This Panama Papers malarkey looks like claiming a few scalps.
I’m not talking about Iceland’s prime minister.
I’m talking about anyone who has ever benefited from a tax loophole, inversion or efficient vehicle…
The mood music is changing
Companies in the US have been trying to avoid high levels of US corporation tax through “tax inversion” deals. This is where a big US company buys an overseas rival, primarily in order to take advantage of the lower tax rate.
(The US has a corporation tax rate of 35%. Yes, it is a surprise, isn’t it? And you thought that America was the home of buccaneering small-state free-market red-in-tooth-and-claw capitalism. Well there you go. Oh, and that rate applies to foreign earnings too.)
As the FT explains, “The tax benefit stems from companies’ use of internal loans to cut their tax bills. By loading up US subsidiaries with debt from head office, foreign companies can deduct interest payments from their US tax bills – a practice called earnings stripping.”
Since 2012, there have been 23 of these deals, according to US government data. Now the US Treasury has decided to put a stop to it.
There will no longer be any benefit to moving a company’s tax residence abroad. The change is being backdated to deals done in the past three years. “Earnings stripping” will also be “severely restricted”, notes Lex.
This has proved particularly bad news for Irish-domiciled, US-listed pharma group Allergan. US giant Pfizer had agreed a $160bn deal to buy the group, with the goal of benefiting from tax inversion.
Now the deal has been pulled. Pfizer will have to pay $400m in expenses related to the deal, according to Bloomberg.
We can spend time tossing about the rights and wrongs of all this. Maybe if the US corporate tax rate wasn’t so high and its general tax regime so overbearing then fewer companies would want to do tax inversions.
And maybe the reason these loopholes exist in the first place is from the usual pandering by politicians to special interests come election time.
That’s all very well. But what you need to know as an investor is that this is happening, and it’s going to continue. Governments are showing everyone who’s boss. The old assumption was that if a country’s tax rules became too harsh, everyone would go elsewhere. That’s gone out of the window with increased global tax co-operation.
Good news for smaller companies
And now, as my colleague Merryn Somerset Webb has pointed out on many occasions, governments are going to go where the money is. And at the moment, a lot of that money is sitting with multinational companies.
There are two main implications for investors. Firstly, it’s a great illustration of how the mood music has changed. Electorates used to be pretty relaxed about the rich and even the super-rich when they were seen as a function of widespread prosperity. They aspired to join their ranks.
But not any more. Now the wealthy – and just “the big” generally – are seen as cronies and the beneficiaries of a rigged system. That’s a direct result of the financial crisis. This is the backlash. And it’ll be indiscriminate.
Barack Obama said of tax inverters (if I can call them that): “They effectively renounce their citizenship. They declare that they’re based somewhere else… It sticks the rest of us with the tab, and it makes hardworking Americans feel like the deck is stacked against them.”
That’s pure rhetoric. In the pantheon of post-crisis bad behaviour, big pharma has to rank fairly far down on the scale – no one ever printed money to save a drug company. But it works. And the timing is perfect.
With Panama hitting headlines everywhere, it’s the ideal moment politically to conflate as much of this stuff together as you can. Label everything you don’t like as tax avoidance by plutocrats, and you’ll be safe.
Secondly, the companies that have benefited from scale and globalisation and an ability to exploit loopholes available to them only because of their size are now in the firing line.
However, the flipside is that their smaller rivals should benefit. Merryn recently interviewed small cap expert and fund manager Gervais Williams of Miton on this point. You should check out the interview here if you haven’t already.