Reuven Avi-Yonah has posted a very brief review of my international tax book in which he states his disagreement with it, and his continued adherence to views that I criticize in the book. That's certainly fine - how boring it would be if everyone agreed, and I was no more surprised to learn that he still disagrees with me than he will be to learn that I still disagree with him.
To be very picky, I should note that I do in fact extensively discuss in the book the well-known international tax policy welfare norm of "national neutrality," which he appears to say that I don't discuss. More importantly, I do not agree with his central argument, which is that, in opposing foreign tax creditability, I ostensibly ignore the fact that "no country is an island." To the contrary, I'd say that it's largely because no country is an island that unreciprocated foreign tax creditability is an ill-conceived national policy.
Wednesday, February 26, 2014
NYU Tax Policy Colloquium, week 5: Chris Sanchirico's "As American as Apple, Inc."
Last week the colloquium didn't meet, as Tuesday was a "legislative Monday" at NYU Law School. But yesterday we resumed with week 5, featuring Chris Sanchirico's paper, "As American as Apple Inc.: International Tax and Ownership Nationality."
The issue raised by the paper is as follows. "Home equity bias" is a well-known phenomenon in the capital finance literature. That is, despite the existence of global capital markets, it appears that investors around the world disproportionately own home-country equity, rather than globally diversified portfolios. At least in the simple case where, say, the only way to invest in the U.S. is via a "U.S. company," this appears to fly in the face of basic principles of optimal diversification, causing home equity bias to be a "puzzle" badly in need of explanation, and possibly also a problem to be addressed.
The paper's focus diverges from that of typical entries in the home equity bias literature in two respects. First, in an empirical examination of what we know about U.S. home equity bias, it focuses on the question of who (as between Americans and foreigners) ultimately owns the stock of big U.S. multinationals in particular. Second, the underlying reason for being interested does not pertain to explaining or trying to address the puzzle if any. Rather, the paper notes that various arguments that commonly are made in U.S. international tax policy debate - in particular, as it happens, by people on the pro-multinationals side - take it as given that home equity bias is an important fact concerning the ownership of stock in U.S. multinationals.
Suppose, for example, that we are looking at General Electric versus Siemens. These are in some ways similar companies, but GE is legally an American company under our place-of-incorporation rule, while Siemens is legally a German company under their headquarters rule. Perception perfectly matches legal status, however. Most people would say that GE is an "American company" whereas Siemens is a "German company." But in the absence of home equity bias, U.S. individuals (and likewise German individuals) might hold roughly the same ownership percentage in GE as in Siemens.
Indeed, in this non-home equity bias scenario, U.S. individuals might even hold a lower percentage in GE than in Siemens, if holding the latter but not the former helped them to diversify against risks of the U.S. economy that they already bear by reason of working, living, consuming, etc. in the U.S. But then again, since both companies are multinationals with investments around the world, we might well be pushed back, in the absence of home equity bias, towards expecting comparable ownership percentages for U.S. individuals.
It is widely assumed, however, that surely home equity bias does hold here, with the consequence that U.S. individuals are assumed to hold a MUCH higher percentage of GE than Siemens. Just to capture what I am guessing might be the standard guess, perhaps the common view would hold that GE is, say 80% owned by American individuals, and Siemens, say, less than 5%. But the paper says: "Not so fast - how confident should we actually be about this empirical claim?"
While the paper's main point concerns the lack of data that is actually reliable (despite multiple data sources), let's start by looking behind the data for a moment. Suppose that, for all U.S. corporate equity, as defined by state incorporation statutes and including everything that is closely held, you could figure out the percentage that is owned by U.S. individuals. Reflecting that some people who live in the U.S. incorporate in order to own and operate their own businesses, one would come up with evidence that appeared to show "home equity bias" but that actually conflated that phenomenon with the distinct one of what people do with their investment portfolios. Now, just as a silly thought experiment, suppose we passed a law requiring all restaurants, fast food places, billiards parlors, and dry cleaning establishments to incorporate. "Home equity bias" would seem to have increased, whereas in fact nothing of substance would actually have changed at the margin that interests us here.
It's one thing, already, to say that we're interested in publicly traded companies (which at least some of the data sources that the paper discusses generally don't break out as a separate category). But the paper notes that multinational companies in particular are the poster child for those as to which you might expect LESS home equity bias, under most of the more credible explanations of the phenomenon in the literature. So the paper argues, after going through the soft spots in one data source after another, that we really don't have any convincing evidence that stock in prominent U.S. multinationals is disproportionately owned by U.S. individuals.
A small additional word in furtherance of the paper's skeptical view of what we actually know about this: Suppose we actually knew who literally owns all the stock - including indirectly, by reason of looking through mutual funds and all such other intermediate entities to the ultimate individual level. Even so, in a world full of derivative financial instruments (options, swap contracts, forward contracts, repo agreements, etc.), this might fall well short of telling us who really bears the economics associated with ownership of a particular company's stock. For example, if you own the stock but we use a swap to transfer most of the economics of the share's performance to me, the data about legal ownership will be getting it wrong. Derivatives, side bets, and all the rest make it even harder to figure out the underlying fundamentals than the paper's detailed and skeptical critique of the various leading data sources already suggests.
OK, why might all this matter? The main reason I think that it matters who "owns" (in the relevant economic sense) the stock of U.S. as compared to foreign multinationals, from the standpoint of U.S. international tax policy debate, is that (a) the entity-level corporate tax is a mechanism for indirectly imposing income taxation on the ultimate owners, and (b) we both do and should think very differently about taxing (whether directly or indirectly) resident individuals as opposed to foreign individuals.
For resident individuals, the main aim is to allocate tax burdens on the basis of some measure of some measure (e.g., income) that at least proxies for some underlying attribute such as ability or material wellbeing. Hence, if we could, we would like to include, say, all of Bill Gates' income in the tax base, whether he earns it at home or abroad, and/or through a corporation or directly.
For foreign individuals, the idea is that it would be nice from, a domestic national welfare standpoint, to get $$ from them if we can. So if we impose taxes on their activity in the US or through US corporations, and they bear this tax as a matter of economic incidence, then we are ahead of the game unless the associated cost to U.S. individuals (deadweight loss, decline in positive externalities from transactions with foreigners, etc.) is disproportionately high. But this is a very different proposition from that for resident individuals, and in practice it may call for being resolved differently. (For example, we probably don't want to tax the foreign individuals at all, in settings where we, not they, bear the economic incidence of the tax.)
Anyway, that's why I think the ownership data would be of interest, as one more potential input into evaluating all the issues in international tax policy. (It's also of interest, of course, as a puzzle or non-puzzle in the capital finance literature.) The main angle pursued in the Sanchirico paper, however, is somewhat different - not reflecting any particular disagreement, but merely because he is hunting different prey.
As the paper notes, pro-U.S. multinational proponents sometimes argue that the presumed predominantly American share ownership of U.S. multinationals provides support for (a) lessening the companies' U.S. tax burdens on competitiveness grounds and (b) viewing foreign dividend repatriation tax holidays as likely to increase U.S. investment. The argument on (a) is that U.S. individuals are the shareholders who putatively are getting enriched. The argument on (b) might go as follows: Suppose a foreign repatriation tax holiday is expressly permitted to fund domestic dividends and share repurchases. Shareholders who were U.S. individuals ostensibly would be more likely to plow the money received back into the U.S. economy.
The paper says, in effect: Let's accept these contentions arguendo and ask if the underlying factual premise is true: Are the U.S. multinationals' shareholders disproportionately American. We really don't know this, and people therefore shouldn't just assume it, thereby weakening the underlying arguments.
I myself, while recognizing that these arguments are being made in the U.S. international tax policy debate, don't regard them as strong ones - no matter how one comes out overall on the underlying issues. Thus, I would be skeptical of their value and weight even if I were to accept (as I previously had been inclined to) the asserted fact of predominantly American share ownership of U.S. multinationals.
For example, I note that the "competitiveness" argument is not easily translated into a compelling claim that people who own U.S. multinationals' stock will earn extra-normal returns if, but only if, the U.S. doesn't tax the companies' foreign source income. And I consider tax holidays a horrible idea because they give companies and investors the lesson that you should just wait for the next holiday. Moreover, I would not expect the holidays to boost the U.S. economy unless we were to accept a not very compelling story in which liquidity constraints (at the shareholder level and/or the domestic firm level) are the big problem that is holding back national macroeconomic performance.
Overall, however, the paper offers a nice lesson in the merits of learning that perhaps you know less than you thought you knew.
It's one thing, already, to say that we're interested in publicly traded companies (which at least some of the data sources that the paper discusses generally don't break out as a separate category). But the paper notes that multinational companies in particular are the poster child for those as to which you might expect LESS home equity bias, under most of the more credible explanations of the phenomenon in the literature. So the paper argues, after going through the soft spots in one data source after another, that we really don't have any convincing evidence that stock in prominent U.S. multinationals is disproportionately owned by U.S. individuals.
A small additional word in furtherance of the paper's skeptical view of what we actually know about this: Suppose we actually knew who literally owns all the stock - including indirectly, by reason of looking through mutual funds and all such other intermediate entities to the ultimate individual level. Even so, in a world full of derivative financial instruments (options, swap contracts, forward contracts, repo agreements, etc.), this might fall well short of telling us who really bears the economics associated with ownership of a particular company's stock. For example, if you own the stock but we use a swap to transfer most of the economics of the share's performance to me, the data about legal ownership will be getting it wrong. Derivatives, side bets, and all the rest make it even harder to figure out the underlying fundamentals than the paper's detailed and skeptical critique of the various leading data sources already suggests.
OK, why might all this matter? The main reason I think that it matters who "owns" (in the relevant economic sense) the stock of U.S. as compared to foreign multinationals, from the standpoint of U.S. international tax policy debate, is that (a) the entity-level corporate tax is a mechanism for indirectly imposing income taxation on the ultimate owners, and (b) we both do and should think very differently about taxing (whether directly or indirectly) resident individuals as opposed to foreign individuals.
For resident individuals, the main aim is to allocate tax burdens on the basis of some measure of some measure (e.g., income) that at least proxies for some underlying attribute such as ability or material wellbeing. Hence, if we could, we would like to include, say, all of Bill Gates' income in the tax base, whether he earns it at home or abroad, and/or through a corporation or directly.
For foreign individuals, the idea is that it would be nice from, a domestic national welfare standpoint, to get $$ from them if we can. So if we impose taxes on their activity in the US or through US corporations, and they bear this tax as a matter of economic incidence, then we are ahead of the game unless the associated cost to U.S. individuals (deadweight loss, decline in positive externalities from transactions with foreigners, etc.) is disproportionately high. But this is a very different proposition from that for resident individuals, and in practice it may call for being resolved differently. (For example, we probably don't want to tax the foreign individuals at all, in settings where we, not they, bear the economic incidence of the tax.)
Anyway, that's why I think the ownership data would be of interest, as one more potential input into evaluating all the issues in international tax policy. (It's also of interest, of course, as a puzzle or non-puzzle in the capital finance literature.) The main angle pursued in the Sanchirico paper, however, is somewhat different - not reflecting any particular disagreement, but merely because he is hunting different prey.
As the paper notes, pro-U.S. multinational proponents sometimes argue that the presumed predominantly American share ownership of U.S. multinationals provides support for (a) lessening the companies' U.S. tax burdens on competitiveness grounds and (b) viewing foreign dividend repatriation tax holidays as likely to increase U.S. investment. The argument on (a) is that U.S. individuals are the shareholders who putatively are getting enriched. The argument on (b) might go as follows: Suppose a foreign repatriation tax holiday is expressly permitted to fund domestic dividends and share repurchases. Shareholders who were U.S. individuals ostensibly would be more likely to plow the money received back into the U.S. economy.
The paper says, in effect: Let's accept these contentions arguendo and ask if the underlying factual premise is true: Are the U.S. multinationals' shareholders disproportionately American. We really don't know this, and people therefore shouldn't just assume it, thereby weakening the underlying arguments.
I myself, while recognizing that these arguments are being made in the U.S. international tax policy debate, don't regard them as strong ones - no matter how one comes out overall on the underlying issues. Thus, I would be skeptical of their value and weight even if I were to accept (as I previously had been inclined to) the asserted fact of predominantly American share ownership of U.S. multinationals.
For example, I note that the "competitiveness" argument is not easily translated into a compelling claim that people who own U.S. multinationals' stock will earn extra-normal returns if, but only if, the U.S. doesn't tax the companies' foreign source income. And I consider tax holidays a horrible idea because they give companies and investors the lesson that you should just wait for the next holiday. Moreover, I would not expect the holidays to boost the U.S. economy unless we were to accept a not very compelling story in which liquidity constraints (at the shareholder level and/or the domestic firm level) are the big problem that is holding back national macroeconomic performance.
Overall, however, the paper offers a nice lesson in the merits of learning that perhaps you know less than you thought you knew.
Friday, February 21, 2014
Foreign travels
It looks like, over the rest of this year, I will be teaching or going to conferences or giving talks in Luxembourg, Italy, Brazil, Austria, and Canada. Have United premier account, will travel.
Thursday, February 13, 2014
Another winter storm
According to the online edition of today's New York Times, the West Side Highway "looks like rural
Maine." Well, if that's true, I'm heading out there to pick
blueberries.
Wednesday, February 12, 2014
NYU Tax Policy Colloquium, week 4: Thomas Brennan's Smooth Retirement Accounts
On Tuesday, Tom Brennan took the train down for Columbia (where he is visiting for the semester, from Northwestern), to present Smooth Retirement Accounts.
The paper discusses traditional and Roth IRAs from two perspectives: utility to the saver, and federal budgetary optics. It then sketches out an alternative (the "smooth" retirement account) that would have Roth economics but different budgetary optics.
To explain: In a traditional IRA, your contribution is deductible, but your withdrawals are taxable (with tax-free inside build-up in between). A Roth IRA contribution is not deductible, but the withdrawal is tax-free.
These two alternatives are economically equivalent if you simply earn the "normal" rate of return and if the tax rate is fixed. E.g., say the tax rate is 50%, 1 year investment with a 10% return. Under traditional, you might spend $200 out-of-pocket, which costs you $100 after-tax, and the account grows to $220, of which you retain $110 after-tax. In the Roth, you simply deposit $100 of after-tax income and get $110, all of which you keep.
One key assumption that's needed for the two methods to be equivalent is that the investment be "arm's length" rather than, say, in your own business with labor income built in, so that you can only earn the normal rate of return. E.g., if you can turn the first $100 you have into $100M because you're Zuckerberg and it's Facebook (but you can't keep going at that rate), then obviously you do better under Roth (at least, if you couldn't have parlayed $200 into $200M), reflecting that in effect labor income or rents or whatever you want to call it has been layered on top of the normal rate of return.
All this is familiar stuff in the biz. Returning to the more particular analysis in the paper, a big difference in practice is that in Roth, the only tax rate that matters is the current one, so you're locked into it (assuming Congress doesn't renege down the line). But in a traditional IRA, the future tax rate may differ from the current one, causing the investment to be tax-favored vs. Roth (or immediate consumption) if the rate declines, and taxed unfavorably if the rate goes up. This could happen due either to changes in statutory tax rates or because of the progressive rate structure (e.g., you are in a lower rate bracket during your retirement years when you withdraw).
Brennan doesn't like this feature of traditional IRAs for two reasons. It subjects the taxpayer to tax rate risk, and progressive rates can distort portfolio choices by reducing the relative payoff for investment with variability but high upsides relative to those that are relatively fixed. So he prefers the Roth approach of avoiding downstream tax rate variability, though he wouldn't mind having the tax paid at the end (a la traditional IRAs) if it was locked in and equal to the deduction rate up front.
OK, the issue of progressive rates and portfolio choice is a broader one in the income tax (or in a progressive-rate consumption tax), though clearly he has a point. Also a legitimate broader concern is the issue of tax rate variability distorting consumption choice between periods. (A standard model consumption tax such as a VAT or retail sales tax creates this problem, of course, if there may be tax rate changes between years. And suppose you are faced, upon making your tax-free Roth withdrawals, with a newly enacted VAT. Then you have indeed been "taxed twice," although it might not be viewed the same way as explicitly reneging on tax-free Roth withdrawal under the income tax.)
On the subject of tax rate risk, clearly it would increase people's utility if, in response to future tax rate risk, they could purchase, for a suitable price, private insurance locking in the current rate for them. Under such a hypothetical insurance system, I'd pay, say, 35% no matter what, and the government would collect based on the actual future rate no matter what, but the insurance company would pay the extra on my behalf if the rate went up, and take the difference out of my hide if the rate went down. This of course is just a thought experiment, not real life or a practical proposal. Presumably one reason such insurance doesn't exist is that the insurer would have difficulty reinsuring or spreading the risk. And there would also be moral hazard issues if the payments depended in part on how much income I actually had in the later period. But I mention it just to make the point that, while such insurance presumably would be a good thing for consumers if feasible, that doesn't mean that it's optimal for the government to allow people to lock in their future tax rate. That leaves other taxpayers as the "counterparty" without any insurance premium.
Example 1, you lock in the current rate in June 1941, then on December 7 it turns out that taxes will have to go way up to pay for a million-soldier, two-front world war. Taxpayers who locked in the earlier rate have concentrated the revenue risk on everyone else. Case 2, President Romney imposes low rates, then the following year President de Blasio enacts high rates. So it's a change in political preferences, not "objective" needs, but here it's at a minimum unclear whether or not we should view allowing an earlier-year opt-out as socially beneficial.
Anyway. As Brennan agrees, it's a complicated question to what extent we should want tax rates to be locked in, despite the clear benefits at one particular margin to enabling this. The point, of course, is that these are complex and interesting issues, not that the paper is "wrong" to use correct analysis of one of the relevant margins to show an advantage to locking in the rate.
Issue 2 is budgetary accounting. With a short-term budget window, traditional IRAs look costlier than they actually are, since the deductions are counted but the later year inclusions are outside the budget window. Roths look cheaper than they actually are, since Congress is only giving away the out-year revenue (plus the tax on inside build-up within the budget window, but that may be just a small part of the whole). Worse still, as Congress showed through budgetary shenanigans in 2010, you can lose long-term revenue by "bribing" people to switch from traditional to Roth IRAs, yet score it as a revenue gain within the budgetary window that you use to pay for other tax cuts. In that scenario (which, again, actually happened), tax cuts (from the bribe that is offered to prompt Roth conversions) are used to "pay" for other tax cuts.
Brennan has an intricate plan in mind that could work as follows. You use a traditional IRA, in the sense that there is an up-front deduction. But as in a Roth IRA, there is no tax rate risk, because you are guaranteed that the withdrawal will be taxed at the same rate that applied to the deposit. But to improve the budgetary accounting, each year a suitable fraction of the accruing future tax liability would be counted as current revenue gain for budgetary accounting purposes. The deemed tax revenues for budgetary accounting purposes are the source of the adjective "smooth," but, as this is already a long blog entry, I will refer you to the paper itself (see the link above) for the precise mechanics.
The budgetary optics problem has a straightforward solution, which is simply to do infinite horizon budgetary accounting rather than artificially truncating the out years that are deemed to be within the budgetary window. Obviously, this raises issues of its own that a large literature has examined. Next best might be coming up with ad hoc budgetary rules that replace pure cash accounting, for both Roth and traditional IRAs, with something that is the same for both of them and also closer to economic accrual than the cash flow treatment of either way. The paper offers one way of moving in that direction. But once you are not going all the way to accrual, by eliminating the budget window, it comes down to a choice between imperfect alternatives. Brennan, who at all times is extremely and indeed completely fair-minded, agrees with this analysis.
The paper discusses traditional and Roth IRAs from two perspectives: utility to the saver, and federal budgetary optics. It then sketches out an alternative (the "smooth" retirement account) that would have Roth economics but different budgetary optics.
To explain: In a traditional IRA, your contribution is deductible, but your withdrawals are taxable (with tax-free inside build-up in between). A Roth IRA contribution is not deductible, but the withdrawal is tax-free.
These two alternatives are economically equivalent if you simply earn the "normal" rate of return and if the tax rate is fixed. E.g., say the tax rate is 50%, 1 year investment with a 10% return. Under traditional, you might spend $200 out-of-pocket, which costs you $100 after-tax, and the account grows to $220, of which you retain $110 after-tax. In the Roth, you simply deposit $100 of after-tax income and get $110, all of which you keep.
One key assumption that's needed for the two methods to be equivalent is that the investment be "arm's length" rather than, say, in your own business with labor income built in, so that you can only earn the normal rate of return. E.g., if you can turn the first $100 you have into $100M because you're Zuckerberg and it's Facebook (but you can't keep going at that rate), then obviously you do better under Roth (at least, if you couldn't have parlayed $200 into $200M), reflecting that in effect labor income or rents or whatever you want to call it has been layered on top of the normal rate of return.
All this is familiar stuff in the biz. Returning to the more particular analysis in the paper, a big difference in practice is that in Roth, the only tax rate that matters is the current one, so you're locked into it (assuming Congress doesn't renege down the line). But in a traditional IRA, the future tax rate may differ from the current one, causing the investment to be tax-favored vs. Roth (or immediate consumption) if the rate declines, and taxed unfavorably if the rate goes up. This could happen due either to changes in statutory tax rates or because of the progressive rate structure (e.g., you are in a lower rate bracket during your retirement years when you withdraw).
Brennan doesn't like this feature of traditional IRAs for two reasons. It subjects the taxpayer to tax rate risk, and progressive rates can distort portfolio choices by reducing the relative payoff for investment with variability but high upsides relative to those that are relatively fixed. So he prefers the Roth approach of avoiding downstream tax rate variability, though he wouldn't mind having the tax paid at the end (a la traditional IRAs) if it was locked in and equal to the deduction rate up front.
OK, the issue of progressive rates and portfolio choice is a broader one in the income tax (or in a progressive-rate consumption tax), though clearly he has a point. Also a legitimate broader concern is the issue of tax rate variability distorting consumption choice between periods. (A standard model consumption tax such as a VAT or retail sales tax creates this problem, of course, if there may be tax rate changes between years. And suppose you are faced, upon making your tax-free Roth withdrawals, with a newly enacted VAT. Then you have indeed been "taxed twice," although it might not be viewed the same way as explicitly reneging on tax-free Roth withdrawal under the income tax.)
On the subject of tax rate risk, clearly it would increase people's utility if, in response to future tax rate risk, they could purchase, for a suitable price, private insurance locking in the current rate for them. Under such a hypothetical insurance system, I'd pay, say, 35% no matter what, and the government would collect based on the actual future rate no matter what, but the insurance company would pay the extra on my behalf if the rate went up, and take the difference out of my hide if the rate went down. This of course is just a thought experiment, not real life or a practical proposal. Presumably one reason such insurance doesn't exist is that the insurer would have difficulty reinsuring or spreading the risk. And there would also be moral hazard issues if the payments depended in part on how much income I actually had in the later period. But I mention it just to make the point that, while such insurance presumably would be a good thing for consumers if feasible, that doesn't mean that it's optimal for the government to allow people to lock in their future tax rate. That leaves other taxpayers as the "counterparty" without any insurance premium.
Example 1, you lock in the current rate in June 1941, then on December 7 it turns out that taxes will have to go way up to pay for a million-soldier, two-front world war. Taxpayers who locked in the earlier rate have concentrated the revenue risk on everyone else. Case 2, President Romney imposes low rates, then the following year President de Blasio enacts high rates. So it's a change in political preferences, not "objective" needs, but here it's at a minimum unclear whether or not we should view allowing an earlier-year opt-out as socially beneficial.
Anyway. As Brennan agrees, it's a complicated question to what extent we should want tax rates to be locked in, despite the clear benefits at one particular margin to enabling this. The point, of course, is that these are complex and interesting issues, not that the paper is "wrong" to use correct analysis of one of the relevant margins to show an advantage to locking in the rate.
Issue 2 is budgetary accounting. With a short-term budget window, traditional IRAs look costlier than they actually are, since the deductions are counted but the later year inclusions are outside the budget window. Roths look cheaper than they actually are, since Congress is only giving away the out-year revenue (plus the tax on inside build-up within the budget window, but that may be just a small part of the whole). Worse still, as Congress showed through budgetary shenanigans in 2010, you can lose long-term revenue by "bribing" people to switch from traditional to Roth IRAs, yet score it as a revenue gain within the budgetary window that you use to pay for other tax cuts. In that scenario (which, again, actually happened), tax cuts (from the bribe that is offered to prompt Roth conversions) are used to "pay" for other tax cuts.
Brennan has an intricate plan in mind that could work as follows. You use a traditional IRA, in the sense that there is an up-front deduction. But as in a Roth IRA, there is no tax rate risk, because you are guaranteed that the withdrawal will be taxed at the same rate that applied to the deposit. But to improve the budgetary accounting, each year a suitable fraction of the accruing future tax liability would be counted as current revenue gain for budgetary accounting purposes. The deemed tax revenues for budgetary accounting purposes are the source of the adjective "smooth," but, as this is already a long blog entry, I will refer you to the paper itself (see the link above) for the precise mechanics.
The budgetary optics problem has a straightforward solution, which is simply to do infinite horizon budgetary accounting rather than artificially truncating the out years that are deemed to be within the budgetary window. Obviously, this raises issues of its own that a large literature has examined. Next best might be coming up with ad hoc budgetary rules that replace pure cash accounting, for both Roth and traditional IRAs, with something that is the same for both of them and also closer to economic accrual than the cash flow treatment of either way. The paper offers one way of moving in that direction. But once you are not going all the way to accrual, by eliminating the budget window, it comes down to a choice between imperfect alternatives. Brennan, who at all times is extremely and indeed completely fair-minded, agrees with this analysis.
Column in local paper
One of the nice features of my neighborhood in the West Village is a local paper that comes out every month, called Westview, which covers local issues, such as the loss of St. Vincent's Hospital (leaving much of lower Manhattan without a nearby hospital or emergency room), along with cultural news and the like from our area.
I write occasional short pieces for Westview, which also was nice enough, a few years ago, to run a feature relating to my novel, Getting It.
Anyway, in this month's issue, I wrote a short op-ed called "Mayor De Blasio's Plan To Increase Taxes on High-Earners."
I encourage those who are interested to click on the link and also to look at other features in Westview. However, here are some highlights from my piece (which overall is only about 500 words):
I write occasional short pieces for Westview, which also was nice enough, a few years ago, to run a feature relating to my novel, Getting It.
Anyway, in this month's issue, I wrote a short op-ed called "Mayor De Blasio's Plan To Increase Taxes on High-Earners."
I encourage those who are interested to click on the link and also to look at other features in Westview. However, here are some highlights from my piece (which overall is only about 500 words):
In the recent mayoral campaign, then-candidate Bill de Blasio’s signature proposal was to address New York’s “tale of two cities” – the extremely rich versus everyone else – by increasing the City’s income tax rate for people with incomes over $500,000, from 3.9 to 4.4%. ... [D]oes the tax policy literature (in which I write professionally) support viewing the proposed tax increase as a good idea? I believe that it does ...
The literature on state and local taxes strongly suggests that, as a general rule, it’s wise to leave progressive taxes to the national level, rather than imposing them sub-nationally (such as in a given city or state). The reason is potential exit from the taxing jurisdiction by high-earners. For example, if one town raised taxes on high-earners while all of its identical neighbors did not, it’s a fair bet that many of the intended targets of the tax would simply leave. Exiting the entire country, if federal income taxes go up for the wealthy, is a lot costlier for taxpayers to execute, and thus is not as much of a problem (Facebook’s Eduardo Saverin notwithstanding).
However, New York is not just one in a sea of identical towns. It has genuine market power these days, as a global destination city like London and very few others.... Clearly, high-earners are willing – at least, up to a point – to pay a premium to live here.
Thus, even if you don’t share Mayor de Blasio’s (and many voters’) discomfort with rising high-end inequality, it would be foolish for New York City not to take advantage of its privileged, albeit not quite impregnable, position. So long as we can secure significantly more tax revenues, with only relatively modest behavioral responses (such as exit by high-earners), it would be like leaving money on the table for the City not to try to extract a bit more.
Obviously, this argument – like that for increasing the minimum wage – can only be pushed so far. Overdo it, and you shoot yourself in the foot. The more the tax on high-earners goes up, the more tax base is likely to be lost per dollar of revenue raised. At some point, one would even run into the Laffer Curve, where raising the tax rate actually loses revenue. In my view, however, we are still well short of that point.
Suppose the de Blasio plan is enacted, and it proves a success. How much will it do to address our “tale of two cities?” ... [T]he answer is: Not all that much. New York City is a cork bobbing on the waves of the global economy. Overall global trends pertaining to high-end inequality will accentuate – or else not – depending on factors that the City cannot control or even much influence. Yet so long as those trends do continue, and so long as we continue to be a favored global destination city – an asset that we must assiduously preserve – taking modest advantage is not wild-eyed radicalism, but simply sober common sense.
UPDATE: A comment that I received offline from a correspondent has persuaded me that I should not be so certain of the accuracy of my assumption in the above piece that NYC is below the peak of the Laffer Curve for the super-rich. For example, if the City raises their income tax rates, they don't have to sell their pied a terres but can be more careful to beat the NYC residency rule. Meanwhile, if they are in town less for this reason, it's conceivable that NYC-area consumption will fall, leading to adverse multiplier effects on NYC even if not national tax revenue. I would certainly welcome any studies or good empirical assessments of this issue that anyone may have available.
UPDATE: A comment that I received offline from a correspondent has persuaded me that I should not be so certain of the accuracy of my assumption in the above piece that NYC is below the peak of the Laffer Curve for the super-rich. For example, if the City raises their income tax rates, they don't have to sell their pied a terres but can be more careful to beat the NYC residency rule. Meanwhile, if they are in town less for this reason, it's conceivable that NYC-area consumption will fall, leading to adverse multiplier effects on NYC even if not national tax revenue. I would certainly welcome any studies or good empirical assessments of this issue that anyone may have available.
Friday, February 07, 2014
New short article published
Last summer, the Hebrew University in Jerusalem conducted a book symposium on my (as of now) recently published book, Fixing U.S. International Taxation. The people commenting on the book were Stephen Shay of Harvard Law School, Yariv Brauner of the University of Florida Law School, and Fadi Shaheen of Rutgers-Newark Law School. I offered a brief response to their comments, and their papers plus my response have now appeared on-line courtesy of the Jerusalem Review of Legal Studies, which is publishing them in its first 2014 issue.
My response is available on-line here. At least, I think it's available. Readers may find (and if so, can let me know) that they need an Oxford / JRLS subscription to open the link.
I would be happy also to offer links to the three comments, but here I'm pretty sure that a subscription is indeed needed to read them. The page that one would go to, in order to access them, is here.
My response is available on-line here. At least, I think it's available. Readers may find (and if so, can let me know) that they need an Oxford / JRLS subscription to open the link.
I would be happy also to offer links to the three comments, but here I'm pretty sure that a subscription is indeed needed to read them. The page that one would go to, in order to access them, is here.
Thursday, February 06, 2014
Signs of age
This Sunday will be the second time in my life that there has been a well-publicized fiftieth anniversary of a public event that I am old enough to remember. This time, of course, it concerns the Beatles' appearance on the Ed Sullivan Show on February 9, 1964.
The first famous event that I can remember from fifty years later was the assassination of President Kennedy. I recall my first grade teacher being called out of the room to hear something on the radio. This seemed very odd, and had certainly never happened before. Then she came back in and told us the news. I found it surreal (not that I knew the word), not just because I was so young, but also because those were such innocent times for people growing up in the U.S. In retrospect, so far as dark events are concerned, there had already been the Cuban missile crisis, not to mention that crazy things had been happening in Vietnam, such as monks burning themselves and the Diem assassination. Go back less than twenty years, and one had the Holocaust. But I am pretty sure that I knew little or even nothing about all that. I was living, so far as I could tell, in more of a Disney-style universe.
Then, over the weekend, Ruby shockingly shot Oswald. I recall our discussing it in class, presumably on Monday. By now the whole run of events felt truly unfathomable and incomprehensible. I remember making a comment in class about how all these shootings were like cowboys and Indians. But even as I said it, I felt that it was inadequate and had failed to convey what I meant (which I evidently couldn't put into words, but had more to do with perplexity than grief).
Anyway, next came the Beatles. I was too young to comprehend the weeks of national gloom that their arrival evidently broke. Nor did I know anything at the time about the famous airport press conference, the girls staking out the hotel, Murray the K playing them around the clock, and so forth. But I did know that my older brother had successfully petitioned my parents to watch the Ed Sullivan Show at 8 o'clock. My regular bedtime was 7:30. Whatever this "beetles" or "Beatles" thing was, I didn't want to miss out just because I was younger. At the same time, however, I had no clue about who or what they were. I was unaware, not just of the "a" in Beatles, but even of their being a musical group. I believe I was envisioning some sort of exciting mechanical, metallic buzzing "beetles" that would be fun to watch on our black-and-white TV.
My parents allowed me to stay up for the Sullivan show, so long as I was ready to go to bed immediately afterwards. But the moment I heard them, I said "I'm going to bed now." At that point, growing up in my household, I am fairly certain that I had never heard rock music before. (If my brother had gotten to hear them on the radio, I hadn't noticed.)
That's it for my contemporaneous memory of the Beatles' first appearance in America.
The first famous event that I can remember from fifty years later was the assassination of President Kennedy. I recall my first grade teacher being called out of the room to hear something on the radio. This seemed very odd, and had certainly never happened before. Then she came back in and told us the news. I found it surreal (not that I knew the word), not just because I was so young, but also because those were such innocent times for people growing up in the U.S. In retrospect, so far as dark events are concerned, there had already been the Cuban missile crisis, not to mention that crazy things had been happening in Vietnam, such as monks burning themselves and the Diem assassination. Go back less than twenty years, and one had the Holocaust. But I am pretty sure that I knew little or even nothing about all that. I was living, so far as I could tell, in more of a Disney-style universe.
Then, over the weekend, Ruby shockingly shot Oswald. I recall our discussing it in class, presumably on Monday. By now the whole run of events felt truly unfathomable and incomprehensible. I remember making a comment in class about how all these shootings were like cowboys and Indians. But even as I said it, I felt that it was inadequate and had failed to convey what I meant (which I evidently couldn't put into words, but had more to do with perplexity than grief).
Anyway, next came the Beatles. I was too young to comprehend the weeks of national gloom that their arrival evidently broke. Nor did I know anything at the time about the famous airport press conference, the girls staking out the hotel, Murray the K playing them around the clock, and so forth. But I did know that my older brother had successfully petitioned my parents to watch the Ed Sullivan Show at 8 o'clock. My regular bedtime was 7:30. Whatever this "beetles" or "Beatles" thing was, I didn't want to miss out just because I was younger. At the same time, however, I had no clue about who or what they were. I was unaware, not just of the "a" in Beatles, but even of their being a musical group. I believe I was envisioning some sort of exciting mechanical, metallic buzzing "beetles" that would be fun to watch on our black-and-white TV.
My parents allowed me to stay up for the Sullivan show, so long as I was ready to go to bed immediately afterwards. But the moment I heard them, I said "I'm going to bed now." At that point, growing up in my household, I am fairly certain that I had never heard rock music before. (If my brother had gotten to hear them on the radio, I hadn't noticed.)
That's it for my contemporaneous memory of the Beatles' first appearance in America.
Wednesday, February 05, 2014
"Awww..." photo of the day
Little Gary, shown here courageously entwined with a cloth crocodile, has enjoyed a 700 percent weight increase since we first adopted him, at the age of about six weeks, in September 2012. He is now just over 9 pounds.
Tuesday, February 04, 2014
NYU Tax Policy Colloquium, week 3: Victor Fleischer & Nancy Staudt's "The Supercharged IPO"
Today in the Tax Policy Colloquium, we discussed the above paper, available here, albeit with technical limitations on the session.
Of the two authors, only Nancy Staudt was able to attend. By the way, she was our second-ever colloquium guest, back in January 1996, when she presented her paper, Taxing Housework. (Our first guest ever was Louis Kaplow discussing state and local taxes; in week 3 we had Bill Andrews discussing corporate taxation and the new view. My co-convenor at the time was David Bradford.)
Anyway, Nancy, unfortunately but understandably, had to leave early. She barely got in yesterday from Los Angeles, switching to a flight that wasn't canceled by yesterday's East Coast storm, and I gather managed to escape this evening just ahead of tonight's East Coast storm. But this required her leaving our session early. I could certainly understand the problem; twice in the last few years I've been trapped in Los Angeles (mid-semester) for 48 extra hours due to an East Coast storm.
To fill the gap, Victor Fleischer participated (from San Diego) by Skype. I really don't like doing this because the technology still isn't so great, unless you have a higher capital investment site than NYU can offer. Vic apparently heard less than half of what was being said on our end, and inevitably we had lag, Internet freezes, etcetera. But it was good to have him participate even virtually, and this enabled us keep the session going under some simulacrum of quasi-normality for the full time.
Anyway, the topic of the paper is a type of deal that has gotten some attention in the tax press, known as a "supercharged IPO." As discussed in the paper, these deals have two main attributes, and the relationship between the two was a main topic of interest. The first attribute is that, in certain initial public offerings (IPOs) in which a given start-up company is taken public, the parties deliberately arrange a taxable, rather than a tax-free transaction. The second attribute is that, in a very few deals but these being the ones that were studied in the paper, the parties agree to a "tax receivables agreement" (TRA). Under a TRA, the buyer agrees to make certain payments to the seller, in effect as deferred installment sale payments, the amount of which depends on the tax savings realized by the buyer, post- transaction, from tax attributes acquired in the course of the deal (and enhanced by the fact that the deal was deliberately made taxable).
OK, let's give an example, before turning to the fact, which came out during the session, that this was not generally the universal or even typical pattern in a "supercharged IPO." Suppose the following. A highly successful start-up business, conducted as a partnership, has assets with a value of $1 billion and a tax basis of zero. Suppose that all of the assets would yield capital gain, taxable (during the pre-2013 years covered by the paper's data analysis) at a 15 percent rate. In other words, no depreciation recapture or "hot assets" (to use the operative tax lingo) that would be taxed at the ordinary income rate. Suppose, moreover, that if the assets were newly acquired, they would get 10-year straight line depreciation. Thus, if acquired for $1 billion, they would yield depreciation and amortization deductions of $100 million per year for 10 years. The tax savings would be $35 million per year for 10 years at the 35 corporate tax rate, assuming that the taxpayer always has enough taxable income for the year to claim all of the available deductions at that rate.
OK, suppose the taxpayers could sell the asset to themselves for $1 billion, for tax purposes. They'd pay $150 million of tax on the $1 billion capital gain. Saving $35 million per year from the cost recovery would yield them the equivalent of a 10-year annuity (again, assuming certainty of realizing the full value). These tax savings would have a present value of $270 million if one uses a 5% discount rate.
Therefore, the self-sale, if permissible would save $120 million of tax in present value. While you can't do that, using an IPO to do it arguably applies the following. In a competitive market, buyers who would have paid $1 billion just for the assets should also pay $270 million for the annuity, so the total sales price, in a taxable deal, should be $1.27 billion rather than just $1 billion. (To keep the arithmetic simple, I am ignoring the fact that this changes all the relevant dollar amounts, and thus the true amount might settle a bit further north.)
OK, so if this is the right scenario to be thinking about - and knowledgeable practitioners in the room suggested that perhaps it actually is not - then Conclusion 1 is that, obviously, the parties should do a taxable rather than a tax-free deal. No need for a fight between sellers who'd want to avoid tax and buyers who'd want to maximize their deductions, since the right way to approach the problem is as one of collective tax minimization. Once you've made the "pie" as large as possible, at the expense of the fisc, there's plenty of time to divide the loot between the two of you so that you're both better off. E.g., at a $1.27 billion price, the buyers get fair value while the sellers are compensated for their $150M tax liability by a $270M increase in their sale price. (Yes, I realize still that I am not fixing the numbers to include the capital gain on the extra sale price, etc.)
Let's call this the underlying "tax arbitrage" here (offsetting 15% & 35% rates create a net tax saving despite the adverse timing of having income before deductions). But that just concerns doing a taxable rather than a tax-free deal. (Practitioners suggested, however, that more realistic scenarios include (a) sellers are going to realize gain anyway, by selling the stock they acquire within a few months even if it's a tax-free deal, so why not get the basis step-up, and (b) a separate set of considerations that guide purely corporate transactions.) Even if we accept the scenario, however, what we haven't explained is why the parties, at least in a small set of cases, might include a TRA.
A typical TRA might provide the following. For each of the next 10 years, Buyer shall make a payment to Seller that equals 85% of the tax savings enjoyed by reason of the tax benefits. So under my facts, each year 85% of the $35 million tax benefit from the cost recovery deductions (i.e., $29.75 million) would be paid to the Seller.
OK, again for arithmetical simplicity, let's make it a 100% TRA, so the annual payments are $35 million. (This is frowned upon in practice, of course, because it would wholly eliminate the Buyer's incentive to actually use the tax benefits.) With a 100% TRA, the mechanism for paying $1.27B to the Seller might be $1B up front, plus $35M per year for 10 years. The question is, why do this? $1.27B in present value can be paid whether you use the TRA or not. And even if you want some deferred payment, why should it depend on the tax benefits. Use or non-use of the TRA should be a matter of complete indifference to the parties - indeed, whether or not they have done a taxable deal, unless there is more to the story.
Here are the 6 theories we discussed that might explain the use of TRAs in practice:
(1) Buyer myopia - Just about everyone who actually knows about these deals insist that the form reflects buyers' failing to value the tax benefits appropriately - and at the limit, valuing them at zero. "That's what the bankers tell everyone," the tax lawyers in the deals will explain to you if you ask. This seems decidedly odd as it implies a market failure that seemingly could be exploited by savvy arbitrageurs (or simply higher bidders) who understand the value of the tax benefits. But if we assumed it were true, it would make use of the TRA an efficient mechanism between the parties. You assign a given asset to the party that actually places a higher valuation on it. As we will see, while this theory may remain hard to accept, arguably all the other theories fare even worse.
(2) Careless buyer doesn't read the fine print - To put this in the strongest possible form, although in practice it may overlap with Theory 1, suppose the Buyers are willing to pay $1.27 billion as that is the value of the business assets plus the tax assets, it fails to read the fine print at page 496 of the transaction documents. Hence, they fail to realize that they are paying twice for the same tax assets: once up front and a second time through the TRA. This is an even harder theory to credit - TRAs are apparently highlighted not smuggled in - but it starts to look more like Theory 1 if we posit that the Buyers don't so much overlook the TRA as value it at zero (in the extreme case) due to their mysterious myopia about the value of tax assets. And in the intermediate case it's just the way they prefer to pay the overall sale price, since they have a lower estimate of the tax assets (even if not zero) than the Seller.
(3) TRA spares the parties the trouble of having to value the tax assets - Rather than fight about how much they're worth, why not just assign them to the Seller through the TRA. But the question here is, why are they harder to value than everything else? You have to figure out how much the company is worth, and once you're projecting annual pre-tax and after-tax earnings you're pretty much there so far as valuing the tax assets is concerned. So this theory is less than wholly persuasive.
(4) Buyers don't like the risk associated with the tax assets - Will the IRS allow them all? Will there be sufficient taxable income to use them in full right away? But if we view this purely as a matter of risk aversion, it seems peculiar in this context. Typically what's happening in an IPO is that the entrepeneurs who bear a concentrated business risk are selling it into the general marketplace in order to diversify. The buyers already were diversified and remain so (indeed, they may become a hair more diversified by reason of doing this). So why would the buyers be more averse to the tax risk here than the Seller?
(5) Lemons problem from asymmetric information - OK, now it might seem that we are finally getting somewhere. This was my favorite theory going in. Suppose the Seller knows more than the buyers about the true value of the tax assets. Is it overstated? Are they subject to successful IRS challenge? With asymmetric information, they have the used car problem. Even if the tax assets truly are worth what they seem, how can they prove this to the buyers? The very fact that they are selling creates a bit of natural suspicion that this is what motivates them. Now, the lemons problem clearly can be a big problem in selling stock to less-informed third parties. But why is it distinctively associated with the tax assets? E.g., asset basis is negotiated in the deal and may be hard for the IRS to challenge. Future profits that would permit the tax benefits to be used in full is already an issue on asymmetric information grounds. How much worse do the tax assets make it? Plus, apparently in the typical TRA the buyers' payment to the Seller is based on the tax benefits claimed, and no refund is subsequently due from the Seller if the IRS disallows tax benefits on audit. In sum, therefore, it is hard to really get this theory off the ground.
(6) Upselling by the lawyers - They want to be able to charge for arranging a TRA, so they tell the parties what a great idea it is. Only, it's apparently the bankers who push for these things, and they aren't increasing their own compensation by doing this unless this makes the deals higher-priced overall or easier to close.
So even though I don't like Theory 1, I am pushed back towards accepting it by the universal testimony of the players plus the weakness of the alternative theories.
If one accepts all this, what should one think of TRAs? They look pretty innocuous, serving merely as devices for permitting efficient pricing and costing the IRS zero on any deal that would have been made with the same overall price terms in any event. (Tax attributes aren't traded from lower-valuing to higher-valuing parties - it's just the after-tax benefit that they shift around.) There would be an SEC / capital markets / consumer protection for banning them if we believed, as under Theory 2, that they are a device for duping investors into overpaying. But that is hard to credit given how prominently they're disclosed.
So about the best one can do, if one wants to argue against them, is to claim that they are associated with the ability to execute tax arbitrage deals (like my $1B / $270M example above) that otherwise would founder due to differential valuations by the parties of the tax benefits. In other words, in this scenario one would ban TRAs in order to discourage tax arbitrage deals by impeding efficient pricing of the deals. (Note, however, that you can also potentially use a TRA in a tax-free deal.) But this one as well is pretty hard to credit. To what extent do we believe that impeding efficient pricing would actually impede "bad" deals while leaving "good" ones (e.g., those where people just want to diversify) unharmed?
I conclude both that there is no particular reason to go after TRAs - instead, address the tax arbitrage directly if one is concerned about it - and that they are simply aren't that big a deal from the policymakers' standpoint. But still interesting to discuss at the session.
Of the two authors, only Nancy Staudt was able to attend. By the way, she was our second-ever colloquium guest, back in January 1996, when she presented her paper, Taxing Housework. (Our first guest ever was Louis Kaplow discussing state and local taxes; in week 3 we had Bill Andrews discussing corporate taxation and the new view. My co-convenor at the time was David Bradford.)
Anyway, Nancy, unfortunately but understandably, had to leave early. She barely got in yesterday from Los Angeles, switching to a flight that wasn't canceled by yesterday's East Coast storm, and I gather managed to escape this evening just ahead of tonight's East Coast storm. But this required her leaving our session early. I could certainly understand the problem; twice in the last few years I've been trapped in Los Angeles (mid-semester) for 48 extra hours due to an East Coast storm.
To fill the gap, Victor Fleischer participated (from San Diego) by Skype. I really don't like doing this because the technology still isn't so great, unless you have a higher capital investment site than NYU can offer. Vic apparently heard less than half of what was being said on our end, and inevitably we had lag, Internet freezes, etcetera. But it was good to have him participate even virtually, and this enabled us keep the session going under some simulacrum of quasi-normality for the full time.
Anyway, the topic of the paper is a type of deal that has gotten some attention in the tax press, known as a "supercharged IPO." As discussed in the paper, these deals have two main attributes, and the relationship between the two was a main topic of interest. The first attribute is that, in certain initial public offerings (IPOs) in which a given start-up company is taken public, the parties deliberately arrange a taxable, rather than a tax-free transaction. The second attribute is that, in a very few deals but these being the ones that were studied in the paper, the parties agree to a "tax receivables agreement" (TRA). Under a TRA, the buyer agrees to make certain payments to the seller, in effect as deferred installment sale payments, the amount of which depends on the tax savings realized by the buyer, post- transaction, from tax attributes acquired in the course of the deal (and enhanced by the fact that the deal was deliberately made taxable).
OK, let's give an example, before turning to the fact, which came out during the session, that this was not generally the universal or even typical pattern in a "supercharged IPO." Suppose the following. A highly successful start-up business, conducted as a partnership, has assets with a value of $1 billion and a tax basis of zero. Suppose that all of the assets would yield capital gain, taxable (during the pre-2013 years covered by the paper's data analysis) at a 15 percent rate. In other words, no depreciation recapture or "hot assets" (to use the operative tax lingo) that would be taxed at the ordinary income rate. Suppose, moreover, that if the assets were newly acquired, they would get 10-year straight line depreciation. Thus, if acquired for $1 billion, they would yield depreciation and amortization deductions of $100 million per year for 10 years. The tax savings would be $35 million per year for 10 years at the 35 corporate tax rate, assuming that the taxpayer always has enough taxable income for the year to claim all of the available deductions at that rate.
OK, suppose the taxpayers could sell the asset to themselves for $1 billion, for tax purposes. They'd pay $150 million of tax on the $1 billion capital gain. Saving $35 million per year from the cost recovery would yield them the equivalent of a 10-year annuity (again, assuming certainty of realizing the full value). These tax savings would have a present value of $270 million if one uses a 5% discount rate.
Therefore, the self-sale, if permissible would save $120 million of tax in present value. While you can't do that, using an IPO to do it arguably applies the following. In a competitive market, buyers who would have paid $1 billion just for the assets should also pay $270 million for the annuity, so the total sales price, in a taxable deal, should be $1.27 billion rather than just $1 billion. (To keep the arithmetic simple, I am ignoring the fact that this changes all the relevant dollar amounts, and thus the true amount might settle a bit further north.)
OK, so if this is the right scenario to be thinking about - and knowledgeable practitioners in the room suggested that perhaps it actually is not - then Conclusion 1 is that, obviously, the parties should do a taxable rather than a tax-free deal. No need for a fight between sellers who'd want to avoid tax and buyers who'd want to maximize their deductions, since the right way to approach the problem is as one of collective tax minimization. Once you've made the "pie" as large as possible, at the expense of the fisc, there's plenty of time to divide the loot between the two of you so that you're both better off. E.g., at a $1.27 billion price, the buyers get fair value while the sellers are compensated for their $150M tax liability by a $270M increase in their sale price. (Yes, I realize still that I am not fixing the numbers to include the capital gain on the extra sale price, etc.)
Let's call this the underlying "tax arbitrage" here (offsetting 15% & 35% rates create a net tax saving despite the adverse timing of having income before deductions). But that just concerns doing a taxable rather than a tax-free deal. (Practitioners suggested, however, that more realistic scenarios include (a) sellers are going to realize gain anyway, by selling the stock they acquire within a few months even if it's a tax-free deal, so why not get the basis step-up, and (b) a separate set of considerations that guide purely corporate transactions.) Even if we accept the scenario, however, what we haven't explained is why the parties, at least in a small set of cases, might include a TRA.
A typical TRA might provide the following. For each of the next 10 years, Buyer shall make a payment to Seller that equals 85% of the tax savings enjoyed by reason of the tax benefits. So under my facts, each year 85% of the $35 million tax benefit from the cost recovery deductions (i.e., $29.75 million) would be paid to the Seller.
OK, again for arithmetical simplicity, let's make it a 100% TRA, so the annual payments are $35 million. (This is frowned upon in practice, of course, because it would wholly eliminate the Buyer's incentive to actually use the tax benefits.) With a 100% TRA, the mechanism for paying $1.27B to the Seller might be $1B up front, plus $35M per year for 10 years. The question is, why do this? $1.27B in present value can be paid whether you use the TRA or not. And even if you want some deferred payment, why should it depend on the tax benefits. Use or non-use of the TRA should be a matter of complete indifference to the parties - indeed, whether or not they have done a taxable deal, unless there is more to the story.
Here are the 6 theories we discussed that might explain the use of TRAs in practice:
(1) Buyer myopia - Just about everyone who actually knows about these deals insist that the form reflects buyers' failing to value the tax benefits appropriately - and at the limit, valuing them at zero. "That's what the bankers tell everyone," the tax lawyers in the deals will explain to you if you ask. This seems decidedly odd as it implies a market failure that seemingly could be exploited by savvy arbitrageurs (or simply higher bidders) who understand the value of the tax benefits. But if we assumed it were true, it would make use of the TRA an efficient mechanism between the parties. You assign a given asset to the party that actually places a higher valuation on it. As we will see, while this theory may remain hard to accept, arguably all the other theories fare even worse.
(2) Careless buyer doesn't read the fine print - To put this in the strongest possible form, although in practice it may overlap with Theory 1, suppose the Buyers are willing to pay $1.27 billion as that is the value of the business assets plus the tax assets, it fails to read the fine print at page 496 of the transaction documents. Hence, they fail to realize that they are paying twice for the same tax assets: once up front and a second time through the TRA. This is an even harder theory to credit - TRAs are apparently highlighted not smuggled in - but it starts to look more like Theory 1 if we posit that the Buyers don't so much overlook the TRA as value it at zero (in the extreme case) due to their mysterious myopia about the value of tax assets. And in the intermediate case it's just the way they prefer to pay the overall sale price, since they have a lower estimate of the tax assets (even if not zero) than the Seller.
(3) TRA spares the parties the trouble of having to value the tax assets - Rather than fight about how much they're worth, why not just assign them to the Seller through the TRA. But the question here is, why are they harder to value than everything else? You have to figure out how much the company is worth, and once you're projecting annual pre-tax and after-tax earnings you're pretty much there so far as valuing the tax assets is concerned. So this theory is less than wholly persuasive.
(4) Buyers don't like the risk associated with the tax assets - Will the IRS allow them all? Will there be sufficient taxable income to use them in full right away? But if we view this purely as a matter of risk aversion, it seems peculiar in this context. Typically what's happening in an IPO is that the entrepeneurs who bear a concentrated business risk are selling it into the general marketplace in order to diversify. The buyers already were diversified and remain so (indeed, they may become a hair more diversified by reason of doing this). So why would the buyers be more averse to the tax risk here than the Seller?
(5) Lemons problem from asymmetric information - OK, now it might seem that we are finally getting somewhere. This was my favorite theory going in. Suppose the Seller knows more than the buyers about the true value of the tax assets. Is it overstated? Are they subject to successful IRS challenge? With asymmetric information, they have the used car problem. Even if the tax assets truly are worth what they seem, how can they prove this to the buyers? The very fact that they are selling creates a bit of natural suspicion that this is what motivates them. Now, the lemons problem clearly can be a big problem in selling stock to less-informed third parties. But why is it distinctively associated with the tax assets? E.g., asset basis is negotiated in the deal and may be hard for the IRS to challenge. Future profits that would permit the tax benefits to be used in full is already an issue on asymmetric information grounds. How much worse do the tax assets make it? Plus, apparently in the typical TRA the buyers' payment to the Seller is based on the tax benefits claimed, and no refund is subsequently due from the Seller if the IRS disallows tax benefits on audit. In sum, therefore, it is hard to really get this theory off the ground.
(6) Upselling by the lawyers - They want to be able to charge for arranging a TRA, so they tell the parties what a great idea it is. Only, it's apparently the bankers who push for these things, and they aren't increasing their own compensation by doing this unless this makes the deals higher-priced overall or easier to close.
So even though I don't like Theory 1, I am pushed back towards accepting it by the universal testimony of the players plus the weakness of the alternative theories.
If one accepts all this, what should one think of TRAs? They look pretty innocuous, serving merely as devices for permitting efficient pricing and costing the IRS zero on any deal that would have been made with the same overall price terms in any event. (Tax attributes aren't traded from lower-valuing to higher-valuing parties - it's just the after-tax benefit that they shift around.) There would be an SEC / capital markets / consumer protection for banning them if we believed, as under Theory 2, that they are a device for duping investors into overpaying. But that is hard to credit given how prominently they're disclosed.
So about the best one can do, if one wants to argue against them, is to claim that they are associated with the ability to execute tax arbitrage deals (like my $1B / $270M example above) that otherwise would founder due to differential valuations by the parties of the tax benefits. In other words, in this scenario one would ban TRAs in order to discourage tax arbitrage deals by impeding efficient pricing of the deals. (Note, however, that you can also potentially use a TRA in a tax-free deal.) But this one as well is pretty hard to credit. To what extent do we believe that impeding efficient pricing would actually impede "bad" deals while leaving "good" ones (e.g., those where people just want to diversify) unharmed?
I conclude both that there is no particular reason to go after TRAs - instead, address the tax arbitrage directly if one is concerned about it - and that they are simply aren't that big a deal from the policymakers' standpoint. But still interesting to discuss at the session.
Subscribe to:
Posts (Atom)
