by T. R. Reid
Caterpillar, Apple, and Google are not the only U.S. companies that have devised ornate structures to duck U.S. tax on their international sales. Among others, Microsoft has used a similar stratagem, assigning the profits from its foreign sales to subsidiaries in Singapore and (no surprise) Ireland. But Microsoft took this game one step further; it found a way to duck U.S. taxes on its sales inside the United States. To do that, Microsoft set up a wholly owned subsidiary company in Puerto Rico called MOPR (that is, Microsoft Operations Puerto Rico). Puerto Rico is, of course, a U.S. territory, but the IRS treats it as a foreign country for corporate tax purposes.
Microsoft headquarters in the United States then assigned to the Puerto Rico operation the North American rights to the company’s intellectual property in software, operating systems, search engines, and Web-based products. Whenever a Microsoft product that uses this intellectual property (which is to say, all Microsoft products) was sold in the United States, about half of the profit from the sale was attributed (on paper) to the Puerto Rican subsidiary. This meant that a subsidiary with a staff that comprised less than 1% of Microsoft employees was credited with earning half of the company’s profit in the United States. Microsoft has negotiated a deal with the cash-starved Puerto Rican government to pay income tax at a rate of about 2% on these profits.
“This structure is not designed to satisfy any specific manufacturing or business need,” concluded a congressional study of the Microsoft tax-avoidance mechanism. “Rather, it is designed to minimize tax on sales of products sold in the United States. . . . By routing its manufacturing through a tiny factory in Puerto Rico, Microsoft saved over $4.5 billion in taxes on goods sold in the United States” over a three-year period.8
Despite these industrious efforts to escape American taxes, Caterpillar, Apple, Google, and Microsoft still declare themselves to be American corporations. Apple’s CEO, Tim Cook, was adamant on this point that day when the senators were grilling him about “stateless income.” “I am often asked,” Cook said, “if Apple still considers itself an American company. My answer has always been an emphatic ‘Yes.’ We are proud to be an American company and equally proud of our contribution to the U.S. economy.”
But the lure of tax avoidance is so strong that other American companies have been perfectly willing to renounce legal ties to their home country and move overseas (on paper at least) in pursuit of a lower rate of corporate income tax. This is done through a process called an inversion. It’s a merger arrangement in which the U.S. enterprise buys (or sometimes is bought by) a foreign company and then moves its legal domicile to the new partner’s home country. Because it is no longer an American corporation—even though the management and much of the workforce stay home in the United States—it no longer has to pay that 35% tax on overseas profits. The term “inversion” is used because many of these deals involve a big American company merging with a much smaller foreign firm. The deal inverts the stature of the two, because the smaller foreign company becomes the owner, on paper, of the much larger and richer American “subsidiary.”
Since 2010—when a group of lawyers at the Skadden, Arps firm worked out the legalities of this maneuver—dozens of U.S. companies have become former U.S. companies by means of inversion.9 Burger King, an iconic American burger, fries, and milk shake franchise founded in Florida in the 1950s, is one item on this varied corporate menu. The fast-food giant pulled off a Whopper of an inversion deal in 2014—and became a Canadian company in the process—when it acquired Tim Hortons, a coffee-and-doughnut restaurant chain north of the border. Burger King, with 13,667 outlets in more than fifty countries, was much bigger than its new partner, Hortons, which had about 4,600 restaurants, almost all of them in Canada. Yet the company resulting from this deal, dubbed Restaurant Brands International, incorporated in Canada. Burger King was still managed from the same corporate office in Miami; it still celebrated the Fourth of July and Presidents’ Day with big promotions across the United States; on paper, though, it became Canadian, which meant its profits were now to be taxed at the Canadian corporate income tax rate, 15%, as opposed to the 35% rate back home. Burger King’s tax break was offset somewhat, though, because the province of Ontario charged another 11.5% in corporate tax.
The more important tax benefit seemed to be that the multibillion-dollar sums Burger King had been holding overseas could now be brought home to the United States, in various ways, without paying the U.S. income tax on that money. As a Canadian company, Burger King no longer had to pay U.S. tax when it brought foreign profits home. This is a standard, fundamental tax-avoidance aspect of inversion but not the most important one. The more valuable tax maneuver that American firms can and do employ after an inversion is a process called earnings skimming. For this one, the now-foreign company lends large sums to the parts of the firm remaining in the United States. The U.S. branch uses the borrowed money to pay its bills and makes an interest payment on the loan to the overseas “headquarters.” Because this is considered a business loan, the interest can be deducted (“skimmed”) from taxable earnings in the United States. In essence, a company borrows from itself, pays interest to itself, and gets a big deduction on its U.S. tax bill—for a transaction that may exist only on paper. Individuals can’t use this trick to cut their tax bills, but it’s legal for corporate taxpayers that are incorporated in a foreign country.
By early 2016, the inversion innovation had become so popular that the New York Times compared the surge in tax-avoiding corporations to the flood of immigrants pouring into Europe from the war-torn Middle East. “A Tidal Wave of Corporate Migrants Seeking (Tax) Shelter” read the clever Times headline. Almost any company in almost any industry was said to be considering a move to renounce the United States and move its titular headquarters offshore to duck taxes. Even firms that had profited from federal spending programs, government bailouts, or other significant benefits funded by U.S. taxpayers were willing to flee the country, and its 35% corporate tax, following the siren call of inversion.
Johnson Controls, for example, was a venerable American manufacturing concern—its founder, Warren Johnson, invented the thermostat in 1883—that became a major supplier (of passenger seats, batteries, and so on) to the auto industry. But in the Great Recession of 2008–9, with the Detroit automobile makers on the brink of bankruptcy, parts suppliers like Johnson Controls were in dire trouble. Johnson’s president, Keith Wandell, went to Washington to plead for federal bailout money for his customers. “We respectfully urge . . . Congress as a whole to provide the financial support the automakers need at this critical time,” he said. Sure enough, Washington came up with some $80 billion in emergency funding for domestic automakers—money that proved a lifeline not only to General Motors and Chrysler but also to their major suppliers, like Johnson Controls. (Johnson Controls later noted that it had asked Congress for bailout money only for the companies it supplied, not for itself.) In addition to this federal support, the company had received tens of millions of dollars of tax breaks from states where it had plants.
How did Johnson Controls demonstrate its gratitude for this timely help from American governments? In 2016, the company announced that it was selling itself to a firm incorporated in Ireland, Tyco International, and would no longer be a U.S. corporation. The firm estimated this move would cut its corporate income tax payments to the U.S. government by about $150 million per year. Tyco, incidentally, was itself a veteran of tax-avoidance inversion tactics, having moved its corporate domicile (on paper at least) from the United States to Bermuda to Switzerland to Ireland over a period of roughly twenty years.
Pfizer, the giant drug firm that makes such staples of the American medicine cabinet as Viagra and Preparation H, concedes in its reports to stockholders that its bottom line is heavily dependent on U.S. government programs financed by taxes. “Any significant spending reductions affecting Medicare, Medicaid, or other publicly funded or subsidized health programs . . . could h
ave an adverse effect on our results,” Pfizer noted in 2014. But this did not stop Pfizer from charging ahead with the biggest attempted inversion ever, in 2016, when it paid $155 billion for an Irish drug company called Allergan and announced plans (later scrapped) to move its corporate domicile to Ireland.
For the most part, the companies following the inversion route say that their move to a foreign jurisdiction is dictated by sound business considerations, not by tax concerns. That’s exactly what Rick Gonzalez, the chief executive of an Illinois-based pharmaceutical firm called AbbVie, said when he announced that the U.S. firm intended to buy a drug company called Shire, which was headquartered on the island of Jersey, in the English Channel. AbbVie would then incorporate in Jersey and avoid much U.S. corporate tax. Gonzalez said, though, that this tax saving was not the reason for the planned merger; the company was moving to that island in the channel in order to provide better service to its customers. But then, before the purchase of Shire could be completed, the U.S. Treasury changed some of the rules surrounding inversions, and suddenly the tax benefits for AbbVie looked much smaller. AbbVie abruptly called off its proposed merger with Shire. Gonzalez issued an angry statement saying the Treasury had “interpreted longstanding tax principle in a uniquely selective manner designed specifically to destroy the financial benefits of these types of transactions.” With that, AbbVie pretty much gave the game away. If the move to the isle of Jersey was not undertaken for tax reasons, why would a tax ruling “destroy the financial benefits” of the deal?10
Sometimes, the political or public relations cost of an attempted inversion turns out to be greater than the potential tax savings. The drugstore giant Walgreens found that out when it bought a stake in the European drugstore chain Alliance Boots and then proposed to move its legal domicile from Deerfield, Illinois, to Bern, Switzerland, where Alliance Boots was headquartered. The company was denounced by people who argued, fairly, that a famous American drugstore heavily dependent on taxpayer-funded Medicare prescription sales ought to be an American taxpayer. The Chicago Tribune came up with the term “Walgreed”; the business columnist Al Lewis called the plan an example of “the looting of America. . . . Yes, your corner drugstore would like to take your co-pay, bill your Medicare policy, and then pay its taxes in Switzerland,” Lewis wrote. Under withering attacks from politicians, the press, and its customers, Walgreens had second thoughts and announced that it would retain its corporate presence in the United States.
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ALL OF THE FIRMS cited here, and countless others, have been attacked by critics ranging from Bernie Sanders to Barack Obama to Donald Trump. They have been called “corporate traitors” and “Benedict Arnold companies” for shifting their tax burden out of the United States. They’ve been called outlaws and criminals for setting up such intricate structures to get around the tax code. In response to this calumny, the corporations reply that they are engaged in perfectly legal activity. They “minimize” their tax bills; they “avoid” paying taxes; but they do not “evade” taxes, because that would be against the law.
The distinction here is set forth in the definitive text Tax Law Design and Drafting, edited by the acknowledged master of the subject, Victor Thuronyi of the International Monetary Fund. (Dr. Thuronyi’s magisterial study is priced at $560, so please stop complaining about the price you paid for this book.) That heavyweight piece of analysis defines tax “evasion” as a “clear violation of the tax laws, such as fabricating false accounts.” Tax “avoidance,” in contrast, is “behavior by the taxpayer that is aimed at reducing tax liability but that does not constitute a criminal offense.” Avoidance can involve “abusing gaps or loopholes in the law” but falls short of “breaching specific statutory duties.” And tax “minimization” is defined as “behavior that is legally effective in reducing tax liability,” such as paying your January bills in December so as to get the deduction in the current tax year.
But of course these distinctions are not always so clear in practice. This has led to the cynical observation that “the rich avoid, the poor evade”; that is, rich taxpayers can afford to pay lawyers who will find a complicated but legal way to duck (that is, “avoid”) taxes, while poorer people just cheat (that is, “evade”). Franklin Delano Roosevelt, no friend of those in the upper brackets, observed in 1935 that “tax avoidance means that you hire a $25,000-fee lawyer, and he changes the word ‘evasion’ into the word ‘avoidance.’”
Defenders of tax avoidance tend to fall back on some favorite judicial utterances that seem to support the notion that a taxpayer is not obliged to pay one cent more than the minimum he can get away with under the law. In Britain, the champion of this position was Lord Clyde, the lord justice general, who famously declared in 1929 that “no man in this country is under the smallest obligation . . . to enable the Inland Revenue to put the largest possible shovel in his stores.” In the United States, the preferred citation comes from the best-named magistrate in U.S. history, the federal circuit court judge Learned Hand. In one of the most widely cited opinions in the history of tax law, Judge Hand declared that “anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” In the same opinion, Hand even seemed to authorize both “avoiding” and “evading” taxes. “A transaction, otherwise within an exception of the tax law,” he wrote, “does not lose its immunity because it is actuated by a desire to avoid, or, if one choose, to evade, taxation.”
Learned Hand’s mellifluous defense of tax avoidance is cherished by the lawyers and consultants who design “convoluted and pernicious strategies.” What these lawyers and consultants generally don’t mention is that in that case—it was Helvering v. Gregory, issued in 1934—Judge Hand also said that there are limits to how far you can go to avoid, or evade, taxes. In the Helvering case that tax lawyers love to quote, Learned Hand actually ruled in favor of the IRS and ordered the avoider to pay up.11
The case involved a wealthy Brooklyn socialite, Mrs. Evelyn Gregory, who was the sole owner of a company called United Mortgage Corporation. That firm, in turn, owned about $133,000 worth of stock in a separate company, the Monitor Securities Corporation. In 1928, Mrs. Gregory decided to sell the shares of Monitor Securities (it turned out to be a smart decision, because Monitor’s shares lost virtually all their value in the 1929 market crash). Under the tax code, her profit on those shares would have been treated as ordinary income, and thus would be taxed at the top income tax rate. But if she could arrange the deal so that her profit was a “capital gain,” she could cut the tax bill in half. To make this arrangement, Mrs. Gregory’s lawyers created a shell corporation—no employees, no board of directors—in Delaware. That newly formed corporation received (on paper) the shares in Monitor, sold them, and distributed the proceeds to Mrs. Gregory. She put the money in the bank and dissolved the Delaware corporation six days after it was formed. She then told the IRS that her earnings on the Monitor shares were “capital gains.” On this basis, Mrs. Gregory paid the tax on her profit at the lower rate. The IRS went to court, arguing that she should have paid at the higher rate for ordinary income.
In his oft-quoted opinion, Hand first lays out the principle quoted above: nobody has to pay a cent more in tax than the minimum required by law. But then he goes on to examine the dubious transactions—the empty corporate shell that existed for all of six days—Mrs. Gregory engaged in to take advantage of the lower tax rate. And he concludes that the whole complex operation was a “sham,” designed only to evade taxes: “The transactions were no part of the conduct of the business of either or both companies; so viewed they were a sham.” Because there was no legitimate business purpose for routing the shares the way she did, Mrs. Gregory had to pay the full amount the IRS demanded. “It is plain,” Judge Hand decides, “that the taxpayer may not avoid her just taxes.” A year later, the Supreme Co
urt affirmed Hand’s ruling; Mrs. Gregory’s “sham” did not work.
It doesn’t seem like too great of a stretch to suggest that some of the machinations employed by Google, Apple, and others to avoid (“or, if one choose, to evade”) taxes might also fall into the “sham” category. For the most part, though, these companies have faced little or no trouble from the IRS. If some corporate treasurer can find a tax lawyer to design an intricate international arrangement that moves U.S. profits overseas and then cuts the tax bill, the IRS tends to stand aside and let it happen. This is partly because the corporations hire sophisticated tax accountants and law firms to make sure that maneuvers like the “Dutch Sandwich” fall within the precise parameters of the tax code.
But it’s also because the IRS, facing budget cuts year after year from a hostile Congress, just doesn’t have the firepower to take on rich, well-lawyered tax avoiders. The commissioner of the IRS, John Koskinen, essentially admitted that this is the case. “When Congress cuts our budget,” the commissioner told me, “they say we have to do more with less. But the fact is, we’re doing less with less because we don’t have the resources to enforce the law the way we would want to.” In the year 2015, the IRS reported that it performed fewer corporate audits than in any year since 2002, and the revenue generated from audits also hit a ten-year low.
