Crickhowell is a small town in Wales on the road from Abergavenny to Brecon. For the early part of my life passing through it meant that either I was about to spend a week or so getting cold wet and miserable on the Sennybridge Army training area or, having got cold wet and miserable, I was on my way back to barracks to clean up, dry out and head up to London for some debauchery. Beyond that I didn’t think about the place much. That changed last week as the result of a BBC programme “The Town That Took On The Taxman.” I now love the place.
Essentially the small businesses in Crickhowell have adopted some of the (entirely lawful) methods used by multinationals to reduce their corporation tax bill. Good on them. Heydon Prowse, the presenter, did a reasonably objective job although he shared the BBC’s general disdain for profit (although it has no objection to running a surplus on its license fee). Perhaps unwittingly they put their finger on the nub of the problem; directors of a company have a duty to their shareholders to maximise profits. One aspect of this is the ruthless reduction of costs, and corporation tax is a cost so directors have to minimise it. It turns out that this is pretty straightforward.
First a quick bit of accounting theory and jargon definition. All businesses sell stuff, and the total value of the amount of stuff they sell in a year is called the turnover. Of course, the stuff sold was not free, so associated with the turnover is the costs of sales. Subtract the cost of sales from the turnover and you have the gross profit.
But the business has more costs than the stuff it sells. Typically it rents buildings, pays administrators and advisors, spends money on marketing and uses electricity and phones. All these costs are referred to as overhead. Subtract the overhead from the gross profit and you have what is generally known as the earnings (more precisely, the earnings before tax, interest, dividends and amortisation – abbreviated to EBITDA). If you subtract the interest from the EBITDA you get the figure used by HMRC to compute corporation tax. In essence the corporation tax bill is 20% of this figure. The remaining balance has to cover the costs of amortisation (essentially depreciation) and pay dividends to shareholders. Never forget that for public companies the shareholders are largely your pension funds. Paying them dividends is what produces a pension for you. Also, remember that if you receive a dividend you will be taxed on it as income.
It should now be obvious that the way to reduce a corporation tax bill is to reduce the value of EBITDA minus Interest. This can be done by either reducing EBITDA of increasing interest (i.e.by borrowing more). Reducing EBITDA means finding another cost, preferably one borne by shareholders (so they get paid). The easiest thing to do this with is a brand. If your company is benefiting form being able to use a brand it should pay for it. The payment for this is ascribed to overhead, and thus reduces EBITDA. Provided the brand is owned in a separate holding company (possibly domiciled in a tax haven) and the holding company is owned by the same shareholders as the trading company (easily arranged) then the payment for use of the brand is a transfer of profit to the shareholders free of tax (although there may be tax costs in getting the money from the holding company to the shareholders, which is why putting it in a tax haven is attractive). In essence this is what google, Manchester United, Amazon and the rest do. And now Crickhowell has joined them.
The BBC, Corbyn and Guardianista view is that this is immoral, which predictably misses the point. The real point is that the increasing globalisation of the world means that corporation tax is now pretty much voluntary. Governments can (and do) try to plug loopholes but companies (who have better lawyers and are generally better motivated) can find ways round it. The bottom line is that the UK is competing with every other country as a place for companies to domicile their activities. In this competition the UK has some huge advantages – the most obvious being its political stability, its currency, a permanent seat on the UN Security Council and (probably most of all) English Law, which is well understood and fairly applied. Other countries, with lower quality jurisdictions, compete on price -i.e. the corporation tax rate. For example, in Ireland it is 12.5% (with some sectors at 6%). In the USA it is 40%, most of the EU is around 30%. In the Isle of Man, the Channel Islands and Grand Cayman it is 0%.
So, you may say, at 20% the UK is looking pretty competitive. Clearly it isn’t as many companies are choosing to domicile elsewhere. So what can be done? The Guardianista solution is to ban companies from doing this – a policy that has failed utterly and can never win as the UK government’s jurisdiction ends at the coast. Naming and shaming has limited effects, particularly for quasi monopoly suppliers like Manchester United and Google. And it is a serious problem as those companies that have avoided their corporation tax bill are better able to compete (their costs are lower and so they can reduce prices while maintaining profitability. The lower pricing should get them increased market share).
How important is corporation tax? The 2015 budget anticipates government revenue of £672 billion. Of this just £42 billion (6.25%) comes from corporation tax. If the government cut the rate to (say) 5%, of even 1% it is a reasonable bet that the resulting £36bn shortfall should be recovered from the effects of increased employment and increased onshore profit. More importantly, and this is the main Crickhowell point, it would enable small companies to compete on a level playing field with the multi-nationals.
Crickhowell is now licensing its Fair Tax product to other towns. Forget Land of My Fathers – Crickhowell is in the land of the just. I might be moving.