Health warning 1: I don’t make any distinction between the words “evasion” and “avoidance” with respect to taxes in this article. Such semantics are the preserve of private bankers, accountants and tax consultants; in my world the two words are the same. This article isn’t about a legal point of view but rather a logical, humanistic point of view; hence such distinctions don’t have any place here.

Health warning 2: This article discusses the operations of a number of globally well-known companies many of whom offer services I have personally enjoyed (Google, Apple) ; others whose services I have availed but not necessarily enjoyed (Vodafone, Starbucks) and lastly companies whose products or services I haven’t personally availed (“Big Pharma”). Throughout, I have attempted to remain as objective as possible when offering opinions but it is important to consider my views in this context of being both a consumer and a writer.

Health warning 3: This article sings praises for tax evasion by companies for reasons that are explained hereon. However, nothing here should be construed as a defense of tax evasion by citizens of any country – which I find morally repugnant and running counter to the implicit treaty that one signs when deciding to live and work in any particular country. I am, however, all in favor of people who emigrate for tax reasons. [1]

It has been an entertaining few weeks for the financial media, what with a scandal or two erupting daily in Europe about companies allegedly evading taxes (see notes below about various companies so named and shamed). An extraordinary focus on the operations of global giants such as Starbucks, Vodafone, Google and Apple has meant that such allegations have resulted in politicians of all hues raising an outcry on these companies profiteering or worse evading taxes.

Rather than outright fraud though, the companies are accused of using accounting legerdemain to minimize taxes in various jurisdictions, in effect transferring profits to places where taxes are lower. The issue at hand is transfer pricing – a strategy followed mainly by multinational companies wherein they charge royalty payments such as for marketing and distribution of brands, payments for intellectual property and research and development expenses among other things – to group companies in places where taxes are much lower.

So for example, a company sells $100 of product in a country, say Country A, against which it incurs direct costs (of materials and labor) of $50; so it has a nominal profit of $50 on which, all other things being constant, let’s say it owes taxes of 30%, or $15. Of course, selling a product or service developed somewhere else means that the company incurs expenses elsewhere: let’s say that it has costs of $50 in that development center, located in Country B say Switzerland or Singapore.

Absent any revenues in Singapore or Switzerland (and these are small countries), you’d then have the company as a group, losing money: profit after taxes in Country A is $35; while it loses $50 in Country B for a grand loss of $15. This is of course wrong from any accounting or shareholder perspective; ideally there would be a charge of $50 from Company B to Company B (an intra-group transfer), which would mean that the group loses no money and pays no taxes.

The counter argument of course goes that the above example is all well and good in theory but in practice most companies abuse the system of transfer pricing to minimize taxes. This becomes a particularly emotional argument at the current juncture of yawning budget deficits and low economic growth prospects in Western countries such as the UK, US and the various countries of Europe.

The generic left-wing argument goes thus: companies are reducing their tax burden in the developed world while benefiting from the superior infrastructure – legal, human and operational – that was at least partly paid for by the government whose money they are now stealing. With higher tax payments from these companies, the argument goes, deficits in the West wouldn’t look quite so bad and therefore there would be less hardship on the common folks who otherwise face cuts in government services and a higher tax burden themselves.

These arguments are seductive – admittedly like many of the ones made by the left that call upon lofty social principles – but invariably are wrongheaded and counter-intuitive when all facts are considered.

The primary argument in favor of tax evasion is that companies are collections of investments, innovations and competitive factor costs (be it capital investments or simply better employees). Funded by private capital sources ranging from high risk (equity) to low risk (bonds), companies are charged with generating an acceptable return on capital for the level of business risk they absorb.

That makes them vastly different from governments, which are essentially intermediary entities between productive and less-productive parts of society. Funded by taxes raised from the productive parts of society or a monopoly on natural resources, governments spend money on maintaining the social fabric of countries. These are simple but not necessary simplistic formulations of the difference between the two.

Now governments certainly have a bunch of social functions including in the provision of defense, security, healthcare and other areas where private sector solutions may not generally reflect social realities against the economic background. The waste of governments also produces a number of useful innovations – such as the the creation of the Internet in the 1960s by the Defense Advanced Research Projects Agency in the United States – all of which end up benefiting society at large. These are however accidents. In general, governments run too expensively to properly transmit the revenues raised from one set to citizens to benefit another set of citizens – “leakage” in other words.

Companies also leak money on vanity projects and ill-advised acquisitions among other things, but they are quickly punished by various stakeholders – banks charge them more for lending, employees leave and equity investors run for the door. In theory, government inefficiency is also punishable in the same ways – markets should charge them more for lending, citizens should emigrate and so on.

However, modern realities are different – in the case of Europe, we have seen many a country suffer from the markets’ adverse reaction, but they haven’t really changed as a result: Greece is still running yawning deficits, while Spain and Portugal remain reconstituted but not restructured. US governments at the federal and state levels have benefited from the exit of investors from Europe, and in effect have gotten away with their own crimes, for now at least.

(America’s relative position in the hierarchy of sovereign bankruptcy has been misconstrued by many – including those of the Paul Krugman school – to the notion that there is no debt crisis in the country now. That is a mistake, which will come to light soon enough).

The point is that governments spend too much because there is no accountability in reality, particularly in the democratic context where more spending equals more popularity at the booth (exhibit 1: the recent US presidential elections). Contrast that with companies wherein excess spending means less profit for shareholders and soon enough a market punishment for either lower earnings or mal-investments.

So what do companies do with the money they steal from governments in the form of lower taxes than is rightfully owed?

This is the second major area of support for companies to pursue tax evasion actively. Companies usually pay dividends to shareholders that is then taxed by governments in the hands of individuals. As tax rates for individuals are usually higher than those for companies, this means no leakage in the system as a whole (as whatever is “saved” in tax by the company is handed over to shareholders as well).

What if there are no dividends – from the likes of Google or Apple? These companies do two things with their money – they reinvest in the form of capital and jobs to pursue new innovations (which brings more jobs – and therefore taxes – immediately, and also improve productivity later). Both of these benefit society at large, and therefore cannot be construed as leakage – particularly when we also consider that at least for short-term profit generation, the corporate model is unequalled by any governments.

So the message to European governments – and in particular those of France, Italy, Spain and the UK – is simple: ignore companies diverting taxes from your countries. Instead, lower your overall corporate tax rates so that companies do not feel the need to escape taxes particularly when weighed against the negative publicity associated with these actions.

Then take a hard look at your own spending and figure out what would the optimal course if you were running a company instead of a government.

1. French actor Gerard Depardieu this week being one example, renouncing his French citizenship in favor of a move to neighboring Belgium. See Actor Renounces His Citizenship in Snit Over French Tax Burden, New York Times, December 16, 2012.
For various articles on companies mentioned here and their tax dealings, see:
2. Starbucks: see here.
3. Google: see here.
4. Apple: see here.
5. Vodafone: see here. and this