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.

Considering the sheer amount of money that the Pentagon spends on contractors for support, approximately $396 billion on contracts for products and services in fiscal year 2008 according to the GAO, the money not spent on payroll taxes can amount to quite a lot. *

From AllGov:

Setting up foreign subsidiaries allows American defense contractors not only to utilize cheaper labor and more favorable regulations, but also avoid paying taxes that fund key government safety net programs. This conclusion was reached by the Government Accountability Office (GAO), which examined 29 defense contractors and their reliance on offshore companies for their work overseas from 2003 to 2008.

GAO investigators found that companies primarily used offshore subsidiaries to avoid contributing to Social Security and Medicare. This avoidance was perfectly legal, thanks to the way Congress crafted the Federal Insurance Contributions Act. Since then, lawmakers passed new legislation in 2008, the Heroes Earnings Assistance and Relief Tax Act, which sought to close this loophole.

From the report (PDF) released yesterday by the U.S. Government Accountability Office.

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 [Heroes Earnings Assistance and Relief Tax] 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.

David Isenberg writes in: Offshore Means Never Having to Pay Payroll Taxes

It seems ironically fitting that private military contractors — which are examples of the presumed benefits of outsourcing — devote so much effort to further outsourcing their operations. According to the GAO from 2003 through 2008, defense contractors increasingly used offshore subsidiaries. Their 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.

Of the total offshore subsidiaries, about 200 were located in tax haven financial privacy jurisdictions such as Singapore, Hong Kong, Ireland, or Luxembourg. Firms like KBR, CSA, and AECOM all have subsidiaries in the Cayman Islands, well-known for its excessive secrecy in facilitating tax evasion. …

Interestingly, as many private military and security contracting advocates claim that the private sector is inherently more cost-effective than the public sector because it can hire lower-cost foreign workers the GAO report noted that the need for security clearances for U.S. personnel working on certain DOD contracts, as well export control provisions, limit the types of defense work that can be conducted through offshore subsidiaries.

None of this is illegal and the Pentagon is aware of the practice. It does not object, as it receives cost savings as the practice allowed contractors to offer lower bids. Of course, the public ends subsiding contractors because it pays reimbursement to those offshore subsidiaries that do make FICA payments. So in the end the only people who suffer, besides taxpayers, are workers who don’t make Social Security, Medicare, and similar contributions.

This is just another example of shifting risk and burden to the lowest level of contractors, those actually working on the ground.

This may be legal, but it is certainly unpatriotic. And it does not represent a cost saving, merely a cost shifting, and very likely a cost increase over having government workers do government work.