Twisting and turning with taxes

Twisting and turning with taxes

19-12-2016 | Insight

“There is increased segregation between the location where actual business activities and investment take place and the location where profits are reported for tax purposes” (OECD). Booking profits in countries with business-friendly tax regimes appears to have become common practice. Of course, the EUR 14 billion penalty that the European Commission imposed on Apple in back taxes is the most striking example in this case. Maybe it’s not one of the most virtuous companies in the world, but it is certainly not the only one that parks profits and cash in countries with a favorable tax climate.

  • Mark  Glazener
    Fund Manager Robeco NV

Although their specific case has attracted a lot of attention, this is actually a much more widespread phenomenon. Recent research in the US by the Citizens for Tax Justice (CTJ) shows that 367 of the 500 companies in the Fortune 500 have one or several subsidiaries in tax havens. For instance, Apple booked nearly USD 215 billion dollars of its earnings abroad, resulting in the company paying USD 65.5 billion less tax. Facebook only pays EUR 3.5 million in tax on profits on a turnover of nearly EUR 5 billion.

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Public opinion

As fund manager of the global equity fund Robeco NV, Mark Glazener closely monitors these developments. Such tax saving strategies can drive up a multinational's bottom line results considerably, but also entail risks which you have to take into account as a fund manager. "In the US, we see that profit margins are being eroded and earnings growth is leveling off. Cash is mainly being used to fund share-buyback programs, something that also inflates the earnings per share.

However, the low tax burden of many companies has become a topic of discussion. If ordinary citizens have to pay their tax bills, why can companies get away with such a low tax payments? It could well be the case that tax burdens are currently at their lowest levels."

Glazener acknowledges that this is certainly not a new theme. "Coca-Cola was refused permission to establish a production site in Vietnam in 2012because the company hardly paid any taxes. Later on, Starbucks was the victim of a public boycott because the company was accused of tax avoidance in Europe. The company then announced that it would ‘voluntarily pay some tax’.”

Taxes and M&A

These are just two examples that show that public (and political) opinion can turn against companies with an aggressive tax policy. And these are the warning signs that you must signal in your fundamental analysis. "As an investor, you look at the direct and indirect risks of each position in your portfolio. A change in a country's tax regime falls in the first category: the direct risks. As do expensive or nonstrategic acquisitions. Certainly recently, tax advantages appear to be the main driver behind billion-dollar takeovers."

‘It is difficult to assess the impact of changing tax regulations’

Glazener cites the reverse takeover of Pfizer by the Irish Allergan as a typical example of a deal that is mainly advantageous because a large share of the company's profits will fall under the Irish tax system. "Profits realized by US companies abroad are taxed again in the US when the cash is repatriated. Many companies consider this undesirable and choose to keep this cash outside the US. The problem is it doesn’t earn anything there. But there is an alternative. You can also do something more profitable with this cash, something that also increases its value by 35%: transfer it to a bank in the US."

In following this path, Pfizer is not an isolated case. "The same considerations certainly also played a role in Microsoft's decision to take over Nokia's mobile phone division. The majority of US companies are playing a tax game."

Indirect risks

Nevertheless, the 'Apple case' makes it clear that increasing profits by means of such tax strategies can backfire on the companies that do it. A profit-enhancing factor can suddenly turn out to be a risk factor. And then there are the indirect risks too, which consist of reputation risk or the negative impact that the situation can have on a host country, for example in a continent such as Africa. Certainly in times of social or public unrest and when income inequality fuels the dissatisfaction and resentment in many countries, corporate tax policy is something that can quickly be targeted and criticized. Public opinion can turn against a company and, as we have seen in the past, this can have a big impact.

"This theme does not have an equal impact on each sector," says Glazener. This is also apparent from a Sustainable Corporate Taxation report published by Robeco SAM in 2014. In the utilities, telecom, energy and banking sectors, taxes are paid correctly. "But in sectors such as healthcare, technology and commercial services, the tax burden is a lot lower because it is easier to allow profits to be booked in favorable tax regimes. Patents are transitory, power stations are permanent," Glazener explains.

Glazener: "As an investor, you look at the tax sensitivity of the positions in your portfolio; but, it is difficult to assess the impact of changing tax regulations. So you work with scenarios. In Apple's case, although it’s a large sum of money in absolute terms, the impact on profitability is of course ultimately a lot smaller due to the company's huge market cap." The question is how will other European countries with a lower tax burden respond to this? Will they also start billing companies for back taxes? "This is a difficult process due to agreements that companies have made with the local tax authorities," Glazener explains, who does believe that tax regimes could come under pressure in the longer term.

Swiss route

Relocating to countries with a lower tax burden is not just something US companies do. European multinationals are also opting to follow this path. The 'Swiss route' is particularly popular among multinationals. "A company like Ahold pays its taxes properly in the Netherlands. However, on its US revenue, which accounts for 70% of its profits, it pays taxes via the Swiss route. US oil service companies such as Schlumberger and Halliburton are doing exactly the same thing."

The question is whether this Swiss route is tenable and whether this strategy is ethical from an ESG perspective. Glazener believes that the Swiss route will continue to exist for the time being. "It is a small country with a good financial infrastructure. But the pressure is increasing." And about the ethical issue: "The tax conduct of companies is completely logical, from a financial point of view. Tax optimization is positive for shareholders, as long as 'fair taxes' are paid. More aggressive forms of tax burden reduction are not tenable in the long term and are ultimately harmful."

Glazener shares this point of view with former British prime minister David Cameron, who also raised this issue during the World Economic Forum in Davos (2013): “Some forms of avoidance have become so aggressive that I think it is right to say these raise ethical issues, and it’s time to call for more responsibility and for governments to act accordingly.”

‘You can always find a small island with a more accommodating tax regime’

PO Boxes

"As a portfolio manager, you look at these issues and try to get a clear picture of this in order to see whether there are any warning signs. We have higher price targets for companies where there is no threat with regard to the payment of taxes. It is part of estimating the financial risks. This means that it is more important than ever to examine a company's tax policy," says Glazener. "Even if it is not yet possible to quantify these risks in analyses. In general, you will have nothing to fear from responsible tax paying companies. Nor will companies with an aggressive tax policy necessarily be subject to an underweight position in our portfolio; but we do take higher risks into account.”

As long as there is no global harmonized tax regime, this issue will continue to play a role for investors, as the Panama Papers proved this year. A global uniform tax rate would be the solution, but this seems to be wishful thinking. "You will still always be able to find a small island with a more accommodating tax regime," Glazener believes. And you can fit a whole lot of PO boxes on such an island.
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