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A Legal and Ethical Examination of Corporate Tax Shelters

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Abstract
This paper seeks to glean an understanding of corporate tax shelters, in respect to legal and ethical considerations. Tax shelters are often viewed with negative connotations, yet the general public holds different perceptions of the various classifications of tax shelters, tax avoidance, tax evasion, and tax flight (Kirchler, Maciejovsky, & Schneider, 2003). While this suggests a tolerance based on legal concerns, there exists a growing accountability for corporate social responsibility, “whereby organizations consider the interests of society by taking responsibility for the impact of their activities on customers, suppliers, employees, shareholders, communities, and others stakeholders, as well as their environment” (Guliani, 2014, p. 1117). Part of this includes, “companies paying their due taxes and obeying the law” (Guliani, 2014, p. 1120). In order to analyze the ethicality of tax shelters, this paper will introduce a variety of corporate tax shelters, discuss corporate tax shelters in relation to tax avoidance and tax evasion, explore the impact of corporate tax shelters on stakeholders, and examine the affect corporate social responsibility has on tax liability.

A Legal and Ethical Examination of Corporate Tax Shelters As each business embarks on a pursuit for profit, companies often find opportunities to reduce tax liabilities in the form of corporate tax shelters. Corporations should be aware that when reducing tax liability, they must consider the legality and the morality of their actions. While the concept of tax shelters has gained negative connotations throughout the years, “tax shelters are transactions or arrangements that generate tax losses without incurring economic losses or risk” (Lisowsky, 2010, p. 1694). This can be accomplished through both legal, illegal, and questionably legal practices. However, while observing legal regulations is imperative to healthy commerce, there is also a growing awareness and accountability of corporate social responsibility from consumers that could impact a company’s use of tax reducing strategies. The public is questioning the ethicality of tax reduction, not asking whether corporations can reduce their tax liability, but rather, whether they should.
Corporate Tax Shelters The term corporate tax shelters refers to a variety of tax reducing strategies, whose “main goal is to lower the corporate tax liability by exploiting discontinuities in the law” (Lisowsky, 2010, p. 1694). This is not limited to illegal or abusive practices. Dennis (2010) claimed that “lawful tax shelters advance a legitimate endeavor. The IRS deems a shelter illegal if its only economic purpose is tax avoidance” (p. 96). Tax shelters are often characterized by “innovative financial instruments or tax-indifferent parties, extremely complex structures, and typically thwart the intended purpose of the various tax statutes. The international arena is particularly rife with such exploitation” (Kaye, 2010, p. 586). While the government works to develop regulations of tax shelters, tax shelters continue to adapt so as to continue their exploitation of tax law.
Deductions & Investments The IRS offers a variety of legal means of reducing tax liability through the availability of deductions and reduced tax rates on capital gains. Tax deductions allow for the reduction of tax liability by adjusting the amount of income on which taxes are paid. Tax investments can reduce tax liability, as the income from investments is taxed at a lower rate than other taxes. Currently, “‘[t]he top rate on gains held longer than a year is 15%” (O’Neill, 2012, p. 230). By strategically placing assets, or by designing partnerships as partnership pass-through or profits only partnerships, income will be taxed at the capital gains rate, not the typical corporate tax rate (O’Neill, 2012). Deductions and investments are both legal methods of reducing tax liability, available to individuals and corporations. While they qualify under the definition of tax shelters, they are not often perceived as tax shelters.
Tax Havens Tax havens are “‘financial conduits that, in exchange for a fee, use their one principle asset – their sovereignty – to serve a nonresident constituency of accountants and lawyers, bankers and financiers, who bring a demand for the privileges that tax havens can supply’” (as cited by Fisher, 2014, p. 343). They are often “characterized by extremely low tax rates for nonresidents and banking secrecy laws” (Fisher, 2014, p. 343). Tax havens serve as the location for a variety of other tax sheltering strategies, such as offshore shell corporations, bank accounts, and transfer pricing (Fisher, 2014). Typically, the term tax shelter “conjures up images of ‘sun-kissed exotic islands reminiscent of the Garden of Eden where a few billionaires, Mafiosi and corrupt autocrats hide their ill-gotten gains’” (Fisher, 2014, p. 344). However, Fisher (2014) stated “many tax havens are developing nations, where a lack of centralized taxation prevents the formation of a beneficial tax infrastructure and paralyzes growth efforts” (p. 344). Tax havens are locations where it is easy to exploit tax law, whether through lack of regulation, or lack of regulation enforcement.
Offshore Companies Offshore companies are one of the two primary tax shelters that utilize tax havens. Offshore subsidiaries serve a variety of useful purposes… the most useful being the pooling together in one place of a massive portion of the income and assets…The goal is to fill the holding company pool to the brim with revenue and then keep that money in play and wash it back through the company –untaxed – only landing it onshore… when tax rates have been engineered through the company’s offshore network to be the most advantageous. (Brittain-Catlin, 2005, p. 47)
One infamous tax haven involved in the creation and maintenance of offshore subsidiaries is the Cayman Islands (O’Neill, 2012). While it’s geographical size may be small, “the Cayman Islands is the fifth largest financial center in the world” (Brittain-Catlin, 2005, p. 47). With over 500 banks, and 65,000 registered companies, the Cayman Islands are at the heart of offshore tax strategies (Brittain-Catlin, 2005). Before Enron declared bankruptcy, they maintained “a total of 881 offshore subsidiaries, of which 692 were incorporated in the Cayman Islands” (Christenson & Murphy, 2004, p. 37-38). Media conglomerate News International “operates through 800 subsidiaries, many registered in offshore tax havens” (Christenson & Murphy, 2004, p. 38). Offshore companies are pivotal to reducing tax liabilities as they allow a corporation to circumvent their own nation’s laws and ascribe to more lenient or convenient regulations.
Financing Arrangements Financing arrangements are the second type of tax shelter that often utilizes tax havens, though is not specific to tax havens. This occurs in the form of transfer pricing. Fisher (2014) cited the definition of a transfer price as follows: a price, adopted for book-keeping purposes, which is used to value transactions between affiliated enterprises integrated under the same management at artificially high or low levels in order to effect and unspecified income payment or capital transfer of those enterprises. (p. 345).
Transfer pricing is typically legal, “commonplace among U.S.-based MNCs, and seventy-seven percent of MNCs in twenty-four countries report placing transfer pricing ‘at the heart of their tax strategy’ in 2008-09” (Fisher, 2014, p. 345). This widespread use demonstrates the normality of tax avoidance as part of corporate operations.
Classifying Tax Strategies Determining whether a tax strategy is classified as tax avoidance or tax evasion can prove a difficult task. Generally, “tax avoidance refers to an attempt to reduce tax payment through legal means, or for instance by exploiting tax loopholes” (Kirchler et al., 2003, p. 536), while “tax evasion refers to an illegal reduction of tax payments, for instance, by underreporting income or by stating higher deduction rates” (Kirchler et al., 2003, p. 536). While the legality of the tax strategy lends credence in this classification, because of the complexity of tax strategies, the legality itself is often difficult to determine. The “U.S. courts have employed various tests to distinguish illegal tax evasion activity from legal tax avoidance activity” (Fisher, 2014, p. 340). These include “such common law doctrines as ‘substance-over-from,’ ‘step transaction,’ ‘business purpose,’ and ‘economic substance’” (Kaye, 2010, p. 586). In regards to these test, Kaye (2010) stated the following:
Professor McMahon views the substance-over-form and the step transaction doctrines as interpretive doctrines that assist in clarifying the facts before applying the statute. In contrast, the business purpose and economic substance doctrines are ‘overarching judicial anti-abuse doctrines’ that are applied after the determination of the facts and the construction of the statute. (p. 588).
While Fisher (2014) stated “one of the most well established methods is the ‘substance-over-form’ test’, pursuant to which the legal form of a transaction may be disregarded in recognition of its underlying economic substance” (p. 340), Kaye (2010) uses a similar description for the economic substance test. Kaye (2010) cited the economic substance “doctrine is most often employed in situations where taxpayers participate in transactions that have no reasonable possibility of profit, other than the tax benefits realized” (p. 589). Thus the economic substance test, a two prong test requiring “the taxpayer to prove economic substance through an objective inquiry” (Kaye, 2010, p. 589) and “show legitimate business purpose through a subjective test” (Kaye 2010, p. 589), will determine the existence of economic substance, while the substance-over-form suggests that the legality of transactions is not limited to the violation of statutes, but extends to the violation of the principle of those statutes.
It is worth noting that Kirchler et al. (2003) argued that even though these tax strategies often have similar effects on the economy, their research suggested “tax evasion was perceived rather negatively… and tax avoidance positively” (p. 535). This could contribute to the fact that “while no MNC would issue public statements acknowledging its intent to evade taxes, some MNCs have openly stated their willingness to avoid taxes” (Fisher, 2014, p. 341). As a result, most of the identified tax shelters maintain a general sense of legality, falling under tax avoidance rather than tax evasion.
Affected Stakeholders Reducing tax liability, whether through tax avoidance or tax evasion, has a significant impact on the economy. Christenson & Murphy (2004) argued that “the scale of tax-avoidance activity has become so enormous that it can be fairly described as a shadow economy operating in the majority of globalized sectors” (p. 39). The large amount of unrealized taxes and the tax avoidance industry have a significant effect on shareholders, tax professionals, the government, and the general public.
Shareholders
While it might be perceived that “avoidance activity results in a transfer of value from the state to the shareholders” (Desai & Dharmapala, 2009, p. 537), this is not found to be accurate. Desai & Dharmapala (2009) found that “tax avoidance and managerial efforts to divert value from shareholders may be intertwined” (p. 546). Thus, shareholders are not likely to benefit from extensive tax avoidance. Instead, they can potentially be harmed by tax avoidance. With corporate tax avoidance becoming “increasingly publicized and stigmatized, news of a corporations engagement in tax avoidance practices likely will have an increasingly detrimental effect on its reputation” (Fisher, 2014, p. 354). A damaged reputation can decrease the corporation’s worth and the shareholder’s value. However, Gallemore, Maydew & Thornock (2014) found no significant evidence of tax avoidance damaging corporate reputation, only observing “a temporary decline in stock price around tax shelter revelations that fully reverses within 30 days” (p. 1127). However, even if shareholders’ aren’t losing value, Desai & Dharmapala’s (2009) research still suggests they don’t gain value from such practices.
Accountants & Lawyers The extensive use of tax avoidance strategies puts tax professionals in a difficult position. The fundamental dilemma of tax practice stems from differences that arise between “serving the client and maintaining the public interest focus” (Stuebs & Wilkinson, 2010, p. 13). Each tax professional is faced with the ethical issue of whether being “technically in compliance with the law” (Stuebs & Wilkinson, 2010, p. 17) is sufficient justification in maintaining their integrity. Sikka & Willmott (2005) make the bold statement that, “as advisors to the government, the big accountancy firms are effectively the standard setters who develop ways of maximizing corporate earnings and profit related executive rewards by selling creative tax avoidance schemes” (p. 417). Sikka & Willmott (2015) specifically criticize the Big Four accounting firms, Ernst & Young, Deloitte and Touche, KPMG and PricewaterhouseCooper, stating they have encouraged and perpetuated tax avoidance by “acting as “a ‘financial mafia’ that routinely participates in equally deadly activities by eroding public revenues that deprive people of jobs, healthcare, education, pensions, security and public goods or facilitate a race-to-the-bottom in which public services become degraded” (p. 417). These accusations may be bold, but the principle of the matter, the degradation of integrity from the engagement in morally questionable activities, is valid.
Government
Determining the extent of tax evasion is difficult to quantify but, 2004 estimates “suggest that the US federal authorities lose some US$ 170 billion annually to corporate tax avoidance” (Christenson & Murphy, 2004, p. 38). Brittain-Catlin stated that “in 1999, U.S. multinationals had $400 billion of untaxed earnings floating around in offshore pools. By the end of 2002, the amount offshore was $639 billion” (p. 51). At a 35% tax rate that equates to $140 billion to $223.65 billion, based on the estimate sitting there, not including the amounts moving continuously. While estimates may vary widely, all literature suggests a substantial portion of money going on untaxed.
General Public The general public is also negatively impacted by the use of corporate tax shelters. When companies minimize their tax liability, this translates to decreased public services due to decreased tax revenue. Additionally, Christenson & Murphy (2004) argued that and corporate tax avoidance leads to the transference of “a larger share of the tax burden onto individual tax payers and consumers” (p. 39).
Corporate Social Responsibility The business environment is adapting; while corporate social responsibility (CSR) related to for-profit companies was previously, “only limited to ensuring maximizing profits for shareholders” (Guliani, 2014, p. 1116), consumers and investors have begun to expect more from companies. Scheffer (2013) made a compelling argument that corporate responsibility is “directly tied to true wealth (in terms of wages, health, education, human rights, infrastructure, the environment, and the rule of law) of a society” (p. 361). Proponents of tax shelters would argue that by participating in society and by providing jobs, corporations are meeting there CSR. However, Guliani (2014) suggests CSR is manifested, in part, through companies paying their due taxes and obeying the law. The use of tax shelters and tax avoidance may be in compliance with the law, but only because it circumvents the laws that do not agree with the strategies.
Scheffer (2013) takes a strong stance against tax avoidance, calling it an “ethical imperative” to minimize the issue. Weisbach (as cited by Katz, 2007) averred that “‘[t]ax-planning, all tax planning, not just planning associated with traditional notions of shelters, produces nothing of value” (p. 804). Instead, they detract from society, as tax avoidance “enables companies to become economic free-riders, enjoying the benefits of corporate citizenship without accepting the costs” (Christenson & Murphy, 2004, p. 39).
Conclusion
The use of tax shelters is widespread, and growing exponentially. However, while tax avoidance may save a company money in the short term, it could have negative long term effects by damaging a corporate reputation, depleting the economic resources of society, encouraging other subversive activities by management, and causing harm to national governments (Fisher, 2014). This should be of great concern, but when it comes to taxation, “self-interest and shady practices have become normalized” (Sikka & Willmott, 2005, p. 435). Gallemore, Maydew & Thornock (2014) suggested that “stakeholders may view tax sheltering as different from corporate misdeeds and thus not react in the same way to tax shelter news as they would of corporate misconduct” (p. 1129). While this may be true, it should not be accepted as normality.
Corporate social responsibility should play an active role in determining tax liability (Fisher, 2014). Corporations should be held accountable for paying their fair share of taxes by investors, consumers, and the government. While the concept of fair share is subjective, further research should attempt to analyze the point at which the cost and benefits of a corporation engaging with society equate. This value could serve as a benchmark for determining what a corporation’s fair share may be. Until this can be accomplished, awareness should be raised to enhance consumer and investor activism and a greater emphasis should be place on integrity and ethics for tax professionals and corporate governance.

References
Brittain-Catlin. (2005). Offshore: tax havens, secrecy, financial manipulation and the offshore economy [Interview Transcript]. Multinational Monitor 26(7/8), 47-51. Retrieved May 8th, 2015, from http://p2048-www.liberty.edu.ezproxy.liberty.edu:2048/login?url=http://search.proquest.com.ezproxy.liberty.edu:2048/docview/208876092?accountid=12085
Christenson, J. & Murphy, R. (2004). The social irresponsibility of corporate tax avoidance: Taking CSR to the bottom line. Development, 47(3), 37-44. doi:10.1057/palgrave.development.1100066
Desai, M. & Dharmapala, D. (2009). Corporate tax avoidance and firm value. The Review of Economics and Statistics, 91(3), 537-546. doi:10.1162/rest.91.3.537
Elam, D. (2010). Ethics case study: KPMG faces indictment over abusive tax shelters. Journal of Business Case Studies, 6(3), 95-100. Retrieved May 8th, 2015, from http://p2048-www.liberty.edu.ezproxy.liberty.edu:2048/login?url=http://search.proquest.com.ezproxy.liberty.edu:2048/docview/516337875?accountid=12085
Fisher, J. (2014). Fairer shores: tax havens, tax avoidance, and corporate social responsibility. Boston University Law Review, 94(1), 337-365. http://p2048-www.liberty.edu.ezproxy.liberty.edu:2048/login?url=http://search.proquest.com.ezproxy.liberty.edu:2048/docview/1510499514?accountid=12085
Gallemore, J. Maydew, E. & Thornock, J. (2014). The reputational cost of tax avoidance. Contemporary Accounting Research, 31(4), 1103-1133. DOI: 10.1111/1911-3846.12055
Guliani, L. (2014). Organisational ethics: paradigm for corporate social responsibility. International Journal of Organizational Behaviour & Management Perspectives 3(3), 1116-1121. Retrieved March 27th, 2015, from http://p2048-www.liberty.edu.ezproxy.liberty.edu:2048/login?url=http://search.proquest.com.ezproxy.liberty.edu:2048/docview/1648131529?accountid=12085
Katz, L. (2007). In defense of tax shelters. Virginia Tax Review, 26(4), 799-814. Retrieved May 8th, 2015, from http://p2048-www.liberty.edu.ezproxy.liberty.edu:2048/login?url=http://search.proquest.com.ezproxy.liberty.edu:2048/docview/205873577?accountid=12085
Kaye, T. (2010). The regulation of corporate tax shelters in the United States. The American Journal of Comparative Law, 58, 585-604. http://www.jstor.org/stable/20744555
Kirchler, E., Maciejovsky, B., & Schneider, F. (2003). Everyday representations of tax avoidance, tax evasion, and tax flight: Do legal differences matter? Journal of Economic Psychology, 24(4), 535-553. Doi: 10.1016/S0167-4870(02)00164-2
Lisowsky, P. (2010). Seeking shelter: empirically modelling tax shelters using financial statement information. The Accounting Review, 85(5), 1693-1720. Retrieved May 8th, 2015, from http://p2048-www.liberty.edu.ezproxy.liberty.edu:2048/login?url=http://search.proquest.com.ezproxy.liberty.edu:2048/docview/750360182?accountid=12085
O’Neill, J. (2012). Innovation and constraints on tax shelters. Faulkner Law Review, 4(1), 225+. Retrieved May 8th, 2015, from http://go.galegroup.com/ps/i.do?id=GALE%7CA329899675&v=2.1&u=vic_liberty&it=r&p=LT&sw=w&asid=5d5b09007266ef79922611d95a981ace
Scheffer, D. (2013). The ethical imperative of curbing corporate tax avoidance. Ethics & International Affairs, 27(4), 361-369. http://dx.doi.org.ezproxy.liberty.edu:2048/10.1017/S0892679413000324
Sikka, P. & Willmott, H. (2005). The tax avoidance industry: accountancy firms on the make. Critical Perspectives of International Business, 9(4), 415-443. http://dx.doi.org.ezproxy.liberty.edu:2048/10.1108/cpoib-06-2013-0019
Stuebs, M. & Wilkinson, B. (2010). Ethics and the tax profession: restoring the public interest focus. Accounting and the Public Interest, 10(1), 13-35. http://dx.doi.org/10.2308/api.2010.10.1.13

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