Introduction
Over the years, the United States government has enacted tax laws and regulations that govern the way businesses, individuals, and companies are taxed. Furthermore, these laws are not fixed, as they have been adjusted to suit the prevailing conditions over the years. Despite this, various loopholes still surface and are used by businesses and companies to evade taxation. These gaps include opening offshore accounts, falsifying accounts books, misusing deductions and tax breaks, foreign investments, and many more.
Taxes are charges levied on the net income of individuals and corporations by various levels of government. These levels may consist of the federal, state, and local administrations. Corporate tax is a tax charged on net profits, and these taxes are paid as a company’s taxable income. These taxes are levied at different rates depending on whether the goods were sold on foreign or domestic soil. Corporate tax can only be charged on companies formed and operated in the United States and foreign corporations operating on American soil.
Overall, governments are responsible for developing their jurisdictions using taxes collected from corporations and individuals. However, this seems almost impossible as many corporations have discovered ways to avoid paying their taxes through loopholes in tax laws that they manipulate and pay little to no taxes. Tax evasion operations might provide possibilities for management to engage in activities aimed at concealing negative reports and misleading shareholders. This paper focuses on Enron and how it used tax loopholes to allow management to fabricate profits while keeping stockholders in the dark about their origins.
Exon Case Summary
Enron avoided paying income taxes for close to five years by establishing hundreds of subsidiaries in tax-haven jurisdictions and employing other strategies. Enron was capable of forming corporations to avoid taxes thanks to the tax-haven entities, which took advantage of regulatory loopholes. The core strategy includes directing earnings to a counterparty who is not liable to U.S. taxes, such as a bank in a tax-haven state. After deducting its compensation, the associate returns the proceeds in a manner that is not deductible under U.S. law (Hakelberg, 2020). Enron evaded taxes for an additional important purpose: stock option deductions. When CEOs activate stock options, the firm deducts the income made by the manager on its company income tax return, although the corporation is not obligated to declare a cost on its profit-and-loss report to investors (Hakelberg, 2020). The gains to the corporation may be substantial, especially if a rising stock price results in the activation of a significant number of choices. That was the case for Enron, while its stock was surging from 1998 to 2000.
Tax Havens and Offshore Accounts
Businesses and corporations have developed a trend of opening offshore accounts in countries where neither the country’s corporate tax nor any form of taxation applies. Such places are referred to as tax havens, with the most popular countries being Bermuda, Cayman Island, Jersey, Gibraltar, Bahamas, and Puerto Rico (Hughes & Womhoff, 2021). In 2018 American corporations operating in Bermuda filed a total of $97 billion as the net profit for that fiscal year, which raised many questions since the gross domestic product for this island was only $7 billion (Hughes & Womhoff, 2021). These companies only had 740 employees, meaning that they generated $130 million for their employers (Hughes & Womhoff, 2021). This would have been impossible in the U.S. since companies are mandated to pay corporate taxes.
Most corporations and investors prefer to invest in such territories to maximize their profits and minimize taxes and losses. This often results in the shortage of tax collected by the IRS in the U.S. In the Enron scandal, the firm established 692 offshore companies registered in the Cayman Islands as a component of a complex tax avoidance scheme (Bhaskar et al., 2019). Data from 1996 to 2000 demonstrate that Enron produced pre-tax earnings of close to US$2 billion across a five-year trading span yet paid zero federal income taxes. Interestingly, Enron was a net receiver of tax refunds during this period. Apart from the Cayman Islands, the corporation established subsidiaries in other countries, notably 119 in Caicos and Turks, 8 in Bermuda, and 43 in Mauritius (Bhaskar et al., 2019). Enron utilized the tax avoidance tactics common to many firms.
Similarly, Enron formed a Global Finance department whose sole responsibility was to generate cash flows. To make use of this strategy, Global Finance invented prepays. The scheme functioned in such a manner that Enron entered a deal with one of their ‘special purpose entities (SPEs) outlining the quantity of gas or energy that Enron is obligated to supply to that company in the foreseeable (Bhaskar et al., 2019). The firm would reimburse Enron in advance with funds obtained from its creditor. The creditor also had a deal with Enron: he was required to supply gas to Enron, and Enron agreed to reimburse him for the gas he delivered. The entire deal will be classified as a debt if the creditor does not make the required service. Enron did not record debt for these deals rather a trading obligation. Indeed, this was not a lawful business, which is why Enron attempted to keep them hidden from the public.
When Enron went bankrupt, stockholders discovered that the company reported future tax savings as current savings. This was accomplished through a chain of complicated transactions comprising the firm’s main office, Canadian branches, corporate airplanes, and other holdings (Hakelberg, 2020). These holdings were incorporated into many transactions, particularly with Deutsche Bank and Bankers Trust, which were designed to reduce Enron’s tax liability over time. Consequently, Enron recorded the tax benefits as instant in the period in which the transactions were completed. As an outcome, the corporation reported over $880 million in tax savings between 1995 and 2001 that did not occur.
The U.S. government introduced several measures to address the above problem. Tax rates for corporations with offshore accounts were lowered to 10.5%, half of what domestic corporations are taxed (Hughes & Womhoff, 2021). The reduction was made to incentivize them to bring their wealth back to the country at a low tax fee (Americans For Tax Fairness, 2014). This strategy was unsuccessful, prompting the government to stop taxing offshore accounts that they kept abroad for those that surpassed a 10% return of the tangible property (Fichtner, 2019). A perfect example of such companies is Apple and Microsoft, which reported a total of $100billion in profit made and held in offshore accounts (Colvin, 2021). Most of these companies choose to keep their money in offshore accounts to be taxed globally rather than come to the U.S. and be taxed on a higher per-country basis.
Tax Credits and Corporate Tax Avoidance
The American government has put in place the tax credit law to encourage companies to indulge in activities that help the community and thus are exempted from taxation. As a result, companies have dodged the taxation bullet by donating to the community. Some companies can also participate in government projects, relief food donations, and scholarships for underprivileged children (Colvin, 2021). While some of these companies genuinely participate in such initiatives, most use them as means of eluding taxation. Conversely, other companies avoid being taxed or even pay low effective taxes through business write-offs, carrying losses forward or backward, negotiating a lot during auditing, and planning their taxes aggressively. Other corporations avoid taxation by carrying forward or backward their losses, and since it is allowed, they keep doing it to ensure they do not pay any taxes.
Enron shifted from conventional historical cost accounting to mark to market (MTM) accounting in 1992, after receiving formal Securities and Exchange Commission (SEC) authorization. MTM is a method for determining the actual worth of accounts that fluctuate in valuation, such as liabilities and assets. MTM’s objective is to accurately assess an institution’s or business’s present financial status. It is a perfectly legal and widespread practice. It is, however, susceptible to manipulation because MTM is not centered on “real” costs but rather on “fair value,” which is more difficult to ascertain (Markham, 2015). MTM marked the start of Enron’s demise since it began documenting anticipated gains as real ones.
In the context of Enron, the firm would establish an infrastructure, like a power station, and instantly record the predicted gain on its accounts, despite not earning a single penny from the venture. Alternatively, if the firm’s income from the hydroelectric plant were lower than the predicted value, rather than suffering a deficit, it would convert the investment to an off-the-books firm, in which the loss remained unrecorded (Bhaskar et al., 2019). Enron was capable of writing off unproductive operations because of this form of accounting without negatively impacting the company’s bottom line. The MTM strategy resulted in the development of tactics intended to conceal deficits and give the impression that the firm was more lucrative than it seemed.
To deal with the accumulating debts, Andrew Fastow, the CFO, devised a systematic strategy to make the corporation seem in good financial health, even though several of its companies were incurring losses. The CFO and other Enron executives organized a strategy to conceal growing debt and bad investments from lenders and stockholders through SPEs or off-balance-sheet special purpose vehicles (SPVs) (Bhaskar et al., 2019). These SPVs were developed with the sole goal of concealing financial reporting issues instead of operational outcomes.
To this end, offshore profit redistribution is based on a completely corporate tax backdoor: deferral. Global firms are permitted to avoid paying taxes on earnings earned by an overseas affiliate only if they are paid back to the main company in the United States as a dividend. Earnings stored abroad are said to as “trapped” by advocates of lower corporate tax rates, although this description is untrue (Clemente et al., 2017). Without a doubt, nothing but a drive to pay reduced taxes hinders firms from reinvesting their earnings in the U. S. In reality, firms repatriate around two-thirds of their overseas profits and settle the taxes owed on them. Enron took advantage of such loopholes to avoid paying taxes and fool investors.
Recommendations
Regulate Offshore Accounts and Foreign Tax Haven
Numerous American investors and corporations have invested and held most of their wealth in offshore accounts where they cannot be subjected to taxation. The government loses billions in revenue due to this practice, which without a doubt remains a challenge to regulate. Nonetheless, the government can resolve this by creating a favorable environment for investing and growing. The federal government can also develop regulations to ensure all foreign earned income is taxed regardless of its location. An ideal way is to collaborate with governments where offshore accounts are predominantly operated to flag such operations. This will defeat the purpose of hiding income overseas, and companies will have no choice but to reinvest it in the country.
Usually, foreign earned income is termed as ‘trapped’ in foreign countries, while in the real sense, it is in the country’s banks and is used to fund projects in the U.S. Nevertheless, these funds cannot be used to pay shareholders their dividends until they are repatriated to the company, attracting taxation. The perfect solution for this will be for the government to replace a portion of the corporate income tax with a shareholder tax. Stakeholders of public companies will be taxed twice on both dividends and capital gains.
Reduce Tax Breaks and Deductions
The federal government should reduce the tax breaks to prevent further manipulation by the corporations. In the case of accelerated depreciation, the government should make it illegal to exaggerate the depreciation rate of a corporation’s assets. This will go a long way in ensuring that the correct figure is presented, hence rightful taxation (Beer et al., 2020). Reduced tax breaks will ensure fair taxation since those taxed the most are low-income earners, while the rich pay only a small tax due to their deductions and breaks. Other tax breaks such as write-offs and carrying forward or backward losses should be regulated since business owners may intentionally lie to the IRS about the sales they have made to pay a small tax at the federal government’s expense (Fichtner, 2019). Those caught attempting to writing-off their prices and sale should be arrested and fined to serve as an example to others. In the case of carrying forward or backward losses, regulations should be put in place to control how they are abused to maximize taxation.
Increase the Federal Corporate Income Rate
The corporate law, which was enacted in 2017, is not as effective as expected. Therefore, it is paramount that the federal government raises the corporate tax rate to solve the problem of revenue shortage in the country. Studies have shown that increasing the corporate income tax rate will help generate an extra $375billion in tax every year, with a high possibility of an increase in the future (Fichtner, 2019). Otherwise, the corporate income tax can also be converted into a cash-flow tax making it a VAT with a wage deduction. It would be crucial in attracting new investors since deductions will be replaced with immediate expenses for physical investments (Norton, 2020). Moreover, companies with offshore accounts and investments will be thrilled to pull back their wealth to their motherland since the transactions will not be taxed.
The United States government practices the worldwide system except for deferring foreign earned income until repatriated. Currently, it is estimated that over $2 trillion is yet to be repatriated (Cox, 2016). It, in turn, costs the federal government vast tax revenue, which could be channeled into government projects. However, this can be solved when the federal government shifts to a worldwide system with no deferrals. Due to increased corporate income tax, most business owners have opted for the non-corporate system to evade corporate income tax. The federal government must develop tax regulations for non-corporate investors to compensate for lost taxes.
Bottom-Line
Compared to other countries, the U.S. has the lowest corporate income tax rate. Due to this low tax rate, the federal government finds it challenging to raise the required revenue to run the country effectively. To take charge of this situation, the government has to raise the taxes for locally based but foreign operated companies (Norton, 2020). Initially, these companies were barely taxed since they do not operate on the nation’s soil even though they have their headquarters in the U.S. Such companies have to be taxed to settle the revenue shortage problem.
Further, the federal government must gradually introduce new manageable tax rules to raise the much-needed revenue without overburdening its citizens. Putting these regulations to use will enable the federal government to curb the growing revenue deficit. Progressively the government will be able to adequately settle foreign debts and complete projects that were left hanging. The federal government will also be required to fund the IRS as a recent study has proved that for every $1 invested in internal revenue service, it will yield $11 (U.S. Department of the Treasury, 2014). Ultimately, these strategies should lead to increased tax collection if implemented as suggested.
Conclusion
Some of the major issues affecting the tax laws of corporates in the country are based on the loopholes in the tax rules and regulations. Corporations and major business owners have discovered various means of manipulating these loopholes to avoid taxation. Some have kept their funds in offshore accounts in countries where tax laws favor them, tax credits and breaks, accelerated depreciation, write-offs, and tax avoidance. To efficiently control this and, in the process, increase the country’s revenue, the federal government has to regulate the tax reductions, and breaks raise the corporate income tax for both domestic and foreign-based. American-owned companies increase scrutiny for companies suspected of accelerating their depreciation and altering books of account. The federal government will prevent further revenue loss in tax avoidance through these adjustments.
The Enron crisis is crucial in regards to learning opportunities for new and seasoned finance experts, as well as for the general public. It shows why effective corporate governance is necessary for every firm to succeed in maintaining and generate profitable growth. Furthermore, it sheds light on how the company’s financial statements must not be exploited. Any abuse may have significant repercussions or consequences on the firm’s sustainability. Owing to the corporation’s insolvency, workers lost various privileges and pension plans. Several other employees arrived on the brink of financial catastrophe. The situation was so serious that the firm’s stockholders lost billions of dollars. Any corporate wrongdoing must be treated as a lesson, and awareness must be developed as to why rules and accountability are important.
References
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