David R. Evanson
Privately Published, Summer, 2006
What Keeps Tax Directors Up At Night
There was perhaps a simpler time when the allocation of headquarters expenses between foreign and domestic subsidiaries was almost an afterthought. Well-intentioned senior management teams sought only to present the fairest possible picture of operations. And while this motivation exists today, it shares the stage with competing agendas. The origin of these agendas are manifold, but taken together, they have conspired to make the allocation of expenses fraught with risks and complexities, which, if not managed carefully, can cause problems with shareholders, the Internal Revenue Service and a myriad of foreign tax authorities.
There’s a silver lining though. If these risks and complexities are skillfully managed, businesses can enjoy more than just the equanimity that accompanies the absence of problems; rather they can materially reduce their marginal tax rates — in some cases from marginal rates of 35% to as low as 25% — and in the process, increase earnings, and ultimately the value of the enterprise.
Alignment in the Universe
As a starting point, it’s worth briefly noting some of the trends and events that have aligned themselves in such a way as to make the allocation of expenses a focal point for so many constituencies. Later on in this article we’ll examine how, these trends notwithstanding, competing sections of the tax code are further burdening those with full or partial responsibility for corporate taxes.
Perhaps the first noteworthy trend is the exponential increase in the amount of business conducted in international markets by U.S. companies. While this comes as a surprise to exactly no one, and is attributable to any number of identifiable events – pick one: the Internet, NAFTA, global capital markets, Asian tiger economies, the Brazilian Miracle, the Soviet fall, the EU rise — a numerical portrait of the trend is nonetheless sobering.
Estimated Growth in International Sales, Earnings & Assets
of the S&P 500, 1999-2005
(In $millions) 1999 2000 2001 2002 2003 2004 2005 CAGR
International Sales 1,070,194 1,125,248 1,069,742 1,233,592 1,486,345 1,774,318 1,772,385 8.77%
Earnings 32,562 37,669 32,459 29,528 29,265 39,531 43,024 4.75%
Assets 857,773 891,958 979,740 1,440,041 1,696,756 1,436,008 1,635,806 11.36%
Source: Standard & Poor’s Corp.
Another equally important trend is the rise of shared services concept. Coca-Cola’s vaunted “One sight, one sound, one sell” strategy lives on in the shared services concept with the notion that there is one central point of control for headquarters expenses. Marketing, human resources, information technology, finance, planning, occupancy, development, legal and executive compensation expenses are increasingly controlled centrally, here in the United States, under the purview of a shared services entity.
The benefits of such a strategy are obvious: reduced staff, lower costs, a focus on process which enables real future costs savings, and a size and scale that makes investments in technology viable. The flip side of these benefits however is a distortion of the expense picture. Suddenly, and without immediate action to the contrary, all expenses become domestic.
The third moving part has been the dramatic increase in disclosure required of U.S. corporations. A rise in international sales was not the only marked trend of the last 10 years. A number of large, well publicized corporate scandals shed light on what ultimately turned out to be inadequate governance policies which culminated in the passage of the Sarbanes-Oxley Act of 2002. It’s too early to tell whether or not the pendulum swung too far in the other direction, but one fact is indisputable: U.S. corporations must shed more light on their operations, and these disclosures offer an opportunity for several constituencies to take issue with how the business allocates headquarters expenses.[Need color here on the nature of disclosures that are now made that were not in the past. As mentioned, the IBM segment data for 2000 looks like the IBM segment date for 2006. Are there some footnote citations we can reference, in character or in actuality that would bring this point to life?]
Attributes Worth Fighting For
The individual and concerted effects of these trends by themselves have brought headquarters expense allocation into a more prominent light. What added a sense of urgency and priority was Section 199 of the Internal Revenue Code which came into existence as one of the central thrusts of the American Jobs Creation Act of 2004.
As the Act’s name suggests, its’ purpose was to create jobs, and accordingly it offered a deduction for companies that produced goods, developed software or built property in the U.S., regardless of whether or not these goods were ultimately exported. The Section 199 deductions are difficult to ignore, either in the aggregate or for individual corporations. They total $76 billion in deductions over a 10 year period and corporations can enjoy a deduction that is a percentage of taxable income, or net income from qualified production activities, whichever is less. For 2005 and 2006 the deduction was 3%, and for 2007, 2008 and 2009 the deduction is 6%, ultimately rising to 9% in 2010 or later.
At a broad brush level, it’s easy to see the implications of Section 199: in order to optimize the corporation’s tax position, the allocation of headquarters expenses would skew domestically. While this jives well the shared services concept it immediately introduces a new risk: the net income produced with a policy of optimizing Section 199 deductions is likely offer a greater differential between purported income for tax purposes and the segment income now freely and voluminously displayed in filings with the United States Securities and Exchange Commission. [Again, a reference to quality or character of these disclosures would be helpful]
Thus a Section 199 deduction, taken in complete isolation – a theoretical, yet for the moment instructive state – very naturally provokes a difficult question: is the aggressive pursuit of this deduction worth it? Will the improvement in my marginal tax rate, hence earnings, outweigh the very real financial risks of a prolonged dispute with the United States Internal Revenue Service over the allocation of domestic versus international headquarters expenses? [What anecdotal or factual evidence is there that the IRS is aggressively eyeing headquarters expenses?]
These are difficult questions which touch on interlinking issues. One of these issues are the reactions of institutional shareholders. There are several well publicized and well known examples of dramatic reductions in share prices as a result of mismanaged marginal tax rates [I’m thinking of Google here, which was really punished two quarters ago for perceived mismanagement of its marginal tax rate. Examples are probably tricky for PWC b/c of client relationships, nonetheless are there any we can bring to light here]. Specifically, will shareholders punish the company for not aggressively taking advantage of a deduction so prominently within its grasp? However, there is another important issue afoot: expenses not taken abroad translate into higher earnings there. Thus the real question becomes two dimensional. That is tax officers must ask themselves not just what is gained through Section 199 attributes, but, more accurately what is lost in other jurisdictions and what is the net impact?
This challenge begins to shed light on one of the chief determinants of success in allocating headquarters expenses: good information. Utilization of incentives will always involve tradeoffs. However, being able quantify the effects of electing one tradeoff for another, enables senior managers to more effectively manage the risks.
Sidebar: Domestic Production Activities Section 199 Deduction in Brief
What is it?: One of the central features of the American Jobs Creation Act of 2004 was a deduction for certain production activities in the United States. The bill provides for approximately $76 billion in deductions over a 10 year period.
What production activities qualify for the deduction? Any lease, rental, license, sale, exchange, or other disposition of tangible personal property, computer software and certain films that have been manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the United States as well as construction performed in the United States; and engineering or architectural services performed in the United States for construction projects performed in the United States.
What is the amount of the deduction?: The deduction is 3% of qualified production income for 2005 and 2006; 6% for 2007, 2008, 2009 and 9% for 2010 and years thereafter. For corporate taxpayers, this will mean a Federal income tax rate of 33.95%, 32.90% and 31.85%, respectively, for the years in question.
How is the deduction computed? The deduction is equivalent to 3% (for 2006) of Qualifying Production Activities (QPA) less the sum of: Cost of goods sold allocable to such receipts; Other deductions directly allocable to such receipts; A ratable portion of other deductions not directly allocable to another class of income
End Sidebar: Domestic Production Activities Section 199 Deduction in Brief
Were it that the challenge posed by Section 199 deductions were as straightforward as the foregoing suggests. As mentioned earlier, competing sections of the tax code lend a multidimensional element, and as will be discussed later on, there is a very real human element that ultimately comes into play.
More concretely however, Section 114 of the tax code, the Extraterritorial Income Exclusion (ETI), offers an exclusion to goods manufactured here and sold abroad and remains in effect through 2006. The exclusion is based on a computation of taxable income which includes headquarter expenses. Therefore to maximize the value of the exclusion, the allocation of headquarters expenses would have a domestic bias.
Meanwhile a third major attribute, Section 904 of the Internal Revenue Code offers a credit for foreign taxes to the extent of a company’s Foreign Tax Credit Limitation. Like Section 114, 904 introduces a domestic bias toward the allocation of headquarters expenses. After all each unit of profit made overseas, can reduce the tax burden in the U.S.
Sidebar: The Extraterritorial Income Exclusion (ETI) in Brief
What is it? The act was necessitated through challenges by the EU before the World Trade Organization regarding the exclusion of some trade related profits from taxation. It was created by the repeal of the Foreign Sales Corporation Tax and provides tax incentives for U.S. businesses through 2006 to increase their foreign sales.
What activities qualify for the exclusion?: Income from the sale, lease or rental of the following goods and services: property manufactured within or outside (though at least 50% must be U.S. sourced) of the U.S. and consumed or used outside of the U.S.; engineering or architectural services for construction outside of the U.S. and management services provided in connection with foreign income.
What is the amount of the deduction?: Fifteen to 40% of qualified exporting income.
How is Qualified Exporting Income calculated?: [Need input here]
End Sidebar: The Extraterritorial Income Exclusion (ETI) in Brief
Overall there is a natural tension which exists between attributes 199, 114 and 904 because they are, in effect offering incentives at cross purposes. Sections 114 and 904 lean toward a domestic allocation of headquarters expenses, while section 199 favors a greater international allocation. For this reason the existence of Section 861 is perhaps more of a blessing than a burden as far as compliance is concerned. The consistency that section 861 requires across attributes 199, 114 and 109 means that corporate tax professionals have a simpler task at hand: rather than picking and choosing among attributes to achieve absolute optimization of their tax footprint, they must rather focus their attention on managing the tradeoffs which consistency dictates.
In the same way that section 861 consistency reduces the number of potential strategic and tactical alternatives in the allocation of expenses, so too does section 482, which requires consistency between domestic and international allocation of expenses. Thus, taken together, sections 861 and 482 very narrowly define the rules of the game.[Does the reader need more technical insight on the meaning of consistency? From our meetings I understood it to mean use of the same algorithm to compute the allocation, i.e. headcount, percentage of sales, percentage of operating profits]
And while the rules of the game are rigidly defined, for tax managers, the simultaneous burdens of managing the marginal tax rate and compliance begins to take on the characteristics of a crucible. Once all of the regulatory requirements are taken into account – securities disclosure as well as tax – competing issues begin to surface with respect to foreign tax authorities, domestic tax authorities, and finally, line managers and executives in domestic and foreign operations.
One very real risk alluded to earlier was the provocation of the Internal Revenue Service through aggressive utilization of the shared services concept and the section 199 deductions. However, there is a symmetry here that is important. On the other side are the international tax authorities, many of whom are voracious, and all of whom are armed with greater segment data thanks to the disclosure provisions of the Sarbanes Oxley Act of 2004. Thus one of the very real risks of utilizing the 114 and 109 attributes is the differential that it creates between financial reporting and tax presentations. These differentials provide a point of departure for further inquiry by foreign tax authorities.[It would seem this point needs strengthening. What is it that is making the foreign tax authorities more aggressive? Any anecdotal or statistical evidence that we can put in here to drive the point home? In addition, is it, as the above paragraph suggests, the additional disclosures made by U.S. firms vis a vis Sarbanes Oxley, that have emboldened them?]
The risk associated with becoming an object of interest for the foreign government where your company does business cannot be underestimated. The viability and value of foreign investment rests with fair treatment, access to new opportunities and the ability to repatriate profits. Thus whether a company is in the wrong or right in how it allocates expenses ceases to become the issue. Rather the existence of a dispute with the host government and how it impacts treatment, access to new opportunities and repatriation of profits, among other items, becomes the issue. These risks must be very carefully weighed against the benefits which can be realized through the utilization of tax code attributes.
While in theory the tax officer’s constituencies consist of domestic and international tax bureaus, there is another important one borne out of practical necessity: senior managers and executives of various business units and segments across the global enterprise. In the same way that governments eschew the idea that expenses are allocated for the purposes of tax optimization, senior managers are even less enamored of headquarters expenses that are at odds with their view of the world and their unit’s contribution to profits. It’s easy and understandable to see where this thinking comes from. Compensation, recognition, and the allocation of human and financial resources can all be negatively impacted by the manner in which headquarters expenses are allocated.
Adding it All Up
The practical reality is that managing the risks, opportunities and contradictions associated with the allocation of headquarters’ expenses requires an approach that is not ‘cookie-cutter’ but, rather highly subjective. Each and every expense needs to be evaluated with the following categories in mind:
Direct foreign benefiting – Do one or more specific foreign countries benefit from the expense?
Direct U.S. benefiting – Do only the U.S. businesses benefit from the expense?
Globally benefiting – Do all operations enjoy value from the expense?
Intangible property generating/maintaining – Allocating expenses to the associated income stream.
Stewardship – Even if the activities under consideration are duplicative, do they protect an investment?
While conceptually, these ‘buckets’ are easy to understand, in practice categorizing billions of dollars of expenses across them presents a number of organizational, logistical and human resources challenges. To attack the problem appropriately businesses need a tool box with software that can act as a scorecard for each expense which is evaluated. But they also need a large team of people with experience and skills in allocating headquarter expenses. Members of this team need to be technically experienced, because the exercise is data intensive; but they also need to be nimble, because the exercise is also labor intensive.[The above is word for word from our meeting. Any more to add?]
Such a team can be assembled internally. However businesses and corporations need to act fast and decisively to develop the resources the tasks require. For corporations doing business around the world, the regulatory and revenue authorities never asleep. They are now armed with more information than ever, and increasingly putting it to work for the benefit of their own treasuries.
What are some of the areas in the world with higher tax rates? Countries and tax rates?
Possible to get a little more insight on what is meant by consistency for 861 and 482? Notes seems to suggest it’s pretty straightforward, say percentage of sales, or earnings, or headcount or whatever.
When we met, we spoke about 482 and 861 consistancy . . . but does 482 work the same way as 861?
Not sure I understand the relationship between 861, 482 and the five buckets. The five buckets seems to be suggesting a different allocation than one might get by the consistency approach. Are they mutually exclusive?
Identification of interpretations from accounting regulators on the subject of segment reporting which in your opinion constitute the most onerous compliance and disclosure challenges from an international tax standpoint.
Examples of language in footnotes, or specific kinds of footnotes that you believe are of particular interest to international (as well as US) tax authorities, and some interpretive comments from you about why they are of interest to these tax authorities.