Saturday, October 23, 2010

Google and the art of "tax arbitrage"!

In the aftermath of the sub-prime mortgage crisis, with its numerous examples of executive excesses and corporate greed, corporate governance issues among businesses have assumed critical importance. It is universally agreed that for all the regulatory oversight, markets cannot be made to run efficiently and fairly without appropriately addressing important corporate governance issues.

One of the most controversial of such concerns revolves around the complex accounting strategies that businesses adopt to avoid taxes. Corporates point to the fact that they are not doing anything illegal but only exploiting a legally available provision to maximize their bottom-lines and thereby shareholder value. Critics argue that such actions, while technically legal, blurs the boundaries between the legal and dishonest, and engenders a culture of opacity and much else.

In this context, it cannot be denied that even as tax authorities across the world focus their energies on curbing domestic tax evasion, there have been very little attention paid on evasion through shifting of incomes and expenditures across national boundaries. Global economic liberalization and closer integration of national economies, coupled with the dramatic expansion of global financial markets, have empowered businesses to indulge in "tax arbitrage".

Businessweek has an excellent account of how Google, which tells employees "don’t be evil" in its code of conduct, employs a strategy to avoid US corporate taxes, that while being legal appears suspicious at best and plain immoral at worst. It is clear that Google is not only a leader in technology but also in its ability to evade taxes!

Google, which has cut $3.1 bn from its tax bill since 2007, pays an effective corporate tax of 2.4% on its overseas profits, the lowest corporate tax rate on overseas profits among the top five US technology companies by market capitalization. It utilizes provisions in US and Irish tax laws to allocate income to tax havens and attribute expenses to higher-tax countries ("transfer pricing"). See this superb interactive guide.

1. US law allows companies to license to a subsidiary the offshore rights to its intellectual property for undisclosed fees. If this fee is kept low (despite the requirement that subsidiaries pay "arms length" prices for technology rights), their taxable income at home becomes less. In Google's case, its deal is with a subsidiary called Google Ireland Holdings.

2. This Dublin-based subsidiary , in turn takes advantage of an Irish law ("Double Irish") that exempts taxes for companies which claim to have their management based elsewhere. Google Ireland Ltd - which employs about 2000 people, gets credit for about 88% of the company's overseas sales (total of $12.5 billion in non-US sales in 2009) - reported a pre-tax profit of less than 1% of sales in 2008 since it paid out $5.4 bn in royalties to its management vested in a Bermuda-based company.

3. The royalty payments from Google Ireland Ltd. in Dublin then takes a quick detour to the Netherlands ("Dutch Sandwich") to avoid triggering an Irish withholding tax. Irish tax law exempts certain royalties to companies in other EU-member nations. In Amsterdam, Google Netherlands Holdings BV, which does not have a single employee, paid out 99.8% of the $5.4 billion it received from Dublin to the unit managed in Bermuda.

4. Bermuda, being an off-shore tax-haven, does not impose any corporate tax. More perversely, the Google's subsidiary (management center) in Bermuda changed legal form in 2006 to become a so-called unlimited liability company, so as to take advantage of another Irish law that permits such firms to not disclose such financial information as income statements or balance sheets. This meant that it became impossible to track its balance sheet.

It is estimated that the US alone loses $60 bn annually due to such "transfer pricing" of taxes. Such international income-shifting helped cut Google’s overall effective tax rate to 22.2% last year, against the US corporate tax rate of 35%. It is also estimated based on a rough analysis that if the company paid taxes at the 35%rate on all its earnings, its share price might be reduced by about $100 from its current $600 plus.

Google's success has encouraged other technology firms to adopt the same model and license the foreign rights to their intellectual capital to subsidiaries in countries with low tax rates, while retaining the expenditures on their balance sheets. Microsoft employs a "Double irish" strategy to avoid tax payments on part of its external income.

This example illustrates the negative externalities generated by Ireland's policy of keeping tax rates low to attract investments. Coupled with its leaky taxation laws, this strategy not only does not benefit Ireland, but also ends up transmitting very costly incentive distortions across the global economy. In other words, Ireland's liberal taxation rules are classic examples of beggar-thy-neighbour policies, which, as the country's recent fiscal crisis shows, does not benefit even Ireland.

This example highlights the need for harmonization of tax policies across economies. Its importance will increase in the coming years with greater global economic integration and as companies start exploiting such tax arbitrage opportunities to minimize their tax payments. In the absence of reasonably uniform standards, such beggar-thy-neighbour policies could end up triggering "tax wars" among the major economies.

Update 1 (20/12/2011)

The Times reports that GE, America's largest corporation, reported worldwide profits of $14.2 billion in 2010, and said $5.1 billion of the total came from its operations in the United States. But it paid no American taxes and even claimed a tax benefit of $3.2 billion. Times writes,

Its extraordinary success is based on an aggressive strategy that mixes fierce lobbying for tax breaks and innovative accounting that enables it to concentrate its profits offshore. G.E.’s giant tax department, led by a bow-tied former Treasury official named John Samuels, is often referred to as the world’s best tax law firm. Indeed, the company’s slogan "Imagination at Work" fits this department well. The team includes former officials not just from the Treasury, but also from the I.R.S. and virtually all the tax-writing committees in Congress.

Though corporate tax rate is 35%, effective tax rates are much lower and corporate share of the nation’s tax receipts have fallen from 30 percent of all federal revenue in the mid-1950s to 6.6 percent in 2009.

Update 2 (29/4/2012)

Times has this story of how Apple uses the same strategy to avoid payment of taxes. For the record, Apple paid cash taxes of $3.3 billion around the world on its reported profits of $34.2 billion last year, a tax rate of 9.8 percent.

This graphic captures the Double Irish tax arbitrage strategy nicely. Apples treats its domestic profits as royalties payable to an Irish subsidiary on patents it owns, so as to avoid paying the 35% corporate tax on its profits. And in Ireland, if the Irish subsidiary is controlled by managers elsewhere, like the Caribbean, then, after paying Irish tax rate of 12.5%, the profits can skip across the world to the tax-free haven in the Caribbean.

When the same product is sold overseas, profits go to a second Irish subsidiary. And because of Irish treaties that make some inter-European transfers tax-free, the company can avoid taxes by routing the profits through the Netherlands. The profits then flow back to the first Irish subsidiary, which sends the profits to the overseas tax haven.


uclalien said...

"This example illustrates the negative externalities generated by Ireland's policy of keeping tax rates low to attract investments."

I read this story (and statement) differently. It should read:

"This example illustrates the negative externalities generated by the United States' policy of keeping tax rates high which discourage investments."

sai prasad said...

The most striking aspect in this story is not the tax avoidance indulged in by Google, but the fact that the entire story is widely known, explained and is circulating all over the world.

I have not read a single story of similar nature, describing the actions of Indian companies, which certainly must exist.

Can u dig up some Indian stories?

Jayan said...

While google, microsoft etc are good names in the big story, I am sure tere will be many Indian companies doing similar tricks.