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Should investors care about corporate tax avoidance?

The recent UK public furore on corporate tax treatment means investors should have a perspective.

It was never going to be an edifying spectacle. The occasion: the UK Public Accounts Committee, 12th November 2012. The topic of debate: tax. More specifically, tax avoidance: the legal act of using loopholes, tax havens and other devices to reduce a corporation’s tax bill. Corporate executives from Amazon, Google and Starbucks were summoned to explain why, despite an enormous amount of trading activity over many years, their companies have had to pay remarkably little by way of corporation tax. Not to be confused with tax evasion (the illegal practice of knowingly misleading authorities on tax owed), tax avoidance takes many forms. For multinational companies, the basic premise is to channel the maximum income possible out of high tax jurisdictions and into countries with lower tax rates. One method used by web-based businesses is registering the main sales office in a country with low taxes. Another common practice is to use internal pricing transfers. Companies often have centralised divisions that purchase key products for the whole business. OECD recommended practice is to sell these products on internally at market rates. This establishes a realistic price for inter-company trades. But by charging higher prices (Starbucks adds on 20% to inter-company coffee trades) and situating the centralised procurement business in a low tax region, companies can route revenue away from high tax countries and reduce the amount of net income exposed to higher rate taxes. Royalties – such as payments for brand rights and access to proprietary technology – operate along the same lines. Holding companies that own a brand’s intellectual property can be set up in tax havens to help channel funds into operations subject to low levels of tax. Another common feature is to charge high interest rates on inter-company loans fromoperations in tax havens to those in high tax countries. Again, the purpose is to channel maximum funds into low tax regions. These methods came to light during the Public Accounts Committee hearing, but they are commonly practiced by many multinationals. Amazon, Google and Starbucks are indicative of a much larger trend.
Why should investors care? The usual argument against investor action on tax avoidance is that companies exist to generate returns for shareholders so tax minimisation is in investors’ interests. Of course there is undeniable merit to this as an amoral argument, but the logic only stands up in isolation from its wider effects. Firstly, investors advocate corporate transparency: it allows for a deeper understanding of the business and greater accountability on how the company is being managed. Tax havens often have laxer reporting requirements and closed banking arrangements, resulting in a ‘lack of transparency and effective public oversight (1), so the use of tax havens is concerning from a governance perspective. More worrying still is how income is used once it reaches a tax haven. US companies defer sending profit back to head office due to the high rates of tax payable once it hits home shores. The US corporate tax rate is 35%. Companies would rather keep ‘cash in foreign holding companies or reinvest the earnings in foreign markets than pay the repatriation tax to make investments in the U.S. or pay a dividend to the shareholders. (2) The impact of what’s become known as stateless income (3) is not yet fully understood (4). It is clear that investors are locked out of receiving it directly but there may be indirect benefits, depending on how the funds are used. Nevertheless, the trend warrants further investigation on the potential implications for investment returns. (It also undermines the idea of a company having a home nationality. This is particularly the case for
web-based businesses, like Amazon or Google, and leads to a lack of clarity on where taxes should be paid.) Secondly, what’s interesting about the latest protestation on corporate tax is that it is, in part, coming from business itself (5). Companies that feel they pay their share, or that operate simpler corporate structures – like operating only in one country with minimal opportunity to shift revenue across boarders – are decrying the unfair advantage enjoyed by their global counterparts. Investors in UK-only companies (and that includes us) should be concerned that investments could be negatively affected by an uneven competitive landscape. Similarly, the indirect impacts of suppressed corporate tax revenues into the Exchequer may also have ramifications for our investment portfolio, for example with investee companies delivering large government contracts. Thirdly, high risk tax strategies can have high impact consequences. Laws can change, loopholes can close and tax havens can become more willing to share information with the international community. As Starbucks has shown, an aggressive avoidance policy, though legal, can affect company performance if disappointed customers decide to take their business elsewhere. To date there’s been little appetite from successive UK governments to tighten up tax laws and the majority of consumers have been happy to enjoy the reduced prices that result from tax avoidance. That is changing. In the UK and Europe, the direction of travel is towards tighter tax rules. The UK is introducing a General Abuse Avoidance Principle. The European Commission is considering legislation that would require the extractives industry to report country-by-country on tax payments and indications suggest that it could be rolled out to other sectors over time. All of this points to greater public scrutiny of corporate taxes in the yearsahead. Finally, it’s easy to forget that corporate taxes contribute to social structures that support a successful and sustainable company. The tax system educates a future workforce, tops up wages of low income employees and operates a judicial system that upholds the rule of law. The benefits of the tax system are a key reason why companies choose to do business in developed Western economies. Companies and investors alike have a shared, vested interest in maintaining the state functions that they derive benefit from. We foresee that companies will continue to minimise their tax payments to the greatest extent possible under a traditional interpretation of their duty to shareholders, if legitimate means exist and if the level of reputational risk is manageable. There is a school of thought that ‘gaming’ is not only endemic but a perfectly respectable response to a taxation system. It’s the job of the taxed to legally minimise their payments. It’s the job of tax collectors to close loopholes, enforce legislation and ensure a level playing field as far as possible. But, the largest companies can afford to hire the best tax brains whose job it is to find novel ways of minimising tax liability, often exercising considerable creativity (after a fashion) in creating purpose-built vehicles. As such, tax avoidance is most effectively tackled at government level via legislative changes. In particular, bilateral tax agreements need to be updated to reflect the growth of internet-based businesses. It’s a generally held principle that tax is payable in jurisdictions where profits are generated from trading. This is easy to identify with physical transactions, but much harder with web-based services (6). Ideally, we would like to see greater international co-operation on tax, so as not to unfairly advantage or disadvantage any country for acting unilaterally. However, we recognise the difficulty in
gaining multi-lateral consensus on reform, particularly from countries that derive great economic benefit from their status as low tax jurisdictions.
The Co-operative Asset Management is keen to hear from any investors interested in a collaborative engagement on greater transparency
in corporate tax reporting. Please contact Ita McMahon for further details.

*Ita McMahon is a Responsible Investment Analyst at The Co-operative Asset Management*Footnotes: