WASHINGTON - In March 2005, one of the Pentagon's most trusted contractors - Virginia-based MPRI, founded by retired senior military leaders - won a $400 million contract to train police in Iraq and other hotspots. Two months later, MPRI set up a company in Bermuda to which it subcontracted much of the work.
It was not the first time that MPRI executives had used a shell company in an offshore tax haven to perform government-funded work. A year earlier, MPRI headed a joint venture that won a $1.6 billion contract to provide US peacekeeping forces in Kosovo and elsewhere. Three months later, MPRI set up a company in the Cayman Islands to do the work.
Like MPRI's Bermuda subsidiary, the Cayman Islands company appears to have no phone number, website, or staff of its own there.
Rick Kiernan, an MPRI spokesman, declined to explain why the company created the two offshore entities and stressed that MPRI operates in "total adherence or compliance with the current law."
But tax lawyers say that MPRI appears to be avoiding the payment of roughly $4 million dollars a year in Social Security and Medicare taxes for the police-training contract alone and is sidestepping scrutiny by hiring workers through offshore entities based outside the jurisdiction of the Internal Revenue Service.
"The employer is trying to take itself out of the audit reach of the IRS," said California-based tax lawyer James R. Urquhart III.
If MPRI had not set up the shell company, it would have been vulnerable to an audit, tax specialists said, because it classifies a significant portion of its roughly 400 American police trainers and advisers working in Iraq and elsewhere as self-employed independent contractors, a practice that allows MPRI to avoid paying Social Security, Medicare, and unemployment taxes.
As a result, workers cannot receive unemployment compensation when their jobs end and may be deprived of other protections under US law.
"They are taking steps to reduce the audit risk," said H. David Rosenbloom, director of the International Tax Program at New York University Law School. "If there is concern about the classification [of workers], as there undoubtedly is, from the company's standpoint they are better off being in a foreign corporation."
Workers classified as self-employed must pay Social Security and Medicare taxes themselves, the equivalent of 15.3 percent of their salaries. If they were classified as employees of MPRI, rather than independent contractors, they would split the cost with their employer.
But sometimes the taxes are not paid at all. A former MPRI worker in Iraq said he was unaware of his tax obligations and did not pay self-employment tax for an entire year on his salary of $154,000. Such levies are very difficult for the IRS to collect, specialists say, and frequently go unpaid.
To combat the problem, the IRS has aggressively audited companies registered in the United States that try to avoid payroll taxes by reporting their workers as independent contractors. The IRS conducts a rigorous test to determine whether a worker is genuinely self-employed and applies heavy penalties to companies that misclassify their workers.
But the IRS cannot conduct audits on overseas employers, such as the shell companies that MPRI set up in Bermuda and the Cayman Islands.
Companies that use such offshore entities to avoid taxes, even as they profit from lucrative federal contracts, have captured the attention of Congress in recent months.
After a Globe article in March detailed how former Halliburton subsidiary KBR avoided hundreds of millions of dollars in payroll taxes by hiring employees through a Cayman Island shell company, the House of Representatives passed a bill prohibiting the practice. Senator John F. Kerry of Massachusetts and Senator Barack Obama of Illinois are cosponsoring a similar effort in the Senate, and they have called on a Senate subcommittee to investigate the practice.
Two weeks ago, Representative Henry Waxman, a California Democrat who heads the House Oversight Committee, launched an investigation, sending letters to 15 federal contractors seeking information about their offshore subsidiaries.
But the business community has begun to defend the practice.
"There is nothing wrong with tax avoidance, particularly for work that is done outside the United States," said Alan Chvotkin, executive vice president of the Professional Services Council, a trade association of companies that perform government work.
Initially, a spokesman for L-3 Communications, the defense giant that owns MPRI, told the Globe that L-3 does not use offshore subsidiaries to hire its American workers.
But a Globe investigation found that MPRI, which L-3 acquired in 2000, hires roughly 400 American workers through its Bermuda shell company, called MPRI International Services. Some workers are classified as employees of the Bermuda company, allowing both the workers and MPRI to avoid paying payroll taxes, resulting in a net loss to Social Security and Medicare funds.
Others are hired as independent contractors, a practice that forces the worker to shoulder the entire tax burden and makes it more difficult for the IRS to collect. Classifying workers as independent contractors has enabled MPRI and some other defense contractors working in Iraq to hire and fire more easily and to avoid some legal obligations to its workers.
Georgetown professor Albert Lauber said it is unlikely that police trainers in Iraq would pass the IRS test for self-employment. He said that genuine independent contractors come into a job with their own equipment, require little training and oversight, and generally get the job done on their own schedule.
MPRI's police trainers, who asked not to be identified, said they do not work that way. One former trainer working for MPRI in Iraq said that police trainers in Baghdad received letters at the end of 2005 saying that they might experience a brief disruption in their payments because "payroll was being moved to Bermuda to satisfy US tax code."
The letters became a running joke among the trainers. "We said, 'What do you mean, to avoid tax codes?' " the former trainer recalled.
Independent contractors living overseas are required to pay self-employment tax, regardless of whether they work with a foreign company or a domestic one. But those taxes often go unpaid when work is contracted through foreign companies that provide no documentation to the IRS.
The former trainer said that during 2005 he paid no payroll taxes and was given no record of his salary, which was directly deposited into his bank account. MPRI provided him with so little salary documentation, he said, that he had difficulty refinancing his home and was confused about his tax obligations.
The following year, he said, MPRI gave him a 1099 form, which American companies are required to provide to self-employed contractors. The trainer said he then paid self-employment tax on his work in 2006.
MPRI remains one of the Pentagon's most favored contractors. Founded in 1987 as Military Professionals Resources, Inc., the company has maintained such close ties with the US armed forces that it once ran the ROTC training programs in more than 200 universities, and it still recruits soldiers for the US military.
Federal contracts helped MPRI grow from a company of a few hundred people in 1997 to nearly 3,000 worldwide. MPRI is a cornerstone of L-3's government services companies, which take in more than $2 billion in annual revenues.
MPRI has had close ties to the US reconstruction effort in Iraq. Jay Garner, the retired US Army general who was the Bush administration's first leader of US-occupied Iraq, had been president of Virginia-based SYColeman, another L-3 subsidiary. One of Garner's top aides in Iraq, retired Army Lieutenant General Jared Bates, took a leave of absence from his job as senior vice president and general manager of MPRI's National Group to serve in Iraq and later became president of SYColeman.
Following the US invasion in 2003, MPRI received a contract to build a training center for the new Iraqi Army. At the time, MPRI's workers in Iraq were employed directly through the company, said Kiernan, the MPRI spokesman.
In 2004, MPRI joined with KBR and two other federal contractors to form Civilian Police International, a joint venture that successfully bid on a $1.6 billion State Department contract to deploy US peacekeepers around the world.
Three months after winning the contract, MPRI formed CPI Police Services Ltd. in the Cayman Islands. More than 200 Americans, mostly retired police officers, work in Kosovo and Afghanistan in full-time posts under the State Department contract, according to State Department officials.
Rex Estilow, president of Civilian Police International, referred all inquiries to Kiernan, who declined to explain why the Cayman Islands entity was set up. "We don't discuss our specific modus operandi," Kiernan said.
MPRI's use of offshore shell companies has received little notice from the agencies that pay for their services. State Department officials say that their contractors have a right to subcontract work, even to their own wholly-owned subsidiaries set up in offshore tax havens.
"A contractor generally has the right to retain and terminate subcontractors as it deems necessary," a State Department official said in an e-mail response to a Globe inquiry.
The US Army, for its part, also has declined to condemn the practice.
"We know that it is a practice that goes on," said Jeffrey Parsons, director of contracting for the Army Materiel Command. "I would not say anyone encourages it, but there are no rules or pratices that would prohibit it. I think that is why Congress is weighing in."
© 2008 The Boston Globe