My latest Dealbook column:
President Obama could change the tax treatment of carried interest with a phone call to the Treasury Department. But the White House will need a precise understanding of the regulatory landscape to make a change that is fair, easy to administer, and will hold up in court.
via How the President Can Increase Taxes on Carried Interest – NYTimes.com.
But the clearest distortion is not size, but location. For multinational corporations based in the United States, taxes create an incentive to expand overseas operations by opening foreign subsidiaries, expanding foreign operations and acquiring foreign companies. Unlike a pure tax shelter, which generates paper losses to avoid taxes, the effects of tax expatriations are real. Taxes distort the organization of corporate activities and shift operations outside our borders.
via How Tax Laws Distort the Pfizer Deal – NYTimes.com – NYTimes.com.
My take on the bitcoin guidance:
Bitcoin is a digital representation of value, not a real currency, according to the latest pronouncement from the Internal Revenue Service.The I.R.S. on Tuesday released guidance indicating that Bitcoins and other so-called virtual currencies that do not have the status of legal tender in any jurisdiction would be treated as property, not currency, for tax purposes. The guidance also indicates that Bitcoin transactions are subject to the same information reporting and withholding requirements as similar transactions in dollars.
via Taxes Won’t Kill Bitcoin, but Tax Reporting Might – NYTimes.com.
A tax proposal released on Thursday by the chairman of the Senate Finance Committee, Max Baucus, addresses a topic that tends to make my students’ eyes glaze over: cost recovery.Cost recovery is a technical topic but one that may shape our economic future, because it affects the calculations of every business manager making a decision about what projects to pursue and what assets to buy.
via Tax Proposal for an Economy No Longer Rooted in Manufacturing – NYTimes.com.
Changes to the tax code always create winners and losers. An ambitious plan to revise the system for taxing multinational corporations, released on Tuesday by the Senate Finance Committee chairman, Max Baucus, would hit technology companies and large pharmaceutical companies especially hard. Companies like Pfizer, Apple, Hewlett-Packard and Microsoft have become masters at reducing their tax liability in the United States by shifting income overseas.
These companies often hoard cash in offshore subsidiaries, and in the past they have successfully lobbied for a tax holiday to repatriate cash at lower tax rates. The Baucus proposal would, among many changes, end this practice of tax deferral and impose a minimum tax of about 20 percent on overseas profits — whether those profits are repatriated to the United States or not.
via Wall Street Could Benefit From Tax Proposal – NYTimes.com.
Other methods of tax avoidance have received less news media attention but are no less troubling. A recent deal by LIN Media, a media company backed by the private equity firm HM Capital Partners and the investment manager Royal W. Carson III, highlights two techniques. LIN Media owns 43 local television stations around the country, including the CBS affiliate WIVB in Buffalo, the Fox affiliate KHON in Honolulu and the CBS affiliate WISH in Indianapolis, along with other media assets.
In July, it merged with itself. Who knew this was possible? While the merger was trivial from a business standpoint, it generated half a billion dollars in tax losses that the company used to shelter its gain from an earlier deal and eliminate its tax liability.
via Tax Wizardry Accomplished With an Offbeat Merger – NYTimes.com.
Potential investors in Twitters’s planned initial public offering may be struggling to estimate how much the company will have to pay in taxes in the future. An article in Politico on Friday highlighted some of the techniques Twitter might use to legally avoid taxes.
Twitter’s biggest potential tax shelter is its history of losing money. Like most growth companies, Twitter has accumulated a lot of operating losses. These losses, in theory, can be carried forward as net operating losses to offset future taxable income. But investors should not count on it.
Buried deep in Twitter’s S-1 on page F-43 is a description of the company’s tax assets. A tax asset is an accounting item that represents a possible reduction of a company’s tax liability in the future.
For the year ending 2012, these tax assets total $91 million, a potentially significant amount of tax savings if Twitter starts turning a profit. But the financial statements then explain that management established a “valuation allowance”—that is, wrote down the value of the tax assets—by $42 million. That means the company believes that much of the value of these assets will not be fully realized.
This kind of valuation allowance is not unusual among newly public companies. According to research by Eric Allen of the University of Southern California, 82 percent of companies that held I.P.O.’s record an allowance that reduces the value of the associated deferred tax asset to zero.
Why did Twitter’s managers and auditors decide to write down the value of these net operating losses? There are two possibilities, only one of which should bother investors.
One possibility is uncertainty about Twitter’s ability to ever generate enough income to absorb all of these accumulated losses. If you never turn a profit and never have taxable income, then tax losses aren’t valuable at all. Obviously, such a signal that management doesn’t expect the company to have income in the future should be of real concern to investors.
The more likely explanation, however, is rooted in the details of the Internal Revenue Code. Section 382 restricts a company’s ability to use tax losses in the event of certain ownership changes.
These restrictions were intended to prevent trafficking in tax losses: Congress wants mergers and acquisitions to occur for business reasons, not merely because a target has tax losses that a buyer might use to offset other taxable income. If an ownership change takes place, then strict limitations apply to the company’s ability to use previous tax losses to shelter income going forward.
Section 382 is drafted in such a way that it focuses on changes in ownership among shareholders who own at least 5 percent of the company, and it accidentally catches some ownership changes that it probably shouldn’t.
In the case of Twitter, one may expect many of the founders, venture capitalists and later-stage investors to sell their interests over the months and years to come. These ownership changes are likely to restrict Twitter’s ability to use net operating losses under the Internal Revenue Service Code.
This is an unfortunate result for Twitter, as it destroys a valuable tax asset. For investors, however, this technical legal explanation is at least better than the alternative of never seeing Twitter make a profit in the future.
via Why Twitter May Have to Pay Income Taxes One Day – NYTimes.com.
Large multinationals based in the United States – among them General Electric, Pfizer, Apple and Citigroup – have been hoarding record amounts of cash overseas, mainly because of the 35 percent tax they would have to pay if they brought it back to the United States.
The American Jobs Creation Act of 2004 offered a temporary tax holiday that allowed firms to repatriate cash at about a 5 percent tax rate, but there were strings attached. The repatriated money was to be used only on permissible activities like research and development, capital expenditures and pension funding. It was not to be used for shareholder dividends or share repurchases.
The purported goal of the legislation was to create jobs, not simply to enrich shareholders at the expense of federal tax revenue. In recent years, companies have lobbied for another tax holiday.
Tax policy experts are suspicious of tax holidays, and most experts question the effectiveness of attaching strings to such legislation. Because cash is fungible, companies might be expected to use the repatriated money for permitted domestic activities that they would have conducted anyway, freeing up other cash to be used for dividends and stock buybacks. If companies merely reshuffle the use of cash without changing behavior, then the tax holiday amounts to a windfall to shareholders, not an effective economic stimulus.
The 2004 tax holiday brought back $312 billion in extraordinary cash dividends from foreign subsidiaries. How much of that cash was used for permitted activities, and how much for impermissible dividends and stock buybacks? A 2011 paper by Dhammika Dharmapala, C. Fritz Foley and Kristen J. Forbes, published in The Journal of Finance, estimated that 60 cents to 92 cents of every repatriated dollar was spent on shareholder payouts in 2005. The paper is Exhibit A in the case against future tax holidays.
A new paper by Thomas J. Brennan of the Northwestern University School of Law challenges that study and finds that, for the 20 companies that repatriated the most cash, 78 cents of every dollar was spent on permissible uses, and just 22 cents on impermissible shareholder payouts. Extending the analysis to 341 companies outside the top 20, Mr. Brennan estimates that about 40 cents of every dollar was spent on impermissible shareholder payouts, still much lower than the earlier estimate.
Mr. Brennan attributes the different findings to a change in research methodology. The Dharmapala paper uses econometric techniques to estimate the marginal increase in repatriation caused by the legislation, focusing on a certain subgroup expected to benefit from the legislation — namely companies that face a low tax rate abroad and have a subsidiary in a tax haven. The Brennan study also uses statistical estimates, but it constrains those estimates with actual publicly available data on what each individual company spent on various activities. Using the data on actual share buybacks and dividends, Mr. Brennan shows that the Dharmapala estimate is too high.
The Brennan study is important for its explanation of how companies responded to the 2004 tax holiday. But it hardly endorses tax holidays as an instrument of international tax policy. Indeed, Mr. Brennan notes that, in a separate paper, he has made the case against temporary tax holidays.
It is important to remember the big picture: there is no evidence that the 2004 tax holiday created any jobs.
Mr. Brennan does not attempt to provide such evidence. Nor does he argue that spending on domestic activities is necessarily more effective in creating economic stimulus than dividends or stock buybacks would have been. After all, a shareholder who receives a dividend from Company A might reinvest the cash in Company B, an action that seems just as likely to create a new job as would spending by Company A.
Moreover, the Brennan study still finds significant amounts of shareholder payouts from repatriated profits, ranging from 20 cents on the dollar for the largest companies to 40 cents for smaller ones. It is sad, and unfortunate, that our expectations of corporate managers have fallen so far that 20 to 40 percent noncompliance might be viewed as a success.
The fact that the managers only incompletely evaded the purpose of the legislation should not be read as an endorsement of tax holidays.
via A Holiday From Taxes, and Often From the Strings Attached – NYTimes.com.
Jeff Bezos’s purchase of The Washington Post raises the possibility that he acquired the paper as a trophy to celebrate his success as the founder and chief executive of Amazon.com. The acquisition comes after the purchase of The Boston Globe by John W. Henry, the owner of the Boston Red Sox and a trading firm billionaire. The purchases are part of a broader trend toward private ownership of media companies.
A classic economic study by Harold Demsetz and Kenneth Lehn finds that concentrated ownership might be explained by the “amenity potential” of certain companies, including mass media and sports teams. John Henry’s holdings nicely illustrate both. As the authors explain, winning the World Series or “believing that one is systematically influencing public opinion” may provide consumption benefits to the owners even if profits are diminished.
The study raises another possibility, however. Concentrated ownership works better in highly volatile environments, where rapid change and external forces make it difficult for public shareholders to monitor and judge the performance of managers. In such “high agency cost” environments, it may be more efficient for a single owner or a dominant shareholder to keep an eye on how managers are dealing with rapid change and disruptive innovation. “The noisier a firm’s environment, the greater the payoff to owners in maintaining tighter control,” the paper explains. “Hence, noisier environments should give rise to more concentrated ownership structures.”
Mr. Bezos has proven highly talented at managing in disruptive, innovative environments. Amazon is a publicly traded company, but Mr. Bezos remains the dominant shareholder, consistent with what the Demsetz and Lehn study predicts. Perhaps the right to control The Washington Post is worth more when Mr. Bezos owns the company. Not because it’s a trophy, or to save the world, but simply because an experienced and talented captain gets to steer the boat through the rough seas ahead.
The Demsetz and Lehn study, published in the Journal of Political Economy 1985, is available here.
via A Trophy Owner Also Familiar With Turmoil – NYTimes.com.
Detroit’s financial woes, exacerbated by underfunded pension liabilities, have brought renewed scrutiny to public pension plans. Senator Orrin Hatch, Republican of Utah, and others have suggested overhauling these plans to shift more responsibility to the private sector. Private insurance companies would assume responsibility for these defined benefit plans, offering annuities to beneficiaries in exchange for employer-paid premiums.
Proponents argue that privatization could reduce the risk of municipal bankruptcy and federal bailouts. One downside is the possible increase in fees associated with external management of retirement savings; it creates another way for Wall Street to extract wealth from Main Street.
Merits aside, overhauling the public pension system would cause some interesting and presumably unintended consequences.
First, phasing out public pension funds could cut off an important source of financing for venture capital and private equity. Pension funds like the California Public Employees’ Retirement System, or Calpers, and the Teachers Retirement System of Texas are among the largest and most powerful institutional investors in venture capital and private equity.
Eliminating a chief source of capital could leave a gap in the fund-raising landscape. Venture capital and private equity funds seek investors with longer time horizons who are willing to accept illiquidity for a premium return. Pension funds now contribute as much as a half of all capital to venture capital and private equity funds, although that estimate includes private pension plans.
Private insurance companies also have long investment horizons and would be as well suited, in theory, to serve as limited partners. But insurance companies have not historically participated as actively in venture capital and private equity, and it might take some time for insurance executives to develop the institutional knowledge and capacity to do so well. Only the top quartile of venture capital and private equity funds historically outperform equity markets, and many insurance companies would not have access to top funds.
A second unintended consequence has to do with the tax status of public pension funds: they are tax-exempt. The legal infrastructure of funds would have to continue to accommodate tax-exempt investors, which include other sources of capital like foundations and university endowments.
But a shift toward taxable investors could change some negotiating dynamics around structuring decisions. Currently, most fund investors, because they are tax-exempt, are mostly indifferent to the tax consequences of the fund structure. At the fund level, fees are mostly paid in the form of carried interest, which allows managers to pay tax at low capital gains rates. Taxable investors might prefer to instead pay incentive fees that are economically similar but may generate ordinary tax deductions for investors and ordinary income for the manager.
At the portfolio company level, fund managers might organize more portfolio companies as pass-through entities to allow for the flow through of tax losses to investors. While tax-exempt public pension funds do not care about the flow-through of losses, insurance companies might.
While it is too early to predict the outcome of public pension legislation, it is not too soon for deal lawyers to start planning to accommodate more taxable investors into fund structures.
via Pension Reform Could Disrupt Investment Funds – NYTimes.com.