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  • David Cay Johnston, a 2001 Pulitzer Prize winner, is author of "The Fine Print: How Big Companies Use 'Plain English' to Rob You Blind." He teaches the tax and business law of the ancient world at Syracuse University College of Law and is the president of the 4,200-member Investigative Reporters & Editors (IRE).

The Conversation: Tax havens let billions vanish into thin air

Published: Sunday, Feb. 17, 2013 - 12:00 am | Page 1E
Last Modified: Friday, Feb. 22, 2013 - 9:16 pm

JOIN THE CONVERSATION: How should the California Legislature deal with rules that allow wealthy residents and multinational corporations to utilize offshore tax havens? Add your comment below. To write a letter, go to sacbee.com/sendletter. Or comment on our Facebook page at facebook.com/sacramentobee.

As you work on your state income tax return, give some thought to how much extra state income tax you must pay to make up for very wealthy California residents and multinational corporations who squirrel away money offshore.

The burden they shifted onto you came to $2.9 billion from wealthy individuals and $4.2 billion from big companies in the 2011-12 state budget year, a pioneering new study estimates. Together the escaped tax comes to $7.15 billion that you have to make up through higher state taxes, fewer services or the state taking on more debt to fund current operations.

That $7.15 billion was the equivalent of a 15 percent surcharge on your state income tax bill.

That $7.15 billion would have been enough money for the Legislature to declare a state income tax holiday from Nov. 10 to the end of the year, giving a boost to your take-home pay just before the expenses of Thanksgiving and the holiday shopping season.

Just the individual income tax dodged by using tax havens comes to $2.94 billion, enough to make the University of California tuition-free, saving parents and students $2.97 billion.

The reason you did not enjoy these tax savings is because of lax rules enacted by Congress and allowed under California law. There are differences between state and federal law, but state rules allow for the use of many offshore tax haven strategies.

Just how much state lawmakers across America shift the burden of supporting government off the wealthiest individuals and largest multinational corporations and down the income ladder is the focus of a pioneering analysis by the U.S. Public Interest Research Group Education Fund.

It estimated that tax havens cost the 50 state governments $39.8 billion in 2011. That's enough money to pay for all state and local costs of firefighting or the cost of parks and recreation.

The report, "The Hidden Cost of Offshore Tax Havens: State Budgets Under Pressure From Tax Loophole Abuse," analyzed various official reports to come up with its numbers. The authors concluded that multinational corporations accounted for $26 billion of the total, individuals the other $13.8 billion.

California, with 12 percent of the nation's population, sustained 18 percent of the losses because of its concentration of very wealthy people and multinational companies. Some of these companies, such as Google and Hewlett-Packard, are well known for their use of tax havens to avoid taxes.

As a journalist who has been exposing abuses of taxpayers since I was a teenager in Santa Cruz 46 years ago, and who has specialized in exposing tax dodges for the past 18 years, the report surprised me.

Before writing a column about this for nonprofit Tax Analysts, publisher of "State Tax Notes," I asked 13 tax folks, plus my CEO wife, about state governments losing revenue to offshore tax havens. Not one of these people had ever given the problem a thought, though it seems obvious once you focus on it.

It's a fair bet that the California Legislature has not given this much thought, either, even though senators and Assembly members enable this tax dodging through the rules they enact. Those rules determine what income will be taxed and what can be tucked away untaxed offshore.

An investigation by a legislative committee, or the staff of the Franchise Tax Board, could establish the actual costs by looking at tax returns and analyzing the data. My guess is that the estimated losses in the federal PIRG report will turn out to be conservative, especially on the individual side.

When it comes to corporations, the techniques to escape California (and federal) taxes are perfectly legal.

Eleven years ago in the New York Times, when I broke the story that Enron did not pay taxes, I showed how it used more than 600 offshore subsidiaries to make money off the federal tax system. A subsequent congressional investigation turned up internal company reports in which top Enron executives referred to the company tax department as a "profit center," something we now know is commonplace at multinational corporations.

In theory, any business can use accounting rules to earn profits in California but report them as earned offshore.

One way to do this is to transfer intellectual property to an offshore subsidiary. Patents for software, formulas for drugs, manufacturing processes for microchips and company logos can all be owned not by the California company directly, but by its Tax Haven Subsidiary #669 in, say, the Caymans.

Royalties paid to use the intellectual property convert profits earned in California into tax-deductible expenses transferred to the company's offshore subsidiaries. Think of it as accounting alchemy, but instead of turning lead into gold it turns taxable black ink on the profit and loss statement into tax-deductible red ink.

But, of course, the money is not a real expense from the perspective of the parent company, which is just moving money from an account in Mountain View to another it owns offshore.

Imagine if you could move a dollar from your left pocket to your right and get a tax deduction.

American companies hold $3.4 trillion in cash and near cash offshore, my analysis of official tax data shows. More than half of that money has never been taxed, the data indicate, or has been very lightly taxed, often at rates of 2 percent or less.

California has some rules to thwart such gaming of its tax system, but those rules are about as substantial as Wonder Bread.

Another technique is to manufacture in a place with cheap labor, such as China or Vietnam. When goods board a ship in Shanghai or Hanoi on the way to the Oakland docks they are sold, on paper, to a Cayman Islands subsidiary. The subsidiary then marks up the price of the goods, reporting a significant profit, before passing the expensive goods to the California operation, which appears to earn a tiny sliver of profit in the state.

Corporations that do this do not have any employees in the Caymans, just a law firm that accepts mail. The transfers all take place on computer screens, which may be in California.

Again, there are rules to address this technique, known as "transfer pricing." The rules are the fiscal equivalent of Twinkies, spongy and empty.

In theory, any business can use these and other techniques to make profits earned in California vanish into offshore accounts. In reality the vast majority of the nation's 6 million corporations cannot do this, however.

Purely domestic firms have no way to use accounting techniques to claim they earned their profits in a tax haven. Second, the lawyers and accountants who live in Bermuda, the Caymans and other such isles live very good lives by charging hefty fees relative to the work they perform, which is not much.

To a multibillion-dollar firm these fees are a trifle, but they would exceed the profits of the vast majority of corporations.

More than 80 percent of all corporate assets in America are owned by just 2,604 of the 6 million companies, Internal Revenue Service data shows. A million of those firms have no assets and another 3.9 million have less than $500,000 in assets.

Sam Blair of the Main Street Alliance, an organization for small business owners, said state rules that favor big multinationals are profoundly unfair. "Most small business owners are never going to set foot in the Cayman Islands, let alone create subsidiaries there," he said. "It's time to level the playing field."

Dan Smith, of U.S. PIRG and one of the study authors, said, "Tax dodging is not the victimless offense. When corporations skirt taxes, the public is stuck with the tab. Since offshore tax dodgers avoid both state and federal taxes, they hurt everyday taxpayers twice."

In the current budget year, individual Californians will pay $7.6 billion more in state income taxes than the year before, state documents show.

That suggests another way to think about how much the Legislature shifts the burden of taxes – that all the extra taxes on the tax return you will file soon could have been avoided if the Legislature had given as much thought to your tax burdens as it does to those who got the greatest gains because they work, invest and profit in California.

© Copyright The Sacramento Bee. All rights reserved.

Read more articles by David Cay Johnston



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