Wednesday, October 8, 2014

Butchering poverty statistics

In The Irish Times today there is an article that compares some measures of poverty in Ireland to the EU average.  It makes a meal of it.  There is a large amount of poverty in Ireland but it would help if it was described accurately.  This piece features this confusing chart.

The panel on the left says the 2012 at-risk-of-poverty rate in Ireland is around 30 per cent; the panel on the right puts the very same measure at around 16 per cent.  The piece suggests that the difference is because:

Ireland’s Central Statistical Office measures poverty and deprivation in a slightly different way to Eurostat

They do not.  They measure them precisely the same.  In fact, the figures reported by the CSO come from a standard survey that is carried out under its remit from Eurostat across the EU (and in a small number of non-EU countries.) It is the European Union Survey on Income and Living Conditions or EU-SILC.  When describing the survey the CSO say (emphasis added):

This survey will be conducted throughout the European Union as the European Council and the Commission has given high priority to fight against poverty and social exclusion. The European Union requires comparable and timely statistics to monitor this process.

The difference between the left and right panels is not differences in definitions; it is because the data used represent different things.  They are different because they are different.

The panel on the left has data on “at-risk-of-poverty or social exclusion” while the panel on the right just relates to “at-risk-of-poverty”.  It is the inclusion of measures of social exclusion in the data used the left panel that results in the difference not any inconsistency in how poverty is measured. 

We have looked at this measure of “at-risk-of-poverty or social exclusion” before (see here) and discussed some of the reasons why Ireland fares very badly under this metric.  Some of the points made there are important in the context of the article published by The Irish Times today but rather than make them again here are a few additional ones.

This is a table a piece comparing at-risk-of-poverty rates in Ireland and the EU should use.  It shows proportion of the population who have an equivalised disposable income of less than 60 per cent of the median.  This is the standard definition of “at-risk-of-poverty”.

AROP Ireland and EU

Ireland’s at-risk-of-poverty rate is below the EU average and has not deteriorated significantly during the crisis.  Yes, it is a relative measure but that is how it is done.  Further, here is a related table from Eurostat that tells an important story.


The 2012 figures for Ireland were not available when Eurostat created the table but the outcomes were:

  • 2012 At-risk-of-poverty rate before social transfer: 39.3%
  • 2012 At risk-of-poverty rate after social transfers: 15.7%

Ireland’s at-risk-of-poverty rate in 2012 was below both the EU28 and EA17 average which were both at 17.0 per cent.

What is notable is that Ireland has the HIGHEST at-risk-of-poverty rate in the EU before social transfers are included.  This is disposable income before receipt of all social transfers except pensions (public and private). This is mainly primary or market income.  Ireland has the most unequal distribution of market income in the EU.

Ireland is not just above the EU average we are above the next highest country by some distance.  Ireland is 39.3 per cent; the second highest country is the UK at 30.5 per cent; the EU28 average is 26.3 per cent. Ireland would be considered an extreme outlier.

Introducing a wealth tax and increasing transfer payments will not fix this.  Ireland has the most successful tax and transfer system at reducing poverty in the EA.  It brings us from worst in class to below the EU average.

When looking at at-risk-of-poverty rates in Ireland the stand-out feature is not the headline rate.  That is below the EU average and is lower than it was from 2003 to 2007.  The standout feature from the EU-SILC about Ireland is this.

VLWI Eurostat

As we have said before, Ireland is almost “off the scales” and is more than 2.5 times the EU average.  Maybe we should try and fix this.  Not a word about that today’s article though.

Tuesday, October 7, 2014

The “double-irish” Luxembourg style

The European Commission have announced that they are opening a state-aid investigation into Amazon’s tax affairs in Luxembourg.  Once again the focus is transfer pricing.  However, the description of Amazon’s tax structure in Luxembourg has a familiar ring.  Here is an extract from the statement by Commissioner Almunia:

The ruling we are looking at concerns Amazon's subsidiary in Luxembourg, which records most of the group's European profits. This company pays a royalty to another entity based in Luxembourg, but not subject to corporate taxation in Luxembourg. Today we observe that through this mechanism most European profits of Amazon are recorded in Luxembourg but are not taxed there. The terms for calculating this royalty are essential. These transfer pricing arrangements are set out in the ruling of 2003 that is the focus of this investigation.

At this stage we consider that the amount of this royalty, which has lowered the taxable profits of Amazon, might not be in line with market conditions.

Or as slightly more technically put in the formal statement:

The tax ruling in favour of Amazon under investigation dates back to 2003 and is still in force. It applies to Amazon's subsidiary Amazon EU Sàrl, which is based in Luxembourg and records most of Amazon's European profits. Based on a methodology set by the tax ruling, Amazon EU Sàrl pays a tax deductible royalty to a limited liability partnership established in Luxembourg but which is not subject to corporate taxation in Luxembourg.  As a result, most European profits of Amazon are recorded in Luxembourg but are not taxed in Luxembourg.

So we have a trading company operating in Luxembourg that records the sales made by Amazon from across the EU - these number in the millions and thus accumulate a large profit.  But then the trading company makes a royalty payment to another Luxembourg-registered company but one that is not subject to tax in Luxembourg.  Thus the payments to the holding company are not taxable in Luxembourg.  These payments will be for the right to use the intangible assets (brand, technologies etc.) that Amazon has developed.  A good description of Amazon’s tax structure is in this 2012 article from Reuters, which has now being confirmed by the EU Commission.

This is very similar to the structure used by Google in Ireland.  Google has a trading company here that books almost all of Google’s advertising sales revenue outside the US.  This trading company makes a royalty payment to a non-resident Irish company which is “managed and controlled” in Bermuda. This is an intangible asset holding company.  A more complete description was provided in a recent IMF Fiscal Monitor (see page 47).

Amazon are essentially engaging in a “double-irish” but doing so in Luxembourg.

The European Commission is not investigating the overall nature of the structure, i.e. the two companies can comprise the “double” because that complies with existing tax laws.  The Commission is investigating the size of the royalty paid by the trading company to the holding company that has the intangible assets.  The question the Commission is setting is whether enough profit is declared by the trading company not whether the overall structure is illegal.

Of course, the whole point of using two companies incorporated in the same country (whether it is Ireland or Luxembourg or any country) is to avail of the “same-country exemption” in the US tax code.  The US taxes US companies on their worldwide income is Amazon, Google and the like are subject to the 35% US corporate income tax on their worldwide profits.  However, using the “same-country exemption” they can engineer a deferral on the payment of this US tax until the profit is repatriated to the US, if ever.

Google does it using two companies in Ireland; Amazon does it using two companies in Luxembourg and there are likely to be many other examples.  There is nothing Ireland or Luxembourg can do about the “same-country exemption” in US tax law.

The OECD is proposing to reduce the effectiveness of these schemes but trying to more forcibly link the location of profits with substance.  At present, these companies can locate the intangible assets in holding companies based in low- or no-tax jurisdictions such as Caribbean Island where there have little more than a brass-plate operation.

The OECD is proposing a DEMP solution to the problem.  The assets must be located close to the substance that either

  • Developed,
  • Enhanced,
  • Maintained, or
  • Protected

the intangible assets.  If a company does not engage in DEMP activities it cannot claim entitlement to the profits from holding the intangible assets.  The profits must be linked to the DEMP substance. 

At present these companies do not engage in DEMP activities in small Caribbean Islands but are locating they profit from their intangibles there.  The companies are benefitting from the zero taxation that these jurisdictions offer and they are using the “same-country exemption” to defer the US tax that is due on this assets.

Both the European Commission, and more importantly, the OECD are examining this issue.  However, they are not questioning the “two-company structure”; they are looking into the transfer pricing agreements between the companies. 

The European Commission are questioning whether more profit should be declared by the trading company while the OECD are proposing that the profit declared by the company holding the intangible asset must be linked to the substance behind the intangible asset.  If the OECD’s proposals come to the fruition they are likely to have a far greater effect.  Neither the Commission or the OECD have any jurisdiction over the “same-country exemption” in US tax law.  Nor over the “look-through rule” and “check-the-box” which can equally be used to engineer a deferral of US corporate income tax for US companies on their non-US profits.

There is nothing illegal or probably even questionable about the two company structure at the heart of the “double-irish”.  What we learned today is that Amazon has a similar two-company structure in place in Luxembourg.  But the “double-luxembourger” doesn’t have the same ring to it.

Tuesday, September 30, 2014

Why is the Apple case so confusing?

Here is a quote from the letter by the European Commission to the Irish government on the Apple state-aid case:
Multinational corporations pay taxes in jurisdictions which have different tax rates. The after tax profit recorded at the corporate group level is the sum of the after-tax profits in each county in which it is subject to taxation. Therefore, rather than maximise the profit declared in each country, multinational corporations have a financial incentive when allocating profit to the different companies of the corporate group to allocate as much profit as possible to low tax jurisdictions and as little profit as possible to high tax jurisdictions.
That’s pretty straightforward: companies try to shift profits from high-tax jurisdictions to low-tax jurisdictions. Ireland is low-tax. Very low tax. So the accusation must be that Apple are shifting excess profits here, right? Here is the EC summarising their position:
The main question in the present case is whether the rulings confer a selective advantage upon Apple in so far as it results in a lowering of its tax liability in Ireland.
The accusation is completely the opposite! The issue is whether the tax liability in Ireland was too small.

The reason is that Apple can find a lower-tax jurisdiction than Ireland namely the United States. Apple can have a tax rate of zero on certain profits in the US. Why pay 12.5 per cent to Ireland when you can pay nothing to the US?

They can do this using some of the deferral provisions in the US tax code (especially that known as "check-the-box” or, as formally introduced, the “look-through rule”). The US has a headline corporate income tax rate of 35 per cent. However in some instances, through a myriad of means, US MNCs can defer the actual payment of this until the profit is transferred to a US-incorporated entity in their structure. Apple has a number of Irish-incorporated companies operating in the US that earn massive profits but US corporate income tax is not paid on these until the profit is transferred to a US-incorporated company.

Essentially, Apple in deciding where to locate its intellectual property Apple has a choice between having profits taxed at 12.5 per cent in Ireland or at zero per cent in the US. It choose zero per cent in the US. Yet, US politicians claim Ireland is the tax haven!

Sen. Carl Levin issued a statement today arguing that the European Commission report supported the findings of his US Senate sub-Committee last May. The chief finding in that report was of a special two per cent rate:
The hearing will examine how Apple Inc., a U.S. multinational corporation, has used a variety of offshore structures, arrangements, and transactions to shift billions of dollars in profits away from the United States and into Ireland, where Apple has negotiated a special corporate tax rate of less than two percent.
Spot the contradiction? The US Senate accuses Apple of shifting profits into Ireland; The EU Commission is accusing that the profits in Ireland are too small. This is as much political as it is legal. On the tax rate applied in Ireland, the Commission say:
The taxable income [.] was taxed at 12.5%, except for limited components taxed at 25% mainly represented by interest payments received.
The profit in Ireland was taxed at 12.5 per cent and some cases it was even taxed at 25 per cent!

Apple currently has a annual profit of close to $40 billion dollars. If Ireland took a 12.5 per cent chunk out of that we can be sure that Carl Levin would be issuing another statement – one accusing Ireland of theft. As Levin himself says “Apple developed its crown jewels -- lucrative intellectual property -- in the United States”.

This intellectual property is not held in Ireland. On the two companies in the spotlight in the Commission investigation, the Commission says:
No rights in relation to the IP concerned are attributed to the Irish branch of AOE.
No rights in relation to the Apple IP concerned are attributed to the Irish branch [of ASI].

Apple kept its intellectual property in the US. So why didn’t it pay the US rate of 35 per cent on its profits? Answer: the “look-through rule” and “check-the-box”. From the Senate report:

Apple avoided U.S. taxation for the entire $44 billion through a combination of regulatory and statutory tax loopholes known as the check-the-box and look-through rules. (page 32)

These figures indicate that, in two years alone, from 2011 to 2012, Apple Inc. used the check-the-box loophole to avoid paying $12.5 billion in U.S. taxes or about $17 million per day. (page 34)

Apple reduced it’s US tax bill by $12.5 billion in just two years using “check-the-box” and the “look-through-rule”. If Apple paid $5 billion of Irish Corporation Tax then the amount that the US could collect from the 2011/12 profits would be $7.5 billion as the US grants a credit for corporate income tax paid elsewhere. So the US can collect more tax when Apple pays less tax in Ireland but it is a US provision that allowed Apple to defer paying $12.5 billion of tax over the two years.

This is because the US system allows Apple to defer the actual payment of tax until the profit is transferred to a US-incorporated entity in Apple’s structure. Apple keeps the profit in Irish-incorporated entities even though they do almost all of their business in the US. Although they are US-based, US law considers these businesses as “offshore”. Again Sen. Levin tells us the reality when talking about ASI and AOE:
In short, these companies’ decision-makers, board meetings, assets, asset managers, and key accounting records are all in the United States. Their activities are entirely controlled by Apple Inc. in the United States.
It is US politicians who voted for a provision that allowed Apple to avoid paying $12.5 billion of tax in just two years.  The "look-through rule" was introduced in 2005 (it formalised in law the 1997 IRS provision called "check-the-box").  The "look-through rule" expired in 2010 but has been extended several times since then.  It was most recently extended as part of the American Taxpayer Relief Act of 2012.  The “look-through rule”  allowed Apple to avoid paying $12.5 billion of taxes in just two years.  Who was among those who voted to retain as recently as January 2013?  Yes, Sen. Carl Levin.  See here.  To be fair Sen Levin did vote against it when originally introduced in 2006.

The same US politicians who would be shouting ‘larceny!’ if Ireland collected 12.5 per cent tax from Apple’s profits passed a provision that allows Apple to pay no tax on large amounts of its profit.  So we have politicians in a country which allows zero tax to be collected on some profit in its jurisdiction accusing a country which collects 12.5% on all profits earned in its jurisdiction of being a tax haven!

The cases are full of contradictions. The European Commission set out the theory that companies shift profits from high-tax jurisdictions to low-tax jurisdictions but then present a case that argues that Apple taxable income in low-tax Ireland is “too low”. The US Senate bemoans about "special rates" and Apple shifting profits to Ireland that are "too high" when its own evidence shows that Apple accumulates its profit in the US and uses US tax rules to achieve a tax rate of zero percent on most of those profits.

But whether we are looking east or west, whether it is the US Senate or the EU Commission, whether the profits are too high or to low there is just one thing that stands out among all the inconsistencies -  everyone is blaming Ireland. And that suits everyone in the US Senate and almost everyone in the European Commission - but we cannot be guilty of completely contradictory accusations.

If Ireland really was directly at fault then there could not be these contradictions. It would be pretty clear what is going on.   Either the profit here is "too high" (US Senate accusation) or "too low" (EU Commission accusation) - it cannot be both.  As it stands, the whole thing is a complicated murky mess of contradictory accusations from east and west. Ireland stands in the middle but seems more intent on trying to absorb the blows rather than repel them. The strategy isn’t working.

Monday, September 29, 2014

Getting behind the story that some are ahead of

The Financial Times, or at least one of their headline writers has been getting excited about an announcement today from the European Commission on their ongoing investigation in Apple’s tax affairs in Ireland.  When published online the article was published as:

FT Apple 1

Nothing has been found “illegal” (yet!) and all that will really be revealed today is the parameters of what it is the European Commission will be investigating, i.e. what it is they think might be illegal.  The text of the piece states this but the headline is a bit ahead of the story.

For the print edition they put it on the front page and got more correct (at least in the sub-heading): the Commission will make an accusation in relation to Apple’s tax dealings in Ireland.

Apple FT 2

The story gets significant coverage and one further interesting aspect is the prospect of a fine being levied on Apple to repay any state aid to Ireland that may have been provided.  For example, The Irish Times report that if there is an adverse state aid finding such an outcome “could leave the iPhone maker with a record fine of as much as several billions of euros.”  The outcome would not be a fine; it would be the repayment of any state-aid given to the company.  In this case it is lower tax then would otherwise be payable.  As Ireland is being investigated for granting state-aid to Apple, this retrospective tax would be payable to Ireland.  There will likely be no retrospective tax payment and even if there was payment would be a few million not a couple of billion.

Apple is a massively profitable company with annual profits of around $40 billion a year but it generates little of that profit in Ireland.  Apple is a US company that designs, manufactures and retails electronic devices and related services for consumers.  Apple has a large presence in Cork but the risk, assets and functions that generate Apple’s massive products are its design, innovations, branding and reputation. 

Lots of companies manufacture and retail consumer electronics.  None of them are as profitable as Apple.  Making electronics and selling them is relatively easy and not very profitable.  Designing devices that consumers are willing to pay €400-€600 is extremely difficult and very profitable.  Apple is best in class at this.

Under existing transfer pricing rules the profit Apple generates will be allocated based on risks, assets and functions.   Apple’s profitable risks, assets and functions (designers, innovators, patents and trademarks) are almost all in the US. 

As a US company with its most profitable functions and assets in US, Apple is liable to pay the US 35 per cent corporate income tax.  The US tax code is a mess and Apple can create a deferral of the actual payment of this tax until the money is notionally repatriated to the US.  The Senate Report on Apple highlighted the importance of two provisions in the US tax code - “check-the-box” and the “look-through rule”. 

Using these provisions Apple was able to initiate a deferral of the US tax that it should pay.  It’s a bit of a complex web but the net result is that Apple is able to avoid paying the US tax it owes by keeping the profits in what are described as “offshore” subsidiaries.  Almost everything about these subsidiaries happens in the US.  They are managed and controlled (residence) in the US.  Their assets (the intangibles) are held in the US.  Their cash holdings (the profits) are held in US banks.  It is the US tax code that considers these offshore.  To everyone else they are in the US.

In is financial statements Apple indicate that they would owe around $36 billion of tax to the US if the profits were repatriated from the subsidiaries to the US parent, Apple Inc.  Ireland gets a headline role in the structure because the subsidiaries are Irish-incorporated, but place of incorporation has little significance when determining where a company must pay corporate income tax – the location of risks, functions and assets does.

The EC investigation into Apple will be very different to the Senate investigation into Apple.  The Senate looked at Apple’s overall tax structure.  The EC will only look at how the risks, functions and assets Apple actually has in Ireland are taxed.  The question will be whether Apple has paid the right amount of tax to Ireland based on the activities that actually take place here. 

The question of the $36 billion that Apple could pay to the US is not at issue.  Apple has activities in Cork but in the broader scheme of Apple’s overall profitability they are not massively important.  For example, Apple in Cork could manufacture a product for the company.  Apple could make a lot of profit from that product but the actual manufacturing of it would not contribute a lot to that. 

Under transfer pricing agreements the profit would be allocated between different functions.  Back in 1990, Ireland was starting to phase out the 10 percent export profits tax.  It is possible that Apple entered a transfer pricing agreement to allocated 20 per cent of the profit from some product to the activities in Ireland (say manufacturing) and 80 per cent of the profit to the activities elsewhere (mainly the designing in the US). 

It can be seen that 20 per cent of the profit taxed at ten per cent gives a two per cent tax rate.  This becomes the effective tax rate if the US does not collect the tax that is attributed to the functions in the US.  Using the deferral provisions in what is known as Subpart F of the US tax code, Apple was able to engineer this.  The issue for the EC is whether the 20/80 profit split is appropriate.  [It is a bit simplistic to describe the transfer pricing arrangement as a straightforward 20/80 profit split but for our purposes here it is sufficient.]

The likelihood is that this type of split was/is appropriate but the way it was suggested Apple got a “special two per cent rate in Ireland” at the US Senate means a state-aid investigation is warranted.  Companies in the EU cannot get “special” treatment.  However, the EC will likely find that this was result of taxing 20 per cent of the profit at 10 per cent beginning in 1990 and subsequently at the 12.5 per cent rate when the uniform Corporate Tax rate was introduced in 2003.  Apple never said it got a “special” rate as what the company actually said was:

“Since the early 1990’s, the Government of Ireland has calculated Apple’s taxable income in such a way as to produce an effective rate in the low single digits …. The rate has varied from year to year, but since 2003 has been 2% or less.”

It is the transfer pricing agreement that determines the amount of taxable income in Ireland.

Of course, Apple became hugely successful and massively more profitable following the launch of the iPhone in 2007.  Under current transfer pricing rules the profits tax on the iPhone should be paid mostly in the US.  Apple used the Irish-incorporated companies (some of which were formed in 1980) as part of its tax structure to generate a deferral of US tax due on the global (i.e. non-US) sales of the iPhone and iPad.  The suggestion that Apple could owe billions in tax to Ireland from these profits is daft. 

The activities and assets that led to these profits were in the US and had nothing to do with Ireland – apart, crucially, from Apple housing them in Irish-incorporated companies.  What happens in the US with the taxing is US profits is beyond the remit of the EC investigation.  The companies may be Irish-incorporated but place of incorporation does not determine the location of tax liabilities. Countries can use incorporation to determine tax residence but that is a different concept. 

A company will be resident in only one country (or at least it should be!) but it will be liable for corporate income tax in every country in which it has a tax presence – based on the location of risks, functions and assets.  There has been the perception that everything these Apple subsidiaries do happens in Ireland.  Yes, they are Irish-incorporated but almost everything they do happens in the US.

These companies hold the non-US rights to Apple’s intellectual property – trademarks, patents etc.  Apple does not have to make any declaration of these to the Revenue Commissioners or enter any transfer pricing agreement to split the profit between Ireland and elsewhere.  The intangible assets behind the iPhone are not created or held in Ireland.  The iPhone is not manufactured in Ireland and only a tiny proportion of them are sold in Ireland.

Apple does not have to enter a profit-sharing transfer pricing agreement with its Irish operations for the iPhone profits.  None of the risks, functions and assets that generate the profits are in Ireland.  It could be the case that 98 per cent of the profits these subsidiaries generate come from the assets behind the iPhone and iPad etc and two per cent comes from the activities that these companies actually do in Ireland (lots of shared services – accountancy, HR etc. – some manufacturing and maybe even a bit of product development.) 

Under the TP agreement 20 per cent of the two per cent is taxable in Ireland while the rest of that and the 98 per cent of the profit that comes from the assets behind the iPhone is taxable in the US.  Apple has a deferral for this so does actually pay the tax at all.

Paying a 12.5 per cent tax on 20 per cent of 2 per cent of the profits is 0.05 per cent.  This becomes the effective tax rate when the 35 per cent tax due to the US on the rest of the profits is not collected at all.  Here is a table from the US Senate Report on Apple.

Apple Tax US Senate

The tax rate for ASI (Apple Sales International) in 2011 was 0.05%.  This was achieved using the structure outlined above.  Apple was able to defer the payment of the US taxes using “check-the-box”.  The Senate report says that in 2011 “check-the-box” allowed Apple to defer paying $3.5 billion in US tax (and $9 billion in 2012!).

Apple Tax US Senate 2

We don’t need to go into how it works; the point is simply that the bulk of the taxes Apple should be paying are owed to the US.  In its announcement back in June, the European Commission said the Irish part of the investigation would focus on:

  • the individual rulings issued by the Irish tax authorities on the calculation of the taxable profit allocated to the Irish branches of Apple Sales International and of Apple Operations Europe;

The key words in the middle of that are “Irish branches”.  ASI has massive profits.  However most of this (maybe around 98 per cent) is due to the assets behind the iPhone and other Apple products and services which have nothing to do with the Irish branches.  The Irish branch probably contributes around two per cent of ASI’s profits.  This two per cent is the focus of the EC investigation.  Even in the extreme case that the EC finds that Ireland should have taxed all of this at 12.5 per cent they amount of tax foregone that would contribute to any retrospective payment would still be small.  In reality the likelihood is that an 20/80 profit split is not materially incorrect and no retrospective payment be imposed.

The fact the all the attention is on Ireland which taxes 0.4 per cent of ASI’s profits at 12.5 per cent while the remaining 99.6 per cent goes largely untaxed because of US rules must delight many of the lobbyists and interested parties in the US. 

When Apple went before the US Senate they knew full well who to blame – and it wasn’t the politicians they were sitting in front of who passed the provisions, such as the “look-through rule” in 2005, that allowed Apple to massively reduce the tax on 99.6 per cent of the profits.  No, the light was shone on the 0.4 per cent.  This worked great in the US Senate but it has come back to bite Apple through the EC investigation. 

The attention on the investigation is huge but the outcome is likely to underwhelm many – particularly the headline writers for the FT.  It is also worth noting that the OECD’s BEPS project would do little to Apple’s tax bill in the existing structure.  One of the driving features of BEPS is to try and ensure profit is aligned with substance, i.e. that companies cannot locate profits in places like Bermuda where they have nothing but a brass-plate operation.

Apple are locating their profits where they have substance – the US – and the taxing right to those profits is given to the right country – the US.  It is US rules that allow Apple to defer actually paying that tax.  Ireland deserves some attention for our role in this, which is probably more errors of omission rather than acts of commission, but not all of it.

Thursday, September 18, 2014

Q2 National Accounts – Some Pictures

Here is a slidedeck with some charts from the QNAs released by the CSO today.

CSO Quarterly National Accounts 2014 Q2

Wednesday, August 20, 2014

Repaying the IMF loans and ‘Financial Stability’

The February 2013 liquidation of the IBRC resulted in the Central Bank of Ireland holding around €25 billion of Irish government bonds with maturities of between 25 and 40 years (there is also €3 billion of a 2025 bond that was used to finance the 2012 Promissory Note payment)

The drop in yields since then means that the market value of these is now likely to be above €25 billion.  Since February 2013, for example, the 10-year yield on Irish government bonds has fallen from 3.8% to 1.9%.  It would be useful to have a current estimate of the market value of these bonds held by the Central Bank but one does not appear to be available.

At the time of the transaction the following was included in a overview presentation published by the Department of Finance (slide 10):

The Central Bank of Ireland will sell the bonds but only where such a sale is not disruptive to financial stability. They have however undertaken that minimum of bonds will be sold in accordance with the following schedule: to end 2014 (€0.5bn), 2015-2018 (€0.5bn p.a.), 2019-2023 (€1bn p.a.), 2024 and after (€2bn p.a.).

A couple of days later the Governor of the Central Bank appeared on RTE’s The Week in Politics and said (from around 05:00):

The Central Bank of Ireland has undertaken to sell these bonds as soon as possible subject to financial stability conditions.

The 2013 Annual Report of the Central Bank contained the following about the €25 billion of Floating Rate Notes (FRNs) acquired by the Bank(footnote (i) to the table in page 123):

The Bank intends to sell the combined portfolio of the FRNs and the fixed rate bond as soon as possible, provided conditions of financial stability permit. The Bank will sell a minimum of these securities in accordance with the following schedule: to end 2014 (€0.5 billion), 2015-2018 (€0.5 billion per annum), 2019-2023 (€1 billion per annum), and 2024 on (€2 billion per annum until all bonds are sold). As part of these minimum sales, the Bank sold €350 million of the 5.4% Irish 2025 Government Bond by end December 2013.

In recent weeks there has been increased attention given to the early repayment of Ireland’s loans from the IMF.  The possibility of this has been discussed here for a while.  Recently the Minister for Finance indicated that the annual interest savings from the early repayment of €15 billion of the IMF loans could be around €375 million.  It seems that attempts will be made with the various EU creditors (requiring getting the agreement of all other Member States) to allow the early repayment of two-thirds of Ireland’s IMF loans.

It appears Ireland is in a position to repay €15 billion of IMF loans, presumably by issuing replacement debt.  It is not clear that agreement will be reached to do this.  If we have the financial wherewithal to refinance the IMF loans who is to say that the Central Bank of Ireland would not be able to sell €25 billion of government bonds, or say two-thirds of them, without being “disruptive to financial stability”?

It is worth repeating that the 2013 Annual Report of the ECB included the following (page 110):

The liquidation of the Irish Bank Resolution Corporation (IBRC) raises serious monetary financing concerns. These concerns could be somewhat mitigated by the disposal strategy of the Central Bank of Ireland.

Indeed.  We might gain a couple of hundred million from reduced interest payments by the Exchequer on the IMF loans but maybe that only rises the possibility that we could lose a couple of hundred million from reduced payments into the Exchequer Account from the Central Bank surplus. 

There has been little to indicate do far that these two sub-plots of Ireland’s government debt are linked but with many moving parts it can be unwise to try and look at different things in isolation.

Friday, August 15, 2014


The implied 10-year yield on Irish government bonds has fallen below two percent.  And as can be seen in the table below the implied eight-year yield is less than one per cent.

Bond Yields 15-08-2014

The yield has been falling for the past while but the drop today is an acceleration of that.

Bond Yields 10yr 15-08-2014

It is hard to see how anyone would give money to the Irish government for eight years at a yield of less than one percent.  Things are improving but risks remain.  Of course, they are not really buying these on the basis that Ireland will repay the money; they are buying on the basis that Mario Draghi will step in to give them their money back.  Draghi has had undoubted success in bringing government bond yields down. Is there any chance he could have similar success in bringing economic growth rates up?

Tuesday, July 8, 2014

Some factors affecting the fiscal arithmetic

The debate around October’s budget has been heightened recently with the positive results in the half-year Exchequer Returns and the large upward update of nominal GDP by the CSO.  The impact of these was explored in this recent post.

There are other factors that will feed into the fiscals sums for 2015.  It is not clear what affect they will have but they may come to prominence over the coming months.  The first is recurring but small, the second is large but once-off and the third is large and recurring (for a while) but seems unlikely to happen.

1. Changes to the EU VAT Directive

From the first of January 2015 “VAT on telecommunications, broadcasting and electronic services supplied by a supplier established within the EU to non-taxable persons established within the EU will also be charged in the Member State where the customer belongs.”  See here.  It is not clear what impact this will have on VAT revenues but one would think it will be positive, though will probably be small. 

The most visible change will probably be in relation to subscriptions paid to BSkyB the VAT on which will now be payable in Ireland.

2. Return payment under the ELG from IBRC liquidation

When IBRC (formerly Anglo and INBS) was liquidated in February 2013 there was just over €1 billion of state-guaranteed liabilities remaining in the zombie bank.  These were covered under the Eligible Liabilities Guarantee that was introduced in early 2010.  When the liquidation was announced the guarantee was triggered and the guaranteed liabilities were immediately paid with €1 billion from the Exchequer.  After making the payment the ELG scheme took the place of the covered liabilities on the balance sheet of the IBRC but as an unsecured and unguaranteed creditor.  When the liquidation is concluded the proceeds of the sales (minus costs) will be divided between the remaining creditors at the time of the liquidation.  Creditors will be repaid based on their status but it does seem that there will be funds to make a payment to unsecured creditors.

It is not clear when this will be made or how much this will be.  If the proceeds are sufficient the amount returned could be close to the €1 billion paid out under the ELG. This is a once-0ff receipt relating to the public interventions in the banking sector.  Ireland has been in the Excessive Deficit Procedure since 2009 but the “once-off” payments to the banks were omitted to give the “underlying” deficit when examining whether Ireland had satisfied the limits set out under the EDP.

If there is a repayment from the IBRC under the ELG then it could be that the “underlying” deficit will be greater than the overall deficit.  Is it only payments to the banks that are excluded to get the “underlying” deficit?  If receipts from the banks are excluded maybe 2015 would be an opportune time to start measuring our performance to the EDP limits with the headline deficit?

3. Early repayment of IMF loans

The benefits of this were discussed here and here back at the start of the year.  The issue arose in a PQ to the Minister for Finance again last week.  He repeated the position that all the programme loans have to be repaid in equal proportion.  Repaying the IMF loans means repayments also need to be made to the EFSF, EFSM and bilateral loans.  But loan agreements can be renegotiated and the Minister outlined how much such a renegotiation would be worth:

It is the obligation to pay everybody if we pay one and makes it not worth pursuing. However, there may be ways around that and it is still worth pursuing that aspect. At present rates in the market and with the rate we are paying on the IMF loan, it is worth about €20 million for every €1 billion we financed. We have about €18 billion of that type of loan from the IMF.

€20 million times 18 equals €360 million – though it will be phased-in in a sense as the IMF loans are amortised (repaid in instalments) over the next few years.  But how long will the Ireland 10-year yield stay below 2.5 per cent?

So we have a small effect that definitely will happen (VAT), a large once-off effect that will happen but mightn’t be counted (ELG) and a large recurring effect that mightn’t happen at all (IMF).  In an imaginary world where they all fell right the 3 per cent of GDP deficit in 2015 should be easily achievable.

Inversions and spotlights etc.

The Irish Times has a piece on US corporate “inversions” which says that “Ireland’s tax regime comes under US spotlight again”.  In this instance an inversion is where a US company merges with a non-US company and the merged holding company has its place of incorporation outside the US.  Under current rules the owners of the foreign company have to comprise at least 20 per cent of the ownership of the merged holding company for such an inversion to take place.  Some of the technical details about inversions and Ireland can be found here.

In the US Congress, Rep. Sander Levin (D), who is on the Ways and Means Committee has highlighted findings from the Congressional Research Library that US companies have been involved in 76 such inversions since 1983. That is an average of less than 3 per year but the rate has increased in the past decade as shown in this related infographic

It is not clear from the documents how many of the inversions have involved mergers with Irish companies or the incorporation in Ireland of the merged holding company but it is probably around 10 per cent of the total.

From an Irish perspective inversions offer very little.  Simon Carswell’s report today says that:

The practice is known as inversions where an American company acquires or merges with a foreign company that allows it to relocate its legal address for tax purposes outside the US to avoid paying the high American corporate tax rate of 35 per cent.

The report refers to inversions by US companies in recent years involving Irish-based firms including pharmaceutical companies Elan, Mallinckrodt and Warner Chilcott to benefit from the lower Irish corporate tax rate of 12.5 per cent.

This might suggest that the merged companies will be paying tax on a greater amount of profits at the 12.5 per cent Corporation Tax to Ireland.  This is unlikely to be the case.  Although the original US company may move its place of incorporation and tax residence to Ireland in many cases there is little substantial change in the operations of the companies.

If the US companies continue to have significant operations in the US (and they will) they will continue to be liable for the US corporate income tax of 35 per cent on the profits earned by those operations.   Place of incorporation has a limited role in determining tax liabilities.  The key factors are the location of a company’s risks, assets and functions with transfer pricing rules used to allocate profit across the company’s risks, assets and functions.  A legal inversion changes none of these.

The fact that the inversion changes so little of the tax liability is shown in further research cited by Rep. Levin but this time from the staff of the Joint Committee on Taxation.  This shows that if a proposal from Rep. Levin to limit US companies ability to invert their place of incorporation abroad the revenue gains over ten years to the US Treasury would be $19.5 billion.  That averages less than $2 billion a year.

The gain is relatively small because the US continues to levy the 35 per cent tax on the operations of the company in the US.  What the US loses out on is the right to levy its 35 per cent tax on the global, i.e. non-US, profits of these companies.  And it is also the case that the extensive deferral provisions for these tax liabilities means that much of that is not collected. 

For comparison in Irish terms the tax revenues gains estimated by the JCT scaled for size in Ireland would be the equivalent of around €15 million in Corporation Tax a year which is 0.4 per cent of current receipts.  Of course, there is more to it than just the tax revenue as companies are seen as reneging on their US identities.

Unless the companies move some risks, functions or assets to Ireland as part of the inversion they are unlikely to pay any additional tax in Ireland (above what was paid on activities in Ireland, if any, before the merger).  Like the US, Ireland has a worldwide basis for the Corporation Tax.  However, the companies will pay corporate income tax in the source country where there risks, functions and assets are. 

Ireland will levy a 12.5 per cent tax on such trading profits but will grant a tax credit for corporate income tax in other countries.  If the amount of tax paid abroad results in an Irish foreign tax credit greater than 12.5 per cent of the taxable income then the amount of additional tax due in Ireland will be nil. 

This is almost always going to be case as virtually every country these companies operate in have a corporate income tax rate greater than Ireland’s 12.5 per cent.  This is particularly the case if the inversions involve US companies which keep most of their risks, assets and functions in the US and remain liable to the US 35 per cent corporate tax rate for profits sourced from the US. 

The gain for the companies is clear.  They will no longer be liable to pay the US 35 corporate income tax on their global, i.e. non-US, profits.  This is one of the highest corporate income tax rates in the world so means that US companies do face an additional tax liability on their non-US profits even when they get a credit for foreign corporate income tax paid in the source country.  Of course, US companies can use the extensive deferral provisions in the US tax code to delay the actual payment of this tax liability until the money is formally repatriated to the US and in some cases this deferral can be indefinite.

By inverting their residence to a a country such as Ireland companies can reduce the additional tax they have to pay on top of the tax paid in the source country.  For most of these companies the source country will remain the US and it is also likely that the US authorities will be more active in assessing the structures, and particularly the transfer pricing arrangements, of these companies to ensure that the appropriate amount of profit is attributed to the risks, assets and functions in the US and not deemed “offshore”.

Also in the piece, Simon Carswell references a note from a US law firm on the practice of inversions.  The note rightly highlights some costs of these inversions to Ireland.  There will be no additional tax revenue but Ireland’s contribution to the EU budget may increase if the companies cause an increase in Irish GNP.  There can be one-off effect (if the US company has retained earning on its balance sheet at the time of it residence relocation to Ireland) and an ongoing effect (if the company generates profits that are not distributed to shareholders but are added to retained earnings).  As the merged company is Irish resident this income is added to Irish GNP.

The ‘takeaway’ in the note is that US firms seeking to invert to Ireland should do more than the basic minimum required which does not require the relocation of any significant risks, assets or functions.  The law firm concludes that:

Although not a requirement, corporations should consider tangible investments beyond the requisite minimum of board meetings, including the establishment of accounting and treasury, legal, intellectual property and business development functions; the appointment of an Irish advisory board or resident Irish directors; and the establishment of regional trading or intellectual property hubs.

If some of these came to Ireland as part of an inversion then there might be gains here.  Absent them we are likely to continue to see articles on Ireland’s Corporate Tax regime.  And the attention may not be in the right place.  Sander Levin was not shining a spotlight on Ireland’s tax regime; he was shining it on the US regime which in the first instance makes these inversions attractive (due to its relatively high rate) and in the second instance allows them (with a low legal barrier to inversions).

There is nothing Ireland can do about these inversions.  We rightfully have freedom of establishment and, within certain limited restrictions, allow people to set up companies here.  There is nothing underhand that makes Ireland attractive for these inversions.  There is the low rate, stable regime, legal system, EU membership, network of tax treaties and all that. 

Changing these could reduce the attractiveness for inversions from which Ireland gains nothing bar unwanted, and maybe even unwarranted, attention but these are the key attributes Ireland uses to attract traditional foreign direct investment which brings a much more tangible benefit – employment.  As the policy of attracting FDI is likely to remain it looks like inversions will be a negative side effect of an attractive regime unless the US can overcome the paralysis in Congress and actually do something about it.  That would be a positive for Ireland but it seems unlikely. 

Thursday, July 3, 2014

Revised National Accounts and Fiscal Targets

The CSO have published the 2013 National Income and Expenditure Accounts along with this explanatory note highlighting the impact of some of the methodological changes.

Real GDP growth in 2013 was 0.2 per cent which is a revision of the previous estimate of –0.3 per cent. Nominal GDP has gone from a first estimate of €164 billion to a revised and updated estimate of €175 billion which is a very significant increase for the fiscal targets.

Here are the main fiscal aggregates as presented in April’s Stability Programme Update.

SPU Main Aggregates

If we leave everything unchanged except the 2013 NGDP (i.e. use the same nominal growth rates and same fiscal projections) we get the following:

SPU Main Aggregates - Revised

The changes are pretty clear.  The end-2013 debt ratio has changed from 123.7 per cent of GDP to 116.1 per cent of GDP even though the debt and the economy which has to service it is exactly the same – it is just measured differently.

The projections used in the SPU now result in a 2015 deficit of 2.8 per cent of GDP (and an ‘underlying’ deficit of 2.7 per cent of GDP which is the one that has been used up to now as the metric for the EDP targets).

The revisions and updates published today by the CSO mean that a larger deficit of around 0.2 per cent of GDP (c.€350 million) is allowable while still targeting the ceiling set for the deficit in the EDP – if that is what one wishes to do.

A second helping factor (and one that actually reflects economic performance rather than statistical revisions) is the revenue buoyancy that is evident in the Exchequer Returns for the first six months of 2014.  The budget day projection for general government revenue in 2014 was €60.9 billion.  This was unchanged in April’s SPU.

SEPA issues aside it seems that tax revenue is ahead of the DoF’s projections by around €500 million.  PRSI contributions are about €100 million ahead of the projection while the surplus from the Central Bank is around €200 million larger than expected.

There are some offsetting factors on the expenditure side – main health overrruns and a larger than expected contribution to the EU Budget.  Voted Capital Expenditure is “behind profile” but that could due to timing issues.

For recurring or standard items the fiscal position is probably around €500 million (c.0.3 per cent of GDP) better than was expected when the Budget and SPU projections were made.  This means the 2014 deficit outturn could be around 4.2 per cent of GDP if these improvements from H1 are just held and maybe even close to 4 per cent if the improvements continue to accumulate.

If the objective is to draft a budget targeting a 3 per cent deficit the fiscal effort required to so might be little more than the introduction of water charges.

PS Is there any indication somewhere of the budgetary impact in Ireland of the changes to the EU 6th VAT Directive that are due to come in force in January 2015?  That is the change that means the VAT payable on, for example, television subscriptions will be collected in the country of the customer rather than the country of the supplier.