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February 04, 2005
Speaking From Both Sides of the Mouth: The Art and Science of Corporate Tax Avoidance
    by William Baue

Three reports--by a US tax watchdog, a pair of US academics, and a UK socially responsible investment firm--find troubling trends in corporate tax strategies.


Reports from both sides of the Atlantic are exposing problems with corporate tax payment strategies. In the UK, the socially responsible investment (SRI) arm of Henderson Global Investors surveyed the board chairs of 335 companies in the FTSE 350, and found less than half of those responding have adopted formal tax policies or reviewed tax strategy in the last year. Given the increasing scrutiny of taxes and the argument by the UK Inland Revenue (the equivalent of the US Internal Revenue Service (IRS)) that "tax is a matter not just of law but of morality," the low level of board attenuation to tax-related issues seems surprising, according to the survey.

"With some notable exceptions, most companies do not appear to have considered systematically the relationship between their tax management and their approach to corporate responsibility," writes report author Rob Lake, Henderson's head of corporate engagement. "The Deputy Chairman of the Inland Revenue, Dave Harnett, has asked, 'with increasing numbers of investors taking an interest in the ethical and social policies of companies […], are we now at a time when corporate responsibility demands a new attitude to tax avoidance."

In the US, the notion that there are ethical considerations associated with tax avoidance seems "quaint," to borrow a phrase with some currency. A respected tax watchdog and a pair of academics report how corporations have cultivated tax avoidance into an art and a science by speaking out of both sides of their mouths. In annual reports and Securities and Exchange Commission (SEC) filings, corporations tell shareowners of higher profits than they report to the IRS and state agencies in tax filings, according to recent reports released by Citizens for Tax Justice (CTJ). Corporations also use tax shelters to artificially reduce debt in order to increase their attractiveness to investors, according to a January 2005 study by finance professors from Duke University and Pace University.

"Tax breaks and shelters allow companies to reduce their taxable profits to a lower level than their actual profits," said Bob McIntyre, CTJ director and coauthor of a report released earlier this week on state corporate taxes and a September 2004 report on federal corporate taxes.

"A simple case, for example: A company tells its shareholders it made $100, after deducting $30 for depreciation," Mr. McIntyre told SocialFunds.com. "It tells the IRS it made $50 in taxable income after deducting $80 for depreciation."

In 2002 and 2003, the 275 companies studied in the September 2004 CTJ report told their shareowners they earned $739 billion but paid taxes on less than half--$363 billion. The most striking developments documented in the report are the "zero tax" and "negative tax" trends. Between 2001 and 2003, almost a third (82) of the 275 companies (from the Fortune 500) paid no federal income tax in at least one year, and 28 companies exploited so many tax breaks that they received tax rebates all three years. These companies, who paid not the statutory 35 percent corporate tax rate but a negative rate, included Pepco Holdings (ticker: POM), which had a -59.6 percent tax rate, Prudential Financial (PRU: -46.2 percent), ITT Industries (ITT: -22.3 percent), and Boeing (BA: -18.8 percent).

The Duke/Pace study, which collects the largest known sample of tax shelters used by corporations during the past 25 years, examines eight common tax shelter strategies used by 43 corporations. The names of the tax shelters described in three appended case studies suggest their complexity: for example, a "cross-border dividend capture shelter" (CBDC) at Compaq (now HPQ) and a "contingent-payment installment sale" (CPIS) at Colgate-Palmolive (CL).

The study finds that sheltering firms have debt-to-total asset ratios that are one-third lower than comparable firms that do not use tax shelters. According to the researchers, this reduced debt can lead to better debt ratings, cheaper borrowing rates, and less risk of violating corporate covenants. The study also helps explain why some large, profitable corporations pay so little corporate tax and appear to use such a small amount of debt.

The Henderson survey asked pointed questions (characterized by one respondent as "very prescient") about the relative aggressiveness or conservativeness of companies' approaches to tax avoidance, but it did not prejudice its interpretation of responses. For example, the one company honest enough to admit its "aggressive" tax management has conducted a board review in the last year and has a board-approved tax policy, which "suggests that a conscious and managed approach is being taken." On the other hand, 17 of the 44 companies with a "medium" approach to tax avoidance have not conducted a board review and 19 do not have a documented tax policy.

"A 'medium' willingness to take on tax risk that is not underpinned by adequate board involvement may suggest flaws in corporate governance," states Mr. Lake in the report.

The notion in the UK report that tax issues raise corporate governance concerns about reputational risk seems foreign to Mr. McIntyre, who has covered the US corporate tax scene for decades.

"It would be nice to think that companies worry about public perception that they're doing bad things, but most seem either not to care, or figure that they can pull the wool over the public's eyes," Mr. McIntyre said. "Most companies that commented on our report admitted that our findings about their low taxes were correct."

"A few boldly--and falsely—claimed that the tax information in their annual reports is wrong," he added. "And some others offered feeble excuses for their low tax payments."

 

 
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