Companies also consider payroll taxes in managing offshore operations. Our analysis of SEC filings found that in 2008, 29 of the top  defense contractors—accounting for 41 percent of DOD contracting  dollars in fiscal year 2008—had at least 1,194 offshore subsidiaries. According to 13 of the top defense contractors we interviewed, 718 of the  738 offshore subsidiaries—or 97 percent—that they reported to the SEC in  fiscal year 2008 were generally used to support global commercial clients,  and foreign government contracts rather than DOD contracts. Our review of 2008 SEC filings  for the 29 publicly traded defense companies found that approximately  one-third reported decreasing their 2008 effective U.S. tax rates through  the use of foreign affiliates, lower foreign tax rates, and indefinite  reinvestment of foreign income outside of the United States. Offshore Subsidiaries Supporting DOD Service Contracts Overseas Were Principally Used to Avoid Payroll Taxes

The primary use of the offshore subsidiaries registered outside the  contract place of performance—many of those reviewed in our six case  studies—was to hire U.S. workers to perform services overseas and  thereby avoid Federal Insurance Contributions Act (FICA) taxes for those  employees. HEART Act Resulted in Contractors Paying FICA Taxes and Impacted Use of Offshore Subsidiaries

After the HEART Act took effect, defense contractors that were not paying  FICA taxes on U.S. personnel working on DOD contracts outside of the  United States began to submit requests for equitable adjustments to  recover their newly increased tax costs. As a result, in fiscal year 2009, four of the five  contractors using offshore subsidiaries to support DOD work requested  reimbursement of at least $140 million from DOD for new FICA payments  on the contracts we reviewed as well as some others. Several contractors stated that they initially used offshore subsidiaries to  hire U.S. workers to perform services overseas in order to offer  competitive prices when bidding for DOD contracts, and as this practice  grew, it became a competitive necessity. Defense Contractors’ Offshore Subsidiaries Continue to Avoid Unemployment Taxes for Their U.S. Workers

While five of the six contractors in our case studies said that reducing  FICA tax payments was the primary reason for using offshore subsidiaries,  this practice also allowed the contractors to reduce costs by avoiding state  and federal unemployment insurance taxes for U.S. personnel working  overseas. In one state where four of the six case study  contractors have a corporate presence, we reviewed documentation for  about 140 former employees of several contractors who were denied  unemployment benefits in 2009. State workforce officials indicated that  these benefits were denied because the employees worked for a foreign  subsidiary and not an American employer. Contractors’ Use of Offshore Subsidiaries Did Not Impede DOD’s Contract Oversight

In the contracts we reviewed, DOD oversight officials were aware of the  roles that offshore subsidiaries played in supporting the contracts. DOD  officials said that oversight mechanisms, such as DCAA’s annual reviews  of incurred costs, provide knowledge of the activities of offshore  subsidiaries in cost-reimbursement contracts. Contracting officials said that the use of offshore subsidiaries did not  negatively affect contract schedule or performance. Contract file and oversight documents we reviewed, such as contractor  price proposals and cost accounting disclosure statements, disclosed the  use of offshore subsidiaries. Conclusion

While defense contractors have increased their offshore subsidiaries used  for commercial purposes, the practice of using offshore subsidiaries to  avoid certain payroll taxes on U.S. government contracts has been  addressed by the HEART Act. As a result, contractors have begun to pay  FICA taxes for U.S. workers hired through offshore subsidiaries to support  DOD contracts, thus contributing to the Social Security and Medicare  Trust Funds. We selected  these contractors based on a range of the amount of government work in  fiscal year 2008, location of identified subsidiaries, and industry type. In addition, we reviewed relevant  Defense Contract Audit Agency (DCAA) audit reports and documentation. In addition, we reviewed guidance and interviewed Department  of Labor officials about federal and state unemployment insurance  eligibility requirements. U.S.
Why GAO Did This Study

Many federal contractors establish offshore subsidiaries to take advantage of labor and market conditions. GAO has found that they also use offshore subsidiaries to reduce their U.S. tax burdens. In 2008, Congress passed the Heroes Earnings Assistance and Relief Tax (HEART) Act which resulted in contractor offshore subsidiaries paying certain payroll taxes for U.S. personnel working abroad. Fiscal year 2009's National Defense Authorization Act required GAO to report on the rationales, implications, and costs and benefits of defense contractors' use of offshore subsidiaries. We (1) assessed trends and purposes for contractors' offshore subsidiaries; (2) identified how contractors use subsidiaries to support defense contracts; (3) assessed DOD's oversight of contractors' use of offshore subsidiaries. To conduct our work, we reviewed data for the 29 U.S. publicly traded contractors with at least $1 billion in DOD spending in fiscal year 2008, reviewed several illustrative contracts selected based on categories of DOD services most often performed overseas, reviewed audit documents, and interviewed DOD officials about oversight.

What GAO Found

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. Between fiscal years 2003 and 2008, they increased their use of these subsidiaries by 26 percent, maintaining at least 1,194 in 2008. We interviewed 13 of the 29 contractors based on a range of the amount of government work, locations of subsidiaries, and industry types; they reported that 97 percent of the subsidiaries generally supported global commercial and foreign government clients, while the remaining 3 percent supported DOD contracts performed overseas. These subsidiaries also helped the 29 contractors reduce taxes, with about one-third decreasing 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. For five of the DOD contracts we reviewed, companies principally used offshore subsidiaries to hire U.S. workers providing services overseas on U.S. government contracts in order to avoid Social Security, Medicare--known as Federal Insurance Contributions Act (FICA)--and other payroll taxes. This practice allowed contractors to offer lower bids when competing for certain services and thereby reduce costs for DOD. Our analysis of two contracts showed that the use of offshore subsidiaries saved DOD at least $110 million annually prior to the HEART Act, through payroll tax avoidance. While this practice provided contract cost savings for DOD, it resulted in these companies avoiding payroll taxes that would have contributed to the Social Security and Medicare Trust Funds. The 2008 HEART Act resulted in offshore subsidiaries of U.S. companies paying FICA taxes for U.S. workers performing services overseas on U.S. government contracts. As a result, in fiscal year 2009, four of the case study contractors using offshore subsidiaries to support DOD work requested reimbursement from DOD of at least $140 million for new FICA payments. Federal and state unemployment payroll taxes, however, were not covered by the HEART Act, and several contractors that used offshore subsidiaries have continued to avoid these taxes. In one state, we reviewed documentation for about 140 former employees of several contractors who were denied unemployment benefits in 2009. State workforce officials indicated these benefits were denied because the employees worked for a foreign subsidiary and not an American employer. DOD officials were aware of the roles offshore subsidiaries played in the DOD contracts we reviewed and stated that oversight mechanisms, such as the Defense Contract Audit Agency's reviews of incurred costs and oversight documents, inform them of the activities of offshore subsidiaries. In contracts we reviewed, evidence of offshore subsidiaries was present in contractor labor rates, cost accounting disclosures, and contractor price proposals. Contracting officials stated that the use of offshore subsidiaries did not negatively impact contract schedule or performance.