Low Tax, High Profits

Published in Investing on 28 February 2012

Look to invest in companies based in low-tax jurisdictions.

If you know who said, "In this world nothing can be said to be certain, except death and taxes", go to the top of the class.*

The truth of the observation still holds, of course, except that the average time of death is rising while corporate tax rates are falling. In the last 20 years, average corporate tax rates in the Organisation for Economic Co-operation and Development (OECD) countries have practically collapsed from 48 per cent to 27 per cent, mainly because of competition among jurisdictions to attract thriving international companies.

The implications of competitive corporate tax rates for investors are becoming more and more important, especially so for those with global aspirations. This is because the economic literature suggests that, other things being equal, companies paying lower taxes will make higher profits, invest more capital and pay higher dividends. In short, low effective tax rates help young companies get off to a flying start while allowing established ones to reward faithful shareholders.

A race between tax jurisdictions is good for countries and investors like. As the Nobel prize-winning economist Milton Friedman wrote in a beautifully argued sentence: "Competition among national governments in the public services they provide and in the taxes they impose is every bit as productive as competition among individuals or enterprises in the goods and services they offer for sale and the prices at which they offer them."

A yawning gap

Successful companies know this, of course, and look for countries where they can retain more of their profits. And the disparity in corporate tax rates has never been higher. As international accountancy and consulting group UHY points out in a 21-country study, the gap in the tax burden between the highest and lowest-taxed economies has climbed to a yawning three times. John Wolfgang, chairman of UHY, remarks: "The difference between countries in the amount of tax they take from business profits is quite staggering."

This is a particularly useful study for investors because it looks at statutory pre-tax profits -- basically, the annual surplus before the authorities get their sticky fingers on it -- rather than just the official corporate tax rate. And the results really are staggering. A big and highly profitable business with pre-tax profits of $100m (all comparisons were made in US dollars) would pay $29.5m less in tax if it were based in Ireland rather than in Japan, which is one reason why a lot of subsidiaries of international companies are located across the Irish Sea.

Off to Rio?

Thinking of investing in Brazil? According to UHY, the difference in tax take on a company making $100,000 pre-tax profit between the home of the 2014 World Cup of football and Ireland would be $21,500. In short, the effective rate is nearly three times higher in Brazil than Ireland, which boasts a corporate rate of 12.5 per cent, the lowest of all 21 countries.

Most countries run progress effective tax systems. Canada, for instance, charges 15 per cent on companies with pre-tax profits of $100,000 and raises the overall take on more profitable companies. As for Blighty, HMRC charges 20 per cent on $100,000 in pre-tax profits and 26 per cent on those over $1m.

Big fat zero

I don't know much about investment in Japan and don't intend to, but I fail to see how much money can be made when companies are slugged with 42 per cent taxes on profits all the way from $1m to $100m. In France, the equivalent rates are 34 per cent and 35 per cent, on top of high social charges. And if you can find a good listed company in Estonia or Dubai where the corporate tax rate is a big fat zero, it's surely worth a look.

Look for the effective tax rate in annual reports. Failing that, you can make a calculation of the percentage of tax paid by comparing pre- and post-tax profits. In the long run, it's the effective tax rate that individual companies pay rather than the official corporate rate that really matters and that often depends very much on how good the chief financial officer is. The effective rate can vary widely because of allowances, regional and local taxes, depreciation charges, losses carried forward and a host of other things.

Down is good

In the long run, the direction that corporate taxes are taking -- namely, downwards -- is good news for investors and society at large. As the OECD, which is generally hostile to "tax havens", had to admit recently, "the more open and competitive environment of the last decades has had many positive effects on tax systems". In short, this environment has brought rates down while at the same time boosting the total amount countries take in taxes.

So, as Friedman implies, don't be shy about hunting out companies with low effective tax rates.

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* It was not Mark Twain as many think, but Benjamin Franklin.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

duffmanchon 28 Feb 2012 , 9:13pm

Countries are not like businesses. A company that fails falls back on the state, a failed state e.g. Afghanistan has nowhere to go.

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