Understanding Corporate Tax Avoidance in the U.S.
What exactly is tax avoidance? For eligible businesses and individuals, it’s a way to prevent tax overpayments. For profitable multinational companies, it’s typically used to exploit the loopholes of the United State’s complex tax system — preventing the federal government from collecting taxes that could’ve been used to fund essential activities.
So where’s the fine line between morally acceptable and unacceptable tax avoidance practices?
What is tax avoidance and how does it work?
In its info sheet, the U.S. Internal Revenue Service (IRS) defines tax avoidance as the action taken by qualified taxpayers to reduce their tax liabilities and maximize their after-tax income.
Unlike tax evasion, the IRS explains that “tax avoidance is perfectly legal” because it uses methods permitted by the Internal Revenue Code. It’s also based on the idea of voluntary compliance wherein individuals are expected to report all their income. To achieve this, keeping good and factual records is vital.
Essentially, tax avoidance keeps people from paying more income tax than necessary. It’s also one of the government’s ways to encourage more people to pay their taxes.
It works by letting taxpayers claim all applicable deductions, credits, or exemptions in their returns to lower the amount they owe to the government. Eligible parents in the U.S., for instance, can claim child-related tax deductions and credits to help them with the costs of raising children.
Another example of this is the coronavirus tax relief offered to businesses impacted by the pandemic.
Having known this, the intent of tax avoidance is good — but it’s a different topic when people use its weaknesses to dodge their legal and social responsibilities.
When does tax avoidance get morally unacceptable?
Although tax avoidance is acceptable by law, some of the strategies used by individuals and companies are viewed as aggressive and unethical.
Aggressive tax avoidance takes place when corporations exploit the loopholes in the tax system. In simpler words, they use inappropriate legal options against the government’s intended purpose. Instead of reducing their taxes within the acceptable amounts, abusive tax planning enables them to pay lower than the required thresholds.
In a report from the Institute on Taxation and Economic Policy (ITEP), it was revealed that 60 profitable 500 Fortune companies paid zero in federal income taxes in 2018. Meanwhile, 379 profitable corporations only paid 11.3 percent of the original 21 percent U.S. corporate tax rate. This means that there are billions of dollars of untaxed corporate profits annually.
It’s a huge loss to the American economy.
Large firms, such as those belonging to the Fortune 500, have major roles in economic growth. They’re not only the primary drivers of new technologies, but they also help achieve economies of scale. As a result, consumers can pay lower prices for products and services.
However, these contributions aren’t enough to exempt them from paying their fair share of taxes. Every dollar these entities fail to pay is equivalent to a dollar lost in funding essential government services.
Under the prevailing rules, multinational entities with operations outside the country of their residence should pay their taxes to the jurisdiction where they perform their business activities. To minimize their fiscal liabilities, they move their operations to tax havens — places with low to zero corporate income taxes.
Apart from this, the other methods considered as aggressive tax avoidance include:
- Listing personal expenses as business expenses
- Utilizing offshore holding companies
- Transfer mispricing
- Tax sheltering
To put a limit to this aggressiveness, governments have implemented certain anti-avoidance rules.
Clearer tax legislation, better enforcement, and the provision of anti-avoidance rules are the key techniques recommended by the United Nations Department of Economic and Social Affairs Financing to combat abusive tax avoidance.
General anti-avoidance rules versus specific anti-avoidance rules
Specific anti-avoidance rules (SAARs) are enacted to counteract known abusive tax avoidance arrangements. However, most countries don’t have well-established avoidance doctrines. The U.S. SAARs, for instance, are usually complicated and technical. Its intricacies allow multinationals to defeat the law and make it work to their advantage. Therefore, SAARs are not enough to combat aggressive avoidance.
When SAARs don’t work, governments turn to general anti-avoidance rules (GAARs) as their last resort to stop companies from playing with fiscal policies.
GAAR has a broader definition, making it less susceptible to avoidance. It also offers no exception, the U.N. explained. This rule applies to all forms of transactions and arrangements, all taxpayers, all types of taxes, and all payments and receipts. Through GAAR, governments can create a balance between:
- taxpayers' ability to structure their transactions accordingly and
- the right of tax authorities to implement taxation rules that can’t be evaded by taxpayers.
Under GAAR, individuals and corporations can be denied tax benefits, especially when there’s insufficient economic substance. Economic substance means taxpayers’ transactions must have a substantial purpose and an economic effect to be considered valid.
The indicators of the lack of economic substance are:
- absence of pre-tax profit and no or limited risk of loss,
- tax-indifferent parties, and
- the lack of change in the financial position of the parties.
Aside from GAAR, the Organisation for Economic Co-operation and Development (OECD) also lays down the other key dimensions of anti-avoidance. You can access them here.
Is the U.S. taking appropriate actions?
Under Trump’s administration (January 2017 - January 2021), the corporate tax rate went down to 21% from 35%. Such tax cuts have resulted in “disproportionate benefits” that only widen the gap between the rich and the poor.
Now that Biden has assumed office, the U.S. is set to see some changes with its tax system. Among the notable moves taken by the current administration are the proposals for:
- The U.S. Corporate Tax Rate increase. The corporate tax rate will increase to 28% from 21%. It also considers trimming down tax preferences for pass-through businesses. Meanwhile, wealthy individuals earning more than $400,000 per year can expect their federal income tax rate to increase to 39.6% from 37%. This proposal is expected to take effect by January 2022.
- A global minimum tax. Multinational corporations will be subject to a minimum tax of at least 15% regardless of their place of operations. The target date for its full implementation is 2023.
Planning taxes appropriately
There’s nothing wrong with seeking ways to lower tax obligations. But when it comes to the point of paying less than you’re responsible for and capable of contributing, tax avoidance becomes morally wrong.
Taxes are critical to supporting economic growth and development. This is why as taxpayers, it’s important to follow proper tax governance and oversee transparent tax practices.
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