Thursday, December 21, 2017

Growth of real wages in the EU15 since the start of 2014

Eurostat published Q3 2017 nominal hourly labour costs data earlier in the week.  Adjusting for inflation, using the Harmonised Index of Consumer Prices, we see the following picture emerge for the wages and salaries component of real labour costs since the start of 2014:

Real Wages and Salaries in the EU15

Using this approach it can be seen that Ireland has had the second-highest increase in real hourly wages since the start of 2014.  This might look good in relative terms but in absolute terms the increases remain modest.

Here is what emerges if we look at annual growth rates (smoothed over four quarters).

Annual Growth in Real Wages and Salaries in the EU15

There are maybe two ways to interpret this.  The first, is that Ireland has the highest growth in real hourly wages in the EU15.  This growth has accelerated slightly in recent times but not massively so.  The second is that the growth of real wages has slowed in almost all EU15 countries with 11 of the 15 having a slower growth rate of real wages compared to a year ago.

The reason for this has not been a slowdown in nominal wage growth, if anything this has slightly picked up with 11 countries showing a higher nominal wage growth in Q3 2017 compared to a year earlier.  The arithmetic mean for the EU15 has gone from 1.1 per cent to 1.5 per cent.  Ireland too has seen an increase in nominal wage growth but not unusually so.  The smoothed average growth has gone from 1.2 per cent in Q3 2016 to 2.1 per cent in Q3 2017.

Annual Growth in Nominal Wages and Salaries in the EU15

The reason for the slowdown in real wage growth across the EU15 has been the uptick in inflation.  The annual inflation rates from the HICP applied to the above nominal wages changes went from a mean of 0.3 per cent in Q3 2016 to a mean of 1.4 per cent in Q3 2016 with the UK, particularly showing a rapid rise in inflation. 

Annual HICP Inflation in the EU15

It’s all to with the second derivatives.  Inflation is rising faster than the increases in the growth of nominal wages hence real wage growth is slowing down – for most countries.

Ireland is one of the exceptions.  The increase in nominal wage growth over the past year in Ireland (0.9pp) is slightly above the simple average increase seen across the EU15 (0.4pp).  Inflation, though, has been non-existent in Ireland for an extended period now and remained close to zero throughout the period shown above.  Over the past year Ireland has had the smallest increase in inflation in EU15 and now has the lowest rate of inflation across the group – and this is including the large contribution made by the rapid increases in private rents. 

So put together our modest, though increasing, growth rates in nominal wages with our low rates of inflation and we get the result that Ireland has the fastest growth of real hourly wages in the EU15. For now anyway.

Wednesday, December 13, 2017

Why the breathless reactions to that Facebook announcement may be excessive

The announcement by Facebook that it was “moving to a local selling model” has been met with some breathless reaction with some thinking it will lead to sleepless nights.  There are a couple of reasons why such a reaction to this announcement may be excessive or why having sales recorded in the location of the customer isn’t the tax-changing panacea that some have made it out to be.  Anyway, here’s the key part of the Facebook announcement:
Today we are announcing that Facebook has decided to move to a local selling structure in countries where we have an office to support sales to local advertisers. In simple terms, this means that advertising revenue supported by our local teams will no longer be recorded by our international headquarters in Dublin, but will instead be recorded by our local company in that country.

There are a couple of reasons for a more reflective reaction.  First, Google announced that it was moving to such a model back in January 2016 while Facebook itself has been booking UK sales with its UK subsidiary since April 2016. Neither have caused the sky to fall in.

When HMRC concluded its six-year audit of Google in the UK in January 2016 Matt Brittin, Head of Google in Europe, gave an interview to the BBC:

“Today we announced that we are going to be paying more tax in the UK.”
"The rules are changing internationally and the UK government is taking the lead in applying those rules so we'll be changing what we are doing here. We want to ensure that we pay the right amount of tax."
The firm has now agreed to change its accounting system so that a higher proportion of sales activity is registered in Britain rather than Ireland.
"We are paying £130m in respect of previous years when the rules were to pay in respect of profits you make in a country and then going forward we will also be paying in respect of sales to UK customers," Mr Brittin said.
Asked whether the back-payments showed Google's critics were right that the company had avoiding paying tax in the past, Mr Brittin replied: "No."
He continued: "We were applying the rules as they were and that was then and now we are going to be applying the new rules, which means we will be paying more tax.
"I think there was concern that international companies were paying only in respect of profits that they make and those were the rules and the pressure was to see us pay in respect of the sales we make to UK customers - and the same for other companies.
"So, we are making a change because we want to continue to comply with the rules and the rules are changing."
I think the last word of the second last paragraph should be “countries” or be extended to “Google companies in other countries”.  So there is no precedent with the Facebook announcement.  Google got there two years before them.

And Facebook have been booking sales in the UK for over a year now as it states in the recently-filed 2016 accounts for Facebook UK Ltd.  In those accounts we are told:
The principal activity of the company in the year under review was that of providing sales support, marketing services and engineering support to the Facebook group and to act as a reseller of advertising services to larger UK customers.  The company’s function expanded to include the advertising reseller business in respect of large UK customers on 1 April 2016. 
Revenue for the year amounted to £842,429,955 (2015: £210,762,610), which is an increase of £631,667,345 on the value of services provided in 2015.  This increase was attributed to the commencement of advertising reseller services from 1 April 2016. 
The impact of this can be seen in the income statement for Facebook UK Ltd.

Facebook UK 2016 Income Statement

The first line shows the £632 million increase in turnover but this is immediately followed by a £450 million increase in the cost of sales.  After a £75 million increase in administrative expenses (mainly staff costs), all told, in 2016 Facebook UK Ltd. ended up with a profit of £58.4 million and a resultant tax bill of £2.6 million.  [Insert meaningless calculations of tax as a proportion of revenue around here.]*

The jump in the cost of sales figure is linked to the company becoming a reseller in April 2016.  In 2015, the company didn’t have any third-party sales.  All of its revenue was derived from providing marketing and support services to Facebook Ireland Ltd.  In 2016, it recorded the revenues from sales to the UK customers it dealt with directly but like with any company that doesn’t make the produce or service it sells it had to buy them from a supplier. 

There have been plenty of calls that revenues should be recorded where the customer is located.  And it could be that Facebook is reacting to the possibility that the implementation and/or interpretation of the BEPS proposals could mean that Facebook Ireland Ltd would be deemed to have a “permanent establishment” through the local company and that any sales done through that PE would be recorded in that country anyway.  By acting now to record the sales in the local companies Facebook is controlling the changes – albeit incurring significant cost to do so.

The recording of sales in the local companies is fine but it must be remembered that the corporate income tax is paid on profit not revenue.  Revenue only translates into profit to the extent that a company has risks, functions or assets that add value.  And if a company doesn’t even make the product it sells it must buy it.  In fact, because of this it may be that the aggregate revenue-profit-tax outcome that arises through all these local companies will not be significantly different than what is achieved through the central company in Ireland now.  There may be differences in where tax is paid but it will be interesting to see if it results in more tax being paid overall. 

Anyway, back to the need for companies who don’t make what they sell to buy it.  This can be from a related or third-party supplier but regardless of the relationship between them the price should be the same, i.e. as based on the arm’s length principle.  So if Facebook UK is selling advertising on a platform that is owned by someone else it must pay the owner of the platform (or its licensee) for the right to sell that advertising or buy the advertising space before selling it on.  The latter appears to be what Facebook is doing in the UK and this is the cost of sales figure that offsets most of the revenue increase that resulted from recording the sales locally in the first place.

Who is Facebook UK buying the advertising space off?  We don’t know who this is but a good guess is probably the company that sold the advertising space to these customers the previous year.  And we all should know who that was.  So while the third-party sales may be recorded with the local company there will still be intra-company sales recorded in Ireland.  The final paragraph of the Facebook statement is not without its significance:
Our headquarters in Menlo Park, California, will continue to be our US headquarters and our offices in Dublin will continue to be the site of our international headquarters.

The revenues will still end up in Dublin it’s just that some third-party sales will be initially recorded with local companies.  Third-party sales to customers that do not have a local company as well as sales in those countries that do from customers who do not interact with the local companies will continue to be recorded in Ireland. 

As the only customers in question are those who interacted with their local company rather than Dublin anyway there is unlikely to significant change to the activities carried out by the staff in Dublin.  It is not as if there are staff in Dublin who will lose key customers or accounts because of this change.  They were been serviced by the local companies as it stands.  One of the important, and valid, criticisms of the old structure was that close on the only thing that happened in Dublin relating to these customers was the conclusion of the sale – the virtual signing of the contract.  The new structure better reflects Facebook’s selling activities.

It is also not clear how this change the amount of Corporation Tax that Facebook will pay in Ireland.  It is likely that Facebook Ireland Ltd is currently remunerated on some form of “cost-plus” basis with the main cost included in the calculation being the staff costs.  If there is no significant change in the activities of Facebook in Ireland, its cost here could remain similar and so too could its Corporation Tax liability here.

There may, however, be changes to the risks, functions and assets that Facebook has in Dublin but they are not detailed in the short statement issued by the company.  It could be that headlines like “Facebook will stop using Ireland as a global hub for tax and revenue” are wide of the mark.

As we have seen this is because it is likely that the advertising services sold in the local markets will still originate with the Irish company and, crucially, we don’t know what Facebook is going to do with its licenses and intellectual property.

As we looked at before (here and here) the transfer of these licenses out of the US is subject to an investigation by the IRS.  At issue there is the price paid for those licenses but the existence of them to grant the rights to sell advertising on the Facebook platform outside the US is likely to continue.  We don’t know where those licenses are currently held but some indications point to the Cayman Islands.

Unless Facebook are going to move significant DEMPE functions (developing, enhancing, maintaining, protecting or exploiting intangible assets) then payment to a cash-box in the Caymans may not be allowed as a deduction for tax purposes when the full implementation of the transfer pricing changes in the BEPS proposals comes into effect.

Facebook will likely seek to move its IP to a location where these DEMPE functions are located.  An obvious choice would be the US where the main innovation and R&D of the company takes place.  But even the proposed changes currently hurtling through Congress are unlikely to make that sufficiently attractive for companies who have managed to get part of their IP outside of the US.

Another alternative is Ireland.  We have already seen significant onshoring of IP and it is possible we will see more.  It would seem natural to co-locate the license to your international sales with your international headquarters.  Hence, the possible significance of that final paragraph in the company’s statement.

The thing is we just don’t know.  Maybe the advertising sold by the local companies won’t originate in Ireland.  Maybe the IP won’t be onshored here.  But until we know that let’s keep a lid on the breathless reactions.

There are risks to Ireland’s FDI model but I’m not sure ICT companies moving to a local selling model for some customers is one to knock us over.  There are tens of billions worth of goods and services sold from Ireland and most is via intra-company sales rather than sales to third-party customers.  We had €14.7 billion of exports to Belgium last year of which €13.5 billion were pharmaceuticals.  I don’t think they were all taken by Belgians. 

There could be benefits for Ireland.  As the sales are being recorded in these countries they will get first dibs at taxing the resulting profits.  If they think they’re not collecting the “right” tax from these sales (whatever that may be) the first bout of finger-pointing should be domestic. 

Of course, if the products or services originate in Ireland and/or the companies have their IP in Ireland then we will be next in line.   And maybe like India is attempting with Google countries may try to describe the payments to Ireland as royalties rather than sales revenues possibly bringing withholding taxes into play (for some non-EU countries at least). Those sleepless nights may arrive yet.

* It’s 0.3% by the way.

Monday, December 11, 2017

Getting somewhere with the Current Account

As part of its response to the 2008 crisis the EU has set up the Macroeconomic Imbalance Procedure which “aims to identify, prevent and address the emergence of potentially harmful macroeconomic imbalances”The identification is done via a scoreboard of indicators with various thresholds

Our concern here isn’t on the choice of indicators, the thresholds chosen or the one-sided nature of the adjustments but on the work done by the CSO to make some of the indicators logical from an Irish perspective.  We know that lots of macro aggregates in Ireland are distorted and unless this is identified a scorecard with arbitrary thresholds could lead misleading conclusions and adjustment requirements.

The CSO first published its version of the Macroeconomic Scorecard for 2013As we considered at the time this provided a very useful breakdown of private sector debt with debts of the NFC sector broken down by Irish-owned and foreign-owned parents.  There were lots of wild claims that debt in Ireland was four, five or more times national income.  The CSO’s work via the macroeconomic scoreboard was important in helping to get the actual position set out.

The work has continued with scorecards produced for 2014 and 2015 with the latest one for 2016 published last week.  The graphics have got flashier and the insights into things like the current account and net international investment position have got better.

The work on the Balance of Payments current account is particularly useful given the importance of this measure.  A distorted current account offers few insights.  Here is Ireland’s headline current account from the Balance of Payments.

BoP Current Account Unadjusted

Over the past few years the breakdowns provided by the CSO focused on the impact of redomiciled PLCs and the changing treatment of aircraft for leasing.  However, the extraordinary recent jumps in the balance are due to the impact of intangible assets and it was clear that this would have to be addressed.

This started with the publication of the modified national income measures back in June which included a modified current account, CA*.  As the CSO explained:

CA* is the current account balance (CA) adjusted for the depreciation of capital assets sometimes held outside Ireland owned by Irish resident foreign-owned firms, e.g. Intellectual Property (IP) and Aircraft Leasing, alongside the repatriated global income of companies that moved their headquarters to Ireland (e.g. redomiciled firms or corporate inversions).

The size of these adjustments was shown in this table (click to enlarge).

BoP Table 1 Original

So if we subtract the depreciation of foreign-owned IP and aircraft for leasing as well as the net income of redomiciled PLCs the outcome is:

Bop Current Account Star Adjustments

The 2016 figure shows that all is not well with this approach and as we discussed here the issue was likely related to the acquisition of aircraft and intangible assets.  These were being bought by Irish-resident entities but being funded by intra-company loans so any deficits arising from these acquisitions are of little concern to the rest of us. 

The CSO have included an updated approach to the modified current account in their 2016 macroeconomic scoreboard that takes this into account.  As they say in a revised version of their note on the modified current account:

Since the original publication the CSO has made a further change to CA* to exclude the cost of investment in aircraft related to Leasing and the cost of R&D related IP from the current account balance. Some firms borrow money abroad to finance their investment by purchasing IP from their parent company. In the long term this debt is repaid from the profit on the IP or the aircraft being leased. It means that this borrowing is not a liability of residents of Ireland and the purchase of this IP needs to be excluded when deriving CA*.

A couple of extra columns have been added to the table showing the adjustments (again click to enlarge).

BoP Table 1 Updated

As before the adjustments for depreciation and redomiciled income are subtracted while now  adjustments for imports are added back in to give the updated version of the modified current account.  The headline and modified current account balances are:

BoP Current Account CA versus updated CA star

This is much better and there is no doubt that this modified current account gives a much more informed view of the underlying position of the economy relative to the headline current account.  This is further evidence of the work being undertaken by the CSO to provide meaningful indicators of the underlying conditions of the Irish economy.

As discussed here there may still be some concerns that the figures for recent years are a little high.  The modified balance is a surplus of €13 billion for 2016.  This may be related to the treatment of expenditure on R&D services as intermediate consumption for Balance of Payments purposes and gross fixed capital formation in the National Accounts. 

If this is an issue it may be remedied in due course and it does not require any changes to the adjustments now proposed to get the modified current account, CA*, as any revisions to the headline balance will automatically apply to the modified balance.  It may have taken a while but there’s no doubt that we’re now getting somewhere with the modified current account and as with other indicators of the Irish economy this is showing that we’re in pretty good shape.

Friday, December 1, 2017

The Aggregate Corporation Tax Computation for Companies with Net Income of More than €10 million

The last post looked at the corporation tax computation for companies with no net trading income.  Here we look at the other end of the scale and consider the aggregate outcome for companies with net trading income of more than €10 million.  Companies in this category make up about 500 of the 145,000 or so companies who filed tax returns for accounting periods ending in 2015.  It should also be noted that the composition of companies in the subgroup may differ across years.

Again, we will show a comparison between the figures for all companies and those in the chosen subgroup.    

Corporation Tax Computation for Companies with 10m Trading Income

Unsurprisingly these companies with the largest net trading income are the source of most on the net trading income in the economy.  Around 88 per cent of net trading income in 2015 (€72.4 billion out of €82.7 billion) arose in companies with a net trading income of more than €10 million.  

Perhaps surprisingly these companies only generated 56 per cent of the starting point: gross trading profits.  These reflects large use of capital allowances and previous losses by other companies especially, as we saw, companies with no net trading income.  The companies here has 16 per cent of the available capital allowances and, for 2015 at least, has less than two per cent of the available prior losses carried forward.

Of other income, these companies reported less than ten per cent of the total amount of rental income and foreign income but did have more than 40 per cent of the capital gains included in the Corporation Tax returns.

Unfortunately we are not given a breakdown of trade charges and group relief by range of net income but it is clear that the vast majority of these arise in these companies.  Before deductions and charges these companies had a Total Income of €74.2 billion in 2015 which after those items translated in a Taxable Income of €45.9 billion. 

Trade charges primarily refers to certain royalty payments.  We would usually expect such expenditure to be included as a deduction when Gross Trading Profits are being derived but Irish legislation set out that certain payments may not be deductible but rather should be deducted as a ‘charge on income’.   Hence we get Trade Charges between Total Income and Taxable Income.

Anyway, our companies with net trading income of more than €10 million had €45.9 billion of Taxable Income in 2015 and 0n this €5.1 billion of Corporation Tax was due giving tax due as a proportion of taxable income of 11.2 per cent in 2015.

The main reason for this being below the heading 12.5 per cent is the use of the R&D credit.  We don’t get a full breakdown of this but we can see that about 85 per cent of the R&D credit used against tax in the current year goes to these companies.  A split of the €359 million for the payment of the excess R&D credit would be nice but it is not provided.

To conclude, perhaps surprising is the amount of Double Tax Relief granted to these companies.  In 2015, they reported Foreign Income of €343 million but were granted €155 million of Double Tax Relief – €155 million is 31 per cent of €497 million (being the sum of the (after-tax) foreign income and the double tax relief).