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Friday, August 17, 2012
GAO examines tax evasion potential of foreign-parented groups primarily operating in U.S.
GAO-12-743, “Information on Foreign-Owned but Essentially U.S.-Based Corporate Groups Is Limited”
A new report by the Government Accountability Office (GAO) has analyzed the prevalence of, and potential tax advantages or abuse stemming from, foreign-parented corporate groups with U.S. subsidiaries that conduct the majority of their worldwide operations in the U.S. Although information on the subject was limited, GAO concluded that this structure may provide an advantage because foreign-controlled domestic corporations and their foreign parents may not be subject to the anti-deferral rules applicable to U.S. parent corporations and their foreign subsidiaries. However, the report also concluded that this structure doesn't provide a greater opportunity to avoid the transfer pricing rules.
Background on the anti-deferral rules. U.S. corporations are generally taxed on income from outside the U.S. just as they are on income from inside the U.S. (Code Sec. 862) This rule is intended to ensure an even playing field and eliminate any tax advantage that would otherwise be derived by a U.S. corporation doing business in a low-tax country. However, subject to certain limitations, the U.S. corporation's foreign-source income is insulated from U.S. tax until it is actually brought back to the U.S. and distributed to the U.S. owners. Thus, U.S. corporations can defer income by simply forming a wholly-owned subsidiary in a low-tax country.
The Code's subpart F “anti-deferral” regime addresses this issue by taxing U.S. shareholders of a controlled foreign corporation (CFC) on their pro rata share of the CFC's subpart F income under Code Sec. 952(a) and investments in U.S. property, regardless of whether these amounts were actually distributed to the shareholders. A CFC is defined as a foreign corporation with regard to which more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned (directly, indirectly, or constructively) by U.S. shareholders, who are specifically defined for CFC purposes as a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote in the foreign corporation. (Code Sec. 957, Code Sec. 951(b)) In effect, these rules make U.S. corporations immediately taxable on certain types of income, such as interest and rents, of their foreign subsidiaries.
Background on the transfer pricing rules. Under Code Sec. 482, IRS is authorized to distribute, apportion, or allocate gross income, deductions, credits or allowances among organizations, trades, or businesses owned or controlled by the same interests in order to prevent tax evasion or to reflect the true taxable income of any such entity. This prevents the shifting of income and deductions among certain related taxpayers for the sole purpose of minimizing taxes.
The standard to be applied is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer. The arm's length result of a controlled transaction must be determined under the method that provides the most reliable measure of an arm's length result.
GAO report. In a report addressed to Senate Finance Committee Chairman Max Baucus (D-MT) and Ranking Member Orrin Hatch (R-UT), GAO states that a multinational corporate group, whether U.S.-owned or foreign-owned, can generally shift income to subsidiaries in low-tax countries to avoid or evade U.S. taxes, even if the majority of their economic activity is in the U.S. However, use of a foreign-controlled domestic corporation (FCDC) structure can provide a tax avoidance or evasion advantage over structures where U.S. parents own foreign subsidiaries.
GAO observed that many corporate groups with U.S. owners achieve the FCDC structure by forming a new foreign corporation in a low-tax country that becomes the owner of the corporate group. This transaction is known as an “inversion,” and it is typically used to reduce the group's overall tax liabilities. Foreign ownership can also occur via takeovers or mergers by foreign corporations, foreign corporations with U.S. subsidiaries incorporating overseas at the onset, or foreign corporations expanding their operations and establishing new subsidiaries in the U.S.
The primary advantage of the FCDC structure is that, unlike U.S. parent companies and their foreign subsidiaries, the anti-deferral rules generally don't apply to an FCDC structure. Rather, the anti-deferral rules only apply to an FCDC if it is also the owner of a CFC, or to the foreign parent of an FCDC if the foreign parent is itself a CFC.
However, with respect to tax evasion through transfer pricing abuse, FCDC structures don't provide any particular advantage since they are subject to the same rules as U.S. corporations with foreign subsidiaries.
Limited data. GAO emphasized that data on foreign-owned but essentially U.S.-based corporate groups was extremely limited, and noted that it was unable to describe how they came to adopt this structure “[w]ithout basic information.” GAO stated the Form 5472 doesn't provide information from which GAO can ascertain the percentage that a group's business in one particular country represents of its worldwide business, and it further doesn't contain information on intermediary parties to an FCDC structure. Form 5472 could, however, be revised to better identify and understand FCDCs.
RIA observation: This report could potentially lead to the Senate Finance Committee proposing legislation to ensure greater transparency for FCDCs, such as heightened information reporting requirements.What GAO Found
The FCDC ownership structure could provide a tax avoidance or evasion advantage relative to a structure where U.S. parents own foreign subsidiaries. Academic experts we spoke to said that the FCDC corporate structure does not provide an inherently greater ability to evade taxes through transfer pricing abuse because transfer pricing rules are the same for the FCDC structure as for U.S. corporations with foreign subsidiaries. However, according to IRS officials and our own research, the FCDC structure could confer a tax advantage because certain rules that can limit potential abuse by U.S. parent companies and their foreign subsidiaries may not apply to FCDCs and their foreign parent companies. These rules (called anti-deferral rules) make immediately taxable to U.S. corporations certain types of income such as interest, rents, and royalties of their foreign subsidiaries. These types of income tend to be easily moveable from one taxing jurisdiction to another and hence more amenable to transfer pricing abuse.
Very little is known about the foreign parents of corporations with a majority of their operations in the United States. Studies of this corporate structure were limited to studies of corporations that inverted to achieve this structure. In an inversion, a corporate group with a U.S. owner typically creates a new foreign corporation in a low tax country that becomes the foreign owner of the corporate group in order to reduce the group’s tax liabilities. Even in these cases, the studies did not claim to have information on all inversions. Our own attempts to identify foreign parents of corporations with a majority of their operations in the United States ran into important limitations. In our first method—comparing U.S. sales to the foreign parent’s worldwide sales as shown on their annual reports—provided unrepresentative results because too few foreign parents broke out U.S. sales separately. In addition, results from our second method—using the country where the foreign parent’s principal business activities were located (as reported on IRS Form 5472)—were difficult because IRS does not define principal countries where business is conducted on the form, allowing taxpayers to claim more than one country as a principal location where business is conducted. Thus, the information on the form does not permit clear inferences about how much business the foreign-controlled corporate group does in any particular country, including the United States. Without basic information about these foreign-owned but essentially U.S.-based corporate groups, describing how they came to adopt this structure is not feasible. The benefits of obtaining more information about the possible effects on tax compliance of these foreign-controlled corporate groups, other characteristics of the corporate groups and how they came to be organized as they are would have to be weighed against the cost of collecting such data.
Why GAO Did This Study
A multinational corporate group, whether U.S.-owned or foreign-owned, with subsidiaries inside and outside of the United States can shift income to its subsidiaries in countries where corporate taxes are lower in order to avoid or evade U.S. taxes. As detailed in previous reports, this income shifting can be accomplished through such practices as manipulating transfer prices (the prices that members of the corporate group charge each other for goods and services). Foreign-owned multinational corporations can do this even if the majority of their economic activity is in the United States. Tax policymakers have long been concerned about the tax compliance implications of these practices.
It is not clear what is known about foreign-parented corporate groups with U.S. subsidiaries where the majority of worldwide operations are in the United States. You asked us to provide information about corporate groups that fit this description. Specifically, we agreed to determine (1) whether there are advantages in this ownership structure for avoiding or evading taxes, and (2) what is known about the number, size, type, and other relevant characteristics of these corporate groups and how they came to be organized with this structure.
For more information, contact James R. White at (202) 512-9110 or email@example.com.
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