Tax Administration: Comparison of the Reported Tax Liabilities of Foreign- and U.S.-Controlled Corporations, 1998-2005
Released: 2008-08-12T00:00:00

Letter

Background

Researchers have studied the factors explaining why FCDCs report lower tax liabilities than USCCs. Generally, the research has recognized that nontax characteristics such as age and industry may explain some of the differences in reported tax liabilities. The researchers have also found that transfer pricing abuses may play a role in explaining the differences. However, measuring the separate effects of these factors on tax liabilities has been difficult due to data limitations.

Factors like the age and industry of corporations may affect tax liabilities by affecting net income. For example, younger corporations may be less likely than older corporations to have net income and, therefore, more likely to report no tax liability than older corporations. If FCDCs tend to be younger than USCCs, age differences may explain some of the difference in reported tax liabilities. We noted in our 1999 report that a study by Grubert (1997) suggested that the lower relative age of foreign- controlled corporations partially explained their lower reported profitability. However, data are not available on all the nontax characteristics that may affect tax liabilities.

Tax liabilities may also be reduced through transfer pricing abuse. Any company that has a related company, such as a subsidiary with which it transacts business, needs to establish transfer prices for those intercompany transactions. The transfer price should be the “arm’s length price,” i.e., the price that would be charged if the transaction occurred between unrelated companies. Section 482 of the Internal Revenue Code provides IRS authority to allocate income among related companies if IRS determines that the transfer prices used by the taxpayer were inappropriate. How transfer prices are set affects the distribution of profits and ultimately the taxable income of the companies. The following is an example of abusive cross-border transfer pricing. A foreign parent corporation with a subsidiary operating in the United States charges the subsidiary excessive prices for goods and services rendered (for example, $1,000 instead of the going rate of $600). This raises the subsidiary’s expenses (by $400), lowers its profits (by $400), and effectively shifts that income ($400) outside of the United States. At a 35-percent U.S. corporate income tax rate, the subsidiary will pay $140 less in U.S. taxes than it would if the $400 in profits were attributed to it.

Researchers have used direct and indirect methods to estimate the extent to which transfer pricing abuses explain the differences in reported tax liabilities. Direct methods analyze the transfer prices used by corporations and compare them to arm’s length prices. This method is difficult to apply because price data are often unavailable and determining the price that would be charged between unrelated parties can be difficult. An alternative, indirect method used by researchers analyzes data about the characteristics of corporations in order to test for a statistical relationship between tax rates and subsidiaries’ profitability or tax liability. In some of these studies, statistical methods are used to explain as much of the difference in reported tax liabilities as can be explained by the nontax characteristics and the remaining unexplained difference is identified as the upper limit of the difference that could be explained by transfer pricing abuse. However, how close this upper limit estimate is to the actual effect of transfer pricing abuse depends on how many of the important nontax characteristics have been included in the first stage of the analysis. As noted above, data are unavailable for some important nontax characteristics.

Low tax burdens can be measured in various ways. Zero tax liability is one way. However, corporations paying only small, but not zero, amounts of tax also face low tax burdens. Furthermore, corporations that pay no or little tax over a number of years have a lower cumulative tax burden. Therefore, measures based on a range of tax amounts and tax years may give a fuller description of which types of corporations pay relatively less. Finally, the amount of taxes paid generally corresponds with the size of the corporation, with large corporations on average paying more than small ones. Tax liability can be measured as the amount of tax paid as a percentage of gross receipts or total assets in order to account for differences in the size of corporations.

FCDCs Reported Lower Tax Liabilities Than USCCs by Most Measures

Our comparison of tax liabilities highlights three measures that are used by tax experts: (1) the percentage of corporations reporting no tax liability, (2) the number of years corporations reported no tax liability, and (3) tax liabilities reported by corporations as a percentage of gross receipts and assets.

A Large Percentage of Both FCDCs and USCCs Reported No Tax Liabilities

A greater percentage of large FCDCs reported no tax liability in a given year from 1998 through 2005, as shown in figure 1. (See table 1 in app. II for the detailed estimates.) From 1998 through 2001, a higher percentage of all FCDCs reported no tax liability than all USCCs, but differences after 2001 were not statistically significant.

As figure 1 shows, the number of large FCDCs and large USCCs that reported no tax liability peaked around 2001 and 2002. These years correspond roughly with a period of economic recession in the United States. However, we did not do any analysis to determine the effect of the recession on the patterns shown if figure 1.

After 2001, the percentage of large FCDCs and USCCs reporting no tax liability began to converge. By 2005, the difference was reduced to 3 percentage points. For corporations other than those filing tax Forms 1120 and 1120-A, the percentage of corporations that reported no tax liability varied by tax year and tax return type. (For detailed comparisons of these corporations, see table 2 in app. II.)

A Greater Percentage of Large FCDCs Reported No Tax Liability over Multiple Years between 1998 and 2005

In the 8 years from 1998 through 2005, large FCDCs in a panel data set that we analyzed consisting of tax returns that were present in the SOI corporate files in every year were more likely to report no tax liability over multiple years than large USCCs in the same panel data set. As figure 2 shows, about 72 percent of FCDCs and 55 percent of USCCs reported no tax liability for at least 1 year during the 8 years. About 57 percent of FCDCs and 42 percent of USCCs reported no tax liability in multiple years—2 or more years—and about 34 percent of FCDCs and 24 percent of USCCs reported no tax liability for at least half the study period—4 or more years. A correspondingly higher percentage of USCCs reported a tax liability in all 8 years, 45 percent for USCCs and 28 percent for FCDCs.

Large FCDCs and USCCs reporting no tax liability in 2005 arrived at that result in similar ways on their tax returns, as shown in figure 3. At a high level, corporate tax returns are organized to (1) calculate gross profit as gross receipts or sales minus the cost of goods sold; (2) calculate total income as gross profit plus other types of income; (3) report various deductible expenses; (4) calculate taxable income as the difference between income and deductions; and (5) calculate the tax liability for the taxable income. Corporations can establish the basis for a zero tax liability at different stages in these calculations by reporting, for example, that they have no total income or no taxable income which results in their having no tax liability. Figure 3 shows the percentage of corporations reporting no tax liability in 2005 by the line on their tax return where they first reported the zero dollar amounts that resulted in no tax liability. For example, the figure shows that 3 percent of large FCDCs and 1 percent of large USCCs established no tax liability by reporting no gross profit on line 3 of their returns. This pattern of similar percentages for large corporations continues throughout the tax return. For example, a similar, small percentage of large FCDCs or USCCs, around 4 to 5 percent, established their zero tax liability on line 11 by reporting zero total income.

As figure 3 shows, the overwhelming majority, about 79 to 80 percent of both large FCDCs and USCCs that reported zero tax liability in 2005, established it on line 28 where they reported zero taxable income before net operating losses. This means that their reported current-year deductions more than offset the positive current-year total income reported on line 11. The two most commonly used deductions, as a percentage of the value of all deductions claimed, were “other deductions” and the deduction for salaries and wages. See table 3 and figure 8 in appendix II for detailed comparisons of tax return line items and deductions.

On the corporate tax return, current-year taxable income is reported before net operating losses from other years are deducted and any tax credits are subtracted from tax liabilities. In 2005, losses from prior years and tax credits had less impact on where on the tax return large corporations first established no tax liability. Figure 3 shows on line 30 that a relatively small number of large corporations—about 10 percent— first established a zero tax liability by carrying forward losses from prior years, and that an even smaller number—about 3 percent—first established no tax liability through their use of tax credits, as reported on line 11 schedule J in the figure.

All FCDCs and USCCs differed in some ways from large FCDCs and USCCs in where on their tax returns they first established no tax liability, reflecting the influence of small corporations. As figure 3 shows, a higher percentage of all corporations established no tax liability on the gross profit and total income lines on their returns than large corporations. All corporations also show a greater impact of losses from prior years, with 19 to 24 percent first establishing no tax liability when they reported taxable income on line 30 after subtracting these losses.

However, there were also similarities between all corporations and large corporations in 2005. As with large corporations, all FCDCs and USCCs were most likely to first establish no tax liability on line 28 of their tax returns—over 46 percent for FCDCs and 58 percent for USCCs. In addition, as with large corporations, tax credits had little impact with only about 1 percent of all corporations first establishing no liability through their use of credits.

Figure 3 also shows that all FCDCs differed from all USCCs more than the large FCDCs differed from large USCCs. Whereas large FCDCs and USCCs differed little in where on the return they established no tax liability, all FCDCs were more than twice as likely to first establish no tax liability on the gross profit and total income lines as all USCCs.

FCDCs Reported Less Tax Liability Than USCCs as a Percentage of Both Gross Receipts and Total Assets

Alternative comparisons of FCDCs and USCCs based on ratios of reported tax liabilities to gross receipts or total assets also showed that FCDCs reported less tax than USCCs. Figure 4 shows that taxes as a percentage of gross receipts and assets were higher for USCCs than FCDCs. FCDCs reported lower tax liabilities in 2005 as a percentage of gross receipts than USCCs. For all FCDCs the percentage was about 1.4 percent, while for all USCCs the percentage was about 1.7 percent. This pattern was similar for large corporations where FCDCs had lower tax liability as a percentage of gross receipts-about 1.3 percent compared to about 2.1 percent for large USCCs.

Another comparison of FCDCs and USCCs based on amounts of tax liability in addition to zero tax liability showed that differences between FCDCs and USCCs became smaller as their reported tax liabilities increased. The difference between the percentage of large FCDCs and USCCs that report no tax liability was about 3 percent in 2005, and this difference reduces to 1 percent when we include corporations reporting tax liabilities less than $100,000 in the comparison. The difference is eliminated entirely when we compare those that report less than $1 million in tax liability. (For details of these comparisons, see table 4 in app. II.)

FCDCs and USCCs Differ by Age, Size, and Industry

Differences in age, size, industry and other nontax factors between FCDCs and USCCs could explain some of the differences in their reported tax liabilities. Also, companies in different industries often have different financial characteristics which could affect relative measures of tax liability. For instance, the relative levels of assets and receipts of companies primarily engaged in wholesale trade differ significantly from those primarily engaged in credit intermediation, such as commercial banks. We did not attempt to explain the extent to which these factors or others, such as transfer pricing abuses, might explain differences in the reported tax liabilities of FCDCs and USCCs.

A Higher Percentage of Large FCDCs Than Large USCCs Were New

A higher percentage of large FCDCs than large USCCs were new corporations (incorporated for 3 years or less) for tax years 1998 through 2005, as shown in figure 5. The percentages of large FCDCs that were new ranged from 9 percent to 14 percent, while for large USCCs the percentages ranged from 7 percent to 10 percent. For all FCDCs and USCCs, except for 1998 through 2000, there were no years with a statistically significant difference between the percentages of these types of corporations that were new. (See table 5 in app. II for the detailed estimates.)

FCDCs Reported Higher Average Gross Receipts and Assets Than USCCs

FCDCs tended to be larger in that in 2005 they reported higher average assets and gross receipts than USCCs, as shown in figure 6. All FCDCs reported an average of about $100 million in assets compared to about $9 million for all USCCs. Large FCDCs also reported higher amounts of assets—an average of about $1.6 billion compared to about $1.1 billion for large USCCs.

FCDCs reported more average gross receipts in 2005. All FCDCs reported an average of about $43 million in gross receipts, while USCCs reported an average of about $5 million. Although the magnitudes were larger for large corporations, the pattern of gross receipts was similar. Large FCDCs reported higher average gross receipts—about $663 million compared to about $447 million for large USCCs.

FCDCs and USCCs Were Concentrated in Different Industries

In 2005, FCDCs and USCCs differed in their distribution across industries. As figure 7 shows, all FCDCs were more concentrated in the wholesale trade and financial services industries, while all USCCs were more concentrated in the nonfinancial services industry. When the focus is limited to large corporations, FCDCs were relatively more concentrated in manufacturing and wholesale trade. Large USCCs were more evenly distributed across the industries shown in figure 7.

Differences in cost ratios across industries are possible explanations for why industry concentration might affect the reported tax liabilities of FCDCs and USCCs. Cost differences could affect profits, and thus tax liabilities. For example, the higher cost of goods sold relative to receipts could contribute to lower taxable income relative to receipts, and consequently lower tax liability relative to receipts. In tax year 2005, all FCDCs were more likely to have higher cost of goods sold, purchases, and interest as a percentage of gross receipts for most industries than were USCCs. The results were similar for large corporations. (For details of these comparisons of cost ratios, see table 6 in app. II.)

Agency Comments

We provided a draft of this report to the IRS for its comments. On July 21, the Research, Analysis and Statistics unit provided comments via e-mail on technical issues, which we incorporated into this report where appropriate.

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Appendix I: Objectives, Scope, and Methodology

The objectives of this assignment were to study (1) how the tax liability of foreign-controlled domestic corporations (FCDC) compares to that of U.S.-controlled corporations (USCC)—including the percentage of corporations reporting zero tax liabilities for tax years 1998 through 2005 and (2) how corporate characteristics, such as age, size, or industry, compare between FCDCs and USCCs. For both of our objectives, we used data from Internal Revenue Service’s (IRS) Statistics of Income (SOI) files on corporate tax returns for tax years 1998 through 2005. These SOI samples were based on returns as filed, and did not reflect IRS audit results or any net operating loss carrybacks from future years. Each tax return is treated as a separate corporation which, in the case of consolidated returns, may be composed of a number of subsidiary corporations. To provide information on the number of years large corporations did not report tax liabilities, we developed a panel data set consisting of the tax returns of large corporations that were present in the SOI corporate files in every year from 1998 through 2005. We did not include corporations that changed ownership status as USCCs or FCDCs during this period. We also did not analyze changes in the composition of corporations that filed consolidated returns. The gross receipts and assets of the corporations present in the panel data set account for on average about 40 percent of gross receipts and assets of all corporations and about 50 percent of the gross receipts and assets of large corporations from 1998 through 2005. Over time, the corporations present in the panel data account for an increasing share of corporate gross receipts and assets. For example in 1998 and 1999 the panel data corporations accounted for about 40 percent of the gross receipts and assets of all large corporations. This percentage increased to about 60 percent by 2005.

To compare all and large FCDCs and USCCs based on the tax liabilities they reported on their U.S. income tax returns, we made estimates for a variety of measures of tax liability. For the purposes of this report, an FCDC is a U.S. corporation with 50 percent or more of its voting stock owned by a foreign person or entity. Foreign control of a U.S. corporation exists when a foreign investor gains control of an existing U.S. company or creates a new company that it incorporates in the United States. Both FCDCs and USCCs are subject to U.S. income tax laws although the tax treatment of some income may differ. Large corporations are those with at least $250 million of assets or at least $50 million of receipts. We also compared differences in FCDCs and USCCs by age and industry sector. We defined new corporations as those for which income tax returns showed incorporation dates within 3 years of the tax year date; all others were considered old corporations. For example, for tax year 2005, new corporations are those with incorporation dates no earlier than 2003. We did not attempt to determine whether corporations were abusing transfer prices. Nor did we attempt to determine the extent to which such abuse explains any differences in the reported tax liabilities of FCDCs and USCCs.

The SOI corporation data we used in our comparison of tax liabilities of FCDCs and USCCs included domestic corporations. We reported separately for corporations that reported tax liabilities on Form 1120 (U.S. Corporation Income Tax Return) and Form 1120-A (U.S. Corporation Short-Form Income Tax Return). We also provided in table 2 of appendix II information on corporations that reported no tax liabilities on Forms 1120-L (U.S. Life Insurance Company Income Tax Return), 1120-PC (U.S. Property and Casualty Insurance Company Income Tax Return), 1120- REIT (U.S. Income Tax Return for Real Estate Investment Trusts), 1120- RIC (U.S. Income Tax Return for Regulated Investment Companies), and 1120S (U.S. Income Tax Return for an S Corporation). Some of these types of corporations, such as REITs and RICs, are pass-through entities that generally do not incur corporate tax liabilities. We did not include foreign corporations in our comparison of FCDCs and USCCs or those that filed Form 1120-F (U.S. Income Tax Return of a Foreign Corporation).

The SOI data in this report is based on SOI’s probability sample of corporate tax returns and thus is subject to some imprecision owing to sampling variability. Using SOI’s sampling weights, we estimated sampling errors for our estimates, which are reported in appendix II. Caution should be used when comparing estimates because not all differences between estimates are statistically significant. Differences between all FCDCs and USCCs, and large FCDCs and USCCs, are statically significant unless noted at the bottom of each figure or table. To ensure that the data were comparable across years, we converted all dollar-based data to 2005 dollars. The data included tax liabilities, total income, gross receipts, assets, cost of goods sold, interest, and purchases reported.

SOI is a data set widely used for research purposes. SOI data are not available to the public except in aggregate form via published tables. These data tables are publicly available either in printed form or on the irs.gov Web site. 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 requested comments on a draft of this report from the Commissioner of Internal Revenue. We conducted our review from November 2007 through July 2008 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.

Appendix II: Additional Tables

The tables in this statistical appendix supplement those in the letter and provide population estimates. After each table, notes indicate the sampling errors. We are confident the true estimates would be within these percentage points in 95 out of every 100 samples. Finally, we conducted tests to determine if there were significant differences between all FCDCs and USCCs and between large FCDCs and USCCs. The comparisons that were not statistically significant are noted in each table.

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Acknowledgments

In addition to the contact person named above, Kevin Daly, Assistant Director; Amy Bowser; Sara Daleski; Laurie King; Donna Miller; and John Mingus made key contributions to this report.