Wednesday, May 14, 2014

European Spring: Right villain, wrong reason

Philippe Legrain’s recent book, European Spring, has generated a good deal of reaction in Ireland.  Although it is a very broad-ranging book, and a recommended read, the focus in Ireland has been very narrow and mainly has been on the following passage:

For example, had Irish banks defaulted on all their debt at the end of September 2010, German banks would have lost €42.5 billion, British ones, €27.5 billion and French ones €12.3 billion.131

When Ireland was forced to seek a loan from EU and the IMF in November 2010132, the Irish government sought to backtrack on its foolish promise, made in the heat of the post-Lehman panic in October 2008, to guarantee all Irish banks’ debts.  Had it succeeded, the doom loop would have been greatly weakened.  Instead eurozone policymakers, notably ECB President Trichet, outrageously blackmailed the Irish government into making good on its guarantee, by threatening to cut off liquidity to the Irish banking system – in effect, threatening to force it out of the euro.  Thus, having exhausted the borrowing capacity of the Irish government, the creditors of Irish banks could now call on loans from other eurozone governments, along with Britain’s, Sweden’s and the IMF.  This was a flagrant abuse of power by an unelected central banker whose primary duty ought to have been to the citizens of countries that use the euro – not least Irish ones.  Bleeding dry Irish taxpayers to repay foreign debts incurred by Irish banks to finance the country’s property bubble was not only shocking unjust.  It was a devilish mechanism not for the safeguarding financial stability in the eurozone – which would be the ECB’s defence for its actions – but rather for amplifying instability.  It entrenched governments’ backstopping of bank debts, sparking fears about countries that had experienced an Irish-style bank-financed property bubble, notably Spain.  And it threatened to drag even countries with a reasonably sound banking system, such as Italy, into the doom loop if the situation deteriorated.

The sentiments expressed in the second paragraph here are not in serious dispute.  It was the case that the Irish government, through then Minister for Finance Brian Lenihan, did ”raise the issue” of  a “dishonouring of senior debt”.

It was then the case that haircuts to senior bank bondholders were ruled out and the ECB had a key role in this though the detail behind the decision are unclear.  In the clip above Brian Lenihan indicates that the ECB’s refusal to contemplate haircuts to senior bondholders (presumably only in Anglo and Irish Nationwide) was “unanimous”.

In an interview with The Irish Times in January of this year Jens Weidmann said of the time:

Jens Weidmann:  The Governing Council then was weighing bail-in versus financial stability risks, and its majority concluded that the latter were more relevant under the concrete circumstances. In that debate the Bundesbank has always considered it important to make investors bear the risks of their investment decisions and already then favoured contributions of investors in the event of solvency problems, especially for banks that are to be wound down. Our common goal is to be able in the future to wind down banks without endangering financial stability.

But a view opposing such haircuts was previously put forward by Jörg Asmussen in a speech delivered in Dublin in April 2012:

Jörg Asmussen: I know that the decisions concerning the repayment of bondholders in the former Anglo Irish Bank have been a source of controversy. Decisions taken by the Irish authorities such as these are not taken lightly. And the consequences of subsequent actions are weighed carefully. It is true that the ECB viewed it as the least damaging course to fully honour the outstanding senior debts of Anglo. However unpopular that may now seem, this assessment was made at a time of extraordinary stresses in financial markets and great uncertainty. Protecting the hard-won gains and credibility from the early successes in 2011 was also a key consideration, to ensure no negative effects spilled-over to other Irish banks or to banks in other European Countries.

It should be noted that Weidmann did not work for the Bundesbank or Asmussen for the ECB at the time these decisions were made in November 2010 so these are views that were subsequently relayed to them.  It is also worth noting that Legrain became an advisor to Barroso in February 2011 so he too was not involved when these discussions took place.

Regardless, it is now clear that the prospect of enforcing losses on senior bondholders in Anglo and Irish Nationwide was ruled out, in large part, at the insistence of the ECB.  But it is hard to see how this decision was made to save German, French or UK banks.  The decision was made to save the skin/face of the ECB.

In November 2010, the amount of senior bonds remaining in Anglo and Irish Nationwide was around €6 billion.  This is a very significant sum in Irish terms but relatively minor in the overall scheme of the European banking system.   A 66 per cent haircut on these would have been €4 billion of losses which would be little more than a ripple in the pool of European bank losses (even assuming such banks held all of them). 

The impact of the undertaking the action on capital and interbank money markets might have been a consideration but those markets broke down anyway.  Little was gained from refusing Lenihan’s request to impose losses on the €6 billion of Anglo/INBS senior bonds.

By November 2010, private banks had relatively little to lose from the bust Irish banks as a result of the repayments made during and, most significantly at the end, of the two-year guarantee introduced in September 2008.  But one institution did stand to lose heavily if the Irish banks collapsed (or if Ireland withdrew from the euro).  That was the institution that provided the money for these repayments to be made – the European Central Bank.

When the guarantee ended the reliance of the ‘covered’ Irish banks on central bank liquidity shot up.  By November the six banks were accessing €88 billion of liquidity from the ECB and also around €42 billion of ELA from the Central Bank of Ireland.

Central Bank Funding

The ECB did not bounce Ireland into a bailout to rescue German banks; it did so to ensure it would not be burned itself.   Central bank funding of the ‘covered’ banks was €130 billion in November 2010 and it peaked at around €150 billion in February 2011.  These are massive figures in all contexts. 

The ECB wanted to tie Ireland into a programme to ensure this was repaid.  And they were successful.  ECB funding to the remaining covered banks is now down to €23.5 billion while the use of ELA all but ended with the liquidation of the IBRC last February.  Reliance on central bank funding by the covered banks has been reduced by 80 per cent.

The first paragraph above extracted from Legrain’s book has some large numbers for potential losses to German, French and UK banks if the Irish banks defaulted in November 2010.  These numbers are meaningless in the context of the Irish banking collapse.  Footnote 131 tells us where they come from:

131 Bank of International Settlements Quarterly Review, March 2011.  Foreign exposures to Greece, Ireland, Portugal and Spain, by bank nationality, end-Q3 2010, converted from US dollars to euros at exchange rate on 30 September 2010 of €1 = $1.3615.

The BIS report referenced can be accessed here with the accompanying statistical annex here.  The figures used by Legrain are from Table 1 on page 15 of the report with panel below showing the figures for claims on Ireland with the German, French and UK bank claims on banks in Ireland circled.

BIS Q3 2010 Ireland

For some reason these figures for Q3 2010 are not the online BIS database. The total liabilities of French, German and UK banks to Ireland are available for Q3 2010 but in  it is not until Q4 2014 that a breakdown by sector (bank, non-bank private and public) is available from the database.

The table below shows the claims for German-, French- and UK- headquartered banks on Ireland (banks, public sector, non-bank private sector and total) for all quarters in 2010 and 2011 and the sectoral breakdown where available from the database. Click to enlarge.

BIS Claims on Ireland Data

The first quarter for which the sectoral breakdown is provided in the BIS database is Q4 2010 and the data shows that at that time the amounts owed by banks in Ireland to German-, French- and UK-headquartered banks were $28.5 billion, $8.1 billion and $18.3 billion respectively.  These are somewhat distant from the $57.8 billion, $16.8 billion and $37.4 billion figures for the previous quarter shown in the Q3 2010 BIS report.  This is not surprising and the reason for the rapid decline is the bank run that happened in Ireland in late 2010.

The figures are precisely true for what they represent: claims of foreign banks on banks in Ireland.  The figures are precisely useless for what they are most frequently used to represent: losses avoided by foreign banks from the rescue of the six ‘covered’ banks in Ireland.

One reason is that saying “German banks would have lost €42.5 billion, British ones, €27.5 billion and French ones €12.3 billion” requires there to have been a 100 per cent default which is patently unrealistic.  However, the main reason for the inappropriateness of the figures in trying measure potential bank losses that were avoided by the bank bailout is that there was far more than six banks operating in Ireland in late 2010. 

The Irish government rescued AIB, Anglo, BOI, EBS, INBS and PTSB.  The €64 billion comes from their rescue.  Included in the above BIS figures are also Ulster Bank, Bank of Scotland (Ireland), Danske, KBS, Rabobank and other foreign-owned retail banks operating in Ireland.

Most importantly though the above figures include the liabilities of banks operating in the IFSC which have close to nothing to do with the domestic Irish economy (apart from providing employment and paying some taxes) and equally nothing to do with the collapse and bailout of the Irish banking system.

A look at the post on the Irish bank run shows that an almost equal amount of deposits were leaving ‘Other Banks’ (i.e. IFSC banks) and all the ‘Domestic Banks’.  In fact, in the last six months of 2010 deposits in banks operating in Ireland fell by €200 billion; the reduction for the covered banks (a sub-group of the ‘Domestic Banks’) was €75 billion.  Most of the deposit flight from Irish banks was in those banks not bailed out by the Irish government. 

Total Deposits by Banks

The deposit flight can be seen in the reduction in foreign bank claims on the Irish banking sector in the above table from $148 billion and the end of Q2 2010 to $83 billion at the end of Q4 2010.  It is clear it is more than just foreign banks who withdrew deposits from banks operating in Ireland – again with most of that from the non-covered banks.

Whatever the BIS data can tell us, and it is useful in some contexts, it can tell us very little about the exposure of foreign banks to the six bailed-out banks in Ireland.  As shown in the table most of the foreign-bank exposure to Ireland is to the non-bank private sector which is likely to be collective investment funds based in the IFSC.

Do we have any insight on the foreign funding used by the six ‘covered’ banks?  Yes, from this research note from the Central Bank of Ireland which looked at the foreign-funding of “Irish-headquartered banks”.  By and large these were the six covered banks (AIB, ANGLO, BOI, EBS, INBS and PTSB) but did also include some banks active in the covered bank market (Pfandbrief banks) who had their headquarters in Ireland from 2002 to 2011.

The funding of Irish-headquartered banks is usefully summarised in this chart.

Foreign Funding of Irish Banks

The conclusion is pretty straightforward:

Throughout the 2000s the UK remained the predominant source of foreign funding for the Irish banking system, representing 77 per cent of foreign funding by mid-2008.  After the UK, creditors in the US and offshore centres accounted for the most substantial shares of foreign funding at 13 and 5 per cent, respectively by mid-2008

Germany was the source of approximately 11 billion or 25 per cent of total foreign funding at end-2002.  Thereafter, absolute German funding fell quite quickly to below 5 billion, or 5 per cent, by end-2006 and to below 1 billion or 1 per cent by end-2007. Pfandbrief banks headquartered in Ireland accounted for nearly eighty per cent of this funding.

The relative unimportance of other euro area countries as a source of the Irish banking system’s foreign funding is surprising.

And the chart is done on a residence basis.  If Irish banks got funding from affiliates abroad it would be included in the above chart.  Most of the covered banks had operations, of varying sizes, in the UK.  So if AIB-UK provided funding to AIB in Ireland it is counted as UK-sourced funding in the above chart. 

It can be seen in the chart below that almost all of the increase in the foreign funding of Irish banks was from banks (the red line) with most of this from non-affiliates (the blue line) than from affiliates (the purple line).

Sectoral Profile of Foreign Funding

It can be seen that at the end of bank guarantee funding from non-affiliated foreign banks collapsed from around €55 billion to around €5 billion.  This was offset by an equally sharp but temporary increase in funding from foreign-affiliated banks.  By the time of the bailout (the middle of the dashed lines) the amount of funding owed by Irish-headquartered banks to foreign banks was very very small.

Of course, the above data doesn’t allow us to pierce through and see where the affiliated foreign banks were getting the funding they were providing to their Irish parents. 

All this really shows is that in November 2010 German, French and UK banks were not in hock to the failed Irish banks.  The Irish banks did get funding by the UK interbank market but that ended with the guarantee a couple of months previously.  At no time did the Irish banks access significant funding from German or French banks.

The ECB did not force Ireland into a bailout and require the repayment of senior bond in Anglo and INBS to save German and French banks; it was done to save the ECB itself which was owed €150 billion by the Irish banks and was trying, and failing, to keep the European banking system fluid.  The ECB was ensuring that it got its €150 billion euro back and was trying to save face because as a central bank it can’t go bust.

Philippe Legrain is right to point out that ECB forced Ireland into costly actions such as the repayment of €6 billion of senior unsecured (and by that time unguaranteed) bonds in Anglo and INBS.  He is wrong to say it was to save German and French banks.  By November 2010, foreign funding from non-banks (c. €25 billion) was much larger than from foreign non-affiliate banks (c. €5 billion) and foreign affiliate bank funding was largest of all.  It is likely that most of the €6 billion repaid on those bonds went to non-banks.

Why did the ECB bounce Ireland into a bailout?  It wasn’t to rescue German and French banks.  It was probably to ensure that Ireland did not have the time to make provisions to put an alternative currency in place.  We don’t know if the government had a Plan B in place in November 2010, and even if there it it is likely to have been something that had close to zero chance of actually happening, but the ECB wasn’t going to give them the opportunity to think about it. 

Monday, May 12, 2014

Apple, Beats, Google and how it is still possible to have a ‘stateless’ Irish company

The announcement of an Apple takeover of Beats Electronics throws up some issues in relation to corporate tax residence. Ireland’s residency rules for companies are relatively straightforward: all companies managed and controlled are deemed resident in Ireland and all companies incorporated in Ireland are resident in Ireland with two exceptions - the 'trading' exception, which applies to some foreign-owned companies which have a trading presence here, and the 'treaty' exemption, if applicable.

Beats Electronics has Irish-incorporated companies in its international structure including a holding company which seems to accumulate most of the non-US profits though it is not clear that Beats has any intellectual property apart from the brand. Regardless, the holding company is tax resident in Jersey rather than Ireland. This cannot be achieved using the trading exemption as Beats Electronics has no tangible presence in Ireland so has to be achieved using the treaty exemption.

And it seems it is. The corporate tax residency rule for companies in Jersey is:

"A company is resident in Jersey if it is incorporated in Jersey or if its business if managed and controlled in Jersey."

So there is a clash. Under Irish law, the profitable Beats Electronics holding company is resident here because it is incorporated here (and isn't eligible to be considered under the trading exemption). And under Jersey law the company is resident there because it is managed and controlled there. But a company can only be resident in one country.

The clash is resolved by the Ireland-Jersey tax agreement which in Article 4(3) states:

"Where by reason of paragraph 1 a person other than an individual is a resident of both Parties, then it shall be deemed to be a resident only of the Party in which its place of effective management is situated."

There is nothing hugely interesting about this. It is possibly worth noting that there is nothing Ireland can do to make the Beats Electronics holding company resident in Ireland absent a change to the Ireland-Jersey tax agreement. It is not a formal tax treaty but it is enough to trigger to 'treaty' exemption.

Residence also plays a role in the tax strategy used by Google. Google has an Irish-incorporated holding company which is eligible for the 'trading' exemption to the test of incorporation because of Google’s presence here. In these cases only the test of central management and controlled is applied to determine residency because Google’s holding company is not managed and controlled in Ireland is not deemed to be tax resident in Ireland.

So where is Google’s holding company tax resident? We know it is not tax resident in Ireland but that doesn't mean it has to be tax resident somewhere else. This situation was highlighted in the US Senate in their May 2012 investigation into Apple’s tax structure and the use "stateless income" in companies that were not tax resident anywhere.

Bermuda has a corporate tax of 0 per cent and the residence rule is:

"A corporation establishes residence when it is incorporated in Bermuda".

Google Ireland Holdings (GIH) is not resident in Ireland because it is not managed and controlled in Ireland. However, nor can GIH be resident in Bermuda because it is not incorporated there. GIH is "stateless" but instead of doing it in Cupertino, California as Apple did with Apple Sales International, Google is doing it in Hamilton, Bermuda. In reality, Google is doing it in Mountain View, California but unlike Apple goes to the limited effort of having a brass-plate operation in Bermuda and maybe the odd board meeting and AGM there. Apple may now have to do likewise.

Perhaps this is where the changes in the Finance Act 2013 come in apparently addressed the issue of Irish-incorporated companies being "stateless". This is what was promised in the 2014 Budget speech delivered by Michael Noonan last October:

Let me be crystal clear. Ireland wants to be part of the solution to this global tax challenge, not part of the problem. That is why today I am publishing a new international tax strategy statement which sets out Ireland’s objectives and commitments in relation to these issues. I will also be bringing forward a change in the Finance Bill to ensure that Irish registered companies cannot be ‘stateless’ in terms of their place of tax residency.

According to the general commentary on the changes this is what was achieved: Irish-incorporated companies that are not deemed to be tax resident in Ireland must show their tax residency otherwise they will be deemed tax resident in Ireland. But the relevant extract from the Act is:

“(5) Notwithstanding subsection (3)—

(a) where a company—
(i) is incorporated in the State and, by virtue of the law of a relevant territory other than the State, would be resident in that relevant territory for the purposes of tax if it were incorporated in that relevant territory but would not otherwise be resident for tax purposes in that relevant territory, and
(ii) is managed and controlled in that relevant territory and, by virtue of the law of the State, would be resident for the purposes of tax in the State if it were so managed and controlled in the State but would not otherwise be resident for tax purposes in the State, and

(b) accordingly, the company would not, apart from this subsection, be regarded, by virtue of the law of any territory, as resident in that territory for the purposes of tax, that company shall be regarded for the purposes of the Tax Acts and the Capital Gains Tax Acts as resident in the State.”

Part (a) of that makes a number of references to a "relevant territory". In this case a relevant territory is "an EU Member State other than Ireland or in a country with which Ireland has a Double Taxation Agreement". Ireland does not have a tax treaty with Bermuda thus Bermuda is not a "relevant territory" so companies managed and controlled in Bermuda do not come under the remit of the provision.

Under Bermudan law Google Ireland Holdings is not tax resident there because it is not incorporated there. Under Irish law GIH is not tax resident here because it is not managed and controlled here and comes under the trading exemption. And, because GIH is not managed and controlled in a "relevant territory" it does not come under the provision from the 2013 Finance Act. It is not clear why the provision in part (a) only applies to a “relevant territory” and not any territory. There may be legal reason for this but it appears to be a provision that could be applied to any territory. It seems like a choice was made to limit it to a “relevant territory”.

The Finance Act did not ensure that Irish registered companies cannot be stateless. The text of the provision means that as long as the Irish-registered non-resident (IRNR) company is managed and controlled outside of a relevant territory it can continue to be "stateless" as long as that country does not apply a test of management and control to determine residency. Bermuda doesn’t. Cayman doesn’t. And probably a few more. The promises of the Budget speech have not been delivered on.

Of course, under US law GIH is viewed as an Irish company and Google can use “check the box” and the “same-country exemption” from the US tax code to engineer a deferral of the US corporate income tax due.

In the scheme of things the “stateless” position of GIH does not get much attention because the rate of corporation tax in Bermuda is zero so regarding it as a resident of Bermuda makes no difference to the commonly-accepted narrative. It did matter in the case of Apple because the "stateless" companies were managed and controlled in the US even though those companies were equally creating a corporation tax of zero. Which in both cases is only prior to any possible formal repatriation of the profits the US parent when the federal US corporate income tax of 35 per cent would be applied as recently highlighted by Ebay.

The provision of the 2013 Finance Act is somewhat less vigorous then seems to be commonly accepted. It was only a limited move against “stateless” companies. Under the change, Irish-incorporated companies eligible to the ‘trading’ exemption from the test of incorporation could not remain stateless by being managed and controlled in a country that only applies the test of incorporation to determine residency. However, this limitation only applies if those companies are managed and controlled in a EU country or a country Ireland has a formal tax treaty with. It does not apply to companies that are managed and controlled in Bermuda, the Cayman Islands or similar territories.

It is still possible to have Irish-incorporated companies that are “stateless” for corporate income tax purposes. Just don’t do it in Cupertino, California and get the US Senate into a tizzy.  In reality Google do it in Mountain View, California but make the limited effort of having a “brass plate” in Hamilton, Bermuda and maybe hold the odd board meeting or AGM there.  It looks like the 2013 Finance Act means Apple will be heading there too.

Friday, May 9, 2014

Trichet and an Oireachtas Banking Inquiry

In an interview last September, former ECB President Jean-Claude Trichet said the following in relation to appearing at a possible Oireachtas Inquiry into the Irish banking collapse:

"Until now, I received no such request from Ireland. The rules in the ECB are that, all our decisions being collegial, the president goes to the European parliament and the governors of central banks go to the national parliaments."

Things have now moved on and the wheels have been set in motion for the Banking Inquiry.  But Trichet has not changed his views which were given in an interview this week and reported here:

Trichet said his decision not to speak before the inquiry was based on rules in the ECB’s constitution.

“If the rule was changed, I would apply the new rule,” he told Newstalk’s Shona Murray. “All decisions are taken collectively by all members and the responsibility of explaining decisions are in the hands of the national governors.”

So what rules is Trichet referring to?.  Here is the relevant reference to parliaments in Protocol No. 4 of the Treaty of the Functioning of the European Union which is the Statute of the European System of Central Banks and of the ECB.

15.3. In accordance with Article 284(3) of the Treaty on the Functioning of the European Union, the ECB shall address an annual report on the activities of the ESCB and on the monetary policy of both the previous and the current year to the European Parliament, the Council and the Commission, and also to the European Council.

That just says the ECB will send its annual report to the European Parliament but it does make reference to Article 284.3 of the TFEU.  What is that?

284.3 The European Central Bank shall address an annual report on the activities of the ESCB and on the monetary policy of both the previous and current year to the European Parliament, the Council and the Commission, and also to the European Council. The President of the European Central Bank shall present this report to the Council and to the European Parliament, which may hold a general debate on that basis.

The President of the European Central Bank and the other members of the Executive Board may, at the request of the European Parliament or on their own initiative, be heard by the competent committees of the European Parliament.

The first paragraph is simply what is included in the Statute of the ESCB and the second point supports Trichet’s point that the President of the ECB can be asked to attend committees of the European Parliament, with no reference made to national parliaments.

At national level we can look to domestic legislation and take the following from section 32L of the Central Bank Act:

(6) If the Governor or a Head of Function is requested by
a Committee of the Oireachtas to—

          (a) attend before the Committee, and
          (b) provide that Committee with information relating to  the Bank’s performance statement,

the Governor or Head of Function shall—
         (i) appear before the Committee, and
         (ii) subject to section 33AK(1A), provide the Committee with such information relating to the performance statement as the Committee requires.

where section 33AK(1A) is a reference to confidential information

(1A) A person to whom subsection (1) applies shall not disclose confidential information concerning—

         (a) the business of any person or body whether corporate or incorporate that has come to the person’s knowledge through the person’s office or employment with the Bank, or
          (b) any matter arising in connection with the performance of the functions of the Bank or the exercise of its powers, if such disclosure is prohibited by the Rome Treaty, the ESCB Statute or the Supervisory Directives.”

This is all well and good about the President of the ECB going to the European Parliament and national governors going to national parliaments but Trichet seems to have forgotten one small point: he is not the President of the ECB.

Thursday, May 8, 2014

Value Added by Sector: The Output Approach

The discourse on national income usually focuses on the expenditure approach to measuring GDP with emphasis on changes in consumption expenditure, government expenditure on goods and services,  fixed capital formation and net exports.

GDP = C + I + G + (X – M)

The output approach looks at a measure of total output minus intermediate consumption to get a measure of value added.  The income approach looks at the beneficiaries of this value added which can be divided in the remuneration of employees (wages and employer social insurance contributions) and mixed income/operating surplus (self employed income, actual and imputed rents, trading profits of companies).  Both the output and income approach will also include the amount of product taxes less subsidies paid to the government sector.  There is a quick look at the three approaches by sector here.

The CSO have published a new dataset giving details of value added by 64 NACE categories estimated using the output approach.  It is the first time the CSO have produced added value data by these sub-categories and only 2010 data is currently available.  The following has the Top 21 sub-categories (each providing a Gross Value Added at Factor Cost of more than €2 billion).  Click to enlarge.

Value Added by Nace Rev 2 Top 21

The table also includes a column for employees.  This is only an approximation as it is taken from Census 2011 which was collected in March 2011 rather than for FY2010 for the output data and also because the NACE sector for around 100,000 employees in the Census was unstated.  But using Value Added and the Number of Employees we get a rough indication of Value Added per Employee.  Value Added is distributed between Gross Operating Surplus of enterprises (profits) and Remuneration of Employees (wages).

The largest contributor to Value Added in Ireland in 2010 was the pharmaceutical sector with €12.8 billion.  This was generated with just over 25,000 employees so most of the Added Value went to Gross Operating Surplus. 

Just fractionally lower are human health and social work activities also with €12.8 billion but requiring almost 200,000 employees to do so meaning most of the Added Value goes to Remuneration of Employees.  This is not surprisingly as €15,448 million of the output in this category is non-market.

It might be surprising given their recent performance to see financial services activities next in the table but the economic concepts of added value and operating surplus are not the same as accounting profits.  Balance-sheet or holding losses do have affect GDP.

Real estate activities are next but two-thirds of the output in this category is the imputed rent from owner-occupied dwellings.  This ensures comparability of GDP figures across countries with different home-ownership rates.

The sectors in the above table where foreign owned companies dominate (contribute more than 85 per cent of turnover) are 21, 26, 32.5 and 58-63.

Categories 58-63 are noteworthy.  These are essentially the software and communications sectors.  Total output in these sectors was €43.3 billion with an Added Value of €12.3 billion from 68,500 employees. The activities in this category (NACE J) are:

NACE Rev 2 J

From the first table it can be seen that the output in categories 62-63 is particularly high at €22.8 billion but that added value is ‘only’ €4.2 billion due to €18.5 billion of intermediate consumption, which is likely the result of large royalty payments for patents and affiliate management fees as imports.

Sectors 21 (manufacture of pharmaceuticals), 26 (manufacture of computer and electronic products)  of 58-63 (software and IT services) are dominated by foreign-owned firms and contributed around €27.5 billion of added value.  Once remuneration of wages is accounted for the remaining Gross Operating Surplus of the companies in these sectors explains much of the difference between GDP and GNP. 

None of this is remotely surprising but the real benefit of the new data will come as the CSO publish figures for later and subsequent years which can be used to track changes over time.

Tuesday, May 6, 2014

Corporation Tax Residence: Is Ireland Exceptional?

This is the question posed by a recent discussion paper by Prof. Jim Stewart.  The conclusion is in the affirmative:

This paper argues that the tax regime in Ireland which allows companies incorporated in Ireland to be non-resident for tax purposes, is exceptional.

Some issues around the Irish rules of tax residence for companies were discussed in a previous post.  The post contains a list of ten countries which solely apply the test of management and control as the basis for determining the tax residency of corporations.  In total there are around 20 countries which adopt such a system, though these countries are in the minority with most countries also applying the test of incorporation.

Although not explicitly defined a central feature of the Stewart article is the concept of “bi-location”.  This appears to arise when a company is incorporated in one country but tax resident in another.  There are more than 20 countries who have residency rules that make that possible.  On that basis Ireland does not appear to be exceptional, though is in the minority.

If a company is managed and controlled in Ireland it will be tax resident in Ireland unless the provisions of a double tax agreement with a treaty country deem it to be otherwise – the ‘treaty’ exception.  If a company is incorporated in Ireland it will be tax resident in Ireland unless it is a ‘relevant’ company – the ‘trading’ exception.  See this note from the Revenue Commissioners.

Under Irish law it is possible for a company to be “bi-located” in the sense it is used in the Stewart article.  Of course, under the rules of permanent establishment (PE) it is possible for a company (through branches) to be located in many countries. 

A company can have a PE in any country in which it operates, subject to the rules for determining PE.  If a company has a PE in any country it will be subject to corporate income tax in that country on the profits earned through the permanent establishment. 

Permanent establishment is not analogous to residence though the Stewart article appears to conflate the two.  When discussing some of Apple’s subsidiaries the article says

Thus both subsidiaries would appear to meet the test of ‘permanent establishment’ in Ireland for corporate tax purposes. The fact that they are not so regarded gives these and other ‘bi-located’ firms a very valuable tax advantage.

It is true that some of Apple’s subsidiaries have operations in Ireland that meet the test of permanent establishment in Ireland.  And they are treated as permanent establishments for corporate tax purposes in Ireland.  There can be no advantage for these companies to not being regarded as permanent establishments in Ireland because they are. 

As stated above PEs in any country pay corporate income tax on the profits earned in that country.  If the Apple subsidiaries have operations in Ireland (they do) they will pay Corporation Tax on the profits earned by those operations in Ireland (they do).

The issue is clouded if one wishes to include the global profits earned by these Apple companies.  Almost everything to do with these companies happens in the United States which is not surprising given that Apple is a US company.

The Stewart article makes specific reference to Apple Sales International (ASI).  Here is US Senator, Carl Levin (D) on ASI:

Prior to 2012, ASI, like AOI,  had no employees and carried out its operations through the action of a U.S.-based board of directors, most of whom were Apple Inc. employees in California. Of ASI’s 33 board meetings from May 2006 to March 2012, all 33 took place in California.

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.

Here is an extract from the questioning of Apple executives at the Senate hearing last May:

Senator LEVIN. Mr. Bullock, does Apple Inc. own directly or indirectly AOI, AOE, and ASI?
Mr. BULLOCK. Yes, Apple Inc. owns directly or indirectly AOI, AOE, and ASI.
Senator LEVIN. All right. So all those companies in Ireland are owned by Apple effectively. Is that correct?
Mr. BULLOCK. They are all legally owned by Apple Inc., yes.

Senator LEVIN. All right. Now, relative to ASI, Mr. Bullock, is ASI functionally managed and controlled in the United States?
Mr. BULLOCK. As a practical matter, applying the Irish legal standard of central management and control, I believe that it is centrally managed and controlled from the United States.
Senator LEVIN. And does Apple agree that it is functionally managed and controlled in the United States?
Mr. BULLOCK. Under Irish law——
Senator LEVIN. No. Under our law, do you believe that?
Mr. BULLOCK. I do not believe that central management and control is a legal term under U.S. tax law.
Senator LEVIN. All right. Do you believe it is functionally managed and controlled in the United States?
Senator LEVIN. Mr. Cook, do you agree?
Mr. COOK. We have significant employees in Ireland. We have about 4,000. And so there is a significant amount of decisions and leadership and negotiations that go on in Ireland. But some of the most strategic ones do take place in the United States.
Senator LEVIN. Would you agree on balance that ASI is functionally managed and controlled in the United States?
Mr. COOK. From a practical matter. I do not know the legal definition of the word.
Senator LEVIN. As a practical matter, you would agree that it is functionally managed and controlled in the United States?
Mr. COOK. Yes, Senator.

ASI is not resident in Ireland for Corporation Tax.  All the top-level functions of the company happen in the United States.  ASI’s board of directors are based in Cupertino, California.  ASI’s assets are managed in Reno, Nevada.  ASI’s cash is kept in banks in New York, New York.

ASI does have some operations through a branch in Ireland.  These operations are judged to be a permanent establishment in Ireland and Apple pays corporate income tax on the profits generated in Ireland.

Apple does not pay Corporation Tax on the profits earned by ASI outside of Ireland.  In the main ASI earns profits by charging royalty fees for the use of Apple’s intellectual property outside of the US.  ASI in California has entered a cost-sharing agreement with its parent for the use of Apple’s IP outside the US.

Sen. Carl Levin called it an “absurdity” that a company operating from Cupertino, California could defer its US tax liabilities because it was deemed to be “offshore”

Apple is exploiting an absurdity, one that we have not seen other companies use. The absurdity need not continue. Although the United States generally looks to where an entity is incorporated to determine its tax residency, it is possible to penetrate an entity’s corporate structure for tax purposes, and collect U.S. taxes on its income, if the entity is controlled by its U.S. parent to such a degree that the shell entity is nothing more than an “instrumentality” of its parent, a sham that should be treated as the parent itself rather than as a separate legal entity. AOI, AOE and ASI all sure seem to fit that description.

The “absurdity” he is talking about is not in Irish tax law; it is in US tax law.  The “absurdity” allows a company that carries out all its operations in the US not be taxed there solely because it is incorporated somewhere else. Sen. Levin subsequently calls it a “sham”:

Our legal system has a preference to respect the corporate form. But the facts here present this issue:  Are these offshore corporations so totally controlled by Apple Inc. that their identity as separate companies is a sham and a mere instrumentality of the parent, and if so, whether Apple’s claim that AOI and ASI owe no U.S. taxes is a sham as well.

The “sham” is not that Apple pays a relatively small amount of Corporation Tax in Ireland.  Apple is a company that designs consumer products in the US, manufactures them mainly in China and sells them to customers around the world.  Apple’s assets, risks and functions in Ireland contribute very little of Apple’s overall profits.

The source of Apple’s global profits is not its operations in Ireland.

It is true that the source of Apple’s global profits (the IP) is owned by a company that is incorporated in Ireland.  Ireland cannot make Apple move the IP to Ireland but we can change the tax residency rules for corporations.

The issue is one of Irish-registered non-resident (IRNR) companies.  Such companies were a central issue when Ireland introduced the test of incorporation to the residency regime for Irish Corporation Tax in the 1999 Finance Act.  See this 1998 note from the Tax Strategy Group in the Department of Finance.

Concerns about IRNR companies are not new.  In the late nineties it was possible links to outright tax evasion that prompted changes.  After 1999 IRNR companies could not be owned by Irish residents and although IRNR companies could be owned by foreign residents they had to be related to a company carrying out a trade in the State.  This was specifically to avoid “brass plate” IRNR companies who had no presence of substance in the State.  This has usually been judged in terms of employment.

[ASIDE: There are growing concerns about “brass plate” company headquarters moving to Ireland.  A headquarters in Ireland is obviously resident here because of the test of management and control but in some cases very little substance is actually in Ireland.  These companies will have permanents establishments in the countries around the world in which they operate and will pay corporate income tax and the profits earned in those countries.  By the time the profit is attributed to the “Irish” headquarters very little, if any, additional tax will be due – as the tax paid elsewhere will likely exceed the 12.5 per cent rate levied in Ireland.  The movement of company headquarters via “brass plate” offers few tangible benefits to Ireland but is a different strand of the corporate income tax issue to the IRNR issue.]

So back to the IRNRs.  Are the Irish residency rules to blame for ASI’s apparent effective tax rate of 0.1%? No.  Apple is an US company and the risks, assets and functions that generate Apple’s profits are in the US.

There are two key features to Apple’s tax structure:

The first is a cost-sharing agreement between the parent and subsidiary for the use outside the US of Apple’s IP.  The agreement allows the subsidiary to use Apple’s IP at a relatively low cost.  The subsidiary gets to use Apple’s IP but the transfer to the parent is based on the cost of producing the IP not the value of it.

The subsidiary gets the very valuable IP at relatively low cost and can then generate massive profits by licensing the IP to Apple’s manufacturing/retailing functions around the world.  Under the worldwide corporate income tax system operated by the US Apple has to pay US corporate income tax (up to the federal rate of 35 per cent plus any state-level corporate income taxes that apply). 

And this brings us to the second key feature of Apple’s tax structure which is the deferral provisions in the US tax code. Apple can put in place a structure that means the US corporate income tax due on the profits earned on its IP outside the US is not actually paid until the profit is repatriated to the US, if ever.

Apple is a US company that owes US taxes.  It may be right that ASI has an effective tax rate of 0.1 per cent but that ignores the fact that Apple owes US corporate income tax (up to the 35 per cent federal rate) on its worldwide profits.  There is no way for Apple to avoid this but using US tax provisions it can delay, sometimes indefinitely, the actual payment.

According to its latest 10K filing, Apple has a deferred tax liability of around $35 billion.  Apple is clearly saying that it owes the tax to someone, the US, but that it has yet to pay it.  In fact, Apple says there is some of it that might never be paid.  Apple has recognised $16.5 billion of deferred tax liabilities on its income statements over the past few years and this liability appears on the overall balance sheet.  Apple is basically saying that it might repatriate some of its profits and has made provision for the tax that will become due if that were to happen.

On the other hand Apple also say that they have an unrecognised deferred tax liability of $18 billion.  This is the tax due on profits that it does not intend to repatriate.  This is tax that is due to the US because the risks, assets and functions that generate the profits are in the US but Apple is able to engineer a deferral of that tax using the provisions of the US tax code.

They are the key elements of Apples tax structure:

  1. The cost-sharing agreement that moves the rights to use Apple’s IP ‘offshore’ (i.e. outside the US); and
  2. The deferral provisions that enable Apple to delay the actual payment of the corporate income tax due to the US.

The Irish residency rules play a limited role.  #1 has nothing to do with Ireland and there are a huge number of ways in which #2 can be triggered.  The Senate Report on Apple is clear that these are key:

The key roles played by ASI and AOE stem from the fact they are parties to a research and development cost-sharing agreement with Apple Inc., which also gives them joint ownership of the economic rights to Apple’s intellectual property offshore. [page 25]

The cost-sharing agreement that Apple has signed with ASI and AOE is a key component of Apple’s ability to lower its U.S. taxes. [page 28]

And how important are the deferral provisions?

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]

“Check-the-box” is a feature of the US tax regime.  The $12.5 billion figure of tax that deferred using the provision is a figure provided by Apple itself.  If Apple has a low effective tax rate it is clear that this is a key reason for it.

There is no disputing that Apple, and other major US companies, are using Irish-incorporated companies in their global tax structures.  But the only tax affected by these is the deferral of US corporate income tax by facilitating use of provisions such as “check-the-box” listed above.  There is nothing that happens in Ireland that affects to right to tax Apple in Australia, the UK, China or any other country.  The US could abolish these deferral provisions almost immediately and much of this debate would  become moot.  But the US is unlikely to do so.

Tax residency has very little to do with Apple’s tax structure.  As the US operates a worldwide system of corporate income tax it doesn’t matter where the subsidiaries are resident.  The Apple parent company is subject to the US 35 per cent federal corporate income tax on its worldwide profits. 

As a result of the deferral provisions Apple, and many other US companies, put in a staging post before repatriating the profits to the US.  In many cases this is Bermuda or the Cayman Islands which have a corporate income tax of zero per cent and no corporate income tax, or nowhere which also obviously has no corporate income tax.  From 2015 IRNR companies will no longer be able to be ‘stateless’ so will have to be resident somewhere.

As long as the current system of international corporation tax uses the source principle and transfer pricing rules based on risks, functions and assets to assign taxing rights in double tax treaties then Apple’s profits will be subject to US corporate income tax.   One aspect of the Stewart article is an absence of any reference to the source principle.  As was previously said here:

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.

And the suggestion that the profits from products designed in the US, manufactured in China and sold in Australia should be subject to Corporation Tax in Ireland has nothing going for it. 

Ireland might be exceptional when it comes to attracting foreign direct investment, particular from the US, but there is nothing exceptional about Ireland’s tax residence rules for companies.  In fact, if we look at the OECD’s current model tax treaty we can see in Article 4 that the tie-breaker for determining the residence of a person other than an individual, i.e. a company is:

Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated.

In last year’s budget a move against Irish-registered non-resident companies being stateless was made so that if not tax resident in Ireland they have to be tax resident somewhere or else they will be deemed tax resident in Ireland.  Will there be a subsequent move to make all Irish-registered companies tax resident in Ireland? 

Possibly, but that would be a big decision.  Not because of any tax implications for MNCs it might have.  There are a myriad of ways for US MNCs to achieve their current tax outcomes.  The keys for them are #1 and #2 above and Irish residency rules are not going to affect those.

The issue with such a move is that it would erode the reputation for stability that the Irish regime has built up.  If a media storm, no matter how misdirected, can result in a change in Irish Corporation Tax companies will have less confidence in the overall investment environment and may choose somewhere that is less attractive but offers greater stability, perceived or otherwise. 

Making all Irish-incorporated companies tax resident in Ireland would cut out all of this nonsense commentary but at what cost?

Thursday, May 1, 2014

The Distribution of Profits in Ireland

At the NERI Labour Market Conference in UCC the presentation from CSO DG, Pádraig Dalton contained the following slide.

Top 50 Enterprises

The data is based on the Business in Ireland 2011 survey published by the CSO.  The detail of what was included or excluded in the figures behind these charts was not provided but the aggregates in the survey are for the ‘Business Economy’, i.e. active enterprises excluding those in direct financial and insurance activities (NACE K).  The “Top 50” were chosen by size of GVA and the same companies are in each chart.

Aggregate turnover for these enterprises in 2011 was €326.1 billion, aggregate GVA was €89.3 billion and, aggregate GOS in these businesses was around €50.6 billion in 2011.

The difference between the €89 billion of GVA and €51 billion of GOS is compensation of employees paid (around €37 billion) and taxes less subsidies on production (around €1 billion). 

Gross Operating Surplus is a measure of the trading profits of companies before allowance is made for interest expenditure (after the FISIM adjustment) and consumption of fixed capital (essentially depreciation).

What is startling from the chart presented by Pádraig Dalton is that just 50 enterprises contributed 61 per cent of the Gross Operating Surplus (trading profits) of companies in Ireland.  These 50 enterprises earned around €31 billion of the overall GOS.

The top 50 had around €36.5 billion of GVA so something around €6 billion of compensation of employees was paid in generating €31 billion of trading profits.  The top 50 enterprises probably have something around 75,000 to 90,000 employees.

The other 190,000 or so enterprises in the country had around €52.5 billion of GVA and from this earned around €20 billion of Gross Operating Surplus meaning around €32 billion went to the compensation of employees to around 0.9 million employees.

Outside of the Top 50, employees get 61 per cent of the GVA created by companies (€32 billion out of €52.5 billion). This appears to be a relatively high labour share (albeit without seeing comparable data for other countries excluding their “Top 50”).  Indeed the CSO say that:

Indigenous Irish-owned enterprises (i.e. excludes foreign multinationals) paid 64.5% of GVA in personnel costs.

The clear question that arises is why are businesses in Ireland apparently so unprofitable?  Six-tenths of the trading profits in the Ireland come from just 50 enterprises most of which are likely to be foreign-owned MNCs.  These companies are not too concerned by the residual remuneration available for their owners from their operations in Ireland.  They are very profitable.

The other 190,000 enterprises in Ireland have €20 billion of Gross Operating Surplus to divide amongst their owners - and also to cover their interest (financing costs) and depreciation charges (capital expenditure) as well.  On average there is just over €100,000 of GOS per enterprise outside the Top 50 but how many enterprises have only one owner?