Friday, March 28, 2014

Retail sales up (on the year)

In adjusted terms, core retail sales fell in February but remain much higher than they were at the same time last year.

Retail Sales to Feb 14

This chart excludes the Motor Trades and a strong upward trend can be seen, for the volume series in particular, from around spring 2013.  Volume in the Motor Trades category is up 15 per cent in the year but fell six per cent in the month.

In annual terms the increase in retail sales volume is close to the level seen during the spike in sales caused by the ‘digital switchover’ in late 2012 and higher than at any other point since the start of 2010.  It can seen that the annual growth in the value series is much more muted.

Annual Change in RSI to Feb

All in all, good but only weakly so.

Tuesday, March 18, 2014

The BoP Current Account: IFSC v non-IFSC

Last week’s slew of economic data from the CSO did little to provide a clear picture of the current direction of the economy.  In the national accounts data, 2013 GDP was down, albeit only slightly, while GNP was up a hefty 3.3 per cent.

GDP is a measure of the output that takes place in a region; GNP is a measure of the income that accrues to residents of a region.  A rise in GNP should be unambiguously good.  However, across the economy there is little to indicate what is driving the increase in income for Irish residents.  Employment is up but little else is.

Also released were the Balance of Payments data and this seems to paint a very positive picture.

BoP Current Account

The turnaround from a 6 per cent of GDP current account deficit in 2008 to a near 7 per cent of GDP current surplus in 2013 is impressive.  This is important for a country with a large foreign debt as one way to repay the debt is to have a net gain from transactions with the rest of the world. [The debt can also be paid down by selling domestic assets to foreigners.]

In part the improvement was driven by the fall in imports after the end of the credit-fuelled consumption and construction boom in 2008.

BoP Merchandise Imports

On issue with this is that the fall was abrupt and was completed by 2009 as construction, car sales and other elements of the economy ground to a halt.  So what has driven the continued improvement in the current account since 2010?

Last year, Prof. John Fitzgerald in a useful note outlined the impact that the retained earnings of companies re-domiciling to Ireland had on the figures.  In essence, when a company moves its headquarters to Ireland any retained earnings it has are counted as Irish “income” at the time the company moves to Ireland.  These are added to GNP as the companies have become Irish resident but they have no impact on the domestic economy.  If the companies subsequently remit them as dividends to their foreign shareholders they will subtract from GNP at that time.

The rise in the inflow of these earnings in 2010 is fairly clear.

BoP Reinvested Earnings

And the net flow due to re-domiciled companies was estimated by John Fitzgerald to be:

JF Redomiciled Companies

Again, one issue with this is the stepped nature of the increase.  This undoubtedly led to an improvement in the current account but in relative terms the current account continued in 2012 and 2013 when the impact of retained earnings seemed to have levelled out (though 2013 figures are not available).

Within the Balance of Payments the CSO provide a breakdown between the “IFSC economy” and the “non-IFSC economy”.  The performance of the current account for each are shown below.


In 2012 and 2013 the current account associated with “IFSC” companies has been increasing while that associated with “non-IFSC” companies has been flat.  The “non-IFSC” current account has improved since 2008 – because of the import reduction and also likely because of the re-domiciled firms – and there is only a very small “non-IFSC” surplus.

It is not clear to what extent the re-domiciled firms are “IFSC” or “non-IFSC” but it can be seen that the “IFSC” current account was largely unchanged in 2010 and 2011 when the effect identified by the John Fitzgerald was increasing.  It seems as though the impact of the re-domiciled firms is reflected in the 2010 improvement in the “non-IFSC” current account.

We can further break the “IFSC” balance into that determined by trade (service exports minus service imports) and that attributable to income (income inflows minus income outflows).

IFSC Balances

Both improves in 2013, but the balance of services for “IFSC” companies improved in both 2012 and 2013.  What is noticeable is that the service trade gains for IFSC companies is not reflected in an outflow of IFSC income.  The trading gains are likely accruing to Irish-resident companies and are thus recorded as part of GNP.

If the changes in the IFSC balances were due to the timing of the re-domiciling of companies it would only show up on the income side.  As the IFSC service balance is also improving it is the case that the improvement in the Balance of Payments current account (and thus the improvement in GNP) is down to the activities of IFSC companies. 

There aren’t many who would consider that an improvement in “Irish” income.  There are gains from this as around €1 billion of corporation tax is paid by IFSC companies annually (though this is a claim from the IFSC itself).  All this highlights the difficulties in ascertaining anything about the direction of the Irish economy given the impact things like the IFSC and MNCs have on the national aggregates.

In 2008 and 2009 Ireland’s current account improved because of the large drop in imports.  It seems much of the improvement since then can be attributed to re-domiciled firms (which are foreign owned) and the activities of IFSC companies.  They are unlikely to be of much use in helping to pay down our external debt.

SMEs and 70 per cent of employment

The relative importance of SMEs to the Irish economy has been touched on during the recent discussion of SME debt.  Sometimes it is stated that SMEs provide 70 percent on employment.  That is not quiet true.  Something along the lines of 70 per cent of people engaged (employee or proprietor) by private sector enterprises are with SMEs is better but it can be seen that this excludes all public sector workers and the self employed.

The 70 per cent figures comes from the CSO’s Business in Ireland 2011 survey which opens chapter one starts with “Six Key Findings from Business in Ireland 2011” of which the first is (emphasis added):

1. Key statistics on small and medium enterprises (SMEs)
In 2011, SMEs (employing less than 250 persons) accounted for 99.8% of active enterprises, 68.6% of persons engaged, 50.1% of turnover and 46.0% of gross value added (GVA). GVA is the gross income from operating activities and is the balance available to enterprises to pay employees and realise a return on investment. It is noticeable that while SMEs employed almost seven in every ten persons in the business economy, they accounted for less than half of GVA.

The seven in ten statistic clear refers to “the business economy”.  As stated this excludes public sector employees and the self-employed.

There are around 1.9 million people working in Ireland.  They can roughly be broken down as:

  • 800,000 in c. 180,000 SMEs (with < 250 employees)
    • 320,000 in c.170,000 micro enterprises (< 10 employees)
    • 260,000 in c.15,000 small enterprises (11 to 49 employees)
    • 220,000 in c.2,500 medium enterprises (50 to 249 employees)
  • 400,000 in c. 500 large enterprises (with > 250 employees)
  • 350,000 in the public sector (excluding semi states)
  • 350,000 self-employed (with and without paid employees)

SMEs count for around 42 per cent of employment in Ireland.  SMEs are the largest source of employment but not 70 per cent of it.

Sunday Business Post 16/03/14

Here is the submitted text for an article in this week’s SBP on SME debt, the state of the banks and this year’s stress tests for eurozone banks.  It continues below the fold.

Should we fear an SME loan meltdown?

In 2007 Prof. Morgan Kelly identified the likely 50 per cent fall in Irish house prices. He set out the implications this would have for construction employment but suggested that the larger banks were “well-capitalized” with unemployment and “macroeconomic dislocation” being the main problems that would emerge. The analysis was incredibly accurate on house prices and the consequences for employment and it wasn’t long before the impact on the banking sector also became clear.

The underlying factor to the most recent warning is not property price falls but the banks calling in loans provided to small and medium enterprises (SMEs) and in the event of their inability to repay the banks would foreclose on the businesses. Again the threat is to employment but it is not limited to 300,000 construction jobs; it is to SME employment across the entire economy.

Tuesday, March 11, 2014

Questions facing Ireland about Apple

In The Irish Times yesterday John McManus had a piece under the headline ‘Ireland faces questions on fruitful Apple tax deal’.  The three questions posed were:

  • Is there a “special” two per cent rate in Ireland for Apple?
  • Is there a “loophole” that allows Irish-incorporated companies to be non-resident here?
  • Is there a deal in Ireland to allow for “income taxed at lower rates”?
  • Should Apple have paid $890 million Irish corporate tax based on the 12.5 per cent rate instead of the $36 million paid?

At the time of the US Senate last May they was a lot of noise around a special 2 per cent tax rate that Apple had apparently negotiated with the Irish government.  There is no doubt that there were targeted and generous tax breaks given to MNCs who set up operations in Ireland in the 1970s and 1980s but there is no 2 per cent rate for Apple.

McManus calls it “the 2 per cent rate it told Congress that it had agreed with Ireland” and writes:

Apple have never withdrawn this assertion, but at the same time they have stood back and let the Government kick up as much dust as they can around the issue.

During the hearing it was the Senators who said there was a two per cent rate not the Apple executives.  Although put to them the Apple executives did not address it in the Senate hearing but around a week later, Apple CEO, Tim Cook, gave an interview (video here) where he said:

“I’ve seen something in the press that says that some people think that we have a deal with the Irish, a special deal with the Irish government, to pay two per cent flat tax rate.  We have no special deal with the Irish government that gives us a two per cent flat tax rate.  So let me just set that aside.”

So no special deals on rates.  Is there a special deal on something else?  McManus further adds:

The counter narrative advanced by the Government was that there is no special deal but Apple instead availed of a loophole in Irish law that allowed companies to be Irish registered but not Irish domiciled. This quirk of Irish tax law opened the door to low tax heaven we were told.

The loophole was closed in the Budget and the Government seems to have got the “no special deals” narrative back on track. Until last week that was.

Yes, Irish law does allow Irish registered companies to be non-resident.  There is nothing unusual or “quirky” about that.  The change announced in the Budget was not about making Irish-incorporated companies resident here.  The change was a minor one which did not change the residency rules. 

It merely said that if an Irish-incorporated company owned or controlled by foreign residents was not deemed to be resident in Ireland, under the test of management and control, that the company had to tell the Revenue Commissioners where they were resident.  There is no change in the ability to have non-Irish resident, Irish-incorporated companies it is just that such companies have to declare their tax residence and cannot be “stateless”.  These residency rules apply to all companies; not just Apple.

To conclude McManus goes back to rates with reference to “income taxed at lower rates” in ASI’s 2009 accounts.

Is this then the special deal that Apple told the US Congress existed but the Government denies? In the absence of any clarification it is a basis for legitimate suspicion and potentially a fatal hole in the “no special deals ” claim.

This puts them in a very difficult position because the EU and the European Commission – who seem to have bought the no special deal line – may be wondering quite rightly if they have been sold a pup. They no doubt would like to know what “income taxed at lower rates” means as should anyone else paying the full statutory rate of 12.5 per cent corporation tax.

The meaning of “income taxed at lower rates” is a legitimate question.  The answer is a tax rate of zero because the US allows Apple to defer the US taxes its owes on certain foreign-source income.

ASI will be taxed on the profits it generates from holding the global rights to Apple’s intellectual property in the country in which it is resident.  This could be in Cayman or Bermuda where there is no corporation tax or a corporation tax of zero.  Instead Apple set up a structure and chose to have ASI tax resident “no where”.  The corporate tax rate in “no where” is also zero.

Everything ASI does is in the US but because it is not incorporated there it is not deemed to be resident there.  ASI is incorporated in Ireland but it is a ‘relevant’ company to which the test of management and control is applied to determine residency.  ASI is not managed and controlled in Ireland.

The “income taxed at lower rates” is achieved by ASI because it is “stateless”.  The US does have the right to collect corporation tax on all the profits earned by ASI but this has been deferred until the profit is repatriated as dividends to the US.

The corporate tax liability on ASI’s profits is 35 per cent.  The corporate tax paid on ASI’s profits is almost nil.  The US does not want to see Apple pay corporation tax on this profit in another country as it will reduce the amount it can collect.  Ireland does not have any questions to answer on this.  It is a US decision to allow ASI to defer its US tax liability.


  • is there a “special” two per cent rate in Ireland for Apple?
  • is there a “loophole” that allows Irish-incorporated companies to be non-resident here? 
  • is there a deal in Ireland to allow for “income taxed at lower rates”?
  • is Apple avoiding paying $850 million of Irish corporation tax?

These are all legitimate questions but the answers are known. 

There is nothing Ireland can do that will result in more tax being paid in any other country.  Ireland can levy tax on profits that are sourced here by non-residents or earned anywhere by residents.  ASI does not source its profits here and is not resident here.  We could make ASI resident here by having all Irish-incorporated companies deemed Irish resident but what would happen then…

UPDATE: The Tánaiste, Eamon Gilmore, was asked these questions in the Dáil today by Joan Collins T.D.  The answer he provided is here

It deals with some of the issues but avoids others.  It is noticeable that the United States, US corporation tax or deferral provisions are not mentioned at all.  In the Senate hearing last May the US Senators were quick to heap blame on Ireland for outcomes caused by US tax laws – many that they had voted for.  On this side of the Atlantic we daren’t even say the name the country.

Residence and the test of management and control

Ireland’s corporate tax regime continues to attract attention.  The 12.5 per cent rate is low by any standards but it is the regime around the rate that is in the spotlight.

Much of the recent attention focuses on the test of residency Ireland applies to companies.  This is an important part of any corporation tax regime.  Apple Sales International is an Irish-incorporated company but is not resident here.  Is this unusual?

Ireland’s corporation tax regime is not unusual in one way: Ireland taxes resident companies on their worldwide income.  This is in contrast to a territorial system where resident companies only pay taxes on profits earned in the country they are resident in.  Some countries, most notably France, adopt territorial systems.  The US, notoriously, has a worldwide system, but unlike the US there are no deferral provisions for Irish companies paying Irish corporation tax on their non-Irish source income.

The deferral provisions available in the US tax code are the key factors behind the tax outcomes attracting attention in the current debate.  But tax residency is also important.  If a company is not a tax resident in Ireland but has operations here it will still be subject to Irish corporation tax, but only on the profits actually sourced here.

This is a common official line in the debate.  Ireland can tax the worldwide profits of companies which are resident here and also the Irish-source of non-resident companies.  A company cannot have profits in Ireland that are untaxed.  Naturally, Ireland cannot tax the worldwide profits of companies which are not resident here.  Claims to the contrary are wide of the mark and in the case of Apple people should remember that Apple is a US company.

Ireland’s residency rules are a relatively straightforward.  In general, a company is resident in Ireland if it is either incorporated in Ireland or has its place of central management and control in Ireland.

However, there are some exceptions to this and for certain companies only the test of management and control is used to determine if they are resident in Ireland.  The test of incorporation is not applied.

Under the “trading” exemption an Irish incorporated company is not treated as Irish resident if it is a ‘relevant’ company.  A ‘relevant’ company must either carry on a trade in the State or be related to a company that carries on a trade in the State and is one that is either ultimately controlled by non-residents or owned by non-residents (based on the stock market its shares are traded on), where the non-residents are in an EU or tax treaty country.  A company will not be a ‘relevant’ company if it is centrally managed and controlled in Ireland.

Thus, only the test of management and control is applied to some foreign-controlled or foreign-owned companies to determine their residence in Ireland even if they are incorporated here.  This provision is not available to “brass-plate” operations.  There must be a trade or “presence of substance” in Ireland.  Foreign companies can have non-resident, Irish-incorporated companies but only if they have a presence, i.e. employment, here.

The fact that the residency of some companies is solely based on the test of management and control is a factor in the “double-Irish” tax strategy used by some US companies to facilitate the deferral of their US tax liability while holding the profits in a low/no tax jurisdiction.

The “double-Irish” depends crucially on the “same-country” exemption in Subpart F of the US tax code.  Without this exemption the strategy is redundant.  In general, US corporation tax must be paid on US companies’ foreign-source passive income as soon as it is earned.  However, there are a number of provisions that allow the deferral of this tax until the profits are repatriated as dividends to the US.

The “same-country” exemption is one such provision.  Transfers of certain passive income between two companies in the same country do not trigger a US corporation tax payment – the view being that a transfer between two companies in the same country would not be done for US tax purposes.

However, what the US views as two companies in the same country (based solely on the test of incorporation) and what other countries view as two companies in the same country (perhaps based on the test of management and control) may not coincide.

In Ireland’s case some US companies have two Irish-incorporated subsidiaries.  The first can be a sales operations which is deemed as resident here and the second a related holding company to which the Irish “trading” exemption applies.  Though incorporated here the holding company will not be deemed a resident here as its effective management and control does not take place here (nor any other part of its structure or operations).  In many cases the holding company will be based in a low/no tax jurisdiction in the Caribbean.

The Irish-resident sales company will make patent royalty payments (passive income) to the Caribbean-resident holding company.  This will not trigger a US tax payment as the US tax laws view the two Irish-incorporated companies to be Irish residents and then the transfer between them benefits from a deferral under the “same-country” exemption.

As stated, the most crucial part of this scheme is the “same-country” exemption in the US tax code.  There would be no “double-Irish” without it.  The second part is the interaction with another country where companies incorporated there are not automatically deemed resident there.  The use of the test of management and control facilitates this.  This allows the companies to be in operated in different countries but the US law views them as being in the same country.

Ireland applies the test of management and control as the sole judge of a company’s residency for certain companies - ‘relevant’ companies as described above.  But Ireland is not unique in applying the test of management and control to determine residency.  There are some countries which apply the test of management and control when determining corporate tax residency to all companies.  These countries include:

The residency laws in these ten countries all allow the creation of “double-Irish” type tax structures where passive income transfers between US MNC subsidiaries can be made without triggering a US corporate tax payment.  There is nothing unique about Irish tax residency rules that facilitates the “double-Irish”.  [A country’s tax treaty network and withholding tax are also factors.]

It could be equally be a “double-Cypriot” or a “double-Mexican” or a “double-Sri Lankan”, and it is almost certain that some US MNCs have set up twin-incorporated companies in these countries to avail of the “same-country” exemption.  It just seems the companies that do it from those countries haven’t been put under the glare of public scrutiny.

But they are there.  Here is a report of Yahoo using a “Double-Singapore” and it even has a “Dutch-Sandwich”.

Yahoo recently introduced another circuitous path through the Netherlands to cut the taxes on profits from its Asian sales: Royalties travel from Singapore, through Dooves’s house, to another subsidiary in Mauritius, a tax-friendly island off the southeast coast of Africa.

They may be about to set up a similar arrangement in Ireland!  But it is not because of anything unusual or unique in Irish residency rules.  As the list above shows ten countries base residency on the test of management and control on which the “same-country” exemption depends. 

There is nothing unique or unusual about Ireland’s residency rules despite much opprobrium to the contrary.  The current international corporate tax regime confers the right on the US to tax the profits earned by Apple through its intellectual property.  The fact that the US does not immediately exercise that right and allows a deferral of the tax (in theory the tax must be paid – eventually) is a matter for the US and the US alone.

Maybe the system will change and the tax rights will be assigned differently, perhaps by formulary apportionment, and it would be helpful if the debate moved to such a discussion.  But why do that when you can just shout about Ireland.

Sunday, March 9, 2014

Who is to blame for ASI’s effective tax rate of 0.1%?

The current OECD-led network of tax treaties is about conferring the rights to tax income that is earned across borders.  The purpose of the treaties is to avoid double taxation so the right to tax is determined by the rules that underpin the treaties.

Under the current system the rights to tax Apple’s profits (earned from US research and development) lie with the US.  The fact that the US, through its deferral provisions, doesn’t exercise that right when the profit is earned but allows a deferral until the profit is “repatriated” is an issue for the US and the US alone.

Neither Ireland, Australia nor any other country have to right to tax those profits.  Ireland can affect the rate levied on profits earned in Ireland but Ireland has no jurisdiction over the profits of non-residents earned in other countries.  There is nothing that can be done here to change that.  Ireland has no right to tax the profits of non-resident companies earned outside of Ireland.

Is Ireland to blame for the US not collecting US taxes? No, but it suits Capitol Hill that Ireland is blamed. 

The current corporation tax system could be changed so that the right to tax the profits is conferred differently but that requires a change of the source, residence and transfer pricing principles currently used.  The OECD’s BEPS programme which change things but the debate is around the system as it is now.

Ireland’s corporation tax regime is deliberately attractive for foreign investment.  In general, however, these deliberations have given more thought to what not to change as opposed to what to change. 

A major part of the attraction is stability.  Things don't change - or at least they didn't up to last October.  Ireland’s corporation tax rate and regime get a lot of attention but what elements can be changed to change the outcome - the amount of tax paid either here or elsewhere?

There is no change that can be introduced in Ireland that will result in more corporate income tax being collected in say, Australia.  Australia could move to impose a greater tax on Apple for the “profits” it earns there but that would violate every tax treaty Australia has entered into which sets out what should be taxed where (source and residence) and how much should be taxed (transfer pricing).  Apple doesn’t earn profit by selling to customers in Australia; it earns profit by designing a product in the US that Australians want to buy.  The current rules attribute the profit to the activity in the US.  If Australia wants to collect more tax from the sale of Apple products there it can do so via an increase in sales taxes.

There is also no change that can be introduced in Ireland that will result in more tax being collected in the US.  There are a huge range of structures that can be put in place to allow US companies to defer the payment of their US corporate tax liability on their foreign-source income.  The “double-Irish” and “stateless income” have got some public attention but many more are possible.

Why do companies engage in these particular strategies? Stability.  Companies don’t like having to change and reorganising their structure is time-consuming and costly.

The “double-Irish” (so-called even though it would work in numerous countries) is based on residency and, crucially, on the “same-country” exemption in Subpart F of the US tax code which allows the transfer of passive income between two related companies without triggering a US corporate tax payment.  Companies use the “same country” exemption because it is a permanent feature of the US tax code – it needs a vote in Congress to be repealed.  And the US law won’t change.  The other part involves finding a country that with appropriate residency rules.  There are lots of possibilities.  The US companies want a country that determines residency on the basis of the test of management and control.

Here is the company residency rule for Malaysia:

A company is resident in Malaysia if at any time during that basis year the management and control of its business is in Malaysia.

Legally that is all that is required to set up a “double-Irish” type structure.  The US company can establish two Malaysian-incorporated companies but have the management of one in another country – such as a Caribbean Island.  The US parent company can transfer passive income between the two companies and use the “same-country” exemption to avoid triggering a US tax payment.  Malaysia won’t tax the second company, the one holding the profits, because it is managed in another country.  This is the “double-Irish”, Malaysian style.

Why don’t US companies use Malaysia instead of Ireland?  There are many reasons but stability is an important one.  They don’t want to have to reconfigure their arrangement because the country changes its rules.  They want stability.

The residency rules in Ireland are actually more restrictive than those in Malaysia. Historically, the residency rule was (from

All companies whose central management and control is exercised in Ireland (whether it is incorporated in Ireland or not) is regarded as resident in Ireland for tax purposes.

This was revised in the Finance Act, 1999, and now:

in general, companies incorporated in the State are resident in the State.

However, there are exceptions to this is.  One is a ‘relevant company’ that is ultimately controlled by persons resident in the EU or in a country with which Ireland has concluded a double taxation treaty and is related to a company that carries on a trade in the State  - the “trading” exemption.

This is a key feature of the Irish corporation tax regime.  It allows the residence of some companies to be determined by their ultimate control – the test of management – but only for companies that are related to companies that trades here.  You can only trade if you have employees.  A “brass-plate” operation is not sufficient; companies need a presence of substance, i.e. employment, to be able to avail of this provision.

Could we change our tax residency rules to make all companies incorporated here resident here?  Of course we could.  That would definitely end any reputation for stability and it would end the opportunity for US companies to avail of the “same-country” exemption here.

We could do this and it is the case that the US companies don’t need the Irish residency rules (or equivalent based on management and control) to achieve the same tax outcome.  In fact using the “look-through” rule they don’t need any residency rules at all to facilitate the passive income transfer to a related company in a low/no tax jurisdiction.  Certain related companies in any two countries will do. 

The “look-through” rule is far less restrictive than the “same-country” exemption and could be considered the “any country” exemption.  Under the “look-through” rule hierarchical subsidiaries of a US company can be treated as a single entity by looking through the lower level to reach the higher level.  Using this, passive income transfers can be made between subsidiaries in different countries as the transfer is considered to have happened within the same entity, so in essence is not considered to have happened at all.

Ostensibly, this was introduced to allow US companies to redeploy their foreign earnings in one country for re-investment and expansion in another country without triggering a US corporate tax payment.  This is true for the majority of companies who use the rule but a small number of hugely profitable companies can use the rule to accumulate profits in low/no tax jurisdictions without triggering a US corporate tax payment.

So why don’t companies use the flexible “look-through” rule instead of the more restrictive “double-Irish”?  Many do but the “look-through” rule is only a temporary feature of the US tax code.  Unlike the “same-country” exemption which requires a vote in Congress to be repealed, the “look-through” rule requires a vote in Congress to be continued.  It actually expired at the end of the 2013 tax year but there is still plenty of time for it to be appended to any bill for it to apply for the 2014 tax year and beyond.

The “look-through” rule gave legislative effect to the “check-the-box” election introduced by the IRS in 1996/7.  “Check-the-box” is little more than an administrative process in the IRS (but obviously one that has huge implications).  “Check-the-box” allows US companies to determine if an entity in their structure should be treated as a taxable entity on its own right or combined with several subsidiaries to form a single taxable entity.  By combining subsidiaries in a single tax entity the company can make passive income transfers between them without triggering a US corporate tax liability – the tax is deferred.

The “check-the-box” provision can be changed at any time.  The IRS actually proposed doing so in both 1998 and 2003 but a non-binding resolution was passed in Congress asking the IRS not to change the provision – the IRS complied.  And anyway, Congress went ahead and partly formalised “check-the-box” with the introduction of the “look-through” rule in 2005.

However, there is sufficient doubt around the provision such that companies will seek a structure that is not dependent on it.  They use it but if “check-the-box” changes they will ensure they can achieve the same result without it.  The “same-country” exemption offers that security hence the use of “double-Irish” type structures.

The “stateless income” scheme of Apple was also based on stability.  First was the certainty that the US would not change its company residency rules. They didn’t.  And certainty that ‘stable’ Ireland would not change its residency rules.  But we did!

Although it was a very small change, and will have no effect on tax outcomes, the knock-on consequences of Ireland changing have yet to be determined.  It is likely that a significant amount of thought went into the decision and as stated above more thought in Ireland goes to determining what not to change rather than what to change.

Apple’s “stateless” income strategy only works if the relevant company is not managed and controlled in Ireland otherwise it would be resident here.  But everything ASI does happens in the US.  Here is the company residency rule, Article 2.8, in the Ireland-France tax treaty:

A company shall be regarded as a resident of Ireland if it is managed and controlled in Ireland. It is agreed that this provision does not prevent the application, according to Irish law, of the corporation profits tax in the case of a company incorporated in Ireland which is not managed and controlled in France.

A company shall be regarded as a resident of France if it is managed and controlled in France.

That is pretty clear.  The residence of a company is based on the test of management and control.  There is no possibility of setting up a “stateless company” between Ireland and France; it has to be managed and controlled somewhere. 

US law does not recognise management and control.  It is a US judgment that a US company which carries out all its operations in the US is not tax resident in the US.  Who is to blame for that?

Ireland’s rate and regime undoubtedly play a role in determining the very low effective tax rates attributed to some US companies but not one that is overly significant.  The 12.5% rate is nice but that only applies to profits earned here (the companies will be subject to making up the balance at the 35% US rate anyway – if the US wants to collect it).  The regime has its attractions but none are so significant that if they were removed the same tax outcomes could not be achieved by US companies.  The government are trying to foster a reputation for transparency and cooperation.  That sort of reputation doesn’t concern the companies; a reputation for stability does.  On the tax side companies use Ireland because they don’t like change.

Yes, we have a low rate.  Plenty of other countries do too.  Yes, we have favourable residency rules for US companies. Plenty of other countries do too.  We have a reputation for stability, not many countries have that.  Britain’s “patent box” is unlikely to form a major part of MNC tax strategies until it becomes embedded as a part of the UK tax system that is unlikely to change (which will take a couple of years of Labour in power).

If Ireland is guilty of anything in the international application of corporation tax, it is stability. A good reputation is hard won but easily lost.  A bad reputation can be hard to shake off.  In any debate if you are explaining you are losing; Ireland is losing.

Saturday, March 8, 2014

Apple is a US company

The media debate about Apple’s tax strategies continues, and continues to be wrong.  The Irish Times today features an editorial under the heading ‘Apple’s lucrative tax loophole’.

The first thing to note is that Apple is a US company and therefore has to pay US taxes on all its profits.  If Apple operates in other countries, as it does, in those countries it only has to pay tax on the profit it actually generates within those countries.

Apple takes on limited risk outside the US.  It engages in manufacturing, distribution, and retailing.  In Apple’s operations none of these are very risky and none of them are very profitable.

The main source of Apple’s profits are the products it designs.  If Apple designs a good product, activity along its manufacturing, distribution and retailing arms will increase.  If Apple designs a poor product that people don’t want to buy, the activity along Apple’s manufacturing, distribution and retailing arms will decrease.

Apple’s manufacturing, distribution and retailing arms contribute almost no risk to Apple and do not add significant value to Apple’s operation; designing innovative products does that.  Apple could, and sometimes does, outsource manufacturing, distribution and retailing.  It does not, nor will not, outsource designing.  Apple is a designer of products.

Apple is rightly taxed where the intellectual property that results from this innovation is located.  That is in the United States and the US rightfully taxes US companies on their global profits.

If Apple makes profits from selling to customers in Australia, the UK, Japan, Ireland or any other country it will have to pay tax at 35% to the US Treasury (less credits for any income tax paid on the profits from any low-margin manufacturing, distribution or retail activities it carries out itself in those countries).

Apple does not owe taxes on the profits earned by its intellectual property to any country but the US.  That investment took place in the US; the R&D was organised and carried out in the US; and the resulting patents and copyrights (and of course Apple’s trademark) are held in the US.  Apple is a US company that owes US taxes.

But here is where the wrinkles come in.  In many instances the US does not immediately collect the tax on the foreign-source (i.e. outside the US) income of US companies.  The US levies the tax but does not collect it. Provisions in the US tax code allow the payment of the corporate tax by US companies to be deferred until the profit is repatriated from certain foreign subsidiaries to the US parent.

There is a universal deferral for the active income from manufacturing.   However, Apple and related “new economy” companies don’t make their profits from manufacturing; they make them from ideas.  Ideas generate what is known as passive income.  A patent holder earns money by charging to allow the use of the idea.  The patent holder doesn’t have to do anything, they charge someone to allow them to do something.

If a US company earns money from passive income it is immediately subject to the 35% US federal rate of corporation tax.  If this was universal it would be end of the story.  Apple earns lots of profits from selling to customers and most of this is rightfully attributed to the high-risk R&D it engages in so if the profits earned by Apple’s patents were taxed at 35% this vacuous debate would not be happening.

In fact, it might be that a proper debate of the global system of corporation tax would occur.  One that discusses, and understands, the merits and faults of the current system based on the source and residence principles, and the oft-proposed moved to formulary apportionment. 

Alas, we are a long way from that.  Why is that the case?  The reason, and almost the only reason, that gives oxygen to this debate is that the US does not collect its 35% federal corporate income tax on the passive income earned by foreign subsidiaries of US parents.  There is a raft of deferral exemptions built into the US tax code that allow these deferrals.

Apple earns huge profits as a result of its US-created intellectual property.  Apple enters a cost-sharing agreement with a foreign subsidiary and licenses it to use its intellectual property in markets outside the US.  This subsidiary, in turn, charges hefty license fees to Apple’s manufacturing and retailing divisions right around the world.

Given the current success of Apple this subsidiary accumulates massive profits.  Under US tax law the earning of this subsidiary are passive income (they come from the licensing of intellectual property) and therefore immediately subject to the 35% corporation tax.  The subsidiary is using intellectual property developed in the US so this is what could be expected to happen.

But it doesn’t.  Although passive income should immediately trigger the US 35% corporate tax it is very simple for US companies to avail of some of the many deferral provisions that have been appended to Subpart F of the US tax code over the years.  These have a variety of names that include the “check the box” provision, the “look-through rule” and the “same- country exemption”. 

The detail is unnecessary but the effect of these is to allow US companies to defer US corporation tax on their foreign-source passive income that would otherwise be immediately subject to the 35% US corporation tax (with credits for any income tax paid in other countries).  If interested there are some useful details in this Forbes article, opprobrium aside.

The starting point is the cost-sharing agreement the parent company enters with the foreign-subsidiary to allow it to avail of the intellectual property.  In Apple’s case this subsidiary is Apple Sales International.

The Irish Times editorial states:

ASI was, under Irish law, regarded as a “stateless” company.

There is, nor ever was, a provision under Irish law that allowed a company to be “stateless”.  Ireland has a pretty standard set of rules for determining whether a company is resident here.  Using those rules ASI is not resident in Ireland and there is nothing untoward about that.  International companies are non-resident in most of the countries they operate.  They are a resident in one.

The key is the other country ASI operates in.  In fact almost all of ASI’s operations are in this other country but that country did not judge it to be resident there.  All of ASI’s activities are carried out in the US, but under US law residency is determined on the basis of place of incorporation.  ASI in incorporated in Ireland.  Again there is nothing unusual about companies being incorporated in one country and being resident somewhere else.

The key here was that Apple designed a company that was tax resident nowhere.  It was gaps between tax codes that allowed this not any loophole in the Irish tax code.  Ireland has moved against it but not to make companies like ASI resident here.  The change will merely ask companies that fail the test of management and control here to state where they are resident with a failure to do so resulting in them being deemed resident here.

This was a move for reputational reasons only.  It will have no impact whatsoever on the tax paid by Apple.  Apple is a US company that owes US tax.  It is laws passed by the US Congress in Washington that allow Apple to defer the tax due on its passive income.

The US companies are happy with this and despite much loud gnashing of teeth the US politicians are happy with this.  The fact that much of the ire is being directed at Ireland suits all the US participants.

If the US immediately taxed the foreign-source passive income of its companies the residency of ASI would almost be an irrelevancy.  If that was the case you can be sure that the US would not be happy if ASI was deemed Irish resident.  Then Ireland would be collecting tax at 12.5% on profits which are the result of US activity and risk-taking.  If so, the amount collected by the US 35% corporate tax rate would be reduced by the 12.5% tax collected in Ireland. Ireland has no entitlement to tax the profits earned by Apple’s intellectual property (but can, and does, tax Apple for the limited activities that take place here).

Apple is not avoiding any Irish tax on the profits earned by its intellectual property.  There is no sane reason to argue that Apple owes corporate tax to Ireland for sales to customers in Australia, Germany, the UK and Japan which generate profits based almost entirely on intellectual property developed in the US (some manufacturing and retailing that takes place here aside).

It is a nonsense argument but one that continues.  And in any debate if you are explaining you are losing.  Ireland is losing.

If the US wants to collect tax on Apple’s foreign-source passive income rather than allow it be deferred it could do it almost overnight.  It would be an easy change.

Instead the US continues to allow deferral provisions that exempt foreign-source passive income from immediately paying US corporation tax (the tax is due but only has to be paid when the foreign-source profit is repatriated to a US-resident company, and in the absence of this transfer then payment of the tax can be deferred indefinitely).

Does Ireland allow US companies to avail of the deferral exemptions available in the US tax code? Of course we do.  But they are US exemptions not Irish ones.  There is no Irish “loophole” that allows US companies to avoid US tax.  [And there is no unilateral provisions in Irish law that affects the tax collected in other countries.]

Suggestions that Apple “reduced its Irish tax bill by over €850 million” as claimed by The Irish Times are beyond ludicrous.  Apple takes almost no risks in Ireland so to suggest that Apple in Ireland generated €850m/0.125 =  €6.8 billion in profit (and that just from selling to Australians) is absurd.  Apple owes US taxes on that profit and it is up to the US to collect it.  We don’t have to be their policeman.

The risk Ireland faces is that the US reforms its tax code and closes off some of the deferral provisions that the US technology and pharmaceutical companies come here to use.  There is lots of noise around US tax reform but no sign of anything substantive emerging.

For now, we should just remember that Apple is a US company that owes US taxes and stop falling into the trap that suits those in the US – blaming Ireland.

Friday, March 7, 2014

Ireland and Apple – again!

The tax strategies of Apple get plenty of coverage in today’s papers.  This follows from an extensive report published by the Australian Financial Review yesterday.  There is no doubt that Apple aggressively manages its global tax affairs and while Ireland is a part of that it is by no means the most important part.

The first part is that corporation tax is not organised on the basis of the some form of “destination” principle like for VAT or sales taxes.  Under a such a system (or one based on formulary apportionment) some corporate income tax would be collected in the jurisdiction in which the products are sold.  There are many complaints from countries where companies like Apple have huge sales but pay very little corporation tax.  This is an argument against the system of corporation tax, not Irish corporation tax.

Corporation tax is based on a combination of the residence and source principles and tax treaties help manage the crossover of taxing rights via rules on double taxation.

Source refers to where the value added is created (albeit subject to shifting through transfer pricing) and residence refers to the domicile or location of the company.  In general, companies deemed resident in a country are taxed on all their net income regardless of where it is earned and non-resident companies are taxed only on their profits sourced within that country.

Apple has large sales in Australia but because corporation tax is only charged on the profits sourced there Apple is able to use transfer pricing to shift the profits out of Australia.  Apple can (legitimately) argue that very little value added is created in Australia and that all it does there is sell to customers.  In Australia, Apple is taking on limited risks, limited functions and has limited assets, thus the logic within transfer pricing principles would say that its return should also be limited.

An argument for corporation tax on the basis of customers needs a huge change in the international system of corporation tax.  It could be done but it is not in place now.

For a company like Apple the key elements of its operation to which added value can be attributed are research and development, intellectual property, manufacturing, distribution and retailing.  Under the current system Apple logically asserts that their added value does not come from their customers but principally from the creativity underpinning their products, which is captured through patents and copyrights.

So once Apple has attributed the value added to the intellectual property the next question is the residence of the company that owns the intellectual property.  As the IP is owned in that country all the net income earned by the IP will be taxed in that country.

And this is where Ireland comes in.  Or is it?

The company that owns Apple’s intellectual property (outside the US) in this case is Apple Sales International (ASI).  ASI is an Irish-incorporated company but incorporation played no role in the description above – residence did.

ASI is not an Irish-resident company.  It, for want of a better description, is like a company that was born here but now lives somewhere else.  Under Irish tax law the residence of some companies is evaluated on the basis of where they are managed and controlled.  ASI is one such company to which this test is applied.  Where is ASI managed and controlled?

Here is US Senator, Carl Levin (D) on ASI:

Prior to 2012, ASI, like AOI,  had no employees and carried out its operations through the action of a U.S.-based board of directors, most of whom were Apple Inc. employees in California. Of ASI’s 33 board meetings from May 2006 to March 2012, all 33 took place in California.

In short, these 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.

Here is an extract from the questioning of Apple executives at the Senate hearing last May:

Senator LEVIN. Mr. Bullock, does Apple Inc. own directly or indirectly AOI, AOE, and ASI?
Mr. BULLOCK. Yes, Apple Inc. owns directly or indirectly AOI, AOE, and ASI.
Senator LEVIN. All right. So all those companies in Ireland are owned by Apple effectively. Is that correct?
Mr. BULLOCK. They are all legally owned by Apple Inc., yes.

Senator LEVIN. All right. Now, relative to ASI, Mr. Bullock, is ASI functionally managed and controlled in the United States?
Mr. BULLOCK. As a practical matter, applying the Irish legal standard of central management and control, I believe that it is centrally managed and controlled from the United States.
Senator LEVIN. And does Apple agree that it is functionally managed and controlled in the United States?
Mr. BULLOCK. Under Irish law——
Senator LEVIN. No. Under our law, do you believe that?
Mr. BULLOCK. I do not believe that central management and control is a legal term under U.S. tax law.
Senator LEVIN. All right. Do you believe it is functionally managed and controlled in the United States?
Senator LEVIN. Mr. Cook, do you agree?
Mr. COOK. We have significant employees in Ireland. We have about 4,000. And so there is a significant amount of decisions and leadership and negotiations that go on in Ireland. But some of the most strategic ones do take place in the United States.
Senator LEVIN. Would you agree on balance that ASI is functionally managed and controlled in the United States?
Mr. COOK. From a practical matter. I do not know the legal definition of the word.
Senator LEVIN. As a practical matter, you would agree that it is functionally managed and controlled in the United States?
Mr. COOK. Yes, Senator.

[If you want to watch this exchange, and the executives squirm a bit, go to around 02:40:00 of the video of the hearing. The full exchange on this issue lasts until around 02:49:30.]

Today we have reports in The Irish Times here and the Irish Examiner here making various claims about Ireland’s role in Apple’s tax strategies.  The most important detail is that ASI is not resident in Ireland.

The report in the Irish Examiner begins:

More than $AUD8.9bn (€5.8bn) in profits have flown from Apple’s Australian operations in the past 10 years to Apple’s Cork subsidiary, it has emerged.

ASI is not Cork-based; it is based in Cupertino, California.  The report subsequently says:

Certain Apple companies registered in Ireland pay no tax in the country due to a loophole in both the Irish and US tax codes.

There is no loophole allowing certain companies to “pay no tax” here.  It is a standard rule.  In fact, in the OECD’s Model Tax Treaty the tie-break rule for determining the residence of a company is the test of management and control, which is what is applied by Ireland. 

In The Irish Times report it says:

According to accounts obtained by The Irish Times for one of those unlimited companies, Apple Sales International (ASI), the consumer electronics giant cut its Irish tax bill by more than €850 million between 2004 and 2008, using an unexplained “lower rate”.

ASI provides “sales and marketing services” to Apple subsidiaries around the world that sell iPods and iPads. Between 2004 and 2008, it reported profits before tax totalling $7.11 billion on sales of more than $29 billion.

The accounts for those years state the corporation tax that would be due using Ireland’s 12.5 per cent rate – €890 million over the five years. But they also show how much corporation tax ASI actually paid to Irish authorities – just €36 million.

As ASI is not resident here, it only has to pay corporation in Ireland here on profits actually sourced here.  ASI generates most of its profits from the intellectual property it holds and that is not located here.  It is located in Cupertino, California.  These profits that ASI accumulates are managed by Braeburn Capital in Reno, Nevada and the money is deposited in New York banks.  The money never even passed through Ireland.

Tax of €36 million on the profits indicated suggests a tax rate of 0.1%.  A useful description that shows how such a low tax rate can be achieved was provided in a post from last May.  None of this is news but it is deemed worthy of front-page coverage today.

So there is just one question that remains. Where is ASI resident?  That is in the United States surely.  Almost everything to do with ASI happens in the United States.  Everything that is, except its incorporation.  ASI is an Irish-incorporated or registered company.

Under US rules, the test of incorporation is used to determine the residence of a company.  ASI is not incorporated in the US therefore is not deemed to be US-resident.  Sen. Carl Levin again

Apple is exploiting an absurdity, one that we have not seen other companies use. The absurdity need not continue. Although the United States generally looks to where an entity is incorporated to determine its tax residency, it is possible to penetrate an entity’s corporate structure for tax purposes, and collect U.S. taxes on its income, if the entity is controlled by its U.S. parent to such a degree that the shell entity is nothing more than an “instrumentality” of its parent, a sham that should be treated as the parent itself rather than as a separate legal entity. AOI, AOE and ASI all sure seem to fit that description.

The “absurdity” he is talking about is not in Irish tax law; it is in US tax law.  The “absurdity” allows a company that carries out all its operations in the US not be taxed there solely because it is incorporated somewhere else. Sen. Levin calls it a “sham”:

Our legal system has a preference to respect the corporate form. But the facts here present this issue:  Are these offshore corporations so totally controlled by Apple Inc. that their identity as separate companies is a sham and a mere instrumentality of the parent, and if so, whether Apple’s claim that AOI and ASI owe no U.S. taxes is a sham as well.

Apple is exploiting a gap between tax codes rather than within them.  Ireland uses the test of management and control to determine ASI’s residency.  As it is managed and controlled in the US it is not resident here.  The US uses the test of incorporation to determine ASI’s residency.  As it is incorporated in Ireland it is not resident there. 

It seemed incredible at the time but ASI was tax resident nowhere.  The “lower rate” that The Irish Times refer to is that tax rate that applies to “stateless income”, i.e. zero.  It is not a rate that is applied by either country [there are no “special” rates in Ireland – well not now anyway; see here and here] it is a rate created by claiming the company is resident nowhere.  That is wrong.

Either or both of Ireland and the US could have moved against this.  Ireland did with the announcement in last October’s budget that Irish-incorporated companies that are not judged to be resident here under the test of management and control must state to the Revenue Commissioners where they are actually resident or they will be deemed to be resident here.  It closed the loophole between the Irish and US tax systems.

The US could have moved in a number of ways.  Apple is, after all, a US company. 

  • The US could follow Sen. Levin’s approach and judge ASI to be an instrumentality of the parent and therefore taxable in the US through its parent. 
  • The US could apply the test of management of control to companies operating there. 
  • The US could amend Subpart F of the US tax code and limit Apple’s ability to defer the tax due on this income.  [It is commonly said that Apple avoids tax using this scheme but the actual effect is to defer the payment of the 35% US corporation tax due on the profits.  Though this deferral can be indefinite if the money is not transferred to a US-resident company.]
  • And finally the US could examine the cost-sharing agreement between Apple and ASI that transfers the global rights of the intellectual property to ASI.  After all, another possible source of the value added is not the intellectual property but the R&D that resulted in the design of the products in the first place. 

But it was Ireland that moved.

Will it make any differences to Apple’s tax bills?  Probably not.  There are lots of provisions in the US tax code that will allow it to continue to defer its US taxes – the “check the box” provision, the “look-through” rule and the “same country” exemption will achieve the same result.  Apple will have to adjust its tax strategy if it wants to maintain the zero rate that it achieved on the “stateless income” until repatriation but that can be achieved by shifting the profits to Bermuda where the rate of corporation tax is … … … zero. 

The dance between companies and countries continues but there is no sign that the countries have cornered them.  There are a lot of eyes on Pascal Saint Amans but apart from an increase in transparency it is still not clear what the OECD BEPS project will actually deliver.  It will not be a shift to a destination-style system of corporation tax based on customers but some system of formulary apportionment is possible (though not in the near term).  The dance will continue for a good while yet.

Wednesday, March 5, 2014

Arrears Capitalisation

Among several interesting developments in the mortgage arrears update from the Central Bank released yesterday is the emergence of ‘arrears capitalisation’ as the most used restructure on the loans covered in the statistics.

Here is a summary of the year-end positions for the type of restructures used since 2010. 

Mortgage Restructures

Over the past year the proportion of arrears capitalisation in the restructure figures has increased from 12.2 per cent to 22.0 per cent.  The largest drop is for interest-only restructures (prior to 2013 interest only agreements were not broken down by those < or > 1 year). 

One question that arises is what exactly does arrears capitalisation mean and what has happened to the 18,516 accounts to which it has been applied?

In their release the Central Bank (in footnote 2) say :

Arrears capitalisation is an arrangement whereby some or all of the outstanding arrears are added to the remaining principal balance, to be repaid over the life of the mortgage.

However, this does not reflect what happens.  Arrears capitalisation does not add any of the arrears to the balance; it sets the arrears to zero and recalibrates the payment based on the principal outstanding and the term remaining on the loan at the time of the restructure.

This new payment will be higher than the payment set out under the original payment but this is not because arrears are added to the balance.  The new payment will be higher because a greater principal amount and more interest needs to be repaid over the remaining term of the loan.  This is undoubtedly because the borrower missed payments and went into arrears but the higher payment can be calculated automatically and is not the result of any arrears being “added on”.

Consider a 20-year, €200,000 mortgage at 4% fixed interest which is five years into its term.  The monthly repayment is €1,212 and after five years the balance should be reduced to €163,800. 

Assume that in year 4 the borrower missed 12 full payments in a row and then resumed making the “full” payments of €1,212 in year five.  The borrower is 12 x €1,212 = €14,544 in arrears and the balance owing at the end of year five will be approximately €179,250.

At the end of the third year the balance would have reduced to €179,180.  During the fourth year of no payments the interest will be added as per usual and with no offsetting payments this will bring the balance up to around €186,400 at the end of year 4.  The resumption of the monthly payments of €1,212 for a year will reduce the balance to €179,250 at the end of year 5.

The borrower owes €179,250 and has arrears of €14,544.  It should be noted that the amount of arrears has nothing to do with the amount owed.  They are calculated separately.  The amount owed is the principal plus daily interest (added monthly) less any repayments made.  The arrears are the amounts of missed repayments relative to those set out in the original contract.

So what to do with the €14,544 of arrears?  The borrower has failed on a necessary contractual obligation so they need to make good the shortfall.

One option is for the borrower to pay €14,544 in a lump sum and have that amount offset against the balance immediately clearing their arrears.  The amount owing would drop to €164,706 (close to where it should be under the original contract) and the borrower could continue making the monthly €1,212 payments to repay the loan over the original 20-year term.

A second option is to repay the arrears, or catch up on their contractual obligation, in instalments.  If the borrower paid an additional €500 per month on top of the €1,212 payment they would have the arrears of €14,544 cleared in 29 months and would be roughly back on track and could again continue with the original €1,212 payment for the remaining 12.5 years or so.

The concept of arrears capitalisation is similar to this but it has the borrower catch up with the repayments right at the end of the original  term so is based on time rather than some monthly overpayment amount on the arrears. 

In our case the borrower owes €179,250 after five years of the original 20-year term.   At the 4% interest rate this cannot be repaid with monthly repayments of €1,212 over the remaining 15 years.  In fact if the borrower continues to make these monthly repayments there will still be around €41,000 owing at the end of original 20-year term.

An alternative is to recalibrate the repayment so that the €179,250 owing at the end of year five is repaid over the remaining 15 years of the mortgage.  To do this at the 4% interest rate would require a monthly repayment of €1,326.  If the borrower makes this monthly repayment to this level the full amount owing will be repaid over the original 20 term of the loan set out in the original contract.

The monthly payment has increased but it is not because any “arrears are added to the remaining principal balance”.  The arrears figure was not used to calculate the new repayment.  The arrears figure is a memo item that reflects the level of missed repayments and, by itself, does not feed into the principal, interest and repayment calculations on the loan.

The new repayment figure is higher because the borrower has borrowed more money for longer than originally intended.  The borrower owes more interest.

Instead of having the balance down to €163,800 by the end of year five; the balance was only reduced to €179,250.  Obviously the difference is because of missed payments (and a small amount of interest on interest) but regardless of the level of arrears the amount owing will be automatically calculated - interest is usually calculated on the closing balance each day and added monthly or quarterly.

Arrears capitalisation is simply recalibrating the monthly repayment so that the balance owing is repaid over the remaining term of the loan.  It also involves setting the arrears to zero as the contractual obligations have changed rather than having them cleared by a once-off or temporary overpayment.

It is also possible to combine the arrears capitalisation with other restructures, primarily term extensions.  In the above example it would be possible to keep the repayment at €1,212 and instead repay the loan over 17 years instead of the remaining 15.

The borrower loses nothing from the arrangement.  It is a win-win for the borrower.  There is nothing added to their loan balance and their credit record will be restored faster with the arrears cleared. 

Here is a summary of the case outlined here: balance owing

  1. Draw down mortgage at outset: €200,000
  2. Make agreed €1,212 payments for 3 years: €179,180
  3. Make no payment for a year: €186,400
  4. Make €1,212 payments for a year: €179,250
  5. Reset the arrears to zero and fully repay the loan with a recalibrated payment of €1,326 for 15 years: €ZERO

If the borrower had stuck to the original repayment schedule the full amount repaid over 20 years (240 months) would have been:

€1,212 * 240 = €290,880

As a result of the missed payments and the recalibration at the end of year five the amount to be repaid over the 240 months will actually be:

(€1,212 * 36) + (€0 * 12) + (€1,212 * 12) + (€1,326 * 180) = €296,856

If the arrears capitalisation is combined with a two-year term extension the total repayments are:

(€1,212 * 36) + (€0 * 12) + (€1,212 * 12) + (€1,212 * 204) = €305,424

In the latter two cases the borrower has to repay more but it is not because any arrears were ever added to their balance it was because they had borrowed money for longer and dditional interest is added in the standard way that interest is calculated.

The description of “arrears capitalisation” is a bit of a misnomer.  It is possible that “arrears amortisation” might be a better description as the borrower has agreed to catch up on their repayments over the remaining term of the loan.

So why is this approach proving so popular now?  If the borrower can stick to the recalibrated payment it has the advantage of returning the loan to the performing category and removes the loan from the arrears statistics.  Are the borrowers meeting the new repayments.  Some are, but many aren’t.

The Central Bank provided a new table of the “success” of each type of restructure.  For the main restructures used on PDH accounts “arrears capitalisation” is the least successful – less than 60 per cent of borrowers are sticking to the new terms.

Mortgage Restructure Dec 2013

The restructure that is the most popular is also the one that has the lowest success rate.  In saying that if 57.9 per cent of the 18,516 accounts to which arrears capitalisation was applied are cured that is over 10,700 accounts that are back “on track”.  This depends on what ‘meeting the terms of the arrangement’ actually means which is unclear.

Of course, there are 42.1 per cent who are not meeting the new terms.  There is some underlying reason why they fell into arrears in the first place.  Unless that was temporary in nature and the borrower’s repayment capacity has been restored they will not be able to meet the new repayment, which will almost certainly be higher (depending on interest rate movements for tracker and SVR mortgages).

In many cases the reduction in repayment capacity is enduring so a restructure to reduce the monthly repayment is necessary and split mortgages which can achieve this are now being rolled out at an accelerated rate.  There still is a long way to go.  The majority of accounts in arrears have yet to restructured.

The CB’s Mortgage Arrears Statistics: Useless?

Yesterday’s release of the Q4 arrears statistics had a stinger that potential mortally undermines the credibility of the figures.  It appeared in the very first paragraph (emphasis mine).

The number of mortgage accounts for principal dwelling houses (PDH) in arrears, fell for the second consecutive quarter in Q4 2013. A total of 136,564 (17.9 per cent) of accounts were in arrears at end Q4 2013, a decline of 3.3 per cent relative to end-Q3, although the size of the decline was impacted by asset sales over the quarter.  

In the Q3 figures there were 141,269 PDH accounts in arrears so the Q4 figures indicate a drop of around 4,700 in the number of accounts in arrears.  That would be good news if it were true but the end of the paragraph tells us that “asset sales” impacted the size of the decline.

It turns out that a bank (well a former bank actually) sold mortgages and such sold mortgages are not reported for the purposes of the Central Bank’s arrears statistics.

It seems the mortgages were a collection of non-performing loans that originated with the now-defunct Bank of Scotland (Ireland) which were sold to a company called Tanager Ltd.  Here is an extract from a December 2013 stock mark announcement from UK bank Llyods (the owner of BOSI):


Lloyds Banking Group plc (the Group) announces today that it has agreed the sale of a portfolio of non-performing Irish retail mortgages (the Portfolio) to Tanager Limited, an entity affiliated with Apollo Global Management, LLC (NYSE:APO), for a cash consideration of £257 million.  The transaction is part of the Group's continued non-core asset reduction programme.

The gross assets subject to the transaction are £610 million.  The Portfolio generated losses of £33 million in the year to 31 December 2012.  The sale proceeds will be used for general corporate purposes and the transaction, although capital accretive, is not expected to have a material impact on the Group, due to existing provisions taken against these assets.

The key points are the gross amount of the loans at £610 million (around €725 million @ €1 = £0.84), that they were sold at a discount of 58 per cent and, most crucially for our purposes here, that the loans were non-performing.  In the Q3 mortgage arrears figure of 141,269 these non-performing loans were included; in the Q4 mortgage arrears figure of 136,564 they were excluded.

If we assume a (high) average mortgage account size of €250,000 then the sale would have involved around 3,000 accounts.  These are non-performing which could relate high LTVs, borrower risks but probably means arrears and the loans could also be spread across PDH and BTL accounts.

Nearly two-thirds of the reduction in the number of PDH accounts in arrears could be because of this sale.  This was the first time that such asset sales were mentioned in the Central Bank’s arrears releases and it is only the Q4 2013 figures (so far) that have been affected by this.

The fact that sold mortgages are excluded from the Central Bank’s arrears figures hugely undermines the value of the series.  The assumption would have been, for me anyway, that the series included all mortgages that originated in Ireland.  For example, when BOSI actually closed in Ireland back in December 2010 and transferred the servicing of its mortgages and other loans to Certus they remained in the CB’s arrears statistics.  There have also been a large amount of mortgages securitised in recent years and they remained in the statistics (though much of this was for self-held bonds).

Differences between the amounts covered in the Mortgage Arrears Statistics and the Credit, Money and Banking Statistics indicated that there was different coverage between the two, i.e. that the arrears statistics were at the level of the borrowers and the banking statistics and the level of the institutions.  For example, Table 18 of the Credit, Money and Banking Statistics show that at the end of September 2013 Irish-Resident Credit Institutions had €95.5 billion of PDH mortgages (€63.9 billion on balance sheet from Table 18.1 and €31.5 billion securitised but serviced by them from Table 18.2).  The Mortgages Arrears statistics cover €108.5 billion.  This €13 billion difference cemented a view that the arrears statistics were more than just banking statistics, or at least were different.

If mortgages can be excluded from the Arrears Statistics just because they are sold it is not clear what value is in the series.  It undermines future attempts to update analysis such as this which used the historical series (which was not affected by such asset sales) to assess the level of aggregate repayments being made on Irish mortgages.  The problem of omitted mortgages will be further exacerbated by subsequent sales such as the impending sale of the INBS mortgage book and possible further sales by BOSI and maybe by Danske. 

Unless the impact of these transactions is explicitly included in the arrears figures produced by the Central Bank it is likely it will be very difficult to tell anything from forthcoming releases.  The Central Bank will know but will they tell us?

Monday, March 3, 2014

Employment as a Leading Indicator

The labour market results from the Quarterly National Household Survey continue to be impressively positive.  There is no doubt that this is a good thing, but the overall impact of the improvements remains uncertain.  The employment gains are not be reflected in other data series: household disposable income, exchequer income tax returns, core retail sales etc. 

In the standard discussion of recessions it is put forward that improvements in unemployment/employment lag behind a general upturn in the economy by two or more quarters.  Ireland seems to be an unusual case where we are seeing employment improvements first.

The annual change in the number of people employed paints a very positive picture in recent quarters.

Annual Change in Employment

In percentage terms, employment is growing at close to rates, which unsurprisingly, have not been seen since 2006 and 2007.  But overall conditions are not like they were then.  Here are the annual percentage changes in total employment and aggregate wages received by households.

Wages and Employment

Employment growth has been positive in annual terms for more than a year.  Growth in aggregate (nominal) wages remains absent, though the series only goes as far as Q3 2013 and recent data are subject to revision.

The pattern of household disposable income reflects the above changes in wages received.  Here is the level of household disposable income for the past eight years.  The point of note here is the absence of any notable upturn in 2013 (during which employment was growing).

Household Disposable Income

Of course, even if aggregate wages were increasing the impact on disposable income would be offset by certain tax increases.  However, if we are looking for labour market improvements it might be useful to just look at income tax.  Cumulative income tax by month does not show any improvement in 2013 relative to 2012.

Cumulative Income Tax 2012-13

Finally, core retail sales could be used a positive affirmation of the labour market statistics.  It is not much but a pattern of rising core retail sales since the spring of 2013 is discernible.

Retail Sales to Jan 14

However, the increase is driven by volume (+2.7 per cent in the year to January) as opposed to value (+0.9 per cent on the year).  We might be buying more but we are not really spending more (the motor trades excepted).

Of course, a drag on household spending continues to be the debt overhang that many households are carrying.  The household sector continues to deleverage relatively rapidly.

Household Loans

Since peaking at nearly €204 billion at the end of 2008 the total loan liabilities had declined to €168 billion by the third quarter of 2013.

It would be useful to dig further into the QNHS figures but some re-classification problems mean that many of the sub-trend categories cannot be interpreted as actual changes.  The CSO highlight this in relation to employment in the Agriculture, Food and Forestry sector (+26,800 but due more to statistical reclassifications than increased activity).  This also has knock-on consequences for divisions into categories such as employee or self-employed, the patterns of which could be useful for explaining the wage, income and tax trends shown above.

So we are left with a position where labour market statistics are very positive – total employment up 3.3 per cent to the end of 2013 – but this is not reflected elsewhere.  In nominal terms aggregate wages, income tax revenues, disposable income and consumption expenditure are all not doing much better than remaining static.

The increases in employment are undoubtedly positive but it is unusual that they are leading wage, income and consumption increases.  It is not clear where these aggregates are currently heading but if the employment increases continue they will also start to rise.  Surely?

INBS Mortgages and the CCMA

There has been a lot of noise about the INBS mortgage book which is being sold as part of the liquidation of the IBRC.  The last insight provided in the performance of these mortgages was in the IBRC Interim Report for June 2012.  Page 72 contains this table on INBS’s mortgages.

IBRC Mortgages

Only 41 per cent by loan amount are neither past due or impaired.  For owner-occupied mortgages 48 per cent of loans were performing while for the buy-to-lets only 18 per cent of loans were performing.  There is delinquency on a huge scale in the INBS mortgages. 

Of the mortgages around 90 per cent were SVR loans with the remaining 10 per cent on fixed rates of various durations.  INBS issued close to no tracker-rate mortgages (trackers make up less than 0.1 per cent of the mortgages).

Much has been made of the issue of whether the INBS mortgage holders will be protected by the provisions of the Mortgage Arrears Resolution Process (MARP).  This is the IBRC MARP policy document.

Under the Code of Conduct on Mortgage Arrears (CCMA) borrowers who are “not co-operating” will be “outside of the MARP and the protections of
the MARP will no longer apply” and the lender “may commence legal proceedings for repossession of the property immediately after classifying the borrower as not cooperating”.  The CCMA definition of “not co-operating” is below the fold. 

It is not clear what responsibility the new owners have to comply with the CCMA/MARP but it is probably the case that very large number of INBS mortgage holders were not covered by the MARP provisions at the start of the IBRC liquidation to begin with.