With 3 days to go before Scots go to the polls to decide on Scottish independence (i.e., Scotland leaving the UK to become an independent, sovereign country), it's an understatement to observe that the UK media and political establishments are melting down. Likewise, many but not all U.S. politicians are apoplectic about corporate tax inversions in which a U.S. headquartered firm buys a foreign company (often smaller) and then relocates its headquarters and corporate charter to the foreign company's country to take advantage of lower corporate tax rates.
So, what's the link between these two seemingly unrelated issues in separate countries? We'll get there. But first, a quick primer on Scottish independence and corporate tax inversions.
I've been to the UK 25 times since I started teaching a summer study abroad course in London in 1997. I also team taught a course in Scotland twice during that period and have been to Scotland seven times for both pleasure and business. And, I follow UK political and business news on a daily basis. So, I've got a bit more background and perspective on this than the average "Yank."
Politically and culturally, England and Scotland are very different. Compared to England, Scotland is much less traditional in terms of culture (some would say counter-culture), much more politically liberal, and much less business friendly. While those are broad generalizations, Americans would draw similar comparisons between the East/West coasts and the Midwest/South.
While Scotland has been a part of the United Kingdom for 3 centuries, the yearning for Scottish independence is at least 700+ years old. While historical inaccuracies abound, the movie Braveheart about the Scottish wars of independence in the early 1300s is a good starting point for understanding why many modern day Scots feel so strongly about independence. My wife and my oldest son and I were in Stirling, Scotland in 1997, 2 years after Braveheart debuted in this small town at the foothills of the Scottish Highlands. Stirling is home to the William Wallace monument and Stirling Castle, which is near a famous battle led by Scottish King, Robert the Bruce. While we had seen Braveheart and had read a book on Scottish history, we were surprised by the strong anti-English sentiment and the intensity with which Scots spoke about independence. It’s fair to say that this trip was the first time that I truly felt the keen differences between Scotland and England.
Today, the key arguments of the Yes Scotland campaign for independence seem to be:
- Stronger economic growth that will make Scotland “richer than the rest of the UK.”
- An improved ability to support the National Health Service, which is struggling in terms of funding, quality, and patient waiting times throughout the UK.
- The ability to continue to offer free university tuition (unlike in the rest of the the UK where university students began paying tuition a few years ago).
- A manageable monetary transition based on continued use of the British pound, or, failing that (the UK says that’s not an option), Scotland’s easy entry into the European Union and adoption of the Euro.
- That a Scottish government will serve the needs of Scotland’s people and businesses better than the UK government.
The UK’s Better Together campaign vigorously contests those arguments and provides detailed explanations and news coverage on why Scotland would be better served remaining a member of the United Kingdom.
Corporate Tax Inversions
Because the U.S. has one of the highest corporate income tax rates (35%) in the world and because it taxes income earned in other countries (no other major country does this), U.S. headquartered firms pay substantially higher corporate taxes than their foreign-based competitors. Both issues are solved via a corporate tax inversion in which in a U.S. headquartered firm buys a foreign company and then relocates its corporate charter and headquarters (the number that actually relocate their HQ is open to dispute) to the purchased company's country. For example, Medtronic, a multinational medical device company headquartered in Minneapolis is buying Covidien, which is headquartered in Massachusetts, but "domiciled" in Ireland, where the corporate tax rate is just 12.5%.
So why are Scottish Independence and Corporate Tax Inversions Related Business Issues?
The primacy of shareholders and the risks associated with political and policy uncertainty.
While it's well accepted that companies should be socially responsible to a number of stakeholder groups (i.e., shareholders, employees, customers, suppliers, governments, and local communities), the boards and CEOs of publicly-owned companies have a clear fiduciary responsiblity to the firm's owners, that is, shareholders. So when forced to choose among various stakeholder groups, shareholder interests will come first. And since shareholders benefit from higher profits which raise stock prices and stock dividends, boards and CEOs will pursue strategic moves that provide competitive advantages, including seeking business climates with favorable tax and regulatory environments.
Political and Policy Uncertainty
Political uncertainty is associated with the risk of major changes in political regimes resulting from war, revolution, death of political leaders, social unrest, or other influential events. Policy uncertainty refers to the risk associated with changes in laws and government policies that directly affect the way foreign companies conduct business. Companies generally use three strategies to mitigate political and policy uncertainty, avoidance (not investing in particular countries, or leaving countries where the risks are perceived as too great), control (lobbying governments to change laws or policies), or cooperation (joint ventures or franchising that change whether a firm is categorized and treated as a foreign owner of a business).
Scottish Independence: The Influence of Shareholder Primacy and Political and Policy Uncertainty
In the last week, many of the largest Scottish-based companies have indicated that they will follow an avoidance strategy by relocating charters and headquarters to England if Scottish voters choose Scottish independence. I’ve linked to their press releases regarding their intentions below.
What's clear is that political and policy uncertainty and stockholder primacy are why these companies will move their HQs and charters to England. They operate under UK laws and policies now, but they don't know what to expect from an independent Scottish government.
The most revealing of these public statements was made by Standard Life, a financial services company based in Scotland. Standard Life’s statement is highlighted below:
As we stated in February, and repeated at our half year results in August, there continues to be uncertainty around a range of issues material to Scotland's future in the event of Scotland separating from the United Kingdom. These include:
- The currency that an independent Scotland would use
- Whether agreement and ratification of an independent Scotland's membership to the European Union would be achieved by the assumed target date (currently 24 March 2016)
- The shape and role of the monetary system going forward
- The arrangements for financial services regulation and consumer protection in an independent Scotland
- The approach to individual taxation, especially around savings and pensions.
In view of the uncertainty around Scotland's constitutional future, we have put in place precautionary measures which would help enable us to provide customers with continuity. This includes planning for new regulated companies in England to which we could transfer parts of our business if there was a need to do so.
This transfer of our business could potentially include pensions, investments and other long-term savings held by UK customers to ensure:
- All transactions with customers outside of Scotland continue to be in Sterling (money paid in and money paid out)
- All customers outside of Scotland continue to be part of the UK tax regime
- All customers outside of Scotland continue to be covered by existing consumer protection and regulatory arrangements e.g. the Financial Services Compensation Scheme and Financial Conduct Authority
- We will continue to serve our customers in Scotland and will consider what additional measures we may need to take on their behalf as a consequence of constitutional change once further clarity and certainty is received.
Standard Life will continue to be listed on the London Stock Exchange. There will be no change to the way in which share dividends are paid to shareholders.
What other concerns does the business community have about Scottish Independence?
- Huge outflow of cash from not only Scotland, but the UK.
- According to DeutscheBank, the threat of economic contraction, just as the UK is coming out of its second recession since 2008.
- An increase in retail prices in Scotland. Scotland does 75% of its business with the UK, so transaction costs related to currency exchange would add 1-2% to UK goods purchased in Scotland.
- That direct foreign investment in Scotland, and the UK, will slow significantly for the next few years as companies either delay investing capital, or decide to go elsewhere, such as Ireland.
U.S. Corporate Tax Inversions: The Influence of Shareholder Primacy and Political and Policy Uncertainty
As explained above, a small number of large, U.S. headquartered firms are buying foreign firms and then relocating their corporate headquarters and charters to take advantage of lower taxes in the acquired firm’s country. According to the non-partisan tax foundation, U.S. based corporations are at a significant disadvantage when it comes to corporate taxes:
- The U.S. has the third highest top marginal corporate tax rate (39%).
- By contrast, the average top marginal corporate tax rate worldwide is 22.6%.
- The U.S. has one of the highest minimum corporate tax rates (35%) in the world (40% when states' corporate taxes are added to the federal tax of 35%).
- Whereas Europe, which has a reputation for being much less business friendly, has an average corporate tax rate of 18.6%, largely thanks to Ireland (12.5%) and Eastern European countries is 18.6%.
- The average corporate tax rate has fallen from 29.5% to 22.6% over the last decade.
- Corporate tax rates have declined in every major region of the world [but the U.S.] in the 34 OECD countries, from 47.5% in 1981 to 25.3% today.
- Has an effective corporate tax rate of 26% (15% federal plus an average of 11% across Canada's provinces).
- Only taxes business income once, unlike in the U.S. where business income is first taxed via the corporate income tax and then taxed again when shareholders pay taxes on corporate dividends (profits distributed to shareholders).
- Only taxes corporate income earned in Canada, unlike the U.S. which taxes all corporate income, including income earned outside the U.S.
These numbers clearly show that U.S. headquartered businesses are exploring corporate tax inversions because they put millions and in some cases (see below) billions of dollars back in their hands to reinvest in their business or distribute to shareholders as dividends (which, as mentioned above, Uncle Sam still taxes).
The irony of the U.S.'s current corporate tax policy is that corporate inversions make it easier to repatriate corporate earnings to be reinvested in U.S. operations!! For example, when eBay repatriated $9 billion in foreign earnings, $3 billion went to U.S. corporate income tax, and $6 billion was left to reinvest for company growth. If eBay had done a corporate tax inversion, it would likely have had $7 billion or more after corporate incomes taxes, rather than $6 billion.
Abbott Laboratories' Chairmen and CEO Miles White explains:
The tax law today views overseas earnings that have not been repatriated as part of the U.S. tax system, regardless of whether a company has inverted. Therefore, those past foreign earnings, if repatriated to the U.S., are still subject to full U.S. taxation.
What does change after inversion is a company's access to its future foreign earnings generated outside of the U.S. tax system. Those future earnings may be used for any capital allocation purpose the company may have, including investment in the U.S., without the additional U.S. repatriation tax. Foreign taxes will have already been paid on those profits earned outside the U.S. It is the additional repatriation tax, imposed by high corporate tax rate in the U.S., that is not paid after inversion.
White goes on to say:
In terms of global competitiveness, the U.S. and U.S. companies are at a substantial disadvantage to foreign companies. Taxes are a business cost. Our disproportionately higher tax rate puts foreign companies at a huge advantage competitively, and their lower tax burden amounts to a subsidy that encourages them to acquire American businesses.
So, while it's abundantly clear that corporate tax inversions address the issue of shareholder primacy via lower taxes, how does uncertainty play into corporate tax inversions?
Because U.S. companies don't pay U.S. corporate income taxes on foreign earnings until they repatriate those earnings, U.S. companies have delayed bringing trillions of dollars of foreign earnings back into the U.S. One option is to use those foreign earnings to fund foreign business investment. Since the funds stay overseas, the 35% U.S. corporate income tax is avoided. Uncertainty in this case is having too much money left after funding foreign business investment. If you've funded prudent overseas opportunities, what do you do with the remaining funds?
But if you need cash to reinvest in U.S. operations, with interest rates so low another option is to sell bonds to investors. For example, Apple has nearly $50 billion in overseas earnings parked outside the U.S. Rather than pay nearly 45% of that in taxes (the combined U.S. and California corporate income tax rates), Apple issued $17 billion of bonds in April 2013 and $12 billion in bonds in April 2014, in each case paying just over 1% interest for 3-year bonds, 4.5% interest for 30-year bonds and only three-quarters of a point above treasury rates for 10-year bonds.. So, a 45% tax hit from repatriated foreign earnings, versus a 1% to 4.5% hit on bond interest, which is also tax deductible. It's not rocket science, is it? Apple is still left with the uncertainty of what to do with the $50 billion in earnings parked outside the U.S., but at least it raised $30 billion to do with as it sees fit (reinvesting in the company or shareholder dividends or stock buybacks) for U.S. operations.
A third uncertainty with corporate tax inversions is what's known as a "corporate tax holiday," in which taxes on repatriated earnings are temporarily suspended. The last such corporate tax holiday was in 2004. Not surprisingly, many corporations are hoping and waiting for another tax holiday to repatriate the $1.9 trillion in earnings parked outside the U.S.
Conclusion: Separate Issues, but Common Causes
While Scottish independence and U.S. Corporate tax inversions are seemingly unrelated issues in separate countries, from a business perspective both issues are largely driven by the uncertainty they create and a primary need to reduce that uncertainty in a way that protects shareholder interests.