Defense Contracting: Recent Law Has Impacted Contractor Use of Offshore Subsidiaries to Avoid Certain Payroll Taxes
Published: 2010-01-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Many federal contractors establish offshore subsidiaries to take advantage of labor and market conditions. GAO has found that they also use offshore subsidiaries to reduce their U.S. tax burdens. In 2008, Congress passed the Heroes Earnings Assistance and Relief Tax (HEART) Act which resulted in contractor offshore subsidiaries paying certain payroll taxes for U.S. personnel working abroad. Fiscal year 2009's National Defense Authorization Act required GAO to report on the rationales, implications, and costs and benefits of defense contractors' use of offshore subsidiaries. We (1) assessed trends and purposes for contractors' offshore subsidiaries; (2) identified how contractors use subsidiaries to support defense contracts; (3) assessed DOD's oversight of contractors' use of offshore subsidiaries. To conduct our work, we reviewed data for the 29 U.S. publicly traded contractors with at least $1 billion in DOD spending in fiscal year 2008, reviewed several illustrative contracts selected based on categories of DOD services most often performed overseas, reviewed audit documents, and interviewed DOD officials about oversight.
section_title: What GAO Found
paragraphs: Many of the top 29 U.S. publicly traded defense contractors--those with $1 billion or more in DOD contracts in fiscal year 2008--have created offshore subsidiaries to facilitate global operations. Between fiscal years 2003 and 2008, they increased their use of these subsidiaries by 26 percent, maintaining at least 1,194 in 2008. We interviewed 13 of the 29 contractors based on a range of the amount of government work, locations of subsidiaries, and industry types; they reported that 97 percent of the subsidiaries generally supported global commercial and foreign government clients, while the remaining 3 percent supported DOD contracts performed overseas. These subsidiaries also helped the 29 contractors reduce taxes, with about one-third decreasing their effective U.S. corporate tax rates in 2008 in part through the use of foreign affiliates, lower foreign tax rates, and indefinite reinvestment of foreign income outside of the United States. For five of the DOD contracts we reviewed, companies principally used offshore subsidiaries to hire U.S. workers providing services overseas on U.S. government contracts in order to avoid Social Security, Medicare--known as Federal Insurance Contributions Act (FICA)--and other payroll taxes. This practice allowed contractors to offer lower bids when competing for certain services and thereby reduce costs for DOD. Our analysis of two contracts showed that the use of offshore subsidiaries saved DOD at least $110 million annually prior to the HEART Act, through payroll tax avoidance. While this practice provided contract cost savings for DOD, it resulted in these companies avoiding payroll taxes that would have contributed to the Social Security and Medicare Trust Funds. The 2008 HEART Act resulted in offshore subsidiaries of U.S. companies paying FICA taxes for U.S. workers performing services overseas on U.S. government contracts. As a result, in fiscal year 2009, four of the case study contractors using offshore subsidiaries to support DOD work requested reimbursement from DOD of at least $140 million for new FICA payments. Federal and state unemployment payroll taxes, however, were not covered by the HEART Act, and several contractors that used offshore subsidiaries have continued to avoid these taxes. In one state, we reviewed documentation for about 140 former employees of several contractors who were denied unemployment benefits in 2009. State workforce officials indicated these benefits were denied because the employees worked for a foreign subsidiary and not an American employer. DOD officials were aware of the roles offshore subsidiaries played in the DOD contracts we reviewed and stated that oversight mechanisms, such as the Defense Contract Audit Agency's reviews of incurred costs and oversight documents, inform them of the activities of offshore subsidiaries. In contracts we reviewed, evidence of offshore subsidiaries was present in contractor labor rates, cost accounting disclosures, and contractor price proposals. Contracting officials stated that the use of offshore subsidiaries did not negatively impact contract schedule or performance.

section_title: Letter
paragraphs: Many federal contractors operate globally through offshore subsidiaries to  take advantage of favorable labor and market conditions. GAO and others  have found that contractors also use offshore subsidiaries to reduce U.S.  taxes and maintain subsidiaries in tax haven and financial privacy  jurisdictions. Congress included a provision in the Heroes Earnings  Assistance and Relief Tax (HEART) Act of 2008 that addressed concerns  about contractor use of offshore subsidiaries to minimize U.S. taxes. This  provision resulted in foreign subsidiaries of U.S. companies working on  U.S. government contracts being required to pay certain payroll taxes.  The Department of Defense (DOD) relies heavily on federal contractors to  support its missions and in fiscal year 2008 spent approximately $396  billion on contracts for products and services. DOD uses thousands of  contractor employees to assist in operations around the world to support  U.S. forces deployed abroad with services ranging from security details to  transportation and facility management.
The Duncan Hunter National Defense Authorization Act for Fiscal Year  2009 directed GAO to report on the rationale, implications, and costs and  benefits for both the contractor and DOD in using offshore subsidiaries,  with respect to several issues, including: tax liability; legal liability;  compliance with cost accounting standards; efficiency in contract  performance; and contract management and contract oversight. To fulfill  our mandate we briefed your staffs on the results of our review. This  follow-on report (1) assesses trends and purposes for defense contractors’  offshore subsidiaries; (2) identifies how selected defense contractors used  offshore subsidiaries to support ongoing defense contracts; and (3)  assesses DOD oversight and management of defense contractors using  offshore subsidiaries.
To conduct our work, we identified 29 U.S. publicly traded defense  contractors with $1 billion or more in DOD spending in fiscal year 2008,  and reviewed information from Securities and Exchange Commission  (SEC) filings to determine which of these contractors had offshore  subsidiaries. From these 29 top defense contractors, we selected 13 to  interview based on a range of the amount of government work in fiscal  year 2008, location of identified subsidiaries, and industry type. In  addition, we interviewed three other defense contractors as part of the  case studies we conducted for a total of 16 contractors interviewed. We  also interviewed knowledgeable attorneys, academics, and tax  professionals to obtain their views about the rationale and implications of  using offshore subsidiaries.
To identify examples of how contractors use subsidiaries and DOD  contractor management and oversight, we identified the categories of  DOD services most often performed overseas and selected six illustrative  contracts as case studies based on several factors including the amount of  contract dollars obligated, contracting command, and services using large  numbers of U.S. personnel. For each of these contracts, we reviewed data  on contractor performance and interviewed DOD oversight staff,  contracting commands, and company officials responsible for these  defense contracts. To determine whether contractors using offshore  subsidiaries selected for case studies were subject to payroll taxes,  including Social Security, Medicare, and federal and state unemployment  taxes for U.S. employees, we reviewed contract file documents for the  contractors and interviewed Defense Contract Audit Agency (DCAA)  officials. As an illustrative example, we also selected one state, Texas, in  which four of the six selected contractors had a corporate presence, and  reviewed 2009 unemployment benefit claims data. We interviewed state  workforce officials to determine the impact on the ability of U.S.  personnel working overseas for offshore subsidiaries to claim  unemployment benefits. We identified and assessed relevant laws,  regulations, GAO reports, and DOD policies applicable to contractor  offshore subsidiaries.
We conducted our review from February 2009 to January 2010 in  accordance with generally accepted government auditing standards. These  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. See appendix I for more details on our  scope and methodology.
subsections: section_title: Background
paragraphs: Our prior work has found that U.S. multinational corporations engage in  offshore operations to reduce labor and administrative costs. For  example, many U.S. companies have found cost efficiencies by  outsourcing manufacturing jobs based in the U.S. to countries with skilled  labor available at lower cost. U.S. and foreign tax regimes also influence  decisions of U.S. multinational corporations regarding how much to invest  and how many workers to employ in particular activities and in particular  locations. Tax rules also influence where corporations report earning  income for tax purposes.
We have reported on the conditions under which a federal contractor in a  low-tax jurisdiction—one that has no or nominal taxes and no requirement  for a substantive local presence—may have a tax cost advantage when  competing for federal contracts. The extent of the advantage depends on  the relative tax liabilities of the contractor and its competitors. We also  previously reported that 63 of the 100 largest publicly traded federal  contractors in terms of fiscal year 2007 federal contract obligations  reported having subsidiaries in jurisdictions identified as tax haven or  financial privacy jurisdictions.
Defense contractors may contain a number of separate legal entities. A  parent corporation may directly own, either wholly or partially, multiple  subsidiary corporations. In turn, these subsidiaries may own other  corporate subsidiaries, and any of these corporations may own stakes in  partnerships. A domestic parent corporation—one that is organized under  U.S. laws—may head a group of affiliated businesses that includes both  domestic and foreign subsidiaries and partnerships.
Companies also consider payroll taxes in managing offshore operations.  Employers withhold these taxes from employee’s wages for Social  Security and Medicare and match the employee’s contribution for these  taxes. Workers make contributions to Social Security through payroll  taxes that the Treasury credits to the Social Security Trust Fund. About 96  percent of the nation’s workforce is in social security-covered employment  and pays tax on its annual earnings. When workers pay social security  taxes, they earn coverage credits, and 40 credits—equal to at least 10 years  of work—entitle them to social security benefits when they reach  retirement age. Different requirements govern the number of coverage  credits necessary to receive disability and survivors benefits for workers  who become disabled or die with relatively short work careers. Most  employers also pay both a federal and a state unemployment tax, which  provide unemployment compensation to workers who have lost their jobs.   Employees in most states do not contribute to unemployment taxes.
DOD uses thousands of defense contractors to provide services ranging  from security details and interpreters to transportation and facility  management in support of U.S. forces in contingency operations around  the world. To oversee these contracts, the Defense Contract Management  Agency (DCMA) is responsible for monitoring contractors’ performance  and management systems to ensure that cost, product performance, and  delivery schedules are in compliance with contract terms and conditions.  DCAA, under the authority of the DOD Comptroller, plays a critical role in  contractor oversight by providing auditing, accounting, and financial  advisory services for DOD and other federal agency contracts. We have  reported extensively on DOD contractor management and oversight  challenges in contingency operations and the need for DOD to have better  contract and contractor personnel information. In part for these reasons,  DOD contract management issues, including sufficient oversight, have  been a long-standing GAO high-risk area.
section_title: Top Defense Contractors Increased Offshore Subsidiary Use to Support Global Commercial Activities and Benefit from Reduced Liabilities
paragraphs: From 2003 through 2008, defense contractors increasingly used offshore  subsidiaries. Our analysis of SEC filings found that in 2008, 29 of the top  defense contractors—accounting for 41 percent of DOD contracting  dollars in fiscal year 2008—had at least 1,194 offshore subsidiaries. Of  the total offshore subsidiaries, about 200 were located in tax haven or  financial privacy jurisdictions such as Singapore, Hong Kong, Ireland, or  Luxembourg. Publicly traded defense contractors increased their  combined use of foreign subsidiaries by 26 percent from 2003 through  2008. Of these new subsidiaries, most were located in the United Kingdom  and Canada, while the largest rate of growth was in the British Virgin  Islands and Aruba. See table 1 for more information on the top 25 defense  contractor subsidiaries.
According to 13 of the top defense contractors we interviewed, 718 of the  738 offshore subsidiaries—or 97 percent—that they reported to the SEC in  fiscal year 2008 were generally used to support global commercial clients,  and foreign government contracts rather than DOD contracts. In some  cases, contractors established offshore subsidiaries for market presence  and proximity to customers as they thought it was important to establish a  presence where they do business overseas to be more responsive to  customer needs. For example, one defense contractor established  subsidiaries in Singapore to assist with equipment manufacturing and  repairs of commercial aircraft operating throughout Asia because it is  more cost-efficient than sending the aircraft back to the United States for  repairs. Ten of the 13 defense contractors told us they establish or acquire  offshore subsidiaries to take advantage of foreign government markets. In  one case, a defense contractor explained that it created a subsidiary in the  Netherlands to hire local nationals in order to win a contract with the  Dutch government. Contractors also noted that, in certain circumstances,  they are required to create offshore subsidiaries to comply with foreign  government requirements. For example, one company told us it  established a subsidiary in Bahrain to comply with Bahrainian law for  doing business in that country. In another instance, one contractor said  that it registered as a local company in Iraq to conduct business in  compliance with Iraqi law.
Aside from taking advantage of foreign government markets for  commercial work, a key benefit of using offshore subsidiaries cited by  contractors and other experts we spoke with was the ability to reduce  overall taxes. Several defense companies explained that the use of  offshore subsidiaries in foreign jurisdictions helps them lower their U.S.  taxes. For example, one defense contractor’s offshore subsidiary  structure decreased its effective U.S. tax rate by approximately 1 percent,  equaling millions of dollars in tax savings. Our review of 2008 SEC filings  for the 29 publicly traded defense companies found that approximately  one-third reported decreasing their 2008 effective U.S. tax rates through  the use of foreign affiliates, lower foreign tax rates, and indefinite  reinvestment of foreign income outside of the United States.
Defense contractors also told us that creating subsidiaries, whether based  in the United States or offshore, protects U.S. parent companies from  certain legal liabilities, although company representatives said this was not  a primary reason for establishing offshore subsidiaries. For example,  defense companies and experts noted that subsidiary structures limit U.S.  parents from liabilities related to changes in foreign law and practices.  Defense contractors said an offshore subsidiary can be used to focus  liability in one place, thus shielding the rest of the company from potential  lawsuits because only the assets of the subsidiary would be susceptible.
While almost all of the 738 offshore subsidiaries were used to support  commercial and foreign clients, 20—about 3 percent—were used to  support DOD contracts in fiscal year 2008. However, we do not know the  percentage of DOD contract dollars supporting activities of offshore  subsidiaries because contract data do not capture the use of offshore  subsidiaries specifically. Most of the 13 defense contractors we  interviewed directed work performed for DOD in a foreign country to a  company subsidiary in that country. For example, one defense  contractor’s German subsidiary was the prime contractor for a facility  operations support services contract in Germany. Another contractor used  an Australian subsidiary to support a Navy research and development  contract performed in Australia. In contrast, we also identified some  defense contractors that used subsidiaries registered outside the place of  contract performance to support DOD service contracts abroad. These  offshore subsidiaries had no staff or business activity where registered.
section_title: Offshore Subsidiaries Supporting DOD Service Contracts Overseas Were Principally Used to Avoid Payroll Taxes
paragraphs: The primary use of the offshore subsidiaries registered outside the  contract place of performance—many of those reviewed in our six case  studies—was to hire U.S. workers to perform services overseas and  thereby avoid Federal Insurance Contributions Act (FICA) taxes for those  employees. According to contractor officials, the practice used in the  cases we reviewed allowed the contractor to bid lower labor costs when  competing for labor-intensive DOD service contracts performed abroad.  Using offshore subsidiaries also permitted contractors to avoid other  payroll taxes, such as federal and state unemployment insurance. Before  the HEART Act took effect in August 2008, FICA tax payments were not  required for U.S. personnel working overseas on U.S. government  contracts for foreign subsidiaries of U.S. companies.  Although this  practice resulted in contract cost savings for DOD, it meant that taxes  were not paid into the Social Security and Medicare Trust Funds as they  would have been had the services been provided by U.S. personnel  employed by a domestic entity. Additionally, because these payments were  not made, employees did not receive coverage credits—earned when  workers pay social security taxes—for this work.
DOD and defense contractor officials explained that the use of offshore  subsidiaries to hire U.S. workers to perform services overseas was a  practice used for labor-intensive service contracts, often for work  performed in countries such as Iraq, Afghanistan, and Kuwait, because of  the potential for FICA cost savings. Four of the six contractors commonly  used offshore subsidiaries when hiring U.S. personnel to work on U.S.  government contracts beyond the contracts we reviewed. Defense  contractor officials explained that the need for security clearances for U.S.  personnel working on certain DOD contracts, as well export control  provisions, limit the types of defense work that can be conducted through  offshore subsidiaries. Typically, when contract functions required  personnel with security clearances, these personnel were hired through  the contractor’s U.S. subsidiary, while personnel who did not require a  security clearance were hired though an offshore subsidiary. For one  contract task order we reviewed, more than 80 percent of the contractor’s  staff were employed by its offshore subsidiary. See table 2 for information  on the six contracts selected for review.
Three of the six DOD contractors used subsidiaries registered, but that did  not have any staff or business activity, in the Cayman Islands. Services  were provided in locations near the contract place of performance. For  example, one company used two Cayman Islands subsidiaries to hire and  pay employees for logistics support contracts performed in locations  around the world, including the Middle East. However, the subsidiaries’  payroll processing work is conducted in Dubai. According to DOD, these  subsidiaries are registered in the Cayman Islands to avoid payroll taxes.  One company official explained that the Cayman Islands are a popular  choice for establishing offshore subsidiaries because of the ease with  which they can be registered due to local laws. Furthermore, employees of  Cayman Islands corporations do not pay taxes in that country. Figure 1  provides an example of how defense contractor subsidiaries were used to  hire and pay U.S. personnel for DOD work performed overseas prior to the  HEART Act.
For five of the six cases we reviewed, DOD reduced contract costs as a  result of the use of offshore subsidiaries to provide payroll functions. Most  of the contracts were cost-reimbursement type contracts, which authorize  agencies to reimburse contractors for allowable costs to the extent  prescribed in the contract. Taxes are a type of allowable cost prescribed in  the Federal Acquisition Regulation. Consequently, if defense contractors  were required to pay taxes such as FICA or state and federal  unemployment insurance, DOD would usually reimburse these costs. Our  analysis of the two largest service contracts with a combined total of more  than $6 billion in fiscal year 2008 obligations indicates that DOD saved at  least $110 million per year by not having to provide reimbursement for  FICA taxes.
subsections: section_title: HEART Act Resulted in Contractors Paying FICA Taxes and Impacted Use of Offshore Subsidiaries
paragraphs: After the HEART Act took effect, defense contractors that were not paying  FICA taxes on U.S. personnel working on DOD contracts outside of the  United States began to submit requests for equitable adjustments to  recover their newly increased tax costs. For the four cost-reimbursement  contracts we reviewed that used an offshore subsidiary, the increased  costs were negotiated with DOD officials and were being processed as  contract modifications at the time of our review. DOD and company  officials stated that total contract costs have increased by approximately 8  to 10 percent in some cases due to both FICA tax payments and increased  contract award fees. As a result, in fiscal year 2009, four of the five  contractors using offshore subsidiaries to support DOD work requested  reimbursement of at least $140 million from DOD for new FICA payments  on the contracts we reviewed as well as some others.
Several contractors stated that they initially used offshore subsidiaries to  hire U.S. workers to perform services overseas in order to offer  competitive prices when bidding for DOD contracts, and as this practice  grew, it became a competitive necessity. DOD officials said they did not  think that using an offshore subsidiary to avoid FICA taxes provided a  competitive advantage to companies since each competitor was free to  adopt the offshore structure if it chose. With the enactment of the HEART  Act, some defense companies have reconsidered the use of offshore  subsidiaries to hire U.S. workers. One contractor said it established a  subsidiary in 1993 to support a DOD logistics contract because, at that  time, company tax advisors proposed using offshore subsidiaries to  achieve cost savings that could be passed on to DOD. This contractor is  considering whether to continue using this subsidiary now that the cost  advantage from FICA tax savings has been removed. Another contractor  said that it had transferred U.S. personnel from its Cayman Islands  subsidiary to a U.S.-based subsidiary and is evaluating whether to close  the subsidiary. A third contractor said that the HEART Act removed the  cost advantage when hiring U.S. citizens and residents to perform work  overseas, but it still uses the subsidiary to manage foreign workers.
Contractors noted that the requirement of the HEART Act that companies  hiring U.S. personnel overseas pay FICA taxes may have unintended  consequences, such as hiring fewer of these employees. Additionally, they  noted that foreign-based contractors now have a cost advantage in  competing for overseas DOD contracts because they are not required to  pay FICA taxes for their U.S. workers. Several company and DOD officials  also stated that a foreign subsidiary could continue to avoid FICA taxes if  the parent company changes its ownership stake in the foreign subsidiary  to 50 percent or less, which is below the ownership threshold defined in  the law. In fact, one defense contractor adopted this practice and sold 50  percent of its wholly owned subsidiary the day before the HEART Act took  effect in order for its foreign subsidiary to avoid paying FICA taxes for  U.S. workers performing DOD work abroad. According to DCAA, another  defense contractor proposed subcontracting U.S. workers who do not  require security clearances through a new offshore company to bypass the  HEART Act requirements.
section_title: Defense Contractors’ Offshore Subsidiaries Continue to Avoid Unemployment Taxes for Their U.S. Workers
paragraphs: While five of the six contractors in our case studies said that reducing  FICA tax payments was the primary reason for using offshore subsidiaries,  this practice also allowed the contractors to reduce costs by avoiding state  and federal unemployment insurance taxes for U.S. personnel working  overseas. For U.S. citizens performing certain work outside the United  States, federal law requires only American employers to pay  unemployment taxes; foreign subsidiaries are not defined as American  employers under the law. The HEART Act did not address unemployment  payroll taxes for U.S. personnel working overseas, and while these taxes  are much lower than FICA taxes, contractors have been able to continue  to avoid them. Our analysis of data from one contractor showed a savings  of almost $6 million in 2009 by not paying state and federal unemployment  insurance taxes for U.S. workers on its federal government contract that  were hired through its offshore subsidiary. Table 3 provides a notional  example of differences in payroll taxes paid for U.S. workers of a domestic  subsidiary versus an offshore subsidiary.
In addition to offshore subsidiaries not owing unemployment taxes, their  U.S. workers may not be eligible for unemployment benefits stemming  from this employment. In one state where four of the six case study  contractors have a corporate presence, we reviewed documentation for  about 140 former employees of several contractors who were denied  unemployment benefits in 2009. State workforce officials indicated that  these benefits were denied because the employees worked for a foreign  subsidiary and not an American employer.
section_title: Contractors’ Use of Offshore Subsidiaries Did Not Impede DOD’s Contract Oversight
paragraphs: In the contracts we reviewed, DOD oversight officials were aware of the  roles that offshore subsidiaries played in supporting the contracts. DOD  officials said that oversight mechanisms, such as DCAA’s annual reviews  of incurred costs, provide knowledge of the activities of offshore  subsidiaries in cost-reimbursement contracts. For the contracts for which  DCMA had oversight responsibilities, officials said that they reviewed  DCAA audits and approved company disclosure statements, which  included information about the contractors’ use of subsidiaries.
Contracting officials said that the use of offshore subsidiaries did not  negatively affect contract schedule or performance.
In the five contracts we reviewed that used offshore subsidiaries, DCAA  conducted audits or examined documents related to the specific activities  of the subsidiary. For example, for two of the contractors, DCAA  conducted on-site audits of the payroll processing activities supported by  the offshore subsidiaries. In one case, the contractors’ offshore  subsidiaries are registered in the Cayman Islands, but its payroll  processing services are performed in Dubai and were audited on location  by DCAA. One DCAA office that monitors several contractors using  offshore subsidiaries has developed guidance to facilitate reviewing the  activities of payroll processing functions.
Contract file and oversight documents we reviewed, such as contractor  price proposals and cost accounting disclosure statements, disclosed the  use of offshore subsidiaries. For example, two of the contract files  included contractor labor rates, which specified the payroll company  (either onshore or offshore) assigned for each position. The rates also  indicate that the fringe benefits paid to employees of the two offshore  subsidiaries were less than benefits for U.S.-based employees. In another  case, one company’s price negotiation memo identified costs related to  two offshore subsidiaries, but it did not indicate that they were foreign  companies or where they were registered.
Although information on the offshore subsidiaries was disclosed in the  contract files, the clarity of information concerning the offshore  subsidiaries’ role in the contracts we reviewed varied. For example, for  one of the contracts, a DCMA official said that information identifying the  contractor’s offshore subsidiary was available, but it took several months  of working with the contractor to confirm the subsidiary’s purpose in  avoiding FICA taxes. In other contracts we examined, the role of the  offshore subsidiary was more readily apparent. For example, one contract  file included documents in which the defense contractor described the  offshore subsidiary as a means of saving DOD the cost of reimbursing  FICA taxes. The contract file indicated that contracting staff reviewed the  company’s information with Army counsel before consenting to the  subcontracting arrangement.
DCAA also has responsibility for reviewing contractor compliance with  federal cost accounting standards (CAS). For the six contracts in our  review, DCAA officials indicated that the contractors complied with CAS.  Contracts and subcontracts executed and performed entirely outside of  the United States, its territories, and possessions are exempt from CAS  requirements. Although performed overseas, according to DCAA and  contracting officials, most of the contracts we examined were not CAS  exempt because some costs were incurred within the United States, and in  each case the contractors followed CAS. In general, defense companies  said that even when their contracts are CAS exempt, they comply with  CAS because the accounting system is already in place.
section_title: Conclusion
paragraphs: While defense contractors have increased their offshore subsidiaries used  for commercial purposes, the practice of using offshore subsidiaries to  avoid certain payroll taxes on U.S. government contracts has been  addressed by the HEART Act. As a result, contractors have begun to pay  FICA taxes for U.S. workers hired through offshore subsidiaries to support  DOD contracts, thus contributing to the Social Security and Medicare  Trust Funds. This requirement will likely lead to a change in corporate  decisions to create offshore subsidiaries for this purpose. DOD also  continues to monitor these contractor practices. Notwithstanding these  changes, the HEART Act did not address unemployment taxes for U.S.  workers of offshore subsidiaries, and some contractors continue to avoid  these taxes. While unemployment insurance taxes are much lower than  those for FICA, this continues to allow for a potential tax advantage for  contractors hiring U.S. workers through offshore subsidiaries for U.S.  government contracts performed overseas.
section_title: Matter for Congressional Consideration
paragraphs: Congress should consider whether further legislative actions are needed to  require payment of unemployment taxes for U.S. workers hired by  offshore subsidiaries to perform services overseas.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Departments of Defense and  Labor, the Internal Revenue Service, and the Securities and Exchange  Commission. Each agency generally agreed with our report and did not  provide additional comments. We also obtained third party views from  defense contractors selected as part of our case studies; they generally  agreed with our findings and provided technical comments, which were  incorporated as appropriate. Texas Workforce Commission officials  reviewed a portion of the draft report related to unemployment benefits  and agreed with our findings.
We are sending copies of this report to other interested congressional  committees and the Secretary of Defense. In addition, this report will be  available at no charge on GAO’s Web site at http://www.gao.gov.
Should you or your staff have any questions on the matters covered in this  report, please contact John Needham at (202) 512-4841 or  needhamjk1@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.
Key contributors to this report were Amelia Shachoy, Assistant Director;  W. William Russell; Jennifer Dougherty; Emily Gruenwald; Ami Ballenger;  Noah Bleicher; Ken Patton; and Susan Neill.
section_title: Appendix I: Scope and Methodology
paragraphs: To understand the trends and purposes of defense contractors’ offshore  subsidiaries, we identified 45 contractors with $1 billion or more in 2008  Department of Defense (DOD) spending, based on data from the Federal  Procurement Data System-Next Generation (FPDS-NG). Of the 45  contractors, we found 29 were publicly traded U.S. companies and we  corroborated this information with officials at the Securities and  Exchange Commission (SEC). We reviewed prior GAO reports, performed  literature searches, and conducted legal research regarding DOD  contractors’ use of offshore subsidiaries.
To identify the 29 companies’ subsidiaries, we reviewed the 2008 Form 10- K reports filed with the SEC, which require companies to disclose their  significant subsidiaries. SEC defines a subsidiary as significant if (1) the  parent corporation’s and its other subsidiaries’ investments in and  advances to the subsidiary exceed 10 percent of the consolidated total  assets of the parent corporation and its subsidiaries, (2) the parent  corporation’s and its other subsidiaries’ proportionate share of total assets  (after intercompany eliminations) of the subsidiary exceed 10 percent of  the consolidated total assets of the parent corporation and its subsidiaries,  or (3) the parent corporation and its other subsidiaries’ equity in the  income from continuing operations exceeds 10 percent of the consolidated  income from continuing operations of the parent corporation and its  subsidiaries. The total number of subsidiaries reported to the SEC is most  likely understated. We also analyzed offshore subsidiary data from 2003  and 2008 for 25 of the 29 contractors to determine differences in the  numbers and locations of offshore subsidiaries over a 5-year period. We  excluded 4 of the 29 contractors that were not publicly traded in 2003 from  our analysis.
To further understand the reasons companies use offshore subsidiaries,  we conducted interviews with tax specialists, senior international  procurement attorneys, as well as tax and legal professors. We performed  literature searches to find examples of legal cases involving the  contractors we selected for case studies and their subsidiaries from 1980  to present. We specifically looked for cases involving liability issues  between a parent company and an offshore subsidiary.
To learn more about how defense contractors use offshore subsidiaries,  we conducted interviews with 13 of the 29 DOD contractors. We selected  these contractors based on a range of the amount of government work in  fiscal year 2008, location of identified subsidiaries, and industry type. In  addition, we interviewed 3 other defense contractors for the case studies  we conducted, for a total of 16 contractors interviewed.
We identified the top service categories procured by DOD outside of the  United States based on fiscal year 2008 FPDS-NG data. The services  selected were logistics support, construction of miscellaneous buildings,  facilities operations, repair and maintenance of vehicles, and architect and  engineer services. From this data, we selected six contracts for services  overseas to provide illustrative examples of services performed outside  the United States based on several factors, including the amount of  contract dollars obligated, type of service provided, contracting command,  and the contract place of performance, as well as services using large  numbers of U.S. personnel. We compared the FPDS-NG data to DOD  Synchronized Pre-deployment and Operational Tracker (SPOT) data to  identify contracts that employed U.S. workers abroad. We also identified  contracts in which the prime contractor was an offshore subsidiary of a  U.S. defense company. For each contract selected, we interviewed  contractor officials, DOD contracting command staff, as well as DOD  officials responsible for oversight of the contracts. Of the six contracts  that met these selection criteria, three of the associated contractors were  among the 13 interviewed from the top 29 defense contractors. Table 4  lists the 16 DOD contractors interviewed.
To assess the FPDS-NG data reliability for the contracts selected, we  corroborated the FPDS-NG data with DOD officials and the contract files.  We confirmed that contract information reported in FPDS-NG, including  the contract identification number, contract type, service provided,  contracted vendors, the contract place of performance, and the fiscal year  2008 dollars obligated were sufficiently reliable for our purposes.
To review DOD oversight and management of defense contractor’s use of  offshore subsidiaries, for each of the six contracts selected, we reviewed  selected contract file documentation, including contracts and task orders,  price negotiation memorandums, requests for consent to subcontract, and  contractors’ proposed pricing data. In addition, we reviewed relevant  Defense Contract Audit Agency (DCAA) audit reports and documentation.  We also reviewed available guidance from contracting commands and  estimates related to implementing the Heroes Earnings Assistance and  Relief Tax (HEART) Act of 2008 and interviewed cognizant DOD officials,  including contracting officers, DCAA and Defense Contract Management  Agency (DCMA) where delegated, as well as the contractors. We reviewed  the Federal Acquisition Regulation (FAR) and the Defense FAR  Supplement to identify any requirements regarding DOD contractors’ use  of offshore subsidiaries as well as Cost Accounting Standards (CAS) and  reviewed DOD’s public comments on the CAS Board’s review of the CAS  exemption for contracts performed entirely overseas.
To determine whether contractors using offshore subsidiaries selected for  case studies owed payroll taxes, we reviewed contract file documents for  the contractors and interviewed DCAA officials. With regard to state and  federal unemployment taxes, we analyzed contractor proposed labor rate  information in 2009 to determine the amount of state and federal  unemployment tax that was avoided on DOD contracts through the use of  offshore subsidiaries. We also selected one state, Texas, in which four of  the six selected contractors had a corporate presence as an illustrative  example. We reviewed data and interviewed the state’s workforce officials  to determine whether employees of those companies were denied  unemployment benefits in 2009 because the employees were hired through  a company’s offshore subsidiary. We assessed the reliability of the state  unemployment data and determined it was sufficiently reliable for our  purposes. In addition, we reviewed guidance and interviewed Department  of Labor officials about federal and state unemployment insurance  eligibility requirements.
We conducted this performance audit from February 2009 through January  2010 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Related GAO Products
paragraphs: International Taxation: Large U.S. Corporations and Federal  Contractors with Subsidiaries in Jurisdictions Listed as Tax Havens or  Financial Privacy Jurisdictions. GAO-09-157. Washington, D.C.:  December 18, 2008.
U.S. Multinational Corporations: Effective Tax Rates are Correlated  with Where Income Is Reported. GAO-08-950. Washington D.C.: August 12,  2008.
DCAA Audits: Allegations That Certain Audits at Three Locations Did  Not Meet Professional Standards Were Substantiated. GAO-08-857.  Washington D.C.: July 22, 2008.
Cayman Islands: Business and Tax Advantages Attract U.S. Persons and  Enforcement Challenges Exist. GAO-08-778. Washington D.C.: July 24,  2008.
Defense Acquisitions: DOD’s Increased Reliance on Service Contractors  Exacerbates Long-standing Challenges. GAO-08-621T. Washington, D.C.:  January 23, 2008.
Offshoring: U.S. Semiconductor and Software Industries Increasingly  Produce in China and India. GAO-06-423. Washington D.C.: September 7,  2006.
Company Formations: Minimal Ownership Information Is Collected  and Available. GAO-06-376. Washington, D.C.: April 7, 2006.
International Trade: Current Government Data Provide Limited Insight  into Offshoring of Services. GAO-04-932. Washington D.C.: September 22,  2004.