Should a company engage in tax avoidance schemes?

The debate surrounding tax avoidance is an ongoing issue for firms to consider. Google’s chairman Eric Schmidt recently stated publically ‘I’m very proud of our tax avoidance scheme,’ demonstrating how some firms actively seek to avoid tax in the most efficient ways. However whilst this reduces tax and in turn increases profits and therefore shareholders wealth, it can be viewed as unethical by consumers who tend to believe companies should pay the correct level of taxes. So what actually is tax avoidance? Well, in its simplest form, Clausing (2009) explains “tax avoidance takes the form of income shifting” going on to state how “financial responses to corporate taxation include efforts to shift income to more lightly taxed locations.” Therefore tax avoidance is essentially the legal, yet unethical shifting of profits to areas with low tax rates in order to reduce their taxation bill. There are a vast number of ways companies can do this from changing the location of assets and employment to altering the structure of affiliate finance or changing transfer prices between different divisions of the company and therefore different countries. I have chosen to discuss this topic this week focussing on Starbucks, due to its recent media limelight in late 2012 surrounding tax avoidance.

To give some background, Starbucks reportedly paid minimal taxes on profits due to transferring profits to tax ‘tax haven’s,’ therefore ensuring that profits arise in countries which have very low tax rates. Starbucks did this is numerous ways, primarily through transfer pricing between divisions in different countries with examples including charging high licensing fees to the UK branch to reduce profits in this area along with purchasing coffee beans for high prices from Dutch branches to increase profits where corporation tax is low. On the outset this may appear unethical, as the organisation is essentially avoiding paying taxes to the UK government. However, Starbucks is a publically listed business and will ultimately want to generate maximum profits, a view likely to be shared by stakeholders such as shareholders and employees. Tax avoidance is a way in which profits can be maximised, therefore resulting in potential benefits such as higher shareholder equity and increased job security for employees for example. When looking further into ethically theory, Crane and Matten (2010) describe that “according to utilitarianism, an action is morally right if it results in the greatest amount of good for the greatest amount of people affected.” Therefore it could be argued that if a great number of stakeholders benefit from this tax avoidance, which is legal, there is a reasonable argument to justify it.

The issue of tax avoidance will have both positive and negative implications for companies as it did in the case of Starbucks. Whilst they are not breaking any laws, transferring profits to lowly taxed areas and therefore away from the UK is likely to be viewed unfavourably by UK citizens. It is difficult to trace to an extent as they are manipulating the system in complex ways, however when it becomes public as it did in October 2012, this can have a negative effect on the business. The ‘Press Association’ (2012) stated “the owner of coffee chain Costa has revealed a surge in sales as rivals Starbucks were criticised for their tax arrangements.” This report suggests that after the tax avoidance became public, customers moved to competing firms which shows how Starbucks lost out. However there is no tangible figure to suggest the impact of this compared the reward in terms of tax saved over the years.

When looking back at Google, it is reported that Google legally avoided $2 billion in worldwide income taxes in 2011, mainly through sheltering its revenues in Bermuda. As a company, Google are simply exploiting legal loopholes to maximise profits and therefore maximise shareholder wealth. They are simply using tax avoidance schemes to bend the rules in the most strategic, tax efficient way, not break them. Whilst consumers may view this as an arrogant, unethical approach taken by Google, will they stop using the service Google offers? I don’t believe they will, or at least I do not believe enough people will change avoid Google to make it beneficial to not exploit such advantages. I also believe as mentioned that their approach to the situation is one which will be strongly shared by shareholders, thus essentially justifying Google’s stance on the matter.

So after looking at the examples of Starbucks and Google in terms of their views and experiences of tax avoidance, should companies engage in such tax avoidance practices and therefore exploit the system in a legal yet unethical manner? I personally believe Google’s approach to their situation is the correct one. If I was a shareholder in Google, I would want the company to maximise my wealth and if this can be done in legal ways, even if these may be viewed as unethical, I would actively encourage this. I also believe that their open stance on the matter is the correct one to take, as they are not ‘covering up’ their tax avoidance practices which avoids reputational issues in the event they are discovered such as the situation at Starbucks. Also stakeholders in the business such as shareholders and employees know where they stand and therefore it is essentially their choice to engage with and be part of the business. The ultimate question would be along the lines of, ‘Why would a company choose to pay more taxes when it doesn’t need to?’ An argument for this may be to improve the overall image of the company, however as a shareholder, I would much rather a highly profitable company which maximises my personal wealth, rather than a ‘nice’ company which acts ethically.

References within this blog

Crane, A and Matten, D (2010) Business Ethics: Managing Corporate Citizenship and Sustainability in the Age of Globalization. Third Edition, Oxford University Press.

The Press Association (2012) Tax row perks up Costa coffee sales. Aol Money. Available at: http://money.aol.co.uk/2012/12/11/tax-row-perks-up-costa-coffee-sales/ (accessed 24/02/13)

What really is the best method of issue when initially floating of the stock market?

Nowadays, two of the most common ways of raising finance for a firm are through debt finance and raising equity capital. Debt finance in most instances is essentially taking out a loan, whether that be in the form of bonds, bank loans or debentures for example, however the other option a firm has is to sell shares in the company, essentially selling a portion of ownership within that company in order to raise capital. Unlike debt financing, there is no obligation to repay these funds, with the shareholders’ main aim is likely to be ‘wealth maximisation’, therefore essentially raising the long term flow of dividends and in turn the value of their holding. If this is the route a firm wishes to pursue in order to raise capital, then they have to list their shares on a stock exchange. In this case, there are a number of different methods a firm has to choose from, with the aim of this blog to explore which is really the best method for companies.

To make this blog slightly more interesting than reading a textbook, we will consider the example of a football club and therefore consider the alternative methods of issue available if Ipswich Town Football Club (ITFC) chose to raise capital though listing on an equity exchange. In reality this is not too much of a fictitious example as there are a number of professional football teams in the UK listed mainly on the London Stock Exchange main market and Alternative Investment Market (AIM). The AIM market tends to attract firms slightly smaller in size to those listing on the LSE main market due to its lower cost and regulatory requirements, however either exchange is arguably suitable for an ambitious club possessing the history and stature such as that of ITFC.

When it comes to listing on the stock market, a firm is likely to have a sponsor (or nominated advisor for the AIM) in the form of an investment bank or stockbroker for example, who essentially is an expert in the field and therefore guides or advises the company through this process. However we will assume that we do not have this luxury to provide us with their expert opinion on which is the most suitable method of floatation and therefore assess each option individually. So what are the main options available?

·         Offer for Sale

·         Offer for Sale (by tender)
·         Offer for Subscription
·         Placing
·         Intermediaries Offer

The offer for sale method of flotation on the stock market is arguably the most simple of them all. Essentially the shares are offered at a fixed price determined by the company directors. Therefore the directors of ITFC along with the sponsor or nominated advisor would decide on a price and offer the shares at this set price. A variation of this method is the method of offer for sale by tender. With this method, investors are encouraged to ‘bid’ based around a target price at the price they wish to pay for the shares. The bids are then gathered to determine a strike price which would sell all of the shares for the maximum value. Investors who have bid below the strike price receive no shares and those optimistic investors who have bid above the strike price receive the shares receive the shares at the determined strike price.  If ITFC decide to issue shares through the tender method an element of risk is incurred, as although it may result in a larger sum overall being raised, investors may be put off by the task of valuing the company themselves along with ITFC incurring greater costs administering the bidding process.

Similarly to the offer for sale method of floatation is the offer for subscription method. With the offer for sale method, underwriters will usually be in place to purchase shares if they are not purchased on the market by investors. However with the offer for subscription method, underwriters are not used and instead if the share issue does not raise a set minimum, the offer is aborted and the whole issue is abandoned. For example ITFC could choose to offer shares at a price of £100 per share, however if the market deemed this too high, thus resulting in only 50% of offered shares being purchased by investors, then with this method they would have the option to abandon the whole idea altogether. This method tends to be more focused around the initial issuing of larger ‘funds’ such as pooled unit trusts for example where a set amount needs to be raised to make it worthwhile to pursue the idea. In the case of ITFC floating, I feel an offer for sale would be suffice with the underwriter purchasing the remaining shares in such a situation.

The next potential method of issue I feel would be appropriate to discuss is placing. Placing is where the sponsor or advisor dealing with the floatation sells the shares to institutions it regularly deals with. For example the sponsor, who is likely to have a wide range of contacts in the industry, may contact different pension funds to sell the shares in this way. This method is likely to be much cheaper than the alternatives as it incurred much lower publicity, marketing and legal costs. However this method of issue severely limited the spread of shareholders by only offering the shares to set institutions, which could lead to issues such as an illiquid secondary market for example. This method tends to be used for small offerings where the costs of an offer for sale are too high. However I feel that a company the size of ITFC would be able to manage these costs and therefore placing should not be used as the sole method. Another common method, often used alongside placing is that of an intermediaries offer. Like placing, the sponsor/advisors contact base is utilised by offering shares for sale with set stockbrokers who in turn offer the shares to their clients. This offer allows a large number of clients to be targeted, however relies heavily on individual stockbrokers carrying out their role, limiting the control of both ITFC and the sponsor in this situation.

So we have analysed each of the alternatives in terms of the potential methods of issue, should Ipswich Town Football Club choose to raise equity capital. Which is the best method is open to interpretation however in most cases I would suggest the best method would be that which is likely to raise the most from the issue of shares. In this case I would suggest the best option would be the offer for sale by tender. This method, which allows investors to bid at the price they wish to pay, will ensure that all shares are sold and at the strike value which maximises the sum being raised. Whilst this method carries high administrative costs, along with there being an element of risk as investors may be put off due to it being up to them to value the company themselves, I feel that investing in a exciting venture like a football club, should provide sufficient interest to encourage investors to bid in sufficient quantities in an offer for sale by tender issuing. In my opinion, this theory is also true across the board when it comes to methods of issue, as I personally believe the additional cost and slight risk involved in offering shares for sale by tender is worth encountering due to the potential for raising larger sums from the floatation offering.

Stock Market Efficiency: A football industry analogy

A textbook definition of market efficiency would describe it along the lines of:

An efficient market is one where the undervaluing and overvaluing of shares does not occur and therefore, abnormal profits cannot be achieved. This is because current and past information is immediately reflected in share prices, resulting in the efficient pricing of all shares on the market. This does not necessarily mean that all share prices are equal to their true value. It simply means that errors made in pricing shares are unbiased and that price deviations from the true value are random. Another factor to consider is the efficient market hypothesis (EMH) which explains how in an efficient market, when new information becomes available, it is incorporated into the share price rapidly and rationally.  

However for the purposes of this blog, we are going to explore this concept using the analogy of football with players as assets instead of shares. So:

An efficient market would be one where the undervaluing and overvaluing of players does not occur. For example in an inefficient market, Ipswich Town may value their centre midfielder Luke Hyam at £2 million. However Alex Ferguson may spot potential talent in the player that Ipswich and other clubs have not seen and sign him for Manchester United at this price to only discover he is actually a £10 million player profiting abnormally from this purchase. However in an efficient market his value would be £10 million as every piece of current information (including potential future growth) is included in the price. When applying the efficient market hypothesis to this example, in the situation of a match, if Luke Hyam makes a good tackle his value may increase rapidly and rationally to £10.1 million (rapidly as it occurs as soon as the tackle is made and rationally as it is a relatively small factor providing only a 1% increase), however if he incurred a potentially career threatening injury his value may decrease to £2.5 million (with the significant price drop reflecting the potential severity of the information).

An efficient market compared to an inefficient market does have its advantages. Firstly it encourages share buying as individuals can be confident that they will get a fair value for their shares when buying and selling them. In our example, managers may be reluctant to buy players if they feel they may be paying an unfair price for them, or if they feel that when it comes to selling the player, the price they receive may not represent their true value. The second advantage of an efficient market is that it provides company managers with the correct signals. Therefore managers can see exactly the impact that the market places on their decisions. Again using our example, the Ipswich Town management may decide to invest in a new training facility, meaning that players can improve their skills and maximise their potential. In an efficient market, if the market views this as positive, it may be reflected by an increase in player values, giving signals to the management that they have performed well. A final advantage is that efficient markets help to allocate resources. Under allocative efficiency, ways are found to ensure that resources are allocated where they can be most productive. If shares are priced efficiently more funds should be allocated to those industries with the potential for higher growth to ensure that the economy as a whole is as efficient as possible. Linking this back to the football example, this suggests that in an efficient market, young players with high potential should be valued higher than those who are soon to retire, to ensure resources are allocated efficiently across the board.

Successful analysts and investors such as Warren Buffet (whose fund management company, Berkshire Hathaway, returned an average annual gain of almost 20% from 1965 to date) would argue that market efficiency does not and will never exist in reality, allowing people such as himself to continue achieving abnormal returns. However does the concept of market efficiency have any disadvantages for investors? I suppose the main disadvantage on the buying side would be that it does not allow investors to exploit inefficiencies which would significantly benefit them. For example if Ipswich Town wanted to improve their team, they could send out their scouting network around the world to find undervalued players and sign them, either to then sell them on for a higher value to make a profit, or to improve their team at a lower cost as a result of market inefficiency. In this situation, Ipswich Town would have benefitted from the market inefficiency. However this would have come at a cost for the exploited teams that have lost players, who in an efficient market would have been valued correctly and therefore valued at a higher price. Linking this back to the stock market, whilst undervalued shares in an inefficient market benefit the buying party, they come at a cost for the selling party who is not achieving a fair value from their sale, suggesting that efficient market provide fairness for all.

To analyse the extent to which markets are efficient, American economist Eugene Fama (1970) devised a three tier grading system based on different types of investment approaches which produce abnormal returns. These are described in further detail and linked to the footballing example below:

1) Weak Form Efficiency. This type of efficiency claims that all past price movements of a stock are contained in the current share price and therefore abnormal returns cannot be achieved from such technical analysis. When applying this to the example within this blog, weak form efficiency would suggest that a player’s current value is based upon all previous movements of his value and therefore analysing how his value has changed over time to predict his future value will not achieve abnormal profit.

2) Semi-strong Form Efficiency. This type of efficiency claims that share prices incorporate all of the relevant publically available information. Therefore fundamental analysis such as analysing the economic climate nor technical analysis such as analysing past price movement can achieve an abnormal profit as all of these factors are incorporated into the current share price. When applied to the example this would suggest that a player’s value fully reflects all publically available information such as training facilities available, the coaching team and potential future improvement, therefore suggesting that a player’s value will be efficient and that no advantage can be gained from analysing such factors.

3) Strong Form Efficiency. This type of efficiency claims that all information, privately and publically held is incorporated into share prices. Therefore all of the people know all of the information and no abnormal returns can be made, not even from insider trading. In an efficient market a director may purchase (illegally) shares in their company if they know positive news is to be released which will result in the share price rocketing up. However in a strong form efficient economy, everybody would have this same information about the future price rise. When applying this to the footballing analogy, Mick McCarthy (Ipswich Town Manager) may discover in training that a player is actually not as good as the public believes he is as he loses the ball every time he is in possession. In an inefficient market he may try to sell this player for his higher perceived value, however in a strong from efficient economy, all information about this player’s ability will be available to the public and no abnormal returns can be achieved.

What Do Shareholders Really Want?

Shareholders are essentially individuals or companies who have decided that their funds would be better invested in the share of ownership of a company rather than investing this money elsewhere, such as in a bank or in other asset classes. But what do these shareholders really want to happen to their funds?

Now, I own shares, mainly in the volatile oil and gas sector, which probably portrays my personal perception and acceptance of the risk and reward concept. But what do I want to happen with these shares? Well, I suppose the ideal situation would be for the price of these shares to rocket sky high so I could sell them and buy Ferrari’s and go travelling forever. However unless something crazily unforeseen occurs, this is not a realistic objective of holding these. A more realistic view would be for my personal wealth to be maximised through maximum long term dividends and in turn, increased share price. This shareholder wealth maximisation view is one likely to be held by the majority of shareholders in business, however in reality is arguably not as easy as it sounds. The long term approach is key to shareholder wealth maximisation. Essentially a business could increase short term profit and pay large dividends with relative ease, however this is unlikely to be beneficial in the long term. To analyse this concept further here is an example:

Manchester United Football Club could sell their star players, their entire first team and make hundreds of millions of pounds which could then be paid out to shareholders in the form of dividends. On the outset this high dividend payment may appear favourable, however the impact this would have on shareholders is likely to be negative. This is because they would then be left with a weak team which would be unlikely to achieve any form of success both domestically and on a European scale. Other areas such as sponsorship would also likely suffer as companies would have less desire to be involved a less successful, less star-filled club along with lower attendances and less matches shown on television for example. Therefore future dividend payments would significantly decrease due to the club’s poorer financial position and the lower potential flow of future dividends and less potential success will lead to the share price falling, thus decreasing long term shareholder wealth. Now using football is probably not the best example, but this concept applies to all companies and demonstrates how profitability can be maximised in the short term, yet this is not necessarily beneficial for long term shareholder wealth maximisation.

As mentioned the concept of shareholder wealth maximisation is not as easy as it sounds. This is because the agents acting on behalf of shareholders, therefore the directors and managers within companies tend to have conflicting interests to those of the shareholders. As a shareholder, I want the directors to maximise my wealth by improving the long term prospects and success of the company. However it is often discussed how directors do not share this view and are more concerned with their own personal success. For example increasing their own pay, avoiding risky projects and focusing on short term profitability are all areas which benefit directors yet do not maximise shareholder wealth. Increasing profitability may look like a director has performed well and increase their yearly bonus, however if they have reduced investment into research and development to achieve this, then it is at the detriment of the long term success of the business. This conflict of interest between shareholders and directors/managers is known commonly as agency theory in business.

In order to avoid such agency issues and managerialism, methods must be implemented to align the actions of directors with the interests of shareholders to essentially achieve a goal congruence between the two. I feel one of the best approaches in this situation is to introduce incentives such as share options, thus giving directors and managers the chance to buy shares in the future at a price determined at the current date. Such a scheme is likely to encourage directors to focus on the maximisation of share price and therefore essentially shareholder wealth, discouraging managers from an otherwise short term focus. There are also a number of other ideas to consider such as offering managers bonuses based on share price growth or offering pension plans to retain directors for longer periods of time. Whilst such methods come at a cost for shareholders, they are likely to increase their long term wealth, which when linking back to the title of this blog, I feel is what shareholders such as myself really want.