Tax Shaming from The Guardian

I bet Greg Mankiw really hates this:

America’s a great country. That’s why people from all over the world — including, lately and tragically, thousands of poor children from Central America — clamor to get in. So why are some of America’s wealthiest companies trying to get out? It’s simple, really — they don’t want to pay US taxes.

At this risk of having my internet name changed to ProGrowthConservative, I’m going to quibble a bit with The Guardian. I think the issue is not whether we keep the repatriation tax or not but whether we enforce the arm’s length standard. Medtronic is already getting a low effective tax rate without changing its tax domicile as is a host of the other companies noted here:

Instead, to avoid US taxes, they are parking their earnings offshore, often in tax havens like Bermuda and the Cayman Islands that levy no corporate income taxes. That tactic, which like the inversions is legal, is being employed by companies that position themselves as good corporate citizens — among them Apple, Coca-Cola, General Electric, Google, Microsoft, Nike and PepsiCo … One popular tactic is to grant patents or intellectual property rights to a subsidiary located in a tax haven, and then pay above-market royalties to that subsidiary, thus shifting profits from a high-tax jurisdiction to a low one.

Are the royalties really above the market rate? Would not the local tax authorities be able to challenge such royalties? Of course, the real issue is that these companies told the IRS that the fair market value of their intangible assets were low when the intangible assets were migrated to the low-tax jurisdictions. Are the good folks at the IRS properly enforcing section 367(d). But the real issue here is tax shaming:

But shouldn’t good citizens pay their fair share of taxes? Socially responsible investors and watchdog NGOs say tax avoidance carries risks for companies that care about their reputation, as all companies should. “It’s short-sighted,” says Adam Kanzer, general counsel and managing director of Domini Social Investments. “Companies like Walgreen’s run the risk of being seen as unpatriotic.” Just two years ago, the Illinois-based drugstore company sought and received tax breaks from the state government, and now it’s ready to leave. Domini this year filed a shareholder resolution to reform Google's tax-avoidance strategy. It said: “Even if they are within the law, aggressive tax minimization approaches pose regulatory, reputational and financial risks.”

This is the part that Greg Mankiw is going to hate. When I talked about the Walgreen proposed inversion, I wrote:

We need to do what the tax attorneys call a section 367(d) analysis. Let’s assume that the 5.5% operating margin being generated by these Walgreens stores can be decomposed into a 3% routine return versus a 2.5% royalty rate for the use of various intangibles (patents, trademarks, etc.). Hallman is suggesting that the Swiss affiliate could charge $1.8 billion per year in royalties. But under section 367(d), the Swiss affiliate would have to pay the U.S. affiliate the fair market value for the transferred intangible assets. What is a reasonable estimate of this fair market value? Is it closer to $20 billion or to $2 billion? I’m sure Walgreens could get some hack who pretends to be a valuation expert to argue for the lower figure. But if one looked at the balance sheet as well as the current market value for the equity of Walgreens and tried to deduce the market’s valuation of its intangibles, this figure would be closer to $40 billion.

Let me admit an error here – the fair market value was closer to $50 billion, which may be one reason why Walgreen did not go through with their proposed inversion. They realized that their investment bankers weren’t being straight with them in terms of the possible reduction in their effective tax rate. But let me close with a complaint about this Starbucks UK story. This story is due to Tom Bergin who was one of the few that got the Burger King story right. Tom wrote:

Like those tech firms, Starbucks makes its UK unit and other overseas operations pay a royalty fee - at Starbucks, of six percent of total sales - for the use of its ‘intellectual property' such as its brand and business processes. These payments reduce taxable income in the UK. McDonald's also charges its UK subsidiary a royalty for ‘intellectual property', although at a lower rate of 4-5 percent. The fees from Starbucks' European units are paid to Amsterdam-based Starbucks Coffee EMEA BV, described by the company as its European headquarters, although Michelle Gass, the firm's president in Europe, is actually based in London. It's unclear where the money paid to Starbucks Coffee EMEA BV ends up, or what tax is paid on it.

Let’s suppose the intercompany royalties ended up with the US parent. The IRS would argue that the 6 percent royalty rate was arm’s length as this is the rate paid by third parties. Its stores in North America are generating profit margins near 20 percent before these royalties so a 6 percent royalty rate leaves them with significant profits. The Starbucks 10-K, however, shows that operating costs in the EMEA region (mainly the UK and Germany for company owned stores) are much higher so that even under arm’s length pricing, their company owned stores will financially struggle. Besides why would a company shift income from a UK affiliate with a 20 percent tax rate to the US with its 35 percent tax rate? Tom Bergin and other reporters are doing admirable work but at times what they write does not make complete sense.