In part two, I review common techniques for companies to protect profits in low-tax havens overseas, and why ESG investors may want to push for more transparent jurisdictions through jurisdictional data. I propose a tentative example of what such disclosures should look like.
Overseas tax avoidance
Tax shenanigans in foreign havens are usually only exposed when there are congressional hearings or disruptive events like the Paradise papers hack. People rarely, if ever, spot tax shenanigans through tax footnotes in corporate 10-Ks.
I discovered congressional hearings in November 1999, November 2003, April 2005, and November 2012 related to offshore tax avoidance. Corporate tax abuses that have come to light primarily as a result of such hearings, congressional studies, and hacks include:
· According to the New York Times, between 2009 and 2012, Apple’s tax avoidance diverted at least $74 billion, leaving the IRS out of control.
· Nike has reportedly shifted substantial profits to zero-tax Bermuda. The mechanism used is very common among US multinational corporations that own some form of intellectual property (IP). Nike has registered intellectual property rights related to its logo, brand and footwear designs with its Bermuda subsidiary. The subsidiary uses a “transfer price” to charge Nike’s subsidiaries in other parts of the world for the use of that intellectual property, allowing Nike to actually pay less tax in the countries where it sells the product, and pay less on its zero. accumulating profits in the Bermuda subsidiary.
With no liquid market for Nike’s logo and branding, no one really knows what transfer price would be appropriate so that the overseas subsidiary can fairly compensate the Bermuda subsidiary that holds the intellectual property. As such, it can be expected that the Nike Bermuda will charge a transfer price at the higher end of the range. On top of that, the marketing and brand IP must have been created here in the US, as the Bermuda subsidiary likely didn’t employ Nike’s top Nike marketing managers. My guess is that the ad agency that planned the ad campaign for Nike is not based in Bermuda either.
· Google’s “Dutch sandwich” arrangement even helped the company avoid low taxes in the overseas tax haven of Ireland. This starts with the standard strategy of keeping the intellectual property in Ireland and thus accumulating income in that low tax subsidiary. To minimize Irish withholding taxes, payments from Google’s Dublin unit are not routed directly to Bermuda. Instead, they were rerouted to the Netherlands because Irish tax law exempts companies from other EU member states from certain royalties. The fees flow first to the Dutch subsidiary Google Netherlands Holdings BV, which pays almost all of the receipts to the Bermuda entity. The Dutch subsidiary reportedly has no employees!
· Two other commonly used techniques are debt and earnings stripping. The idea is to borrow more in high-tax areas and less in low-tax areas. Therefore, profits can be shifted from a high-tax regime to a low-tax regime. A related practice is earnings stripping, whereby a foreign parent company can extend loans to its U.S. subsidiary. Alternatively, unrelated foreign borrowers who are not taxed on U.S. interest income may make loans to U.S. companies. Thus, interest expense is accounted for in the high-tax U.S. jurisdiction, while interest income is collected in the low-tax foreign jurisdiction.
· Another commonly used technique is the “tick box” clause. A subsidiary of a US parent company in a low-tax country can lend to its subsidiary in a high-tax country, and the interest can be deducted from US taxes because the high-tax country recognizes the company as an independent company. Generally, interest received by a subsidiary in a low-tax country will be considered passive income or income subject to prevailing U.S. taxation.
However, under the tick-box rules, a high-tax corporation can elect to be disregarded as a separate entity by “checking the box” on the form. So, from a US perspective, there will be no interest income payments because the two are the same entity. A congressional research paper suggests that check boxes and similar hybrid entity operations could also be used to avoid other types of revenue, such as that from contract manufacturing arrangements.
· The cross credit method can also help US corporations to reduce taxes. Income received in the U.S. from a low-tax country can be tax-evaded by cross-crediting: using excess foreign tax paid in one jurisdiction or on one income to offset U.S. tax that would otherwise be payable on other income.
A careful reading of the 10-Ks of the aforementioned companies would blind informed investors to the fact that the companies actually execute such tax avoidance strategies.
I’ve even heard from colleagues that it’s best for investors to be unaware of such plans, since the job of the CEO and the board is to minimize the taxes paid, thereby maximizing net income. I find this objection strange. To the extent that disclosure would assist an informed investor in predicting future after-tax cash flows or after-tax income or the uncertainty associated with such future after-tax cash flows and income, I suggest that investors have a right to know. If nothing else, avoid the risk of embarrassing headlines from the media or NGOs (Non-Governmental Organizations) who follow such shenanigans. More relevant to ESG investors, the best ESG a US company can perform is paying its fair share of taxes.
What if something could/should/have been done?
Publication of public company tax returns
Many of these issues could be resolved relatively easily if public companies released their tax returns, or if Congress or other regulators required public companies to do so, as I’ve argued before. That’s especially important because investors know little about the tax-planning tactics multinationals use to park profits in overseas tax havens.
For example, Ford did disclose that “as of Dec. 31, 2021, $16.7 billion of non-U.S. earnings were deemed reinvested indefinitely in non-U.S. operations for which no tax deferred was provided.” Essentially Technically, $16.7 billion is stashed overseas, and Ford’s tax-spending figure doesn’t include potential future tax liabilities it would have to pay to the IRS if those profits were brought back to the United States. It’s also not obvious which of the enumerated techniques (transfer pricing, low-tax-haven intellectual property, check-box clauses or debt or earnings stripping, cross-credit, or some other technique) were used by Ford.
More Detailed GAAP Disclosures
The compromise is for better disclosure of taxes to track revenue, costs, interest, and thus taxes across multiple geographic jurisdictions. GRI (Global Reporting Initiative) proposes the following set of disclosures. I believe this collection is a good starting point for conversations around eventual rulemaking.
In particular, clause 207-4 of the GRI document sets forth the following disclosures:
A sort of.all tax jurisdictions If the entity included in the organization’s audited consolidated financial statements or publicly recorded financial information is a tax resident.
b. For each tax jurisdiction reported in Disclosure 207-4-a:
· The name of the resident unit;
· The main activities of the organization;
· the number of employees, and the basis for calculating that number;
· Third-party sales revenue;
Income from intra-group transactions with other tax jurisdictions;
· Pre-tax profit/loss;
· Tangible assets other than cash and cash equivalents;
· Corporate income tax paid in cash;
· Corporate income tax on accrued profits/losses;
· Reasons for the difference between the corporate income tax accrued at the statutory tax rate and the tax payable on profit and loss before tax.
Additionally, for each taxing jurisdiction reported in Disclosure 207-4-a, the company will report:
· The total salary of employees;
· Withholding and payment of taxes;
· Taxes collected from clients on behalf of the tax authorities;
· Industry-related and other taxes or payments to governments;
· Significant uncertain tax position;
· The balance of intra-company debt held by entities in the tax domain and the basis for calculating the interest rate on debt payments.
The GRI Standards are a good start, but more work is needed to modify or expand these disclosure requirements to address specific tax avoidance schemes that are common under US tax law.
EU Country Reports
New EU rules will soon require multinationals with consolidated revenues of 750 million euros to report whether their parent company is EU or have a certain size of EU subsidiary or branch. The rule will put many American multinational companies with large operations in the EU in trouble.
The report will request information from all members of the group (i.e. including non-EU members) in seven key areas: activity profile, headcount, net turnover (including related party turnover), profit and loss before tax, accrual and disbursement of profit before tax , and finally the amount of cumulative benefit. If there are material differences between the reported amount of income tax accrued and the amount of income tax paid, the report may include a general statement explaining these differences.
On the surface, the EU’s requirements look looser than the GRI grid discussed in the previous paragraph, but in the case of EU subsidiaries or US multinationals, the EU structure has the advantage of being law. Marcel Olbert of the London Business School notes that country-by-country reporting helps users find cases where pre-tax profitability is much higher (by employees or as a percentage of turnover), especially in Hong Kong, Luxembourg, and the Cayman Islands versus Germany, compared to major mainstream markets such as the UK, UK or the US.
While I agree with Marcel, I see at least three limitations to the EU’s CbCR proposal. First, I’m not sure whether the country-by-country proposals would allow investors and users to clearly identify transfer pricing shenanigans. This is partly because companies are required to provide accounting income rather than income, information that remains confidential, on country-by-country tax returns.
Second, the reliance on pre-tax profits in the EU reporting structure masks the legitimate interest expense of intercompany interest charges, which may be a tax strategy. In addition, pre-tax accounting income typically includes multiple one-time charges or benefits or income that are not related to transfer pricing.
Third, in the EU it remains difficult to combine the rate reconciliations and movements of the deferred tax asset and liability accounts with national data. That said, tax shenanigans reflected in tax accounts rather than GAAP financial statements will continue to be invisible under the EU system.
The only real answer to this question is to require public companies to release their tax returns. EU reporting by country is a good start and GRI’s model outperforms country and country reporting.
All in all, I hope I’ve convinced you that we need better corporate tax-related disclosures than we currently have. An informed investor wants some clarity to be able to project a sustainable effective tax rate so that she can project future after-tax cash flows and after-tax income. ESG investors may need more detailed jurisdictional data to assess the exact nature of tax avoidance practiced by US companies, especially multinationals.
As I say in class, the best ESG a company can do is pay its fair share of taxes!