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The Tax Shell Game

In the early 1980s, I was working for an international oilfield service company. The company made no secret that it was about profits, and careers were built on being part of a profitable division. To keep the scorecard known, all employees had reasonable access to their division's financial summaries, which included two sets of books. I will explain that later.

I will just call this company “Z International Ltd.,” which was listed on several international stock exchanges. Practically speaking Z International Ltd. was just a front for its many subsidiaries. It was these subsidiaries that did the work and funnelled their profits upwards.

Legally speaking, I was working for Z Canada Ltd. But Z Canada Ltd. was 100% owned by Z International Ltd. I believe there were at two subsidiaries based in the United States. I will just call them Z USA Ltd. and Z Manufacturing Ltd. Z Canada Ltd. didn't have a lot to do with Z USA, but it bought a lot of oilfield tools from Z Manufacturing.

Z Manufacturing was based in Houston. It was a medium-sized factory that employed about 200 people, many of them machinists and electronic techs. They built much of the oilfield equipment for the Z subsidiaries around the world. Z Manufacturing did not have any customers outside of the Z group.

At that time, the corporate tax rate in the USA was lower than what it was in Canada. In order to minimize its taxes, Z International would order Z Manufacturing to charge a BIG premium to Z Canada for oilfield tools. When I saw the two sets of books, an oilfield tool that cost $5,000 to manufacture in Houston was priced at $40,000 for Z Canada. That is an eight-fold premium. By being charged so much for in-house manufacturing, Z Canada was really not in a profitable situation to pay much Canadian corporate tax.

So how could a company justify keeping the Canadian operation going? Here's how: the second set of books was based on the actual cost of the tools. With depreciation schedules on equipment based on the lower cost, Z Canada was reasonably profitable. These profits were extracted tax-free into the USA through the overpriced tools.

I assume that Z Manufacturing showed immense profits and paid the appropriate corporate USA tax. They then passed on their profits to Z International. With Z Manufacturing's taxes being lower than what would have been paid in Canada had the profits been reported in Canada, Z International ended up with a higher post-tax profit. Z International probably didn't care where it paid taxes; it just wanted to minimize them. It moved the post-tax profits to shareholders of Z International. Lower taxes meant more dividends. 

In essence, Z Manufacturing had two purposes. First, it manufactured oilfield tools for all Z subsidiaries. Second, it was a tax minimizing tool for Z International. If the corporate taxes were higher in the subsidiary's tax jurisdiction than in the USA, a big premium was added to the cost of the tools. If the jurisdiction had a lower corporate tax rate than the USA, then the tools were sold at cost (or even at a loss). In this case, the subsidiary would pay the local tax, then pass the profits directly to Z International, more or less bypassing Z Manufacturing and American taxes. By adjusting the cost of the tools for Z Manufacturing's "customers," Z International always got the benefit of the lower-taxed jurisdiction.

And by keeping two sets of books--one for the tax collectors and one for management decision-making--Z Canada was still profitable.

That was a shell game played in the 1980s. Z accountants figured out how to price oilfield tools to minimize taxes. But the tools were essentially built for internal usage.

Tax minimization tricks are probably much more sophisticated today.

Published on debatepolitics.com in 2017

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