Addressing the Fiscal Cliff

 | Feb 13, 2013 | 12:00 PM EST  | Comments
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This commentary originally appeared at 8:15 a.m. EST on Feb. 13 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

"If you know the position a person takes on taxes, you can tell their whole philosophy. The tax code embodies all the essence of life: greed, politics, power, goodness, charity."

-- Former IRS commissioner Sheldon Cohen

It is my contention that dealing with our debt and deficits (i.e., the fiscal cliff) is probably easier to resolve than most believe. As a matter of necessity, it must be accomplished by:

  • cutting spending;
  • reforming Social Security, Medicare and Medicaid;
  • accelerating the pace of domestic economic growth;
  • reducing government waste; and
  • raising taxes.

As a starting point, there is the U.S. tax code.

There is so much waste and accumulated abuse of our tax code that savings are abundant if our politicians only looked under those rocks.

As Ralph Nader has written, the U.S. tax code (all 7,500 pages of it) "is the victim of severe tampering and perforating by corporate lobbyists and tax attorneys and unattended to by inadequate IRS enforcement."

One particular abuse that should have bipartisan approval and that seems impossible to defend lies inside an innocent-looking, green-trimmed, white, five-story building in the Cayman Islands: the Ugland House office on South Church Street.

The unassuming but appropriately named Ugland House is currently the home of over 18,500 corporate entities that reside there for the express purpose of avoiding (though some might say evading) U.S. taxes. It houses hedge funds and other partnerships as well as some of the largest U.S. corporations extant -- all of which benefit appreciably from the avoidance of current federal income taxes by assuming a Grand Caymans address of incorporation.

Considering that the Cayman Islands have a tax rate of 0.0% and the fact that some of the largest U.S. corporations received billions of dollars from the bailout, one would assume the government would recoup some of this corporate welfare in the form of taxes. Instead, some of these corporations have not paid any federal income taxes for years.

In late 2011, Citizens for Tax Justice analyzed the tax payments of 280 of the Fortune 500's largest companies. Seventy-eight of the 280 companies paid zero or less in federal income taxes during at least one year from 2008 to 2010. Thirty corporations paid less than nothing in aggregate federal income taxes over the entire 2008-2010 period.

How are America's largest corporations avoiding so many taxes? A practice called transfer pricing. This accounting practice lets companies buy and sell products and services with their own offshore subsidiaries and set prices themselves, according to David Evans in the Bloomberg article "The $150 Billion Shell Game" from 2004.

This practice is just as relevant nine years later. Corporations abuse the accounting practice by shifting profits overseas to avoid U.S. taxes. Their prices are set artificially high for imports and low on exports. In the U.S., the corporations are allowed to claim the high expenses on the imports and the smaller profits on the exports in their IRS filings.

Profits earned through a foreign subsidiary of a U.S. corporation are not taxed until the cash is repatriated in a dividend back to the U.S. parent company. As a result, while the statutory federal corporate income tax rate stands at 35%, it is estimated that the effective tax rate of the largest publicly traded companies in the U.S. is closer to 20%.

Regardless of one's party affiliation, the very existence of the Ugland House appears indefensible.

Back to Nader: "Any significant push toward fundamental tax reform has to start by chipping away at the corporatized, commercial Congress which uses tax breaks, deferrals, credits and exemptions as inventory to sell for campaign cash in increasingly costly campaigns."

If the basic purpose of taxation is to raise revenue needed for public services. Why should hardworking citizens underwrite corporations who skate the tax code? How does filling the coffers of profitable companies who avoid taxes through a labyrinth of skillful tax avoidance -- including Bank of America (BAC), General Electric (GE), Oracle (ORCL), Cisco Systems (CSCO), Microsoft (MSFT), Apple (AAPL), Verizon (VZ) and so many other companies -- and their ridiculously high-paid executives benefit the lives of everyday citizens?

At most large multinational U.S. corporations the tax department is a well-oiled and systematic profit center. In 2010 GE earned $7 billion in the U.S. but paid no federal taxes to the U.S. government. Verizon and Bank of America didn't pay federal taxes either. Yet all three companies were provided with the resources, public services and infrastructure to conduct their business.

By most estimates over $1 trillion of profit earned by U.S. companies sits in offshore cash and short-term investments in offshore holding companies and has never been taxed by the U.S. Two conspicuous examples include Microsoft and Apple, which hold $50 billion and $100 billion in cash, respectively, in offshore accounts.

The ever-growing pile of offshore cash has introduced new potential risks to the balance sheets of these corporations at home. Companies are avoiding paying the taxes on the repatriation of their overseas profits but still have to fulfill the obligations to shareholders in the form of dividends, share repurchases, debt repayments and pension contributions. Given the easy borrowing terms of low interest rates here in the U.S., companies are taking on more debt instead of paying Uncle Sam in taxes.

While corporations continue to hoard cash offshore, they are simultaneously improving margins by shipping American jobs and factories abroad. Corporate profits improve but tax revenue is hardly impacted by the process. This has contributed to the loss of more than 5 million U.S. manufacturing jobs and the closure of more than 56,000 factories since 2000, according to Sen. Bernie Sanders (I-Vt.).

Sen. Sanders has introduced new legislation with Rep. Jan Schakowsky (D-Ill.) with the Corporate Tax Dodging Prevention Act (S.250) in an effort to stop American banks and corporations from sheltering profits in places such as Ugland House and other tax havens to avoid paying U.S. taxes. The act will also cease rewarding companies that ship jobs overseas with tax breaks. The Joint Committee on Taxation has estimated in the past that the provisions in the bill will raise more than $590 billion in revenue over the next decade.

The legislation will certainly raise some arguments on Capitol Hill. The situation remains that the U.S. is the only major country that has substantial taxes on the repatriation of profits earned overseas. The GOP argues that the U.S. needs to move toward a territorial system for international taxation. Under this system, foreign-source income would be taxed only in the country where it was earned and not be taxed at all in the U.S. This approach would reduce the tax burden on U.S. companies and eliminate the disincentive for corporations to repatriate their foreign profits, according to the Brookings Institute 2012 article, "A Sensible Plan to Bring U.S. Corporate Profits Home."

The major point of contention with this system is that certain profits would not be taxed at all in the U.S.

The alternative proposition from President Obama is the international minimum tax. Under this proposal, all income of U.S. corporations must be immediately taxed, either by the U.S. or some foreign country, at a rate greater than or equal to this as yet unspecified international minimum tax rate. If a corporation reported profits in a country that collects no corporate tax, the U.S. would immediately tax those profits at the international minimum tax rate. This would help reduce the appeal of the tax haven, according to Brookings.

Very few people actively support the current system of taxing the foreign profits of U.S. corporations. A combination of the two systems would provide the best compromise: a territorial tax system for the valid tax-collecting nations and the international minimum tax rate for those that collect little or no corporate tax (e.g. the Cayman Islands). At this point in time, however, compromise is a four-letter word in Washington, D.C. Sen. Sanders' new legislation proposition is a good start toward addressing the tax dodging of U.S. companies.

What is the logic of this tax dodge by some of country's largest companies?

Seagate's (STX) Brian Ziel's explanation in 2004, which is commonly stated by other corporations as a rationale for overseas subsidiaries that do not pay U.S. federal taxes: "The competitive benefits relate both to taxes saved on certain income earned outside of the United States and the ability to efficiently deploy assets around the globe to remain competitive" (Bloomberg).

As I wrote in Barron's Other Voices last year, the average American has been the victim of screwflation over the last decade. Corporations have prospered and have increased their share of GDP at the expense of the middle class, which has seen its wages and salaries stagnate while the cost of the necessities of life has steadily increased. Those large U.S. corporations that have opportunistically reduced their tax bills through Cayman Islands subsidiaries and other schemes are the same companies that have sliced fixed costs (and have recently achieved 57-year highs in profit margins) by paring down payrolls and utilizing temporary employees in place of permanent ones.

Perhaps before considering raising taxes on either the middle or even the upper class of U.S. wage earners, an explosive device should be detonated in order to destroy the rules that form the foundation of the ignominious Ugland House.

Tax what the large corporations burn, not what they earn, by getting rid of the shell game operated in the Ugland House in the Cayman Islands and elsewhere.

Citizens for Tax Justice estimates that tax havens in the Cayman Islands and elsewhere outside of the U.S. cost our government about $100 billion per year in tax receipts. Many of my hedge fund friends will no doubt push back from the notion of abolishing overseas tax havens, but we are entering a period of shared sacrifice in the four years ahead. Our legislators have hard decisions to make in reducing the country's budget deficit, but this seems one of the easier decisions.

There is an additional concern that is being addressed in Washington, D.C.: the notion of carried interest.

Carried interest is generally treated (preferentially) as capital gains in hedge fund and private-equity partnerships. The taxation of carried interest has been an issue for several years as the compensation earned by investors increased with the size of private-equity funds and hedge funds. Since private-equity firms tend to hold investments long term, the gains qualify as long-term capital gains, which have favorable tax treatment. Managers taking advantage of the maximum 15% tax rate on long-term capital gains have raised concerns. The view that managers are taking advantage of tax loopholes to receive what is comparably a salary without paying the ordinary 35% marginal tax rate is not sitting well with members of Congress nor their constituents. Taxing the gains at the marginal tax rate has drawn ire of several managers on Wall Street, but the move is necessary if Congress is going to close the tax loophole to address our country's budget issues.

After dealing with numerous other tax loopholes, our leaders in Washington, D.C., can begin to seriously address the enormous systemic waste that has been built up over the years in the bulging bureaucracy of our government.

Now there is some serious and heavy lifting!

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