Wednesday, April 16, 2014

The rise in GNP

Of the notable features of the first estimates of the 2013 national income statistics was the 3.4 per cent rise in real GNP.  The following table draws on data from the subsequently released quarterly non-financial accounts for Q4 2013 to get some insight into this. 

Final year figures for 2013 have not yet been released so the 2013 figures in the table reflect the sum of the individual quarterly outturns for 2013 so are incomplete and subject to revision.  Figures for earlier years are annual figures taken from the non-financial accounts.  All the figures are nominal.  Click to enlarge.

GNI from GDP

The table starts with Gross Domestic Product (GDP) ends with Gross National Income (GNI).  GNI is very similar to GNP with the only difference being minor flows of international (i.e. EU) taxes and subsidies on products. 

What do we see? The 2013 increase in GNI was 3.8 per cent which is close 4.0 per cent increase in nominal GNP shown in the preliminary results from the quarterly national accounts.   It can also be seen that the starting point of nominal GDP was largely unchanged over the last year with a rise of 0.1 per cent recorded.

From there the primary reason for the €5.1 billion increase in GNI is the €3.4 billion reduction in the retained earnings of companies in Ireland.  It is likely that most of this is owed to non-residents (the Rest of the World sector) and is related to the fall in profitability in the pharmaceutical sector arising from the ‘patent cliff’.

An unusual feature of this is that it is not reflected in the GDP figure which serves as the starting point in the above transition to GNI .  It must be the case that something else rose to offset the GDP impact of the reduction in profits of foreign-owned firms.

Part of this can be seen in the table above: product taxes collected by the government.  These rose by around €1 billion during the year.  This increases GDP but on their own are not enough to explain the stability of GDP.

Within the GNI calculation itself it can be seen that dividends received by the domestic sectors increased by €1.4 billion.  Dividends received by government, financial corporations and non-financial corporations all increased in 2013.  Click to enlarge.

Dividends and Retained Earnings

The increase in the dividend receipts and retained earnings resources of non-financial corporations since 2010 is particularly noticeable but, as stated, much of the 2013 increase is attributed to the government and non-financial corporate sectors.  If these arose from the profits of domestic firms then it would be reflecting in the GDP and GOS figures but to the extent that these dividends are paid from abroad they would be a reason behind the increase in GNI.

Finally, in the first table there is the measure of “Property Income” which excludes dividends and retained earnings and includes interest, rent and income attributed to insurance policy holders (pensions and life assurance).  By far the largest elements of this is interest.  The net amount of this property income increased from €6.2 billion in 2012 to €7.4 billion in 2013. Here are the recent interest flows (these are the interest amounts after the FISIM adjustment).

Interest

The numbers are very large.  Looking at the net flows with the Rest of the World we have interest paid by ROW to Ireland minus Interest paid by Ireland to ROW which gives:

  • 2012: €35,989m -  €28,081m = €7,908m
  • 2013: €32,972m - €24,153 = €8,819m

Ireland has a large external debt but there is more interest paid into the country than leaves (after the FISIM adjustment).  In 2013, this net flow provisionally increased by €0.9 billion.  This probably didn’t have a large impact on GNI though. 

The lower panel of the above table shows that almost all of the interest is received by the non-financial corporate sector: €39.1 billion out of €41.1 billion.  Most of this again is received by collective investment funds which form part of the IFSC.  And most of the return/profit earned on this will be in the €25.5 billion of dividends/retained earnings owed by financial corporations shown in the previous table with the likelihood being that most of that is owed to non-residents.  For the years up to 2012 it can be seen that the bulk of dividends/retained earnings is owed to the Rest of the World (in 2012 it was €57.4 billion out of €80.6 billion).

So interest doesn’t really explain the increase in GNI.  One point worth noting in the table is the drop in interest receipts of the household sector from €4.3 billion to 2008 to €0.6 billion in 2013 (after the FISIM adjustment).  Lower interest rates are good for borrowers but not for households with savings.

Anyway, why did GNP rise?

  • GDP remained unchanged (with increased product taxes offsetting some of the fall in company profits from the ‘patent cliff’)
  • Retained earnings owed by companies fell by €3.4 billion (with most of the likely owed by non-resident companies)
  • Dividends received by domestic sectors increased by €1.3 billion (with some of this likely paid by non-resident companies)

But this doesn’t really answer the question.  The key is GDP remaining flat in spite of the drop of profits for foreign-owned companies.  So the question is not why did GNP rise, but why did GDP stay flat.

Tuesday, April 8, 2014

Effective Corporate Tax Rates for the EU28

The issue of effective rates for corporate income tax is getting some attention at the moment.  Suggestions that the effective rate for Ireland is around 11 per cent are generating the expected responses.

One of the measures of the effective tax rate proposed is corporate income tax paid (D51B) as a proportion of the Net Operating Surplus (B2N) of non-financial corporations (S11) and financial corporations (S12).

A further question is how this compares relative to the equivalent rate for other EU countries.  Here are the answers, where available, for the EU28. Click to enlarge.

EU28 ETRs

The Irish figure is again 10.9 per cent, which can clearly seen to be ‘low’ relative to the un-weighted EU28 average of 19.2 per cent.  And this of course is deliberately and transparently so.  At 12.5 per cent Ireland has one of the lowest headline rates for corporation tax in the EU.  There is nothing hidden or secret about that.

Only two countries have an average annual rate lower than Ireland: Estonia (1.7 per cent) and Lithuania (7.0 per cent).  Latvia (13.1 per cent) and Bulgaria (13.2 per cent) have the next lowest rates above Ireland’s.

There are probably lots of important details that need to be understood when interpreting the above table (the rate for Germany seems unexpectedly low) and people can make of it what they wish.  From an Irish perspective it can simply be noted that the Eurostat data show a figure of 10.9 per cent.

Just what was guaranteed and who was bailed out?

We are all aware that the decision of September 30th 2008 resulted in a the creation of a contingent liability of around €440 billion for the State but details about this total have been scant. 

We know that €75 billion was a result of the Deposit Guarantee Scheme, the limits of which has been substantially increased just over a week previously and this chart from page 77 of the Nyberg Report provided an overall breakdown of the €375 billion of liabilities covered by the near-blanket guarantee.

Guaranteed Liabilities

Via an FOI request by TD Stephen Donnelly, new figures (well new to me anyway) giving the breakdown of these liabilities by institution have now been released.  This may be raking over old ground but here are the figures. Click to enlarge.

Guaranteed Liabilities by Institution

There are no hot embers and the figures are much as would be expected from looking at the annual reports of the banks issued for this period (though only Anglo had a year-end at the time that coincided with end-September 2008).

The figures of central interest are undoubtedly those for Anglo and INBS.  These are the institutions which, in retrospect, should not have been saved.  All told, the State provided €34.7 billion of capital injections to shore up these delinquent institutions.  Most of this money went to depositors.

Between them Anglo and INBS had €77.4 billion covered by the guarantee.  Of this, €2.4 billion was date subordinated debt none of which matured during the two years of the guarantee and was subsequently subject to haircuts of between 50 and 70 per cent.  That leaves €75.0 billion of liabilities to meet the €34.7 billion of losses covered by the State’s capital injections.  For simplicity we will combine the two banks as one, which of course did subsequently happen.

If this could have been known at the time, or some immediate way was found to freeze these liabilities until the total loss was known then a haircut of 39 per cent would have been required.  If a fixed 39 per cent haircut was applied across the board then the following losses would have resulted.

Anglo-INBS Rescue

If put into resolution, the customer deposits up to €100,000 protected by the Deposit Guarantee Scheme (DGS) would need to be made good and the DGS would then take the place of the depositors but as an unsecured creditor of the bank.  That is why the DGS appears in the above table of estimated losses and means the €34.7 billion would be spread across most of the banks’ creditors.  [If the DGS deposits were paid from the assets of the bank the required haircut on the other creditors would rise to 46 per cent to give the €34.7 billion of savings. But that is not how it would work.]

Even if the bank was put into immediate resolution the DGS scheme would have had to meet a loss of around €5.2 billion and presumably this would have come from public resources.  Of course there is also the question of where €13.2 billion would have come from to make good the covered deposits up front.  It was going to be the “cheapest bailout in the world”.

After the losses that have remained to be absorbed by the State (via the DGS) we can see that depositors outside the DGS were sheltered from around €20 billion of losses through the guarantee and senior unsecured bonds from around €9 billion.  This assumes that the same fixed haircut is applied to all creditors and that the resolution wasn’t botched to the same extent that the Cypriot case was four years later. 

Haircuts to depositors would have been a very remote possibility in September 2008.  If the resolution option was taken it is likely that all deposits would have been made good in the manner of the DGS-backed deposits with the State taking their place as an unsecured creditor. 

To cover all the deposits in Anglo and INBS this would have required finding €63.8 billion up front with the State only getting €38.7 billion of this back if the resolution resulted in the same level of losses that have been provided for to date.  A deposit rescue of Anglo and INBS would have cost the State €25.1 billion.

Simplifying assumptions aside this shows that, by amount, the big winners from the decision to guarantee Anglo and INBS were depositors, not bondholders.  Bondholders did dodge something around €9 billion of losses through the failure to put Anglo and INBS into resolution around the time it became known they were insolvent.  €9 billion is a massive amount of money.

Friday, March 28, 2014

Retail sales up (on the year)

In adjusted terms, core retail sales fell in February but remain much higher than they were at the same time last year.

Retail Sales to Feb 14

This chart excludes the Motor Trades and a strong upward trend can be seen, for the volume series in particular, from around spring 2013.  Volume in the Motor Trades category is up 15 per cent in the year but fell six per cent in the month.

In annual terms the increase in retail sales volume is close to the level seen during the spike in sales caused by the ‘digital switchover’ in late 2012 and higher than at any other point since the start of 2010.  It can seen that the annual growth in the value series is much more muted.

Annual Change in RSI to Feb

All in all, good but only weakly so.

Tuesday, March 18, 2014

The BoP Current Account: IFSC v non-IFSC

Last week’s slew of economic data from the CSO did little to provide a clear picture of the current direction of the economy.  In the national accounts data, 2013 GDP was down, albeit only slightly, while GNP was up a hefty 3.3 per cent.

GDP is a measure of the output that takes place in a region; GNP is a measure of the income that accrues to residents of a region.  A rise in GNP should be unambiguously good.  However, across the economy there is little to indicate what is driving the increase in income for Irish residents.  Employment is up but little else is.

Also released were the Balance of Payments data and this seems to paint a very positive picture.

BoP Current Account

The turnaround from a 6 per cent of GDP current account deficit in 2008 to a near 7 per cent of GDP current surplus in 2013 is impressive.  This is important for a country with a large foreign debt as one way to repay the debt is to have a net gain from transactions with the rest of the world. [The debt can also be paid down by selling domestic assets to foreigners.]

In part the improvement was driven by the fall in imports after the end of the credit-fuelled consumption and construction boom in 2008.

BoP Merchandise Imports

On issue with this is that the fall was abrupt and was completed by 2009 as construction, car sales and other elements of the economy ground to a halt.  So what has driven the continued improvement in the current account since 2010?

Last year, Prof. John Fitzgerald in a useful note outlined the impact that the retained earnings of companies re-domiciling to Ireland had on the figures.  In essence, when a company moves its headquarters to Ireland any retained earnings it has are counted as Irish “income” at the time the company moves to Ireland.  These are added to GNP as the companies have become Irish resident but they have no impact on the domestic economy.  If the companies subsequently remit them as dividends to their foreign shareholders they will subtract from GNP at that time.

The rise in the inflow of these earnings in 2010 is fairly clear.

BoP Reinvested Earnings

And the net flow due to re-domiciled companies was estimated by John Fitzgerald to be:

JF Redomiciled Companies

Again, one issue with this is the stepped nature of the increase.  This undoubtedly led to an improvement in the current account but in relative terms the current account continued in 2012 and 2013 when the impact of retained earnings seemed to have levelled out (though 2013 figures are not available).

Within the Balance of Payments the CSO provide a breakdown between the “IFSC economy” and the “non-IFSC economy”.  The performance of the current account for each are shown below.

IFSC v non IFSC

In 2012 and 2013 the current account associated with “IFSC” companies has been increasing while that associated with “non-IFSC” companies has been flat.  The “non-IFSC” current account has improved since 2008 – because of the import reduction and also likely because of the re-domiciled firms – and there is only a very small “non-IFSC” surplus.

It is not clear to what extent the re-domiciled firms are “IFSC” or “non-IFSC” but it can be seen that the “IFSC” current account was largely unchanged in 2010 and 2011 when the effect identified by the John Fitzgerald was increasing.  It seems as though the impact of the re-domiciled firms is reflected in the 2010 improvement in the “non-IFSC” current account.

We can further break the “IFSC” balance into that determined by trade (service exports minus service imports) and that attributable to income (income inflows minus income outflows).

IFSC Balances

Both improves in 2013, but the balance of services for “IFSC” companies improved in both 2012 and 2013.  What is noticeable is that the service trade gains for IFSC companies is not reflected in an outflow of IFSC income.  The trading gains are likely accruing to Irish-resident companies and are thus recorded as part of GNP.

If the changes in the IFSC balances were due to the timing of the re-domiciling of companies it would only show up on the income side.  As the IFSC service balance is also improving it is the case that the improvement in the Balance of Payments current account (and thus the improvement in GNP) is down to the activities of IFSC companies. 

There aren’t many who would consider that an improvement in “Irish” income.  There are gains from this as around €1 billion of corporation tax is paid by IFSC companies annually (though this is a claim from the IFSC itself).  All this highlights the difficulties in ascertaining anything about the direction of the Irish economy given the impact things like the IFSC and MNCs have on the national aggregates.

In 2008 and 2009 Ireland’s current account improved because of the large drop in imports.  It seems much of the improvement since then can be attributed to re-domiciled firms (which are foreign owned) and the activities of IFSC companies.  They are unlikely to be of much use in helping to pay down our external debt.

SMEs and 70 per cent of employment

The relative importance of SMEs to the Irish economy has been touched on during the recent discussion of SME debt.  Sometimes it is stated that SMEs provide 70 percent on employment.  That is not quiet true.  Something along the lines of 70 per cent of people engaged (employee or proprietor) by private sector enterprises are with SMEs is better but it can be seen that this excludes all public sector workers and the self employed.

The 70 per cent figures comes from the CSO’s Business in Ireland 2011 survey which opens chapter one starts with “Six Key Findings from Business in Ireland 2011” of which the first is (emphasis added):

1. Key statistics on small and medium enterprises (SMEs)
In 2011, SMEs (employing less than 250 persons) accounted for 99.8% of active enterprises, 68.6% of persons engaged, 50.1% of turnover and 46.0% of gross value added (GVA). GVA is the gross income from operating activities and is the balance available to enterprises to pay employees and realise a return on investment. It is noticeable that while SMEs employed almost seven in every ten persons in the business economy, they accounted for less than half of GVA.

The seven in ten statistic clear refers to “the business economy”.  As stated this excludes public sector employees and the self-employed.

There are around 1.9 million people working in Ireland.  They can roughly be broken down as:

  • 800,000 in c. 180,000 SMEs (with < 250 employees)
    • 320,000 in c.170,000 micro enterprises (< 10 employees)
    • 260,000 in c.15,000 small enterprises (11 to 49 employees)
    • 220,000 in c.2,500 medium enterprises (50 to 249 employees)
  • 400,000 in c. 500 large enterprises (with > 250 employees)
  • 350,000 in the public sector (excluding semi states)
  • 350,000 self-employed (with and without paid employees)

SMEs count for around 42 per cent of employment in Ireland.  SMEs are the largest source of employment but not 70 per cent of it.

Sunday Business Post 16/03/14

Here is the submitted text for an article in this week’s SBP on SME debt, the state of the banks and this year’s stress tests for eurozone banks.  It continues below the fold.

Should we fear an SME loan meltdown?

In 2007 Prof. Morgan Kelly identified the likely 50 per cent fall in Irish house prices. He set out the implications this would have for construction employment but suggested that the larger banks were “well-capitalized” with unemployment and “macroeconomic dislocation” being the main problems that would emerge. The analysis was incredibly accurate on house prices and the consequences for employment and it wasn’t long before the impact on the banking sector also became clear.

The underlying factor to the most recent warning is not property price falls but the banks calling in loans provided to small and medium enterprises (SMEs) and in the event of their inability to repay the banks would foreclose on the businesses. Again the threat is to employment but it is not limited to 300,000 construction jobs; it is to SME employment across the entire economy.

Tuesday, March 11, 2014

Questions facing Ireland about Apple

In The Irish Times yesterday John McManus had a piece under the headline ‘Ireland faces questions on fruitful Apple tax deal’.  The three questions posed were:

  • Is there a “special” two per cent rate in Ireland for Apple?
  • Is there a “loophole” that allows Irish-incorporated companies to be non-resident here?
  • Is there a deal in Ireland to allow for “income taxed at lower rates”?
  • Should Apple have paid $890 million Irish corporate tax based on the 12.5 per cent rate instead of the $36 million paid?

At the time of the US Senate last May they was a lot of noise around a special 2 per cent tax rate that Apple had apparently negotiated with the Irish government.  There is no doubt that there were targeted and generous tax breaks given to MNCs who set up operations in Ireland in the 1970s and 1980s but there is no 2 per cent rate for Apple.

McManus calls it “the 2 per cent rate it told Congress that it had agreed with Ireland” and writes:

Apple have never withdrawn this assertion, but at the same time they have stood back and let the Government kick up as much dust as they can around the issue.

During the hearing it was the Senators who said there was a two per cent rate not the Apple executives.  Although put to them the Apple executives did not address it in the Senate hearing but around a week later, Apple CEO, Tim Cook, gave an interview (video here) where he said:

“I’ve seen something in the press that says that some people think that we have a deal with the Irish, a special deal with the Irish government, to pay two per cent flat tax rate.  We have no special deal with the Irish government that gives us a two per cent flat tax rate.  So let me just set that aside.”

So no special deals on rates.  Is there a special deal on something else?  McManus further adds:

The counter narrative advanced by the Government was that there is no special deal but Apple instead availed of a loophole in Irish law that allowed companies to be Irish registered but not Irish domiciled. This quirk of Irish tax law opened the door to low tax heaven we were told.

The loophole was closed in the Budget and the Government seems to have got the “no special deals” narrative back on track. Until last week that was.

Yes, Irish law does allow Irish registered companies to be non-resident.  There is nothing unusual or “quirky” about that.  The change announced in the Budget was not about making Irish-incorporated companies resident here.  The change was a minor one which did not change the residency rules. 

It merely said that if an Irish-incorporated company owned or controlled by foreign residents was not deemed to be resident in Ireland, under the test of management and control, that the company had to tell the Revenue Commissioners where they were resident.  There is no change in the ability to have non-Irish resident, Irish-incorporated companies it is just that such companies have to declare their tax residence and cannot be “stateless”.  These residency rules apply to all companies; not just Apple.

To conclude McManus goes back to rates with reference to “income taxed at lower rates” in ASI’s 2009 accounts.

Is this then the special deal that Apple told the US Congress existed but the Government denies? In the absence of any clarification it is a basis for legitimate suspicion and potentially a fatal hole in the “no special deals ” claim.

This puts them in a very difficult position because the EU and the European Commission – who seem to have bought the no special deal line – may be wondering quite rightly if they have been sold a pup. They no doubt would like to know what “income taxed at lower rates” means as should anyone else paying the full statutory rate of 12.5 per cent corporation tax.

The meaning of “income taxed at lower rates” is a legitimate question.  The answer is a tax rate of zero because the US allows Apple to defer the US taxes its owes on certain foreign-source income.

ASI will be taxed on the profits it generates from holding the global rights to Apple’s intellectual property in the country in which it is resident.  This could be in Cayman or Bermuda where there is no corporation tax or a corporation tax of zero.  Instead Apple set up a structure and chose to have ASI tax resident “no where”.  The corporate tax rate in “no where” is also zero.

Everything ASI does is in the US but because it is not incorporated there it is not deemed to be resident there.  ASI is incorporated in Ireland but it is a ‘relevant’ company to which the test of management and control is applied to determine residency.  ASI is not managed and controlled in Ireland.

The “income taxed at lower rates” is achieved by ASI because it is “stateless”.  The US does have the right to collect corporation tax on all the profits earned by ASI but this has been deferred until the profit is repatriated as dividends to the US.

The corporate tax liability on ASI’s profits is 35 per cent.  The corporate tax paid on ASI’s profits is almost nil.  The US does not want to see Apple pay corporation tax on this profit in another country as it will reduce the amount it can collect.  Ireland does not have any questions to answer on this.  It is a US decision to allow ASI to defer its US tax liability.

So,

  • is there a “special” two per cent rate in Ireland for Apple?
  • is there a “loophole” that allows Irish-incorporated companies to be non-resident here? 
  • is there a deal in Ireland to allow for “income taxed at lower rates”?
  • is Apple avoiding paying $850 million of Irish corporation tax?

These are all legitimate questions but the answers are known. 

There is nothing Ireland can do that will result in more tax being paid in any other country.  Ireland can levy tax on profits that are sourced here by non-residents or earned anywhere by residents.  ASI does not source its profits here and is not resident here.  We could make ASI resident here by having all Irish-incorporated companies deemed Irish resident but what would happen then…

UPDATE: The Tánaiste, Eamon Gilmore, was asked these questions in the Dáil today by Joan Collins T.D.  The answer he provided is here

It deals with some of the issues but avoids others.  It is noticeable that the United States, US corporation tax or deferral provisions are not mentioned at all.  In the Senate hearing last May the US Senators were quick to heap blame on Ireland for outcomes caused by US tax laws – many that they had voted for.  On this side of the Atlantic we daren’t even say the name the country.

Residence and the test of management and control

Ireland’s corporate tax regime continues to attract attention.  The 12.5 per cent rate is low by any standards but it is the regime around the rate that is in the spotlight.

Much of the recent attention focuses on the test of residency Ireland applies to companies.  This is an important part of any corporation tax regime.  Apple Sales International is an Irish-incorporated company but is not resident here.  Is this unusual?

Ireland’s corporation tax regime is relatively unusual in one way: Ireland taxes resident companies on their worldwide income.  This is in contrast to a territorial system where resident companies only pay taxes on profits earned in the country they are resident in.  Most countries adopt territorial systems.  The US, notoriously, has a worldwide system, but unlike the US there are no deferral provisions for Irish companies paying Irish corporation tax on their non-Irish source income.

The deferral provisions available in the US tax code are the key factors behind the tax outcomes attracting attention in the current debate.  But tax residency is also important.  If a company is not a tax resident in Ireland but has operations here it will still be subject to Irish corporation tax, but only on the profits actually sourced here.

This is a common official line in the debate.  Ireland can tax the worldwide profits of companies which are resident here and also the Irish-source of non-resident companies.  A company cannot have profits in Ireland that are untaxed.  Naturally, Ireland cannot tax the worldwide profits of companies which are not resident here.  Claims to the contrary are wide of the mark and in the case of Apple people should remember that Apple is a US company.

Ireland’s residency rules are a relatively straightforward.  In general, a company is resident in Ireland if it is either incorporated in Ireland or has its place of central management and control in Ireland.

However, there are some exceptions to this and for certain companies only the test of management and control is used to determine if they are resident in Ireland.  The test of incorporation is not applied.

Under the “trading” exemption an Irish incorporated company is not treated as Irish resident if it is a ‘relevant’ company.  A ‘relevant’ company must either carry on a trade in the State or be related to a company that carries on a trade in the State and is one that is either ultimately controlled by non-residents or owned by non-residents (based on the stock market its shares are traded on), where the non-residents are in an EU or tax treaty country.  A company will not be a ‘relevant’ company if it is centrally managed and controlled in Ireland.

Thus, only the test of management and control is applied to some foreign-controlled or foreign-owned companies to determine their residence in Ireland even if they are incorporated here.  This provision is not available to “brass-plate” operations.  There must be a trade or “presence of substance” in Ireland.  Foreign companies can have non-resident, Irish-incorporated companies but only if they have a presence, i.e. employment, here.

The fact that the residency of some companies is solely based on the test of management and control is a factor in the “double-Irish” tax strategy used by some US companies to facilitate the deferral of their US tax liability while holding the profits in a low/no tax jurisdiction.

The “double-Irish” depends crucially on the “same-country” exemption in Subpart F of the US tax code.  Without this exemption the strategy is redundant.  In general, US corporation tax must be paid on US companies’ foreign-source passive income as soon as it is earned.  However, there are a number of provisions that allow the deferral of this tax until the profits are repatriated as dividends to the US.

The “same-country” exemption is one such provision.  Transfers of certain passive income between two companies in the same country do not trigger a US corporation tax payment – the view being that a transfer between two companies in the same country would not be done for US tax purposes.

However, what the US views as two companies in the same country (based solely on the test of incorporation) and what other countries view as two companies in the same country (perhaps based on the test of management and control) may not coincide.

In Ireland’s case some US companies have two Irish-incorporated subsidiaries.  The first can be a sales operations which is deemed as resident here and the second a related holding company to which the Irish “trading” exemption applies.  Though incorporated here the holding company will not be deemed a resident here as its effective management and control does not take place here (nor any other part of its structure or operations).  In many cases the holding company will be based in a low/no tax jurisdiction in the Caribbean.

The Irish-resident sales company will make patent royalty payments (passive income) to the Caribbean-resident holding company.  This will not trigger a US tax payment as the US tax laws view the two Irish-incorporated companies to be Irish residents and then the transfer between them benefits from a deferral under the “same-country” exemption.

As stated, the most crucial part of this scheme is the “same-country” exemption in the US tax code.  There would be no “double-Irish” without it.  The second part is the interaction with another country where companies incorporated there are not automatically deemed resident there.  The use of the test of management and control facilitates this.  This allows the companies to be in operated in different countries but the US law views them as being in the same country.

Ireland applies the test of management and control as the sole judge of a company’s residency for certain companies - ‘relevant’ companies as described above.  But Ireland is not unique in applying the test of management and control to determine residency.  There are some countries which apply the test of management and control when determining corporate tax residency to all companies.  These countries include:

The residency laws in these ten countries all allow the creation of “double-Irish” type tax structures where passive income transfers between US MNC subsidiaries can be made without triggering a US corporate tax payment.  There is nothing unique about Irish tax residency rules that facilitates the “double-Irish”.  [A country’s tax treaty network and withholding tax are also factors.]

It could be equally be a “double-Cypriot” or a “double-Mexican” or a “double-Sri Lankan”, and it is almost certain that some US MNCs have set up twin-incorporated companies in these countries to avail of the “same-country” exemption.  It just seems the companies that do it from those countries haven’t been put under the glare of public scrutiny.

But they are there.  Here is a report of Yahoo using a “Double-Singapore” and it even has a “Dutch-Sandwich”.

Yahoo recently introduced another circuitous path through the Netherlands to cut the taxes on profits from its Asian sales: Royalties travel from Singapore, through Dooves’s house, to another subsidiary in Mauritius, a tax-friendly island off the southeast coast of Africa.

They may be about to set up a similar arrangement in Ireland!  But it is not because of anything unusual or unique in Irish residency rules.  As the list above shows ten countries base residency on the test of management and control on which the “same-country” exemption depends. 

There is nothing unique or unusual about Ireland’s residency rules despite much opprobrium to the contrary.  The current international corporate tax regime confers the right on the US to tax the profits earned by Apple through its intellectual property.  The fact that the US does not immediately exercise that right and allows a deferral of the tax (in theory the tax must be paid – eventually) is a matter for the US and the US alone.

Maybe the system will change and the tax rights will be assigned differently, perhaps by formulary apportionment, and it would be helpful if the debate moved to such a discussion.  But why do that when you can just shout about Ireland.

Sunday, March 9, 2014

Who is to blame for ASI’s effective tax rate of 0.1%?

The current OECD-led network of tax treaties is about conferring the rights to tax income that is earned across borders.  The purpose of the treaties is to avoid double taxation so the right to tax is determined by the rules that underpin the treaties.

Under the current system the rights to tax Apple’s profits (earned from US research and development) lie with the US.  The fact that the US, through its deferral provisions, doesn’t exercise that right when the profit is earned but allows a deferral until the profit is “repatriated” is an issue for the US and the US alone.

Neither Ireland, Australia nor any other country have to right to tax those profits.  Ireland can affect the rate levied on profits earned in Ireland but Ireland has no jurisdiction over the profits of non-residents earned in other countries.  There is nothing that can be done here to change that.  Ireland has no right to tax the profits of non-resident companies earned outside of Ireland.

Is Ireland to blame for the US not collecting US taxes? No, but it suits Capitol Hill that Ireland is blamed. 

The current corporation tax system could be changed so that the right to tax the profits is conferred differently but that requires a change of the source, residence and transfer pricing principles currently used.  The OECD’s BEPS programme which change things but the debate is around the system as it is now.

Ireland’s corporation tax regime is deliberately attractive for foreign investment.  In general, however, these deliberations have given more thought to what not to change as opposed to what to change. 

A major part of the attraction is stability.  Things don't change - or at least they didn't up to last October.  Ireland’s corporation tax rate and regime get a lot of attention but what elements can be changed to change the outcome - the amount of tax paid either here or elsewhere?

There is no change that can be introduced in Ireland that will result in more corporate income tax being collected in say, Australia.  Australia could move to impose a greater tax on Apple for the “profits” it earns there but that would violate every tax treaty Australia has entered into which sets out what should be taxed where (source and residence) and how much should be taxed (transfer pricing).  Apple doesn’t earn profit by selling to customers in Australia; it earns profit by designing a product in the US that Australians want to buy.  The current rules attribute the profit to the activity in the US.  If Australia wants to collect more tax from the sale of Apple products there it can do so via an increase in sales taxes.

There is also no change that can be introduced in Ireland that will result in more tax being collected in the US.  There are a huge range of structures that can be put in place to allow US companies to defer the payment of their US corporate tax liability on their foreign-source income.  The “double-Irish” and “stateless income” have got some public attention but many more are possible.

Why do companies engage in these particular strategies? Stability.  Companies don’t like having to change and reorganising their structure is time-consuming and costly.

The “double-Irish” (so-called even though it would work in numerous countries) is based on residency and, crucially, on the “same-country” exemption in Subpart F of the US tax code which allows the transfer of passive income between two related companies without triggering a US corporate tax payment.  Companies use the “same country” exemption because it is a permanent feature of the US tax code – it needs a vote in Congress to be repealed.  And the US law won’t change.  The other part involves finding a country that with appropriate residency rules.  There are lots of possibilities.  The US companies want a country that determines residency on the basis of the test of management and control.

Here is the company residency rule for Malaysia:

A company is resident in Malaysia if at any time during that basis year the management and control of its business is in Malaysia.

Legally that is all that is required to set up a “double-Irish” type structure.  The US company can establish two Malaysian-incorporated companies but have the management of one in another country – such as a Caribbean Island.  The US parent company can transfer passive income between the two companies and use the “same-country” exemption to avoid triggering a US tax payment.  Malaysia won’t tax the second company, the one holding the profits, because it is managed in another country.  This is the “double-Irish”, Malaysian style.

Why don’t US companies use Malaysia instead of Ireland?  There are many reasons but stability is an important one.  They don’t want to have to reconfigure their arrangement because the country changes its rules.  They want stability.

The residency rules in Ireland are actually more restrictive than those in Malaysia. Historically, the residency rule was (from revenue.ie):

All companies whose central management and control is exercised in Ireland (whether it is incorporated in Ireland or not) is regarded as resident in Ireland for tax purposes.

This was revised in the Finance Act, 1999, and now:

in general, companies incorporated in the State are resident in the State.

However, there are exceptions to this is.  One is a ‘relevant company’ that is ultimately controlled by persons resident in the EU or in a country with which Ireland has concluded a double taxation treaty and is related to a company that carries on a trade in the State  - the “trading” exemption.

This is a key feature of the Irish corporation tax regime.  It allows the residence of some companies to be determined by their ultimate control – the test of management – but only for companies that are related to companies that trades here.  You can only trade if you have employees.  A “brass-plate” operation is not sufficient; companies need a presence of substance, i.e. employment, to be able to avail of this provision.

Could we change our tax residency rules to make all companies incorporated here resident here?  Of course we could.  That would definitely end any reputation for stability and it would end the opportunity for US companies to avail of the “same-country” exemption here.

We could do this and it is the case that the US companies don’t need the Irish residency rules (or equivalent based on management and control) to achieve the same tax outcome.  In fact using the “look-through” rule they don’t need any residency rules at all to facilitate the passive income transfer to a related company in a low/no tax jurisdiction.  Certain related companies in any two countries will do. 

The “look-through” rule is far less restrictive than the “same-country” exemption and could be considered the “any country” exemption.  Under the “look-through” rule hierarchical subsidiaries of a US company can be treated as a single entity by looking through the lower level to reach the higher level.  Using this, passive income transfers can be made between subsidiaries in different countries as the transfer is considered to have happened within the same entity, so in essence is not considered to have happened at all.

Ostensibly, this was introduced to allow US companies to redeploy their foreign earnings in one country for re-investment and expansion in another country without triggering a US corporate tax payment.  This is true for the majority of companies who use the rule but a small number of hugely profitable companies can use the rule to accumulate profits in low/no tax jurisdictions without triggering a US corporate tax payment.

So why don’t companies use the flexible “look-through” rule instead of the more restrictive “double-Irish”?  Many do but the “look-through” rule is only a temporary feature of the US tax code.  Unlike the “same-country” exemption which requires a vote in Congress to be repealed, the “look-through” rule requires a vote in Congress to be continued.  It actually expired at the end of the 2013 tax year but there is still plenty of time for it to be appended to any bill for it to apply for the 2014 tax year and beyond.

The “look-through” rule gave legislative effect to the “check-the-box” election introduced by the IRS in 1996/7.  “Check-the-box” is little more than an administrative process in the IRS (but obviously one that has huge implications).  “Check-the-box” allows US companies to determine if an entity in their structure should be treated as a taxable entity on its own right or combined with several subsidiaries to form a single taxable entity.  By combining subsidiaries in a single tax entity the company can make passive income transfers between them without triggering a US corporate tax liability – the tax is deferred.

The “check-the-box” provision can be changed at any time.  The IRS actually proposed doing so in both 1998 and 2003 but a non-binding resolution was passed in Congress asking the IRS not to change the provision – the IRS complied.  And anyway, Congress went ahead and partly formalised “check-the-box” with the introduction of the “look-through” rule in 2005.

However, there is sufficient doubt around the provision such that companies will seek a structure that is not dependent on it.  They use it but if “check-the-box” changes they will ensure they can achieve the same result without it.  The “same-country” exemption offers that security hence the use of “double-Irish” type structures.

The “stateless income” scheme of Apple was also based on stability.  First was the certainty that the US would not change its company residency rules. They didn’t.  And certainty that ‘stable’ Ireland would not change its residency rules.  But we did!

Although it was a very small change, and will have no effect on tax outcomes, the knock-on consequences of Ireland changing have yet to be determined.  It is likely that a significant amount of thought went into the decision and as stated above more thought in Ireland goes to determining what not to change rather than what to change.

Apple’s “stateless” income strategy only works if the relevant company is not managed and controlled in Ireland otherwise it would be resident here.  But everything ASI does happens in the US.  Here is the company residency rule, Article 2.8, in the Ireland-France tax treaty:

A company shall be regarded as a resident of Ireland if it is managed and controlled in Ireland. It is agreed that this provision does not prevent the application, according to Irish law, of the corporation profits tax in the case of a company incorporated in Ireland which is not managed and controlled in France.

A company shall be regarded as a resident of France if it is managed and controlled in France.

That is pretty clear.  The residence of a company is based on the test of management and control.  There is no possibility of setting up a “stateless company” between Ireland and France; it has to be managed and controlled somewhere. 

US law does not recognise management and control.  It is a US judgment that a US company which carries out all its operations in the US is not tax resident in the US.  Who is to blame for that?

Ireland’s rate and regime undoubtedly play a role in determining the very low effective tax rates attributed to some US companies but not one that is overly significant.  The 12.5% rate is nice but that only applies to profits earned here (the companies will be subject to making up the balance at the 35% US rate anyway – if the US wants to collect it).  The regime has its attractions but none are so significant that if they were removed the same tax outcomes could not be achieved by US companies.  The government are trying to foster a reputation for transparency and cooperation.  That sort of reputation doesn’t concern the companies; a reputation for stability does.  On the tax side companies use Ireland because they don’t like change.

Yes, we have a low rate.  Plenty of other countries do too.  Yes, we have favourable residency rules for US companies. Plenty of other countries do too.  We have a reputation for stability, not many countries have that.  Britain’s “patent box” is unlikely to form a major part of MNC tax strategies until it becomes embedded as a part of the UK tax system that is unlikely to change (which will take a couple of years of Labour in power).

If Ireland is guilty of anything in the international application of corporation tax, it is stability. A good reputation is hard won but easily lost.  A bad reputation can be hard to shake off.  In any debate if you are explaining you are losing; Ireland is losing.