Tax Break

John Fisher, international tax consultant

Archive for the tag “European Sovereign Debt Crisis”

It’s peace and democracy, stupid

Bayern Munich 3 Chelsea 4

We accountants do not care much for the front section of the newspaper. If  a story cannot be reduced to prime numbers, it is not for  us. After a cursory glance at the headlines we skip to Section B to be hypnotized by the latest business and finance news followed by yesterday’s football, baseball and cricket results. Reaching the back page we take a quick look at the paper’s weather forecast and then commit its earthly remains to the nearest bin.

I am grateful, therefore,  to Nobel Laureate (Economics) Paul Krugman who shone a different – albeit obvious – light on the Euro Crisis in a recent New York Times article:

 “Failure of the euro would amount to a huge defeat for the broader European project, the attempt to bring peace, prosperity and democracy to a continent with a terrible history”.

I wonder how long they had to queue?

I am British, which explains why I have been in denial on this issue for so long. When Britain negotiated belated entry to the EEC  (the forerunner of the EU) in 1973 and promptly held a referendum two years later to decide whether to have the marriage annulled, the British Government talked lots about the importance of a Common Market. What they always avoided was the unhidden agenda of the six founding fathers – West Germany, France, Italy, Netherlands, Belgium and Luxembourg – of achieving political union: a United States of Europe. The Six had one thing in common – they had all, in recent memory, been overrun by  foreign troops. Britain, too, had been overrun  by foreign troops – Americans  – who were overpaid, oversexed and over here but, while this was hardly less traumatic (especially for the husbands dying for King and Country overseas), it did not compromise Britons’ fierce commitment to independence that has remained uninterrupted for a thousand years.

The  twenty other countries that have joined since 1973 generally fit the “We had better share some independence rather than risk our heads being kicked-in every 50 years” philosophy shared by the Six.

As has been clear from Day 1 (or, to be more precise, D Day) Britain has no place in the EU. It is a  bridge between the Old World and the New and should have  economic status not dissimilar to Switzerland – access to the Single Market is all that it ever really wanted.

With Britain out, political union could proceed and the Euro could thrive (I joke not).

Of course there will still be a few minor roadblocks along the way like: cultural diversity; getting over a history of regularly pulverizing each other; and Greece (World War 1940-45, Civil War 1946-49). But it was pleasing to recently see troubled Spain (Civil War 1936-39) taking  a leaf out of Germany’s fiscal notebook  (World War 1939-45, World Cup 1966).  The slow march towards the Common Consolidated Tax Base – a precursor to fiscal union, itself a precursor to political union – advanced another step.

It will be recalled that Spain is having a little trouble meeting its Teutonically imposed budget targets this year. It needs to raise more taxes.

So, following Germany’s lead a few years ago, the Spanish legislature invited the Interest Expense to step up to the executioner’s block  for a haircut.

While international tax advisers will be aware that Spain has been quite a paradise for the tax planning of interest expenses (double dips et al), it does look like it is time to put the castanets  back in their box and get down to serious business.

The rain in Spain falls mainly in the plain

To replace the old Thin Cap (3:1) rules which apply to shareholder finance, the Spanish have introduced a general net interest deduction limitation  of 30% of , basically, EBIDTA (a la Germany). To the uninitiated, who may find this as understandable as the programming language of their computer – I will explain it in English like wot it is spoken. Ladies and Gentlemen, hold on to your hats.

You start with the financial statements of the Spanish company (or consolidated tax group)  and open them at the Profit and Loss Statement. Using your eyes and a calculator you work out operating profit – earnings before interest, taxes, depreciation and amortization  (EBIDTA)  plus a few secret ingredients. If interest expense minus interest income arrives at more than 30% of the operating profit you start to sweat and move on to Stage 2.  In Stage 2, if it is a single company (as opposed to a consolidated group) the rules will only apply if financing expenses are derived from certain related party transactions. In addition, up to one million euro of net interest expense is always deductible. If you are wondering why Stage 2 is not performed before Stage 1, you are right – the accountant will now have to decide whether he can charge his client for the wasted hours on the EBITDA calculations. Accountants  sometimes do that sort of thing. Amounts not deductible will be carried forward for up to 18 years to be included in the same 30% limitation each year while, if the net finance expenses are less than 30% in a given year, they can be carried forward for up to 5 years.

What, sadly, the Spanish have omitted is a (brilliant) German  exception to the rule. For Germany, where an entity is in a consolidated group  even if  the 30% rule is breached, as long as the equity ratio (equity to debt) of the company is not less than 99% of the equity ratio of the consolidated group the rule will not apply. What is clever here is that they are effectively saying that if the German situation reflects a more conservative position than the international group as a whole – then it is fair to assume that the interest charge is not designed specifically to hurt Germany and should be allowed.

While, to paraphrase Neil Armstrong this may be “One small step for Spain, one smaller step for Europe” it is still a step in the right direction of unified policies.

It couldn’t happen to a nicer airline

Some years ago I flew Iberian to Spain and vowed never again (Iberian, not  Spain). Among the numerous insults I suffered on the flight (and I was flying Business – Heaven knows what happens in Coach), was when the young female flight attendant came round offering immigration cards and, smiling politely, I refused as “I am a British citizen”. “You still need an immigration card. Britain is not part of the EU” she growled. I smiled benignly and informed her that Britain had been part of Europe when her country was still a fascist dictatorship. They didn’t allow me on the Business Bus when the plane landed. I suppose old fascist dictatorships die hard.

Czech mate

I have just sold Czechoslovakia and this is the receipt

Slovakia spent most of the twentieth century as the hapless side-kick in a Vaudeville double act that was incessantly down on its luck thanks to British and French betrayal, German invasion, Soviet domination and Soviet invasion. When Czechoslovakia finally broke up peacefully in 1993 the junior partner had an uphill battle to establish itself. But establish itself, it did.

The masterstroke came in 2004 when the center-right government announced that henceforth the country would be subject to a Flat Tax – a 19% rate for corporate profits (but not dividends), business income, employment income  and VAT. Slovakia was not the first former Eastern Bloc country to adopt a Flat Tax – that distinction belonged to Estonia as far back as 1994 – but it was considered to be a model of success and did wonders for the reputation of Arthur Laffer and his Curve that showed the relationship between the tax rate and government revenue. The election of a centre-left government earlier this month is slated to spell the end of the Flat Tax.

The concept of a Flat Tax is a simple one – adopt a relatively low rate of taxation with a very broad tax base. The tax is defined as a Proportional Tax – you pay a fixed proportion of your income –  as opposed to the more common Progressive Tax – where marginal tax rates increase with income.

The big advantages of Flat Taxes are that they encourage foreign direct investment and sustainable economic growth while, at the same time, being more transparent, easier to administer and providing less incentive for tax evasion. The absolute opposite of this is probably the US Tax Code of which President Richard Nixon’s Treasury Secretary William Simon once commented that he wished for a system that “looked like someone had designed it on purpose”.

Marx getting a firm grip on western civilization

The biggest objection to Flat Taxes is that they do not meet the common or garden definition of “Social Justice”. Karl Marx (still venerated in North Korea and Cuba) popularized “from each according to his ability to each according to his need” and that epithet has managed to stick to the tax systems of countries whose attitudes to socialism range  from passionate love to passionate hate. But the old windbag of Highgate Cemetery did not have a monopoly on the meaning of “Social Justice” –  I believe, like Irving Berlin, that the world would not be in such a  snarl, had Marx been Groucho instead of Karl –  and there are good, if less popular, arguments for the social justice of proportional taxes.

In any event, the Occupy Movement and its various offshoots, have ensured that vote-hungry governments hammer the rich and the banks without reference to the effect on GDP and the ultimate welfare of those they seek to avenge. In the   1960’s a British Labour politician was embarrassingly caught traveling First Class on a train; he explained ingeniously- if ironically – that his party’s ambition was for everyone to travel First Class.

It looks like Slovakia is suffering from a political reality which could do very nasty things to its economy. Unlike the profligate Eurozone countries of Southern Europe, Slovakia did not get itself in a total mess over the last few years (at least not Euro -wise).  Along with everybody else, however, it has agreed to limit its budget deficit ( 3% of GDP this year, down from 4.6% in 2011). In order to achieve that it needs to either decrease government spending or increase taxation – economic growth will not close the gap in the immediate future. GDP is amongst the lowest in the Eurozone and government spending is still relatively modest –  so it is down to taxation.

But the question is – what taxation?  The  Flat Rate system in Slovakia is not a pure system – although the individual tax rate is 19% there are personal allowances a personal income deduction for non-working spouses and pensions and charitable contributions. On the other hand there are punitive social security taxes. Overall this is referred to as a marginal flat tax (or sometimes a progressive average tax rate). What seems to be clear is that whatever the reason – and some commentators have stressed the relative importance of factors other than the tax rate – the system has worked and as one top international tax expert once told me “If it ain’t broke don’t fix it”.

Will Fico take the fizz out of the Flat Tax?

The plan of Robert Fico and his center-left Smer party, just returned to power after a brief stint in opposition, is reported to be to introduce a 25% higher rate for high earners and jack up the corporate tax rate to 22% for companies with significant profits. This all fits in nicely with populist social justice arguments but risks destabilising the very system on which impressive foreign investment has been based. A former finance minister has urged him to look to taxes that do not directly affect competition – singling out excise, environmental and property taxes.

The pity really is that countries like Slovakia have to fall in with Europe’s austerity package at all. The previous government fell over its support for the European Financial Stability Fund designed to address the European Sovereign Debt Crisis of which Slovakia was not guilty. It is lucky for Europe that Mr Fico and his predecessor did not take a leaf out of  British Prime Minister Neville Chamberlain’s book. Explaining his sell-out of Czechoslovakia to the House of Commons in 1938 he said:  “How horrible, fantastic, incredible it is that we should be digging trenches and trying on gas masks here because of a quarrel in a far-away country between people of whom we know nothing”. Anybody know the way from Bratislava to Athens?

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