Money and Politics

Corporate Tax Magic

U.S. tax policy lets companies deduct overseas income taxes from their domestic tax bill. But a clever corporate tax scam lets companies escape taxes in both the United States and foreign countries.

With the Internal Revenue Service (IRS) ready to close the "controlled foreign corporation" loophole, multinational corporations are mobilizing to preserve a favored tax trick.

In January, the Treasury Department announced plans to restrict multinational companies' ability to cut their tax burdens using complex -- though perfectly legal -- arrangements known as "hybrid branches."

Here's how it works. A large U.S.-based multinational corporation has a holding company in a place like the Cayman Islands. The holding company sets up a subsidiary in Brazil as a "hybrid branch." The Cayman-based parent loans money for operations to the Brazilian subsidiary, which, in turn, makes interest payments on the debt to the parent.

Now for some tax magic. The Internal Revenue Service waves its wand and says the branch -- and therefore any transactions it has made -- does not exist. So the multinational parent pays no income tax to the United States on any transactions from the Brazilian operation.

But what about taxes the hybrid branch owes Brazil? Time for some more magic. The same branch treated as non-existent by the United States is recognized as a separate entity in Brazil -- one allowed to deduct the interest payments made to its Cayman parent. These deductions reduce the taxes the branch pays Brazil. Presto! A multinational corporation avoids paying any U.S. taxes on these financial transactions while using those same transactions to drastically reduce its tax burden to foreign governments.

So a system originally designed to protect companies from taxation in two countries has the effect of sheltering them from tax burdens in both.

The Treasury Department in January issued a daring announcement in the form of "Notice 98-11:" If a multinational corporation significantly reduced its taxes to foreign governments by deducting the hybrid branch interest payments, the Internal Revenue Service was going to acknowledge the branch's existence and tax its income.

"U.S businesses striving to be competitive in the United States could have been disadvantaged by tax burdens higher than those imposed on their multinational counterparts that availed themselves of hybrid structures," said Treasury Secretary Robert Rubin. Translation: U.S. companies without these hybrid branches cannot compete fairly against those that use the technique.

For the large multinationals, Treasury's decision to start recognizing hybrids threatened a reduction in their bottom lines.

Enter Daniel Berman. A lobbyist with the firm Sutherland, Asbill & Brennan, Berman represents the "Notice 98-11 Deferral Group" made up of companies like Philip Morris, Hallmark Cards and Coca-Cola Enterprises. As former deputy international tax counsel at the Treasury Department, Berman is uniquely qualified for the job.

Berman told Multinational Monitor that the use of hybrid branches "lowers multinational corporations' tax burdens immediately, which makes them more competitive immediately, and this increases profitability to shareholders."

He argues that the Treasury will take in less -- not more -- revenues by taxing these branches because the multinationals will simply stop using interest payments to lower their taxes abroad. Instead, he contends, they will pay more taxes to foreign governments and take bigger foreign tax credits on their U.S. returns.

"Why should the United States be the tax police of the world?" asks LaBrenda Garrett-Nelson of the Washington Counsel, a lobbying firm representing another coalition of multinationals. Like Berman, she says Treasury's proposals would serve only the purpose of increasing the revenues of foreign governments.

The Washington Counsel has paired up in this lobbying battle with the accounting firm of Ernst & Young. Accountants placed many of their clients in these hybrid tax arrangements. Accounting firms Price Waterhouse and Deloitte and Touche are leading other coalitions of multinationals. The Price Waterhouse coalition is headed by Kenneth Kies, who served as chief of staff on the Joint Committee of Taxation.

These groups are not the only ones lobbying the Treasury Department. House tax-writing committee members including Chairman Bill Archer, R-Texas, and ranking Democrat Charles Rangel, D-New York, each wrote letters to Treasury Secretary Robert Rubin warning him that he was stepping on their turf. Treasury was trying to legislate through the regulatory process, they said, and Congress would not stand for it. Rangel also said Notice 98-11 has created uncertainty for multinationals that is "unfair and harmful to U.S. business interests."

But Rubin did not back down.

In late March, Treasury issued temporary rules on tax treatment of hybrids. Senate Finance Committee Chairman William Roth, R-Delaware, responded by inserting a provision in legislation overhauling the Internal Revenue Service that would bar Treasury from carrying out rules on 98-11 for six months. Merrill Lynch, a key player in the 98-11 debate, was Roth's second biggest contributor between 1991 and 1996.

In addition to the IRS bill, Roth also expressed the opinion that Treasury should withdraw its proposals and that "Congress, not the Department of Treasury nor the Internal Revenue Service, should determine the international tax policy issues presented with respect to the treatment of hybrid transactions."

With few outsiders paying attention, the Fortune 500's influential Washington lobbyists and congressional allies might be able to make all this tax nastiness disappear quietly. Roth's moratorium is expected to be made law this summer. 

   -- Jennifer Schecter