Just as ludicrous is that it’s over 18 months since President Trump promoted a law designed to undermine this sort of tax management. This aimed to take away the incentive to shelter profits overseas, and involved cutting US corporate tax from 35 per cent to 21 per cent. It was said that corporations would repatriate three trillion dollars worth of “trapped” offshore profits into the US Treasury.
According to Mr Seltzer, it hasn’t worked – for the simple reason that there never was such a physical stash of profits sitting in far off tax havens. Much of the cash was sitting in the US all along – in bank accounts, securities and US Treasury bonds. Little has changed. Companies can continue to route their global sales through Ireland, for example, then pay royalties to their Dutch subsidiaries and funnel their profits into their Bermudan subsidiaries, where the corporate tax rate is zero. The key word here is “royalties”. By transferring intellectual property (such as the rights to software or to a drug formula) to offshore subsidiaries, companies can not only reduce their tax liability in a high tax jurisdiction but also use this IP to back bonds issued domestically. For example, Mr Setzer says, Pfizer could pay Apple onshore for a bond sold to Pfizer’s offshore account, or vice versa. The cash comes home. The profits remain abroad.
Tax: a mulled whine?
“Not only US corporations benefit from such loopholes,” Martin Wolf, the internationally renowned economist and chief economics commentator of the Financial Times, wrote recently. Other observers such as Dame Margaret Hodge, the former Labour MP, have been more explicit. Companies (legally) “create an artificial structure of companies across the world with the sole purpose of shifting profits out of the UK to avoid paying tax”, she says in her book Called to Account. Both Mr Wolf and Dame Margaret argue that tax planning is one of the causes of wealth inequality.
The underlying dilemma is where the boundary between tax efficiency and tax avoidance lies as companies adapt to minimise their tax liabilities within changing tax rules. Is such tax planning always ethical?
National champions de-moated?
Some years ago, Mr Wolf was an advocate of free trade and globalisation, but these days he’s more concerned about their negative impacts. He points out that while acquisitions by dominant companies might broaden or deepen their market positions, they also frustrate competitive challenges. In a recent article ('How to reform today’s rigged capitalism'), he says that “in the past decade, Amazon, Apple, Facebook, Google, and Microsoft combined have made over 400 acquisitions globally” and that again, this is not just a US phenomenon: “lack of competition…” he says, “has led to higher prices, lower investment and lower productivity growth”. Consumers and workers lose out. Shareholders gain.
The implied message is that pressure is mounting on governments to toughen competition constraints. Such a tightening could make it harder for companies to preserve their dominance through strategic acquisitions. Their moats, which protect them against incursions from competitors, might in time become less watertight.
The problem is that competition rules are needed to block oligopolies. But for the UK, which is preferable – to encourage companies to become national champions so that they can compete globally (even if that means that they have a dominant domestic position) or to constrain them so that they face more competition in the home market (to keep prices down and encourage more domestic investment)? We can’t always have it both ways. The ethical dilemma: for individual companies, are their moats, so popular with value investors, for the common good or just for theirs?
Uneasy money
According to Mr Wolf, another cause of income and wealth inequality is the ready availability of credit. Accounting conventions treat interest as a cost, so the higher the level of interest, the lower the level of profits – and, since companies are taxed on profits, the lower the tax bill.
That can distort behaviour. It encourages some companies to flatter their earnings per share by borrowing instead of issuing more shares – or alternatively, borrowing to buyback their own shares. Or to borrow in a high tax jurisdiction and keep cash in a low one. As it becomes easier to borrow, he argues, the financial sector reaches a point beyond which the “sector’s ability to create credit and money finances its own activities” – and this diverts investment into non-productive areas. Throw in almost non-existent interest rates and it’s an incentive for one company to borrow to take over another.
In short, too much credit hampers the growth of productivity. He believes that we are in that situation now – there’s simply too much readily available credit and debt in the system. His solution? Eliminate the tax-deductibility of interest so that debt finance is put on a par with equity.
Easy credit leads to another effect. It helps private equity to buy publicly listed companies – and then to gear them up with debt. And it helps private equity finance unlisted companies that otherwise might have floated on the stock market. There are fewer publicly quoted companies because more of the economy is being diverted into private equity. Private equity is free from much of the public scrutiny (and the resulting bureaucracy) that constrains public companies – and this greater freedom raises another issue: public and private companies hardly compete now on a level playing field.
The dilemma is whether the market is currently distorted by the tax treatment of debt. Some companies might need to borrow to grow; others to survive, but in either case, their profits are likely to be low or negative anyway. Others might regard borrowing as something that they have to do as a defence against predatory third parties who themselves are high on debt. Whatever the reason, some companies are habitually highly geared (see table).
If companies were taxed on their profits after their interest costs had been added back on, some might initially cut back on investment, but if that also applied to their competitors, it could strengthen competitive moats. Over time, would the positive benefits outweigh the negative ones?
A new year resolution?
At this time of year, most company directors and executives are in the process of reviewing their strategies for the coming year. But at the moment, the timing makes long-term planning a challenge, for if new governments are to make dramatic changes, they need to get them in relatively early in the electoral cycle. What exactly they’ll be remains to be seen. There’s also the uncertainty of trade deals – how long will they take and how will they pan out? The aim of trade deals is to open up more favourable export markets – but that cuts both ways: one country’s exports are another country’s imports. Some sectors can expect more competition. In the meantime, all companies can do is to be prepared to adapt.
The recent election result was achieved on the back of raising expectations that inequality would reduce. However the new government responds, companies can expect increased resentment whenever the gap between executive and employee pay is publicised. UK public companies can also expect further pressure from commentators and politicians to improve their environmental, social and governance values (ESG) – even though there seems to be less concern about ESG in privately owned companies.
So back to those dilemmas. Will initiatives to tackle inequality succeed as long as those three factors that Mr Wolf has identified (distorted tax structures, out-of-balance competition, and too much easy credit) persist? He says that “what we increasingly seem to have is an unstable rentier capitalism, weakened competition, feeble productivity growth, high inequality and, not coincidentally, an increasingly degraded democracy”. If this view has any traction at government level, its response could have implications on how companies operate.
Companies manage significant changes through internal consultations and often after pilot schemes. Governments normally put theirs out for external consultation, but there’s always the temptation to cut corners. That’s a risk, but it could leave wriggle room for companies, since, as Mr Trump demonstrated with his US tax law, unless governments get to the bottom of the problem, they won’t come up with effective solutions.
