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. 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 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.) 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.