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 ZZZZ International Ltd., which was listed on several international stock exchanges. Practically speaking ZZZZ 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 ZZZZ Canada Ltd. But ZZZZ Canada Ltd. was 100% owned by ZZZZ International Ltd. I believe there were at two subsidiaries based in the United States. I will just call them ZZZZ USA Ltd. and ZZZZ Manufacturing Ltd.. ZZZZ Canada Ltd. didn’t have a lot to do with “USA”, but it bought a lot of oilfield tools from “Manufacturing”.
ZZZZ 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 ZZZZ subsidiaries around the world. ZZZZ Manufacturing did not have any customers outside of ZZZZ.
At that time, the corporate tax rate in the USA was lower than what it was in Canada. In order to minimize its taxes, ZZZZ International Ltd. would order ZZZZ Manufacturing to charge a BIG premium to ZZZZ 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 ZZZZ Canada Ltd. That is a eight-fold premium. By being charged so much for in-house manufacturing, ZZZZ Canada Ltd. was really not in a profitable situation to pay much Canadian corporate tax.
So how could a company with profit as a motivator actually 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, ZZZZ Canada Ltd. was actually reasonably profitable. These profits were extracted tax-free into the USA through the overpriced tools.
I assume that ZZZZ Manufacturing Ltd. showed immense profits and paid the appropriate corporate USA tax. They then passed their profits to ZZZZ International Ltd. With Manufacturing’s taxes being lower than what would have been paid in Canada had the profits been reported in Canada, ZZZZ International Ltd. ended up with a higher post-tax profit. ZZZZ International probably didn’t care where it paid taxes; it just wanted to minimize them.
In essence, ZZZZ Manufacturing had two purposes. First, to manufacture oilfield tools for all ZZZZ subsidiaries. Second, to be a tax minimizing tool for ZZZZ 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 ZZZZ International Ltd., more or less bypassing ZZZZ Manufacturing. By adjusting the cost of the tools for ZZZZ Manufacturing’s “customers,” ZZZZ 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 — ZZZZ was still a culture of profits.
That was a shell game played in the 1980s. ZZZZ 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.
