Why Earnings At Multinationals Might Be In Jeopardy

Includes: AAPL, GOOG, SPY
by: George Kesarios

This is not something new, but it is big. So big, that I am willing to place a bet that over the next several years, the earnings for many of the companies mentioned below (and then some) will be a whole lot less, than what has been discounted by many analysts today. The issue at hand is transfer pricing.

As reported by Reuters:

UK lawmakers will quiz executives of Starbucks (NASDAQ:SBUX) , Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN) on Monday about how they have managed to pay only small amounts of tax in Britain while racking up billions of dollars worth of sales here.

The Public Accounts Committee, which is charged with monitoring government financial affairs, has invited the companies to give evidence amid mounting public and political concern about tax avoidance by big international companies.

Britain and Germany last week announced plans to push the Group of 20 economic powers to make multinational companies pay their "fair share" of taxes following reports of large firms exploiting loopholes to avoid taxes.

A Reuters report last month showed that Starbucks had paid no corporation, or income, tax in the UK in the past three years. The world's biggest coffee chain paid only 8.6 million pounds in total UK tax over 13 years during which it recorded sales of 3.1 billion pounds.

Google's filings show it had $4 billion of sales in the UK last year, but despite having a group-wide profit margin of 33 percent, its main UK unit had a tax charge of just 3.4 million pounds in 2011.

The company avoids UK tax by channeling non-U.S. sales via an Irish unit, an arrangement that allowed it to pay taxes at a rate of 3.2 percent on non-U.S. profits. Amazon's main UK unit paid less than 1 million pounds in income tax last year. The company had UK sales worth $5.3-7.2 billion, filings show.

Amazon avoids UK taxes by reporting European sales through a Luxembourg-based unit. This structure allowed it to pay a tax rate of 11 percent on foreign profits last year - less than half the average corporate income tax rate in its major markets.

Let me give you some background on what is going on. Big companies have subsidiaries in tax havens and are able to legally avoid paying taxes on profits in many countries around the world.

The simplest examples is this: Company A buys goods China from and sells these goods to Greece. But before arriving in Greece, the goods are overpriced through a subsidiary in Cyprus and the profits stay in Cyprus, where the profits are taxed at 10%. And it's not only the big multinationals doing this, it's everybody, including local companies.

A few days ago the NY Times ran an article on Apple (NASDAQ:AAPL) whereby it said that the effective tax rate of Apple's profits on sales in California is ZERO. It seems that the same legal gimmicks that many international companies use to avoid paying taxes around the world, are also used in the U.S. via tax havens,like the Sate of Nevada, where the corporate income tax is zero.

But it not only Apple. Again via the New York Times:

Dozens of other companies, including Cisco (NASDAQ:CSCO), Harley-Davidson (NYSE:HOG) and Microsoft (NASDAQ:MSFT), have also set up Nevada subsidiaries that bypass taxes in other states. Hundreds of other corporations reap similar savings by locating offices in Delaware.

A while ago, Bloomberg also ran an article on Google, whereby it says that Google's overseas tax rate is 2.4%.

Google's income shifting -- involving strategies known to lawyers as the "Double Irish" and the "Dutch Sandwich" -- helped reduce its overseas tax rate to 2.4 percent, the lowest of the top five U.S. technology companies by market capitalization, according to regulatory filings in six countries.

Google, the owner of the world's most popular search engine, uses a strategy that has gained favor among such companies as Facebook Inc. and Microsoft Corp. The method takes advantage of Irish tax law to legally shuttle profits into and out of subsidiaries there, largely escaping the country's 12.5 percent income tax. (See an interactive graphic on Google's tax strategy here.)

The earnings wind up in island havens that levy no corporate income taxes at all. Companies that use the Double Irish arrangement avoid taxes at home and abroad as the U.S. government struggles to close a projected $1.4 trillion budget gap and European Union countries face a collective projected deficit of 868 billion euros.

Transfer pricing is not new and everyone knows it has been going on forever. However, now that almost every single western country has a fiscal cliff to climb, the issue is coming of age and more than likely, we will see political pressure from abroad to clamp down on these tactics worldwide.

I can tell you for a fact that here in Greece, tax authorities have only now begun to scratch the surface. While transfer price guidelines have been in place by the OECD for a long time, local authorities never bothered with them, for fear of alienating these big companies, that at least offer some tax revenue and jobs in many jurisdictions (Ireland for example).

However Germany as well as England are about to enforce that the profits associated with product sales are paid where these products are sold.

Now that is easier said than done, but it is something that will (should) guide investors from now on, for if stringent transfer price guidelines are enforced, that can change the earnings picture in just about every company we know of.

Investment implications

Again from Bloomberg:

Google's transfer pricing contributed to international tax benefits that boosted its earnings by 26 percent last year, company filings show. Based on a rough analysis, if the company paid taxes at the 35 percent rate on all its earnings, its share price might be reduced by about $100, said Clayton Moran, an analyst at Benchmark Co. in Boca Raton, Florida. He recommends buying Google stock, which closed yesterday at $607.98.

I am not sure of other companies, but 70% of Apple's profits come from overseas. I think we can knock a much bigger number from Apple's stock price, if it has to pay 25% tax on its overseas earnings. And you can knock a much bigger number off Google, where their overseas tax bill is only 2.4%.

Remember, almost 50% of total profits of S&P listed companies come from overseas. If these profits are as low as have been reported in the press and are suddenly taxed overseas, then that will change the after tax earnings picture of almost every company in the S&P 500 space and will also have an effect on stock prices.

I cannot even begin to guess as to when this issue will unfold if ever, but I can tell you that it's an ongoing issue and something that investors have to keep an eye on. So keep an eye on what's going on with the G20, for if there is to be an agreement of some sorts, it will start from there. And if international companies will be forced to give up some of those overseas profits, the earnings landscape and the fair value of everything as we know it, will change before our very eyes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.