Multinational Tax Management

When people think about tax they gulp, it is the bane of society to most people.  Purposely not paying tax is what we call tax evasion, this is illegal. What is not illegal however, is tax avoidance. In a business sense avoiding higher taxes puts your business in a tax optimal position. What is clear is that most people do not like paying taxes, however unless we are rich and powerful we have to put up with it. If you are rich and powerful i.e. Mick Jagger or a large corporation there are ways to avoid paying high tax rates in some of the countries you operate in.

Quoting Hryck and Andreoli: ‘It has always been appropriate to organizations business transactions to minimize a company’s tax burden’. Corporation tax is the tax companies have to pay for the profits they earn, however, this is not a fixed amount and can vary from country to country. Corporation tax has a direct impact on the value of a company’s stock therefore it is only right that a company seeks the lowest rate. In the global world we now live in tax rates can make a substantial difference to where a multinational firm will locate their Headquarters. Competition between countries to attract international business creates pressure to lower corporate tax rates.

The economic climate we are currently facing has only increased the need to attract corporations. In the news of late has been the USA announcing that they are planning to cut their corporate tax rate from 35%-28%. With one of the highest corporate tax rates of the developed nations in the words of Barrack Obama ‘It’s not right and it needs to change. The non-profit group Citizens for Tax Justice working alongside the Institute on Taxation and Economic Policy looked at 280 of the biggest and most profitable U.S. companies. They found the following results:

A quarter of them paid less than 10% in taxes over the three years 2008 to 2010.

Only about a quarter of the companies studied paid close to the official 35% rate

The average annual tax rate for all 280 was 18.5% over the three years, barely half the official rate, yet they reported almost $1.4 trillion in pre-tax profits

How and where do these companies avoid paying taxes? In terms of location they move their headquarters to tax havens. All over the news in the past few weeks has been the possible merger of mining giants Glencore and Xstrata. These companies are run by South African citizens, listed on the LSE and have their Headquarters just two miles apart in the mountainous city of Zug in Switzerland. The basic rate of corporation tax here is 15.4% compared with 25% in the U.K and 28% in South Africa. In 2010 Glencore had profits of $3.8bn if the company had their headquarters in the USA they would be paying nearly 20% more in corporate taxes. It’s not rocket science to why Glencore and Xstrata are located where they are.

Another way companies go about avoiding tax is through transfer pricing. I’ll try to explain this as simply as possible. A Company has a subsidiary in another country. The tax rate for the subsidiary is higher than that of the company.  Therefore, if profits are more where the subsidiary is located the company will lose more through tax. What the company will do, is charge a higher transfer price on good and services sold to the subsidiary. Therefore, profits decrease for the subsidiary and increase for the company. The company is able to retain more cash which would have been lost through tax. This is basically very cheeky and governments do try and implement regulations to stop transfer pricing going on but it can be a hard task.

To put it politely the public get annoyed by companies trying tirelessly to avoid tax. However, shareholders should be happy because after all the companies are doing this to maximise shareholder value aren’t they? What we can learn about multinational firms is that they are very manipulative and will do everything in their means to avoid tax. However, if this was the case then every company in the world would be located in the Bahamas! Other things such as the country’s infrastructure have to be taken into account. It may not be feasible for businesses to move to a tax friendly country. A business’s strategy and structure has to be taken into account. Some businesses may even see it as unethical and feel it is their responsibility to stay and pay taxes in their domestic nation.

Sources Used: FT, Bloomberg, InvestorWords, Hryck, D. & Andreoli, B. (2005), Arnold: Corporate Financial management (2008), Moffett et al: Fundamentals of Multinational Finance. (2009)

Raising Finance

In order for firms to expand and invest they require the adequate capital to do so. Firms could raise the money internally through retained earnings. Take Apple Inc. for example in their 2011 10-K annual report released on October 26th 2011 they were found to have $81.57 billion in cash available. Therefore, if Apple Inc. wanted to invest in a new project getting cash would not be much of an issue. Most firms however, are not in the fortunate position Apple Inc. find themselves in.

However, Apple Inc. has not always had billions in the bank. The way many companies start up is through raising money externally. This will initially be through debt finance such as loans from the bank. As the company expands more opportunities of accessing finance become apparent. One is equity finance; which mainly involves the issue of ordinary shares. Different forms of debt finance also become available such as being able to issue bonds.

Equity finance, what is it all about?  Well as already mentioned it is the issue of ordinary shares. However, you don’t necessarily have to be listed on a stock market to sell shares in your company. It could be as simple as selling a stake in the company in return for a lump sum investment from family and friends. However, family and friends may not have adequate capital available to fund the ambitions of the company. This is where professional investors come in to the mix. We call these venture capitalists.  These investors are primarily concerned with getting a high return from their investment due to the risk involved. Although there may be risk involved for the venture capitalist it is great way for up and coming businesses to raise finance. If you want a prime example of a venture capitalist then tune into the TV programme Dragons Den.

The other way to raise equity finance is by listing on a stock exchange and issuing ordinary shares. This is an easy way to raise finance for a company. The capital does not even have to be repaid and there is no obligation to pay dividends. The only problem with raising finance this way is that companies lose control, as shareholders in return for their investment are allowed a say in company matters. Listing on stock exchanges can also be expensive and the market values of companies’ shares also have to exceed a certain amount. In May 2011 Glencore became the largest public offering in the London stock exchange’s history.  Its reason for exposing itself to public scrutiny was so it had the financial firepower to participate in the natural resources industry. This is the main advantage of listing on stock exchanges it provides you with more power!

Do you really want to lose control of your business? If not then there is always debt finance. This could simply be obtained as a loan from a bank. Unfortunately in the current economic climate the issue of bank loans for businesses are extremely hard to come by. The government has tried to improve lending to businesses through Project Merlin. The BBC outlines that under Project Merlin, Barclays, HSBC, Lloyds Banking Group, RBS and Santander UK, were to make it easier for smaller firms in particular to access credit. However, recent Bank of England figures show that under project merlin the five banks are failing in some of their lending targets. 

Let’s get a bit more complicated in terms of debt finance and talk about bonds. We see them talked about all over the news, particularly Greek bonds, but what are they? Simply put by the oxford dictionary of finance and banking; a bond is an IOU issued by a borrower to a lender. They are issued by governments and companies as a means of raising capital. The holder of the bond is the creditor and the issuer the debtor. The bond guarantees its holder both repayments at a later date and a fixed rate of interest.

Bonds are seen to be pretty safe for the creditors; they are also a good way for firms to raise finance. The risk of bonds tends to fall on the creditors, if inflation or interest rates go up, but there is little risk on the debtor side. Bonds can be quite an attractive prospect for creditors as returns can be substantial. The European Central Bank for example paid about €40bn for Greek bonds which currently have a face value of €55bn. Investors who bought Irish bonds when the country was struggling amidst the credit crunch can expect a 50% return on their investment.

Of course firms don’t have to choose between equity and debt finance, they can use a mixture of the two. The weighted average cost of capital (WACC) another complex term is used to work out the average costs of these types of financing. By taking a weighted average, we can see how much interest the company has to pay for every unit of cash it finances. The WACC is used by investors to assess whether they will get a good return on the money they invest in.

There are problems with raising money through equity and finance. However, I personally would not like to have my business funded primarily through debt. This is what caused the problems which led to the credit crunch and is why banks are sketchy when it comes to lending. It is the reason why we are suffering a crisis in the Eurozone. On the other side of the coin companies need to take on debt in order to raise the required capital to expand. What we have is a catch 22 situation. Debt is seen as bad but it needs to be taken on to achieve good.

Sources Used: /http://investor.apple.com/, Business Link, Investopedia, BBC, FT, FT lexicon, Reuters, Oxford dictionary of finance and banking (2008).

Efficient Market Hypotheses (EMH) – Total Nonsense?

EMH is defined by investopedia as the following:

An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

If this is the case how come the likes of investors such as Warren Buffett make millions if not billions by beating the market every day?

Three forms of efficiency were identified by Fama (1970). The first was weak which basically asserts that all past and current market prices are fully reflected in the share price. This means that the use of technical analysis by investors would be of no use. The second form of efficiency is semi-strong and is described as being where all public information available is reflected in the share price. Therefore fundamental analysis would be of no use. Lastly there is the strong form of efficiency where all information is reflected in the share price.

Weak form of EMH is the closest to being true of the real world stock market. EMH is seen as nonsensical by most. Information cannot be known by everyone at the same time. People in the business generally know the sales and profit figures before investors. This is when insider trading can occur which is illegal but still goes on. Recently in the news seven people were charged with insider trading to do with the computer company Dell. There was also a bit of suspicion when Bob Robbins, chief operating officer Tesco sold part of his shares in the company a week prior to a profit warning.

If cases such as those mentioned occur then clearly EMH is a nonsensical theory which is not practical in reality. Even if information was available to everyone at the same time people are not homogenous. People behave differently on the information they receive some investors may be looking long term others short term. EMH is a theory which sounds good but in reality just doesn’t stand up to the mark. If everyone knew which stock to buy then we wouldn’t see the likes of Warren Buffett claiming he doesn’t pay enough tax on the billions of dollars he earns by beating the market!

Sources Used: bbc.co.uk, investopedia, Blackboard

Shareholder Wealth Maximisation

Simply put by Arnold (2008) maximising shareholder wealth means maximising the flow of dividends to shareholders through time. However, the question is do companies really aim to maximise shareholder value or are they more concerned with other objectives?

Take for example Tesco; their primary aim is to penetrate as much market share as possible. However, is this strategy maximising shareholder value or just showcasing Tesco’s obsession with market share. Within the last month Tesco’s share price has taken a substantial nose dive knocking £5bn off the company’s value. The reason for this was a profit warning over poor Christmas sales. A week prior to the event Noel Robbins the chief operating officer sold 5% of his shares in the company worth around £200,000. Tesco explain that Mr Robbins was not in hold of any price sensitive information but sold the shares for family expenditure. (bbc.co.uk)

Whatever the case at Tesco clearly the strategy they are enforcing is not serving the best interests of their shareholders. They have possibly become too obsessed with achieving market share and less so about maximising shareholder wealth. In the words of Finkelstein (2003) in his book why smart executives fail Tesco are “Brilliantly fulfilling the wrong vision”.

The standard norm in assessing how a company is doing is to look at their earning per share (EPS). Investors often use this figure when deciding whether to invest in a company or not. However, it can be a misleading figure and cannot be in the interest of maximising shareholder wealth. EPS offers a narrow focus and may reveal relatively little about the true economic performance of a company. The figure can be manipulated easily. Many companies buy back shares purely to boost the EPS and to indicate to shareholders there is nothing wrong with the company. Just recently the Indian oil giant Reliance Industries bought back $2bn of its shares (Financial Times). This was on the back of an unusually weak quarterly posting of its results in January. Share buy backs may in some cases be the result of the company having too much cash. Therefore to maximise shareholder wealth the company buy shares back reducing the risk of using the surplus cash in risky investments. Coincidentally on buying $2bn of its shares back the share price rose by around 2%.

In order to maximise shareholder value we must set targets for senior management. One such target could be return on capital employed. The problem with setting such targets is that they are open to manipulation. Managers tend to manipulate figures in order to achieve a bonus. However, we’d like to think in most cases that management hit targets through sheer hard work. In the news at the moment is the case of Stephen Hester CEO of RBS. After waiving to political and public pressure he has decided not to take his £1m bonus. In his case he hit the targets required of him therefore he should get his bonus. Not so according to the politicians who believe he has hardly achieved a sterling performance.

The problem now in the banking sector is that they are scrutinised by everyone in what has turned into a lynch mob mentality. What does this mean for shareholder wealth? Well, if top management are not given incentives to maximise shareholder wealth then they are not going to work hard to hit the targets. The problem in the sector is that bonus’s have become common place as a reward for mediocre performance.

The brokerage firm ICAP has announced a squeeze on bonuses (Financial Times), due to weaker trading volumes. CEO Michael Spencer explained “Growth rates and compensation clearly ought to have some sort of relationship. This is good for shareholder wealth maximisation because it means top management are rewarded properly for their efforts. Compare this to another story in the news at the minute regarding the CEO of Trinity Mirror.  Sly Bailey has been criticised by the shareholders of the company for the salary she is on. They believe the salary she takes home is not representative of the size of the company she runs. Sarah Wilson CEO of Manifest points out Ms Bailey is on a FTSE 100 package and the company is not even in the FTSE 250! When Sly Bailey took over the company it was worth £1.1bn now it’s worth £119.1m. This is a problem in the sector because in order to retain the best talent wages and bonuses are spiralling out of control. They are not representative of the work done to achieve shareholder wealth maximisation.