Why investors need to keep an eye on this most taxing of issues

The kerfuffle caused by the Paradise Papers is unlikely to die down for some time as it shines a light on corporate behaviour that is not entirely flattering.

This column will not go into the ins and outs of the individual cases mentioned for fear of both entering a legal minefield and becoming embroiled in a debate which can be as much about politics as it is economics, given that it touches on the role private

enterprise relative to that of the State and how they are supported and funded. To highlight two possible positions:

  • One part of the political spectrum may argue that for the UK to raise barely 8% of its £700 billion in Government income in corporation tax is too little, especially at a time when UK corporate profits stand at or near record highs as a percentage of GDP. The Tax Foundation’s assertion that the average national corporate tax rate has dropped from 39% to 23% since 1980s will not reassure those who fear rampant corporatism and inadequate provision of social support and healthcare for those who need them most. The link between rising corporate profits and subdued wages is even more stark in the USA, as this chart below suggests:

US corporate profits are growing at the apparent expense of wages, relative to GDP

US copporate profits

Source: FRED, St. Louis Federal Reserve database

  • A different part of the political spectrum will take a different perspective, arguing that the tax burden is already high enough and that companies will not just pay tax themselves, but create jobs which in turn generate further revenue for Government and further jobs in turn as workers spend their hard-earned disposable income. This was very much the view of no less a Briton that former Chancellor of the Exchequer and Prime Minister Sir Winston Churchill who once said: “I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to pull himself up by the handle.”

In an attempt to step back from such side-taking and focus on the implications for investors’ portfolios, AJ Bell has looked at the tax payments made by FTSE 100 firms over the past 12 months.

In conclusion, 42 members of the UK’s FTSE 100 paid a tax rate in their last financial year that came in below the UK’s then official 20% corporate rate and 11 paid less than 10%.

However, conspiracy theorists are likely to be disappointed, since the global nature of their operations and legitimate tax breaks such as those for loss carry forwards or investment generally explain the difference.

This does raise three issues however:

  • Investors do need to check out the tax rate a company is paying, in case it proves unsustainably low (in which case increases could hurt future earnings growth) or there is scope for it to come down (and potentially boost earnings, cashflow and even dividends).
  • Investors should view the tax charge as part of their analysis of the quality and not just the quantity of companies’ earnings. Growth that is generated merely by salting down the tax rate is lower quality than earnings increases that come from progression in the top line or profit margins, especially when those gains are achieved through the magic combination of volume growth and pricing power.
  • Investors must check out the triggers for executive bonuses, share awards and stock options. If earnings per share are a key consideration, then some executives may be tempted to push as hard as they can on areas such as the tax charge. As Warren Buffett’s long-time business partner Charlie Munger once said: “Show me the incentives and I will show you the outcome.” While tax avoidance is not illegal (unlike tax evasion), investors need to be aware of how earnings are being generated to ensure that trouble is not being stored up for the future, in the form of a backlash from regulators or customers.

Taxing matter

AJ Bell’s analysis of the tax paid by the 100 members of the FTSE 100 during their last full financial year reveals the following:

  • On a statutory basis the 100 members of the UK’s leading stock market benchmark paid £32.9 billion in tax in their last financial year. That equated to a tax charge of 33.7%.
  • Adjusting for (allegedly) exceptional items such as restructuring charges or non-cash accounting items such as asset write-downs and impairments, the adjusted tax bill was £31.6 billion for a charge of 24.6% - higher than the 20% statutory corporate tax rate which applied for the fiscal 2016-2017 tax year and higher than the 23% rate that is estimated by the Tax Foundation to be the worldwide average national corporate tax rate. This should provide reassurance that profits are not being unduly juiced by unsustainably low tax charges.
  • On an adjusted basis, 11 firms paid a rate below 10% and another 31 paid a rate below the 20% UK corporate tax rate. More than fifty, however, paid a rate above 20% and the low rates are the result of an international business mix and legitimate tax breaks rather than anything that could be described as tax evasion.

The twenty lowest (adjusted) FTSE 100 corporate tax rates paid in the last financial year

Tax rate (Adjusted) Tax rate (Adjusted)
BP  (107.5%) Morrison (Wm) 5.9%
3i  (0.2%) SSE 10.2%
British Land  0.0% easyJet 13.7%
Land Securities 0.0% Sky 13.9%
NMC Health 0.1% Royal Dutch Shell 14.8%
Scottish Mortgage Inv. Trust 0.1% DCC 14.8%
Hammerson  0.6% National Grid 15.2%
SEGRO 1.2% Paddy Power Betfair 15.5%
Carnival 1.7% Prudential 15.6%
AstraZeneca 4.1% ITV 15.8%

Source: Company accounts. Covers each company’s last financial year and not the UK fiscal year 2016-17.

With regard to the 11 who paid below 10%, there is little for conspiracy theorists to chew on.

  • BP made a loss last year owing to a plunge in the oil price
  • 3i and Scottish Mortgage are investment companies and thus benefit from well-established tax breaks relating to their money management activities
  • British Land, Hammerson, SEGRO and Land Securities benefit from the tax breaks associated with their status as Real Estate Investment Trusts (REITs) introduced by then Chancellor Gordon Brown in 2007.
  • Morrisons benefitted from a deferred tax credit (relating to prior provisions for future taxes).
  • Carnival’s 1.7% tax rate (a bill of $49 million on a pre-tax profit of $2.8 billion) relates to a number of international tax treaties, the UK tonnage tax on shipping (where companies must have suitable status, qualifying vessels and commitments to train seafarers and the Panama domicile of its US cruise ship business.
  • The other eye-catcher is AstraZeneca, down at 4.1% ($146 million paid on pre-tax income of $3.6 billion) but there is again a simple explanation. The drug giant benefited from a $453m adjustment following agreements between the Canadian tax authority and the UK and Swedish tax authorities in respect of transfer pricing arrangements for the 13-year period from 2004 to 2016. Excluding these effects, the global company’s reported tax rate would have been 17%.

Big bills

Eight FTSE 100 firms paid more than £1 billion in corporation tax worldwide on a statutory basis. Vodafone was the single largest payer at €4.7 billion (£3.9 billion) on a stated basis, for a paid rate in excess of 100% of profits, although changes in tax laws in Luxembourg cut the adjusted rate to 24.6% and the bill to €761 million (around £650 million).

Twenty highest FTSE 100 tax payments (adjusted basis) in the last financial year

£ millions £ millions
BHP Billiton 3,026 Vodafone 645
HSBC 2,706 Shire 641
BP 1,821 Royal Dutch Shell 612
Lloyds  1,724 Reckitt Benckiser 558
Unilever 1,570 Anglo American 548
BAT 1,406 Centrica 524
Rio Tinto 1,157 Diageo 496
Barclays 993 Glencore  471
BT 663 Standard Chartered 443
GlaxoSmithKline 647 RELX 438

Source: Company accounts. Covers each company’s last financial year and not the UK fiscal year 2016-17. Used average exchange rates for the year where companies report in dollars or euros.

Even though the lowest of the FTSE 100’s tax rates are legitimate, given established accounting rules and tax treaties, the global nature of some of the businesses involved and – in some cases – simply difficult trading conditions, not everyone will be satisfied.

At a time of perceived austerity and pressure on public services, when UK corporate tax represents barely 8% of the UK total tax take, it may not be that smart for companies to be seen to be pushing as hard as possible to lower tax to the minimum, despite their desire or need to offer shareholder value to keep the ultimate owners of the company happy, namely the shareholders.

The UK raised £52 billion in corporation tax payments in 2016-17

UK raised £52 billion in tax payments

Source: HM Treasury
*Figures shown in £ billion

After all, the electorate is quite capable of voting in a government which may look to squeeze harder (or frighten the incumbent into doing so) to the potential detriment of near-term profits and thus share and stakeholders.

Any company should look to protect itself and the interests of each of shareholders, stakeholders and management from intervention by not overstepping the mark in the first place. A Rollerball-style society where corporations do as they please is not acceptable.

As the US Democratic Senator Elizabeth Warren pointed out once on Capitol Hill in Washington, even the most skilled entrepreneur does not succeed ‘on their own.’ They hire staff who are largely educated and kept healthy by the state and companies benefit from the rule of law and infrastructure provided and protected by the state, so they should contribute accordingly.

No laughing matter

However, the corporate and other tax rates need to be carefully calibrated for two reasons.

  • The incentive to work and strive is diminished if taxes are seen as too punitive, with the result that companies will not create the jobs which themselves provide revenue for the state from income tax, national insurance and other sources such as VAT and excise when employees spend their pay.
  • Money flows away from where it feels unwelcome (owing to high taxes or corruption) to where it feels welcome (owing to lower taxes and rule of law). This is known as Wriston’s Law of Capital, after the banker and one-time chairman and chief executive of American financial services giant Citicorp.

The Paradise Papers appear to back up Wriston’s view and as such the debate over the Laffer curve, which seeks to establish the optimal level of tax to generate the maximum amount of revenue, remains a serious issue. The “right” level of corporate tax can become a matter of politics as much as it is economics and all investors can do is ensure that their portfolio picks are behaving legitimately and not relying on low or falling tax rates to manufacture profits growth – as such low-quality earnings may not be sustainable over the long term.

Russ Mould, AJ Bell Investment Director