A few weeks ago, I wrote a blog recapping some of the ways companies use trade mispricing to dodge their bill from Uncle Sam. In response, Financial Task Force reader Ilan Bouchard asked, “why don’t these companies just set up subsidiaries outside of the U.S. and keep their finances in a lower tax jurisdiction?” The answer is: they do. It’s called transfer pricing and it’s all the rage. Multinational corporations use transfer pricing to shift profits from a comparatively high-tax country (like the U.S. or UK) to a low-tax jurisdiction (like the Cayman Islands or Aruba) by selling assets between subsidiaries.

An example is the massive pharmaceutical company GlaxoSmithKline, which is famous for products like Tums, Nicoderm, and Zantac. In 2006 it was taken to court by the IRS and eventually fined $3.4 billion for using transfer pricing to evade taxes between 1985 and 2005. But Glaxo hasn’t had its fill of court cases and tax evasion just yet. The drug company is at it again, currently embroiled in an additional $1.9 billion court case with the IRS. As reported by the Wall Street Journal, “The drug maker owes back taxes, interest and penalties stemming from tax deductions Glaxo generated by making payments to itself.” I wonder if the executives at Glaxo know that you’re only supposed to take drugs when you’re sick.

Transfer pricing is not illegal (although shifting taxes to a foreign subsidiary to avoid taxes is). It’s also extremely common. Actually, about 60% of world trade by multinational corporations occurs internally. And according to an often quoted GAO report, of the 100 largest U.S. corporations, 83 have subsidiaries in tax havens.

Here are some of the usual suspects:

Citigroup:
Second largest U.S. bank, brought in $159 billion in revenue in 2007
Infamous for: never ending government bailout money. To date, the federal government has injected over $45 billion in the bank.
Subsidiaries in tax havens: 427, more than any other U.S. corporation

Morgan Stanley
Global financial services provider with $779 billion in assets under its management
Infamous for: paying billions to settle various lawsuits, including a sex discrimination suit, a fine for regulatory lapses, and a settlement for unfair labor practices.
Subsidiaries in tax havens: 273

Exxon Mobile.
World’s second largest public company and in 2007, the oil company amassed some $372 billion in revenue.
Infamous for: The 11 million gallon “Exxon Valdez” oil spill, which covered 1,300 miles of the Alaskan coastline. Exxon was widely criticized for its failure to respond. The oil company also reported record profits in the same quarter in 2008 that oil prices rose by nearly 91%.
Subsidiaries in tax havens: 32

News Corporation.
Founded and owned by Rupert Murdoch, it is one of the world’s largest media conglomerates
Infamous for: a dominating hold on all facets of American media and more communications power than any despot or dictator in history.
Subsidiaries in tax havens: 152

While many of these offshore subsidiaries are based in Europe (Switzerland, Ireland, Guernsey, Luxembourg) and Asia (Hong Kong is particularly popular), a majority of them are in the U.S.’s backyard (the Caribbean and Central America). Below is a map of these tiny islands and some of the large U.S. corporations headquartered within their borders. These lists are by no means exhaustive.

The most glaring suspect is Citigroup (aka Keyser Söze), which has over 420 subsidiaries in tax havens (the most by nearly 200), has a presence in almost every island, and ninety subsidiaries in the Cayman Islands alone. That’s one entity for every 577 residents of the Caymans. Suddenly I don’t care that Citigroup is still on Uncle Sam’s life support, lost $27 billion in 2008, but still paid $9 billion in executive bonuses. Wait. No. This makes it worse.

On a happier side, there are seventeen corporations that have zero subsidiaries in tax havens (of the 100 largest). Here are a few noteworthy businesses:

CVS Caremark
Home Depot
Macy’s
United Parcel Service (its lead competitor, FedEx, has 21)
Verizon Communications

There have been several attempts to control this problem. Most notably, the OECD has adopted an “arms length principal” in evaluating transactions within multinational corporations. The principle states that transactions between parent and subsidiary corporations must be valued as if the parties were not related to each other (i.e. at the market price). The arms length principle is now commonly used in bilateral tax treaties between developed countries and tax havens.

There are a lot of down sides to arm’s-length, which I won’t get into. The easiest way to say it is this: one minute the usual suspects and their profits are there “and like that… they’re gone.”

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