Google's effective foreign tax rate last year was only 2.4%. This is despite Google's primary markets being some of the highest taxed in the world, with an average corporate tax rate of over 20%, according to Bloomberg. This may seem unusual, but Google (Nasdaq:GOOG) is not alone among the world's largest corporations. Microsoft (Nasdaq:MSFT), Facebook and other high-tech firms reportedly pursue similar transfer-pricing strategies. Across the board, multinational companies are able to minimize taxes by employing teams of global tax experts to find loopholes in tax regulations.
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Here are three of the most prominent tax strategies in use today:
Transfer Pricing Strategy
Unlike individuals who are taxed on gross income, corporations are generally taxed only on their profits. Thus to minimize taxes, corporations try to find creative ways to lower their paper profits in high-tax countries, and shift those profits to low-tax countries.
Here is how the game is played. A multinational company establishes a legal entity in a low-tax country. Then, the company can assign the rights to its intangible assets to the newly formed entity. Now, the company in a high-tax country must pay royalties for using the intangible assets to the company in the low-tax country.
But how much should it pay in royalties? This is very difficult to assess, since intangible assets can be very difficult to value. In effect, the company now has a free hand to set an arbitrarily high royalty rate. The company in the high-tax country now can achieve arbitrarily higher expenses and lower paper profits due to the royalty payment. The income from the royalty payment goes to the company in the low-tax country. In this way, profits are effectively shifted to low-tax countries. (Discover how to keep score of companies to increase your chances of choosing a winning stock; read What You Need To Know About Financial Statements.)
According to Bloomberg, this is one of Google's primary tax strategies, saving the company an estimated $3.1 billion over the past three years. The details of the transaction involve sending profits to Ireland, then to the Netherlands and finally to a tax-haven country. Obscure tax regulations in Ireland make this one of the most effective ways to carry out the transfer pricing strategy.
Trademark Holding Companies
The transfer pricing strategy described above is not just used to avoid international taxation. A variation of transfer pricing can also be employed to avoid state income taxes.
The setup is basically the same. The company assigns trademarks to a separate trademark holding company in a low-tax state. The company in the high-tax state must now pay arbitrarily high royalties for use of the trademark, lowering its net income in the high-tax state. Delaware is often chosen as the best "low-tax" state for this strategy, since it does not impose a corporate income tax on passive investment vehicles that license intangible assets. Thus, companies are able to lower net profits in their high-tax states while generating tax-free income to their Delaware trademark holding companies.
The classic example of this tax strategy in practice was Geoffrey Inc., a trademark holding company established by Toys "R" Us. Toys "R" Us in South Carolina paid royalties to this entity, lowering its taxable net income for state tax purposes. In the landmark case Geoffrey Inc. v. South Carolina, the Supreme Court of South Carolina held that South Carolina could tax the royalty income of Geoffrey Inc., thus negating the effectiveness of this tactic in this situation. However, the practice continues in other states that have not yet found a way to negate this strategy. (These tax-free zones might sound appealing, but the consequences often aren't. Check out Taking A Look At Tax Havens.)
Captive real estate investment trusts (REITSs) are similar to the strategies above in that they attempt to create more paper expenses for the company. To set up this strategy, a corporation first transfers all of its real estate properties into a REIT (real estate investment trust). The REIT is then owned primarily by a subsidiary of the company.
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Using this method, the company is now required to pay rent on its real estate to the REIT, decreasing its net profit. REITs are subject to special rules, such that they do not have to pay corporate taxes on their profits so long as they distribute more than 90% of their income to their owners as dividends. So, the captive REIT can return all of the rent income to the company subsidiary without being taxed. The final piece of the puzzle comes from a rule meant to avoid double-taxation. That is, dividends are generally not taxable to corporate entities.
Thus, using a captive REIT, a company is able to essentially pay rent to itself, and yet also claim the rent as an expense to lower its taxable net income. The Wall Street Journal reported that this tactic has been used by Wal-Mart (NYSE: WMT), Bank of America (NYSE: BAC), Autozone (NYSE: AZO) and others. The Journal estimated that Wal-Mart was able to save about $350 million in state income taxes over a four-year period using this strategy.
The Bottom Line
The U.S. tax code is approximately 67,000 pages long, according to NPR. That's the equivalent of about 65 copies of War and Peace. As much as the IRS and other taxing authorities fight to deny corporate tax avoidance strategies that they discover, the vast complexity of domestic and international tax legislation stacks the odds against them.
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