Imminent Danger Of Higher Taxes Ahead

by: George Kesarios

I have written about tax avoidance practices before (here, here and here). For some reason however, I feel that both analysts and the market have not taken this issue into consideration. And the way I see it, any way you slice it and dice it, many companies will be forced to pay more money in taxes and thus, will probably be forced to report less earnings in the future.

The issue at hand are accounting tricks (legally mind you) that many companies use, and are thus able to pay less taxes -- or no taxes at all in many cases -- on their international profits.

It's not just companies like Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) that have been in spotlight lately, about 50% of the companies in the S&P 500 index (NYSEARCA:SPY) are affected in some form or another.

As Reuters reported, the G20 group of economies has backed a fundamental rethink of the rules on taxing multinational corporations, taking aim at loopholes used by companies to avoid billions of dollars in taxes.

The plan of action, drawn up by the Organisation for Economic Co-operation and Development (OECD), said the existing system didn't work, especially when it came to taxing companies that trade online. Pascal Saint-Amans, Director of the OECD's Centre for Tax Policy, said these changes are a "once in a century" opportunity to overhaul the rules, which date back to the League of Nations in the 1930s.

Please note the last sentence -- the entire international book of tax rules will change. This will have profound implications on the way companies do business and on cross-border flows. In fact, Switzerland, Ireland and the Netherlands, which have been accused as tax heavens, not only are cooperating, but are backing the new rules 100%.

Some of the changes proposed are as follows

Currently, tax systems respect inter-company contracts even if in reality they seek to shift profits out of countries where they are earned into low or no-tax jurisdictions. This will be done with. Profit allocation will not be possible via simple contractual arrangements.

The practice of companies not creating tax residences or permanent establishments in countries where they have major operations, will not be possible in the future.

The corporate practice of designating units in tax havens as holders of group funds, patents or brands that can then be lent or licensed, for generous fees, to affiliates in countries where customers or factories are located will be almost impossible to do.

International treaties designed to avoid double taxation of profits earned from cross-border activities will also be changed. Double non-taxation practices will be impossible to implement.

Companies mostly affected

Besides Apple that has been a lot in the news, I think these changes will mostly affect Google. 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, according to a story in Bloomberg.

Starbucks (NASDAQ:SBUX) has long been scrutinized by U.K tax authorities. Accounts filed by its UK subsidiary show that since it opened in the UK in 1998, the company has racked up over 3 billion pounds ($4.8 billion) in coffee sales, and opened 735 outlets but paid only 8.6 million pounds in income taxes.

Microsoft (NASDAQ:MSFT) allocates profits derived from research conducted in the United States to a unit in Ireland, a U.S. Senate investigation last year showed.

Just several days ago, lawmakers in Germany prompted for an investigation of Amazon's (NASDAQ:AMZN) German unit, after it channeled $8.7 billion of German sales in 2012 to its Luxembourg unit, but only paid 3 million euros of income tax in Germany.

Even Nokia (NYSE:NOK) has had some problems in India, after authorities have been cracking down on alleged tax evasion by local and multinational companies, a move that analysts say is partly an effort to raise tax revenue, as the WSJ reported.

Bottom line

I am not sure when these changes will take effect and when countries will legislate them. It might take several more years. What is evident however is that we are in the final innings of negotiations and the next move will be for governments to pass into law the changes described above.

Even if many companies already have a deferred tax liability on their balance sheet, and theoretically will not owe any taxes (just cash that will offset the deferred tax liability), I am not so sure the deferred tax liability will be the end of it. I am very curious as to how many balance sheets will end up when many of these new international tax rules go into effect.

One think I am sure, these new rules will mean more taxes for many companies around the world, something that I feel the market has yet to encompass into the long term earnings picture.

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.

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