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Corporate America’s foreign cash machine: Signs it may be slowing

Mar 31, 2014
Time for U.S. companies to pay more taxes?

FORTUNE -- Costless stock options. Lending to subprime borrowers. The irrelevance of earnings and cash flow for Internet companies because they can always tap capital markets. Those are some of the good ideas gone bad on Wall Street, all seemingly foolproof at first. Costless stock options warped earnings and investor expectations for years until accountants forced their cost into financial reporting. Subprime lending was corrected by a financial crisis costing taxpayers billions. Internet companies? We know how those turned out.

The international tax game might also make the list of good ideas gone bad. Governments keep losing revenues while still providing services as U.S. companies dodge taxes on foreign earnings, but that can’t last forever.

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The cumulative untaxed foreign earnings for 322 of the 500 companies listed in the Standard & Poor’s Index reached $2 trillion at the end of 2013, with $530 billion tucked inside 57 technology companies and another $426 billion in 43 health care companies, according to figures compiled by R.G. Associates. It’s an incredible amount of potential tax base for governments around the world to lose, but those losses appear to be waning. Some technology firms -- Apple (aapl) and Google (goog) among them -- showed year-to-year declines in the estimated amount of untaxed foreign earnings, according to R.G. Associates. In fact, the entire technology and health care sectors showed declines compared to 2012, suggesting firms may be seeing the handwriting on the wall as governments look to coordinate efforts to fix problems plaguing international taxation.

Clever international corporate tax management has many troubling aspects. For one thing, only those firms whose primary assets are intangible and portable play the tax management game well. The obvious beneficiaries are firms in the technology and health care sectors, whose prime assets are intellectual property; those at a disadvantage are firms whose primary operating assets are domestically embedded. (When did you last hear of a railroad taking advantage of international tax laws?) Another troublesome aspect is that the perennial drone of the news media about the unfairness of light corporate tax bills corrodes the confidence of all taxpayers, subtly persuading them that cheating is a good idea.

The problem is that the world’s governments have not been effective at keeping tax laws relevant in today’s economy, while corporate tax management has evolved several generations beyond. Some aspects of international tax treaties have their origins in the 1920s, like requiring a permanent business establishment in a country so that it may be taxed by that country’s government. In today’s world, a company can do business anywhere without establishing permanence by conducting trade over the Internet.

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A unilateral action by just one country won’t fix its problem, because it could be offset by another country’s actions. While cooperation among countries is an elusive thing, it’s not impossible. The Organisation for Economic Co-operation and Development (OECD) has been aggressively developing proposals to address tax base erosion and international profit shifting. The OECD has moved surprisingly fast, developing a 15-step “action plan” that it expects to complete by December 2015, with major parts to be completed by this fall. The goal is to provide guidance and methods for countries to change their tax laws in a coordinated fashion and bring them into the 21st century.

Proposals to fix international taxation on a cooperative basis are one thing; writing tax laws in the U.S. by Congress is quite another. The OECD’s plans for revising international tax treaties and taxation principles won’t automatically change any country’s laws, much less those of the United States. Yet if the OECD is successful in creating a model of coordinated tax policies, tax regimes might be established globally, making it harder for one country to go it alone. Congressional tax writers pay attention to the OECD’s efforts and might incorporate some of their thinking as various tax proposals evolve.

The weaning process may well be under way.

Jack T. Ciesielski is president of R.G. Associates, Inc., an asset management and research firm in Baltimore that publishes The Analyst's Accounting Observer, a research service for institutional investors.

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