Thursday, February 18, 2010

Offshore Havens for the Defense Industry

A pile of dollar bills, courtesy of Tracy O/flickr

A recent US government report criticizing large American defense contractors of avoiding taxes by moving operations offshore could have interesting implications for the relationship between the industry and the state, Jody Ray Bennett writes for ISN Security Watch.

Unplug the Signal: The Truth Will Not Be Televised....

By Jody Ray Bennett

Nearly one year after the G20 announced a commitment to crackdown on the use of international tax havens, giant US defense contractors continue to enjoy lightly regulated offshore financial centers to avoid taxation and escape paying millions in employee benefits.

In a report released in late January by the Government Accountability Office (GAO), the independent watchdog organization that investigates how the federal government spends taxpayer dollars, research found several large defense contractors with registered offshore subsidiaries and other holdings.

The findings of the report are rather interesting: “Many of the top 29 U.S. publicly traded defense contractors - those with $1 billion or more in DOD contracts in fiscal year 2008 - have created offshore subsidiaries to facilitate global operations,” and since 2003, have “increased their use of these subsidiaries by 26 percent, maintaining at least 1,194 in 2008.”

The report analyzed the following 13 companies: Lockheed Martin Corporation, The Boeing Company, General Dynamics Corporation, L-3 Communications, KBR Inc, ITT Corporation, General Electric, Computer Sciences Corporation, Health Net Inc, Harris Corporation, Honeywell International Inc, DynCorp International Inc, Rockwell Collins Inc, Fluor Corporation, Combat Support Associates and AECOM Technology Corporation.

Offshore incentives

Industry analysts, however, are distinguishing these large defense contractors from many of the companies that characterize the private military and security industry such as Blackwater (Xe) and Triple Canopy.

“For the moment [the GAO report] will not have great impact on the private military and security industry, as distinct from the more traditional defense industry sector [because] the GAO Report focused on publicly traded companies, while many of the companies in the PMSC sector are not publicly traded,” David Isenberg, independent analyst of private military and security contracting and author of the book Shadow Force: Private Security Contractors in Iraq, told ISN Security Watch.

“Most of the companies listed in the GAO report range from fairly to very large firms. These firms generate lots of revenue and thus have a greater incentive to go offshore to try and shelter their money from US taxes. But many firms in the sector are of much smaller size and have less reason to go offshore,” Isenberg said.

Nevertheless, the GAO explained that while offshore subsidiaries comprise only 3 percent of those who do business with the Department of Defense, “about one-third [of the companies] decreas[ed] their effective U.S. corporate tax rates in 2008 in part through the use of foreign affiliates, lower foreign tax rates, and indefinite reinvestment of foreign income outside of the United States.”

Three percent of the defense industry is significant, especially since government contracts have, in large part, enabled companies that sell defense, security, intelligence and logistics services to grow to a multi-billion dollar industry.

The regulation game

Companies continue to use subsidiaries in places such as Barbados, the Cayman Islands, Lichtenstein and the United Arab Emirates. As a result, the report found several companies were able to use subsidiaries in these countries to “hire US workers providing services overseas on US government contracts in order to avoid Social Security, Medicare - known as Federal Insurance Contributions Act (FICA) - and other payroll taxes.”

Subsidiaries also “allowed contractors to offer lower bids when competing for certain services and thereby reduce costs for DOD.”

Industry proponents cite these DOD savings as an advantage of the business practice. Indeed, the report found that after analyzing just two contracts, companies that avoided paying payroll taxes through the use of offshore subsidiaries “saved DOD at least $110 million.”

In 2008, the US Congress passed the Heroes Earnings Assistance and Relief Tax (HEART) Act, effectively forcing these companies that use offshore subsidiaries to pay FICA taxes. However, the law failed to make rules regarding state and federal payroll taxes while companies later “requested reimbursement from DOD of at least $140 million for [the] new FICA payments.”

“I doubt the GAO report will have much impact on the reputation of the industry, given all the other issues it has to contend with. However, there are a couple of issues it does raise, [such as] avoiding payroll taxes like FICA and thus screwing the contractors in the field who are worthy of note,” Isenberg told ISN Security Watch.

Indeed, the report mentioned its review of documentation “for about 140 former employees of several contractors” who were later “denied unemployment benefits in 2009” because “the employees worked for a foreign subsidiary and not an American employer.”

“It also has other interesting implications for the perennial cost-effectiveness argument that industry likes to make,” Isenberg said.

More interestingly, however, were the words that came from the defense industry business elites, some of whom contended that there was a growing competitive trend between the industry and government that would place both at a disadvantage.

Just weeks before the GAO report was released, Norm Augustine, former CEO of Lockheed Martin, released his own prediction:

“The issues facing the nation and the world increasingly transcend the ability of either government or industry to solve alone. For example, the government clearly has overall responsibility for homeland security, yet 90 percent of the assets to be protected currently reside in the private sector. At the same time, as the federal debt grows along with the non-discretionary part of the federal budget, heightening fiscal pressures will be placed on the procurement process. As a consequence, [the] industry is unfortunately likely to find itself more and more a competitor with government than a partner [and the] problem will be exacerbated by the inability or unwillingness of qualified individuals with industry experience to serve terms in government.”

Clearly, the former executive of the top defense contractor in the US realizes the business advantage of industry executives who seek positions in government. Although unknown is the direction in which industry and government travel, Augustine concludes, “As one who has spent a significant part of his professional life in each government and industry, I truly hope the above is wrong but that would not be how I would bet.”

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