International Taxation
Tax Haven Companies Were More Likely to Have a Tax Cost Advantage in Federal Contracting Gao ID: GAO-04-856 June 30, 2004The federal government was involved in about 8.6 million contract actions, including new contract awards, worth over $250 billion in fiscal year 2002. Some of these contracts were awarded to tax haven contractors, that is, U.S. subsidiaries of corporate parents located in tax haven countries. Concerns have been raised that these contractors may have an unfair cost advantage when competing for federal contracts because they are better able to lower their U.S. tax liability by shifting income to the tax haven parent. GAO's objectives in this study were to (1) determine the conditions under which companies with tax haven parents have a tax cost advantage when competing for federal contracts and (2) estimate the number of companies that could have such an advantage. GAO matched federal contractor data with tax and location data for all large corporations, those with at least $10 million in assets, in 2000 and 2001, in order to identify those companies that could have an advantage.
There are conditions under which a tax haven contractor may have a tax cost advantage (lower tax on additional income from a contract) when competing for a federal contract. The extent of the advantage depends on the relative tax liabilities of the tax haven contractor and its competitors. One way for a contractor to gain a tax cost advantage is by reducing its U.S. taxable income from other sources to less than zero and by using its losses to offset some or all of the additional income from a contract, resulting in less tax on the contract income. A company would thereby gain an advantage relative to those competitors with positive income from other sources and may be able to offer a lower price or cost for the contract. While some domestic corporations may also have a tax cost advantage, tax haven contractors may be better able to reduce U.S. taxable income to less than zero because of opportunities to shift income to their tax haven parents. Whether a contractor has a tax cost advantage in competing for a particular contract depends on the tax liabilities of other competitors. Also, the contractors with a tax cost advantage are not necessarily the successful competitors because the tax cost savings may not be reflected in actual prices, and prices may be only one of several factors involved in awarding contracts. Using tax liability as an indicator of ability to offset contract income, GAO found that large tax haven contractors in both 2000 and 2001 were more likely to have a tax cost advantage than large domestic contractors. In 2000, 56 percent of the 39 large tax haven contractors reported no tax liability, while 34 percent of the 3,253 large domestic contractors reported no tax liability. In 2001, 66 percent of large tax haven contractors and 46 percent of large domestic contractors reported no tax liability.
GAO-04-856, International Taxation: Tax Haven Companies Were More Likely to Have a Tax Cost Advantage in Federal Contracting
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Report to the Chairman, Committee on Governmental Affairs, U.S. Senate:
June 2004:
INTERNATIONAL TAXATION:
Tax Haven Companies Were More Likely to Have a Tax Cost Advantage in
Federal Contracting:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-856]:
GAO Highlights:
Highlights of GAO-04-856, a report to the Chairman, Committee on
Governmental Affairs, U.S. Senate
Why GAO Did This Study:
The federal government was involved in about 8.6 million contract
actions, including new contract awards, worth over $250 billion in
fiscal year 2002. Some of these contracts were awarded to tax haven
contractors, that is, U.S. subsidiaries of corporate parents located
in tax haven countries. Concerns have been raised that these
contractors may have an unfair cost advantage when competing for
federal contracts because they are better able to lower their U.S. tax
liability by shifting income to the tax haven parent.
GAO‘s objectives in this study were to (1) determine the conditions
under which companies with tax haven parents have a tax cost advantage
when competing for federal contracts and (2) estimate the number of
companies that could have such an advantage. GAO matched federal
contractor data with tax and location data for all large corporations,
those with at least $10 million in assets, in 2000 and 2001, in order
to identify those companies that could have an advantage.
What GAO Found:
There are conditions under which a tax haven contractor may have a tax
cost advantage (lower tax on additional income from a contract) when
competing for a federal contract. The extent of the advantage depends
on the relative tax liabilities of the tax haven contractor and its
competitors. One way for a contractor to gain a tax cost advantage is
by reducing its U.S. taxable income from other sources to less than
zero and by using its losses to offset some or all of the additional
income from a contract, resulting in less tax on the contract income.
A company would thereby gain an advantage relative to those competitors
with positive income from other sources and may be able to offer a
lower price or cost for the contract. While some domestic corporations
may also have a tax cost advantage, tax haven contractors may be better
able to reduce U.S. taxable income to less than zero because of
opportunities to shift income to their tax haven parents. Whether a
contractor has a tax cost advantage in competing for a particular
contract depends on the tax liabilities of other competitors. Also,
the contractors with a tax cost advantage are not necessarily the
successful competitors because the tax cost savings may not be
reflected in actual prices, and prices may be only one of several
factors involved in awarding contracts.
Using tax liability as an indicator of ability to offset contract
income, GAO found that large tax haven contractors in both 2000 and
2001 were more likely to have a tax cost advantage than large domestic
contractors. In 2000, 56 percent of the 39 large tax haven contractors
reported no tax liability, while 34 percent of the 3,253 large domestic
contractors reported no tax liability. In 2001, 66 percent of large tax
haven contractors and 46 percent of large domestic contractors reported
no tax liability.
Tax Status of Large Tax Haven and Domestic Contractors in 2000 and
2001:
[See PDF for image]
Source: GAO analysis of IRS data.
[End of table]
www.gao.gov/cgi-bin/getrpt?GAO-04-856.
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[End of section]
Contents:
Letter:
Results in Brief:
Background:
Scope and Methodology:
There Are Conditions under Which Tax Haven Contractors May Have a Tax
Cost Advantage:
Tax Haven Contractors Were More Likely to Have a Tax Cost Advantage
Than Domestic Contractors:
Concluding Observations:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: A Simple Qualitative Model for Assessing Potential
Contracting Advantages:
Appendix II: Additional Information about Contractors in 2000:
Information on Large Contractors in 2000:
Appendix III: Staff Acknowledgments:
Tables:
Table 1: Tax Liabilities and Interest Expenses of Large Contractors and
Noncontractors in 2001:
Table 2: Tax Status of Large Tax Haven and Domestic Contractors in 2000
and 2001:
Table 3: Tax Cost Advantage of Corporations with Headquarters in a Tax
Haven Country:
Table 4: Tax Liabilities and Interest Expenses of Large Contractors and
Noncontractors in 2000:
Letter June 30, 2004:
The Honorable Susan M. Collins:
Chairman:
Committee on Governmental Affairs:
United States Senate:
Dear Chairman Collins:
The federal government was involved in about 8.6 million contract
actions, including new contract awards, worth over $250 billion in
fiscal year 2002. Some of the companies that were awarded these
contracts were U.S. subsidiaries of corporate parents located in tax
haven countries.[Footnote 1] In this report, we will refer to such
contractors as "tax haven contractors." We reported in October 2002
that four of the top 100 federal contractors that were publicly traded
corporations in fiscal year 2001 were tax haven contractors and that
three of these were originally U.S.-headquartered corporations that had
reincorporated in tax haven countries through corporate
inversions.[Footnote 2]
Because tax haven contractors may have opportunities to shift income
between the U.S. subsidiary and the corporate parent in ways that
reduce U.S. tax, you have raised concerns that tax haven contractors
may have an unfair cost advantage over U.S.-headquartered contractors
when competing for federal contracts. Because of the concerns, you
asked us to determine the extent, if any, to which tax haven
contractors have an advantage when competing for federal contracts.
After reviewing the relevant literature, determining what data were
available, and meeting with your staff, we decided to (1) determine the
conditions under which corporations with parents in tax havens have a
tax cost advantage when competing for federal contracts and (2) to the
extent possible, estimate the number of companies that have
characteristics consistent with having such an advantage. We did not
try to determine the size of any tax cost advantage or whether the tax
cost advantage had an effect on the competition for specific contracts.
To address our objectives, we collected and analyzed information on
government contracting practices and business decision-making
processes. Using this information, we built a simple qualitative model
to explain the conditions under which a corporation may gain a tax cost
advantage in competing for federal contracts over other competitors
whose headquarters are not located in tax haven countries. We matched
contractor data from the General Services Administration's (GSA)
Federal Procurement Data System (FPDS) to tax and location data of
corporations from the Internal Revenue Service's (IRS) Statistics of
Income (SOI) division to estimate the number of companies with
characteristics that the qualitative model identifies as consistent
with a tax advantage. For our analysis of contractors in 2000, we
selected the 3,924 corporations that appeared in both FPDS and SOI in
that year that had total assets of at least $10 million. For our 2001
analysis, we selected the 4,264 corporations in both databases that had
total assets of at least $10 million. In this report, we refer to
corporations with at least $10 million in assets as large
corporations.[Footnote 3] The SOI sample includes the universe of such
large corporations in 2000 and 2001. Because it is the universe, there
is no sampling error for the information that we report about these
corporations.
Some companies may have reasons to locate in tax haven countries that
are unrelated to tax advantages. For example, some companies may locate
their operations in tax haven countries because of business conditions
in the tax haven related to costs and profitability. Location in a tax
haven country does not by itself establish that a company has adopted a
tax-minimizing strategy.
We requested comments on this draft from the Commissioner of Internal
Revenue and the Secretary of the Treasury. We conducted our review from
July 2003 through June 2004 in accordance with generally accepted
government auditing standards.
Results in Brief:
There are conditions under which contractors, including tax haven
contractors, may have a tax cost advantage when competing for
contracts, including federal government contracts. The extent of the
tax cost advantage depends on the relative tax liabilities of a
contractor and its competitors. The tax cost of the contract is the tax
liability on the additional income derived from the contract. One way
for a contractor to gain a tax advantage is by reducing its U.S.
taxable income from other sources to less than zero and by using its
losses to offset some or all of the additional income from a contract,
resulting in less tax on this income. A company would thereby gain an
advantage relative to companies with positive income from other sources
and may be able to offer a lower price or cost for the contract. While
some domestic corporations may also have a tax cost advantage, tax
haven contractors may be more likely to have such an advantage because
of opportunities to shift income to their tax haven parents. Whether a
contractor has a tax cost advantage in competing for a particular
contract depends on the tax liabilities of other competitors. Also, the
contractors with a tax cost advantage are not necessarily the
successful competitors because the tax cost savings may not be
reflected in actual prices, and prices may be only one of several
factors involved in awarding contracts.
Using tax liability as an indicator of ability to offset income from
the contract, we determined that in both 2000 and 2001, large tax haven
contractors were more likely to have a tax cost advantage than large
domestic contractors. In 2000, 56 percent of the 39 tax haven
contractors reported no tax liability, while 34 percent of the 3,253
domestic contractors reported no tax liability. In 2001, 66 percent of
tax haven contractors and 46 percent of domestic contractors reported
no tax liability. While in 2000 and 2001 tax haven contractors were
more likely to have zero tax liability, companies may have low or zero
tax liabilities for a variety of reasons, such as overall business
conditions, industry or company-specific performance issues, or the use
of income shifting.
Background:
Corporations can be located in tax haven countries through a variety of
means, including corporate inversions, acquisition, or initial
incorporation abroad. Location in a tax haven country can change a
company's tax liability because the United States taxes domestic
corporations differently than it taxes foreign corporations.
U.S. Tax Treatment of a Domestic Corporation:
The United States taxes the worldwide income of domestic corporations,
regardless of where the income is earned; gives credits for foreign
income taxes paid; and defers taxation of foreign subsidiaries until
their profits are repatriated in the form of dividends or other income.
However, a U.S. parent corporation is subject to current U.S. tax on
certain income earned by a foreign subsidiary, without regard to
whether such income is distributed to the U.S. corporation.
Through "deferral," U.S. parent corporations are allowed to postpone
current taxation on the net income or economic gain accrued by their
subsidiaries. These subsidiaries are separately incorporated foreign
subsidiaries of U.S. corporations. Because they are not considered U.S.
residents, their profits are not taxable as long as the earnings are
retained and reinvested outside the United States in active lines of
business. That is, U.S. tax on such income is generally deferred until
the income is repatriated to the U.S. parent.
The U.S. system also contains certain anti-deferral features that tax
on a current basis certain categories of passive income earned by a
domestic corporation's foreign subsidiaries, regardless of whether the
income has been distributed as a dividend to the domestic parent
corporation. Passive income includes royalties, interest and dividends.
According to the Internal Revenue Code (I.R.C.), passive income is
"deemed distributed" to the U.S. parent corporation and thus denied
deferral. The rules defining the application and limits of this
antideferral regime are known as the Subpart F rules.
In order to avoid double taxation of income, the United States permits
a taxpayer to offset, in whole or in part, the U.S. tax owed on this
foreign-source income. Foreign tax credits are applied against a
corporation's U.S. tax liability. The availability of foreign tax
credits is limited to the U.S. tax imposed on foreign-source income. To
ensure that the credit does not reduce tax on domestic income, the
credit cannot exceed the tax liability that would have been due had the
income been generated domestically. Firms with credits above that
amount in a given year have "excess" foreign tax credits, which can be
applied against their foreign source income for the previous 2 years or
the subsequent 5 years.
This system of taxation of U.S. multinational corporations has been the
subject of ongoing debate. Specific issues in international taxation
include whether to reform the U.S. system by moving from worldwide
taxation to a territorial system that exempts foreign-source income
from U.S. tax. These issues have become more prominent with the
increasing openness of the U.S. economy to trade and investment.
U.S. Tax Treatment of a Foreign Corporation:
The United States taxes foreign corporations on income generated from
their active business operations in the United States. Such income may
be generated by a subsidiary operating in the United States or by a
branch of the foreign parent corporation. It is generally taxed in the
same manner and at the same rates as the income of a U.S. corporation.
In addition, if a foreign corporation is engaged in a trade or business
in the United States and receives investment income from U.S. sources,
it will generally be subject to a withholding tax of 30 percent on
interest, dividends, royalties, and certain types of income derived
from U.S. sources, subject to certain exceptions. This tax may be
reduced or eliminated under an applicable tax treaty.
Scope and Methodology:
For objective 1, we collected and analyzed information on government
contracting practices and business decision-making processes. We also
reviewed the economics literature and reports of the Department of the
Treasury and the Joint Committee on Taxation to determine how
differences in the tax treatment of corporations can contribute to a
tax cost advantage. Using the information we obtained, we built a
simple qualitative model to explain the conditions under which a tax
haven company may have a tax cost advantage in competing for federal
contracts relative to other companies whose headquarters are not
located in tax haven countries. For a description of the model, see
appendix I.
For objective 2, we used the qualitative model to identify companies
that had characteristics consistent with having a tax cost advantage.
We matched contractor data (name and taxpayer identification numbers)
from the GSA's FPDS for 2000 and 2001 to tax and location data from the
IRS's SOI corporation file. In this matched database, we analyzed
information about large corporations, those with at least $10 million
in assets.[Footnote 4] We identified the large corporations with
characteristics consistent with a tax cost advantage compared to other
large corporations and counted the number of these advantaged and
disadvantaged corporations. We divided the SOI data into categories
that differentiated between federal contractors (domestically owned and
foreign owned) and noncontractors (domestically owned and foreign
owned). We further divided the foreign-owned corporation data by those
headquartered in tax haven countries from those not headquartered in
tax haven countries.[Footnote 5]
Data Limitations and Reliability:
SOI is a data set widely used for research purposes. SOI corporation
files are representative samples of the population of all corporations
that filed tax returns. Generally, SOI data can be used to project tax
return information to the universe of all filers. However, the total
corporations that matched in both the SOI and FPDS databases could not
be used to project the results of our analysis to the universe of all
corporations. Because SOI's sampling rate for smaller corporations is
very low, our matched database contained very few smaller corporations
and would not lead to reliable estimates of the properties of the
universe of smaller corporations. Therefore, the results of our
analysis cannot be projected to the universe of all corporate filers.
However, our results do represent the universe of large tax haven
contractors. SOI samples corporations with at least $10 million in
assets at a 100 percent rate so that the SOI sample includes the
universe of these larger corporations. For this reason, we report the
results of our analysis without sampling error.
IRS performs a number of quality control steps to verify the internal
consistency of SOI sample data. For example, it performs computerized
tests to verify the relationships between values on the returns
selected as part of the SOI sample and manually edits data items to
correct for problems, such as missing items. We conducted several
reliability tests to ensure that the data excerpts we used for this
report were complete and accurate. For example, we electronically
tested the data and used published data as a comparison to ensure that
the data set was complete. To ensure accuracy, we reviewed related
documentation and electronically tested for obvious errors. We
concluded that the data were sufficiently reliable for the purposes of
this report.
We have previously reported that there are limitations to the accuracy
of the data in FPDS.[Footnote 6] The data accuracy issues we reported
on involved contract amounts and classification of contract
characteristics. For this report, the only FPDS data we used were the
contractors' names and taxpayer identification numbers. Our previous
report did not address the accuracy of these data elements. Therefore,
our match of the FPDS and SOI data may contain some nonsampling error;
that is, due to inaccurate identification numbers, we may fail, in some
cases, to correctly identify large corporations in SOI that were also
federal contractors. However, we expect this nonsampling error to be
small, and we concluded that the data were sufficiently reliable for
the purposes of this report.
There Are Conditions under Which Tax Haven Contractors May Have a Tax
Cost Advantage:
Contractors, including tax haven contractors, that have a lower
marginal tax rate on the income from a contract than other contractors
would have a tax cost advantage when competing for a contract.
Furthermore, there is some evidence that a tax haven contractor may be
able to shift income between the U.S. subsidiary and its tax haven
parent in order to reduce U.S. taxable income.
Contractors with Lower Marginal Tax Rates May Have a Tax Cost
Advantage:
There are conditions under which a contractor could have a tax cost
advantage when competing for a contract. The tax cost of the contract
is the tax paid on the additional income derived from the contract. A
contractor that pays less tax on additional income from a contract
gains a tax cost advantage compared to companies that pay higher tax.
One way to gain a tax cost advantage is by offsetting income earned on
the contract with losses from other activities. The contractors with a
tax cost advantage are not necessarily the successful competitors
because the tax cost savings may not be reflected in actual bid prices
or price proposals, and prices or costs are only one of several factors
involved in awarding contracts. This reasoning holds for all
contractors, including tax haven contractors, and all contracts,
including federal contracts.
The appropriate measure of the tax cost of the contract is the
corporation's marginal tax rate. The marginal tax rate is the rate that
applies to an increment of income. As such, the marginal tax rate would
be the rate that applies to the additional income that would arise from
the federal contract. For example, if a contractor in a 34 percent tax
bracket earns $1 million of additional income from the contract, it
would owe $340,000 in additional tax. The 34 percent statutory tax rate
is this contractor's marginal rate.
A lower marginal tax rate may confer a tax cost advantage when
companies are bidding on contracts because it indicates a higher after-
tax rate of return on the contact. All other things being equal, a
lower marginal effective tax rate is equivalent to a reduction in cost,
that is, a reduction in either the tax rate or cost would produce a
higher after-tax return. For example, a contractor with a 30 percent
marginal tax rate on a contract producing $1 million of income pays
$300,000 in taxes and receives $700,000 in additional after-tax income.
On the other hand, a contractor with a 34 percent marginal tax rate on
the same contract producing $1 million of income pays $340,000 in taxes
and receives $660,000 in additional after-tax income. The $40,000
difference in after-tax income due to the difference in marginal tax
rates is the tax cost advantage. In this example, the contractor with
the tax cost advantage can, in theory, underbid the competitor by as
much as $40,000 and earn an after-tax income at least as large as the
competitor. In this sense, the competitor with the lower marginal tax
rate would have a tax cost advantage over a competitor with a higher
marginal tax rate.
A contractor gains a tax cost advantage if it has a lower marginal tax
rate compared to other companies that are competing for the contract.
However, the available data are not sufficient to measure marginal
rates accurately. In order to compute marginal rates, detailed
information is required about the tax status of the contractors and
types of spending by the contractors associated with the contracts.
Although the marginal tax rates are not available, conditions under
which the marginal rates may be lower for some companies than others
can be inferred from their current taxable income. Specifically, a
company that has positive taxable income may be more likely to have a
positive tax liability on the incremental income from the contract than
companies with zero or negative taxable income. Therefore, a company
with zero taxable income may have a lower marginal tax rate relative to
companies with positive taxable income.[Footnote 7] Tax losses in the
United States on other activities could absorb incremental income
generated from a contract. All other things being equal, a company
competing for a federal contract that reported taxable income in the
United States would face a higher tax cost than a competitor without
taxable income.
While a zero tax liability provides an indicator of a tax cost
advantage, it does not necessarily mean that the advantage exists.
Whether a contractor with zero tax liability has a tax cost advantage
when competing for a particular contract depends on the tax liabilities
of the other competitors. The contractor with zero tax liability would
have no tax cost advantage if all the other competitors also had no tax
liability.
Even if a contractor can be shown to have a tax cost advantage when
competing for a federal contract, this advantage does not imply that
the contractor's bid or proposal will be successful. A tax cost
advantage may not be reflected in the contractor's bid or price
proposal, the content of which depends on the business judgment of the
contractor. For example, in order to include more profit, a contractor
may decide not to use any tax cost advantage to reduce its price. Even
if the tax advantage is reflected in the bid or price proposal, other
price or cost factors that affect whether the bid or proposal is
successful may not be equal across the companies competing for the
contract. For example, a bidder may have a tax cost advantage over
other bidders, but if its costs of labor and material are higher, its
tax cost advantage may be offset by its higher costs for those other
elements of its bid. Further, where price or cost is not the only
evaluation factor for award of the contract, any tax cost advantage may
be offset by the relative importance of other factors such as technical
merit, management approach, and past performance. Generally, the
contractor's tax cost advantage would become a competitive advantage
where other contractors would have to reduce their prices (or costs)
and/or improve the nonprice (or noncost) elements of their proposals to
offset the tax cost advantage.
Tax Haven Contractors May Be Able to Shift Income to Reduce U.S.
Taxable Income:
Tax haven contractors may be more likely to have lower tax costs than
other contractors because they may be able to shift U.S. source income
to their tax haven parents, reducing U.S. taxable income. Some, but not
all, domestic contractors - those that have overseas affiliates - may
also be able to shift income. Any income earned by the U.S. subsidiary
from a contract for services performed in the United States would be
U.S. taxable income. Such income would be taxed in the United States
unless it is shifted outside the United States through such techniques
as transfer pricing abuse.
Location in a tax haven country can confer tax advantages that are not
related to income shifting and do not give a company an advantage when
competing for federal contracts. When a parent locates in a tax haven
country, taxes on foreign income can be reduced by eliminating U.S.
corporate-level taxation of foreign operations. However, these tax
savings are unrelated to the taxes paid on income derived from the
contract for services performed in the United States and have no effect
on the tax cost of the contract.[Footnote 8] The tax haven contractor
potentially gains an advantage with respect to contract competition
because of the increased scope for income shifting to reduce U.S.
taxable income below zero.
A tax haven contractor may be able to shift income outside of the
United States by increasing payments to foreign members of the
corporate group. The contractor may engage in transfer pricing abuse,
whereby related parties price their transactions artificially high or
low to shift taxable income out of the United States. For example, the
tax haven parent can charge excessive prices for goods and services
rendered (for example, $1000 instead of $500). This raises the
subsidiary's expenses (by $500), lowers its profits (by $500), and
shifts the income ($500) to the lower tax jurisdiction outside the
United States. Transfer pricing abuse can also occur when the foreign
parent charges excessive interest on loans to its U.S. subsidiary.
[Footnote 9] Interest deductions can also be used to shift income
outside the United States through a technique called "earnings
stripping." Using this technique, the foreign parent loads the U.S.
subsidiary with a disproportionate amount of debt, merely by issuing an
intercompany note, thereby generating interest payments to the parent
and interest deductions against U.S. income for the subsidiary.
However, the U.S. subsidiaries would still be subject to the I.R.C.
rules that limit the deductibility of interest to 50 percent of
adjusted taxable income whenever the U.S. subsidiary's debt-equity
ratio exceeds 1.5 to 1.
Determining whether companies shift income to obtain a tax cost
advantage is difficult because differences among companies that may
indicate shifting can also be explained by other factors affecting
costs and profitability. For example, while differences in average tax
rates and interest expenses may be consistent with income shifting,
they do not prove that such activities are occurring. The differences
might be explained by other factors, such as the age of the company.
As table 1 shows, tax haven contractors in 2001 had greater interest
expense and lower tax liabilities relative to gross receipts than
domestic or all foreign contractors. The greater interest expense
associated with lower tax liabilities may indicate that the tax haven
contractors have used techniques like earnings stripping to shift
taxable income outside the United States. The pattern of tax
liabilities and interest expense in 2000 is the same as in 2001 in all
respects except one: the ratio of interest expense to gross receipts
for tax haven noncontractors is lower than the ratio for domestic or
all foreign contractors in 2000. (For details, see app. II.):
Table 1: Tax Liabilities and Interest Expenses of Large Contractors and
Noncontractors in 2001:
All foreign;
Contractors: Number of companies: 740;
Contractors: Tax liability as a percentage of gross receipts: 0.89%;
Contractors: Interest expense as a percentage of gross receipts: 6.55%;
Noncontractors: Number of companies: 7,093;
Noncontractors: Tax liability as a percentage of gross receipts: 1.01%;
Noncontractors: Interest expense as a percentage of gross receipts:
8.53%.
Tax haven;
Contractors: Number of companies: 50;
Contractors: Tax liability as a percentage of gross receipts: 0.75%;
Contractors: Interest expense as a percentage of gross receipts: 8.33%;
Noncontractors: Number of companies: 787;
Noncontractors: Tax liability as a percentage of gross receipts: 0.91%;
Noncontractors: Interest expense as a percentage of gross receipts:
16.32%.
Domestic;
Contractors: Number of companies: 3,524;
Contractors: Tax liability as a percentage of gross receipts: 1.18%;
Contractors: Interest expense as a percentage of gross receipts: 7.12%;
Noncontractors: Number of companies: 33,293;
Noncontractors: Tax liability as a percentage of gross receipts: 1.76%;
Noncontractors: Interest expense as a percentage of gross receipts:
12.90%.
Total;
Contractors: Number of companies: 4,264;
Contractors: Tax liability as a percentage of gross receipts: 1.14%;
Contractors: Interest expense as a percentage of gross receipts: 7.04%;
Noncontractors: Number of companies: 40,386;
Noncontractors: Tax liability as a percentage of gross receipts: 1.59%;
Noncontractors: Interest expense as a percentage of gross receipts:
11.92%.
Source: GAO analysis of IRS data.
Notes: Large contractors and noncontractors are companies with total
assets greater than or equal to $10 million. The number of companies
does not sum to the total because tax haven contractors are included
among all foreign contractors.
[End of table]
This pattern of interest expenses and tax liabilities is largely
consistent with tax haven contractors inflating interest costs to shift
taxable income outside of the United States but does not prove that
this has occurred. The differences may be due to such factors as the
age and industry of the companies, their history of mergers or
acquisitions, and other details of their financial structure and the
markets for their products. Furthermore, low or zero tax liability is
not necessarily an indicator of noncompliance. Companies may have low
or zero tax liabilities for a variety of reasons, such as overall
business conditions, industry-or company-specific performance issues,
and the use of income shifting.
The evidence on the extent to which income shifting is occurring is not
precise. Studies that compare profitability of foreign-controlled and
domestically controlled companies show that much of the difference can
be explained by factors other than income shifting.[Footnote 10]
However, the range of estimates can be wide, contributing to
uncertainty about the precise effect, and the studies do not focus on
income shifting to parents in tax haven countries. The 1997 study by
Harry Grubert showed that more than 50 percent, and perhaps as much as
75 percent, of the income differences could be explained by factors
other than income shifting. A Treasury report on corporate inversions
did discuss income shifting to parents in tax haven countries but did
not provide any quantitative estimates of the extent of such shifting.
According to the report, the tax savings from income shifting are
greatest in the case of a foreign parent corporation located in a no-
tax jurisdiction.[Footnote 11] The Treasury report cites increased
benefits from income shifting among other tax benefits as a reason for
recent corporate inversion activity and increased foreign acquisitions
of U.S. multinationals.
Tax Haven Contractors Were More Likely to Have a Tax Cost Advantage
Than Domestic Contractors:
Using tax liability as an indicator of ability to offset contract
income, we determined that large tax haven contractors were more likely
to have a tax cost advantage than large domestic contractors in both
2000 and 2001. In both years, tax haven contractors were about one and
a half times more likely to have no tax liability as domestic
contractors.[Footnote 12] As table 2 shows, in 2000, 56 percent of the
39 tax haven contractors reported no tax liability, while 34 percent of
the 3,253 domestic contractors reported no tax liability. In 2001, 66
percent of the 50 tax haven contractors and 46 percent of the 3,524
domestic contractors reported no tax liability.
Table 2: Tax Status of Large Tax Haven and Domestic Contractors in 2000
and 2001:
2000:
U.S. federal contractors: Tax haven;
Contractors with tax liability: Number of companies: 17;
Contractors with tax liability: Percentage of companies: 44%;
Contractors without tax liability: Number of companies: 22;
Contractors without tax liability: Percentage of companies: 56%.
U.S. federal contractors: Domestic;
Contractors with tax liability: Number of companies: 2,132;
Contractors with tax liability: Percentage of companies: 66%;
Contractors without tax liability: Number of companies: 1,121;
Contractors without tax liability: Percentage of companies: 34%.
2001:
U.S. federal contractors: Tax haven;
Contractors with tax liability: Number of companies: 17;
Contractors with tax liability: Percentage of companies: 34%;
Contractors without tax liability: Number of companies: 33;
Contractors without tax liability: Percentage of companies: 66%.
U.S. federal contractors: Domestic;
Contractors with tax liability: Number of companies: 1,888;
Contractors with tax liability: Percentage of companies: 54%;
Contractors without tax liability: Number of companies: 1,636;
Contractors without tax liability: Percentage of companies: 46%.
Source: GAO analysis of IRS data.
[End of table]
Under the conditions of our model, contractors with no tax liability
would have a tax cost advantage compared to the contractors that did
have tax liabilities in these years. Consequently, in 2000, the tax
haven contractors without tax liabilities were likely to have a tax
cost advantage compared to the 17 other tax haven contractors and 2,132
domestic contractors that had tax liabilities. The 1,121 domestic
contractors without tax liabilities were also likely to have a tax cost
advantage compared to these same companies. In 2001, the tax haven
contractors with zero tax liability were likely to have a tax cost
advantage compared to the 17 other tax haven contractors and 1,888
domestic contractors that had tax liabilities. Because they reported no
tax liability, 1,636 domestic contractors were also likely to have a
tax cost advantage with compared to these same companies.
This analysis of possible tax advantages does not show that income
shifting is the only potential cause of the advantage. As mentioned
above, the tax losses that confer the advantage may be due to income
shifting, but may also be due to other factors such as overall business
conditions, industry and age of the company, or company-specific
performance issues.[Footnote 13] In addition, the analysis does not
show the size of the advantage in terms of tax dollars saved. The
amount saved depends, in part, on the amount of additional income from
the contract. If the contractor with no tax liability has insufficient
losses to offset the additional income, it would pay taxes on at least
part of the income, reducing the potential advantage. Lastly, the
analysis identifies tax haven contractors that meet the conditions for
having a tax cost advantage with respect to income from the contract in
2000 and 2001. The data do not indicate whether they have an overall
tax cost advantage on a contract that produces income in other years.
Furthermore, to the extent that losses are used to offset income in the
current year, they cannot be used to offset income in other years.
These smaller loss carryovers would reduce the overall tax cost
advantage.
Concluding Observations:
The existence of a tax cost advantage for some tax haven contractors
matters to American taxpayers. First, the advantage could, but does not
necessarily, affect which company wins a contract. A contractor with a
tax cost advantage could offer a price that wins a contract based more
on tax considerations than on factors such as the quality and cost of
producing goods and services. Second, the potential tax cost advantage
may contribute, along with other tax considerations, to the incentives
for companies to move to tax haven countries, reducing the U.S.
corporate tax base.
The issue of tax cost advantages for tax haven contractors is related
to the larger issue of how companies headquartered or operating in the
United States should be taxed. For example, the questions about how the
worldwide income of U.S. multinational corporations should be taxed are
part of a larger debate and beyond the scope of this report. Because of
these larger policy issues, we are not making recommendations in this
report.
Agency Comments and Our Evaluation:
In a letter dated June 22, 2004, the IRS Commissioner stated that
because IRS's only role in our report was to provide us with certain
tax data, IRS's review of a draft of this report would be limited to
evaluating how well we described the tax data it provided. The
Commissioner stated that IRS believes that the report fairly describes
these data. On June 28, officials from the Department of the Treasury's
Office of Tax Policy provided oral comments on several technical
issues, which we incorporated into the report where appropriate.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its date. At that time, we will send copies to the Secretary of
the Treasury, the Commissioner of Internal Revenue and other interested
parties. We will also make copies available to others on request. In
addition, this report will be available at no charge on GAO's Web site
at [Hyperlink, http://www.gao.gov].
If you have any questions concerning this report, please contact me at
(202) 512-9110 or [Hyperlink, whitej@gao.gov] or Kevin Daly at (202)
512-9040 or [Hyperlink, dalyke@gao.gov]. Key contributors to this
report are listed in appendix III.
Sincerely yours,
Signed by:
James R. White:
Director, Tax Issues:
[End of section]
Appendixes:
Appendix I: A Simple Qualitative Model for Assessing Potential
Contracting Advantages:
A parent corporation that locates in a tax haven country may reduce
U.S. tax on corporate income by shielding subsidiaries from U.S.
taxation and by providing opportunities for shifting of U.S. source
income to lower tax jurisdictions. Such a corporation could have an
advantage because it is able to have a lower marginal tax rate on U.S.
contract income than its domestic competitors or other foreign
competitors. The simple qualitative model in this appendix specifies a
set of conditions under which corporations with a tax haven parent may
have a lower marginal U.S. tax rate.
The principal means by which a parent corporation that locates in a tax
haven country may have lower U.S. tax liabilities are as follows.
* The corporation pays no U.S. tax on what would have been its foreign
source income if it were located in the United States. To the extent
that foreign subsidiaries are owned by a foreign parent, the U.S.
corporate-level taxation of foreign operations is eliminated. Tax
savings would come from not having to pay tax on the corporate group's
foreign income.
* The corporation may be able to shift income outside of the United
States by increasing payments to foreign members of the group. The
corporation may engage in transfer pricing abuse, whereby related
parties price their transactions artificially high or low to shift
taxable income out of the United States.[Footnote 14] Transfer pricing
abuse can also occur when the foreign parent charges excessive interest
on loans to its U.S. subsidiary. Interest deductions can also be used
to shift income outside the United States through a technique called
earnings stripping. Using this technique, the foreign parent loads the
U.S. subsidiary with a disproportionate amount of debt, merely by
issuing an intercompany note, thereby generating interest payments to
the parent and interest deductions against U.S. income for the
subsidiary. The subsidiaries would still be subject to the thin
capitalization rules (I.R.C. section 163 (j)) that limit the
deductibility of interest to 50 percent of adjusted taxable income
whenever the U.S. subsidiary's debt-equity ratio exceeds 1.5 to 1.
When a parent corporation locates in a tax haven country, the
elimination of U.S. corporate-level taxation of foreign operations can
reduce taxes on foreign income. However, these tax savings are
unrelated to the taxes paid on income derived from the contract and
have no effect on the tax cost of the contract. Any income earned by
the U.S. subsidiary from a contract for services performed in the U.S.
would be U.S. taxable income. Therefore, the elimination of the
corporate-level taxation of foreign operations provides no competitive
advantage to a corporation that is competing for a U.S. government
contract.
A corporation has a U.S. tax advantage in competing for a government
contract when it would pay a lower marginal U.S. tax rate on the income
from that contract than would the other companies competing for that
same contract. The available data are not sufficient to measure
marginal rates accurately. However, the likelihood that the rates are
lower for some companies than others can be inferred from their current
tax liabilities. The manipulation of interest payments and other
transfer pricing can reduce U.S. taxable income. We can infer that the
corporation may have a lower marginal tax rate on its U.S. contract
income if the manipulation allows a corporation that would otherwise
have positive taxable income to reduce its taxable income (excluding
the net income from the contract) to a negative amount. Table 3 shows a
set of situations, or cases, in which a corporation may and may not
have a cost advantage when bidding on a contract.
Table 3: Tax Cost Advantage of Corporations with Headquarters in a Tax
Haven Country:
Case: 1;
U.S. income of a company in the United States: +;
U.S. income of a company with its parent located in a tax haven
country: -;
Company has a tax cost advantage with parent in tax haven country: Yes.
Case: 2;
U.S. income of a company in the United States: +;
U.S. income of a company with its parent located in a tax haven
country: +;
Company has a tax cost advantage with parent in tax haven country: No.
Case: 3;
U.S. income of a company in the United States: -;
U.S. income of a company with its parent located in a tax haven
country: -;
Company has a tax cost advantage with parent in tax haven country: No.
Source: GAO qualitative model of tax cost advantage.
[End of table]
In order to use this model to identify corporations with a tax cost
advantage, we make two assumptions: (1) corporations with positive U.S.
taxable income pay tax at the same rate based on the schedule of
corporate tax rates (that is, their income before the contract income
puts them in the same tax bracket) and (2) corporations with negative
income have sufficient losses to offset income from the contract. With
these assumptions, we can draw inferences about relative marginal tax
rates for the three cases. A U.S. corporation that has positive U.S.
taxable income (before taking the income from the contract into
account) and has a parent located in a tax haven country does not have
a competitive advantage compared to a U.S. corporation with positive
income (Case 2). Because they have positive income and pay the same
rate of tax, neither has a lower marginal tax rate than the other.
Likewise, a corporation with a tax haven parent that has U.S. tax
losses and zero tax liability would not have an advantage compared to
another corporation with tax losses (Case 3). Because the marginal tax
rate is zero for both these corporations and they have sufficient
losses to offset the contract income, neither has a tax cost advantage.
However, a corporation that has a tax haven parent and U.S. tax losses
would have an advantage when compared to a corporation with positive
income (Case 1). In this case, the corporation with losses has a zero
marginal rate, which provides a tax cost advantage compared to a
corporation with taxable income and a positive marginal rate. The
assumption that a corporation with zero tax liability has sufficient
losses to offset contract income may not be true in particular
instances. For example, a corporation may obtain more than one contract
(in the public or private sector) and the marginal tax rate on income
from a particular contract will depend on how the losses are allocated
across income from all the contracts. However, a corporation with zero
tax liability is more likely to be able to offset the additional income
than a corporation with positive tax liability. In this sense, tax
liability is an indicator of the ability to offset income from the
contract.
The qualitative model does not identify the causes of the advantage.
The tax losses that confer the advantage may be due to income shifting,
but may also be due to other factors. In addition, the model does not
show the size of the advantage in terms of tax dollars saved. The
amount saved depends, in part, on the amount of additional income from
the contract. If the contractor with no tax liability has insufficient
losses to offset the additional income, it would pay taxes on at least
part of the income, reducing the potential advantage compared to
contractors that have positive tax liabilities. Lastly, the model is
used to identify tax haven contractors that meet the conditions for
having a competitive advantage with respect to income from the contract
in 2000 and 2001. The data do not indicate whether they have an overall
tax advantage on a contract that produces income in other years.
[End of section]
Appendix II: Additional Information about Contractors in 2000:
The additional table of tax liabilities and interest expense for 2000
is provided for comparison with the data reported in the letter. It
shows substantially the same pattern.
Information on Large Contractors in 2000:
Table 4 shows that in 2000, tax haven contractors had greater interest
expense and lower tax liabilities relative to gross receipts than
domestic or all foreign contractors. The pattern of tax liabilities and
interest expense in 2000 is the same as in 2001 in all respects except
one: the ratio of interest expense to gross receipts for tax haven
noncontractors is lower than the ratio for domestic or all foreign
contractors in 2000. The greater interest expense associated with lower
tax liabilities may indicate, but does not prove, that the tax haven
contractors have used techniques like earnings stripping to shift
taxable income outside the United States.
Table 4: Tax Liabilities and Interest Expenses of Large Contractors and
Noncontractors in 2000:
All foreign;
Contractors: Number of companies: 671;
Contractors: Tax liability as a percentage of gross receipts: 1.25%;
Contractors: Interest expense as a percentage of gross receipts: 5.01%;
Noncontractors: Number of companies: 7,173;
Noncontractors: Tax liability as a percentage of gross receipts: 1.27%;
Noncontractors: Interest expense as a percentage of gross receipts:
11.62%.
Tax haven;%
Contractors: Number of companies: 39;
Contractors: Tax liability as a percentage of gross receipts: 0.31%;
Contractors: Interest expense as a percentage of gross receipts: 9.92%;
Noncontractors: Number of companies: 787;
Noncontractors: Tax liability as a percentage of gross receipts: 1.10%;
Noncontractors: Interest expense as a percentage of gross receipts:
6.32%.
Domestic;
Contractors: Number of companies: 3,253;
Contractors: Tax liability as a percentage of gross receipts: 1.55%;
Contractors: Interest expense as a percentage of gross receipts: 7.13%;
Noncontractors: Number of companies: 35,433;
Noncontractors: Tax liability as a percentage of gross receipts: 1.90%;
Noncontractors: Interest expense as a percentage of gross receipts:
13.01%.
Total;
Contractors: Number of companies: 3,924;
Contractors: Tax liability as a percentage of gross receipts: 1.50%;
Contractors: Interest expense as a percentage of gross receipts: 6.81%;
Noncontractors: Number of companies: 42,606;
Noncontractors: Tax liability as a percentage of gross receipts: 1.76%;
Noncontractors: Interest expense as a percentage of gross receipts:
12.71%.
Source: GAO analysis of IRS data.
Notes: Large contractors and noncontractors are those with total assets
greater than or equal to $10 million. The number of companies does not
sum to the total because tax haven contractors are included among all
foreign contractors.
[End of table]
[End of section]
Appendix III: Staff Acknowledgments:
Amy Friedheim, Donald Marples, Samuel Scrutchins, James Ungvarsky, and
James Wozny made key contributions to this report.
(450244):
FOOTNOTES
[1] In such cases, the U.S. subsidiary is a U.S. corporation,
incorporated in the United States, but is owned by a parent company
incorporated in a tax haven country. The term tax haven is used by the
Organisation for Economic Co-operation and Development (OECD) to refer
to a country that has no or nominal taxes on corporate income and also
meets other criteria related to the transparency of its legal and
accounting systems and to its openness to the exchange of tax
information with other countries.
[2] See U.S. General Accounting Office, Information on Federal
Contractors That Are Incorporated Offshore, GAO-03-194R (Washington,
D.C.: Oct. 1, 2002). An inverted company is a U.S. subsidiary of a
foreign parent where ownership of the U.S. subsidiary had been
transferred to the foreign parent. The term "inversion" is used to
describe a broad category of transactions through which a U.S.-based
multinational company restructures its corporate group so that after
the transaction the ultimate parent of the corporate group is a foreign
corporation. See U.S. Department of the Treasury, Office of Tax Policy,
Corporate Inversion Transactions: Tax Policy Implications (Washington,
D.C.: May 17, 2002).
[3] The designation large corporation, as used in this report, is not
related to the business size standards used in determining small
business status for federal government contracts.
[4] We did not include in our analysis corporations that were real
estate investment trusts, regulated investment companies, or subchapter
S corporations because these pass-through entities are treated
differently for tax purposes than ordinary corporations.
[5] As of December 2003, OECD had identified 39 countries or
jurisdictions that they consider to be tax havens. In this report, we
refer to these countries and jurisdictions as tax haven countries. They
are Andorra, Anguilla, Antigua and Barbuda, Aruba, Bahamas, Bahrain,
Barbados, Belize, Bermuda, British Virgin Islands, Cayman Islands, Cook
Islands, Cyprus, Dominica, Gibraltar, Grenada, Guernsey, Isle of Man,
Jersey, Liberia, The Principality of Liechtenstein, Malta, The Republic
of the Marshall Islands, Mauritius, The Principality of Monaco,
Montserrat, The Republic of Nauru, Netherlands Antilles, Niue, Panama,
St. Christopher (St. Kitts) and Nevis, St. Lucia, St. Vincent and the
Grenadines, Samoa, San Marino, Seychelles, Turks & Caicos, U.S. Virgin
Islands, and Vanuatu.
[6] U.S. General Accounting Office, Reliability of Federal Procurement
Data, GAO-04-295R (Washington, D.C.: Dec. 30, 2003).
[7] Besides depending on taxable income and potential availability of
tax losses to offset income, the likelihood of a zero marginal rate
also depends on the availability of accumulated tax credits, which can
directly offset tax liabilities. We emphasize taxable income here
because the availability of tax losses is more directly connected to
the income shifting discussed in the next section. Our estimate of the
number of contractors with an advantage is based on whether they have
positive or zero tax liability, which includes the effects of both loss
and credit carryforwards.
[8] For a more detailed description of the potential tax advantages,
see app. I.
[9] There are various provisions in the I.R.C. designed to limit income
shifting. The limits include the requirement (Section 482) that
transactions between related parties use arm's length prices, that is,
the prices that unrelated parties would or should use for the
transactions.
[10] See, for example, Harry Grubert, "Another Look at the Low Taxable
Income of Foreign-Controlled Companies in the United States," Tax Notes
International (Arlington, Va.: Dec. 8, 1997), 1,873-97, and David S.
Laster and Robert N. McCauley," Making Sense of the Profits of Foreign
Firms in the United States," Federal Reserve Bank of New York Quarterly
Review (New York: Summer-Fall 1994).
[11] U.S. Department of the Treasury, Office of Tax Policy, Corporate
Inversion Transactions: Tax Policy Implications.
[12] The relative probability of contractors having no tax liability
can be computed by comparing relative frequencies (percentages) of tax
haven and domestic contractors with no tax liability. In 2000 and 2001,
the relative frequencies were 1.65 (.56 divided by .34) and 1.43 (.66
divided by .46), respectively.
[13] In a prior report, we found that the ratios of tax liability and
interest expense to gross receipts varied by industry. However, after
controlling for the age and industry of the corporations, we found that
U.S. subsidiaries of foreign parent corporations were more likely to
have zero tax liability than domestic corporations from 1996 through
2000. See U.S. General Accounting Office, Tax Administration:
Comparison of the Reported Tax Liabilities of Foreign-and U.S.-
Controlled Corporations, 1996-2000, GAO-04-358 (Washington, D.C.: Feb.
27, 2004).
[14] There are various provisions in the I.R.C. designed to limit
income shifting. The limits include the requirement (Section 482) that
transactions between related parties use arm's length prices, that is,
the prices that unrelated parties would use for the transactions.
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