The UK’s Tax Avoidance Deficit
To put the discussion of tax avoidance into context we must first look at the figures. The HRMC released figures quoting revenue losses of £6.3billion as a result of tax avoidance, although other sources states figures between £3 billion and £13billion. Either way, at the outset it appears that huge amounts of money are being snatched away from the treasures’ coffers. But let’s put this into context further, the FTSE 100 companies alone have a market capitalisation of £1.8trillion and profits (after tax!!) of over £75billion, and that’s just the top 100 companies. So it seems they pay a fair amount anyway?
International Corporations Managing Tax Bills
Who is getting away with this £6.3billion and how? Well, the simple answer is most companies with the ability to hire top accountants. But looking specifically at Diageo, the owner of many brands, for example Guinness, Smirnoff, and Jonnie Walker, has employed a few clever accounting tricks to lower its tax bill. Diageo is listed on the London Stock Exchange and has its headquarters in London and therefore, it should be paying corporation tax of 28%. Between 2005 and 2008, inclusive, Diageo averaged a tax bill of 18%. Over that time frame the corporation tax rate was 30% and Diageo should have paid a total of £2,478million. Diageo only paid £1,454million during this time. This is brilliant news if you’re a shareholder: by reducing the tax bill there is an extra £1billion floating around for either wealth building projects or dividends. Then again, is it not the purpose of a corporation to build as much value for shareholders as possible? The great economist Adam Smith would have taken great delight in such shareholder wealth generation.
So how do they manage their tax bill to save money? It’s fairly simple really; Diageo splits each of its brands into subsidiaries located in different countries, and any profits arise abroad rather than in the UK. This is called transfer pricing. As an example, Guinness is based in Ireland and benefits from a lower tax rate of 12.5% on any profits made from the sales of that brand. This means that Guinness’ tax bill is reduced by over half when compared to the UK. A further way Diageo ensures ensure tax efficiency is by ownership transferring. Diageo has transferred the legal ownership of UK based brands such as Jonnie Walker to a Dutch company called Diageo Brands BV. The Dutch corporation tax for Diageo would normally be 25.5%, however, there is an exemption clause that means Diageo can reduce that to 0% (See link below for details of ownership trading). This means that tax efficiency is achieved as Diageo is not paying any tax on their profits. These two methods ensure sales based in the UK and around the globe are being diverted into countries like Ireland and the Netherlands, so any profits are subject to reduced taxes. Diageo has structured its organisation in a tax advantageous position.
Currency Risk Management
Diageo, as a multinational organisation, has to manage the risks that are associated with any transactions that are between currencies. Diageo recently announced its commissioning of a new brewery is Tanzania at a cost of $55million. Diageo had to consider the financial risk posed by the exchange rate between US dollars and Kshs (Tanzanian Shilling) between committing to purchase the plant and actually paying for it. This time frame creates risk, as any fluctuation in either currency can make the plant either more expensive or cheaper than originally planned. There are several basic techniques that can be used such as leading or lagging payments for reducing transaction exposure. Netting or matching payments is also an option when dealing between subsidiaries and third parties. There is always the option to simply do nothing and hope the currency markets balance out your transaction costs over time. Alternatively, there are some basic hedging techniques used to reduce risk, for example forward market, money market, futures or currency option hedging. All these techniques have their individual benefits that must be assessed by the finance manager and will usually depend on the size of the transaction to the company.
Another currency risk that Diageo has to manage is the translation of its subsidiaries values into UK sterling to form part of its annual report. It is important to differentiate between transaction exposure, which is a pure cash loss, and translation exposure, which is loss of book value and does not involve any loss of cash. Each subsidiary (under the old UKs IAS 27 and current IFRS 3) must be included in the consolidates accounts, meaning Diageo has to convert its North American, European, Asian and International companies results into British Sterling. Again, any negative fluctuations in currency can destroy the value of foreign subsidiaries and thus destroy shareholder value. Therefore, it is important for managers, at least, to consider managing the exposure through hedging, especially when the values of subsidiary companies are relatively large to the company.
How Diageo restructured its company to place brands into Dutch corporations:
http://www.guardian.co.uk/business/2009/feb/02/tax-gap-diageo-johnnie-walker.
References:
http://www.hm-treasury.gov.uk/press_46_10.htm
http://www.ftse.com/Indices/UK_Indices/Downloads/FTSE_100_Index_Factsheet.pdf
http://www.guardian.co.uk/business/interactive/2009/feb/02/tax-database
http://www.actionaid.org.uk/doc_lib/addicted_to_tax_havens.pdf
http://www.diageo.com/Lists/Resources/Attachments/640/Diageo_AR10_full_report.pdf
http://www.guardian.co.uk/business/2009/feb/02/tax-gap-avoidance
http://www.telegraph.co.uk/finance/migrationtemp/2802209/FTSE100-companies-see-profits-double.html
http://www.guardian.co.uk/business/tax-gap-blog/2009/feb/13/diageo-taxavoidance
http://www.diageo.com/en-sc/investor/Pages/resource.aspx?resourceid=1135
http://www.eabl.com/inner.asp?pcat=mediacentre&cat=newspressreleases&sid=492
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