would have invested anyway but is unlikely to result in much, if any, new investment.

Companies are allowed to deduct from their taxable income the expenses of running the business, so that what’s taxed is net profit. Businesses can also deduct the costs of purchases of machinery, software, buildings and so forth, but since these capital investments don’t lose value right away, these deductions are taken over time. In other words, capital expenses (expenditures to acquire assets that generate income over a long period of time) usually must be deducted over a number of years to reflect their ongoing usefulness.

In most cases firms would rather deduct capital expenses right away rather than delaying those deductions, because of the time value of money, i.e., the fact that a given amount of money is worth more today than the same amount of money will be worth if it is received later. For example, $100 invested now at a 7 percent return will grow to $200 in ten years.

Bonus depreciation is a temporary expansion of the existing breaks that allow businesses to deduct these costs more quickly than is warranted by the equipment’s loss of value or any other economic rationale.

A report from the Congressional Research Service reviews efforts to quantify the impact of bonus depreciation and explains that “the studies concluded that accelerated depreciation in general is a relatively ineffective tool for stimulating the economy.”[4]

Research Tax Credit
$77 billion

A report from Citizens for Tax Justice explains that the research credit needs to be reformed dramatically or allowed to expire.[5] One aspect of the credit that needs to be reformed is the definition of research. As it stands now, accounting firms are helping companies obtain the credit to subsidize redesigning food packaging and other activities that most Americans would see no reason to subsidize. The uncertainty about what qualifies as eligible research also results in substantial litigation and seems to encourage companies to push the boundaries of the law and often cross them.

Another aspect of the credit that needs to be reformed is the rules governing how and when firms obtain the credit. For example, Congress should bar taxpayers from claiming the credit on amended returns, because the credit cannot possibly be said to encourage research if the claimant did not even know about the credit until after the research was conducted.

As it stands now, some major accounting firms approach businesses and tell them that they can identify activities the companies carried out in the past that qualify for the research credit, and then help the companies claim the credit on amended tax returns. When used this way, the credit obviously does not accomplish the goal of increasing the amount of research conducted by businesses.

Active Financing Exception (aka GE Loophole)
$70.8 Billion

“Subpart F” of the tax code attempts to bar American corporations from “deferring” (delaying) paying U.S. taxes on certain types of offshore profits that are easily shifted out of the United States, such as interest income. The “active financing” exception to subpart F allows American corporations to defer paying taxes on offshore income even though such income is often really earned in the U.S. or other developed countries, but has been artificially shifted into an offshore tax haven in order to avoid taxes.

The “active financing” exception should never be a part of the tax code.

The U.S. technically taxes the worldwide corporate profits, but American corporations can “defer” (delay indefinitely) paying U.S. taxes on “active” profits of their offshore subsidiaries until those profits are officially brought to the U.S. “Active” profits are what most ordinary people would think of as profits earned directly from providing goods or services.

“Passive” profits, in contrast, include dividends, rents, royalties, interest and other types of income that are easier to shift from one subsidiary to another. Subpart F tries to bar deferral of taxes on such kinds of offshore income. The so-called “active financing exception” makes an exception to this rule for profits generated by offshore financial subsidiaries doing business with offshore customers.

The active financing exception was repealed in the loophole-closing1986 Tax Reform Act, but was reinstated in 1997 as a “temporary” measure after fierce lobbying by multinational corporations. President Clinton tried to kill the provision with a line-item veto; however, the Supreme Court ruled the line-item veto unconstitutional and reinstated the exception. In 1998 it was expanded to include foreign captive insurance subsidiaries. It has been extended numerous times since 1998, usually for only one or two years at a time, as part of the tax extenders.

As explained in a report from Citizens for Tax Justice, the active financing exception provides a tax advantage for expanding operations abroad. It also allows multinational corporations to avoid tax on their worldwide income by creating “captive” foreign financing and insurance subsidiaries.[6] The financial products of these subsidiaries, in addition to being highly fungible and highly mobile, are also highly susceptible to manipulation or “financial engineering,” allowing companies to manipulate their tax bill as well.

As the report explains, the exception is one of the reasons General Electric paid, on average, only a 1.8 percent effective U.S. federal income tax rate over ten years. G.E.’s federal tax bill is lowered dramatically with the use of the active financing exception provision by its subsidiary, G.E. Capital, which Forbes noted has an “uncanny ability to lose lots of money in the U.S. and make lots of money overseas.”[7]

Section 179 Small Business Expensing
$69.3 billion

Congress has showered businesses with several types of depreciation breaks, that is, breaks allowing firms to deduct the cost of acquiring or developing a capital asset more quickly than that asset actually wears out. There are massive accelerated depreciation breaks that are a permanent part of the tax code as well as many that are (at least officially) temporary, like bonus depreciation (which has already been described) and section 179. Section 179 allows smaller businesses to write off most of their capital investments immediately (up to certain limits).

A report from the Congressional Research Service reviews efforts to quantify the impact of depreciation breaks and explains that “the studies concluded that accelerated depreciation in general is a relatively ineffective tool for stimulating the economy.”[8]

One positive thing that can be said about section 179 is that it is more targeted towards small business investment than any of the other tax breaks that are alleged to help small businesses.

Section 179 allows firms to deduct the entire cost of a capital purchase (to “expense” the cost of a capital purchase) up to a limit. The most recent tax extenders package included provisions that allowed expensing of up to $500,000 of purchases of certain capital investments (generally, equipment but not land or buildings). The deduction is reduced a dollar for each dollar of capital purchases exceeding $2 million, and the total amount expensed cannot exceed the business income of the taxpayer.

These limits mean that section 179 generally does not benefit large corporations like General Electric or Boeing, even if the actual beneficiaries are not necessarily what ordinary people think of as “small businesses.” 

There is little reason to believe that business owners, big or small, respond to anything other than demand for their products and services. But to the extent that a tax break could possibly prod small businesses to invest, section 179 is somewhat targeted to accomplish that goal.

Deduction for State and Local Sales Taxes
$33.7 billion

Permanent provisions in the federal personal income tax allow taxpayers to claim itemized deductions for property taxes and income taxes paid to state and local governments. Long ago, a deduction was allowed for state and local sales taxes, but that was repealed as part of the 1986 tax reform. In 2004, the deduction for sales taxes was brought back temporarily and extended several times since then.

Because the deduction for state and local sales taxes cannot be taken along with the deduction for state and local income taxes, in most cases, taxpayers will take the sales tax deduction only if they live in one of the handful of states that have no state income tax.

Taxpayers can keep their receipts to substantiate the amount of sales taxes paid throughout the year, but in practice most people use rough calculations provided by the IRS for their state and income level. People who make a large purchase, such as a vehicle or boat, can add the tax on such purchases to the IRS calculated amount.

There are currently nine states that have no broad-based personal income tax and rely more on sales taxes to fund public services. Politicians from these states argue that it’s unfair for the federal government to allow a deduction for state income taxes, but not for sales taxes. But this misses the larger point. Sales taxes are inherently regressive and this deduction cannot remedy that since it is itself regressive.

To be sure, lower-income people pay a much higher percentage of their incomes in sales taxes than the wealthy. But lower-income people also are unlikely to itemize deductions and are thus less likely to enjoy this tax break. In fact, the higher your income, the more the deduction is worth, since the amount of tax savings depends on your tax bracket.

The table above includes taxpayer data from the IRS for 2011, the most recent year available, along with data generated from the Institute on Taxation and Economic Policy (ITEP) tax model to determine how different income groups would be affected by the deduction for sales taxes in the context of the federal income tax laws in effect today.

As illustrated in the table, people making less than $60,000 a year who take the sales-tax deduction receive an average tax break of just $100, and receive less than a fifth of the total tax benefit. Those with incomes between $100,000 and $200,000 enjoy a break of almost $500 and receive a third of the deduction, while those with incomes exceeding $200,000 save $1,130 and receive just over a fourth of the total tax benefit.

Renewable Electricity Production Tax Credit
$28.4 billion

The renewable electricity production tax credit (PTC) subsidizes the generation of electricity from wind and other renewable sources. The credit is 2.3 cents per kilowatt for electricity generated from wind turbines and less for energy produced by other types of renewable sources.

First created in 1992, the PTC is one tax extender that may actually expire. It has been criticized by many conservative lawmakers and organizations that tend to not object to other tax extenders, perhaps because they see wind energy as a competitor to fossil fuels.[9]

Unlike most other tax extenders, the PTC was last extended for only one year. However, the cost estimate for the PTC was larger than usual at that time because that law also expanded the PTC by allowing wind turbines (and other such facilities) to qualify so long as their construction began during 2013, whereas before the turbines had to be up and running by the end of the year.

Controlled Foreign Corporations Look-Through Rule (aka Apple Loophole)
$20.3 billion

Another exception to the general Subpart F rules requiring current taxation of passive income, the “CFC look-thru rules” allow a U.S. multinational corporation to defer tax on passive income, such as royalties, earned by a foreign subsidiary (a “controlled foreign corporation” or “CFC”) if the royalties are paid to that subsidiary by a related CFC and can be traced to the active income of the payer CFC.[10]

The closely watched Apple investigation by the Senate Permanent Subcommittee on Investigations a year ago resulted in a memorandum — signed by the subcommittee’s chairman and ranking member, Carl Levin and John McCain — that listed the CFC look-through rule as one of the loopholes used by Apple to shift profits abroad and avoid U.S. taxes.[11]

Tax Credit for Residential Energy Efficiency
$18.5 billion

The section 25C tax credit for energy improvements is capped at $500 and can go towards the costs of improving doors, windows, insulation, roofing or other improvements that make a home more energy efficient. While this is a perfectly reasonable role for the federal government to play, there is no obvious reason why it is best carried out through the tax code.

Work Opportunity Tax Credit
$16.4 billion

The Work Opportunity Tax Credit ostensibly helps businesses hire welfare recipients and other disadvantaged individuals. But a report from the Center for Law and Social Policy concludes that it mainly provides a tax break to businesses for hiring they would have done anyway:[12]

WOTC is not designed to promote net job creation, and there is no evidence that it does so. The program is designed to encourage employers to increase hiring of members of certain disadvantaged groups, but studies have found that it has little effect on hiring choices or retention; it may have modest positive effects on the earnings of qualifying workers at participating firms. Most of the benefit of the credit appears to go to large firms in high turnover, low-wage industries, many of whom use intermediaries to identify eligible workers and complete required paperwork. These findings suggest very high levels of windfall costs, in which employers receive the tax credit for hiring workers whom they would have hired in the absence of the credit.

15-Year Cost Recovery Break for Leasehold, Restaurants, and Retail
$16.2 billion

As already explained, Congress has showered all sorts of businesses with breaks that allow them to deduct the cost of developing capital assets more quickly than they actually wear out. This particular tax extender allows certain businesses to write off the cost of improvements made to restaurants and stores over 15 years rather than the 39 years that would normally be required.

It is unclear why helping restaurant owners and store owners improve their properties should be seen as more important than nutrition and education for low-income children or unemployment assistance or any of the other benefits that lawmakers insist cannot be enacted if they increase the deficit.

Deduction for Tuition and Related Expenses
$2.4 billion

The deduction for tuition and related expenses is not among the larger tax extenders, but it’s worth understanding because it is one of the provisions that lawmakers sometimes cite a reason to support the tax extenders legislation. Given that this deduction makes up only 0.3 percent of the cost of the entire tax extenders legislation, it cannot possibly be justification for supporting the legislation.

The deduction for tuition and related expenses is also bad policy. It is the most regressive tax break for postsecondary education. The distribution of tax breaks for postsecondary education among income groups is important because if their purpose is to encourage people to obtain education, they will be more effective if they are targeted to lower-income households that could not otherwise afford college rather than well-off families that will send their kids to college no matter what.

The graph below was produced by the Center for Law and Social Policy (CLASP) using data from the Tax Policy Center, and compares the distribution of various tax breaks for postsecondary education as well as Pell Grants.

The graph illustrates that not all tax breaks for postsecondary education are the same, and the deduction for tuition and related expenses is the most regressive of the bunch. Some of these tax breaks are more targeted to those who really need them, although none are nearly as well-targeted to low-income households as Pell Grants. Tax cuts for higher education taken together are not well-targeted, as illustrated in the bar graph below.

Americans paying for undergraduate education for themselves or their kids in 2009 or later generally have no reason to use the deduction because starting that year another break for postsecondary education was expanded and became more advantageous. The more advantageous tax break is the American Opportunity Tax Credit (AOTC), which has a maximum value of $2,500. The deduction for tuition and related expenses, in contrast, can be taken for a maximum of $4,000, and since it’s a deduction that means the actual tax savings for someone in the 25 percent income tax bracket cannot be more than $1000.

 

The AOTC is more generous across the board. Under current law, the AOTC is phased out for married couples with incomes between $160,000 and $180,000, whereas the deduction for tuition and related expenses is phased out for couples with incomes between $130,000 and $160,000. For moderate-income families, the AOTC is more beneficial because it is a credit rather than a deduction. The working families who pay payroll and other taxes but earn too little to owe federal income taxes — meaning they cannot use many tax credits — benefit from the AOTC’s partial refundability (up to $1,000).

Given that a taxpayer cannot take both the AOTC and the deduction, why would anyone ever take the deduction? The AOTC is available only for four years, which means it would normally be used for undergraduate education, while the deduction could be used for graduate education or in situations in which undergraduate education takes longer than four years. The deduction can also be used for students who enroll for only a class or two, while the AOTC is also only available to students enrolled at least half-time for an academic period during the year.

Even for graduate students and others in extended education, under current law the Lifetime Learning Credit (LLC) is generally a better deal than the tuition and expenses deduction. Because the upper income limit for the LLC is lower — $124,000 if married, $62,000 if single, the tuition and expenses deduction primarily benefits taxpayers paying for graduate school or other lifetime learning whose income is above these thresholds.

III. How the Tax Extenders Bill Could Be Made Tolerable with Amendments

In a rational world, lawmakers who feel compelled to enact the tax extenders would at least amend the legislation to offset the cost and make some of the tax policies more effective or less harmful to the U.S. economy.

Some potential amendments would mainly accomplish the first goal, offsetting the costs of the tax extenders, without affecting the operation of the tax extenders provisions themselves. Other potential amendments would improve or mitigate the tax extenders themselves.

Example of Amendments that Would Offset Cost of Tax Extenders

The following example describes three proposals from the president’s budget that would crack down on offshore tax avoidance by corporations and would, combined, raise nearly $80 billion over a decade, which is almost enough to offset the $85 billion cost of the Senate’s legislation to extend the package of tax breaks for two years.[13]

One obvious place to start closing corporate tax loopholes would be to enact the President’s proposal to crack down on corporate “inversions,” in which an American corporation reincorporates itself as a “foreign” company, without changing much about where it actually does business, simply to avoid U.S. taxes. This is likely on lawmakers’ minds because of news that inversions may be pursued by the pharmaceutical giant Pfizer and the drug store chain Walgreen Co.[14]

A loophole in current law allows the entity resulting from the merger of a U.S. corporation and a foreign corporation to be considered a “foreign” company even if it is 80 percent owned by shareholders of the American corporation, and even if most of the business activity and headquarters of the resulting entity are in the U.S. The President’s proposal would treat the resulting entity as a U.S. corporation for tax purposes if the majority (rather than over 80 percent) of the ownership is unchanged or if it has substantial business in the U.S. and is managed in this country. The president’s proposal is projected to raise $17.3 billion over a decade.

Another proposal in the president’s budget would address “earnings-stripping.” Corporate inversions are often followed by earnings-stripping, which makes U.S. profits appear, on paper, to be earned offshore. Corporations load the American part of the company with debt owed to the foreign part of the company. The interest payments on the debt are tax deductible, officially reducing American profits, which are effectively shifted to the foreign part of the company. The president’s proposal would address earnings-stripping by barring American companies from taking deductions for interest payments that are disproportionate to their revenue compared to their affiliated companies in other countries. This proposal is projected to raise $40.9 billion over a decade.

Another proposal in the president’s budget would tax excess returns from intangible property (like patents or copyrights) transferred to very low-tax countries, in order to crack down on the type of tax avoidance pharmaceutical companies like Pfizer and tech companies engage in.[15] There is already a category of offshore income (including interest and other passive income) for which U.S. corporations are not allowed to defer U.S. taxes. This proposal would, reasonably, add to that category “excess foreign income” (with “excess” defined as a profit rate exceeding 50 percent) from intangible property like trademarks, patents, and copyrights when such profits are taxed at an effective rate of less than 10 percent by the foreign country.

Multinational corporations can often use intangible assets to make their U.S. income appear to be “foreign” income. For example, a U.S. corporation might transfer a patent for some product it produces to its subsidiary in another country, say the Cayman Islands, that does not tax the income generated from this sort of asset. The U.S. parent corporation will then “pay” large fees to its subsidiary in the Cayman Islands for the use of this patent.

When it comes time to pay U.S. taxes, the U.S. parent company will claim that its subsidiary made huge profits by charging for the use of the patent it ostensibly holds, and that because those profits were allegedly earned in the Cayman Islands, U.S. taxes on those profits are deferrable (not due). Meanwhile, the parent company says that it made little or no profit because of the huge fees it had to pay to the subsidiary in the Cayman Islands (i.e., to itself). The arrangements used might be much more complex and involve multiple offshore subsidiaries, but the basic idea is the same. The president’s proposal would significantly restrict the use of these schemes and is projected to raise $21.3 billion over a decade.

Examples of Amendments that Would Improve the Effectiveness, or Reduce the Harm, of Provisions Included in the Tax Extenders

Some of the provisions among the tax extenders need to be reformed if they are to do any good for the American economy. For example, there are three types of reforms that Congress can make to the research credit to ensure that it actually accomplishes its goal of increasing research conducted by private firms.[16]

First, the definition of the type of research activity eligible for the credit could be clarified. One step in the right direction would be to enact the standards embodied in regulations proposed by the Clinton administration, which were later scuttled by the Bush administration. As it stands now, accounting firms are helping companies obtain the credit to subsidize redesigning food packaging and other activities that most Americans would see no reason to subsidize. The uncertainty about what qualifies as eligible research also results in substantial litigation and seems to encourage companies to push the boundaries of the law and often cross it.

Second, Congress could improve the rules determining which part of a company’s research activities should be subsidized. In theory, the goal is to subsidize only research activities that a company would otherwise not pursue, which is a difficult goal to achieve. But Congress can at least take the steps proposed by the Government Accountability Office to reduce the amount of tax credits that are simply a “windfall,” meaning money given to companies for doing things that they would have done anyway.

Third, Congress can address how and when firms obtain the credit. For example, Congress should bar taxpayers from claiming the credit on amended returns, because the credit cannot possibly be said to encourage research if the claimant did not even know about the credit until after the research was conducted.

There are other reforms that Congress could attach to a tax extenders bill that would address general problems with our tax system while also mitigating some of the worst features of the tax extenders. For example, the worst thing about the so-called “active financing exception” (aka GE Loophole) that was described earlier in this report is that it allows American corporations to defer paying U.S. taxes on their offshore financial income even while they immediately take deductions against their U.S. taxes for interest payments on debt used to finance the offshore operations. This problem would be addressed if Congress enacted the president’s proposal to bar interest deductions for offshore business until the profits from that offshore business are subject to U.S. taxes.

Under current law, American corporations essentially can borrow money to invest in foreign operations and immediately deduct the cost of that borrowing even though they can put off — forever if they choose — paying any U.S. taxes on the profits from those offshore operations. This is true for most types of multinational business. But it is even more alarming that this opportunity for tax avoidance is extended to financial firms with the active financing exception, given that financial firms would seem to have the most ability to exploit this weakness in the tax laws.

The president’s proposal would remove this opportunity for tax avoidance for all types of firms and remove the most worrying aspect of the active financing exception. The proposal is projected to raise $51.4 billion over a decade.

 


[1] Jeremy W. Peters, Senate Deal Is Reached on Restoring Jobless Aid, New York Times, March 13, 2014. http://www.nytimes.com/2014/03/14/us/senate-reaches-deal-to-pay-for-jobless-aid.html?hpw&rref=us&_r=0

[2] Citizens for Tax Justice, “Murray-Ryan Budget Deal Avoids Government Shutdown but Does Not Close a Single Tax Loophole, Leaves Many Problems in Place,” December 18, 2013. http://www.ctj.org/taxjusticedigest/archive/2013/12/murray-ryan_budget_deal_avoids.php

[3] Congressional Budget Office, “The Budget and Economic Outlook: 2014 to 2024,” February 4, 2014. http://www.cbo.gov/publication/45010

[4] Gary Guenther, Section 179 and Bonus Depreciation Expensing Allowances: Current Law, Legislative Proposals in the 112th Congress, and Economic Effects, September 10, 2012. http://www.fas.org/sgp/crs/misc/RL31852.pdf

[5] Citizens for Tax Justice, “Reform the Research Credit — Or Let It Die,” December 4, 2013. http://ctj.org/ctjreports/2013/12/reform_the_research_tax_credit_--_or_let_it_die.php

[6] Citizens for Tax Justice, “Don’t Renew the Offshore Tax Loopholes,” August 2, 2012. www.ctj.org/ctjreports/2012/08/dont_renew_the_offshore_tax_loopholes.php

[7] Christopher Helman, “What the Top U.S. Companies Pay in Taxes,” Forbes, April 1, 2010,  http://www.forbes.com/2010/04/01/ge-exxon-walmart-business-washington-corporate-taxes.html.

[8] Gary Guenther, “Section 179 and Bonus Depreciation Expensing Allowances: Current Law, Legislative Proposals in the 112th Congress, and Economic Effects,” Congressional Research Service, September 10, 2012. http://www.fas.org/sgp/crs/misc/RL31852.pdf

[9] “Coalition to Congress: End the Wind Production Tax Credit,” September 24, 2013,

http://www.eenews.net/assets/2013/09/24/document_pm_02.pdf; Nicolas Loris, “Let the Wind PTC Die Down Immediately,” October 8, 2013. http://www.heritage.org/research/reports/2013/10/wind-production-tax-credit-ptc-extension

[10] Citizens for Tax Justice, “Don’t Renew the Offshore Tax Loopholes,” August 2, 2012. www.ctj.org/ctjreports/2012/08/dont_renew_the_offshore_tax_loopholes.php

[11] Senators Carl Levin and John McCain, Memorandum to Members of the Permanent Subcommittee on Investigations, May 21, 2013. http://www.hsgac.senate.gov/download/?id=CDE3652B-DA4E-4EE1-B841-AEAD48177DC4

[12] Elizabeth Lower-Basch, "Rethinking Work Opportunity: From Tax Credits to Subsidized Job Placements," Center for Law and Social Policy, November 2011. http://www.clasp.org/resources-and-publications/files/Big-Ideas-for-Job-Creation-Rethinking-Work-Opportunity.pdf

[13] All of the revenue projections in this section are from Joint Committee on Taxation, “Estimated Budget Effects Of The Revenue Provisions Contained In The President's Fiscal Year 2015 Budget Proposal,” JCX-36-14, April 15, 2014. https://www.jct.gov/publications.html?func=startdown&id=4586

[14] Citizens for Tax Justice, “The Problem of Corporate Inversions: The Right and Wrong Approaches for Congress,” May 14, 2014. http://ctj.org/ctjreports/2014/05/the_problem_of_corporate_inversions_the_right_and_wrong_approaches_for_congress.php

[15] Citizens for Tax Justice, “The President's Fiscal Year 2015 Budget: Business Tax Reform Provisions,” March 12, 2014. http://www.ctj.org/ctjreports/2014/03/the_presidents_fiscal_year_2015_budget_business_tax_reform_provisions.php

[16] Each of these three types of reforms is explained in detail in Citizens for Tax Justice, “Reform the Research Credit — Or Let It Die,” December 4, 2013. http://ctj.org/ctjreports/2013/12/reform_the_research_tax_credit_--_or_let_it_die.php



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