Finding fault in a mysterious tax benefit for non-U.S. companies

By David Cay Johnston
Published: March 23, 2007

NEW YORK: A 2003 tax cut that President George W. Bush promoted as a way to create jobs in the United States includes a provision that has given some foreign companies a financial advantage over their U.S. competitors by making it cheaper for them to raise capital.

The heart of the issue is in the treatment of the payments to investors as either interest, as with bonds, or dividends, as with stocks, which qualify for a lower tax rate under the 2003 law.

Foreign companies can sell securities known as hybrids, which are bonds whose interest payments are treated as dividends that are taxed at the lower rate. The option is not available to U.S. companies.

The advantage under the 2003 law can be significant. It can cost a U.S. company as much as $540 million more than a foreign company to pay $1 billion to U.S. investors.

The Bush administration has generally kept silent about this advantage, which was widely known in tax circles. In June, the Internal Revenue Service quietly told the U.S. Congress that it planned to study the issue but no date was set for completing that review. To qualify for the advantage, foreign companies sell bonds with no maturity date, known as perpetual debt, and arrange to trade them on U.S. stock exchanges.

One Democrat in Congress who has long fought tax shelters introduced legislation Friday to halt the subsidy.

"Why are we spending American taxpayer dollars to subsidize foreign companies?" asked Richard Neal of Massachusetts. "I'll be taking a serious look at this issue in the Ways and Means Committee, and if the Bush administration believes this provision is worthwhile, they should step forward publicly and justify its place in our tax code."

Investors in the United States must pay income taxes of as much as 35 percent on interest earned from lending money to U.S. companies, but their tax is limited to just 15 percent on foreign bonds with no maturity date.

Americans are taxed at the 15 percent rate on dividends, but for U.S. companies, dividends paid on shares come from after-tax profits. Foreign companies, on the other hand, are allowed to deduct the cost of their payments on the hybrid bonds in their home countries. The fact that some foreign companies are making use of the subsidy was discerned from details in disclosure statements.

The Royal Bank of Scotland and Prudential, a British insurance company, confirmed that they are among the companies that have issued billions of dollars of securities tailored to take advantage of the 2003 tax law.

Carolyn McAdam, a spokeswoman for the Royal Bank of Scotland, said that "these issues have always been oversubscribed by U.S. savers, and these savers are getting a higher interest on this money than" they would by buying U.S. Treasury bonds. She said the company recently converted these debt instruments into preferred stock.

Prudential said that it had raised $550 million this way and planned to issue more such securities.

Investors who buy the bonds can end up with more money in their pockets even if the bonds pay a lower rate than other corporate bonds of the same quality. That is because of the difference in tax rates between U.S. corporate bonds and the foreign hybrids.

The competitive advantage for foreign companies was not in the Bush administration's original proposal, which was intended to make dividends flow tax free to investors provided that they were paid from profits that had been taxed by the United States. This follows from the administration's effort to tax income from capital only once, not first as corporate profits and then as income to individuals. Bond interest, including that from the foreign hybrids, is taxed once, when the investors receive the money.

The foreign subsidy was created during 48 hours of deal making behind closed doors in which the tax-free proposal became a law taxing most dividends at 15 percent. Until this law, individuals paid taxes on wages, interest and dividends at the same rate.

Congress does not require members who had provisions added to tax bills to identify themselves publicly nor to identify who requested, or would benefit, from such additions. At the time, Democrats, then in the minority, complained that Republicans cut them out of the process in which the bill was reworked.

The provisions appeared on the surface to bar companies with their tax headquarters in places like Bermuda and the Cayman Islands from qualifying for the 15 percent rate on dividends. But other provisions effectively undid that prohibition and, in doing so, opened the door wide for companies to gain an advantage and offer the hybrid securities.

Dean Baker, an economist and author of "The Conservative Nanny State," a critique of Bush administration economic and social policies, said that "it makes no sense to give foreign corporations a lower cost of capital than American companies."

Most significantly, Baker said, is that taxing dividends at a different rate than interest "encourages gaming the system," making it harder to enforce the tax law fairly.

The Treasury Department would say little beyond calling the tax cut "an unqualified success" at encouraging investment and creating jobs.

"I don't have any comment" except for passing on a printed reference to the IRS plan to study the issue, Brookly McLaughlin, the Treasury deputy assistant secretary for public affairs, said in e-mail messages responding to requests for further information.

At the White House, Tony Fratto, the deputy press secretary and a former public affairs officials at the Treasury Department, said that he did not "know if this particular friction in the tax code was considered in 2003 — most of the policy makers who worked on the legislation are no longer in the administration."

Peter Canellos, a semi-retired tax expert, said it was still a mystery as to how the provisions got into the 2003 tax cut bill.

"Like a lot of tax law," he said, "It's not there because it makes good sense. It's just there."