Tuesday, October 16, 2018

The household sector accounts make sense again

It’s a well-worn path that Ireland’s national accounts are so heavily distorted by the impact of MNCs that getting any reliable signal from some of the most commonly-used aggregate measures is close to impossible.  The work of the CSO has led to the publication of some bespoke measures from the Irish accounts such as GNI* and CA* that strip away some of the distortions.  These have been welcome additions to the accounts.

Within the accounts themselves the household sector may be a good place to look for underlying trends.  The outcomes for the household sector should reflect many of the underlying trends in economy for incomes, spending, saving, investment and borrowing.

About 18 months ago we did a deep dive and pulled together a coherent narrative from the accounts. In summary, household current spending (consumption) and capital spending (capital formation) was below household income so that the household sector was an aggregate net lender and was using these funds to repay loan liabilities. 

But then, this time last year, the apparent coherence was revised away and the figures at that time reported the household sector to have been a net borrower since 2014.  We returned to this a few times (here, here, here and here). 

At the time we were still waiting to get a clear view of CA* so the net lending/borrowing position of the household sector would have been an important indicator when looking for signs of pressures in the economy.  Except, after last year’s revisions, it didn’t make sense.  But this has now been restored.

If we go all the way to the bottom line we can see the result of the latest revisions.

Household Sector Net Lending Revised Oct 2018

There has been a massive upward revision in the accounts to the net lending position of the household sector.  For the period 2014-2017 in cumulative terms, the household sector has switched from being a net borrower of €1 billion to being a net lender of €16 billion. 

This is much closer to what we would expect given the scale of debt reduction untaken by the household sector in recent years with loan liabilities reducing from over €200 billion in 2008 to under €140 billion now. 

Household Sector Loan Liabilities

It never made sense that the funds for these repayments were coming from the sale of unlisted shares.  That the accounts now show that a large part is coming from unspent income eases any concerns about the build-up of financial pressures in the household sector: the “deleveraging hypothesis” trumps the “overheating hypothesis”, for now at least.  The deleveraging will not continue for ever.

Although not of central concern there may be some interest in looking at where the revisions were entered into the accounts.  Some of it happened in the current account.  There has been some upward revision to the gross savings rate from what was shown this time last year but not massively so.

Household Sector Savings Rate Revised Oct 2018

This has largely been because of an upward revision to household income.  For example, gross disposable income for 2016 has been revised from €95 billion to €97 billion with the result that the gross savings rate is now 1.5 percentage points higher.  The output produced and wages paid by the household sector itself were revised up.

But some of the more significant changes happened in the capital account.  Here are the previous and revised figures for gross capital formation of the household sector.

Household Gross Capital Formation Revised Oct 2018

The 2016 figure for household capital formation has been revised from €8.0 billion down to €5.2 billion.  The main item in the capital formation of households is housing; both the improvement of existing units and the acquisition of new units.  There is even less of this going on then previously thought which is a major reason for the revisions in the net lending shown at the top.

Whatever the reason we now have a set of household accounts that make sense.  The household sector is not spending all its income and is a significant net lender which is what we would expect given the scale of the reduction in household loan liabilities in recent years.  As hinted above this points to wondering what will happen when the deleveraging stops.

Friday, October 12, 2018

The Irish Hare is set to complete its second lap

Here is a chart from Honohan and Walsh (2002) showing Ireland going through a 25-year imbalance cycle from 1975 to 2000.  Internal imbalances are shown through the unemployment rate with external imbalances shown through the balance of payments current account deficit (these are shown using the reverse sign so positive numbers indicate deficits).

Celtic Hare Lap 1

Back in 2009, Honohan pondered whether the hare was heading off on another lap.  He was right (and first raised the possibility with co-author Walsh as early as 2007). 

Anyway, here is an update of the imbalance chart using the modified current account rather than the headline one.  Outturn data from the CSO is used for 2004 to 2017 with figures for 2018 to 2020 coming from the latest Department of Finance forecasts included with Budget 2019.

Celtic Hare Lap 2

The latest lap began with the current account deterioration from 2004 (though it should be noted that the range of the horizontal axis in the second chart is about half that of the first).  The current account did begin to improve after 2008 but this was coincident with the explosion in unemployment (same axis range in both charts) as consumption and, most notably, investment fell. 

Since 2012, we have been closing the loop through rapid falls in unemployment and improvement in the current account.  The current account did deteriorate in 2017 though this may have been an MNC effect related to the acquisition of stocks.  The latest forecasts from the Department of Finance show a continued erosion of the current account surplus from that point as a result of consumption and investment rises.  The forecasts have us getting us back to where we were in 2004 sometime next year or the year after so the final closing of the loop as shown above is still a forecast rather than an outturn.

If it does happen the hare will set a new PB: cutting the the lap time 25 years to 15 years (albeit, as noted by Honohan, the course was shorter this time). What’s in store for the celtic hare? Hard to know.  But let’s hope it takes a breather before heading off on its third lap.

Monday, September 24, 2018

The household sector in the NIE

There are some neat modifications of the tables published in National Income and Expenditure (NIE) accounts included with the 2017 update.  Recent years and have seem improvements in how the household sector is covered in the accounts and this continued with the publication of the full set of tables for the 2017 NIE.  There is a useful information note here.

Here is a table setting out the gross disposable income of households in nominal terms.  This is after tax and transfers with the “gross” referring to depreciation. Click to enlarge.

Gross Disposable Income of Households NIE2017

The main use of disposable income by households is consumption and the main consumption items for the same year are set out in the following table.

Household Consumption Expenditure NIE2017

After consumption expenditure in 2017 households had just over €10 billion available for capital formation (investment) or net lending.  If investment expenditure was more than €10 billion then the household sector would be a net lender as the sum of consumption and investment expenditure could not be funded from disposable income.

We don’t get insight into this from the NIE accounts but we will do so from the Institutional Sector Accounts (ISAs).  The 2017 ISA annual figures will be published in the next few weeks where we will hopefully see the extent to which the household sector is a net lender (i.e. using some of that €10 billion shown above to repay debt). 

Wednesday, July 18, 2018

When can we expect the next wave of IP onshoring?

The 2017 National Income and Expenditure Accounts will be published by the CSO on Thursday.  In a detailed information note the CSO have set out some of the updates and revisions we can expect.  Some of updates relate to the treatment of expenditure on imports of R&D services and tally with a lot of what we said here.

While these welcome updates are likely to be the most significant changes introduced by the CSO they are unlikely to be headline grabbers.  But they will significantly improve the usefulness of key measures of the economy such as the modified current account balance in the Balance of Payments, CA*, and the level and recent nominal growth rates of modified Gross National Income, GNI*. 

It is a bit of a punt but it is possible that for 2017 we will see CA* record a surplus somewhere in the range of 2-4 per cent of GNI*, while the recent nominal growth rates of GNI* may fall in the range of 5-8 per cent per annum.  These are impressive, and plausible, numbers.

But impressive and all as these might be it is likely that more attention will be directed at seeing how this pointer in section 4.1 of the CSO information note plays out:

The CSO’s Large Cases Unit (LCU) continues to work with data providers on their R&D-related activity. As part of this work, additional purchases of R&D-related IP assets have been identified in recent years and will be included as imports of services in the upcoming National Accounts and Balance of Payments results, with offsetting additions to the capital stock in the National Accounts. As a result of these new additions to the stock of intangible assets, the GNI* indicator will also include revisions to its depreciation adjustment for R&D-related IP assets in recent years.

We don’t have a GNI* depreciation adjustment for 2017 so that can’t be revised, thus it could be that these newly-identified onshoring events relate to years up to 2016.  And we do have another data source which now goes up to 2016 where these transactions are likely to make an impact – the aggregate Corporation Tax calculation published by the Revenue Commissioners.

The table below shows the national accounts depreciation adjustment for MNC imports of intellectual property products from last year’s NIE release and the capital allowances claimed for intangible assets under Section 291A of the Taxes Consolidated Act which was introduced with the Supplementary Budget of April 2009.

IP CFC and S291A CA

While these obviously are related concepts the figures do not have to match each other but they are strongly correlated which is best shown by the change in 2015 when both series rose by €25 billion ± €1 billion.  Conceptual differences aside it looks like there is some scope in most years for the national accounts version to be revised up.

This seems particularly true for 2016.  In last year’s NIE the CSO increased their depreciation measure for these IP products by €2.7 billion.  The recently-released aggregate CT calculation from the Revenue Commissioners shows a €6.9 billion increase in 2016 for the amount of capital allowances claimed for intangible assets.  There is a €4 billion difference between the changes.

It should also be noted that the time period covered by each series is different.  The CSO data covers activity that happens in a calendar year; the Revenue data reflects the details in CT returns filed for accounting periods ending during the calendar year.  So, for example, a company with a June 30th year-end will have the figures from its CT return included for one year even though the figures reflect activity that happened in the second half of the previous calendar year. 

This is only a minor wrinkle and should wash out between the series over a couple of years.  But it should be noted that changes in the Revenue data for a particular year could relate to activity that began the previous year and if a June 30th company introduced a change from July 1st 2016 it won’t appear in the Revenue data until 2017 but it could affect the revised 2016 data the CSO is set to publish this week.

So while little more than an enlightened guess we could see a couple of billion added to the national accounts depreciation measure in question here for years up to 2016. 

So what would a €4 billion increase in any year mean for the national accounts?  If we assume a 10-year lifespan then we could be looking at an increase in the capital stock of these intangible assets of around €40 billion.  Given recent developments it is likely that the upward revision to GDP (and GNP) would be around €4 billion.  This could add 1.5 to 2.0 percentage points to the growth rate of each.  GNI* will largely be unaffected as the upward movement in GDP will be offset by the increase in the depreciation adjustment that is subtracted to get this modified measure of national income.

So while the improvements to CA* and GNI* will be main source of added-value from this release they will have to fight for attention if tens of billions of intangibles are further added to the estimates of Ireland’s capital stock of intangible assets.

And, of course, we have absolutely no idea what could be introduced for 2017.  It is possible that the recent wave of IP onshoring was linked to “stateless” companies who would have been impacted by changes introduced to Ireland’s residency rules in the 2014 Finance Act that became effective from the start of 2015 and the implementation via the OECD’s BEPS process of country-by-country reporting by MNCs to the tax authorities in the countries in which they operate.  A country report for “Republic of Nowhere” would probably have raised a few eyebrows.  Maybe we have a few laggards but one would have thought that most of the impacted companies would have restructured before the end of 2016.

Of course, a second wave of onshoring is likely in response to the 2015 Finance Act changes to Ireland’s residency rules which become fully effective at the start of 2021 and, more importantly, proposed changes to Ireland’s transfer pricing rules which would see the latest OECD guidelines based on BEPS Actions 8 to 10 incorporated into Irish legislation. 

This would see royalty payments for IP disallowed as a tax deduction if the recipient of the royalties does not have sufficient DEMPE functions to warrant receipt of the royalties (DEMPE functions are the development, enhancement, maintenance, protection and exploitation of IP).

Up to now Irish legislation has been blind to the location, residence and substance of entities receiving outbound royalty payments but if BEPS Actions 8 to 10 are incorporated into Irish transfer rules (and it has been recommended that this should be done before the end of 2020) then the substance of such entities will matter.  Companies can continue to make royalty payments to them but they would only be eligible as a deduction for Irish Corporation Tax purposes if the receiving entities have sufficient DEMPE functions.  Cash-box entities in the Caribbean are unlikely to satisfy the criteria.

So either companies reroute the royalty payments to an entity that has the required DEMPE functions – such as the parent company in the US that undertakes most of these MNCs R&D activity – or restructure their operations in Ireland.  If recent events are anything to go by this restructuring will involve the onshoring of the IP licenses previously located with the cash-box entities in the Caribbean or other offshore financial centres..

Thus, the taxable income of the Irish operating company will move from being reduced by “renting” the IP and making annual royalty payments for the use of the IP to being reduced by “buying” the IP and claiming capital allowances each year based on the cost of acquiring and maintaining the IP.

Could we have seen a few early movers in 2017 even though such a change could have been delayed until 2021? Maybe, but it seems unlikely.  There was a reasonably-flagged change to S291A that became effective from midnight on the night of Budget 2018.  This saw that amount of capital allowances that could be used in any one year limited to 80 per cent of the relevant taxable income. 

This guarantees that some of the intangible-asset-related profit will be exposed to tax each year though if the cap is binding it means it takes a longer period for the capital allowances to be exhausted as the full amount is still available to be used.  It seems unlikely that a company would have moved in advance of the introduction of this change when they could continue with the royalty-based structure until the end of 2020. 

And it seems even more unlikely when the alternative is a capital-allowances-based structure that is essentially limited by the amount that can be claimed arising from the initial acquisition cost versus the open-ended and virtually unlimited amounts that can be used in the royalty-based structure.

But maybe it would be a consideration with a particular profit outlook and risk appetite. Such risk assessments could include the possibility of an EU State-aid investigation (and maybe the risk appetite of national tax authorities for the same could also be a factor).  If you were a typical US MNC availing of the “double-irish” to defer your US tax liability you might get the heebie-jeebies when reading the full version of the Amazon-Luxembourg state-aid case.

Even with that it is more probable than not that the second wave of IP onshoring to Ireland will not be seen until nearer to 2020.  Although the analysis is preliminary it does not appear that the Tax Cuts and Jobs Act passed by the US Congress last December will significantly change the incentives involved for existing IP that companies have moved offshore.  

And with over €70 billion of outbound royalty payments currently being made from Ireland the potential scale involved is huge. However, section 5.1 of the CSO information note indicates that this will be revised down by some amount but it should be remembered that this is on the basis of a national accounting interpretation of what is going on not a tax interpretation. 

This issue aside it could be that the total value of the assets involved is of the order of something approaching a trillion euro while the associated gross profits / capital allowances could be double the levels seen by the end of 2016 bringing the annual amounts to something around €100 billion. 

Could any of this have arrived in 2017? Maybe.  Just as it’s a possibility that there were some late first-wave movers that only got around to getting their affairs in order in 2017.  As flagged by the CSO there will be changes to the national accounts with revisions to the data relating to onshoring that took place up to 2016. 

At this stage the rest of us really are blind as to what could have happened in 2017.  Maybe the NIE release on Thursday will see us stunned like startled earwigs again, and then again maybe it won’t, but IP onshoring is something we should be expecting to see much more of as we move towards the end of the decade.  Buckle up!

Tuesday, July 17, 2018

Capital Allowances and companies with Net Trading Income that is negative or nil

The previous post went through the overall outturns from the 2016 aggregate Corporation Tax calculation which was recently published by the Revenue Commissioners.  As detailed there the figures for capital allowances are worthy of attention.  The amounts of capital allowances used against gross trading income for the last four years for which we have data are:

  • 2013:  €15,955m
  • 2014:  €18,621m
  • 2015:  €46,153m
  • 2016:  €59,254m

Additional research from staff of the Revenue Commissioners tells us that a large part the increased claims for capital allowances are linked to intangible assets.  Here are the amount of capital allowances claimed for expenditure on intangible assets from 2014 to 2016.

  • 2013:    €2,522m
  • 2014:    €2,652m
  • 2015:  €28,871m
  • 2016:  €35,737m

It is worth noting that capital allowances claimed as shown in above figures is not the same as capital allowances used which were shown in the first set of numbers.  A company may claim capital allowances but unless it has income against which to offset those capital allowances the capital allowances remain unused and can be carried forward as a loss for use in subsequent period when there may be income to use them against.  There is a story here but it doesn’t relate to intangibles which is the focus here and is something we may land on in future.

The CSO host a databank from the Revenue which provides some distributional details of income, deductions and allowances used for Corporation Tax purposes.  The next table shows claims of capital allowances for plant and machinery (which includes intangible assets) by range of net income since 2013.

Plant and Machinery Capital Allowances by Range of Net Income

It can be seen that two income ranges are responsible for almost all the capital allowances claimed: companies with net incomes greater than €10 million and companies with negative or nil net income.  And of these, most of the action is within companies with negative or nil net income.  Since 2014, the amount of capital allowances claimed by such companies has gone from €12.6 billion to €47.5 billion.

The distributional data has been made available much quicker by the Revenue this year and we can put together a rough CT calculation for companies with negative or nil net trading income.  There are some missing items but there enough to allow us to see what is going on.

Corporation Tax Computation for Companies with No Trading Income

The fifth row gives the duck eggs for Net Trading Income (0 0 0 0) but above that we can see that these companies had significant amounts of Gross Trading Profits.  These profits went from €13.5 billion in 2014 to €40.0 billion in 2015 to €49.9 billion in 2016.  These gross profits are included in GDP but it is Taxable Income that matters for CT payments. 

And we see that after the application of losses, and most importantly, capital allowances, the resulting net trading income of these companies with almost €50 billion of Gross Trading Profits in 2016 was zero.  It doesn’t matter what the tax rate is, the tax due on trading incomes of zero is zero.   Some companies in this category do pay Corporation Tax but that is due to Other Income such as rental, foreign or capital gains rather than Trading Income.

The Gross Trading Profits shown in the above table are responsible for a large part of the recent surge in GDP.  But they have no role in explaining the recent rise in Corporation Tax.

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