Apple Inc. is the current poster child for corporate tax avoidance. It's long been known for the piles of cash it keeps in its foreign subsidiaries, rather than bringing the money back to the United States and paying corporate income taxes in its home country. The most recent development for Apple – the European Union ordering Ireland to collect $14.5-billion (U.S.) in unpaid taxes – underscored the scope of the company's tax-reduction efforts.
Apple is not alone, however, and the phenomenon of corporations paying lower taxes is not limited to the United States. Major Canadian companies have boosted earnings significantly in recent years by paying less in taxes, according to a recent report from CIBC World Markets' Institutional Equity Research department. They estimate that over the past 30 years, lower taxes have accounted for 17 per cent of the earnings growth in the S&P/TSX composite index.
Most of that earnings gain is due to Canada's declining corporate tax rate, which has fallen from 49 per cent in 1986 to 26 per cent, currently. "Canada is generally a 'boy scout' in the tax world, and as a rule, we do not believe that Canadian companies are aggressive in avoiding tax," write Ian de Verteuil and Shahzaib Merwat of CIBC.
But not all of the decreased tax bill at major Canadian companies is owing to rate reductions: The effective tax rate – taxes reported on the income statement as a percentage of the pretax income – for companies in the S&P/TSX 60 is 20 per cent, about six percentage points lower than 26-per-cent rate in the law.
For investors, the CIBC analysts have a twofold message. One: On a global basis, given countries' fiscal woes and increased attention to tax avoidance, "it is reasonable to assume that tax rates are going higher" – and that may reverse the recent earnings boost. And two, in that environment, "it is worth focusing on those companies that have below-average tax rates, as the risk to these companies is rising."
Of course, if there is an increase in taxes, it will be a reversal of a long-term trend. The major Western industrial countries have cut corporate tax rates over the last three decades: While once nearly every country had a top corporate tax rate above 40 per cent, now all are below that mark. Canada has gone from one of the higher taxers of corporate income to one of the lower ones in a peer group that includes Britain, Japan, Germany, France and the United States.
However, say the CIBC analysts, "We doubt corporate tax rates can decline any further. Indeed, there will likely be debate on whether tax rates will move in the other direction." If so, that will have a noticeable impact on corporate earnings growth: In the last 20 years, when S&P/TSX earnings growth has been just an annual average of 2.74 per cent, tax reductions have contributed 0.73 percentage points, or 26 per cent, of the growth. (Mr. de Verteuil, in an interview, says the collapsed earnings of the energy sector has depressed the overall earnings-growth number, so the 26 per cent figure is "extreme.")
In the United States, the numbers for the tax-based earnings boost are closer to 10 per cent, which some may ascribe to the higher statutory rate in that country. But, the CIBC analysts note that while Canada's federal corporate tax rate is nine percentage points higher, the effective tax rate for the S&P500 is just six points higher – suggesting wider use of tax-minimizations strategies in the United States. That country's Treasury Department is hard at work reversing some of the more aggressive tactics, and the EU's attack on Apple suggests more multilateral action among countries, the CIBC analysts say.
Who, then, are the Canadian companies that are best in paying the least taxes? It's important to note, as the CIBC analysts do, that no two companies are identical and all have unique aspects of their tax policy that make it "virtually impossible to state whether a tax rate is too low (or too high)" for a certain company. However, in many (but not all) sectors of the S&P/TSX composite, there are significant variations in the effective tax rate, some for reasons knowable, some not.
At the risk of oversimplifying, companies are allowed to apply past losses to reduce their current income (and income taxes). Over the last five years, these "loss carryforwards" have cut taxes at Element Financial Corp., Air Canada Inc. and Western Forest Products Inc. past zero and into a negative effective tax rate – i.e. profits from taxes, at least on an accounting basis. (In any given year, what's sent to the Canada Revenue Agency can differ from what's reflected on the income statement given to shareholders, for reasons we shall not enumerate here.)
In all, the CIBC analysts identified 21 companies in the S&P/TSX composite whose effective tax rates over the last five years were notably lower than the average for their industry sector. (See chart.) "While numerous reasons exist for the companies to have much lower tax rates, investors should be aware that some of these entities are exposed to increased tax risk," the CIBC analysts write.
They may not be Apple, of course. But any company that's adding to profits through low tax payments – and the investors who own their shares – should keep an eye on the shifting winds of public policy on corporate taxation.