Tuesday, January 17, 2017

Ireland’s trade in aircraft–our largest goods import

In 2015 our trade statistics moved to a transfer of ownership basis for recording trade in aircraft.  Prior to this aircraft were recorded in the country where they were registered.  They are now recorded in the jurisdiction where the owner is resident. 

The previous approach generally only picked up aircraft owned by Aer Lingus and Ryanair with some sundry others.  The revised approach means that aircraft owned by leasing companies which are resident in Ireland are now included.  This has seen the recorded annual trade in large aircraft for Ireland move from double digits to treble digits, with imports now regularly exceeding €10 billion.

Here is revised data back to the year 2000 based on the transfer of ownership approach.

792.40 Aircraft

Since the year 2000, Irish-resident entities have purchased over 3,000 wide-body aircraft while selling about 1,000 less.  The value of imports is €96.2 billion compared to €23.6 billion for aircraft sold.  It can be seen that the average value of aircraft purchased is about three times the average value of aircraft sold (€31 million versus €11 million).

Aircraft imports for 2016 already exceed €10 billion even though the detailed data from the Trade Statistics have as yet only being compiled to October.  Aircraft are Ireland’s largest goods import exceeding food and live animals (€6.6 billion in 2015), oil and gas (€4.9 billion), medicinal and pharmaceutical products (€5.4 billion), organic chemicals (€3.8 billion), cars and other road vehicles (€3.5 billion).  Since 2010, wide-body aircraft have average 15 per cent of total goods imports in the External Trade Statistics.

All these aircraft are included in Ireland’s capital stock.  Aircraft leasing forms part of the Administration and Support Services Activities sector (Nace N).  Given the value of wide-body aircraft it is fairly safe to assume that most of the Transport Equipment assets held by this sector are held by aircraft leasing companies. [Aer Lingus, Ryanair and aircraft leased by operators will be in Nace H – transportation and storage.]

The left panel of the following table gives the nominal value of transport equipment assets in the sector.

Capital Stock of Aircraft

At the end of 2014, Ireland had a stock of wide-body aircraft with a gross value (i.e. valued at the price of new capital goods) of something approaching €86 billion., double the level recorded in 2009.  If the age and depreciation are taken into account the value was around €50 billion at the of 2014.  These increases in the capital stock of aircraft will also be contributing to increases in the provision for depreciation in the national accounts (though can only be part of the reason why the provision for depreciation jumped from €30 billion to €60 billion in 2015). 

The 2016 capital stock figures won’t be published until the end of the year but the figures for transport equipment are likely to be suppressed, just as they were in 2015 due to confidentiality reasons (in another category).  The Irish Aviation Authority says that there are over 4,000 aircraft under Irish management with a value of $120 billion.

We can get some indication of the evolution of Ireland’s stock of wide-body aircraft from other CSO data. The trade data show that since the start of 2015 net imports have been €13 billion.  The trade data will include purchases by Irish-resident entities but will omit the transfer to Ireland of aircraft owned by entities who re-domicile and become Irish-resident.

We can also get an indication from the Balance of Payments by looking at export income from operational leasing.  This is given in the right panel above along with the ratio of such income to the net capital stock of transport equipment in NACE N.

While the import of the aircraft is largely GDP neutral – as the negative import figure will be offset by a positive investment figure – the income from these leasing activities is GDP positive (as, one assumes, is the export sale of the aircraft).

The change in treatment means that Ireland’s current account balance in the Balance of Payments has been revised down (by the revised net trade amount in aircraft).  For 2015 it can be seen from the first table that this reduced the current account by around €6 billion.  That knocked a small bit off the bizarre look of our current account which recorded a €26 billion surplus in 2015 (with that largely being the gross operating surplus that a small number of Irish-resident subsidiaries of MNCs are using to  repay debt as discussed here).

Monday, January 16, 2017

The business sector in Ireland in the latest institutional sector accounts

The previous post looked at the household sector in the Non-Financial Institutional Sector Accounts published last week by the CSO.  Here we look at the non-financial corporate sector, which is where all the action is in relation to the recent leaps in Ireland’s national accounting aggregates (26 per cent GDP growth and all that), but really doesn’t tell us much about the general performance of Ireland’s business sector.

First, here’s the current account with all the figures relating to Q1 to Q3 totals for the years from 2012 to 2016.

NFC Sector Accounts Q1-Q3  2012-2016

The big jump can seen in the Gross Domestic Product (close to value added) for 2015.  The 2014 figure was €82.8 billion and the 2015 figure was €123.3 billion.  The step-level change was maintained in 2016.

As noted in the household accounts, there has been a rapid rise in the amount of wages paid from the corporate sector.  The table above shows that ‘compensation of employees’ from non-financial corporates has increased from €30 billion in the first three quarters of 2012 to just over €38 billion for the same period in 2016.

But with value added rising by a much greater amount than employee compensation that means Gross Operating Surplus of the NFC sector is also much greater. In fact, GOS in the first three quarters of 2016 is double the level recorded in 2012: €87.4 billion versus €43.6 billion.

Perhaps unexpectedly, a substantial increase of more than €40 billion in the Gross Operating Surplus of the NFC sector has not transformed into a similar increase in dividend payments or retained earnings liabilities to shareholders.  In 2012, the sum of dividends paid to and retained earnings owed to shareholders was just under €26 billion for the first three quarters of the year.  For the same period of 2016 these summed to €34 billion.  A rise, yes, but only equivalent to about one-fifth of the rise in Gross Operating Surplus.

This means that the resources available by use by Irish-resident entities (though not necessarily Irish-owned) has increased substantially.  Compared to the first three-quarters of 2012, the Gross National Income of the NFC sector has increased 150 per cent: going from €22.9 billion for Q1-Q3 2012 to €57.3 billion in Q1-Q3 2016.  Gross National Income is a key input into the determination of a country’s EU contribution.

The companies are paying additional Corporation Tax on this income with income and wealth taxes for the first three quarters of the year rising from €1.8 billion in 2012 to €3.4 billion in 2016.  We should pause a little before reaching too many conclusions about the additional tax just yet as the income measures we are looking at are all gross, i.e. before the deduction of depreciation.

By subtracting income tax and netting off some capital transfers we are left with the Gross Disposable Income of the NFC sector and consistent with all the other measures this has shown a huge increase since 2012 with most (but not all) of the increase occurring with the step-level change in 2015.  Retained earnings owed to re-domiciled PLCs also introduces some volatility into the series.  See this note from the CSO.

Anyway, if NFCs have generated more than €50 billion of Gross Disposable Income (which is also Gross Savings as companies do not have any final consumption expenditure) in the first three quarters of 2016 it is probably worth trying to see what they are doing with it.  To that end, we can start by looking at the capital account to see if they are investing it.

NFC Sector Capital Accounts Q1-Q3  2012-2016

The first panel shows us that a huge amount of the increase in Gross Savings is being absorbed by an increase in depreciation (consumption of fixed capital).  Companies in Ireland are generating substantially more gross income but a lot of this will be devoted to their capital stock which will require re-investment or replacement – or that’s what the figures indicate at any rate.  As we don’t know what the assets are the link between their depreciation and the amount required to maintain and/or replace them is difficult to know.

There has been an increase of more than 50 per cent in the level of investment undertaken by the NFC sector from under €20 billion in the years up to 2014 to more than €30 billion for the two years since (again the figures are Q1 to Q3 totals).  But it can be seen that even with this additional investment the amount is less than the consumption of fixed capital (i.e. depreciation) so for each of the past two years net capital formation has been negative – investment in new capital has not been sufficient to cover the depreciation of existing capital.

However, it is impossible to tell if this is telling us anything important about the Irish business sector as the figures are so heavily polluted by the impact of a relatively small number of MNCs.  Investment is up because of purchasing of IP by Irish-resident entities and depreciation jumped massively because entities with huge amounts of IP on their balance sheets became Irish-resident.  The underlying position of domestic Irish companies is impossible to tell from these figures.

Anyway to continue with our story.  With investment less than savings this means that the NFC sector is a net lender, as it has been for four of the past five years with substantial amounts arising for each of the past two years.  The figures in the table only cover nine months of each year but show that the NFC sector has had around €30 billion of net lending available.  For full-year outturn the amount for the past two years is likely to come to over €40 billion. 

What are the companies doing with this money?  Repaying debt would seem the likely answer.  The CSO only publish the institutional sector financial accounts on an annual basis so they don’t really offer the up-to-date figures that are required.  We can, though, get some insight from the international investment position data published with the Balance of Payments.

Here are the debt liabilities to direct investors of Irish-resident entities since 2012. 

Direct Investment Debt 2016

The huge jump (of a quarter of a trillion!) in Q1 2015 is likely related to entities with huge debts becoming Irish-resident.  These entities brought assets with them and these assets  resulted in the huge increase in the amount of gross operating surplus generated here.  There are likely to be lots of moving parts with some companies borrowing and others repaying debt but the overall thrust of the net lending of the NFC sector going to repay the debt shown here is more than likely correct.  And maybe leads to questions about the inclusion of it in our Gross National Income if these assets move on again.

And what does all of this tell us about the domestic Irish business sector? Absolutely nothing.

Friday, January 13, 2017

The latest household sector accounts

The CSO have published the Q3 2016 update of the Non-Financial Institutional Sector Accounts.  Here we focus on the household sector and try to reproduce the accounts in a somewhat readable form.

First, the current account with figures for the sum of the first three quarters extracted for a selection of years.

Household Sector Accounts Q1-Q3  2007-2016

Estimates of output and intermediate consumption are only provided with the annual versions of these accounts so we start with Gross Domestic Product (akin to value added).  After subtracting wages paid by the household sector (by the self-employed etc.) and netting out taxes and subsidies on production we are left with Gross Operating Surplus/Mixed Income of the household sector.

This has risen to €17.8 billion from the €15.0 billion trough for the first three quarters of 2011 but remains below the 2007 peak of €19.2 billion (likely due to much reduced self-employed and contracting work in the construction sector).

Compensation of employees (wages) is up on 2007 levels.  The total of wages received from all sectors for the first three quarters of 2007 was €57.8 billion while the first quarters of 2016 recorded a total of €62.1 billion.  This improvement is driven by increases in wages paid from the corporate sectors with wages from the government and household sectors largely flat.

Compensation of employees from the non-financial corporate sector for the first three quarters of the year has improved from €29.5 billion in 2011 to €38.3 billion in 2016, a 29.8 per cent increase that definitely does mean something positive.  Pay from financial corporates is up on 2007 but has been flat for the past few years.

With our heavily-indebted households also benefitting from lower interest rates (though note the FISIM adjustment affects the interest figures in the table) it means that the Gross National Income of the household sector is now ahead of the 2007 level with Q1-Q3 aggregates of €77.9 billion then versus €82.1 billion now.  And compared to the trough of €66.9 billion in 2011 the increase is obviously much larger.

Although taxes on income and wealth and social contributions paid to the government (mainly PRSI) are higher than 2007 (up €3.5 billion) these are largely offset by increased social benefits paid by the government sector (up €3 billion).  This means that the changes in Gross Disposable Income largely track the changes in Gross National Income (though obviously there will be distributional effects that these aggregate data cannot pick up).

Gross Disposable Income has grown 10 per cent in the past two years.  The annual rate of growth for the first three quarters of the year has slowed from the 5.8 per cent recorded in 2015 to 3.6 per cent in 2016.  Still a pretty impressive lick all the same.

While the household sector has extra income available for consumption it is not being spent.  Gross Disposable Income for Q1-Q3 might be around €4 billion up on its 2007 level but household consumption expenditure is fairly close to the 2007 level (€66.3 billion in Q1-Q3 2016 versus €65.5 billion in 2007).

Income growing by more than spending means that the savings rate is higher.  The gross savings rate has hovered around 13 per cent in Q1-Q3 for the past few years compared to 10 per cent in 2007.  Our annual consumption splurge in Q4 will probably bring the full-year rate for 2016 down to around 11 per cent but this is well up on the levels seen in the years up to 2007 when it was consistently below 10 per cent.

Of course, the next question is what are we doing with those savings?  In 2007 we were using them (and a whole lot of borrowing) to buy houses.  That ended abruptly and the picture from the capital account has been wholly different since then.

Household Sector Capital Accounts Q1-Q3  2007-2016

In 2007, the household sector’s Gross Saving of €7.1 billion was significantly less than the €18.6 billion of gross capital formation undertaken by the household sector (mainly on new houses).  This meant that the household sector was a net borrower in the non-financial accounts to the tune of €11.6 billion.  [Of course, overall borrowing by the household sector was much larger but a lot of that was to buy existing houses of each other so appears in the financial accounts.]

The household sector has been a net lender since 2009 averaging just over €4 billion a year for a total of €29 billion.  Gross Capital Formation by the household sector has begun to increase and the growth rates are impressive.  The figures in the above table show a growth rate of 15 per cent in 2015 with this rising to 20 per cent in 2016.  But this is from an very low base.

It can be seen that for most recent years Gross Capital Formation was just ahead of depreciation (consumption of fixed capital) so there would have been little increase or improvement in the capital stock held by the household sector (mainly houses).

There has been a significant reduction in the gross indebtedness of the household sector.  Total loans outstanding were €203 billion at the end of 2008 and will likely have fallen to €140 billion at the end of 2016.  Some of the €29 billion of net lending identified above will have been used to repay debt while others will have sold assets to repay debt.

All in all, the ISAs show strong improvement in the current account for the household sector but the capital and financial accounts show that this is needed, and more, as we continue to work through the legacy effects of the boom/bust.

Friday, October 14, 2016

Facebook responds to IRS court filings

Back in July we briefly looked at court filings the IRS had made into Facebook’s 2010 tax return in the US.  At the time Facebook had yet to respond; but they have now.

Earlier this week Facebook filed their own petition and there is a useful summary here.

Although the additional tax claimed by the IRS for 2010, $1.7 million, is relatively small there are a number of offsetting factors that give rise to the net figure.  Central to the case is the transfer of economics rights of  intellectual property owned by Facebook Inc. to Facebook Ireland Holdings in September 2010 after which date the two companies entered a cost-sharing agreement (CSA) for the continued development and licensing of Facebook’s technology.

As a result of the transfer and the cost-sharing agreement Facebook Ireland Holdings is granted the license to use Facebook’s technology outside of North America.  The IRS make some minor quibbles about the treatment of payments under the CSA but their major issue is the valuation of the IP that existed at the time the CSA for future developments was entered into.

Facebook Inc. put a net present value of $6.7 billion on the intangibles and calculated royalty payments on the basis of that.  The IRS meanwhile have assessed that the intangibles had an NPV of $13.9 billion at the time.  There is quite a substantial gap. In a separate filing related to discovery Facebook claim that their answer was “overly generous”:

Facebook explained that once the IRS errors were corrected, the IRS economic model yielded essentially the same value that Facebook used to prepare its tax returns, or even that Facebook’s tax return position was overly generous to the IRS.

The rights to the intangibles were transferred to Facebook Ireland Holdings on September 15, 2010 and the IRS estimate that an additional royalty payment based on their valuation of $85 million should have been made to Facebook Inc. for the remainder of the year.  Over a full year this would equate to additional payments of around $300 million, assuming payments on a straight-line basis.

So the IRS have revised up Facebook Inc.’s gross royalty income for 2010 by this $85 million (and will likely seek upward revisions of $300 million for a number of years after if the case is upheld).  One would expect that this would have led to a larger tax bill for Facebook Inc. for 2010 of around $30 million (assuming the 35% US CIT rate applies) but the IRS made a number of other adjustments.

Most of these were minor but the biggest of them was that the IRS increased Facebook Inc.’s deduction for Net Operating Loss by around $700 million.  The use of this deduction almost fully offset the additional tax due on the increased royalties.

The IRS adjustments mean that Facebook Inc. will not have the Net Operating Loss deductions applied to 2010 available for future periods and will face higher tax in the US due to the increased royalties that Facebook Ireland Holdings will have to pay. And this latter point highlights the key aspect of many of the global tax strategies used by US MNCs - getting the economic rights to IP developed in the US into entities outside the US (or at least considered ‘offshore’ for US tax purposes).  In this instance ‘offshore’ seems to be Grand Cayman but mentions of that in all the filings to date: nil.

Anyway, if the IRS require much larger payments to Facebook Inc. for the technology developed in the US then Facebook will have much larger US tax payments.  As the company itself says:

On July 27, 2016, we received a Statutory Notice of Deficiency (Notice) from the IRS relating to transfer pricing with our foreign subsidiaries in conjunction with the examination of the 2010 tax year. While the Notice applies only to the 2010 tax year, the IRS states that it will also apply its position for tax years subsequent to 2010, which, if the IRS prevails in its position, could result in an additional federal tax liability of an estimated aggregate amount of approximately $3.0 - $5.0 billion, plus interest and any penalties asserted. We do not agree with the position of the IRS and will file a petition in the United States Tax Court challenging the Notice. If the IRS prevails in the assessment of additional tax due based on its position, the assessed tax, interest and penalties, if any, could have a material adverse impact on our financial position, results of operations or cash flows.

In theory, of course, this is tax that Facebook would have to pay anyway.  But it has set up a structure, as many other companies have, to defer the tax due on earnings made outside the U.S. until those earnings are “repatriated” to a U.S.-registered entity in the company.  Facebook does not make a provision for this deferred tax in its accounts (one reason being that it does not intend to repatriate the profits) so actually paying this tax will have a “material adverse impact” on its operations.

Thursday, September 1, 2016

Why tax campaigners should be aghast at the Apple ruling

The European Commission ruling that Apple should pay €13 billion of Corporation Tax to Ireland has been met with approval in some quarters.  But one problem is that many of those who are approving have a completely different view of how companies should be taxed when compared to the broad logic used by the Commission to reach the €13 billion figure.  It is as if the ruling should be welcomed for the simple reason that it involves more tax (or at least appears to involve more tax).

Would other companies like to replicate the outcome that the ruling reflects?  Absolutely. And particularly for non-US companies as US companies are subject to US tax on their worldwide earnings.  But what about a company in France or Germany?  Would they like to have 60 per cent of their profits taxed at 12.5 per cent in Ireland. You bet they would.

So how can they achieve that?  If we follow the logic of the EC ruling it would be relatively straightforward.

Let’s take a company in France as an example.  The company should aim to have as much of its profits accumulated in a single subsidiary as possible using transfer pricing to maximise the difference between the prices it pays and receives.  There will tax due on the profits on other subsidiaries but the company should be looking for a central ‘hoover’ type subsidiary where as much of the profit as possible is located. 

It could be a company that buys off manufacturing units and then sells on to distribution or retail units or even final customers.  It doesn’t really matter just as long as it captures the maximum amount of profit possible.

This subsidiary can be in France, it can hold intellectual property (which may be how the profit is allocated to it), it can record sales on its accounts, its board of directors can stay in France, its accounts can be maintained in France and its financial assets can be kept in France.  It is crucial though that the company has no employees or physical assets in France.  The company must exist in France “on paper only” (leaving aside the fact that this is  is actually how companies exist).

This subsidiary should then set up a branch in Ireland where the only employees of the subsidiary are located.  The Irish employees implement the decisions of the board of directors.  They can deal with production units within the company and external suppliers.  The can do inventory management on the output to be produced.  They can oversee the logistics of the transport and delivery of the product.  And they can manage the invoicing and payments with customers.

How much profit should be attributed to the Irish branch that undertakes these functions?  Here is the Commission outlining position in the case of the Apple subsidiaries which had their head office in the US and a branches in Ireland with their only employees:

The Commission's investigation has shown that the tax rulings issued by Ireland endorsed an artificial internal allocation of profits within Apple Sales International and Apple Operations Europe, which has no factual or economic justification. As a result of the tax rulings, most sales profits of Apple Sales International were allocated to its "head office" when this "head office" had no operating capacity to handle and manage the distribution business, or any other substantive business for that matter. Only the Irish branch of Apple Sales International had the capacity to generate any income from trading, i.e. from the distribution of Apple products. Therefore, the sales profits of Apple Sales International should have been recorded with the Irish branch and taxed there.

The "head office" did not have any employees or own premises. The only activities that can be associated with the "head offices" are limited decisions taken by its directors (many of which were at the same time working full-time as executives for Apple Inc.) on the distribution of dividends, administrative arrangements and cash management. These activities generated profits in terms of interest that, based on the Commission's assessment, are the only profits which can be attributed to the "head offices".

Per the EC ruling ALL of the profits of this subsidiary should be “recorded with the Irish branch and taxed there”.  The tax to be allocated to France is nil – except for the interest earned on French bank accounts.

If the company can set up this structure they can get a good chunk of their profits taxed at Ireland’s 12.5 per cent and may not have to pay any more corporate income tax on those profits.

How big a chunk depends on the structure of the company and what it does.  Apple is an unusual case in that so much of its profit is derived from IP – design, brand, reputation, innovation etc.  Its central hoover subsidiary had about 60 per cent of the companies profit accumulating in it.  And per the Commission ruling this 60 per cent of Apple’s profits will be subject to Ireland’s 12.5 per cent rate of Corporation Tax. 

This isn’t much of a gain for Apple as US companies are liable for the US 35 per cent federal corporate income tax on their worldwide earnings (though obviously they can defer this).  But France operates a territorial system.  In theory, at least, this means that French companies are only taxed on their profits earned in France.  Profits earned abroad are not subject to French tax.

So our example company could set itself up with a French subsidiary that has a branch in Ireland and have all the profit of that subsidiary taxed in Ireland as long as the only employees of that company are in Ireland.  And it doesn’t matter how many employees. Just a few will do. 

Now we really have Ireland acting as a tax haven.  Think of the possibilities.  Companies all over the world can set up this central subsidiary that hoovers up as much of their profit as possible (within the confines of transfer pricing regulations).  This subsidiary maintains its board of directors in the home country but sets up a branch in Ireland that has the subsidiary’s only employees.  As long as this is the only “operating capacity” of the subsidiary then ALL of the profits will be allocated to the Irish branch and taxed in Ireland.

This would lead to huge profit shifting and significant exploitation of Ireland’s 12.5 per cent Corporation Tax rate.  Countries with territorial system would see large parts of their tax bases shifting to Ireland.  There is no other country in the world where this would be possible but the application of the EC ruling means that this is what Ireland should do. 

Any time the Revenue are faced with a non-resident company with an Irish branch then 100 per cent of profits of that company should be taxable in Ireland if Ireland is the only country that company has employees in.  This is being a tax haven on a grand scale.

How would the authorities in France react if one of its companies tried to pull this stunt?  They would be up in arms.  And rightly so.  There is no way they would accept Ireland taxing 100 per cent of the profits of that subsidiary just because Ireland was the only country it had employees in. 

They would say to Ireland to look at the branch operating there and collect tax based on the risks, functions and assets in the branch and leave the residual profit with the “head office” for the French to tax.  France will only allow Ireland to collect tax based on what happens in the Irish branch.

But this would put Ireland in contradiction to the EC ruling.  The two paragraphs quoted above clearly state that if the subsidiary only has employees in an Irish branch ALL of the profits are taxable in Ireland.  The Revenue Commissioners are between a rock and a hard place.  To avoid falling foul of further state-aid inquires all branches should be treated as the EC ruling requires but France will only allow Ireland to levy tax on the functions that the Irish branch actually undertakes.

This is why there have been many people saying that the EC ruling “flies in the face of international tax practice”.  But not only does it do that it opens the possibility of Ireland becoming a tax haven of grand proportions.  Maybe we should scrap the IDA and set up an agency with the tagline “set up a branch in Ireland, pay all your tax here”.  For companies in countries that have territorial tax systems it would be hugely attractive.  There could be tens of billions in revenue in it for us (if it was possible, which it is not!).

This is all a bit whimsical.  And although what the Commission have done in the case of Apple goes against all principles of taxation what is here is not enough to say they are wrong on the particulars of that case.  We will come back to that.  But it does highlight the inconsistency of some of the reaction to the ruling. 

If other companies set up structures to try and avail of what the ruling offers they would be accused of tax avoidance by many of those welcoming the ruling.  And they would be right. So, rather than welcoming this ruling, if anything, campaigners should be aghast at what this ruling means.  Do they really want the tax system to function as implied by the two paragraphs quoted above?