Eurozone’s permanent austerity based on failed ideology

This is an excerpt from the economic discussion document launched by MEP Matt Carthy on October 27, entitled The Future of the Eurozone. Download the full document for a referenced version of Chapter One, below.

BACK IN 1929 when the Wall Street crash hit, the response of then-US President Herbert Hoover was to restrict government spending – an action now almost universally acknowledged as having turned the stock market crash into the Great Depression.

The free-market ideology underpinning Hoover’s austerity policies held that an economy with high unemployment could return to full employment through market forces alone. Instead of boosting public spending, the government should do the reverse. By cutting government spending and increasing taxes, the government deficit would be reduced, which would restore market “confidence”. This restoration of confidence would lead to increased private investment, and the market would adjust itself to return to full employment.

The confidence fairy

The confidence theory was demonstrated back in 1929 to be incredibly damaging and to achieve precisely the opposite effect of what it aimed to achieve. The actual effect of implementing austerity in a period of economic downturn was to cause a contraction in the economy, thus weakening the economy further, causing tax revenues and national income to fall, and the deficit to increase. The contractionary impact of austerity policies during a downturn was explained by John Maynard Keynes during the 1930s, and Keynesian models have proved to be a reliable predictor of growth (or lack thereof) in the wake of the 2007-2008 crisis.

Countless books, academic studies and articles have outlined how the programmes imposed by the Troika – the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF) – on the Eurozone’s “peripheral” economies since 2008 have exacerbated the crisis. In the decades before the global financial crisis, these same policies had caused the exact same devastating contractionary effects when imposed under the guise of “structural adjustment programs” by the IMF across Africa, Asia and Latin America.

But while Keynesianism was experiencing an academic and policy revival internationally following the global financial crisis, Europeans somehow managed to cling to the confidence theory, which persisted in the decades beyond the Great Depression to this day. It is the dominant theory that has shaped both the structure of the Eurozone and European Union (EU), and the EU response to the global financial crisis of 2008.

In 2011 at the height of the Eurozone crisis, Nobel Prize-winning economist Paul Krugman memorably dismissed this theory as the “confidence fairy”. Two years later, commenting on the theory’s persistence in the face of overwhelming evidence to the contrary, he added: “European leaders seem determined to learn nothing, which makes this more than a tragedy; it’s an outrage.” Fellow Nobel Prize-winning economist Joseph Stiglitz has dubbed the free-market fundamentalists’ obsession with reducing deficits as “deficit fetishism”, pointing out that “no serious macroeconomic model, not even those employed by the most neoliberal central banks, embraces this theory in the models they use to predict GDP”.

Europe’s lost decade

It is common for scholars to refer to the results of the IMF structural adjustment programmes from the 1970s-1990s in Latin America, Asia and Africa as having caused these continents “a lost decade” or “lost decades”. Europe has lost a decade but there is a danger that it may lose several more – not only because of the policy responses to the crisis but because of the actual structure of the Eurozone. The results of the European response to the crisis are damning. Three patterns are obvious: the Eurozone countries have in general fared far worse in terms in terms of recovery than countries outside of the common currency; the recovery within the Eurozone has been sharply asymmetrical, with divergence between strong and weak countries increasing; and there has been a significant rise in inequality across Europe.

Growth in the US and Britain has been weak since the crisis but it has far outpaced the Eurozone recovery. It is difficult to even use the word “recovery” to describe the Eurozone experience – only last year did Eurozone GDP reach its pre-crisis level. In June 2016, the Eurozone unemployment rate was still in the double figures at 10.1 per cent; while the EU-28 had unemployment of 7.7 per cent. But the unemployment figures in several of the crisis countries remains double the Eurozone average – in Greece by 2017 the unemployment rate was 21.7 per cent while at the same time in Spain the jobless rate was 17.8 per cent. The figures are masked by the huge levels of emigration that the crisis countries experienced as well as the fact that number of hours worked per worker has declined across the Eurozone.

Stiglitz notes that youth unemployment persists at twice the level of overall unemployment. “The persistence of high unemployment among youth will have long-lasting effects – these young people will never achieve the incomes they would have if job prospects had been better upon graduation from school.”

While the Eurozone stagnated for a full decade following 2007, countries within the EU but outside the Eurozone had a GDP 8.1 per cent higher than in 2007 by 2015. The United States had a GDP almost 10 per cent higher in 2015 than in 2007. Over the same period, the Eurozone’s GDP grew by just 0.6 per cent.

When measuring living standards it is more accurate to examine GDP per capita than GDP overall, and while in the US GDP per capita increased by more than 3 per cent from 2007-2015, while over the same period in the Eurozone it actually declined by 1.8 per cent. As living standards have declined – devastatingly in crisis countries, and especially in Greece – income inequality has also risen drastically. In its Economic Forecast last autumn, the European Commission warned of a potential “vicious circle” as expectations of long-term low growth affect investment decisions, and that “the projected pace of GDP growth may not be sufficient to prevent the cyclical impact of the crisis from becoming permanent”.

The declining level of growth in the British economy since the Brexit vote means a “strong downward revision of euro area foreign demand”, while the “sizeable depreciation of sterling vis-à-vis the euro is expected to have an adverse direct impact on euro area exports to the UK”. Eurozone exports were forecast to decrease slightly this year and stagnate in 2018, while possible financial crashes in China or the US and the ongoing non-performing loan banking crisis in the Eurozone pose serious risks.

Despite these sober warnings, European leaders and the financial press have raucously celebrated the anemic growth in the Eurozone’s GDP in the first two quarters of this year, of 0.5 per cent and 0.6 per cent respectively – crucially, driven by a slow increase in domestic demand as opposed to export-led growth. But this celebration ignores the fact that in normal circumstances, these figures would be viewed as abysmal, and that global economic forces pose serious threats to this fragile recovery.

Fairies and leprechauns

Predictably, these feeble shoots of growth are described as being the result of austerity policies by those who have claimed for the past 10 years that austerity will start to work any day now. A slightly recalibrated confidence theory has been proposed by a small number of economists associated with the neoliberal school of thought since the 2008 crisis – that of an “expansionary fiscal contraction”, with Harvard’s Alberto Alesina and Goldman Sachs’s Silvia Ardagna leading the charge with their joint paper in 2009. What they are actually recommending largely amounts to recovery through beggar-thy-neighbour competitive devaluations (or in the common currency, internal devaluation).

Stiglitz points out that these instances of economic recovery are actually cases where certain countries had “extraordinarily good luck” in that “just as they cut back on government spending, their neighbours started going through a boom, so increased exports to their neighbours more than filled the vacuum left by reduced government spending”. Several papers from the IMF itself have backed up this analysis.

This is largely what happened in the Irish economic recovery, which has become the EU’s poster child for austerity policies. The narrative goes that the Irish state followed the German model – it followed all of the EU rules and implemented the Troika’s structural reforms, slashed government spending to reduce the deficit, cut wages to increase competitiveness, and as a result restored market confidence, depressed domestic consumption and experienced a corresponding rise in exports.

The reality is more complex, and is based on a combination of growth in jobs in the indigenous sector, including the services sector, arising from favourable exchange rates for the Irish state; and on the illusory “growth” of GDP caused by the industrial-scale corporate tax avoidance strategies undertaken by US multinationals in the technology, pharmaceutical and aircraft-leasing sectors.

There has also been a certain level of export-led growth since 2009 but it has been hugely exaggerated and difficult to reliably quantify. But this export-led growth did not in any way fit into the German model and “expansionary austerity” narrative of an internal devaluation based on lowering wages and domestic demand. Rather than being based on manufactured exports with a competitive edge because of wage cuts, export growth took place among firms in high-wage service sectors such as technology and finance during a period in which wages in these sectors were going up.

Of course, last year’s ludicrous announcement that Irish GDP had grown by more than 26 per cent in 2015 raised an enormous red flag that all may not be what it seems in Ireland’s economic recovery. Krugman, coiner of the “confidence fairy” term, found another apt folkloric description for the occasion: “leprechaun economics”.

These figures were so detached from reality that they were cause for serious alarm but, incredibly, the Irish government welcomed them. According to the figures, per capita income apparently rose to 130,000 in 2015, and the state’s industrial base doubled in just one year. But the Net National Income grew by 6.5 per cent in 2015 while consumer spending rose by 4.5 per cent. These income and consumption figures are a far more accurate reflection of real economic activity and growth. Official GDP figures have a major and serious role to play in fiscal planning, spending and borrowing. They need to be credible and a measurement of real economic activity.

Most alarmingly, the figures reveal a glimpse at the level of dubious accountancy tricks being played by multinationals in Ireland during a period in which the Irish government claimed it was committed to playing its part in the global crackdown on tax avoidance. The Irish Central Statistics Office (CSO) identified relocations and inversions by multinational enterprises as the major contributing factors to the so-called growth. It seems as though there was a rush by multinationals to ‘turn Irish’ in 2015 in the context of global action on tax avoidance and tax havens, through inversions – where a multinational corporation changes tax domicile after it buys up a smaller Irish-registered company. The transfer of financial assets and intellectual property patents into Ireland does nothing to actually create jobs or contribute to growth in the real economy.

In response to the fantasy figures for 2015, the Central Bank of Ireland published a study stating that to measure growth or activity without the reality being skewed by the activities of multinationals, GNI* (Gross National Income, modified) should be used instead. GDP and Gross National Income differ as a result of the “net factor income from abroad” (eg, repatriated profits and dividends of multinationals). While GDP is a measurement of the income generated by the economy, GNI measures the income actually available to its residents. Irish GDP is more than 20 per cent greater than GNI, one of the largest differences among all economies globally (the two figures can usually be used interchangeably).

But even using GNI is not sufficient to get an accurate picture of real economic activity according to the CSO, which developed a measure of “modified gross national income” or GNI*. GNI* is Gross National Income “adjusted for retained earnings of re-domiciled firms and depreciation on foreign-owned domestic capital assets” – ie, modified to account for depreciation on intellectual property owned by technology and pharmaceutical firms. When GNI* is used to measure the Irish economic recovery, the picture is not so rosy. “The Irish economy is about a third smaller than expected. The country’s current account surplus is actually a deficit. And its debt level is at least a quarter higher than taxpayers have been led to believe,” the Financial Times reported on the first set of “de-globalised” data on the Irish economy in July this year.

For 2016, the value of the Irish economy according to its GDP was €275 billion, but according to its GNI* its value was €190 billion – a huge difference that indicates that not only is the Irish economy not nearly as strong as the official narrative portrays, but also that the Irish state may have facilitated multinationals in avoiding up to €85 billion in tax in one year alone. The CSO reported that in 2015, government debt was 79 per cent of GDP but 100 per cent of GNI*; and that while the state’s fiscal deficit was 1.9 per cent of GDP, it was 3.4 per cent of GNI*, well above the 3 per cent limit imposed by the EU’s fiscal rules.

There has also been growth in employment over the past three years in the Irish indigenous sector. For example, job growth took place in the agriculture and food sectors, and in accommodation and tourism. This growth was based on two related factors. The first was the depreciation of the euro against the dollar and sterling as a result of the crisis, and the second was the relatively higher economic growth in Britain and the US, the Irish state’s two largest trading partners. The (temporary) lower value of the euro was critical to the recovery experienced in the Irish indigenous sector. The relative growth in the US and Britain was also influenced by the fact that these two states are not constrained by the Fiscal Compact rules – borrowing in the US and Britain did not fall below 3 per cent since 2008.

But the specific circumstances of the Irish state’s trading patterns mean that this “recovery” cannot be transposed or replicated in other member states of the EU. It also poses significant risks, especially the risk of a significant fall in the value of sterling as a consequence of Brexit. A sharp depreciation of sterling against the euro – something we are already beginning to see – would likely jettison this recovery. Worrying signs of a technology bubble, a new Irish housing bubble and a massive shadow banking sector are all factors that may also influence this recovery. Crucially, the structure of the Eurozone itself, and the austerity ideology it has enshrined, make another economic slump inevitable.

The evidence shows that the Irish recovery happened in spite of, not because of, the EU austerity recipe – and it would have happened sooner, and with far less pain to the Irish people, had ideologically driven deficit fetishism been rejected.

A fiscal straitjacket

In 1992 the member states of the European Economic Community (EEC) signed up to the Maastricht Treaty, which laid the foundation for the common currency. The Maastricht Treaty enshrined the so-called convergence criteria – a set of rules members and potential members of the common currency were obliged to follow. To join the Economic and Monetary Union (EMU), states had to pledge to control inflation, and government debt and deficits, and commit to exchange rate stability and the convergence of interest rates. The blanket, one-size-fits-all fiscal rules in the criteria – that member states must keep public debt limited to 60 per cent of GDP and annual deficits to below 3 per cent of GDP – were proposed by Germany, based on its national Stability and Growth Pact.

The convergence criteria, as the term suggests, were aimed at achieving convergence among the diverse economies that were to form the Eurozone. The founders of the euro acknowledged the tendency for economic shocks to hit diverse economies asymmetrically in a monetary union. Without convergence, a common currency won’t work – for example, with diverse economies the interest rate set by the ECB for the entire Eurozone may impact positively on one country but negatively on another country with different economic characteristics. Without convergence, it would be difficult if not impossible to ensure full employment and current account (external) balance among different economies at the same time.

There are many spillover effects that one economy can have on another in a monetary union – for example trade imbalances and internal devaluations – but the only one that the Maastricht Treaty focused on was members’ fiscal policy. “Somehow they seemed to believe that, in the absence of excessive government deficits and debts, these disparities would miraculously not arise and there would be growth and stability throughout the Eurozone; somehow they believed that trade imbalances would not be a problem so long as there were not government imbalances,” Stiglitz comments.

Governments facing an economic downturn have three main ways they can aim to restore the economy to full employment: to stimulate exports by devaluing their currency; to stimulate private investment and consumption by lowering interest rates; or to use tax-and-spending policies – increase spending or lower taxes. Membership of the Eurozone automatically rules out using the first two mechanisms, and the fiscal rules largely remove the third option from governments.

(The confidence fairy is almost always accompanied by a fervent belief in “monetarism” among neoliberals – ie, that only monetary policy by an independent central bank should play any role in economic adjustment, and anything else would amount to dreaded government intervention in the economy.)

When a Eurozone member state experienced a downturn, its deficit would inevitably rise as a result of lower tax revenue and higher expenditure on social security. But when the convergence criteria kicked in, causing governments to cut spending or raise taxes, it would invariably worsen the downturn by dampening demand. Moreover, debt and deficits did not, and do not, cause economic crises. Ireland and Spain were running surpluses when they experienced a crisis, and both had low public debt.

The convergence criteria are purely ideological and economically unsound. But as the European Central Bank (ECB) was preparing to begin operating to control inflation and interest rates, Germany pushed for the adoption of an EU-wide Stability and Growth Pact in 1997, including non-Eurozone members, to enshrine the fiscal control aspects of Maastricht, and more generally to increase EU surveillance and control over member states’ national budgets.

The Stability and Growth Pact has been called a lot of names in its day – the “Stupidity Pact”, a “Suicide Pact”, the “Instability Pact”, and more. And it is deserving of each one. In 2002, then-President of the European Commission Romano Prodi told reporters the pact was “stupid”, while French Commissioner Pascal Lamy called it “crude and medieval”. In practice, the Stability and Growth Pact has proved to achieve the opposite effects it claims to aim for. Cuts to government spending have a contractionary effect and cause the economy to shrink; when the national income shrinks, spending on unemployment benefits have to rise, and the situation gets worse. This is exactly what happened in the aftermath of the recessions in Ireland, Spain, Greece and Portugal.

Early in the 2000s, both Germany and France repeatedly breached the fiscal rules. But they were not penalised, and were always provided with an extension to try to meet the targets. Almost all EU member states have breached the rules at some point – during the recession only Luxembourg did not go over the 3 per cent deficit target. Fiscal contraction will exacerbate unemployment, but it may eventually restore a current external account balance – when demand for imports becomes so low as a result of the recession that exports catch up.

University of London Professor George Irvin has described German Chancellor Angela Merkel’s insistence that government profligacy is at the root of the Eurozone crisis as betraying “near-total ignorance of how economies work”. “Budget balance for a national economy is fundamentally different from that of the household or the firm. Why? Because budgetary (or fiscal) balance is one of three interconnected savings balances for the national economy. The other two fundamental economic balances are the current external account balance… and the private sector savings-investment balance. If any one account is out of balance, an equal and opposite imbalance must exist for one or both of the remaining accounts,” he wrote.

But despite the vast evidence that the Stability and Growth Pact was counterproductive and unenforceable, Germany pushed for the fiscal rules to be tightened yet again in 2012 through the Fiscal Compact Treaty, which created the obligation for the convergence criteria targets to be inserted into the national law of the ratifying states.

The Fiscal Compact

In 2010, Germany proposed the reform of the Stability and Growth Pact to make it stricter, and “in return” pledged to support the creation of a Eurozone bailout fund that member states could draw upon if they were in dire straits – with strict fiscal conditions attached, of course. The reforms aimed at enforcing compliance of the Stability and Growth Pact known as the “Six-Pack” and “Two-Pack” of additional regulations and directives were adopted at EU level.

In 2012, an intergovernmental treaty – the Treaty on Stability, Coordination and Growth – was signed by all EU Member States with the exception of Britain and the Czech Republic. (When Croatia joined the EU in 2013, it declined to sign.) The Treaty, known as the Fiscal Compact, incorporated the Stability and Growth Pact, the Six-Pack and Two-Pack requirements, and more. Its central principle is that member states’ budgets must be in balance or in surplus, which the Treaty defines as not exceeding 3 per cent of GDP.

Critics of the Stability and Growth Pact had called on the EU to focus not on the general deficit but rather the structural deficit – what the deficit would be if the economy were at full employment. But instead of dropping the general deficit limit, the Fiscal Compact has adopted rules on both the general deficit and the structural deficit. The structural deficit limits are set by the Commission on a country-by-country basis and must not exceed 0.5 per cent of GDP for states with debt-to-GDP ratios of more than the 60 per cent limit, and must not exceed one per cent of GDP for states within the debt levels.

The “debt-brake” rule is the convergence criteria rule that government debt cannot exceed 60 per cent of GDP. The Fiscal Compact enshrines the rule that members in excess of this limit are obliged to reduce their debt level above 60 per cent at an average of at least 5 per cent per year. The structural deficit rule – called the “balanced budget rule” – must be incorporated into the national law of signatory states under the Fiscal Compact. An “automatic correction mechanism”, which is to be established at member state level and kicks in when “significant deviation” from the balanced budget rule is observed, must also be incorporated into national law.

Of all the member states who signed the intergovernmental treaty, only the Irish state put the Fiscal Compact to a referendum. The Fiscal Compact Treaty was adopted by just over 60 per cent of the voting electorate, with around 50 per cent turnout. The Fine Gael/Labour government’s decision to hold a referendum was not based on a belief in the right of the Irish people to have their say on their economic future, but rather their desire to go one step beyond simply incorporating the permanent austerity rules into legislation, and to insert them into the Constitution – despite the fact that the government’s Fiscal Advisory Council recommended the legislation option. Fine Gael, Fianna Fáil and Labour representatives urged the people to vote yes, dangling the carrot of access to the new bailout fund. The vote in favour was hailed by the government as an endorsement of its austerity policies.

The reality is that the Irish electorate was blackmailed into voting in favour of a proposal that endorsed a damaging austerity framework based on free-market fundamentalism as a result of the threat of crisis funds being withheld in future, and by the promise of the debt burden being relieved through the direct recapitalisation of the failed Irish banks by the future European Stability Mechanism. And after the approval of the Fiscal Compact Treaty and the constitutionalisation of austerity in Ireland, the Fine Gael-led government quietly dropped its call for the EU to recapitalise the Irish banks. Unbelievably, by 2015, the same Irish government representatives who had urged voters to approve the Fiscal Compact Treaty were pleading with EU authorities for more flexibility for Ireland’s implementation of the rules.

Irvin points out that Germany’s debt-brake cannot be good for other Eurozone countries, or even possible, for three reasons – that Germany’s exports to the Eurozone are by definition another member state’s imports; that there is insufficient global demand to sustain all Eurozone economies becoming net exporters like Germany; and that the public debt-brake completely ignores the problem of private debt, especially in the over-leveraged banking sector.

In a scathing critique of the Fiscal Compact, Francesco Saraceno and Gustavo Piga highlight that “no other country in the world has ever considered [such a rule], and with good reason” and say that the adoption of the Fiscal Compact has been “untimely, unfortunate and unequivocally wrong”. “Its uniquely negative effects, as the experience of Italy clearly shows, lie in the perverse features whereby, even if a government is allowed to renege year after year on the promised path toward a balanced budget, it is still required, every year, to recommit to a medium term (3-4 years) adjustment toward that balance. In so doing, business expectations are negatively affected, private investment plans are postponed, and stagnation becomes a permanent feature of the economy,” they write.

Return fiscal powers to member states

There have been repeated efforts, led by Germany, to exercise control over the budgets of member states. For several decades now, France’s demand for a European monetary union was always met with the German response that it must be accompanied by fiscal union, or German-led surveillance and control over national budgets. The same argument continues today, based on the same flawed ideology.

There have been several important proposals to reform the Fiscal Compact – for example, to focus only on the structural deficit; or to exclude capital investment from the rules. But while these proposals may loosen the straitjacket a little, it would be better to just take it off. As part of the Fiscal Compact treaty, the Council is required to adopt a formal decision on the Fiscal Compact by 1 January 2018 on whether or not to insert it into the EU Treaty. Saraceno and Piga argue: “If a number of important countries were to veto that move, this could set in motion a profound rethink of the appropriate fiscal policy infrastructure supporting the euro zone in future, one consistent with recent developments in macroeconomics.”

The Fiscal Compact has already been proven to be unworkable. The European Council voted last year to adopt the Commission’s recommendation to impose no fines for excessive deficits on Spain and Portugal in a clearly politically motivated decision. The austerity lie is losing its power, with even the IMF and the Commission questioning its benefits after a decade of stagnation. Barry Eichengreen and Charles Wyplosz argue that the attempt to centralise fiscal policy at the EU level is “doomed” and should be abandoned. In a paper on minimum conditions for the survival of the Eurozone, they write: “The fiction that fiscal policy can be centralised should be abandoned, and the Eurozone should acknowledge that, having forsaken national monetary policies, national control of fiscal policy is all the more important for stabilisation.”

How do vulture funds manage to pay practically no tax in Ireland?

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This is the fourth in a 4-part series on tax avoidance in the Irish state.

1.Irish state marketed for tax avoidance since 1950s

2.Yes, we’re still a tax haven for tech giants

3.Ireland’s IP Knowledge Box – another tool for tax dodgers

4.How do vulture funds manage to pay practically no tax in Ireland?

The three key mechanisms for tax avoidance that have been used by multinational corporations (MNCs) in the Irish state over the past decade have been the Double Irish, inversions, and the use of Special Purpose Vehicles (SPVs) under the Irish state’s lax securitisation regime introduced in Dublin’s International Financial Services Centre (IFSC) under the Taxes Consolidation Act 1997.

Bloomberg reported in February this year that a survey by the Financial Stability Board found that the Irish state’s shadow banking sector ranked third with China as the largest in the world after the US and Britain, and at more than 2.3 trillion euros it was 10 times the size of the Irish economy. Half a trillion euros were held by unregulated SPVs, the FSB found. A Financial Vehicle Corporation (FVC) is a securitisation instrument as defined by the European Central Bank FVC Regulation, but while SPVs share many of the same features they are outside the Regulation.

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The Central Bank estimated that in 2015 there were 779 FVCs holding €415 billion – required by the ECB to report quarterly data since 2009 – and 600 SPVs in 2012 holding €150 billion. In its Macro-Financial Review published in June this year, the Central Bank said there was, as of December last year, 820 SPVs holding €322 billion in assets. SPVs were not required by the Central Bank to file reports until last year. SPVs are generally used for loan origination but can also carry out securitisation activities.

Section 110 companies

The Central Bank says that tax provisions introduced in the 1991 Finance Act aimed at allowing the creation of structures that were broadly profit and tax-neutral in order to facilitate the securitisation of mortgages. This was then expanded beyond the IFSC with Section 110 of the Taxes Consolidation Act 1997, which came into effect in 1999.

The assets that could be held, managed or leased by a Section 110 company was extended by the Finance Acts of 2003, 2008 and 2011. SPVs and FVCs use “orphan companies” usually held by a charitable trust in order to keep assets off the balance sheet of their true parent companies. The originating companies of the majority of SPVs in Ireland are from the US, Britain, Germany, France, Italy and Russia. The collapse of two Dublin-based SPVs that originated from German bank Sachsen Landesbank in 2007 led to a €17 billion emergency banking bailout by the state of Saxony.

To qualify under Section 110 the company must be resident in Ireland; acquire qualifying assets of at least €10 million; and notify Revenue that it wants to fall under the Section 110 framework. The qualifying assets can include shares, bonds, securities, insurance and reinsurance contracts, hire purchase contracts, money market fund investments and more. Since 2012, qualifying assets can include commodities, carbon credits, plant and machinery.

While an SPV is a taxable entity, and should be taxed at the non-trading corporation tax rate of 25 per cent, under Section 110 its taxable profit will be measured according to the rules of a trading company – so the SPV is entitled to a tax deduction for all trade expenses, such as interest paid. As a result, SPVs “can utilise various techniques to strip profit out on its underlying investments and can reduce or eliminate the tax it is required to pay” according to law firm Dillon Eustace. The International Tax Review states that Section 110 companies are “typically structured so that income earned is matched with its expenditure resulting in minimal taxable profits”.

The result is that SPVs, in particular vulture funds buying up distressed mortgages in Ireland, are earning millions of euros annually from mortgage-holders and shifting it offshore but are paying as little as €250 in tax to Irish Revenue. According to various media reports, between 2011 and April 2016, vulture funds in the Irish state purchased loan portfolios worth €62.9 billion against the backdrop of a mortgage arrears, housing affordability and homelessness crisis.

Banks are increasingly selling off distressed mortgages to vulture funds at reduced prices, who have proven to pursue repossessions of homes even more aggressively, fuelling the housing and homelessness crisis. In May Ulster Bank announced the sale of 900 family homes with distressed mortgages as part of a €2.5 billion property loan portfolio to vulture funds. This follows the purchase in March of 200 family homes by a Goldman Sachs vulture fund in Tyrellstown, Dublin.

It has been reported that the largest purchasers were Goldman Sachs, Cerberus, Deutsche Bank, Lone Star, CarVal and Apollo. In 2014 the Irish arm of US vulture fund Lone Star, which holds distressed German mortgages, generated €1.24 billion but paid less than €1 million in tax. Cerberus’s 2014 accounts show it generated more than €140 million of revenue on its Irish assets, but paid less than €2,500 in tax.

Goldman Sachs subsidiary Beltany’s 2014 accounts show that it generated income of €44 million – but paid just €250 in corporation tax. Cayman-linked Mars Capital generated revenue of €14 million in 2014 but also paid just €250, as did Launceston Property Finance, which originates from Luxembourg-registered CarVal and generated €16 million. Some of these banks are under the direct supervision of the European Central Bank, leading Sinn Féin MEP Matt Carthy to write to the ECB in June to request it to investigate the relationship between these banks, their associated vulture funds, tax avoidance and evictions in Ireland.

SPV structure

Source: Grant Thornton law firm, ‘SPV taxation’, 30 September 2015

Irish tax law enables tax avoidance by Section 110 companies

The specific features of Irish tax law that enable Section 110 companies to do this include the fact that there are no ‘thin capitalisation’ laws in Ireland (there is no minimum profit required for a company for tax purposes, so an SPV can strip out all of its taxable profits if it chooses). Any costs of raising finance are tax-deductible under Section 110.

The most important provision of the law has been Section 110(4) which permits a Section 110 company to take a deduction for “profit participating interest” if certain conditions are met. The Finance Act 2011 introduced anti-avoidance provisions that sought to deny deductibility for that profit element of interest, but included exceptions that made the measures meaningless.

The anti-avoidance provisions do not apply (so interest is fully deductible) where the recipient of the interest or other distribution is either a person resident in Ireland, or a person (resident in an EU Member State or tax treaty country who is not “connected” with the SPV) who is a pension fund, government body or other person who is exempted from tax which generally applies to profits, income or gains in that jurisdiction. Just in case any of those exemptions do not do the trick, the Finance Act 2011 also introduced an exemption on withholding tax on interest paid through quoted eurobonds.

The Finance Act 2011 also expanded the list of qualifying assets from only financial assets to also to include commodities, carbon credits and plant and machinery, aimed at making Ireland more an attractive site for the aircraft leasing industry. Tax treaties can be used to reduce withholding taxes on inbound payments for lease rentals, and Irish-resident SPVs can receive incoming investment management services without being subject to Irish VAT.

Section 110 companies are allowed to calculate profits according to the old Irish generally accepted accounting principles (GAAP 2004) instead of the new Irish GAAP or International Financial Reporting Standards (IFRS). Dillon Eustace law firm, which advises Ireland’s National Asset Management Agency and Lone Star, among others, says the legislation was amended after industry successfully lobbied Revenue over concerns that International Accounting Standards “could compromise the profit neutrality of an SPV”.
The 2010 transfer pricing rules do not apply to Section 110 companies.

Total return swaps, where the SPV swaps all of its receipts with another company in its group in return for enough funds to discharge liabilities, should be liable to tax but apparently are not in practice and are used as a profit-extracting mechanism. Dillon Eustace advises clients: “There may be a technical liability to Irish income tax for recipients (i.e. the swap counterparty) who are not resident in a country with which Ireland has a double tax treaty but, in practice, this liability is not enforced by the Irish tax authorities.”

Ireland’s membership of the EU and OECD (and its ‘white-listed’ status) and the listing of securities on the Irish Stock Exchange are further incentives for SPVs to domicile in Ireland.

SPVs generally use an orphan entity ownership structure that ensures the entity is not owned by its originating bank or hedge fund but by a charitable trust. Revenue have raised concerns about the use of charities for this purpose as revealed through Sinn Féin TD Pearse Doherty‘s Freedom of Information request last month. Dublin’s corporate law firms generally establish the charitable trust or provide the use of their existing charitable trusts to SPVs.

For example, Matheson has established its own charity, the Matheson Foundation, which it regularly uses to help incorporate SPVs for its clients. Its website says: “The Matheson Foundation has two clear goals: to help children in Ireland to fulfil their potential; and to encourage corporate philanthropy in Ireland.” The Central Bank has found that most FVCs and SPVs incorporated in Ireland have no employees.

Qualifying Investor Alternative Investment Funds

A second key instrument used by international banks and hedge funds to avoid paying tax in the Irish state is the Qualifying Investor Alternative Investment Fund (QIAIF), which replaced the Qualifying Investor Fund (QIF), which was originally established by NAMA in 2012. The QIAIF is primarily a structured fund for real estate investment and is often used together with an SPV to ensure access to double tax treaties. QIAIF assets in Ireland are valued at €302 billion. They require a minimum subscription per investor of €100,000 and are subject to almost no other requirements.

QIAIFs are entirely tax-exempt from income tax and capital gains tax regardless of where the investors are resident, as well as being exempt from withholding tax for any payments made to non-Irish resident investors. Irish Real Estate Investment Trusts (REITs), a vehicle with a collective ownership structure for real estate investment established in 2013, are also exempt from income and capital gains tax from rental payments in most conditions.

The Irish Collective Asset Management Vehicle

The Irish Collective Asset Management Vehicle (ICAV) Act 2015 came into effect in March last year. It introduced a fifth type of corporate fund structure, alongside the investment company, unit trust, common contractual fund and investment limited partnership, and appears to have been established with the explicit goal of facilitating tax avoidance by US investors.

Matheson law firm describes the ICAV as “the culmination of a joint government and industry project to make available to promoters a legal framework for a corporate fund vehicle that is specifically designed for investment funds. Matheson partners were extensively involved in the industry project to introduce the ICAV.” It adds that “it is expected to become the vehicle of choice for UCITS and Alternative Investment Funds in Europe”. If the government’s reaction to accusations it was facilitating tax avoidance by SPVs was disingenuous, its claims to be unaware of the use of the new ICAV structure for tax avoidance is ludicrous.

The ICAV has several features that distinguish it from other fund vehicles:
*An ICAV can classify itself as transparent under the US check-the-box rules in order to avoid taxation that may apply in the US to passive foreign investment companies.
* An ICAV has its own legislative code that will allow it to avoid compliance with several Irish and EU company law requirements.
* It is not required to spread risk, unlike an investment company.
*An existing Irish investment company can convert to an ICAV easily, and a foreign corporate investment fund can domicile in Ireland and convert to an ICAV without incurring Irish tax in either case. Matheson suggests the jurisdictions where migration to Ireland will occur are the British Virgin Islands, the Cayman Islands and Jersey.

Despite the Irish government’s formal support for the OECD-BEPS process and its limited moves to respond to international pressure since 2014, there are a large number of significant legislative gaps that remain in place in the Irish state that not only allow tax avoidance by MNCs and global financial giants, but actively encourage it. Each step forward has been accompanied by “exemptions” that serve to make the reform ineffective, and appear to have been directly designed by the US Chamber of Commerce, the Big Four accounting firms and the major Dublin corporate law firms: Matheson, Arthur Cox, William Fry, Dillon Eustace and others, in a stark illustration of the “captured state” concept applying in Ireland.

Some of these legislative problems will be addressed to a certain extent by the transposition of the European Anti-Tax Avoidance Directive over the next period (though certain provisions, such as exit taxation, won’t take effect until 2020). There are a number of issues that will not be addressed by the ATAD, and a number of glaring loopholes that need to be closed in the meantime – Section 110 being the most urgent of all.

Ireland’s IP ‘Knowledge Box’ – another tool for tax dodgers

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This is the third article in a 4-part series on tax avoidance in Ireland.

1.Irish state marketed for tax avoidance since 1950s

2.Yes, we’re still a tax haven for tech giants

3.Ireland’s IP Knowledge Box – another tool for tax dodgers

4.How do vulture funds manage to pay practically no tax in Ireland?

US technology and pharmaceutical giants in the Irish state have benefited from varioustax credits, incentives and loopholes specifically relating to intellectual property and research and development, in addition to the low Irish corporation tax rate. But very little actual R&D is carried out in Ireland as a result of FDI, with US MNCs preferring to base R&D centres in Israel, China and India.

R&D tax credits against corporation tax were introduced in 2004 and expanded in Budget 2015 as the news that the Double Irish was to be phased out was announced. A 25 per cent tax credit is available on all qualifying R&D expenditure in addition to a 12.5 per cent tax deduction – so, a total of a 37.5 per cent tax deduction on such expenditure, or in other words, a corporate tax rate on R&D activity of around 3.3 per cent. Any company which trades in the Irish state and carries out R&D activities in Ireland or in the European Economic Area and incurs expenditure is eligible.

Before 2015, a base year of 2003 was in place – ie, a company could only claim credit for expenditure over and above what it incurred in 2003. This was to be a rolling base year in order to incentivise companies to spend more but the year didn’t change, and the base year was abolished altogether in Budget 2015. Under a Freedom of Information request, the Irish Times found in January 2015 that Department of Finance officials “expressed concern that changes to tax breaks in Budget 2015 would cost at least €50 million in foregone taxes annually and reward a relatively small number of companies” – just 15 firms, in fact, including one that would benefit by €14 million. The names of the companies were blacked out in the FOI release, but according to the Irish Times, “records indicate many of the firms that stood to benefit lobbied in favour of the move”.

There were no audits carried out on the tax credit scheme for the first decade of its existence. It was reported in September 2015 that 200 audits carried out in 2013 found “several multinational firms have been found to be aggressively and improperly claiming tax credits for research and development to lower their corporation tax bills” and resulted in firms being made to repay €21 million in back taxes. Revenue has identified the tax credit as a “significant risk” and used scientists and technical experts in its audits to determine if the companies were genuinely carrying out R&D.

The OECD modified-nexus regime

Also announced in Budget 2015 (with the phasing out of the Double Irish), and introduced in Budget 2016, was the Knowledge Development Box, a corporate tax rate of 6.25 per cent for profits arising from certain forms of IP. Ireland had already introduced the first “patent box”, a lower rate of tax on IP-related profits, in 2000 before the introduction of the 12.5 per cent corporate tax rate. A British patent box with a rate of 10 per cent from British and/or European patents was introduced in 2013. Luxembourg, the Netherlands, Cyprus, Spain, France, Portugal, Belgium and Malta have all introduced special low tax rates for profits from patents.

Patent boxes have been described as mechanisms for tax avoidance. The OECD-BEPS project proposed action to reduce the potential for profit-shifting abuse through patent boxes by ensuring there was a genuine link, or nexus, between the lower tax rate and R&D that was initially developed in the home state. A German-British compromise in November 2014 resulted in the so-called modified nexus approach being adopted by the OECD, which retained requirements for genuine local initial IP development but added concessions for Britain including a transition period and a 30 per cent “uplift” in what counts as qualifying expenditure to reflect outsourced intra-group research activities and costs.

While the Irish government initially opposed the modified nexus approach publicly during the German-British negotiations, and actively sought the advice of US MNCs in drafting its own legislation, Finance Minister Michael Noonan clearly saw the writing on the wall. Part of the OECD agreement was that all new entrants into existing patent box schemes that did not comply with the modified nexus approach would have to cease by 30 June 2016 and be abolished by 2021. When introducing the KDB in Budget 2016, Noonan stated that it would be the first and only patent box in the world to be fully compliant with the OECD’s modified nexus approach. Following the adoption of the German-British modified nexus approach, the European Commission withdrew its investigation into patent boxes.

Ireland’s Knowledge Development Box

The Irish KDB took effect on January 1 this year. It will apply a 50% allowance in tax relief to “qualifying profits”, resulting in a 6.25% tax rate. Qualifying profits arise from specified trade in “qualifying assets”, being intellectual property resulting from research and development carried out in Ireland or an EU member state. The intellectual property forms that can be qualifying assets are defined as being copyrighted computer software, inventions protected by patents and supplementary protection certificates, and plant breeders’ rights. The formula for calculating the qualifying profits under the KBD is below:

Qualifying Expenditure + 30% Uplift Expenditure  x  Qualifying Asset = Qualifying Profit
Overall Expenditure

Qualifying expenditure is expenditure incurred in R&D activities that lead to the development, improvement or creation of the qualifying asset. Cost-sharing agreements where costs are outsourced to intra-group parties are excluded, but such intra-group expenditure and acquisition costs can be added as uplift expenditure up to 30 per cent. The overall expenditure is the full amount of costs incurred in the R&D and acquisition of the IP, so the qualifying expenditure is measured as a proportion of this. The qualifying asset is the profits made by the specified trade in the IP product and can include any royalty or other sum received in respect of the use of that qualifying asset – including sales income attributed to the qualifying asset on a “just and reasonable basis”.

The specified trade in the qualifying asset can include:
– the managing, developing, maintaining, protecting, enhancing, or exploiting of the IP;
– the researching, planning, processing, experimenting, testing, devising, developing or other similar activity leading to an invention or creation of intellectual property; or
– the sale of goods or the supply of services that derive part of their value from the activities described  above.

KBD open to abuse

The corporate lobby initially expressed disappointment about the government’s use of the modified nexus approach, with one lobbyist saying: “What the Government could have done is waited longer to produce it. If they waited a few years more the temperature could have dropped and there would have been less focus on international tax, and they may have been able to pick up ideas from other countries… It has certainly impacted on how effective the KDB will be for the future in terms of an incentivisation vehicle.”

The Big Four accountancy firms and some corporate law firms have been more optimistic – while they have criticised the “onerous” tracking and tracing provisions that require a separate profitability stream to be accounted for each asset, they have nevertheless welcomed the KBD as a means to reduce tax bills that will specifically benefit the technology and pharmaceutical MNCs provided they jump through a few extra hoops. For example, the pharmaceutical sector generally uses “serialisation” features that correspond with the tracking and tracing provisions, but these would need to be developed in the technology sector.

Deloitte stated: “In our view, the introduction of the Irish KDB regime is welcome, although the narrow scope of IP assets that will qualify for the regime ultimately will result in limited uptake [ie, not trademarks] outside of the pharmaceutical and technology sectors.” William Fry law firm has said: “Overall, the KDB is to be welcomed as it bolsters Ireland’s competitive tax regime and complements existing tax benefits for IP such as research and development relief and the capital allowances available in relation to intangible assets. Given the limitations where research and development is carried out by group companies, in the first instance, the KDB relief may be more beneficial to indigenous companies. However, with proper planning, the relief may also prove to be of benefit to multinational enterprises.”

There is no doubt that the KBD will benefit MNCs disproportionately and that the KBD is wide open to abuse. The definition of R&D activities is identical to the definition in the R&D tax credit legislation, and it too can be self-reported by corporations when filing their accounts. The hugely problematic nature of measuring the value of intangible assets remains. The weak existing transfer pricing regulations on the arm’s length principle from the 2010 legislation will be applied. There is a right for Revenue to consult with experts on the R&D being claimed if it wishes to, as under the R&D tax credit regime, but a corporation can appeal against such consultation on the grounds that disclosure would be prejudicial to its business.

Put simply, there is nothing in the KBD legislation to prevent it from being used to concentrate profits offshore. The Double Irish system where all non-US sales pass through Irish subsidiaries to dramatically reduce the tax bill can continue but in a simplified way, with both Irish subsidiaries being tax-resident in Ireland, with one that can collect sales profits and another that holds IP rights and receives royalties that are taxed at the 6.25 per cent rate.

Inevitable profit-shifting – a theoretical example

Here is just one theoretical example of how the KBD can be exploited: a technology MNC, Pear Inc, is headquartered in Silicon Valley where 90 per cent of its overall R&D is carried out. It has two subsidiaries in Ireland called Pear Ireland Ltd and Pear Ireland Holdings. Pear Inc develops a software programme, called iThing, with 100 per cent of the R&D carried out in San Francisco. Pear Ireland Ltd then works on the next generation of the product – iThing 2.0.

It could claim to spend 70 per cent of the relatively small amount of R&D expenditure needed to make a few changes or improvements to the original iThing programme in Ireland, resulting in the creation of iThing 2.0. The new programme would not need to be patented with the Irish Patent Office because computer programmes are generally excluded from patentability but are specifically included in the qualifying asset IP definition in the KBD.

Because the new variation of the programme is in itself a qualifying asset, the overall expenditure does not necessarily need to include the original expenditure incurred in San Francisco, only the 30 per cent of expenditure not attributed to Ireland. As intra-group cost-sharing agreements are not allowed under the KBD, Pear Ireland Ltd can under certain circumstances add 30 per cent uplift, equaling 100 per cent of overall expenditure.

To be sure, Pear Ireland Ltd can simply obtain an advanced opinion from the compliant Irish Revenue to affirm its calculation that it incurred 70 per cent of the R&D costs, as the track and trace provisions are only required to be checked by the home state. Pear Ireland Ltd then licenses the IP to Pear Ireland Holdings, which collects all of the non-US sales profits from iThing 2.0 but reduces its taxable income through paying royalties and/or licensing fees to Pear Ireland Ltd under the clearly ineffective existing arm’s length legislation.

Then 100 per cent of the royalties and licensing fees received are attributable to the R&D expenditure carried out in Ireland, calculated as qualifying profit under the KBD and taxed at 6.25 per cent (this is on top of the 37.5 per cent tax deduction available for R&D expenditure through the combined R&D tax credit and the 12.5 per cent R&D tax deduction). This is an extremely simplistic example of a structure but it could obviously be improved in terms of tax avoidance through the more creative use of royalty payments and subsidiaries around the world including in tax havens.

No evidence that patent boxes stimulate R&D

There is little evidence that patent boxes do anything to increase genuine R&D or attract FDI in the productive economy in the states they exist in. Speaking in Dublin in March this year, the head of the OECD’s centre for tax policy Pascal Saint-Amans, said the development of knowledge or patent boxes does little to actually foster innovation and the creation of intellectual property.

This was followed by an OECD report in June this year which said Ireland’s public financial support to R&D businesses was “skewed” towards R&D tax credits that benefited MNCs, and explicitly called for public resources to be redirected away from MNCs to local SMEs, where there was little growth, in order to develop indigenous enterprise and increase productivity. Despite more than a decade of generous R&D tax credits and other tax incentives to promote FDI, less than one-third of IDA Ireland companies invest in R&D at all.

But despite its limitations and potential for abuse, a system of R&D tax credits, targeted towards SMEs and indigenous enterprise, has a broader economic and social value if implemented correctly – whereas there is no such corresponding social and economic benefits arising from a patent box regime. A research paper on patent boxes in 2014 argued: “Tax incentives for R&D expenditure reward firms for the societal benefits from innovation that they themselves are unable to appropriate. It is hard to make the argument that a patent box serves the same purpose: patent boxes introduce a preferential rate for income from innovations that are already protected by Intellectual Property Rights (IPRs). IPRs enable firms to capture a large part of the societal benefits, such that the need for a tax incentive for protected innovations becomes unclear.”

The supposedly limited opportunities the modified-nexus compliant KBD presents for US MNCs to reduce their tax bills makes it all the more likely that it has been introduced in the full knowledge that it will be exploited, while the government will turn a blind eye. Based on the form of successive Irish governments in relation to tax avoidance, we can guess that the government had two goals with introducing the KBD: to send a political message to US MNCs that the Irish government remained committed to ensuring the Irish state could continue to be used as a conduit for tax avoidance despite the phasing out of the Double Irish; and to introduce yet another mechanism that is wide open to abuse in order to please MNCs.

In the context of the phasing out of the Double Irish and an international crackdown on the use of offshore tax havens, the Irish KBD is an attractive mechanism for creative “onshore” tax avoidance. Matheson law firm advises its clients that offshore tax havens such as Bermuda and the Cayman Islands don’t have “the necessary economic infrastructure to which value and ultimately profits can justifiably be attributed”, whereas Ireland on the other hand can construct “profit-generating centres defensible by reference to functions, risks and tangible assets of the Irish operation,” advice that has become all the more relevant in the post-BEPS context.

Continued: How do vulture funds manage to pay practically no tax in Ireland?

Yes, we’re still a tax haven for tech giants

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Irish Taoiseach Enda Kenny with Apple CEO Tim Cook

This is the second article in a 4-part series on tax avoidance in the Irish state.

1.Irish state marketed for tax avoidance since 1950s

2.Yes, we’re still a tax haven for tech giants

3.Ireland’s IP Knowledge Box – another tool for tax dodgers

4.How do vulture funds manage to pay practically no tax in Ireland?

The Double Irish is the most notorious way that the Irish tax regime has facilitated tax avoidance over recent decades, but it is far from the only way. The MNCs engaged in the most blatant and aggressive tax avoidance in Ireland are technology giants Apple, Google, Microsoft and Facebook, and pharmaceutical corporations. Use of the Double Irish has relied on Irish-incorporated companies in tax havens including Bermuda, the Netherlands and Luxembourg, which are the top three locations for both outward and inward Irish direct investment.

A Moody’s report released on May 20 this year shows that US companies have accumulated $1.68 trillion in cash, with 72 per cent of it held in offshore tax havens. This sum has increased by almost $1 trillion since 2007. Apple, Microsoft, Google, Cisco and Oracle were the five multinationals holding the largest amount of wealth, with $504 billion combined.

The top three, Apple, Google and Microsoft, have all used Ireland as the center of their tax avoidance strategy, and can continue to do so until 2021 – while the government announced in 2014 that the Double Irish was to be scrapped (by changing residency rules to make companies that are incorporated in Ireland Irish-resident for tax purposes), it will remain in place for existing companies until 2021. Transfer pricing, cost-sharing agreements, inversions and tax rulings are some of the key ways MNCs avoid tax in Ireland, and unlimited liability status under Irish law has provided them with a cloak from public scrutiny. These mechanisms are complemented by failures in the US tax code. The top three US MNCs engaging in tax avoidance in Ireland are Microsoft, Google and Apple.

Microsoft

Microsoft established a plant in Ireland in 1985 following the introduction of a 10 per cent rate on software export profits in 1983. Its operations remained minor until the tech boom in the 1990s. Microsoft may not have been the first US MNC to exploit the Double Irish and other tax loopholes but it was the first to be comprehensively exposed, in the Wall Street Journal’s 2005 report. The investigation revealed how Dublin law firm Matheson Ormsby Prentice’s offices hosted a letterbox subsidiary of Microsoft Corporation which was established by Microsoft Ireland Operations Ltd in 2001, called Round Island One Ltd. (Matheson Ormsby Prentice, now called Matheson, also represents Google.)

In 2005 Round Island was controlling $16 billion in Microsoft assets and had gross profits of $9 billion in 2004. Another Dublin-based subsidiary, Flat Island One – a holding company of Round Island – was used to license rights to software throughout Europe, the Middle East and Africa. The revelation of the scheme posed several questions regarding the valuing of IP contributed by offshore units. To try to meet the US arms-length requirement, US MNCs rely on cost-sharing agreements, which Flat Island had with a US-based Microsoft unit called MELLC. In 2006 the two Irish subsidiaries applied for private unlimited liability company status, which exempts companies from filing detailed public accounts.

In hindsight, the scheme revealed in 2005 actually seems naïve – it apparently only relied on exploiting a cost-sharing agreement and Ireland’s 12.5 per cent tax rate. The establishment of letterbox companies in Bermuda, Singapore and Puerto Rico soon followed. Another subsidiary was later created in Ireland, Microsoft Ireland Research (MIR). The US Senate Subcommittee inquiry into tax avoidance by Microsoft in 2012 showed that the company had avoided paying at least $6.5 billion between 2009-2012 through the use of its subsidiaries in Ireland, Bermuda, Singapore and Puerto Rico. While it was estimated that more than 85 per cent of the research and development was carried out in the US, and MIR carried out one per cent of R&D, a cost-sharing agreement gave MIR 30 per cent of the credit for R&D. The Senate inquiry memorandum stated that MIR reported making $4.3 billion profits in 2011, about $11 million per employee in Ireland, with an effective tax rate of 7.2 per cent.

These days Microsoft routes its European, Middle Eastern and African sales through three separate subsidiaries, all registered in Ireland, before the profits finally end us in Bermuda (in an Irish-registered letterbox company). The first company where sales income arrives is Microsoft Ireland Operations Ltd. MIO Ltd is owned by MIR, which is part of the cost-sharing agreement with the US parent, and licenses products to MIO Ltd. Then profits move in the form of royalties to Round Island One, which although it is Irish-registered is now based in Bermuda. Finally the profits end up in another Irish-registered Bermuda letterbox company, RI Holdings. In February 2014 it was reported that an unidentified foreign government was investigating Microsoft’s three Irish-registered Bermuda letterbox companies for tax avoidance and tax evasion through the OECD’s 2005 Tax Information Exchange Agreement.

Google

In 2010, Bloomberg reported that Google had reduced its tax bill by $3.1 billion in the previous three years by using the Double Irish and moving profits through Ireland and the Netherlands to Bermuda. By first passing through the Netherlands, the profits were exempt from an Irish withholding tax for outgoing royalties as Irish law exempted royalties flowing to the Netherlands (and other EU-registered companies) from this tax. Google Inc. had secured an advanced pricing agreement (APA) with the IRS in 2006 after three years of negotiations, in which its intangible property for Europe, the Middle East and Africa was licensed to Google Ireland Holdings. Google Ireland Holdings owns Google Ireland Ltd, which has tangible property and employees in Dublin. Google Ireland Ltd is the entity through which the vast majority of non-US sales pass.

But while in 2009, 88 per cent of its $12.5 billion worth of non-US sales went through Google Ireland Ltd, it reported pre-tax profits of less than one per cent of these sales in 2008 because it shifted the profits to Google Ireland Holdings through royalty payments. While Google Ireland Holdings was incorporated in Ireland it was not tax resident there but in Bermuda where it based its ‘effective centre of management’. In reality it is a letterbox company with no employees located in a tax haven with a corporate tax rate of zero.

The ‘Dutch Sandwich’ aspect of the strategy – sending money first through the Netherlands and then to Bermuda or another tax haven – was used to prevent patent royalty profits from being subject to a 20 per cent withholding tax by Irish Revenue through a tax treaty but it became no longer even necessary for MNCs to use the Netherlands in this way after July 2010 when the US Chamber of Commerce successfully lobbied the Irish government to amend its tax code to get rid of the withholding tax. As revealed by the Financial Times in May 2013, the US Chamber of Commerce submission to the Irish government suggested Ireland’s attractiveness as a location for IP investment could be “significantly improved” by scrapping the withholding tax on patent royalties.

In 2012, Google Inc. transferred all of its foreign income – $8.1 billion – through Ireland and paid an effective global tax rate of 4.4 per cent, a total of $358 million, including $22 million to Irish Revenue. The British HMRC struck a deal with Google in January this year in which Google agreed to pay £130 million in back taxes that it had avoided paying on British sales through routing the money through Google Ireland Ltd. This was a fraction of the amount Google actually owed, and ending the practice was not part of the agreement. French authorities began investigating Google’s transfer pricing arrangements in 2011 and in January this year the French government announced it was seeking €1.6 billion in back taxes. In May this year French police and tax inspectors raided Google Ireland Ltd’s headquarters in Paris, as part of an investigation into “aggravated financial fraud and organised money laundering”. The French authorities also said they are seeking to prove that Google Ireland Ltd has a “permanent establishment” in France which would be subject to paying French taxes.

Apple

Apple has gone above and beyond all other MNCs in using Ireland to avoid paying tax – for a period of five years its main European, Middle East and Africa subsidiary didn’t just reduce its tax bill but avoided paying any tax anywhere. The scheme was outlined comprehensively by US Senator Carl Levin in the Senate Subcommittee inquiry into offshore profit-shifting by Apple in May 2013, in a concluding speech accompanied by a detailed memorandum.

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The Senate report outlined how through the use of three Irish-registered letterbox companies, Apple Inc could claim they existed nowhere for tax purposes. Apple Operations International, or AOI, is solely owned by Apple Inc and in turn owns most offshore entities. AOI is incorporated in Ireland but not tax resident there. The second company, Apple Sales International (ASI) holds IP rights to sell Apple products in Europe, the Middle East and Asia. The third, Apple Operations Europe, is also registered in Ireland but not resident there. Sales income for ASI from 2009-2012 was $74 billion.

In 2011, ASI paid tax of 0.05 per cent – $10 million of $22 billion income – to Ireland. Levin said: “[These three ghost companies’] decision makers, board meetings, assets, asset managers, and key accounting records are all in the United States. Their activities are entirely controlled by Apple Inc. in the United States. Apple’s tax director acknowledged to the Subcommittee staff that it was his opinion that AOI is functionally managed and controlled in the United States. The circumstances with ASI and AOE appear to be similar.”

More than 95 per cent of Apple’s R&D is carried out in the US. Levin outlined how through a cost-sharing arrangement on R&D between Apple Inc and ASI, from 2009-2012 ASI paid $5 billion to Apple Inc, while Apple Inc paid $4 billion under the cost-sharing agreement over the same period. But while Apple Inc declared profits of $38 billion (subject to the US corporate tax rate of 35 per cent), letterbox company ASI declared profits of $74 billion and paid less than one per cent in tax to Ireland. “Common sense says Apple would never have offered such a lucrative arrangement in an arm’s-length deal with an unrelated party.”

The Apple case demonstrates not only exploitation of the Double Irish residency rules, but also the use of supposedly informal ‘advanced opinions’ – private tax rulings – issued by Revenue to certain MNCs. In Levin’s words: “Why Ireland? Another highly successful but, until now, hidden tax strategy: Apple has quietly negotiated with the Irish government an income tax rate of less than 2 percent, well under the Irish statutory rate of 12 percent as well as the tax rates of other European countries and the United States. And as we’ve seen, in practice Apple is able to pay a rate far below even that low figure.” Apple representatives told the Senate Subcommittee: “Since the early 1990’s, the Government of Ireland has calculated Apple’s taxable income in such a way as to produce an effective rate in the low single digits …. The rate has varied from year to year, but since 2003 has been 2% or less.”

The Senate Subcommittee memorandum examines the relationship between Irish tax law on residency and loopholes in the US tax code (subpart F), specifically the ‘check-the-box’ and ‘look-though’ rules. The check-the box loophole was introduced in the 1990s and allows companies to literally check a box on its declarations to the IRS stating what kind of entity they are for tax purposes – meaning MNCs can declare offshore subsidiaries as part of one single corporation and therefore not taxable. The look-through loophole introduced in 2006 provides relief from the anti-deferral rules for Controlled Foreign Companies in the US tax code.

The European Commission opened an investigation in June 2014 as to whether the tax rulings, or advanced opinions, provided by Irish Revenue to Apple subsidiaries in 1991 and 2007 constitute illegal state aid that selectively preferenced the companies. The key points of the Commission’s preliminary findings in September 2014 were that the 1991 tax ruling appeared to have been “reverse engineered”, and that the 2007 amended tax ruling which calculated a 10-20 per cent increase on AOE’s costs was “meaningless in relation to the computer industry”. Unlike most tax rulings, which usually last for three to five years, the 1991 ruling had no end date. The Commission said there was evidence the tax rulings was “motivated by employment considerations”, and that the terms of the tax rulings did not comply with the arm’s length principle for setting conditions between companies of the same corporate group.

Three figures have been estimated regarding what amount Apple would owe in back taxes to the Irish state if the Commission finds the tax rulings were illegal. Bloomberg Intelligence has estimated $8 billion, while JP Morgan Chase & Co has estimated it may owe $19 billion. Pro-corporate lawyers reported in the media have estimated Apple will face just $200 million in back taxes.

One of the most important facts to come to light in the US Senate Subcommittee inquiry’s 2013 report, and highly significant for the European Commission’s investigation, is that the last accounts that had been filed for AOI (then called Apple Computer Inc Ltd) was in 2005 for fiscal year 2004. As Finfacts founder Michael Hennigan points out: “Irish Revenue officials must have been aware of the change of status of AOI from a tax-paying company in Ireland to a tax-exempt status?” As evidence of the “reverse-engineered” nature of the advanced opinion issued by Revenue in 1991, the Commission released the following excerpts of a note of a meeting between Apple and Revenue in 1990, where a figure of taxable profit was agreed upon without reference to the actual profits of the company, shifted to the manufacturing category with a corporate tax rate of 10 per cent (which did not expire in Irish law until the end of 2010), and then left in place until 2007 despite the massive rise in Apple’s profits over this period:

[The tax advisor’s employee representing Apple] stated that the company would be prepared to accept a profit of $30-40m assuming that Apple Computer Ltd. will make such a profit. (The computer industry is subject to cyclical variations). Assuming that Apple makes a profit of £100m it will be accepted that $30-40m (or whatever figure is negotiated) will be attributable to the manufacturing activity. However if the company suffered a downturn and had profits of less than $30-40m then all profits would be attributable to the manufacturing activity. The proposal essentially is that all profits subject to a ceiling of $30-40m will be attributable to the manufacturing activity.

[The representative of Irish Revenue] asked [the tax advisor’s employee representing Apple] to state if was there any basis for the figure of $30-40m and he confessed that there was no scientific basis for the figure. However the figure was of such magnitude that he hoped it would be seen to be a bona-fide proposal.

Continued: Ireland’s IP Knowledge Box – another tool for tax dodgers

Irish state marketed for tax avoidance since 1950s

Revenue

This is the first in a 4-part series on tax avoidance in the Irish state, and focuses on the history of the relationship between corporation tax rates, avoidance and foreign direct investment.

1.Irish state marketed for tax avoidance since 1950s

2.Yes, we’re still a tax haven for tech giants

3.Ireland’s IP Knowledge Box – another tool for tax dodgers

4.How do vulture funds manage to pay practically no tax in Ireland?

The Irish state has pursued an economic development policy based on attracting foreign direct investment since the 1950s. A low rate on corporate income and profits tax and loose financial regulation have been features of the state since this time, though for decades they were unsuccessful at attracting FDI. In 1956, the Export Profits Tax Relief provided a rate of zero corporation tax for manufactured exports. This system of tax exemptions for certain areas and industries developed over the following two decades. In the 1970s, the Industrial Development Authority (IDA) “started aggressively marketing Ireland’s tax system internationally, under slogans such as ‘no tax’ and ‘double your after-tax profits’.”

After the Irish state joined the European Economic Community in 1973 it was forced to turn this system of specific exemptions into a single rate across the whole manufacturing sector to comply with EEC rules on non-discrimination. As a result, the Fianna Fáil government introduced a corporate tax rate of 10 per cent for all manufacturing companies in 1981, followed by a 10 per cent rate for financial services in 1987, with the creation of the International Financial Services Centre (IFSC) in Dublin’s docklands. Other sectors of the economy lobbied for a reduction in the corporate tax rate applicable to them, and in 2003 the single corporate tax rate of 12.5 per cent for all companies’ trading profits was introduced, while passive income and company capital gains were to be taxed at 25 per cent.

A significant part of the debate surrounding Ireland’s corporation tax regime has centered on the role of the 12.5 per cent rate in generating the Celtic Tiger economic growth spurt in the 1990s and 2000s. The dominant narrative expounded by establishment political parties, media and state institutions is that the introduction of the 12.5 per cent rate was the single biggest factor that contributed to the boom. But the surge in growth in GNP began in 1993, a decade before the introduction of the 12.5 per cent rate, and more than a decade after the introduction of the 10 per cent rate in manufacturing. This was the year the Irish state joined the European Single Market, with Irish citizens gaining easy access to housing finance with no exchange rate risk from the mobile financial capital available for the first time. The resulting property boom and spike in consumption were the key factors contributing to the sharp rise in GNP from 1993 onwards. Barry Eichengreen wrote: “Claims on the Irish banking system peaked at some 400 per cent of GDP… It reflected the freedom with which Irish banks were permitted to establish and acquire subsidiaries in other EU countries.”

The graph below from the Fools Gold blog (by the Tax Justice Network and Warwick University) is a visual illustration of the timing and factors associated with the boom.

Ireland-GNP-graph

Irish GNP from 1955-2012

FDI inflow into Ireland expanded on a huge scale during the 1990s. It rose from 2.2 per cent of GDP in 1990 to 49.2 per cent of GDP in 2000. There were many contributing factors to this, with accession to the single market – and the growth in GNP and consumption that this prompted – being the most crucial. Other often-cited factors include Ireland’s joining of the single currency in 1999, its geographical location and its skilled, low-waged and English-speaking workforce. Currently foreign (mainly US) multinational corporations (MNCs) account for around 90 per cent of ‘exports’ and employ an estimated 150,000 people, around 8 per cent of the workforce. There is no doubt that FDI has since the 1990s played a dominant role in the Irish economy. The low corporate tax rate has certainly contributed significantly to this inflow of FDI, in addition to the factors outlined above. The two policy factors that have been equally or even more important than the low corporate tax rate are the large number of other ‘peculiarities’ of the Irish corporate tax regime, and the creation and promotion of the IFSC in Dublin as a centre for global finance that is almost totally unregulated.

Public debate on the corporate tax regime in Ireland

There are extreme economic and social costs associated with this model of economic development, in Ireland and internationally. The costs associated with the lack of regulation in the IFSC, and its promotion of the shadow banking system, have been demonstrated clearly and painfully in the €70 billion financial collapse of the Irish banking sector of 2008. The costs associated with Ireland’s corporate tax regime are also enormous. Public policy debates around Ireland’s corporate tax regime in recent years have centered on two key issues: domestically, whether the 12.5 per cent rate is sufficient, and whether it is in fact the effective rate paid by US MNCs; and Ireland’s role in the global chain of tax avoidance. A third, more neglected, issue of debate is economic over-dependence on US MNCs and the long-term poor performance of Irish indigenous industry, though this has now come into the public domain to a certain extent with the publication of this year’s 26.3% growth in GDP as a result of distortions largely caused by MNCs’ inversions and other accountancy tricks.

Throughout the 2000s it became clear that the nature of Ireland’s corporate tax regime meant mainly US-based MNCs were using the state in conjunction with offshore tax havens to massively reduce their global tax bills. A study by tax expert Martin Sullivan published in Tax Notes in 2004 showed that Ireland was the most profitable country in the world for US corporations. The following year, an investigation by the Wall Street Journal revealed that Microsoft was using a subsidiary based in the offices of a Dublin law firm to reduce its annual tax bill by at least $500 million. In 2009, in response to plans by the incoming Obama administration in the US to tackle tax avoidance, state agency Industrial Development Authority (IDA Ireland) hired a lobbying group in Washington DC to support the status quo.

Since the rise in international tax justice activism in 2010, successive Irish governments have been at pains to insist, “Ireland is not a tax haven”. Government representatives have stated that Ireland’s low tax rate is the “cornerstone of our economic policy”; that it is statute-based and effectively enforced. A still-running debate on the effective rate paid by US-based MNCs was sparked in 2011 when Finance Minister Michael Noonan claimed the effective rate of tax in Ireland was 11.9%, while in France it was (he claimed) only 8.1 per cent. Speaking in France in 2014, Taoiseach Enda Kenny quoted a PriceWaterhouse Coopers/World Bank report (2014) that stated Ireland’s effective corporate tax rate was 12.3 per cent. He was speaking in response to questions over Yahoo’s decision to transfer finance operations to Ireland from France. Kenny also claimed that the effective rate in France was 8 per cent (in fact, this rate refers only to SMEs and the effective corporate tax rate for MNCs in France is 33 per cent). A paper from Prof Jim Stewart from Trinity College Dublin pointed out that the PwC study was based on a small, domestic company that makes ceramic flowerpots and has no imports or exports. He wrote: “These assumptions automatically rule out tax planning strategies which are widely used by subsidiaries of MNCs.”

Using data from the US Bureau of Economic Analysis, Stewart showed that: “US subsidiaries operating in Ireland have the lowest effective tax rate in the EU at 2.2%. This tax rate is not that dissimilar to effective tax rates in countries generally regarded as tax havens such as Bermuda at 0.4%.” The Department of Finance commissioned an official study later in 2014 by economists Kate Levey and Seamus Coffey to reject Stewart’s findings, which excluded in their calculations the $144 billion in profits that US MNCs move through Ireland to other jurisdictions, saying it was not taxable in Ireland as though these entities may have been incorporated in Ireland they were not ‘resident’ and therefore the money was not taxable. Tax justice activists said this was precisely the point. Meanwhile, the Irish Times carried out a survey of the top 1,000 corporations operating in Ireland that found an average effective tax rate of 15.5 per cent – which has no bearing on the debate as it was a measurement of the companies’ overall global effective rate. Finfacts has reported that the largest corporate law firm in Ireland, Arthur Cox, said in a 2011 briefing on ‘Uses of Ireland for German Companies’: “The effective corporation tax rate can be reduced to as low as 2.5% for Irish companies whose trade involves the exploitation of intellectual property… A generous scheme of capital allowances as well as a tax credit for money invested in research and development in Ireland offer significant incentives to companies who locate their activities in Ireland.”

It was of course not only tax credits that provided for the low effective rate for US MNCs but massive transfers of wealth using IP-related mechanisms. Even Coffey, author of the government-commissioned refutation of Stewart’s claim of a 2.2 per cent tax rate of US MNCs, separately explained that the relatively low rate of taxable profits made by Irish subsidiaries of US MNCs resulted from profit-shifting from Ireland to Bermuda and the Cayman Islands through the payment of massive patent royalties, which amounted to nearly €30 billion in 2011. The US BEA “attribute these profits to Ireland as the holding companies are Irish incorporated”. The Tax Justice Network reports that studies using various ways of calculating the overall effective corporate tax rate in the Irish state found rates of between 2.5 per cent and 4.5 per cent. In 2014, a study by Eurostat on the implicit corporate tax rate (a backward looking measurement of the average effective tax burden) found an effective rate in Ireland of 6 per cent in 2012, down from 9.3 per cent in 2002, while the implicit tax rate on labour was 28.7 per cent in 2012, up from 26 per cent in 2002.

Continued: Yes, we’re still a tax haven for tech giants