Proposed tax legislation has promised a cut in top corporate tax rates from 35 percent to 20 percent. Part of the language tries to address some popular tax avoidance strategies that corporations take. But don’t expect attempts at engineering complex legal mechanisms for minimizing and avoiding taxes to disappear.
Strategic tax planning is why, with that 35 percent top rate, the effective tax rate is close to 15 percent. Examining companies you follow for their use of tax loopholes offers great potential stories with impact. David Cay Johnston of The New York Times won a Pulitzer in 2001 for “his penetrating and enterprising reporting that exposed loopholes and inequities in the U.S. tax code, which was instrumental in bringing about reforms.”
Here are a few of the mechanisms to look for.
Shifting intellectual property
Transfer pricing is the technical term for transactions that happen between related companies, and there are many rules governing it. But when you combine transfer pricing with subsidiaries in other tax jurisdictions, you’ve got the makings of massive tax avoidance.
In simplified form, a parent company has a wholly-owned subsidiary in another country either without corporate income tax or with very low tax rates. The parent company transfers ownership of important intellectual property—patents, trademarks, copyrights, business methods, business processes, trade secrets— to the subsidiary and then pays royalties for their use. The fees are considered deductible expenses. The money, really profit that’s been shifted, is no longer taxable. The subsidiary can charge similar fees to all the operating subsidiaries of the main company. The subsidiary can then lend the cash to the company or subsidiaries, or even fund activities, such as research and development, that create more useful intellectual property to lease back.
This tactic can also work within the country, using different state jurisdictions to lower state income taxes.
You don’t hear quite as much about these as a few years ago, but inversions are still an important area. A company arranges an acquisition by another (usually smaller) firm in a country with a low corporate tax rate. In essence, the bigger company takes over the smaller, but structures the transaction so that the resulting parent firm is in the lower tax district. Taxes are still owed to the U.S. for business transacted here, but not on money made in other countries. The parent corporate is then able to invest money in the U.S. without paying taxes on bringing the cash in.
This works because most countries work on a territorial basis on taxes: A company only owes taxes in a country if the money is made there. The U.S., however, has a tax on global profits (with allowances often made for amounts of tax paid elsewhere). Tax legislation may shift the U.S. into a territorial model as well. That could undercut the effectiveness of this model, but the outcome will depend on the final bill, particularly any tax imposed on repatriating foreign earnings.
Real estate holding companies
Just as a corporation can transfer ownership of intellectual property to a subsidiary, it can do the same with its real estate holdings. Factories, office buildings, warehouses and other facilities become the property of the holding company, which then leases use of the property back to the company. As you might expect, the subsidiary adds profit into the lease price, which gets deducted as an expense. Walmart, Bank of America and Autozone are three companies that have reportedly used the strategy. Through the use of mechanisms common in commercial real estate, the subsidiary may be able to operate at a loss on paper, reducing or eliminating taxes on what is received.