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The Ethics of Tax Avoidance
Tax avoidance is a legal way to reduce taxes. However, many people think it is an unethical activity, because tax avoidance is usually used by large companies and wealthy people to minimize their tax liabilities. Corporations have many ways to avoid taxes, and the most common way they used is accounting operation. Many large corporations can avoid tens of millions of dollars taxes by hiring experienced accountants or accounting firms. The purpose of the paper is to demonstrate some accounting operations for avoiding taxes and introduce the ethical dilemma that accountants or accounting firms face when they help companies avoid taxes.
Have your ever tried to avoid your taxes? Being difference with tax evasion, tax avoidance is a lawful method used by individuals and organizations to reduce tax liability. However, tax avoidance is regarded as unethical behavior, because it takes advantages of loopholes in the laws. Very early on, tax avoidance has been developed to a global problem. Many multinational corporations seek a tax avoidance by hiring experienced accounting firms such as “big four”, PwC, Ernst & Young, KPMG and Deloitte. And the “big four” also offer tax avoidance schemes to help their clients avoid taxes. In UK, the “big four” provided the government with their advanced accountants to draw up tax laws, and on the other hand, they advised their clients on how to exploit of loopholes of tax laws. (Syal, 2013) The spokesman of HMRC, a non-ministerial department of UK responsible for collection of tax, said, “Tax avoidance is bending the rules of the tax system to gain tax advantage that Parliament never intended.” In United States, more than $90 billion tax was avoided in 2008. (Drange, 2013) On the other hand, the US federal government announced a deficit of $454.8 billion in 2008. In China, the government lost more than $30 billion tax revenue each year due to tax avoidance. And, because tax avoidance is lawful, it is very difficult to punish these companies and accounting firms through justice. But, despite the legality of tax avoidance, the individuals and entities who avoided tax would be questioned from ethics. The primary purpose of the paper is to analyze the ethical dilemmas of tax avoidance and to provide several suggestions for resolving the tax problem. The rest of the paper includes four parts. In the first part, I will introduce the accounting operations that commonly used to avoid taxes. I will present three tax avoidance schemes used by multinational corporations. In the second part, the ethical dilemma faced by the accounting firms and companies will be analyzed. I will introduce Utilitarian Approach and Deontological Approach and applied these approaches to tax avoidance. Then, I will briefly discuss about the effects of tax avoidance. Finally, I will give some suggestions to government for resolving the tax avoidance problem. To get evidence of tax avoidance and produce solutions, I reviewed above 10 academical papers and news reports including Chinese and English. I also reviewed several famous legal rulings of tax avoidance. Based on evidences I gathered, I expect that the tax laws will be modified and improved in the future and most governments around the world will work together to against tax avoidance.
Accounting Operations for Tax Avoidance (Tax Avoidance Schemes)
Large corporations, especially the multinational corporations have many methods to avoid taxes. They usually get some “tax advices” from their audit firms. The “big four” can make £25 billion every year by selling their tax avoidance schemes. (Sikka, 2015) In this part, I will introduce three tax avoidance schemes which commonly used by corporations.
WordCom was one of the largest telecommunication corporations in United States. However, on July 21, 2002, WordCom declared bankruptcy and was acquired by Verizon Communication on February14, 2005. From 1998 to 2001, WordCom avoided $350 millions of dollars in state taxes through its tax avoidance schemes which was designed by KPMG (Petersen, 2004). According to the tax avoidance schemes, which was internally referred as a “tax minimization program”, WorldCom classified the “foresight of top management” as an intangible asset, which can be licensed to the subsidiaries of WordCom. Because all subsidiaries needed the “foresight of top management”, for getting the license, they paid $20 billion in royalty fee to WordCom for the period 1998-2001. The subsidiaries then got tax relief for hundreds of millions of dollars by counting the royalty as business expenses deductible on state taxes. (Gross, 2004). Furthermore, to minimize its taxes, WordCom channeled the royalty income into operations in states, such as Mississippi, that do not tax royalty income was registered in a favorable tax jurisdiction, so even if the income of WorlCom increased a lot due to royalty received from its subsidiaries, it paid very little taxes on its income (Petersen, 2004). This tax avoidance scheme is still used by many companies today. Especially for the companies with subsidiaries in many different jurisdictions, it helps the companies transfer the tax obligation to lower-taxed jurisdictions.
General Electric (GE) is the national largest corporation, which ranked as the 14th most profitable company in 2011. GE had a consolidated net income for $15 billion in 2014; for $13 billion in 2013; for $13 billion in 2012 and for $14 billion in 2011. (SEC 10K, 2014) However, it is astonishing that GE paid no federal income taxes from 2008 to 2013. “In fact, GE got tax refund of $3.2 million in 2010.” (Courant, 2015) GE avoided its taxes by sending its profits to the offshore subsidiaries which located in tax havens. In 2013, GE owned 18 subsidiaries in tax havens and maintained $110 billion offshore. (Smith, 2014) In its 2013 10-K, GE said, “At December 31, 2012 and 2011, approximately $108 billion and $102 billion of earnings, respectively, have been indefinitely reinvested outside the United States.” Shifting the profits to subsidiaries in tax havens is the most common method for multinational companies to avoid taxes. Because U.S. tax law stipulates that corporations do not have to pay its income tax on its overseas profits until they are brought into the United States (Drawbaugh, 2014), many multinational corporation including Microsoft, Apple and GE hold their earnings offshore for many years to avoid American taxes. The most commonly used technique for transferring profit is “Double Irish With A Dutch Sandwich”, which was first used in 1980s by Apple Inc. A private research firm reported that in 2013, the foreign profits that held overseas by American corporation to avoid taxes was up to $2.1 trillion. (Drawbaugh, 2014) And, by transferring the profits to subsidiaries which registered in tax havens, the US multination corporations can avoid about $90 billion in federal taxes each year. (Phillips, 2014)
Facebook is the biggest social networking service company in the world, which was founded in 2004 by Mark Zuckerberg. Facebook also is one of the most profitable companies in the world. In 2016, the profits of Facebook were $10.28 billion. However, similar to General Electric, Facebook also paid very small federal taxes. Between 2010 and 2015, “Facebook only paid 16.5% in U.S. taxes and official corporate tax rate in U.S. is 35%.” (ITEP, 2017) On the one hand, Facebook, like most multinational companies, transferred its profit to overseas subsidiaries. On the other hand, Facebook also avoided its tax by “stock option loophole”. Stock option was granted by companies to employees and executives as compensation. The employees and executives who receive stock option can exercise the stock option before expiration date (Wikipedia, 2017). Facebook reported that its aggregate intrinsic value of the option exercised in the years ended December 31, 2015, 2014 and 2013 was $403 million, $624 million, and $4.58 billion, respectively. (SEC 10-K, 2015) And, when those options were exercised, Facebook was allowed to deduct from its taxable income the difference between the stock’s fair value and the dollars amount paid by employees for the stock (Bickley, 2012). Taking advantage of the loophole, Facebook saved $5.8 billion in taxes between 2010 and 2015. (ITEP, 2017) Some corporations including Facebook disclosed the deduction of tax in “excess stock-option tax benefits”. Some company did not disclose it. The tax benefit can be very high. For example, Godman Sachs reported $1.6 billion of tax benefits between 2008 and 2012. And there is a few corporation recorded only tiny amounts. (Mclntyre, 2014)
The Ethical Dilemma
Human being needs to make many decisions every day. And, once the decision is about ethics and neither of two choices is unambiguously accepted or preferable, the ethical dilemma comes up. When people face the ethical dilemma, they need ethical standards to support their minds about what is right and what is wrong. After a long period of development, the ethical discipline has exhibited four fundamental ethical standards or approaches: Utilitarian Approach, Deontological Approach, Virtue Ethics and Communitarian Ethics. In this paper, I will primarily introduce two of them, Utilitarian Approach and Deontological Approach.
For the accountants and management, they also faced the ethical dilemma when they are making decisions about whether they should avoid taxes. If they decide to avoid taxes, they can reduce the tax liabilities and get more money, but the public interest will be damaged and they may be blamed by the government and citizens. Especially for the CPAs, they may be revoked the license because of tax avoidance. However, if they decide not to avoid, the companies then need to pay more taxes. Next, I will analyze the ethical dilemma by Utilitarian Approach and Deontological Approach.
Utilitarian approach (Utilitarianism) was developed by Jeremy Bentham in 1780. Utilitarianism is a kind of Consequentialism, which means the consequence of one’s conduct provides an ultimate basis for any judgement about the rightness or wrongness of the conduct. (Bentham, 1780) The Utilitarian motto is “The greatest good for the greatest number”. Note that Utilitarian approach takes into account all affected individuals and communities. In this paper, both taxpayers and society are affected by tax avoidance. Under the Utilitarian approach, we evaluate only the results of tax avoidance for both taxpayers and society. If tax avoidance can create more utility for both taxpayers and society, then tax avoidance is ethical under the Utilitarianism. Vice versa.
For taxpayers, it is easy to judge that avoiding taxes is a favorable and profitable action. Taking advantage of the tax avoidance schemes can help these taxpayers reduce liabilities, thus increasing the taxpayers’ utility. For society, it is obvious that tax avoidance reduces the revenue of government, and then the government does not have enough money to provide better lives to the citizens. In a word, the reduction in government revenue because of the use of tax avoidance schemes resulted in a reduction in societal utility. (Cottrol, 2014) The question at this point is to compare the increase of taxpayers’ utility and the deduction of societal utility, which is determined by quality of the government administration. If the government can perform its duty well and use the tax revenue effectively and efficiently, then tax avoidance is unethical under the Utilitarianism because the overall utility is lower. However, if the quality of the government administration is bad, for example, many governmental officials are corrupt and appropriate the tax revenue for their own private use, the deduction in societal utility will be little, thus the tax avoidance is ethical under the Utilitarianism.
Deontological Approach, also called Duty-based Ethics, was proposed by Immanuel Kant. Kant was very dissatisfied with the Utilitarianism. He believed that “people cannot predict the future consequence with any substantial degree of certainty and the motives of behaviors is more important than the consequence”. According to Deontological Approach, people are ethical when the behavior is well-motivated. And, when a person acts out of respect for the moral law, he has a good will. (Kant, 1785) Kant’s definition of moral law includes three formulations:
“Act only according to that maxim by which you can also will that it would become a universal law.
Act in such a way that you always treat humanity, whether in your own person or in the person of any other, never simply as a means, but always at the same time as an end.
Every rational being must so act as if he were through his maxim always a legislating member in a universal kingdom of ends.”
In this paper, we only talk about the first formulation, which is more related to tax avoidance. To analyze it, we should first define the maxim and then decide that weather it can become a universal law. The maxim that used by these tax dodgers should be defined as: “taxpayers always try to avoid their taxes to reduce tax liabilities” (Cottrol, 2014). And, can this maxim become a universal law? The answer is no. The tax dodger does not desire all other taxpayers use tax avoidance scheme to reduce tax liabilities. (Cottrol, 2014) If all tax payers avoid their taxes, then the government would lose major revenues, which may even lead to government shutdown. To prevent it, the government would raise tax rate, create new taxes and punish tax dodgers very harshly. Therefore, even if the taxpayers reduced their tax liabilities, they still did not get any benefits because they have to pay new taxes and get punishment from government. So, it looks impossible that all taxpayers would avoid their taxes and the maxim would become a universal law. Therefore, tax avoidance is unethical under the Deontological Approach.
The Effects of Tax Avoidance
Tax avoidance is able to help companies reduce tax liabilities and increase after-tax earnings. Therefore, tax avoidance strategy transfers the wealth from government to shareholders (Kim, 2012). According to Semaan’s study about tax reformation of South Korea, firms with high levels of tax avoidance experience a statistically lower drop in shareholder value. Semman interpreted that investors believe corporate tax avoidance, on average increase value. (Semaan, 2017) However, another study did by Santa in 2014 indicated that tax avoidance activities do not always increase shareholder value. The effects of the activities should also consider the corporate governance.
In most cases, companies can increase the firm value by avoiding taxes. But in fact, many companies do not take advantage of tax avoidance schemes used by others (Kim, 2012). The major reason is that tax avoidance also affects managerial reputation. The tax strategy of company cannot only use to reduce the company’s tax liability, but it should also consider about the company’s long-term value. When a company is avoiding taxes, it is actually avoiding its social responsibility. The companies who avoided taxes are vulnerable to accusation of greed and selfishness, thus damaging the reputation (Philippa, 2013). For example, the reputation of Amazon and Starbucks was damaged very seriously because of both companies paid low levels corporate taxes in recent years. According to a new survey, Amazon’s reputation score falls from 80 out of 100 to 74 and Starbuck’s reputation score fall from 61 out of 100 to 56 (Chapman, 2017).
Perfect Tax Laws
The weaknesses of tax laws are the major reason for tax avoidance. Because the tax laws have some deficiencies, the taxpayers can take advantages of the loopholes to avoid taxes. Therefore, an effective tax laws can be the most powerful weapon in fighting tax avoidance and the root to reduce tax avoidance transactions (Zhang, 2017)
Lower Tax Rate
Tax rate is most key factor that can influence tax avoidance, because most multinational corporations avoid taxes by transferring their profits to the jurisdictions which has a very low tax rate, such as Caribbean, the most famous tax heaven. Reducing the tax rate is an effective method for government to collection taxes revenues.
On November 2rd, 2017, the U.S. government released The Tax Cut and Job Act (“Act”), which reduced the tax rate significantly for both individual and corporate. Under the Act, the corporate was lower from 35% to 20% and it is much easier and less costly for multinational corporation to bring foreign earning back United States. The Act is win-win for both government and corporations. The government can collect more tax revenues because more corporations will repatriate their foreign profit to the United States. And, such repatriation can also create jobs and increase paycheck for U.S. citizens. On the other hand, the corporation can pay less income taxes.
Escalate Anti-Avoidance Rule
When tax avoidance become more and more popular, the government should establish anti-avoidance rules to counter such abused behavior. Currently, many countries include United States, China, New Zealand and others have established General Anti-Avoidance Rules (GAAR) which are targeted at the arrangement or transactions made specifically to avoid taxes (Wikipedia, 2017).
1. US GAAR
US GAAR had five principle rules includes ‘substance over frim’ doctrine, ‘business purpose’ doctrine, ‘step transaction doctrine’, ‘sham transaction’ doctrine and ‘economic substance’ doctrine. Besides these doctrines, U.S. Tax Code also allows the Internal Revenue Service (IRS) deal with many specific situations associated with tax avoidance. (Cottrol, 2014) Here, I will introduce the most important two doctrines.
First, substance-over-form doctrine arose from the Supreme Court case Gregory v. Helvering. In this court, judge announced that, “as general rule, the incident of taxation depends on the substance rather than from form of transaction.” (Klasing, 2014) This doctrine helps the government recognize the situation where taxpayers mischaracterized a transaction to avoid taxes on purpose. For example, some corporations may mischaracterize its equity as debt. By alleging an “interest expense”, the corporation can decrease its tax liability. The substance-over-form doctrine helps court re-characterize the debt as equity, preventing tax avoidance (Klasing, 2014).
Second, business purpose doctrine, which also developed from the Supreme Court decision in Gregory v. Helvering, said that taxpayers must prove that the transaction has a business reason or commercial sense other than only to avoid taxes. (Cottrol, 2014) For example, WordCom classified the “foresight of top management” as its intangible asset and licensed it to the subsidiaries. The transaction between the WordCom and its subsidiaries was just for avoiding taxes instead for improving profits. Therefore, this transaction violated the business purpose principle.
2. EU ATA PACKAGE
The European Commission (EU) published the Anti-Tax-Avoidance Package (ATA Package) on Jan 28, 2016. The ATA Package is used to prevent tax avoidance schemes used by Multinational Corporations and increase tax transparency. The ATA Package includes many rules such as GAAR, switch-over clause and otehrs. And one of the most important rule is Controlled Foreign Company (CFC) rule, which prevent multinational companies from transferring their most profits to low-tax jurisdictions for tax avoidance. Under CFC rule, the undistributed earnings of foreign companies need to be transferred to the parent companies. Currently, many multinational corporations avoid many taxes by indefinitely reinvesting its foreign earnings. For example, Apple hold $252.3 billion “cash” outside of United States and announced that most of these “cash” was planned to be indefinitely reinvested. The CFC rules from ATA Package can help to prevent such activities.
3. Chinese GAAR
The oldest Chinese GAAR was released by State Administration of Taxation (SAT) in 2008. So far, the Chinese GAAR has been escalated several times and became more complete. For example, in 2014, SAT issued Administration Regulations for the General Anti-Avoidance Rule, which provides a more comprehensive and transparent legal environment for GAAR implementation in China (Bloomberg, 2017). And, in 2017, Wang Jun, the Commissioner of the SAT signed the BEPS Action 15 Multilateral Instrument on Tax Treaty Measures to Tackle BEPS ((Bloomberg, 2017). The Chinese GAAR helped the Chinese government collect lots of tax revenues. During 2012, the total tax collection contributed from GAAR amounted to approximately $5.6 billion, representing about 74 times the 2005 amount (International Tax Review, 2013)
Although most countries around the world established GAAR and the GAAR has been developed for long time. There are still some deficiencies in the GAAR. For example, there are very less penalties for using tax avoidance schemes, which there is little or no disincentive to tax avoiders (TUC, 2013)
Taxation is the primary source of government revenue. In 2015, more than 95% U.S. federal revenues came from tax revenues. On the other hand, individuals and corporations in general are not willing to pay more taxes. However, refusing pay taxes or paying less taxes is illegal, so many individuals and corporations try to take advantages of tax avoidance schemes which are lawful. This paper introduces some tax avoidance schemes include WordCom, General Electric and Facebook. In addition, the paper also does ethic analysis for tax avoidance. Under Utilitarian Approach, the quality of government administration is the primary factor to decide whether tax avoidance is ethical or not. And, under Deontological Approach, the tax avoidance is unethical because it cannot become a universal behavior. Furthermore, this paper briefly analyzes the effects of tax avoidance. The shareholder value of the companies which can avoid much taxes, in general, increase in short term. But, the reputation of corporation and management will be damaged by avoiding taxes. Finally, this paper also gives three suggestions for decreasing tax avoidance. To prevent tax avoidance, many countries published GAAR. However, escalating the GAAR is needed because there are still many deficiencies. Besides the GAAR, the government also should perfect the tax laws and reduce tax rate, which can help to prevent multinational countries from tax avoidance.
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