How profitable firms dodge tax

Squeals of protest (perhaps tinged with envy) greeted a recent Reuters story that coffee giant Starbucks' British unit has paid just £8.6m in tax on more than £3bn worth of sales since it opened in Britain in 1998. And it's not the only one paying a surprisingly low amount of tax. How do firms manage this? And what if anything should investors look out for?

Which tax are we talking about?

It's wrong to say that Starbucks and other multinationals make no contribution to the Treasury. They still pay all sorts of taxes, including business rates and income taxes on their staff's behalf. Indeed, Starbucks says its overall tax rate in 2011 was 31%. We're talking about a specific tax here: corporation tax.

This is paid on profits from a firm's trading activities. For Starbucks, that's mainly making and selling coffee. Starbucks and others that have hit the headlines have perfectly legally engaged in tax avoidance. They have employed tax accountants to try to minimise their bills via legal loopholes.

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The subjective nature of profit

So how has Starbucks cut its bill so far? There are two key facts you need to know before we get to specifics. First, a firm pays corporation tax on its profits, not its sales. So the fact that a company has billions in sales is almost irrelevant.

Secondly, HM Revenue & Customs (HMRC) takes its own unique view of a firm's profits. It is perfectly possible to pick up a profit-and-loss account and see sales of £100m, profit (sales minus trading costs and overheads) of £30m, and a tax charge of just £1m.

That may seem odd. British corporation tax is between 20% and 25% for 2012, depending on a firm's size. How could a company pay just £1m of tax on £30m profit roughly 3%? It's because HMRC uses different rules to accountants and investors to decide how much profit a firm has made, and so what tax is due.

And tax accountants and lawyers will do everything they can to cut these taxable profits to zero. Three of the current favourite tricks are debt financing, royalty deals and past losses.

Dodge 1: debt financing

One reason firms like to borrow money rather than raise it from shareholders is that interest payments on debt are tax-deductible, whereas dividend payouts on shares are not. So one way for Starbucks to cut its taxable profits in Britain is by financing its British business using loans from its American parent company. The higher the rate, the more tax can be offset.

Who sets the interest rate on these IOUs? You guessed it, the global head of finance for the company. They can't use any old figure if the rate is too high, HMRC will question whether it has any commercial basis, and may disallow some of the interest charged against the UK business's profits. But this is up for negotiation and it's a negotiation the likes of Starbucks and its advisers are good at.

Dodge 2: royalty agreements

You can't just open a stall and start selling Starbucks coffee in Starbucks cups. You need a licence granted by another member of the Starbucks group. This could be based anywhere: Holland would be a good choice, as tax rates are low.

Let's say the Dutch part of Starbucks holds the royalty agreement and associated rights. It charges the British unit, say, 6% of sales (the figure quoted by Reuters) to make and sell its coffee, use the brand, etc. Now, 6% may not sound like a lot, but it is 6% of a huge number. Starbucks' UK sales were around $636m in 2011 alone, says Reuters. That's enough to wipe out about $37m of its profits.

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Why 6%?, HMRC might ask. After all, if the royalty fee was only 3% of sales, the associated hit to profits would be lower, and taxable profits higher. However, Starbucks can argue that its brand and licence are unique, so it is at liberty to set the size of the fee levied on its UK business.

If HMRC knew the equivalent charge made by another coffee chain in Britain was only 1% of sales, HMRC might smell a rat. But again this is all up for negotiation there is no set rule.

Dodge 3: past trading losses

Here's the icing on the cake. Having spent heavily on marketing and made losses in its early days getting established in Britain, a firm can use these losses to reduce future tax bills once it is profitable. So if a company makes losses based on tax rules of £10m in 2011, and profits of £10m in 2012, it can set one off against the other and pay no tax in either year.

What to watch out for

This is all very interesting but how does it help investors? Companies avoiding taxes isn't necessarily bad news indeed, financially it's often good for shareholders. But one red flag to watch for is if a firm's corporation tax charge is much lower than 20%-25% of its reported profits, but it doesn't seem to be pulling any Starbucks-style tricks.

In this case, it may be recognising income HMRC doesn't agree with. In other words, the finance director may be trying to make the firm look more profitable than it really is. So if a company has an oddly low tax rate and doesn't seem to be using any clever tax wheezes, you should be on your guard.

Can tax avoidance be stamped out?

Multinationals shift profits into jurisdictions with the lowest tax rates all the time using "transfer pricing" (internal charges designed to move profits from a high tax country to a lower tax one). Chancellor George Osborne and his German counterpart Wolfgang Schuble have called on the world's top economies to combat this and force firms to pay their fair share.

But it can only work if all the major global tax jurisdictions, in particular the US, agree. That won't be easy, as each country has its own tax rates and rules. Making changes can be costly, time consuming and politically poisonous.