a

GAO

United States General Accounting Office

Report to the Chairman, Committee on 

Governmental Affairs, U.S. Senate

June 2004 INTERNATIONAL 

TAXATION

Tax Haven Companies 

Were More Likely to 

Have a Tax Cost 

Advantage in Federal 

Contracting

GAO-04-856
www.gao.gov/cgi-bin/getrpt?GAO-04-856. 

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact James White at 

(202) 512-9110 or whitej@gao.gov. 

Highlights of GAO-04-856, a report to the 

Chairman, Committee on Governmental 

Affairs, U.S. Senate 

June 2004

INTERNATIONAL TAXATION 

Tax Haven Companies Were More Likely 

to Have a Tax Cost Advantage in Federal 

Contracting 

There are conditions under which a tax haven contractor may have a tax 

cost advantage (lower tax on additional income from a contract) when 

competing for a federal contract. The extent of the advantage depends on 

the relative tax liabilities of the tax haven contractor and its competitors. 

One way for a contractor to gain a tax cost advantage is by reducing its U.S. 

taxable income from other sources to less than zero and by using its losses 

to offset some or all of the additional income from a contract, resulting in 

less tax on the contract income. A company would thereby gain an 

advantage relative to those competitors with positive income from other 

sources and may be able to offer a lower price or cost for the contract. 

While some domestic corporations may also have a tax cost advantage, tax 

haven contractors may be better able to reduce U.S. taxable income to less 

than zero because of opportunities to shift income to their tax haven 

parents. Whether a contractor has a tax cost advantage in competing for a 

particular contract depends on the tax liabilities of other competitors. Also, 

the contractors with a tax cost advantage are not necessarily the successful 

competitors because the tax cost savings may not be reflected in actual 

prices, and prices may be only one of several factors involved in awarding 

contracts. 

Using tax liability as an indicator of ability to offset contract income, GAO 

found that large tax haven contractors in both 2000 and 2001 were more 

likely to have a tax cost advantage than large domestic contractors. In 2000, 

56 percent of the 39 large tax haven contractors reported no tax liability, 

while 34 percent of the 3,253 large domestic contractors reported no tax 

liability. In 2001, 66 percent of large tax haven contractors and 46 percent of 

large domestic contractors reported no tax liability. 

Tax Status of Large Tax Haven and Domestic Contractors in 2000 and 2001 

 Contractors with tax liability Contractors without tax liability

U.S. federal 

contractors 

Number of 

companies

Percentage of 

companies 

Number of 

companies

Percentage of 

companies

2000 

Tax haven 17 44 22 56

Domestic 2,132 66 1,121 34

2001 

Tax haven 17 34 33 66

Domestic 1,888 54 1,636 46

Source: GAO analysis of IRS data. 

The federal government was 

involved in about 8.6 million 

contract actions, including new 

contract awards, worth over 

$250 billion in fiscal year 2002. 

Some of these contracts were 

awarded to tax haven contractors, 

that is, U.S. subsidiaries of 

corporate parents located in tax 

haven countries. Concerns have 

been raised that these contractors 

may have an unfair cost advantage 

when competing for federal 

contracts because they are better 

able to lower their U.S. tax liability 

by shifting income to the tax haven 

parent. 

GAO’s objectives in this study were 

to (1) determine the conditions 

under which companies with tax 

haven parents have a tax cost 

advantage when competing for 

federal contracts and (2) estimate 

the number of companies that 

could have such an advantage. 

GAO matched federal contractor 

data with tax and location data for 

all large corporations, those with at 

least $10 million in assets, in 2000 

and 2001, in order to identify those 

companies that could have an 

advantage. 
Page i GAO-04-856 International Taxation

Contents

Letter 1

Results in Brief 3

Background 3

Scope and Methodology 5

There Are Conditions under Which Tax Haven Contractors May 

Have a Tax Cost Advantage 7

Tax Haven Contractors Were More Likely to Have a Tax Cost 

Advantage Than Domestic Contractors 13

Concluding Observations 15

Agency Comments and Our Evaluation 15

Appendixes

Appendix I: A Simple Qualitative Model for Assessing Potential 

Contracting Advantages 17

Appendix II: Additional Information about Contractors in 2000 20

Information on Large Contractors in 2000 20

Appendix III: Staff Acknowledgments 21

Tables Table 1: Tax Liabilities and Interest Expenses of Large Contractors 

and Noncontractors in 2001 12

Table 2: Tax Status of Large Tax Haven and Domestic Contractors 

in 2000 and 2001 14

Table 3: Tax Cost Advantage of Corporations with Headquarters in 

a Tax Haven Country 18

Table 4: Tax Liabilities and Interest Expenses of Large Contractors 

and Noncontractors in 2000 20
Contents

Page ii GAO-04-856 International Taxation

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Abbreviations

FPDS Federal Procurement Data System

GSA General Services Administration

I.R.C. Internal Revenue Code

IRS Internal Revenue Service

OECD Organisation for Economic Co-operation and Development

SOI Statistics of Income
Page 1 GAO-04-856 International Taxation

United States General Accounting Office

Washington, D.C. 20548

A

June 30, 2004 Letr

The Honorable Susan M. Collins

Chairman

Committee on Governmental Affairs

United States Senate

Dear Chairman Collins:

The federal government was involved in about 8.6 million contract actions, 

including new contract awards, worth over $250 billion in fiscal year 2002. 

Some of the companies that were awarded these contracts were U.S. 

subsidiaries of corporate parents located in tax haven countries.1

 In this 

report, we will refer to such contractors as “tax haven contractors.” We 

reported in October 2002 that four of the top 100 federal contractors that 

were publicly traded corporations in fiscal year 2001 were tax haven 

contractors and that three of these were originally U.S.-headquartered 

corporations that had reincorporated in tax haven countries through 

corporate inversions.2

 

Because tax haven contractors may have opportunities to shift income 

between the U.S. subsidiary and the corporate parent in ways that reduce 

U.S. tax, you have raised concerns that tax haven contractors may have an 

unfair cost advantage over U.S.-headquartered contractors when 

competing for federal contracts. Because of the concerns, you asked us to 

determine the extent, if any, to which tax haven contractors have an 

advantage when competing for federal contracts.

1

 In such cases, the U.S. subsidiary is a U.S. corporation, incorporated in the United States, 

but is owned by a parent company incorporated in a tax haven country. The term tax haven 

is used by the Organisation for Economic Co-operation and Development (OECD) to refer 

to a country that has no or nominal taxes on corporate income and also meets other criteria 

related to the transparency of its legal and accounting systems and to its openness to the 

exchange of tax information with other countries. 

2

 See U.S. General Accounting Office, Information on Federal Contractors That Are 

Incorporated Offshore, GAO-03-194R (Washington, D.C.: Oct. 1, 2002). An inverted company 

is a U.S. subsidiary of a foreign parent where ownership of the U.S. subsidiary had been 

transferred to the foreign parent. The term “inversion” is used to describe a broad category 

of transactions through which a U.S.-based multinational company restructures its 

corporate group so that after the transaction the ultimate parent of the corporate group is a 

foreign corporation. See U.S. Department of the Treasury, Office of Tax Policy, Corporate 

Inversion Transactions: Tax Policy Implications (Washington, D.C.: May 17, 2002).
Page 2 GAO-04-856 International Taxation

After reviewing the relevant literature, determining what data were 

available, and meeting with your staff, we decided to (1) determine the 

conditions under which corporations with parents in tax havens have a tax 

cost advantage when competing for federal contracts and (2) to the extent 

possible, estimate the number of companies that have characteristics 

consistent with having such an advantage. We did not try to determine the 

size of any tax cost advantage or whether the tax cost advantage had an 

effect on the competition for specific contracts.

To address our objectives, we collected and analyzed information on 

government contracting practices and business decision-making processes. 

Using this information, we built a simple qualitative model to explain the 

conditions under which a corporation may gain a tax cost advantage in 

competing for federal contracts over other competitors whose 

headquarters are not located in tax haven countries. We matched 

contractor data from the General Services Administration’s (GSA) Federal 

Procurement Data System (FPDS) to tax and location data of corporations 

from the Internal Revenue Service’s (IRS) Statistics of Income (SOI) 

division to estimate the number of companies with characteristics that the 

qualitative model identifies as consistent with a tax advantage. For our 

analysis of contractors in 2000, we selected the 3,924 corporations that 

appeared in both FPDS and SOI in that year that had total assets of at least 

$10 million. For our 2001 analysis, we selected the 4,264 corporations in 

both databases that had total assets of at least $10 million. In this report, 

we refer to corporations with at least $10 million in assets as large 

corporations.3

 The SOI sample includes the universe of such large 

corporations in 2000 and 2001. Because it is the universe, there is no 

sampling error for the information that we report about these corporations. 

Some companies may have reasons to locate in tax haven countries that are 

unrelated to tax advantages. For example, some companies may locate 

their operations in tax haven countries because of business conditions in 

the tax haven related to costs and profitability. Location in a tax haven 

country does not by itself establish that a company has adopted a taxminimizing strategy.

We requested comments on this draft from the Commissioner of Internal 

Revenue and the Secretary of the Treasury. We conducted our review from 

3

 The designation large corporation, as used in this report, is not related to the business size 

standards used in determining small business status for federal government contracts.
Page 3 GAO-04-856 International Taxation

July 2003 through June 2004 in accordance with generally accepted 

government auditing standards.

Results in Brief There are conditions under which contractors, including tax haven 

contractors, may have a tax cost advantage when competing for contracts, 

including federal government contracts. The extent of the tax cost 

advantage depends on the relative tax liabilities of a contractor and its 

competitors. The tax cost of the contract is the tax liability on the 

additional income derived from the contract. One way for a contractor to 

gain a tax advantage is by reducing its U.S. taxable income from other 

sources to less than zero and by using its losses to offset some or all of the 

additional income from a contract, resulting in less tax on this income. A 

company would thereby gain an advantage relative to companies with 

positive income from other sources and may be able to offer a lower price 

or cost for the contract. While some domestic corporations may also have 

a tax cost advantage, tax haven contractors may be more likely to have 

such an advantage because of opportunities to shift income to their tax 

haven parents. Whether a contractor has a tax cost advantage in 

competing for a particular contract depends on the tax liabilities of other 

competitors. Also, the contractors with a tax cost advantage are not 

necessarily the successful competitors because the tax cost savings may 

not be reflected in actual prices, and prices may be only one of several 

factors involved in awarding contracts.

Using tax liability as an indicator of ability to offset income from the 

contract, we determined that in both 2000 and 2001, large tax haven 

contractors were more likely to have a tax cost advantage than large 

domestic contractors. In 2000, 56 percent of the 39 tax haven contractors 

reported no tax liability, while 34 percent of the 3,253 domestic contractors 

reported no tax liability. In 2001, 66 percent of tax haven contractors and 

46 percent of domestic contractors reported no tax liability. While in 2000 

and 2001 tax haven contractors were more likely to have zero tax liability, 

companies may have low or zero tax liabilities for a variety of reasons, such 

as overall business conditions, industry or company-specific performance 

issues, or the use of income shifting.

Background Corporations can be located in tax haven countries through a variety of 

means, including corporate inversions, acquisition, or initial incorporation 

abroad. Location in a tax haven country can change a company’s tax 
Page 4 GAO-04-856 International Taxation

liability because the United States taxes domestic corporations differently 

than it taxes foreign corporations.

U.S. Tax Treatment of a 

Domestic Corporation

The United States taxes the worldwide income of domestic corporations, 

regardless of where the income is earned; gives credits for foreign income 

taxes paid; and defers taxation of foreign subsidiaries until their profits are 

repatriated in the form of dividends or other income. However, a U.S. 

parent corporation is subject to current U.S. tax on certain income earned 

by a foreign subsidiary, without regard to whether such income is 

distributed to the U.S. corporation.

Through “deferral,” U.S. parent corporations are allowed to postpone 

current taxation on the net income or economic gain accrued by their 

subsidiaries. These subsidiaries are separately incorporated foreign 

subsidiaries of U.S. corporations. Because they are not considered U.S. 

residents, their profits are not taxable as long as the earnings are retained 

and reinvested outside the United States in active lines of business. That is, 

U.S. tax on such income is generally deferred until the income is 

repatriated to the U.S. parent. 

The U.S. system also contains certain anti-deferral features that tax on a 

current basis certain categories of passive income earned by a domestic 

corporation’s foreign subsidiaries, regardless of whether the income has 

been distributed as a dividend to the domestic parent corporation. Passive 

income includes royalties, interest and dividends. According to the 

Internal Revenue Code (I.R.C.), passive income is “deemed distributed” to 

the U.S. parent corporation and thus denied deferral. The rules defining 

the application and limits of this antideferral regime are known as the 

Subpart F rules. 

In order to avoid double taxation of income, the United States permits a 

taxpayer to offset, in whole or in part, the U.S. tax owed on this foreignsource income. Foreign tax credits are applied against a corporation’s U.S. 

tax liability. The availability of foreign tax credits is limited to the U.S. tax 

imposed on foreign-source income. To ensure that the credit does not 

reduce tax on domestic income, the credit cannot exceed the tax liability 

that would have been due had the income been generated domestically. 

Firms with credits above that amount in a given year have “excess” foreign 

tax credits, which can be applied against their foreign source income for 

the previous 2 years or the subsequent 5 years. 
Page 5 GAO-04-856 International Taxation

This system of taxation of U.S. multinational corporations has been the 

subject of ongoing debate. Specific issues in international taxation include 

whether to reform the U.S. system by moving from worldwide taxation to a 

territorial system that exempts foreign-source income from U.S. tax. These 

issues have become more prominent with the increasing openness of the 

U.S. economy to trade and investment.

U.S. Tax Treatment of a 

Foreign Corporation

The United States taxes foreign corporations on income generated from 

their active business operations in the United States. Such income may be 

generated by a subsidiary operating in the United States or by a branch of 

the foreign parent corporation. It is generally taxed in the same manner and 

at the same rates as the income of a U.S. corporation. In addition, if a 

foreign corporation is engaged in a trade or business in the United States 

and receives investment income from U.S. sources, it will generally be 

subject to a withholding tax of 30 percent on interest, dividends, royalties, 

and certain types of income derived from U.S. sources, subject to certain 

exceptions. This tax may be reduced or eliminated under an applicable tax 

treaty.

Scope and 

Methodology

For objective 1, we collected and analyzed information on government 

contracting practices and business decision-making processes. We also 

reviewed the economics literature and reports of the Department of the 

Treasury and the Joint Committee on Taxation to determine how 

differences in the tax treatment of corporations can contribute to a tax cost 

advantage. Using the information we obtained, we built a simple 

qualitative model to explain the conditions under which a tax haven 

company may have a tax cost advantage in competing for federal contracts 

relative to other companies whose headquarters are not located in tax 

haven countries. For a description of the model, see appendix I.
Page 6 GAO-04-856 International Taxation

For objective 2, we used the qualitative model to identify companies that 

had characteristics consistent with having a tax cost advantage. We 

matched contractor data (name and taxpayer identification numbers) from 

the GSA’s FPDS for 2000 and 2001 to tax and location data from the IRS’s 

SOI corporation file. In this matched database, we analyzed information 

about large corporations, those with at least $10 million in assets.4

 We 

identified the large corporations with characteristics consistent with a tax 

cost advantage compared to other large corporations and counted the 

number of these advantaged and disadvantaged corporations. We divided 

the SOI data into categories that differentiated between federal contractors 

(domestically owned and foreign owned) and noncontractors 

(domestically owned and foreign owned). We further divided the foreignowned corporation data by those headquartered in tax haven countries 

from those not headquartered in tax haven countries.5

 

Data Limitations and 

Reliability

SOI is a data set widely used for research purposes. SOI corporation files 

are representative samples of the population of all corporations that filed 

tax returns. Generally, SOI data can be used to project tax return 

information to the universe of all filers. However, the total corporations 

that matched in both the SOI and FPDS databases could not be used to 

project the results of our analysis to the universe of all corporations. 

Because SOI’s sampling rate for smaller corporations is very low, our 

matched database contained very few smaller corporations and would not 

lead to reliable estimates of the properties of the universe of smaller 

corporations. Therefore, the results of our analysis cannot be projected to 

the universe of all corporate filers. However, our results do represent the 

universe of large tax haven contractors. SOI samples corporations with at 

least $10 million in assets at a 100 percent rate so that the SOI sample 

4

 We did not include in our analysis corporations that were real estate investment trusts, 

regulated investment companies, or subchapter S corporations because these pass-through 

entities are treated differently for tax purposes than ordinary corporations.

5

 As of December 2003, OECD had identified 39 countries or jurisdictions that they consider 

to be tax havens. In this report, we refer to these countries and jurisdictions as tax haven 

countries. They are Andorra, Anguilla, Antigua and Barbuda, Aruba, Bahamas, Bahrain, 

Barbados, Belize, Bermuda, British Virgin Islands, Cayman Islands, Cook Islands, Cyprus, 

Dominica, Gibraltar, Grenada, Guernsey, Isle of Man, Jersey, Liberia, The Principality of 

Liechtenstein, Malta, The Republic of the Marshall Islands, Mauritius, The Principality of 

Monaco, Montserrat, The Republic of Nauru, Netherlands Antilles, Niue, Panama, St. 

Christopher (St. Kitts) and Nevis, St. Lucia, St. Vincent and the Grenadines, Samoa, San 

Marino, Seychelles, Turks & Caicos, U.S. Virgin Islands, and Vanuatu.
Page 7 GAO-04-856 International Taxation

includes the universe of these larger corporations. For this reason, we 

report the results of our analysis without sampling error.

IRS performs a number of quality control steps to verify the internal 

consistency of SOI sample data. For example, it performs computerized 

tests to verify the relationships between values on the returns selected as 

part of the SOI sample and manually edits data items to correct for 

problems, such as missing items. We conducted several reliability tests to 

ensure that the data excerpts we used for this report were complete and 

accurate. For example, we electronically tested the data and used 

published data as a comparison to ensure that the data set was complete. 

To ensure accuracy, we reviewed related documentation and electronically 

tested for obvious errors. We concluded that the data were sufficiently 

reliable for the purposes of this report. 

We have previously reported that there are limitations to the accuracy of 

the data in FPDS.6

 The data accuracy issues we reported on involved 

contract amounts and classification of contract characteristics. For this 

report, the only FPDS data we used were the contractors’ names and 

taxpayer identification numbers. Our previous report did not address the 

accuracy of these data elements. Therefore, our match of the FPDS and 

SOI data may contain some nonsampling error; that is, due to inaccurate 

identification numbers, we may fail, in some cases, to correctly identify 

large corporations in SOI that were also federal contractors. However, we 

expect this nonsampling error to be small, and we concluded that the data 

were sufficiently reliable for the purposes of this report. 

There Are Conditions 

under Which Tax 

Haven Contractors 

May Have a Tax Cost 

Advantage 

Contractors, including tax haven contractors, that have a lower marginal 

tax rate on the income from a contract than other contractors would have a 

tax cost advantage when competing for a contract. Furthermore, there is 

some evidence that a tax haven contractor may be able to shift income 

between the U.S. subsidiary and its tax haven parent in order to reduce U.S. 

taxable income. 

6

 U.S. General Accounting Office, Reliability of Federal Procurement Data, GAO-04-295R

(Washington, D.C.: Dec. 30, 2003).
Page 8 GAO-04-856 International Taxation

Contractors with Lower 

Marginal Tax Rates May 

Have a Tax Cost Advantage

There are conditions under which a contractor could have a tax cost 

advantage when competing for a contract. The tax cost of the contract is 

the tax paid on the additional income derived from the contract. A 

contractor that pays less tax on additional income from a contract gains a 

tax cost advantage compared to companies that pay higher tax. One way to 

gain a tax cost advantage is by offsetting income earned on the contract 

with losses from other activities. The contractors with a tax cost 

advantage are not necessarily the successful competitors because the tax 

cost savings may not be reflected in actual bid prices or price proposals, 

and prices or costs are only one of several factors involved in awarding 

contracts. This reasoning holds for all contractors, including tax haven 

contractors, and all contracts, including federal contracts.

The appropriate measure of the tax cost of the contract is the corporation’s 

marginal tax rate. The marginal tax rate is the rate that applies to an 

increment of income. As such, the marginal tax rate would be the rate that 

applies to the additional income that would arise from the federal contract. 

For example, if a contractor in a 34 percent tax bracket earns $1 million of 

additional income from the contract, it would owe $340,000 in additional 

tax. The 34 percent statutory tax rate is this contractor’s marginal rate. 

A lower marginal tax rate may confer a tax cost advantage when companies 

are bidding on contracts because it indicates a higher after-tax rate of 

return on the contact. All other things being equal, a lower marginal 

effective tax rate is equivalent to a reduction in cost, that is, a reduction in 

either the tax rate or cost would produce a higher after-tax return. For 

example, a contractor with a 30 percent marginal tax rate on a contract 

producing $1 million of income pays $300,000 in taxes and receives 

$700,000 in additional after-tax income. On the other hand, a contractor 

with a 34 percent marginal tax rate on the same contract producing 

$1 million of income pays $340,000 in taxes and receives $660,000 in 

additional after-tax income. The $40,000 difference in after-tax income due 

to the difference in marginal tax rates is the tax cost advantage. In this 

example, the contractor with the tax cost advantage can, in theory, 

underbid the competitor by as much as $40,000 and earn an after-tax 

income at least as large as the competitor. In this sense, the competitor 

with the lower marginal tax rate would have a tax cost advantage over a 

competitor with a higher marginal tax rate. 

A contractor gains a tax cost advantage if it has a lower marginal tax rate 

compared to other companies that are competing for the contract. 

However, the available data are not sufficient to measure marginal rates 
Page 9 GAO-04-856 International Taxation

accurately. In order to compute marginal rates, detailed information is 

required about the tax status of the contractors and types of spending by 

the contractors associated with the contracts. 

Although the marginal tax rates are not available, conditions under which 

the marginal rates may be lower for some companies than others can be 

inferred from their current taxable income. Specifically, a company that 

has positive taxable income may be more likely to have a positive tax 

liability on the incremental income from the contract than companies with 

zero or negative taxable income. Therefore, a company with zero taxable 

income may have a lower marginal tax rate relative to companies with 

positive taxable income.7

 Tax losses in the United States on other activities 

could absorb incremental income generated from a contract. All other 

things being equal, a company competing for a federal contract that 

reported taxable income in the United States would face a higher tax cost 

than a competitor without taxable income.

While a zero tax liability provides an indicator of a tax cost advantage, it 

does not necessarily mean that the advantage exists. Whether a contractor 

with zero tax liability has a tax cost advantage when competing for a 

particular contract depends on the tax liabilities of the other competitors. 

The contractor with zero tax liability would have no tax cost advantage if 

all the other competitors also had no tax liability.

Even if a contractor can be shown to have a tax cost advantage when 

competing for a federal contract, this advantage does not imply that the 

contractor’s bid or proposal will be successful. A tax cost advantage may 

not be reflected in the contractor’s bid or price proposal, the content of 

which depends on the business judgment of the contractor. For example, 

in order to include more profit, a contractor may decide not to use any tax 

cost advantage to reduce its price. Even if the tax advantage is reflected in 

the bid or price proposal, other price or cost factors that affect whether the 

bid or proposal is successful may not be equal across the companies 

competing for the contract. For example, a bidder may have a tax cost 

7

 Besides depending on taxable income and potential availability of tax losses to offset 

income, the likelihood of a zero marginal rate also depends on the availability of 

accumulated tax credits, which can directly offset tax liabilities. We emphasize taxable 

income here because the availability of tax losses is more directly connected to the income 

shifting discussed in the next section. Our estimate of the number of contractors with an 

advantage is based on whether they have positive or zero tax liability, which includes the 

effects of both loss and credit carryforwards. 
Page 10 GAO-04-856 International Taxation

advantage over other bidders, but if its costs of labor and material are 

higher, its tax cost advantage may be offset by its higher costs for those 

other elements of its bid. Further, where price or cost is not the only 

evaluation factor for award of the contract, any tax cost advantage may be 

offset by the relative importance of other factors such as technical merit, 

management approach, and past performance. Generally, the contractor’s 

tax cost advantage would become a competitive advantage where other 

contractors would have to reduce their prices (or costs) and/or improve the 

nonprice (or noncost) elements of their proposals to offset the tax cost 

advantage.

Tax Haven Contractors May 

Be Able to Shift Income to 

Reduce U.S. Taxable 

Income

Tax haven contractors may be more likely to have lower tax costs than 

other contractors because they may be able to shift U.S. source income to 

their tax haven parents, reducing U.S. taxable income. Some, but not all, 

domestic contractors - those that have overseas affiliates - may also be able 

to shift income. Any income earned by the U.S. subsidiary from a contract 

for services performed in the United States would be U.S. taxable income. 

Such income would be taxed in the United States unless it is shifted outside 

the United States through such techniques as transfer pricing abuse. 

Location in a tax haven country can confer tax advantages that are not 

related to income shifting and do not give a company an advantage when 

competing for federal contracts. When a parent locates in a tax haven 

country, taxes on foreign income can be reduced by eliminating U.S. 

corporate-level taxation of foreign operations. However, these tax savings 

are unrelated to the taxes paid on income derived from the contract for 

services performed in the United States and have no effect on the tax cost 

of the contract.8

 The tax haven contractor potentially gains an advantage 

with respect to contract competition because of the increased scope for 

income shifting to reduce U.S. taxable income below zero.

8

 For a more detailed description of the potential tax advantages, see app. I.
Page 11 GAO-04-856 International Taxation

A tax haven contractor may be able to shift income outside of the United 

States by increasing payments to foreign members of the corporate group. 

The contractor may engage in transfer pricing abuse, whereby related 

parties price their transactions artificially high or low to shift taxable 

income out of the United States. For example, the tax haven parent can 

charge excessive prices for goods and services rendered (for example, 

$1000 instead of $500). This raises the subsidiary’s expenses (by $500), 

lowers its profits (by $500), and shifts the income ($500) to the lower tax 

jurisdiction outside the United States. Transfer pricing abuse can also 

occur when the foreign parent charges excessive interest on loans to its 

U.S. subsidiary. 9

 Interest deductions can also be used to shift income 

outside the United States through a technique called “earnings stripping.” 

Using this technique, the foreign parent loads the U.S. subsidiary with a 

disproportionate amount of debt, merely by issuing an intercompany note, 

thereby generating interest payments to the parent and interest deductions 

against U.S. income for the subsidiary. However, the U.S. subsidiaries 

would still be subject to the I.R.C. rules that limit the deductibility of 

interest to 50 percent of adjusted taxable income whenever the U.S. 

subsidiary’s debt-equity ratio exceeds 1.5 to 1.

Determining whether companies shift income to obtain a tax cost 

advantage is difficult because differences among companies that may 

indicate shifting can also be explained by other factors affecting costs and 

profitability. For example, while differences in average tax rates and 

interest expenses may be consistent with income shifting, they do not 

prove that such activities are occurring. The differences might be 

explained by other factors, such as the age of the company. 

As table 1 shows, tax haven contractors in 2001 had greater interest 

expense and lower tax liabilities relative to gross receipts than domestic or 

all foreign contractors. The greater interest expense associated with lower 

tax liabilities may indicate that the tax haven contractors have used 

techniques like earnings stripping to shift taxable income outside the 

United States. The pattern of tax liabilities and interest expense in 2000 is 

the same as in 2001 in all respects except one: the ratio of interest expense 

9

 There are various provisions in the I.R.C. designed to limit income shifting. The limits 

include the requirement (Section 482) that transactions between related parties use arm’s 

length prices, that is, the prices that unrelated parties would or should use for the 

transactions. 
Page 12 GAO-04-856 International Taxation

to gross receipts for tax haven noncontractors is lower than the ratio for 

domestic or all foreign contractors in 2000. (For details, see app. II.)

Table 1: Tax Liabilities and Interest Expenses of Large Contractors and Noncontractors in 2001

Source: GAO analysis of IRS data. 

Notes: Large contractors and noncontractors are companies with total assets greater than or equal to 

$10 million. The number of companies does not sum to the total because tax haven contractors are 

included among all foreign contractors.

This pattern of interest expenses and tax liabilities is largely consistent 

with tax haven contractors inflating interest costs to shift taxable income 

outside of the United States but does not prove that this has occurred. The 

differences may be due to such factors as the age and industry of the 

companies, their history of mergers or acquisitions, and other details of 

their financial structure and the markets for their products. Furthermore, 

low or zero tax liability is not necessarily an indicator of noncompliance. 

Companies may have low or zero tax liabilities for a variety of reasons, 

such as overall business conditions, industry- or company-specific 

performance issues, and the use of income shifting.

Contractors Noncontractors

Number of 

companies

Tax liability as a 

percentage of 

gross receipts 

Interest expense 

as a percentage 

of gross receipts 

Number of 

companies

Tax liability as a 

percentage of 

gross receipts 

Interest expense 

as a percentage 

of gross receipts 

All foreign 740 0.89 6.55 7,093 1.01 8.53

Tax haven 50 0.75 8.33 787 0.91 16.32

Domestic 3,524 1.18 7.12 33,293 1.76 12.90

Total 4,264 1.14 7.04 40,386 1.59 11.92
Page 13 GAO-04-856 International Taxation

The evidence on the extent to which income shifting is occurring is not 

precise. Studies that compare profitability of foreign-controlled and 

domestically controlled companies show that much of the difference can 

be explained by factors other than income shifting.10 However, the range of 

estimates can be wide, contributing to uncertainty about the precise effect, 

and the studies do not focus on income shifting to parents in tax haven 

countries. The 1997 study by Harry Grubert showed that more than 50 

percent, and perhaps as much as 75 percent, of the income differences 

could be explained by factors other than income shifting. A Treasury 

report on corporate inversions did discuss income shifting to parents in tax 

haven countries but did not provide any quantitative estimates of the extent 

of such shifting. According to the report, the tax savings from income 

shifting are greatest in the case of a foreign parent corporation located in a 

no-tax jurisdiction.11 The Treasury report cites increased benefits from 

income shifting among other tax benefits as a reason for recent corporate 

inversion activity and increased foreign acquisitions of U.S. multinationals. 

Tax Haven Contractors 

Were More Likely to 

Have a Tax Cost 

Advantage Than 

Domestic Contractors

Using tax liability as an indicator of ability to offset contract income, we 

determined that large tax haven contractors were more likely to have a tax 

cost advantage than large domestic contractors in both 2000 and 2001. In 

both years, tax haven contractors were about one and a half times more 

likely to have no tax liability as domestic contractors.12 As table 2 shows, in 

2000, 56 percent of the 39 tax haven contractors reported no tax liability, 

while 34 percent of the 3,253 domestic contractors reported no tax liability. 

In 2001, 66 percent of the 50 tax haven contractors and 46 percent of the 

3,524 domestic contractors reported no tax liability.

10 See, for example, Harry Grubert, “Another Look at the Low Taxable Income of ForeignControlled Companies in the United States,” Tax Notes International (Arlington, Va.: Dec. 8, 

1997), 1,873-97, and David S. Laster and Robert N. McCauley,” Making Sense of the Profits of 

Foreign Firms in the United States,” Federal Reserve Bank of New York Quarterly Review 

(New York: Summer-Fall 1994).

11 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion Transactions: 

Tax Policy Implications.

12 The relative probability of contractors having no tax liability can be computed by 

comparing relative frequencies (percentages) of tax haven and domestic contractors with 

no tax liability. In 2000 and 2001, the relative frequencies were 1.65 (.56 divided by .34) and 

1.43 (.66 divided by .46), respectively. 
Page 14 GAO-04-856 International Taxation

Table 2: Tax Status of Large Tax Haven and Domestic Contractors in 2000 and 2001

Source: GAO analysis of IRS data.

Under the conditions of our model, contractors with no tax liability would 

have a tax cost advantage compared to the contractors that did have tax 

liabilities in these years. Consequently, in 2000, the tax haven contractors 

without tax liabilities were likely to have a tax cost advantage compared to 

the 17 other tax haven contractors and 2,132 domestic contractors that had 

tax liabilities. The 1,121 domestic contractors without tax liabilities were 

also likely to have a tax cost advantage compared to these same 

companies. In 2001, the tax haven contractors with zero tax liability were 

likely to have a tax cost advantage compared to the 17 other tax haven 

contractors and 1,888 domestic contractors that had tax liabilities. 

Because they reported no tax liability, 1,636 domestic contractors were 

also likely to have a tax cost advantage with compared to these same 

companies. 

This analysis of possible tax advantages does not show that income shifting 

is the only potential cause of the advantage. As mentioned above, the tax 

losses that confer the advantage may be due to income shifting, but may 

also be due to other factors such as overall business conditions, industry 

and age of the company, or company-specific performance issues.13 In 

addition, the analysis does not show the size of the advantage in terms of 

Contractors with tax liability Contractors without tax liability

U.S. federal 

contractors

Number of 

companies

Percentage of 

companies

Number of 

companies

Percentage of 

companies

2000

Tax haven 17 44 22 56

Domestic 2,132 66 1,121 34

2001

Tax haven 17 34 33 66

Domestic 1,888 54 1,636 46

13 In a prior report, we found that the ratios of tax liability and interest expense to gross 

receipts varied by industry. However, after controlling for the age and industry of the 

corporations, we found that U.S. subsidiaries of foreign parent corporations were more 

likely to have zero tax liability than domestic corporations from 1996 through 2000. See U.S. 

General Accounting Office, Tax Administration: Comparison of the Reported Tax 

Liabilities of Foreign- and U.S.-Controlled Corporations, 1996-2000, GAO-04-358

(Washington, D.C.: Feb. 27, 2004). 
Page 15 GAO-04-856 International Taxation

tax dollars saved. The amount saved depends, in part, on the amount of 

additional income from the contract. If the contractor with no tax liability 

has insufficient losses to offset the additional income, it would pay taxes 

on at least part of the income, reducing the potential advantage. Lastly, the 

analysis identifies tax haven contractors that meet the conditions for 

having a tax cost advantage with respect to income from the contract in 

2000 and 2001. The data do not indicate whether they have an overall tax 

cost advantage on a contract that produces income in other years. 

Furthermore, to the extent that losses are used to offset income in the 

current year, they cannot be used to offset income in other years. These 

smaller loss carryovers would reduce the overall tax cost advantage.

Concluding 

Observations

The existence of a tax cost advantage for some tax haven contractors 

matters to American taxpayers. First, the advantage could, but does not 

necessarily, affect which company wins a contract. A contractor with a tax 

cost advantage could offer a price that wins a contract based more on tax 

considerations than on factors such as the quality and cost of producing 

goods and services. Second, the potential tax cost advantage may 

contribute, along with other tax considerations, to the incentives for 

companies to move to tax haven countries, reducing the U.S. corporate tax 

base.

The issue of tax cost advantages for tax haven contractors is related to the 

larger issue of how companies headquartered or operating in the United 

States should be taxed. For example, the questions about how the 

worldwide income of U.S. multinational corporations should be taxed are 

part of a larger debate and beyond the scope of this report. Because of 

these larger policy issues, we are not making recommendations in this 

report.

Agency Comments and 

Our Evaluation

In a letter dated June 22, 2004, the IRS Commissioner stated that because 

IRS’s only role in our report was to provide us with certain tax data, IRS’s 

review of a draft of this report would be limited to evaluating how well we 

described the tax data it provided. The Commissioner stated that IRS 

believes that the report fairly describes these data. On June 28, officials 

from the Department of the Treasury’s Office of Tax Policy provided oral 

comments on several technical issues, which we incorporated into the 

report where appropriate.
Page 16 GAO-04-856 International Taxation

As agreed with your office, unless you publicly announce its contents 

earlier, we plan no further distribution of this report until 30 days after its 

date. At that time, we will send copies to the Secretary of the Treasury, the 

Commissioner of Internal Revenue and other interested parties. We will 

also make copies available to others on request. In addition, this report will 

be available at no charge on GAO’s Web site at http://www.gao.gov.

If you have any questions concerning this report, please contact me at (202) 

512-9110 or whitej@gao.gov or Kevin Daly at (202) 512-9040 or 

dalyke@gao.gov. Key contributors to this report are listed in appendix III.

Sincerely yours,

James R. White

Director, Tax Issues
Page 17 GAO-04-856 International Taxation

Appendix I

A Simple Qualitative Model for Assessing Apendxies

Potential Contracting Advantages ApendxiI

A parent corporation that locates in a tax haven country may reduce U.S. 

tax on corporate income by shielding subsidiaries from U.S. taxation and 

by providing opportunities for shifting of U.S. source income to lower tax 

jurisdictions. Such a corporation could have an advantage because it is 

able to have a lower marginal tax rate on U.S. contract income than its 

domestic competitors or other foreign competitors. The simple qualitative 

model in this appendix specifies a set of conditions under which 

corporations with a tax haven parent may have a lower marginal U.S. tax 

rate.

The principal means by which a parent corporation that locates in a tax 

haven country may have lower U.S. tax liabilities are as follows.

• The corporation pays no U.S. tax on what would have been its foreign 

source income if it were located in the United States. To the extent that 

foreign subsidiaries are owned by a foreign parent, the U.S. corporatelevel taxation of foreign operations is eliminated. Tax savings would 

come from not having to pay tax on the corporate group’s foreign 

income.

• The corporation may be able to shift income outside of the United States 

by increasing payments to foreign members of the group. The 

corporation may engage in transfer pricing abuse, whereby related 

parties price their transactions artificially high or low to shift taxable 

income out of the United States.1

 Transfer pricing abuse can also occur 

when the foreign parent charges excessive interest on loans to its U.S. 

subsidiary. Interest deductions can also be used to shift income outside 

the United States through a technique called earnings stripping. Using 

this technique, the foreign parent loads the U.S. subsidiary with a 

disproportionate amount of debt, merely by issuing an intercompany 

note, thereby generating interest payments to the parent and interest 

deductions against U.S. income for the subsidiary. The subsidiaries 

would still be subject to the thin capitalization rules (I.R.C. section 163 

(j)) that limit the deductibility of interest to 50 percent of adjusted 

taxable income whenever the U.S. subsidiary’s debt-equity ratio exceeds 

1.5 to 1.

1

 There are various provisions in the I.R.C. designed to limit income shifting. The limits 

include the requirement (Section 482) that transactions between related parties use arm’s 

length prices, that is, the prices that unrelated parties would use for the transactions. 
Appendix I

A Simple Qualitative Model for Assessing 

Potential Contracting Advantages

Page 18 GAO-04-856 International Taxation

When a parent corporation locates in a tax haven country, the elimination 

of U.S. corporate-level taxation of foreign operations can reduce taxes on 

foreign income. However, these tax savings are unrelated to the taxes paid 

on income derived from the contract and have no effect on the tax cost of 

the contract. Any income earned by the U.S. subsidiary from a contract for 

services performed in the U.S. would be U.S. taxable income. Therefore, 

the elimination of the corporate-level taxation of foreign operations 

provides no competitive advantage to a corporation that is competing for a 

U.S. government contract.

A corporation has a U.S. tax advantage in competing for a government 

contract when it would pay a lower marginal U.S. tax rate on the income 

from that contract than would the other companies competing for that 

same contract. The available data are not sufficient to measure marginal 

rates accurately. However, the likelihood that the rates are lower for some 

companies than others can be inferred from their current tax liabilities. 

The manipulation of interest payments and other transfer pricing can 

reduce U.S. taxable income. We can infer that the corporation may have a 

lower marginal tax rate on its U.S. contract income if the manipulation 

allows a corporation that would otherwise have positive taxable income to 

reduce its taxable income (excluding the net income from the contract) to 

a negative amount. Table 3 shows a set of situations, or cases, in which a 

corporation may and may not have a cost advantage when bidding on a 

contract.

Table 3: Tax Cost Advantage of Corporations with Headquarters in a Tax Haven 

Country

Source: GAO qualitative model of tax cost advantage.

In order to use this model to identify corporations with a tax cost 

advantage, we make two assumptions: (1) corporations with positive U.S. 

taxable income pay tax at the same rate based on the schedule of corporate 

tax rates (that is, their income before the contract income puts them in the 

same tax bracket) and (2) corporations with negative income have 

Case

U.S. income of a 

company in the 

United States

U.S. income of a company 

with its parent located in a 

tax haven country

Company has a tax cost 

advantage with parent in 

tax haven country

1 + - Yes

2 + + No

3 - - No
Appendix I

A Simple Qualitative Model for Assessing 

Potential Contracting Advantages

Page 19 GAO-04-856 International Taxation

sufficient losses to offset income from the contract. With these 

assumptions, we can draw inferences about relative marginal tax rates for 

the three cases. A U.S. corporation that has positive U.S. taxable income 

(before taking the income from the contract into account) and has a parent 

located in a tax haven country does not have a competitive advantage 

compared to a U.S. corporation with positive income (Case 2). Because 

they have positive income and pay the same rate of tax, neither has a lower 

marginal tax rate than the other. Likewise, a corporation with a tax haven 

parent that has U.S. tax losses and zero tax liability would not have an 

advantage compared to another corporation with tax losses (Case 3). 

Because the marginal tax rate is zero for both these corporations and they 

have sufficient losses to offset the contract income, neither has a tax cost 

advantage.

However, a corporation that has a tax haven parent and U.S. tax losses 

would have an advantage when compared to a corporation with positive 

income (Case 1). In this case, the corporation with losses has a zero 

marginal rate, which provides a tax cost advantage compared to a 

corporation with taxable income and a positive marginal rate. The 

assumption that a corporation with zero tax liability has sufficient losses to 

offset contract income may not be true in particular instances. For 

example, a corporation may obtain more than one contract (in the public or 

private sector) and the marginal tax rate on income from a particular 

contract will depend on how the losses are allocated across income from 

all the contracts. However, a corporation with zero tax liability is more 

likely to be able to offset the additional income than a corporation with 

positive tax liability. In this sense, tax liability is an indicator of the ability 

to offset income from the contract. 

The qualitative model does not identify the causes of the advantage. The 

tax losses that confer the advantage may be due to income shifting, but 

may also be due to other factors. In addition, the model does not show the 

size of the advantage in terms of tax dollars saved. The amount saved 

depends, in part, on the amount of additional income from the contract. If 

the contractor with no tax liability has insufficient losses to offset the 

additional income, it would pay taxes on at least part of the income, 

reducing the potential advantage compared to contractors that have 

positive tax liabilities. Lastly, the model is used to identify tax haven 

contractors that meet the conditions for having a competitive advantage 

with respect to income from the contract in 2000 and 2001. The data do not 

indicate whether they have an overall tax advantage on a contract that 

produces income in other years.
Page 20 GAO-04-856 International Taxation

Appendix II

Additional Information about Contractors in 

2000 ApendxiI

The additional table of tax liabilities and interest expense for 2000 is 

provided for comparison with the data reported in the letter. It shows 

substantially the same pattern.

Information on Large 

Contractors in 2000

Table 4 shows that in 2000, tax haven contractors had greater interest 

expense and lower tax liabilities relative to gross receipts than domestic or 

all foreign contractors. The pattern of tax liabilities and interest expense in 

2000 is the same as in 2001 in all respects except one: the ratio of interest 

expense to gross receipts for tax haven noncontractors is lower than the 

ratio for domestic or all foreign contractors in 2000. The greater interest 

expense associated with lower tax liabilities may indicate, but does not 

prove, that the tax haven contractors have used techniques like earnings 

stripping to shift taxable income outside the United States.

Table 4: Tax Liabilities and Interest Expenses of Large Contractors and Noncontractors in 2000

Source: GAO analysis of IRS data. 

Notes: Large contractors and noncontractors are those with total assets greater than or equal to 

$10 million. The number of companies does not sum to the total because tax haven contractors are 

included among all foreign contractors.

Contractors Noncontractors

Number of 

companies

Tax liability as a 

percentage of 

gross receipts 

Interest expense 

as a percentage 

of gross receipts 

Number of 

companies

Tax liability as a 

percentage of 

gross receipts 

Interest expense as 

a percentage of 

gross receipts 

All foreign 671 1.25 5.01 7,173 1.27 11.62

Tax haven 39 0.31 9.92 787 1.10 6.32

Domestic 3,253 1.55 7.13 35,433 1.90 13.01

Total 3,924 1.50 6.81 42,606 1.76 12.71
Page 21 GAO-04-856 International Taxation

Appendix III

Staff Acknowledgments ApendxiI

Amy Friedheim, Donald Marples, Samuel Scrutchins, James Ungvarsky, 

and James Wozny made key contributions to this report.

(450244)
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