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Apple, Google May Profit on a Tax Holiday


Those companies and others say they'll bring home billions in earnings—but only if they get a big tax break

Google (GOOG) Ireland is not a branch office of the U.S.-based search giant. It's a separate corporation, and the IRS can't touch a dime that Google Ireland earns from its core business until it sends profits back home to the mother ship. The term of art for bringing the money back is repatriation—the same as for a soldier captured abroad.

U.S. multinationals have more than $1 trillion in profits stashed in overseas subsidiaries. Some of the companies with the most money squirreled away say they're prepared to bring a big chunk of it home. All they want in return is a temporary tax break that wouldn't cost the U.S. Treasury anything, since it's money that would otherwise be kept abroad and not taxed at all. The tax break would actually raise billions of dollars from applying the reduced tax rate to the money that's been repatriated.

What's not to like? John T. Chambers, Cisco's (CSCO) chief executive officer, told securities analysts in February that "you're now seeing political leaders at all levels understand" the case for a tax holiday on repatriated foreign profits. "I think this one has well over a 60 percent probability of being resolved in a positive way," he said. Although a lobbying campaign is just getting under way, Representative Brian P. Bilbray (R-Calif.) has already introduced a bill that would let companies bring home money tax-free if they used it for research and development or facilities expansion.

Aside from Cisco, the growing coalition for repatriation relief includes Adobe (ADBE), Apple, CA Technologies (CA), Duke Energy (DUK), Google, Microsoft (MSFT), Oracle (ORCL), Pfizer (PFE), and Qualcomm (QCOM)—powerhouses all. The group is seeking fundamental changes in tax law, but if it can't get them right away, it still wants the tax holiday. Its opening position is that there should be no conditions on how the money is used. Chambers argued in a Wall Street Journal op-ed last October that a repatriation might create as many as 2 million jobs.

It's a seductive argument—reap billions in tax revenue from money that's currently untaxed and generate economic growth to boot. On closer inspection, though, the coalition's argument has some logical loopholes. A nearly identical holiday passed by Congress in 2004 and taken mostly in 2005 did little to boost jobs or investment, according to several independent economic studies. Some economists say a holiday today might be even less effective because cash isn't a constraint in 2011—it's bountiful, thanks to the Federal Reserve's loose-money policy. U.S. nonfinancial corporations have $1.9 trillion in liquid assets, the Fed says. No more than half of that—probably significantly less—is offshore. (An unknown portion of the $1 trillion-plus in foreign-held profits isn't cash. It's tied up in foreign factories, offices, and the like and can't easily be repatriated.)

"The problem is lack of demand or lack of investment opportunities" in the U.S., says Dhammika Dharmapala, an economist and law professor at the University of Illinois. Plus, granting another holiday so soon might induce companies to stash even more money abroad, convinced that if they wait long enough another holiday will arrive, says Thomas J. Brennan, a professor at Northwestern University School of Law.

Lawmakers have thus far been cool to the idea of a repatriation holiday. Passing one without reform "makes a farce out of the whole system," says Kent Conrad, a North Dakota Democrat on the Senate Finance Committee. Even corporate America isn't unanimous in its support. "A one-time repatriation of profits is a bad idea," says United Technologies (UTX) Chief Financial Officer Gregory J. Hayes. "My fear is that we'll have a repeat of 2004. If companies repatriate these profits and spend it on things like share buybacks, that will create such negative connotations around tax reform with the public."

Still, the idea lingers. Congress and the Obama Administration are turning over trash cans in search of ways to accelerate growth and bring down the unemployment rate without stimulus measures that increase already-huge budget deficits. Hence the appeal of what looks like a free lunch. For government, the challenge is to choose emergency fixes that won't end up causing long-term harm. "The problem is, there's no lobby group for good government," says John L. Buckley, former chief Democratic tax counsel for the House Ways and Means Committee.

Tax collectors have been struggling to get their hands on the profit from international operations since the early days of the corporate income tax, which was enacted in 1909. Each year brings another strategy for legal tax avoidance. "All are alike," President Franklin D. Roosevelt wrote to Congress in 1937, "in that failure to pay results in shifting the tax load to the shoulders of others less able to pay and in mulcting the Treasury of the Government's just due."

Legal avoidance may not be new, but it is booming, according to data collected by Bloomberg Businessweek from the footnotes of annual 10-K statements of companies on file at the Securities and Exchange Commission. Congress says that companies don't have to pay tax on actively earned profits from their foreign subsidiaries as long as they keep the money permanently reinvested outside the U.S. in subsidiaries that are organized as foreign corporations. Each year the parent companies state in their 10-Ks how much money is stored in that category. (Passive income such as interest is immediately taxable.) For 30 big companies, the profits kept abroad grew 560 percent, to $740 billion, from the end of 2000 to the end of 2010, SEC filings show.

The temporary holiday passed in 2004 was supposed to shrink the pile. It allowed companies to repatriate profits attributed to their foreign operations at a 5.25 percent tax rate instead of the usual 35 percent. (Companies get a credit for foreign tax already paid.) According to the IRS, $362 billion came back to the U.S., of which $312 billion was eligible for the reduced tax rate. The amount repatriated was 45 percent of the total held abroad at the end of 2004. In one of the more extreme repatriations, Hewlett-Packard (HPQ) brought back $14.5 billion—nearly all of the $15 billion that it had abroad, SEC filings show.

In the long run, though, the holiday was rife with unintended consequences. Research by Northwestern's Brennan indicates companies rationally concluded that if they were granted one special one-time tax break, they might very well be granted another. That gave them the incentive to attribute even more of their profits to foreign operations, like a shopper waiting for an end-of-season sale. By the end of 2006 the total "permanently" reinvested abroad had exceeded the 2004 peak. It has continued to grow since.

Business did indeed lobby for seconds soon after its first helping of tax relief. In 2009, just five years after the 2004 break, Congress debated giving another one as a stimulus-bill amendment sponsored by Democratic Senator Barbara Boxer of California and Republican Senator John Ensign of Nevada. The amendment was defeated 42-55 on the floor of the Senate—a victim, perhaps, of the anti-business sentiment sweeping the nation after the financial crisis.

Cutting taxes on big businesses that stow profits abroad is never going to be an applause line for candidates on the campaign trail. Then again, it doesn't have to be. All business has to do is get a bill through Congress and signed by the President—using carefully targeted contacts, not billboards and airtime. To that end, the pro-holiday coalition has quietly assembled an all-star lobbying and communications team heavy on Democratic representation, possibly to counter the impression that tax relief for big business is solely a Republican objective.

The team's chief communications strategist is Anita Dunn, the Democratic media consultant who served as President Barack Obama's interim communications director during his first year in office. Politico.com first reported her involvement on Mar. 4. Dunn runs strategic communications and public relations for SKDKnickerbocker, a new firm created from the merger of Washington's Squier Knapp Dunn Communications and New York's Knickerbocker Consulting. The lead lobbyists are former Representative Jim McCrery of Louisiana, who was the ranking Republican on the House Ways and Means committee, and Jeffrey A. Forbes, the former chief of staff to Senate Finance Chairman Max Baucus (D-Mont.).

The pro-holiday message has gained traction, at least a little. As Bloomberg News reported on Feb. 11, President Obama's consistent pledge to "end tax breaks for companies that ship jobs overseas" disappeared from his stump speech after Republicans won the House in November and Obama began talking with executives about a corporate tax code overhaul. In his State of the Union address, Obama even proposed cutting the corporate tax rate while simultaneously closing loopholes. In a show that the Administration wants to work with business, not against it, Treasury Secretary Timothy Geithner has expressed openness to some kind of repatriation-tax holiday as long as it's linked to "comprehensive" tax reform.

The economics of a holiday, however, are less pliable than the politics. While many economists agree there's something wrong with a tax code that induces companies to keep profits abroad when they could be more efficiently deployed in the U.S., fewer say that a one-time tax break is the right remedy.

Take Federal Reserve Chairman Ben Bernanke. The coalition's talking points include what sounds like a plug from him in congressional testimony on Mar. 2. "As you know," Bernanke said, "I've suggested looking at the corporate tax code, and one aspect of it is the territoriality provision. If you were to allow firms to bring back cash, you know, from abroad without additional taxation or limited additional taxation, there might be more incentive for them to bring it home—and use it domestically."

Sounds like an endorsement. On closer reading, though, it's apparent that Bernanke wasn't talking about a one-time holiday, but about changing the method of taxation to a territorial system, in which only profits earned in the U.S. are taxed. The same goes for a December quote cited in the talking points from Mark Zandi, chief economist of Moody's Economy.com: "The (repatriation) proposal is a reasonable, albeit very modest, idea." Says Zandi now: "At this point I don't think I would go down that path" of a stand-alone tax holiday. "It makes much more sense to fold it into broader tax reform."

Even on theoretical grounds the tax holiday is debatable. Cutting taxes can stimulate the economy if it improves companies' incentives to invest and expand. But the holiday, as a break on profits that have already been made, would not improve incentives, says Edward D. Kleinbard, former chief of staff of the Joint Committee on Taxation, who is a professor at the University of Southern California's Gould School of Law.

To build the economic case for a holiday, the coalition cites several studies, including two from 2003 and 2008 by Allen Sinai, president of consulting firm Decision Economics, which predicted their impact based on an econometric model. But the studies—sponsored by the American Council for Capital Formation, which favors lower corporate taxes—didn't consider the outcome of the 2005 repatriation. Some analyses that did showed disappointing results. The 2005 repatriation "did not increase domestic investment, employment, or R&D," but did boost share buybacks, concludes a forthcoming Journal of Finance article by Illinois' Dharmapala, C. Fritz Foley at Harvard Business School, and Kristin J. Forbes at the MIT Sloan School of Management.

One anecdote makes the point acutely: Hewlett-Packard, even as it was pulling its $14.5 billion home from abroad, announced plans in 2005 to reduce its workforce by 14,500. "Given that the last holiday did not result in repatriating firms increasing investment levels, it seems the burden is on the advocates of another holiday to explain why things would be different this time," Dharmapala said in an interview. Sinai, of Decision Economics, stands by his research: "I'm quite sure there were some jobs created," he said. Hewlett-Packard declined comment.

Legal tax avoidance intensified after World War II, as the U.S. dominated the world economy. Companies with newly established foreign operations had fresh opportunities to shift income. The Kennedy Administration worried that the flow of dollars out of the country was jeopardizing U.S. adherence to the gold standard. In 1962, Congress passed Subpart F of the Internal Revenue Code, which reduced companies' ability to keep foreign profits out of reach of the U.S. tax authorities by "deferring" taxation in overseas vehicles. But Subpart F didn't lock the door.

As is often the case in Washington, the scandal isn't what's illegal—it's what's legal, in this instance tax-avoidance systems with names like the Double Irish and the Dutch Sandwich. As detailed in a Bloomberg Businessweek investigative story on May 17-23, Forest Laboratories (FRX), which makes the blockbuster antidepressant Lexapro, sells nearly 100 percent of its drugs in the U.S.—and cuts its U.S. taxes dramatically by attributing the bulk of its profits to a law office in Bermuda. Another story in the magazine last year explained how Google reduced its income taxes by $3.1 billion over three years by shifting income to Ireland, then the Netherlands, and ultimately to Bermuda. Microsoft has used a similar arrangement. Records in the Cayman Islands and Ireland show that Facebook is setting up such a structure too.

The clearest evidence that companies are carefully managing where they report their taxable profits is that earnings overseas have grown faster than sales abroad. In 2008, large U.S. pharmaceutical companies reported about 80 percent of their pretax profits overseas, up from about a third a decade earlier, according to Martin A. Sullivan, a contributing editor to trade journal Tax Notes and a former U.S. Treasury Dept. tax economist. Those companies' foreign sales grew far more slowly during that period: from 38 percent of revenue to 52 percent.

In fact, the very success of tax-avoidance strategies is what motivates the push for a holiday. U.S. multinationals have an embarrassment of overseas riches, more than they can use. But if they bring profits home, they must pay the difference between the U.S. tax rate and the superlow rate they have already paid abroad. That would sting: In 2007 through 2009, Google reported an average tax rate of just 2.4 percent on the earnings it claims it earned overseas. If Google and others can get the repatriation rate down to 5.25 percent as in 2005, the pain will be more tolerable. (In 2005 tax-planning strategies helped lower the average tax paid on repatriated funds to just 3.7 percent, according to the Joint Committee on Taxation.)

Critics of a proposed repatriation break complain that it would reward companies that have aggressively shifted profits into tax havens. "This is the system they bought into. Now they present [paying tax on] the fruits of their success as some kind of a hideous punishment," says USC's Kleinbard.

There's broad agreement that, if done right, corporations and the federal government would benefit far more from a new tax code than a tax holiday. Many multinationals, including companies on both sides of the holiday debate—such as Cisco and United Technologies—want the U.S. to adopt a territorial system similar to that used by most of the rest of the world. Under such a system, the U.S. would largely stop trying to go after companies' worldwide income and instead would mostly tax profits earned in the U.S., whether by U.S.-based or foreign-based companies. The only other sizable countries that still use a system like the one in the U.S. are Chile, Israel, Mexico, Poland, and South Korea. Supporters of a territorial taxation include the bipartisan National Commission on Fiscal Responsibility and Reform created last year by Obama.

But a pure territorial system has its own disadvantages. Because it doesn't tax companies' foreign income, it amps up the gains from shifting income to low-tax jurisdictions. So it works only if accompanied by close supervision and rules against gaming the system. Most developed countries, including Germany and Australia, have regulations to curb this sort of gaming, meaning that their systems, while opposite in concept to that of the U.S., are not all that different in practice.

Lowering the U.S. tax rate on all earnings, foreign and domestic, from 35 percent is a high priority of business groups. But thanks to loopholes, what companies actually pay as a percentage of their income is around 30 percent. That's roughly the same as in several large industrialized countries in Europe and lower than the effective rate reported by Japanese companies, according to recent research by Kevin S. Markle


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