In Part II, I review the commonly used corporate techniques to shelter profits in overseas low tax havens and why an ESG investor might want to push for more transparent jurisdiction by jurisdiction data. I suggest a tentative role model of what such disclosures should look like.
Tax shelters overseas
Tax shenanigans in shelters abroad usually come to light only when congressional hearings are held or a disruptive event such as the Paradise paper hack happens. One can rarely, if ever, discover tax shenanigans via the tax footnote in a company’s 10-K.
I found congressional hearings related to overseas tax shelters in November 1999 and November 2003 April 2005, and November 2012. The corporate tax abuses that came to light mostly because of such hearings, congressional research and hacks include:
· Apple’s tax avoidance efforts shifted at least $74 billion from the reach of the Internal Revenue Service between 2009 and 2012, as per the New York Times.
· Nike is reported to have moved substantial profits to zero tax Bermuda. The mechanism used is pretty common among US multinationals that have some form of intellectual property (IP). Nike registers IP related to its logo, branding, and shoe designs in its Bermudian subsidiary. That subsidiary charges Nike subsidiaries in the rest of the world using “transfer prices” for using that IP allowing Nike, in effect, to pay less tax in the countries where it sells its products and accumulate profits in its zero tax Bermudan subsidiary.
Because there is no liquid market in Nike’s logo and branding, no one really knows what transfer price is appropriate such that overseas subsidiaries can fairly compensate the Bermudan subsidiary that holds the IP. Hence, one can expect Nike Bermuda to charge a transfer price at the higher end of the range. On top of that, the marketing and branding IP was surely created here in the US as the Bermudan subsidiary most likely does not employ Nike’s top marketing managers of Nike. My guess is that the advertising agency that plans ad campaigns for Nike is not located in Bermuda either.
· Google’s “Dutch Sandwich” arrangement helps the company avoid even the low taxes charged by Ireland, an overseas tax haven. This begins with the standard strategy of leaving IP in Ireland and hence accumulating income in that low tax subsidiary. To minimize Irish withholding tax, payments from Google’s Dublin unit don’t go directly to Bermuda. Instead, they are rerouted to the Netherlands because Irish tax law exempts certain royalties to companies in other EU-member nations. The fees first go to a Dutch unit, Google Netherlands Holdings B.V., which pays out about almost all its collections to the Bermuda entity. The Dutch subsidiary tellingly has no employees!
· Two other techniques commonly used are debt and earnings stripping. The idea is to borrow more in the high-tax jurisdiction and less in the low-tax one. Thus, profits can be shifted from the high tax regime to a low tax one. A related practice is earnings stripping, where a foreign parent may lend to its US subsidiary. Alternatively, an unrelated foreign borrower not subject to tax on US interest income might lend to a US firm. Hence, interest expenses are booked in the high tax US jurisdiction whereas interest income is collected in the low tax foreign jurisdiction.
· Another technique commonly used is the “check the box” provision. A US parent’s subsidiary in a low-tax country can lend to its subsidiary in a high-tax country, with the interest deductible for US tax purposes because the high-tax country recognizes the firm as a separate corporation. Normally, interest received by the subsidiary in the low-tax country would be considered passive or income subject to current US tax.
However, under check-the-box rules, the high-tax corporation can elect to be disregarded as a separate entity by literally “checking the box” on a form. Thus, from the perspective of the US, there would be no interest income paid because the two are the same entity. A Congressional research paper suggests that check-the-box and similar hybrid entity operations can also be used to avoid other types of income, for example, from contract manufacturing arrangement.
· A cross-crediting approach can also help a US firm cut taxes. Income from a low-tax country that is received in the United States can escape taxes because of cross crediting: the use of excess foreign taxes paid in one jurisdiction or on one type of income to offset US tax that would be due on other income.
A close reading of a 10-K of the companies mentioned above will leave the informed investor quite clueless about the actual execution of such tax avoidance strategies by the company.
I have even heard from colleagues that investors are better off not knowing about such schemes as the CEO and the board’s job is to minimize taxes paid and hence maximize net income. I find this objection bizarre. As long as disclosures assist an informed investor to forecast future after tax cash flows or after-tax income or the uncertainty associated with such future after tax cash flows and income, I would suggest the investor has a right to know. If nothing else, to avoid headline risk of being embarrassed by the press or by an NGO (non-governmental organization) that tracks such shenanigans. More pertinent to an ESG investor, the best ESG a US company can perform is to pay its fair share of taxes.
What if anything can/should be/has been done?
Publish public company tax returns
A lot of this hand wringing can be addressed relatively easily if public companies publish their tax returns or if congress or other regulators would make public companies do so, as I have argued before. This is especially important because the investor knows next to nothing about tax planning strategies used by multinationals to squirrel away profits in overseas tax havens.
For instance, Ford does disclose that “at December 31, 2021, $16.7 billion of non-U.S. earnings are considered indefinitely reinvested in operations outside the United States, for which deferred taxes have not been provided.” In essence, $16.7 billion is stashed away overseas and Ford’s tax expense number does not include potential future tax liabilities that will have to be paid to the IRS (Internal Revenue Service) if such profits were brought back to the US. It is also not obvious which of the enumerated techniques (transfer pricing, IP in low tax havens, check the box provision or debt or earnings stripping, cross crediting or some other technique) was used by Ford.
More detailed GAAP disclosures
A compromise is to ask for better tax disclosures to track revenues, costs, interest and hence tax across several geographical jurisdictions. The GRI (Global Reporting Initiative) has proposed the following set of disclosures. I believe that set is a great starting point for the conversation around eventual rule making.
In particular, clause 207-4 of the GRI’s document proposes the following disclosures:
a. All tax jurisdictions where the entities included in the organization’s audited consolidated financial statements, or in the financial information filed on public record, are resident for tax purposes.
b. For each tax jurisdiction reported in Disclosure 207-4-a:
· Names of the resident entities;
· Primary activities of the organization;
· Number of employees, and the basis of calculation of this number;
· Revenues from third-party sales;
· Revenues from intra-group transactions with other tax jurisdictions;
· Profit/loss before tax;
· Tangible assets other than cash and cash equivalents;
· Corporate income tax paid on a cash basis;
· Corporate income tax accrued on profit/loss;
· Reasons for the difference between corporate income tax accrued on profit/loss and the tax due if the statutory tax rate is applied to profit/loss before tax.
In addition, for each tax jurisdiction reported in Disclosure 207-4-a, the company will report:
· Total employee remuneration;
· Taxes withheld and paid on behalf of employees;
· Taxes collected from customers on behalf of a tax authority;
· Industry-related and other taxes or payments to governments;
· Significant uncertain tax positions;
· Balance of intra-company debt held by entities in the tax jurisdiction, and the basis of calculation of the interest rate paid on the debt.
The GRI standard is an excellent start, but more work needs to be put in to modify or extend these disclosure requirements to address the specific tax avoidance schemes common under US tax laws.
EU’s country by country reporting
The EU’s new rules will soon require multinationals with a total consolidated revenue of EUR 750 million to report either if they are EU parented or otherwise have EU subsidiaries or branches of a certain size. The rule will ensnare quite a few US multinationals with large EU operations.
The report will require information on all members of the group (i.e., including non-EU members) within seven key areas: brief description of activities, number of employees, net turnover (including related party turnover), profit or loss before tax, tax accrued and paid, and finally the amount of accumulated earnings. To the extent there are material discrepancies between reported amounts of income tax accrued and income tax paid, the report may include an overall narrative providing the explanation for these discrepancies.
On the surface, the EU requirement looks laxer than the GRI grid discussed in the previous paragraph, but the EU structure has the advantage of already being law as far as EU subsidiaries of US multinationals are concerned. Marcel Olbert of London Business School points out that the country-by-country reporting helps users spot cases where the pre-tax profitability is much higher (by employee or as a percent of turnover) especially in tax havens such as Hong Kong, Luxembourg, and the Cayman Islands compared to major mainstream markets such as Germany, U,K or the US.
While I agree with Marcel, I see at least three limitations of the EU’s country-by-country reporting proposal. First, I am not sure the country-by-country proposal allows investors and users to clearly identify transfer-pricing shenanigans. This is partly because firms are required to present accounting income as opposed to income as per the tax return by country, which is information that continues to be confidential.
Second, reliance on profit before tax in the EU reporting structure obscures legitimate interest expenses from intercompany interest charges, which are potentially tax maneuvers. Moreover, pretax accounting income usually contains several one-time charges or gains or income that may have nothing to do with transfer pricing.
Third, it continues to be difficult, in the EU, to tally the rate reconciliation table and movements in deferred tax asset and liability accounts with country-by-country data. That is, tax shenanigans reflected in tax accounts not in GAAP financial statements will continue to be invisible under the EU system.
The only real answer to this problem is to ask public firms to publish their tax returns. The EU country by country reporting is a good start and the GRI’s model is better than the country and country reporting.
In sum, I hope I have convinced you that we need far better disclosures related to corporate taxes relative to what we have today. An informed investor would like some clarity to be able to forecast a sustainable effective tax rate so that she can forecast future after tax cash flows and after-tax income. An ESG investor might want more detailed jurisdiction by jurisdiction data to assess the exact nature of tax sheltering practiced by US companies, especially multinationals.
As I say in class, the best ESG a company can do is to pay its fair share of taxes!