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July 24, 2007
Tax breaks
Speaking of tax breaks, here is an interesting story from today's New York Times Tax Break Used by Drug Makers Failed to Add Jobs:
Two years ago, when companies received a big tax break to bring home their offshore profits, the president and Congress justified it as a one-time tax amnesty that would create American jobs.
Drug makers were the biggest beneficiaries of the amnesty program, repatriating about $100 billion in foreign profits and paying only minimal taxes. But the companies did not create many jobs in return. Instead, since 2005 the American drug industry has laid off tens of thousands of workers in this country.
And now drug companies are once again using complex strategies, many of them demonstrably legal, to shelter billions of dollars in profits in international tax havens, according to their financial statements and independent tax experts.
In one popular accounting move, companies declare their foreign markets as far more profitable than their American businesses — even though drug prices are typically higher in the United States than anywhere else in the world.
Drug makers are not the only American multinationals using tax loopholes to declare large portions of their income beyond the reach of the Internal Revenue Service. The Brookings Institution estimates that multinational companies are using overseas tax shelters to lower their payments to the Treasury by about $50 billion a year.
Interestingly, this investment distorting tax incentive is only discussed in the Treasury Department's background paper on corporate taxation (see previous posting) in an Appendix on taxing international income.
The story goes on to talk about this relates to the issue of transfer of intellectual property offshore:
Tax experts like Michael J. McIntyre, a law professor at Wayne State University in Detroit, say the drug makers are taking advantage of antiquated rules that work better for manufactured products like steel and automobiles.
Under this system, when companies transfer products between divisions in different countries, they must account for the sales internally through “transfer pricing.” But they have significant discretion in how they set prices for these transactions.
That turns out to be especially so for high-margin products like drugs, which in pill form cost only a few cents each to make once they have been invented, but can be sold for several dollars apiece. The hefty profit margins result in part from patents that can protect the drugs from competition for years. And by transferring those valuable patents overseas, companies can declare that their profits should follow the patents overseas as well.
Under the rules of transfer pricing, if a company moves patents or other so-called intangibles from its United States division to a foreign subsidiary, the foreign unit is supposed to pay the American division a fair-market price. But outsiders have a difficult time determining if companies have properly assessed the value of patents, trademarks and other intangible properties.
To further complicate matters, some corporate subsidiaries in tax-haven countries, like Singapore and the Netherlands, now directly finance research in the United States. So they own the patents without ever having to “buy” them from their American parents, Mr. McIntyre said.
“They don’t even have to push it offshore,” Mr. McIntyre said. “It’s already offshore. And once it’s offshore, they strip the income from the onshore activity.”
In theory, companies are only deferring taxes on the profits they shelter overseas, not permanently avoiding tax. If they bring the money back to the United States to distribute to their shareholders, they still have to pay American taxes on it.
But those rules were temporarily suspended when President Bush signed legislation in 2004 to let companies return overseas profits at a rate of 5.25 percent, far below the official tax rate of 35 percent, if they moved the money back by 2006.
The story concludes with a suggestion:
Some experts now say the current system of taxing overseas profits should be scrapped. Even the companies that take advantage of loopholes might benefit if the system were changed, because they could save money on tax planning and have more certainty that the I.R.S. would accept their returns, said Michael C. Durst, a former I.R.S. official who is now special counsel to the law firm Steptoe & Johnson.
The simplest solution, Mr. Durst said, would be shifting to a system in which companies would assign a portion of profit to each country where they made a sale, relative to the size of the sale. Instead of trying to tax profits made overseas, the United States government would simply take its share of the profits on American sales. Such a system would be harder for the companies to game, Mr. Durst said.
But he and other tax experts say that any effort to close loopholes, to be politically viable, might have to be combined with a lowering of the corporate tax rate from its current 35 percent. And no one expects any legislation of that sort, at least not before the next election.
That is an interesting suggestion. The key will be looking at all the loopholes, not just a few tax incentives like the R&E tax credit.
Posted by Ken Jarboe at July 24, 2007 9:43 AM
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