Corporate International Tax Management

"In this world nothing is certain but death and taxes" - Benjamin Franklin

The quote above is a very famous saying by former US president Benjamin Franklin and
illustrates the truth that taxes are an unavoidable part of life. But is this necessarily true? In reality, tax evasion describes the action of avoiding tax by illegal means and is potentially a very serious crime both on an individual but also corporate level. However, tax avoidance is an often controversial procedure whereby an individual or corporation uses the tax system to their own advantage and as a result benefits from paying lesser amounts of tax. The current UK main rate of corporation tax is 25%, so it easy to see why companies would pursue legal methods of paying a lesser rate. The controversy arises from the assumption that the ordinary citizens of the UK will suffer from large companies avoiding paying the level of tax that is required. With less tax being received from these companies, governments will need to obtain the funds from elsewhere or potentially reduce spending on public services due to less taxation revenues being obtained.

One policy that was introduced initially to protect tax payers has been used as a means for some tax payers to actually avoid paying the required rate. Double taxation treaties have been agreed between several countries, aiming to avoid people and businesses paying tax twice on the same income. An example would be if a company based in one country produced a good in another country but shipped it back to the original country. A double taxation treaty between the two countries would mean that the company would not pay tax on a particular income more than once. However, many companies abuse this policy by relocating operations or even just relocating the head office of their company to a country with a low tax rate. By doing this they can choose to pay tax at the lower rate and avoid paying the higher rate tax required in their original country. A relatively recent example of this occurred with Hendersons the asset management group.

In 2008, they decided to register their headquarters in the Republic of Ireland. Moving from the UK to the Republic of Ireland allowed them to take advantage a lower rate of tax (12.5% in Ireland compared to 25% in the UK). Despite the high initial cost of the move (thought to be around £4.5m), the group have been reported saying that the long-term tax benefits will prove much more significant than than the cost of the move. Hendersons are not the only company to have decided on such a move, many other UK companies have been attracted to relocating part of their business to Ireland due to fact it shares a common time zone and language with the UK as well as the obvious tax benefits. It is clear from this example that companies are more than willing to adjust their operations in an effort to avoid paying higher level of tax.

Another method companies use to avoid tax is known as transfer pricing. Transfer pricing allows multinational companies to transfer profits and costs to different subsidiaries in an effort to avoid paying higher levels of tax. An example of transfer pricing occurs with the three main companies in the banana industry. Del Monte, Dole and Chiquita (all US companies) pay a very small amount of tax in the US and also in the Latin countries where the majority of their bananas are produced. By shifting certain costs to the subsidiaries in the US and the Latin countries where the tax rate is relatively high they are able to report lower levels of profit and therefore are eligible to pay lower rates of tax. On the other side, profits are transferred to subsidiaries in countries where there is a very low or even zero level of tax. This allows them to pool most of their profits together in a country where the tax level is low and therefore have a significantly reduced tax bill. This can be achieved by subsidiaries in countries with a higher level of tax over invoicing subsidiaries in countries with a lower level of tax.

Transfer pricing is often used by companies today, and again is a controversial process. Is it fair that rich, multinational companies bend the rules in their favour so that they end up paying less tax? They are clearly benefiting from avoiding tax but who suffers? In the case of Del Monte, Dole and Chiquita, avoidance of higher levels of tax through transfer pricing could have a serious effect on poor countries in Latin America. Multinational companies like these are avoiding paying tax in certain countries in an effort to increase overall profits, but as a result ordinary people could suffer from less tax being obtained in their home countries resulting in less spending on public services. This is a very contentious topic and questions the ethics of large corporations. Personally I can see why companies would want to reduce their tax bill, and within reason that is ok. But the extent of which some companies exploit current tax systems in a very questionable, but never the less legal way is immoral.

Raising finance and the cost of capital

Finance can be raised either internally or externally by businesses. Raising finance internally involves using retained earnings gained over previous years to finance new projects, this is an option available to companies who hold a lot of cash, however not every business is in such a position. This blog will focus on the process raising finance externally and the cost of raising this capital. External finance comes in two forms, equity finance and debt finance.

Equity finance mainly involves issuing shares in the company in exchange for money. The money raised from the issuing of these shares can then be made available to the company to finance new projects for example. Facebook is a company currently in the headline for it's IPO (initial public offering). On 1st February 2012 Facebook announced it's IPO, and is expected to offer up to $5bn. However, one may ask is this public offering necessary? Facebook is already a very profitable company and it is difficult to see what it would do with this money seeing as it already seems to be making enough to fund future projects.

Would it not be in a position to raise finance internally if it needed to fund a future project? 
Is this decision just a way a increasing the value of the company?If the money raised from the IPO was just invested in the bank for example, it could be argued that this is not good use of shareholder funds. Also it is important to note the value of Facebook as being anywhere between $75bn and $100bn. This means the $5bn being offered makes it a relatively small IPO in comparison to the value of the company, with only between 5% to 7% of the shares being made publicly available. This again could be seen as a way of increasing the value of the company by the current shareholders without giving up much control.

Another recent example of a company raising finance through issuing shares, but with a different aim is General Motors IPO in 2010. This has been the biggest IPO to date, valued at $23.1bn, however this followed the company filing for Chapter 11 bankruptcy. The decision to list the company publicly was taken in order to raise money to pay back the US government who had helped finance General Motors with over $9bn in bid to help restructure the company in return for a stake of 66%.
Following the IPO, the US government's stake was reduced to 26.5%   and recently the company announced it's highest ever profit of $7.6bn.

Another form of finance available for companies is debt finance. Debt finance involves raising money using a number if financial instruments such as loans and issuing bonds to individuals or institutional investors. In return for lending the money (either through a loan or bond) the investor is promised by the business that they will pay back the principal and interest of the loan/bond over an agreed period of time. One difference to note between equity and debt finance is that shareholders are not guaranteed to receive even their original investment back after purchasing shares. Any money made from investing in shares will depend on the future success of the company, whereas the company is obliged to pay back money borrowed from issuing bonds or taking out a loan. Companies often use a mix of equity and debt capital in order to finance future projects.

It is important to consider the cost of capital when discussing the raising of finance. Glen Arnold defines the cost of capital as,

"the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by the returns offered on alternative securities with the same risk."

Many companies use the weighted average cost of capital (WACC) in order to identify the minimum return needed from its own investments to satisfy the lenders who have invested in the company. The WACC identifies the average of the costs of the sources of finance used by the company (either debt or equity finance or a combination of the two) and proportionately weighs each cost with the appropriate source of finance. By calculating the WACC, a company can identify how much interest it must pay for every pound/dollar it raises.

Despite being able to identify the required returns to satisfy shareholders, many companies continue to pursue projects that offer returns much lower than the desired figure calculated by the WACC. This is often referred to as a 'loss leader' approach and has been adopted by a number of companies such as airline despite it potentially being a shareholder wealth destroying activity.

Why would a company act in such a way? Well there are a number of reasons. One is to price their competitors out of the market in the hope that they will be unable to compete in the future and allow them to then increase their prices once they have reduced the competition.

This was true in the case of Ryan Air who have often reduced their air fares to extremely low levels when faced with increased competition from other companies such as Aer Lingus. Another airline called 'Go' also tried to offer low cost fares from RyanAir's base in Dublin but ended up withdrawing it's services after RyanAir reduced it's own fares.

It is clear to see that there are a number of different options that companies are faced with when considering the raising of finance and also many different reasons why a company would want to in the first place, not always to fund future projects as in the case of General Motors!

Stock market efficiency

Stock market efficiency refers to reactions by share prices following certain events that are relevant to the company in question. This information can come in several forms and is not exclusively related to actual events that have occurred. The stock price can be influenced by how investors perceive certain information, even if the information is not valid and purely based on a rumour.

The efficient market hypothesis was formulated professor Eugene Farma and argues that stock prices are fully reflective of all information available about that particular stock and therefore no individual investor holds any advantage over fellow investors due to the fact that the information concerning the stock is available to all. However, this theory is widely disputed. Real life examples, non more striking that Warren Buffet's continued success in trading, suggest that the stock market indeed can be beaten. One must consider how a market can be random when individuals such as Mr Buffet continue to profit from trading.

Consideration into the reactions of share prices following significant news should be taken. One would assume that 'good news' related to a certain company would reflect positively on the the value of the share prices. However, there are several examples where the opposite has occurred. Recently the Ford Motor Group announced a profit of $6.6 billion for 2010, it's largest recorded profit in over 10 years. How did this positive news effect the share price? You would be forgiven for assuming that such impressive profit figures would surely result in positively in the share price - this was not the case. Shares in ford fell by more then 12%.

This seemingly unusual occurrence can be explained by considering the stock market as a leading economic indicator i.e. stock prices reflect what investors think will happen rather than what has actually already happened. In this case investors had predicted that Ford was going to achieve impressive profit levels and therefore the share price had already been influenced by this assumption. Despite record levels of profit being achieved, investors had predicted even better performance and as a result the share price was over valued. This meant that in order for the share price to remain the same or even increase, even better profit figures would have had to been achieved to correspond with the initial assumptions of the investors. The reduction in share price following the news is an example of 'market correction', and reiterates the fact that the previous higher share price was indeed too high.

The fact that share prices can react negatively following positive news poses the question of whether or not investing in the stock market is in fact merely a game of chance. Kendal argues that prices change in random fashion with no systematic link being apparent between one price movement and the next ones. This ties in with the concept of 'Random Walks', whereby analysis of past information bears no relevance to upcoming events, similar to a drunk man stumbling along the road not knowing which way to turn. A passer by would not be able to predict the drunk man's next steps purely by looking at his previous ones.

 Personally I think the continued success of certain traders such as Warren Buffet who have beaten the market and made significant profits from investments is enough evidence to suggest that analysing certain information can indeed allow you to make wise, successful investment decisions. Warren Buffet, who attributes much of his success to learning from Benjamin Graham, is a pioneer of value investing and continues to implement his strategy of buying undervalued shares. Surely anyone who succeeds so often and over such a long period of time is proof that performance in the stock market is not random? I think so.

Eastman Kodak – An example of significant destruction of shareholder value

On January 19^th 2012, Eastman Kodak filed for chapter 11 Bankruptcy protection, over 130 years after it was first founded. The recent demise of this company is an explicit example of destruction of shareholder value and finally answered the question of whether this former global pioneer in analogue photograph technology could exist and adapt successfully in the digital era. Following the announcement to file for bankruptcy, Kodak’s share price dropped to an all-time low of 36 cents per share and was promptly suspended from trading. Despite inventing the world’s first digital camera in 1975, Kodak never managed to remain competitive in this field. Kodak traditionally made most of its money from selling photography film, and were unable to keep up with competitors who were quicker to adapt to the digital era. This hesitation has ultimately decided the company’s fate. The company has employed many different strategies over the years, including focusing on home printing technology. However, the share price has continued to fall, resulting in bankruptcy being suggested by CEO Antionio Perez as a litigation strategy. Perez argues that bankruptcy would help Kodak maximize the value of patents related to digital imaging, which are used in virtually every modern digital camera, smartphone and tablet, according to Kodak.

This case is a shocking example of what could happen when a company fails to adapt to the faster pace and lower cost structures of the digital world. Other examples include Blockbuster videos failure to anticipate the introduction of online video rental services and have suffered greatly from competition from companies such as Netflix and Lovefilm. When considering the value creation and the value action pentagon, this could also be seen as a relevant case. Despite Kodak attempting to adopt new strategies such as focusing on home and commercial printing technology, they have failed to make much of an impact and have drastically lost their position in their core market of photograph technology.

In conclusion, Kodak is just of many examples of a company that can be looked at when considering the subject of shareholder value creation/destruction.