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     Dec 3, 2011

Tax code folly
By Reuven Brenner

In November 2009, eBay Inc announced that an investor group led by Silver Lake had acquired a majority stake in Internet calling company Skype from the company. Skype's Estonian founders, Niklas Zennstrom and Janus Friis, retained a 14% stake and Silver Lake, investors including Andreessen Horowitz and the Canada Pension Plan Investment Board (CPPIB) held 56%, and eBay retained 30%. The deal valued Skype at $2.75 billion.

A year and half later, in April 2011, Skype's regulatory filing put the value of the company at about $5.1 billion. A month later, Microsoft bought the company for $8.5 billion, and there have been debates whether or not Steve Ballmer overpaid.

A simple numerical calculation shows that he did not. The "premium" Microsoft paid to Skype's owners was roughly what

they would have paid to the US government if Microsoft repatriated its money. If Microsoft brought back $8.5 billion to the US, it would have paid the 35% corporate tax, roughly $3 billion.

Thus, as far as Microsoft is concerned, its "net" payment for Skype amounted to $5.5 billion. However, instead of the US government getting $3 billion, private equity investors, the Canadian Pension Investment Board and eBay shareholders got most of it. Thank the US Congress for such a windfall.

This redistribution from potential tax revenues to private equity could not have happened if corporate taxes were not in the 35% range, inducing US companies to hold their money in foreign jurisdictions with much lower corporate taxes.

US companies with worldwide operations hold cash in foreign lands because they do not pay US corporate tax on the earnings of their foreign subsidiaries as they occur: They pay it only when the company repatriates them to the US.

While it is true that select pensioners and shareholders occasionally benefit from such arrangements too, as many pension funds hold private equity firms in their portfolio, they would benefit far more if such fiscal incentives to structure deals did not exist, since more companies would take the IPO route, and private equity financiers would not be able to get a few billion dollars for quickly flipping over a company.

To make Skype-type deals, the acquiring company had to accumulate the money outside the US, and the companies they would be acquiring would have to have the incentives to register outside the United States too.

With an estimated $600 billion held overseas, mainly by technology and pharmaceutical companies, successful start-ups have fewer incentives to take the IPO route in the US, have greater incentives to register in foreign lands too, and wait for being privately acquired. By registering their patents and copyrights in either the Netherlands or Luxembourg, their private sale or purchase would also pay little in the way of taxes.

Which is what they do: Skype was incorporated in Luxembourg, a jursidiction virtually free of corporate tax. Google's international operations are located in Ireland, where corporate taxes are 12.5%, but Google does not pay even this lower rate on the $12.5 billion revenues from its foreign operations.

The money from Google Ireland goes to Google Netherlands Holdings, and Ireland-based companies do not pay tax on money flowing into a company registered in another European Union country. After this tax-free Dutch detour, the money ends up in Bermuda.

Why is Netherlands in the middle? In part because the country has some unique legal entities, allowing corporations to pay no taxes. The Stichting are the most common not-for-profit organizations in the Netherlands though for-profit companies manage to get this tax exempt status, IKEA being the most prominent. It, like Google, end up paying 3% in taxes.

It's worth making a quick detour to see how this is achieved, since it shows what options are open to Washington if it wants US companies to compete internationally and also deal with preventing quick tens of millions of compensations to managers of private equity firms.

IKEA's parent is Ingka Holding, a Dutch company, entirely owned by Stichting Ingka, to which Ingvar Kamprad, its founder, donated all his shares in 1982. This non-profit is dedicated to "innovation in the field of architectural and interior design".

However, the foundation's cash is transferred to Stichting IKEA Foundation, which can use the money for "for investing long-term in order to build a reserve for securing the IKEA group, in case of any future capital requirements". (This Thanksgiving, every US family should pray for getting such charity, use the money to invest in future generations and secure the family name. Or, instead of praying, vote for it, next year.)

This is not the end of IKEA's legal structure. Inter IKEA Systems, another private Dutch company but not part of the Ingka Holding group, holds the intellectual property rights to its "trademark" and "concept". The owner of this Dutch entity is Inter IKEA Holding, registered in Luxembourg. A separate company in the Netherlands Antilles owns it, which in turn is run by a trust registered in Curacao. IKEA, as noted, ends up paying roughly 3% in corporate taxes.

Which brings us back to Skype. The Silver Lake Funds that owned shares in Skype were registered in the Cayman Islands, and eBay's Skype ownership was held by eBay International AG unit based in Bern, Switzerland. As long as the US has corporate taxes in the 35% range, whereas those in the rest of the world are much lower, one should expect:
  • such registrations to continue;
  • for the estimated $600 billion of US companies held abroad not to be repatriated;
  • for technology and any patent-holding US young companies to register abroad and rely less on the domestic IPO route.

    All the above have the impact of fewer IPOs, restricting options of the vast majority of US citizens to invest. Add to the above the increased regulatory and compliance burdens of the last few years and, last but not least, the extremely low interest rates and it is not surprising that private equity and venture capital have been by far the two best-performing asset classes in the US during most of the last 20 years, according to a recent Cambridge Associates report, but benefiting relatively few.

    If Washington wants to prevent redistribution of wealth from the vast majority of taxpayers to a few players in financial markets, only a drastic revision of the corporate tax code would do. Paradoxical as this may sound in this misguidedly deficit-focused debate, where growth and rebuilding-equity is needed the solution is to drastically lower some taxes while eliminating a large range of loopholes.

    If Washington also managed to stabilize the dollar while changing the tax code, the disappearance of trillion dollars in derivatives would bring about a further retrenchment of not only the financial sector but the legal/accounting sectors too, and bring about a much-needed reallocation of mathematical, statistical and business minds to other parts of the economy. The future of the retiring mass of Baby Boomers' pensions would start to be looking better too.

    Reuven Brenner holds the Repap Chair at McGill University's Desautels School of Management, and serves on the Board and investment committee of McGill's pension fund.

    (This is an edited version of an article that is also published by Forbes.)

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