There’s a few articles in the press about the debt ceiling these days, have you noticed?

Yes, of course, unless you’ve been in a log, you’ve heard about our bursting debt ceiling, our deficit, and all the associated goodness. It’s been a wonderful time for students of manipulation – there’s so much to report on that we’re thinking of hiring a manipulation intern. Apply within. There’s only so much we can keep up with.

To give you an example, let’s talk a little about taxes.

Hey, it’s August, it’s a slow month, and what else do you have to read about? Specifically, I want to talk about corporate taxes.

In the US, corporations pay a tax rate of about 28%. It’s on the high side – only Japanese, German, and a few other nations tax their corporations more. It’s also been relatively steady over the years. And yet, corporations only contribute an ever smaller amount of the total tax receipts of the government:

Notice the red line? It’s dropping, and dropping fast. In the 1950s, corporate taxes accounted for 30% of tax revenue in the US. Today, it’s closer to 6%.

What’s going on? It turns out that most companies have learned how to dodge taxes. The effective tax rate is meaningless, if you have no taxes to pay! So tax manipulation has become a very popular pastime for large corporations these days.

GE, for example, is one of the best companies at avoiding US taxes. In the last 5 years,for example, it has shown a profit of $26B, and paid negative $4.1B in taxes.

"No, I have no idea how that works either."

That means that the US taxpayers gave GE $4B to compensate it for making $26B in profits. You have to admire the GE tax lawyers.

The question is – how do these companies manipulate the tax code?

Take Google, for example. Like most high-tech US companies, it uses a number of different tricks to reduce its tax burden. The most common one is called the “Double Irish”. It’s relatively simple:

First, Google created a subsidiary in Ireland. It is this Irish office that sells advertising to all of Google’s clients in Europe and Asia and the Middle East. All that Adwords cash – $12B of it – from Rome to Paris to Dubai, makes it way to Dublin, to Google’s Irish HQ.

Specifically, here.

This already has a positive impact for Google – the $12B in overseas revenue that Google Ireland collects means that Google US can now show $12B less of income, which means $4.6B of tax that Uncle Sam will never see.

Now, those $12B can’t stay in Ireland, because eventually the Irish government would want some of it, so Google Ireland needs to get rid of it somehow. It does so by paying almost all of it as ‘license fees’ to the entity that owns all of the rights to Google’s IP outside of the US, called Google Ireland Holding. Google Ireland Holding is also an Irish company, but it is headquartered in Bermuda. It has no employees, but it owns all of Google’s IP, so Google Ireland sends it all of the $12B it collected as license fees (it actually goes first to the Netherlands, because Ireland tax law actually taxes license payments to everyone except Dutch companies, but the Dutch Google company is an empty shell that simply shunts the cash to Bermuda).

Since Google Ireland had $12B in revenues and paid out the same to the Bermuda company, it has no profit, and therefore pays no taxes to Ireland either. So, so far, $12B worth of payments have made their way from thousands of customers to a bank account in Bermuda, and Google has not paid any taxes on any of it.

Why Bermuda?

The beaches, Man!

What happens to the cash once it hits Bermuda? Bermuda has no corporate tax, and the specific company structure that Google uses to house them means that it doesn’t need to disclose financial statements. Basically, the cash becomes untraceable, and can be used to fund projects across the world virtually tax-free.

The fact that this strategy has a name – “the Double Irish”, or the “Dutch Sandwich” gives you a pretty good idea how common those strategies are. They are perfectly legal – they simply manipulate transfer prices and subsidiaries to make sure that the revenues of companies large enough to set them up is largely tax sheltered.

By the way, do you know this place?

Ugland House

It’s Ugland House, in the Cayman Islands. It’s the home of 18,000 companies, that all use it as the headquarters of their off-shore vehicles in structures like the Double Dutch. As I said, this is a popular manipulation.

It can also create some amusing dynamics. For example, Rupert Murdoch owns around 800 companies, many of them located in the Caymans and Bermuda. It’s a web of linked companies that effectively means that Murdoch, the owner of Fox News, News Corp, and the Sunday Times, pays an effective tax rate of 6%. But it also means that his most profitable company is not Fox News, or the Sunday Times – it’s News Publisher, a Bermuda company that has made more than $2B in profits in the last few years – without a single employee.

But Ugland House or Dutch sandwiches can only take you so far. GE, known for pushing the envelope, exploited a lot more tax breaks to reach its negative tax rate. For one thing, its tax department has almost 1,000 people dedicated to finding new ways to reduce taxes. For another, it tends to have a lot of influence in Washington. GE has spent $200M on lobbyists and PR firms in Washington in the last few years. What did these $200M buy it?

For one thing, the US corporate tax code included a provision called active financing, which basically meant that if GE financed a plane or a wind turbine abroad, it didn’t have to pay US tax on that revenue. It basically allowed GE to finance everything from fridges to jet engines outside of the US and pay no taxes on all that cash. It took GE years and millions of dollars to get that exception passed into law under George Bush, and it was very, very valuable.

But as the economy soured, Congress began to frown at this gaping loophole. Charles Rangel, a Senator who chaired the Ways and Means committee, voiced his displeasure at the loophole and his intention to close it. Mr. Rangel met the head of GE’s tax department, and obviously he found the right words, because after the meeting Mr. Rangel decided that he really wanted to keep the tax loophole open after all.

In unrelated news, a month later, the GE foundation donated $30M to NY public schools, including $11M to schools in Mr. Rangel district. It was the largest donation ever made to the city’s school. Also in unrelated news, Mr. Rangel was eventually censored by Congress for soliciting donations in returns for beneficial treatment in front of his committee.

"Yay! I am only the 23d member of the House to be censured. Ever! And the first in 3 decades!"

And GE is not alone. Did you ever wonder, for example, why Microsoft bought Skype for $9 Billion? One reason may have been that Skype is a company that’s actually headquartered in Luxembourg. That means that Microsoft could use Bermuda-type cash to buy it for $9B. Had Skype been a US company, that $9B would have needed to be brought into the US, and Uncle Sam would need to be paid $4B. But since Skype is a Luxembourg company, Uncle Sam could only look, longingly, at a transfer of $9B that had essentially no tax implications.

* * *

Remember my post on why the rich had an inherent advantage over the poor? Large corporations right now have the best of both worlds – they have the advantages of being located in a stable country where the laws are structured largely to support them, and a tax code that allows them to effectively avoid a huge tax burden, and so they pay 6% for the privilege of being American companies. Exxon Mobil, for example, made $19B in profits in 2009, and paid got a tax rebate for $156M. Bank of America paid no income tax in 2008. None.

Compare that to a mom-and-pop shop, on the other hand, which doesn’t have the resources to structure this kind of manipulations, and ends up paying 39% for the same privilege of being located in the US, with all of the protection that this entails.

These are very complex, very valuable manipulations, but the problem becomes that as they become known and everyone eventually uses them, corporations pay less and less taxes, and now two thirds of corporations pay no tax at all. How long that can be sustained remains to be seen, but once a manipulation becomes mainstream, it tends to lose effectiveness, so it will be interesting to see how these manipulations endure. Somehow, I am not worried about GE – 1,000 smart accountants and lawyers will find a way to keep it afloat, I’m sure.