The tax man is knocking on doors. In June, the Internal Revenue Service informed Motorola that the global communications giant owed an estimated $500 million in back taxes due to transfer-pricing errors. The IRS is also taking a hard look at pharmaceuticals giant GlaxoSmithKline for alleged transfer-pricing problems. The agency says the London-based company owes the United States an estimated $5.2 billion (yes, with a "b") in back taxes and interest on profits its U.S. unit earned between 1989 and 1996.
Is this a sign that the IRS is trying to make up for its own resource constraints by enforcing existing tax law more aggressively? Attorney Louis Marett thinks so. "They are looking for the low-hanging fruit," says the chairman of the tax-practice group at Testa, Hurwitz & Thibeault LLP, in Boston. He expects the IRS to go where the money is, conducting fewer audits of individuals and smaller companies and more audits of larger companies.
In particular, says Marett, the agency will focus on tax shelters and transfer pricing. The IRS is making good on a May 2003 directive aimed at curbing transfer-pricing abuses. The practice, which involves the sale of goods from one business unit to another in a different country, is a notoriously gray area that has often confounded regulators. The agency has tried to address the issue at the pre-audit stage with its advance pricing agreement program, in which companies can agree with the IRS on appropriate pricing levels prior to filing their tax returns. Marett says "dozens and dozens" of companies are participating in the program.
In Motorola's case, the IRS claim arose from a field audit of the company's operations from 1996 to 2000. The agency argues that the company didn't record enough of its profits in the United States during the period, and thus underpaid taxes on those proceeds. Motorola CFO David Devonshire calls the dispute routine. "Like all companies doing business internationally, we are audited each year covering many issues, including transfer pricing," he says. He adds that the company resolved a disagreement arising from the same audit in the second quarter, which resulted in a $197 million addition to net income from reserves that had been set aside for tax adjustments. Motorola has said it intends to "vigorously dispute" the latest charge. (The IRS declined to comment.)
GlaxoSmithKline plans to contest the IRS's claim, and says it expects a trial sometime in 2005 or 2006. —Kate O'Sullivan
Deficit Bending
Last month, the Congressional Budget Office announced it expects a record federal budget deficit of $422 billion for fiscal 2004. While the CBO projects the deficit will shrink to $348 billion in 2005, its outlook for the next 10 years is grim. If current laws and policies remain in place, the deficit could reach a cumulative $2.3 trillion for the years 2005 to 2014. And if the Bush tax cuts do not expire as scheduled, the 10-year hole will deepen to $3.6 trillion.
Economist Ken Goldstein of The Conference Board says the news is both good and bad. As a percentage of gross domestic product, the current budget deficit (about 3.5 percent of GDP) is smaller than the deficits of the late 1980s and early 1990s (which fell in the range of 5 to 6 percent). However, Goldstein says the current deficit could be big enough to have an impact on the capital markets.
"It's going to be a lot more expensive for businesses to raise capital in a year's time," he predicts. Furthermore, state and local governments are in much worse shape than they were 20 years ago. With the baby boomers set to retire soon, "the worst is still to come" in terms of stress on the fiscal sector, says Goldstein. —Joseph McCafferty
A Trademark Move
In the late 1990s, business-method patents came into vogue as Internet pioneers staked out intellectual property. Priceline.com patented its "reverse auction" sales method in 1998, for example, and Amazon.com patented its "one-click" ordering system a year later.
Now financial-services firms are getting into the act. In July, Goldman Sachs & Co. received a patent for a hedging strategy. "We've locked down for our shareholders our best thinking on a tough problem," says John A. Squires, chief patent counsel for Goldman Sachs.
Conceived by managing director David J. Marshall, the hedging strategy addresses the risks faced by companies offering deferred-compensation plans. Typically, companies hedge these plans either through corporate-owned life insurance (COLI) or by buying the same mutual funds selected by participating employees. Neither approach is bulletproof: COLI plans have some tax effects, and some carriers permit only limited investment options; mutual funds generate taxable income if the plan sponsor adjusts its holdings to mirror changes employees make in their allocations.
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