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Meltdown 101: How do foreign tax havens work?

By MATTHEW PERRONE – 1 hour ago

WASHINGTON (AP) — President Barack Obama’s proposals to crack down on foreign tax shelters target obscure, complex financial practices that help some of the nation’s biggest corporations hold on to billions of dollars.

How do these tax loopholes work, and what would today’s proposals mean for companies?

Here are some questions and answers about tax shelters.

Q: What are foreign tax shelters?

A: Tax shelters are countries with corporate tax rates much lower than those of the U.S., which make them popular for U.S. businesses looking to lower their tax bills.

Whereas the U.S. corporate tax rate is 35 percent, Iceland’s is 15 percent and Switzerland’s is just 8.5 percent. Many countries in the Caribbean don’t tax corporations at all. Companies shift profits to subsidiaries in such low-tax countries to avoid paying the Internal Revenue Service.

Q: How do companies use tax shelters to save money?

A: One of the most popular tactics involves setting up multiple overseas subsidiaries to move profits from high-tax countries to low-tax countries. Under so-called “check the box” rules, companies can register their subsidiaries as separate units that aren’t subject to U.S. tax rules.

In one scenario, a U.S. company could use operations in the Virgin Islands to avoid paying taxes on investments in Sweden. The company does this by setting up three new corporations: a subsidiary in Sweden, a holding company in the Virgin Islands as well as another subsidiary owned by the holding company.

The Virgin Islands subsidiary makes a loan to the Sweden subsidiary for a new facility there. The interest on the loan would be income for the subsidiary in the Virgin Islands and a tax deduction for the Swedish subsidiary.

Many companies use such set ups to funnel income from high-tax Europe to no-tax Caribbean. While the company would pay taxes on the transaction if it occurred in the U.S., “check the box” rules allow the company to avoid paying taxes in both Sweden and the U.S.

Q: What happens to money stored in tax havens?

A: In most cases it stays there. Companies can avoid paying taxes on overseas profits indefinitely, as long as they don’t bring it back to the U.S.

“They never bring the profits back, or if they do, they only bring a very small amount back,” said Amy Mathias, an analyst with the investment adviser, Washington Research Group. Most companies use the money to build new facilities, hire more workers and expand business overseas.

Q: How widespread is the use of tax shelters?

A: A January report by congressional investigators found that 83 of the 100 largest publicly traded companies in the U.S. operate subsidiaries in tax havens, like the British Virgin Islands and Bermuda, where there is no corporate tax.

Use of subsidiaries varies greatly among big corporations. Banking giant Citigroup has more than 4,000 subsidiaries, according to the Government Accountability Office, a nonpartisan investigative arm of Congress. Procter & Gamble, which sells Tide laundry soap, Cover Girl makeup and hundreds of other consumer products, has about 80.

Q: How do these practices affect the federal government?

A: Members of Congress estimate that the federal government loses $100 billion in tax revenues each year due to offshore tax abuse. Obama said Monday that his proposed changes in the tax code would generate an average of about $21 billion a year in new tax revenues.

Q: How would the Obama proposal change the way companies operate overseas?

A: The proposal outlined today would not force companies to return profits from overseas to the U.S., a worst case scenario for many company executives. Instead Obama would stop companies from deducting expenses in the U.S. that help support their operations overseas. This would have the effect of increasing their tax burden, since companies are generally able to deduct the vast majority of their expenses.

Q: If the practices being targeted today are so detrimental, why did Congress permit them in the first place?

A: Tax experts say the “check the box” rules were originally designed to prevent companies from paying excessive taxes on their various subsidiaries. The rules also cut down on the paperwork needed to file taxes.

“It’s perfectly legal and it’s a wonderful financial planning tool,” said Alan Appel, a counsel in the law firm Bryan Cave LLP. “But it was never envisioned that these practices would occur in the international area.”

Q: What do company executives think of the proposal?

A: As expected, representatives for some of the largest multinational corporations came out against today’s proposal, saying it would force companies to eliminate jobs in the U.S. that support their operations abroad.

“Imposing up to $200 billion on manufacturers doing business overseas is going to have a negative impact on the industry,” said Dorothy Coleman, a vice president with the National Association of Manufacturers. “About 95 percent of the world’s consumers are in foreign markets and if we want to continue to grow foreign business, we have to be able to compete.”

Copyright © 2009 The Associated Press. All rights reserved.

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