AUGUST 1980 - VOLUME 1 - NUMBER 7
Firms Keep Auditors at Arms Length
by Jonathan Rowe
Off the coast of Nova Scotia, suspended in thin air between a conveyer belt on a loading pier and the cargo ships docked underneath, there existed a corporation called Export. Export was an elusive thing. It had no executives, no secretaries, did none of its own accounting, billing or even its own tax returns. One could have sat on the loading dock, day and night, eyes fixed on the air space in which Export resided, and one would have seen nothing that even suggested its existence.
Export was a brainchild of the accountants of the United States Gypsum Company. It did virtually nothing. But it had a function. This bodiless presence "bought" gypsum rock, mined by U.S. Gypsum's Canadian subsidiary, as the rock fell off the conveyor belt, and "sold" the rocks to U.S. Gypsum itself as the rocks hit the hold of the ships a few feet below.
For this ersatz exertion, Export received a profit of 50 cents per ton that otherwise would have accrued to U.S. Gypsum's own gains. Since Export hovered, conceptually, beyond Canadian soil, it was exempt from Canadian tax. The way Gypsum's lawyers had drawn up the legal papers. for their formless child, moreover, Export qualified as something called a "Western Hemisphere Trading Corporation." So benighted, Export's profits. which came to over $ I million per year, were taxed at much lower rates in the U.S. than if Gypsum had reported these profits itself.
No government bureaucrats imposed these extraordinary paperwork and accounting chores upon U.S. Gypsum. Nor did the company's management rail against the same. Export is a real-life example of what Robert Reich, director of policy planning at the U.S. Federal Trade Commission, has called "paper entrepreneurship" - the concoction of gain not by making and selling products, but by massaging and multiplying the paper through which production and selling take place.
All this complexity ultimately falls into the laps of the tax collectors of the world. How can they possibly impose tax law and order on the accounting schemes of globe-encompassing corporations? Sorting out this accounting, determining how much income should be reported where, is the frontier problem in tax administration today.
For many jurisdictions-particularly many smaller developing countries the lack of effective enforcement tools frustrates a strong desire to collect more taxes, and gives rise to a jungle law in which multinationals decide themselves what they want to pay.
It is not, moreover, necessarily a question of higher or lower taxes on multinationals. That can be a separate issue of national policy. Certainly, some governments deliberately choose ineffective enforcement methods to keep their tax favors to corporations away from public view. Better tools will not help in such cases where will is lacking.
Government officials, however, should not deceive themselves that ineffective enforcement methods "keep everybody happy" without additional costs. Especially in the wealthier jurisdictions, the use of ineffective enforcement methods whether deliberate or not, is tremendously wasteful. It shifts business energies and competition away from making and selling better products and services, and toward the productivity wastelands of U.S. Gypsum-like accounting schemes, flooding corporations and governments alike in a sea of unnecessary paper.
The FTC's Reich, for instance, points out that the United States has 20 times more lawyers and 10 times more accountants per capita than Japan, which is rapidly leaving the 1'.S. in the dust in terms of productivity. A major U.S.-based accounting firm bragged to Business Week that "we can save a company five times our tax planning fee." Who wants to take risks with messy things like factories and machinery, when the\ can quintuple their money just b} hiring some accountants? "If our corporate managers only turned their energy to more positive pursuits." laments maverick tax accountant and author Abraham Briloff, "[U.S.] GNP would be booming, and we could be solving the great problems of mankind."
The channels of international commerce are crawling with accounting contrivances. A full 40 percent of all transactions in world trade are between parts of the same corporation, and the public record is replete with well-documented cases such as these:
The complexity of these schemes can be byzantine. Consider the U.S. Gypsum arrangement. The mid-air subsidiary was just the first chapter of this epic tax finagle. The gypsum rock was transported on tankers registered in tax-free Panama, by another company owned by U.S. Gypsum and called, appropriately enough, Panama Gypsum. The $17.7 million in shipping charges were thus siphoned away from the U.S. and Canadian tax collectors. On top of this, Panama Gypsum leased one of its ships from still another U.S. Gypsum subsidiary, the Gypsum Packet Company. The tax consequences of this particular move we can only imagine.
Such organizational gymnastics are relatively straightforward, moreover, compared to the more esoteric contrivances involving intracorporate loans and royalties, exchanges of patents, trademarks, copyrights, and knowhow, and the allocation of research and development costs and central management expenses. "Profits are only a product of accountants. . . you never really know what they are," Alan Greenspan, economic advisor to Gerald Ford and Ronald Reagan, has said.
And taxes and social waste are not all that are at stake. Multinational accounting strokes send ripples in all directions. European labor unions complain that profit-shifting deprives their members of bonuses and raises due them under labor contracts. (American unions, having less access to employer financial data, have not pressed such claims.) A few years ago Paris employees of the Chase Manhattan Bank raised a brouhaha by alleging publicly that the bank was cutting them out of profit sharing proceeds by this means.
Such diverse matters as regulations governing repatriation of capital, and restrictions on the "dumping" of foreign-produced goods at prices that undercut local manufacturers, similarly hinge on the ability of governments to pierce accounting ruses and relate corporate profits to the nations in which the corporations operate.
The story of why tax gamesmanship continues to flourish begins with the U.S. Treasury. By adhering doggedly to antiquated enforcement concepts, Treasury has become the torch-bearer of unwieldy tax procedures that lead the smaller tax jurisdictions of the world into virtual helplessness in this arena.
What would be the most costly, complicated, and bureaucratic method that public officials could possibly adopt to counter the multinational accounting maelstrom? Probably, it would be to agree to play the tax accountants' own game, on their own court: to accept the accounting mumbo-jumbo as essentially legitimate, and work from there.
The U.S. Treasury, through the Internal Revenue Service, does exactly this. It begins with the assumption that a multinational corporation is precisely what it is not-a federation of independent businesses between-which dealings normally are at arms length on an open market. Under this assumption, an Exxon subsidiary or division in France, Liberia, Canada, California, Montana, and the Netherlands,, Antilles becomes a "separate entity" and not part of the same corporate body. Accounting manipulations become, not business as usual, but nasty aberrations from an eighteenth century ideal in which competition and arms-length dealing prevailed.
Under the Treasury's "arms-length or "separate entity" approach, therefore, government auditors must try to correct the "aberrations." They must work their way through the dealings between the multinational's myriad subsidiaries, invoice-by-invoice, and reconstruct these dealings to what they theoretically would have been if 'the subsidiaries were independent businesses. In effect, the IRS tries to untangle the contents of the corporate spaghetti bowl, strand-by-strand.
This procedure is horrendously complex, a "factual nightmare," one state tax administrator calls it. A. multinational corporation may have hundreds of separate subsidiaries -Mobil has over 200-between which the dealings are prolific. ln one litigated case, the IRS agent had to check-and the company had to produce-billings .between a Swiss subsidiary and its outside customers that had piled up, at the rate of 1000 per week. Complicating things further, in most cases, there are simply no comparable transactions, by the company in question or by any other company which the tax agents can use as reference points. Reconstructing arms length prices is an exercise that requires those involved "to do something that is impossible and to produce something that does not exist" says Los Angeles tax attorney and author Zoltan Milhaly.
To make matters worse, secrecy laws shield corporate subsidiaries in many countries. Those of Switzerland and the Bahamas arc-notorious, and the latter recently tightened its strictures yet further. Former Justice Department attorney Tom Fields, now with the tax reform group Taxation with Representation, recalls how an IRS investigation of the oil companies was stymied when it ran afoul of the British "Official Secrets" Act which protected oil company tanker subsidiaries.
Given all these difficulties, it is riot surprising that the arms-length approach fails 40 percent of the time by the IRS's own count.
Through sheer bureaucratic momentum the IRS can get some mileage out of this administrative clunker nevertheless. IRS agents routinely slap questionable assessments on the companies under audit, setting off the negotiations by which the vast majority of arms length cases are settled. "Very few cases have been litigated, considering the amounts at stake," says Jane O. Burns of the Indiana University School of. Business. "That tells me something nobody knows what they are doing." Burns found that approximately 70 percent of arms, length cases are settled through negotiations with an IRS field agent.
In those cases which are not settled, the litigation can be monumental. "The depositions [preliminary written questions addressed to witnesses] alone are interminable," says Richard Pomp, a law professor at the University of Connecticut. For instance, DuPont and the U.S. Government were in court for over 14 years, at a cost of over $1 million each over the profit-diversion scheme mentioned above. '
An extraordinary DuPont internal memorandum unearthed during the grueling 14-year litigation gives insight into the defendants in such cases. Mulling over a possible IRS attack on their profit laundry operation while it was still in the planning stages, DuPont's management had concluded:
"It would seem to be desirable to bill the tax haven subsidiary at less than an "arm's length" price because (I) the pricing might not be challenged by the revenue agent. (2) if the pricing is challenged, we might sustain such transfer prices (3) if we cannot sustain the prices used, a transfer price will be negotiated which 'should not be more than an "arm's length" price and might well be less; thus we would be no worse off than we would-have been had we billed at the higher price." In other words, there was everything to gain, and nothing to lose. So why not?
Third World nations, lacking both the IRS's bureaucratic bulk and the capacity for such litigation, are doomed before they start. In some developing countries, the tax department consists of little more than a room full of high school graduates. The picture of such recruits-"understaffed, undertrained, and intimidated" in the words of one observer-trying to untangle the accounting schemes of a multinational drug company, tells us much of what we need to know about the inappropriate administrative technology the U.S. Treasury is promoting. Attorney Pomp, who consults with Third World governments on these problems, cites the enforcement official of one developing nation who told him, "We know we are getting fleeced. But we don't know what to do about it. We just hope we aren't getting fleeced too badly."
Despite these shortcomings, or perhaps, in part, because of them, the U.S. Treasury has embraced the arms-length concept with a missionary zeal. Through tax treaties with other nations, it is elevating this concept to the stature of international law. Largely through Treasury's influence, the arms length concept has become synonymous with effective tax enforcement, even among those who truly desire that end. Two years ago, the European Trade Union Confederation, attacking multinational tax avoidance, embraced the principle of "arms length dealings" as a keystone in combating the problem.
The attitude persists that if only the enforcement resources can be mustered, the reign of arms length dealing can be restored. The rule is unquestioned; it just needs more enforcement. But it needs more than enforcement. It needs questioning. It doesn't work.
To admit economic reality, to acknowledge that "arms length" dealing is a figment of eighteenth century Adam Smith economics, bearing little relevance today, is, not to throw in the towel. It is, rather, simply to recognize the need for a new enforcement premise.
Such a premise is available, and working. It recognizes the multinational corporation for what it is, a "unitary," centrally managed business enterprise. To the wonderment of many, the premise was pioneered by the states of the United States.
Jonathan Rowe is associate director of Citizens for Tax Justice, a public interest tax reform action group in Washington, D.C. From 1977 to 1979, he served as deputy director of the Multi-State Tax Commission.