Business Eyes Tax Break On Foreign Profit Measure Could Mean Billions For Financial Services Concerns

While President George W. Bush wrangles with Congress over his $1.6 trillion tax cut for individuals, the nation's largest multinational financial services, insurance, and manufacturing corporations are pushing to get a multibillion dollar windfall of their own.

The companies, which range from Citigroup Inc. to the American Express Co. to the Ford Motor Co., are seeking to make permanent a controversial provision that allows them to avoid paying taxes on the profits they earn overseas. The law, which was vigorously opposed by the Clinton Treasury Department, has been in place since 1998, but is set to expire this year.

The companies argue that they need the tax exemption to compete effectively in the global marketplace. Without it, they say, they risk becoming takeover targets for their international rivals.

"We have a tax regime that treats those companies less favorably than they will be treated if they are located in Germany or France or some equally attractive location," says Kenneth Kies, chief tax lobbyist for PricewaterhouseCoopers who is pressing for the exemption on behalf of more than a dozen companies, including the General Electric Co., the Bank of AmericaCorp., and the Prudential Insurance Company of America.

Earlier this month, a group of business associations, including the Financial Services Roundtable and the Equipment Leasing Association of America, wrote to Treasury Secretary Paul O'Neill and White House economic adviser Lawrence Lindsey urging them to make the foreign profits deferral permanent. A bill to make the provision permanent is expected to be introduced soon by Senate Finance Committee members Orrin Hatch (R-Utah.) and Max Baucus (DMont.). A similar provision will likely be introduced in the House by Rep. Jim McCrery (R-La.) and Rep. Richard Neal (D-Mass.).

The Bush Treasury Department has not yet taken a position on this matter, although Kies says he expects the new administration's support. Assistant Secretary for Tax Policy Mark Weinberger's former firm, accounting giant Ernst & Young, is lobbying for the provision on behalf of dozens of clients, including American Express and Ford.

Weinberger says he will consult with the department's general counsel to see if he needs to recuse himself from the matter because of his former ties to Ernst & Young.

The Clinton administration's opposition to an extension was based on the Treasury Department's assertion that it would lead to a hemorrhaging of tax revenue from overseas.

The expanded exemption still allows income to be shifted to "tax havens or countries with preferential tax regimes," then Assistant Secretary for Tax Policy Donald Lubick wrote to Sen. Byron Dorgan (D-N.D.) in 1999.

"This not only will lead to avoidance of current U.S. taxation on passive foreign income but also encourages income currently derived in the United States to be shifted abroad," Lubick wrote in response to Dorgan, ranking member of the Senate Treasury Appropriations Subcommittee.

The provision allows U.S. financial services companies to defer paying taxes on money earned abroad until they bring the money back to the United States. But, say critics, it is unlikely that corporations will ever bring that money back into the country where they will have to pay taxes on it.

The nation's leading tax journal, Tax Notes, was blunt in its criticism of the provision when it was enacted in 1998.

"Financial intermediaries don't want to pay tax to the United States on their foreign income, and they don't want to pay tax anywhere else either, thank you very much," Tax Notes concluded.

Estimates on how much the provision costs the U.S. government in lost revenue vary dramatically, but everybody agrees that the yearly cost quickly escalates into billions of dollars. The Joint Tax Committee scored the provision at $800 million in the year 2001, while the Treasury Department estimated it at $1.4 billion. In its latest budget forecast, the Congressional Budget Office, using the Joint Tax Committee numbers, put the cost at around $3.8 billion a year by the 2011. Tax Notes, using different criteria, predicted the cost to soar to $10 billion annually.

Passive Profits

One of the financial service industry's main arguments for making the deferral permanent is to give it parity with U.S. manufacturers, who can defer paying taxes on money they earn overseas until they bring it back into the United States. Companies like Ford, that now enjoy the tax benefit for its overseas manufacturing, would like to have the provision permanently apply to its foreign financial services divisions.

The financial services industry used to have this right, but lost it in 1986 after perceived abuses led Congress to exempt it from the provision. Congress noted that because financial services income is "inherently manipulable," it was too easy under the law for the industry to move its profits between low- and hightax countries.

According to a report released in December by the Clinton Treasury Department, the current provision, which was temporarily reinstated in 1998, is still flawed.

Under the tax code, the criteria to determine which overseas earnings can be deferred are too slippery to be applied to financial services companies, the report says. The foreign affiliate of a U.S. computer company, for instance, can defer the taxes on the profits it makes from selling manufactured goods overseas, the socalled active profits.Any money earned from those profits through interest or investment, so-called passive profits, are subject to immediate U.S. taxation. When the law was revised in 1998, the distinction between active and passive earnings for the financial services industry was, say Clinton Treasury officials, blurred beyond recognition. Profits in financial services are made through interest and investment, making it difficult, if not impossible, to assess where and in what manner the money from an overseas transaction was earned. For instance, a U.S. financial services company could set up an affiliate in Switzerland, where the tax laws are relatively loose, and simply declare that all of its profits were active and that it owes no taxes.

Furthermore, unlike a manufacturing business, financial services requires little more infrastructure than a desk and a good computer connection. This means that it is extremely easy to game the system and set up a shell investment corporation in countries with lax regulation and low taxes.

A U.S. company could then set up an affiliate in, say London, for U.S. government tax purposes. But while it could be doing most of its business there, it could, for English tax purposes, route its earnings through a corporate entity in Bermuda.

"Money being pretty fungible and flowing where it wants, the incentive is to locate abroad," says Lubick, who now works as a consultant helping developing countries set up their tax administration systems.

Nobody knows exactly how much money is staying overseas. Although the law has been in effect for more than two years, this is far too short a time by Treasury Department standards to measure its effects. Audits of individual companies usually take at least four years, and compiling industrywide statistics on overseas tax payments takes even longer.

The Treasury report concluded that, while the 1998 law did impose some restrictions on the industry, in the end the global flow of electronic capital is so vast and quick-and international finance laws are so complex and varied-that the current deferral law makes it very difficult to prevent financial services companies from funneling profits through low-tax countries.

Kies has little sympathy for the Clinton Treasury's concerns. "When the government says, 'Gee, we are going to have this terrible compliance problem to deal with,' it's not a persuasive position for them to take," says Kies, the former chief of staff of the Joint Tax Committee who, as head of the PricewaterhouseCoopers tax lobbying operation, helped negotiate the current deferral laws.

The Clinton administration's concerns are all hypothetical and do not reflect the way companies do business, says Dennis Ross, the former deputy assistant secretary for tax policy in the Reagan and Bush administrations who is now general counsel to Ford, which is seeking to extend the provision on behalf of its financing division.

The Clinton Treasury simply did not like deferrals, Ross says. If the provision get abused, he adds, Congress and the IRS can always fix it.