Tax Analysts®Tax Analysts®

My Subscriptions:

Featured News

September 4, 2006
High-Tech Companies' Tax Rates Falling
by Martin A. Sullivan — martysullivan@comcast.net

Full Text Published by Tax Analysts®

Document originally published in Tax Notes
on September 4, 2006.
By Martin A. Sullivan -- martysullivan@comcast.net

Over the last decade, large U.S. technology companies have reduced by nearly 10 percentage points the effective tax rates reported in their financial statements. That conclusion is based on Tax Analysts' examination of 10 high-tech firms that together repatriated more than $1 billion of foreign earnings under a provision in the American Jobs Creation Act of 2004 (P.L. 108-357). For those companies, the average effective tax rate in 1994 was 31.8 percent. By 2005 the average reported rate dropped to 22.2 percent (adjusted for the one-time effect of section 965, the repatriation provision in the Jobs Act), even though the top statutory federal corporate tax rate has stood unchanged at 35 percent. The 10 companies are listed in the table below, and the decline in their average effective tax rate is shown in Figure 1, on the next page.

       High-Tech Companies With Largest Amount
       Of Earnings Repatriated Under Section 965
                (dollar amounts in billions)
                                               Average
                             Repatriated      Worldwide
        Company                Foreign          Profit,
     (Fortune 500 rank)        Profits        2004-2006

 Hewlett-Packard (11)            $14.5           $3.6
 IBM (10)                          9.5           10.8
 Intel (49)                        6.2           10.2
 Motorola (54)                     4.6            3.7
 Dell (25)                         4.1            4.2
 Oracle (196)                      3.1            3.8
 EMC (249)                         3.0            1.1
 Baxter International (240)        2.1            1.0
 Becton Dickinson (397)            1.3            0.8
 Texas Instruments (167)           1.3            2.2

 Source: Company annual reports. Profit here refers to before-
 tax profit from continuing operations. Repatriated earnings were
 first reported in "High-Tech Firms Bring Home $58 Billion,"
 Tax Notes, Aug. 14, 2006, p. 556.

The reduction in the high-tech companies' average tax rate is even larger than the decline U.S. pharmaceutical companies experienced over the same period. (See Tax Notes, Aug. 7, 2006, p. 472, Doc 2006-14640 , or 2006 TNT 152-5 (1).) For pharmaceutical companies, a decline in the average effective tax rate from 28.7 percent to 23 percent coincided with a massive shift in profits from domestic to foreign subsidiaries. From 1994 to 2005 the foreign share of pharmaceutical companies' profits increased from 38 percent to 70 percent. Those patterns suggest that pharmaceutical companies were using transfer pricing adjustments to lower their tax bills worldwide.

But for high-tech companies, as a group, there has been no such cross-border movement of profits. Although there is a lot of variation, there is no clear indication of a profit shift from U.S. to foreign affiliates. Figure 2, on the next page, shows that the foreign share of the companies' worldwide profits has remained close to 50 percent, with the exception of the boom-bust years of 2000- 2002.

What can we conclude from the data? Is there any evidence from financial statements that high-tech firms are shifting profits to low-tax countries?

Financial statement data on taxes must always be interpreted with caution, but I will venture a few remarks.

First, although IRS Commissioner Mark Everson specifically mentioned in testimony before the Senate Finance Committee that transfer pricing problems were prevalent in both the drug and high- tech industries, it is clear that the larger problem is with drug companies. (For Everson's June 13 testimony, see Doc 2006- 11401 or 2006 TNT 114-9 (2).)

Second, looking at averages may mask tax-motivated profit shifting by individual companies. When we look more closely at the data for high-tech companies, we find that the behavior of the two most profitable firms in the sample, Intel Corp. and IBM Corp., may be the reason we do not detect an aggregate profit shift to foreign subsidiaries.


Figure 1. Average Effective Tax Rate
Of 10 U.S. High-Tech Companies



Source: Company annual reports. See notes at end of article
for details.

Figure 2. Foreign Income as a Percentage of Worldwide Income
For 10 U.S. High-Tech Companies



Source: Company annual reports. See notes at end of article
for details.

For Intel, there is no pattern of income shifting either way. For IBM, there has been a clear shift, but the shift is in the opposite direction of what we see in pharmaceutical and other high- tech companies. During the late 1990s, IBM's U.S. profits increased from about one-third to one-half of its worldwide total. The increase coincided with a reduction in IBM's effective tax rate, which dropped from a percentage in the high 30s to its stated goal of about 30 percent. That implies that IBM shifted income out of high-tax foreign countries to the United States to reduce its worldwide tax bill.

Most of the remaining companies in the sample have reduced their effective tax rates and shifted income from the United States to foreign jurisdictions. The most prominent example of that pattern is Hewlett-Packard Co., based in Palo Alto, Calif. Hewlett-Packard reported foreign profits each year from 2001 through 2005, but it reported domestic losses in four of those years -- a pronounced change from the five-year period of 1994 though 1998, when domestic profits accounted for 33 percent of the company's total profits. As a result, the company's effective tax rate dropped from 34 percent in 1994 to 10 percent in 2005.


Figure 3. Total U.S. Income and Total Foreign Income
Of 10 U.S. High-Tech Companies



Source: Company annual reports. See notes at end of article
for details.

Earnings Management

Another curious aspect of the high-tech companies' data is the foreign-domestic split in profits over the business cycle. In general, for those companies, U.S. profits rise rapidly during boom years and drop sharply during a slowdown. In comparison, foreign profit levels seem to hardly move at all. (Statisticians would say the variance of domestic profits is much greater than the variance of foreign profits.) Figure 3 above depicts that trend.

Why does that pronounced but unusual pattern occur? One possible explanation stems from quirks in methods commonly used to set transfer prices. The most common methods adjust transfer prices so that one of the two parties in the related-party transaction achieves a reasonable rate of return, given its functions and risks. Because subsidiaries are smaller and less complex than their parent companies, it is easier to determine target profit levels for subsidiaries. So, in the case of companies based in the United States, transfer prices are set so that foreign subsidiaries achieve specific targeted levels of profit and the U.S. parents are assigned the residual profit. Therefore, as overall profits vary over the business cycle, foreign profits remain steady while U.S. profits bounce around.

There is a lot for CFOs to like about that outcome. In addition to having low effective tax rates, companies like to smooth the level of after-tax income reported to shareholders. Therefore, there will be a tendency to reduce reported profits when times are good and boost reported profits when business is slow.

One way to smooth after-tax profits is to lower a company's effective tax rate when profits are low and raise it when they are high. That is exactly what happens when profit levels of foreign subsidiaries are targeted. In general, accounting authorities frown on that type of "earnings management." Nevertheless, it may be the case that U.S. transfer pricing rules are unintentionally helping companies achieve one of their less commendable financial reporting objectives.


Notes

All data are for fiscal years ending in the year indicated. Oracle, whose fiscal year ends on January 31, is the exception. In this study, Oracle's fiscal year values are lagged one year. So, for example, fiscal 2005 values are categorized as 2004.

Effective tax rates shown in Figure 1 are unweighted averages. Tax rates for a few companies in a few years were excluded because one-time events or profit levels close to zero rendered tax rates with misleadingly large or small values. Effective tax rate values were excluded for Texas Instruments (1996, 2001, 2002, and 2003), Intel (2001), EMC Corp. (2001 and 2002), and Dell Inc. (1994 through 1996).

Effective tax rates for 2005 have been adjusted to remove the one-time effect of the 5.25 percent tax companies pay on foreign profits repatriated under section 965.

Eight of the companies in the sample explicitly reported the dollar amounts of domestic and foreign income in the income tax footnotes of their annual reports. Two companies, Dell and EMC, only explicitly reported amounts of foreign income; their domestic income was calculated by subtracting reported foreign income from estimated total income. Estimated worldwide (before-tax) income was computed by dividing the provision for income taxes by the company's effective tax rate. So, for example, Dell's before-tax worldwide income was calculated by dividing its provision for income taxes ($958 million) by its effective tax rate of 0.3 (in decimals) to arrive at a profit estimate of $3.193 billion.



About Tax Analysts

Tax Analysts is an influential provider of tax news and analysis for the global community. Over 150,000 tax professionals in law and accounting firms, corporations, and government agencies rely on Tax Analysts' federal, state, and international content daily. Key products include Tax Notes, Tax Notes Today, State Tax Notes, State Tax Today, Tax Notes International, and Worldwide Tax Daily. Founded in 1970 as a nonprofit organization, Tax Analysts has the industry's largest tax-dedicated correspondent staff, with more than 250 domestic and international correspondents. For more information, visit our home page.

For reprint permission or other information, contact communications@tax.org