Month: September 2016

Lessons from Edcon

The Edcon story – was it a failure of capital structure or of management? Or a bit of both?

Bain and Company, a private equity fund, has thrown in the towel on its involvement with Edcon, a private company that it has owned and controlled since 2007. When it took over, it immediately converted the equity stake it had acquired from Edcon shareholders for some R25bn (with almost no long term debt on the Edcon balance sheet) into additional Edcon debt of some R24bn, with some additional finance of about R5bn provided as loans from its controlling shareholders. It has now reversed this transaction, converting the considerable outstanding debts of Edcon back into equity. Edcon is the owner and manager of Edgars, a leading clothing retailer as well of other retail brands, including CNA and Boardmans.

The 2008 balance sheet reported total Edcon assets of R38.1bn, up from R9.5bn the year before. Much of the these extra assets were created by writing up the intangible assets, including goodwill, that Bain had paid up for and raised Edcon debt against. The cash flow statement for 2008 reports “investments to expand operations: R24.4bn”. This was a euphemism – the cash was patently used to reconstruct the balance sheet, not to expand operations.

More important for the new shareholders than the description in its financial reports, it failed to persuade the SA Revenue Service (SARS) that the extra borrowing was undertaken to produce extra income. As a result, Edcon continued to have to use some of the cash it was generating from operations to pay significant amounts of tax as well as the interest it was committed to paying. In the early period, the 47 weeks to 29 March 2008, it paid cash taxes of R246m. And despite the fact that large ongoing accounting losses that were incurred as interest expenses greatly exceeded trading profits, it continued to deliver cash to SARS at the rate of over R100m per annum. More recently, according to the cash flow statement in the 13 weeks to 26 December 2015, cash taxes paid amounted to R32m.

This appears as a large mistake when Edcon was originally reconstructed. Presumably, had Bain registered a new company to buy out the Edcon assets from its shareholders and this company had then funded the purchase with debt, the interest expense would have been allowed as incurred in the production of income. And the consequent losses could have been carried forward to offset future income and to raise the current value of the company.

Much of this debt was to mature in 2014-15 (a commitment that Edcon was unable to fulfil) as was long apparent and well-reflected in the much diminished market value of its debt that traded on global markets. It will be appreciated that the Edcon financial losses have mostly been incurred by its creditors, not by Bain and Company. The statement of Edcon’s financial position in December 2015 reports a shareholders’ loan of R828m, well down from the more than R5bn recorded in 2008. Clearly Bain and its co-shareholders have walked away with nothing to show for their efforts. The company is by all accounts now worth less than was paid for it in 2008.

In the charts below we convert the 71% of Edcon euro debt it incurred into rands at current exchange rates. In January 2008 a euro cost R11.12. As may be seen, the rand value of this euro debt is now significantly higher than it was in early 2008. But the rand value of this original debt had actually fallen significantly by 2010, providing an opportunity to restructure the debt with profit that apparently was ignored.

And if the burden of this euro debt burden was dragging down the operating performance of the retail operations (denied essential working and other capital, as it has been argued by management) then there was ample opportunity surely to add more equity capital with which to compete with the competition. And the competition has been doing very well, partly at Edcon’s expense, as measured by value of the General Retail Index of the JSE.

We have rebased this index and the retailers’ dividend per share to January 2008. We have also converted these additional rand values into euros at current values. As may be seen, the share market backdrop for clothing retailers and their ilk on the JSE was encouraging, but more so in rands than in euros (until very recently) with its combination of weaker retail share prices and a weaker rand. It seems clear that had Edcon operated in line with its competition, it could have added value for its shareholders and its debt, particularly had it been converted to rand debt (which would have been manageable).

 

With the agreement of its creditors, who now own all of the shares in Edcon in exchange for cancelling its loans, and with new debt raised of about R6bn, Edcon can continue to operate normally, much to the relief of it managers, workers and landlords. The horrors of business rescue have thus been averted, to the presumed advantage of its creditors and its future prospects. Given that Edcon continues to realise significant trading profits, it makes every sense for it to stay in business to deliver value for its new shareholders. For the third quarter of F2016 Edcon reported a trading profit of R763m and depreciation and amortisation of R248m, making for cash flows from operations of over R1bm for the quarter (though down by 7.7% on Q3 of F2015). Net financing costs of R958m for Q3 F2016 were also reported, 10% higher than Q3 in F2015. Coincidentally the debt on the Edcon balance sheet of F2016 was of about the same rand book value of about R22bn it reported in F2007. Its euro value, as may be seen, is considerably lower.

Bain and its funders clearly failed to realise the prospective gains they envisaged when they geared up the Edcon balance sheet. The potential rewards to the owners of the much reduced equity capital were potentially very large had the company proved able to service its debts. On returning to public company status, the possibly R5bn of equity finance provided might have doubled in value had the market value of the company gained an additional R10bn of value over the 10 years.

To put it another way: had Edcon performed as well as the average general retailer did on the JSE over the period, these gains would have been realised. But the average JSE-listed clothing retailer was not encumbered by nearly as much debt, particularly the 71% of its debt denominated in euros. This appears as the major original strategic error made by Bain to which it never made the adjustment. Combining rand revenues that Edcon would generate, with hard currency debt, represents a highly risky strategy. Perhaps the SA debt market would not have been willing to subscribe the large amount of the extra debt raised. But there was surely always the opportunity to fully hedge the foreign currency risk. But this would have meant paying interest at a South African rather than a euro or dollar rate, a cost that, had it been incurred, may well have (correctly perhaps with hindsight) undermined the investment case for a highly leveraged play on the SA retail market.

The Edcon experience has unfortunately not been able to add to the case for private equity over the public equity alternative in SA, that is to say, to use public money to take a (large) listed company private. The case for private equity is not based on its superior financial structure of more debt and less equity, though clearly the leverage adds greatly to the potential returns for equity holders (assuming all turns out well for the company). Moreover, the conversion of a public company to a private one, through private equity funds, or more or less the same thing, through a management buyout, may not be possible without significant reliance on debt finance. The case for private equity is that the few shareholders with much to gain and lose have every incentive to closely and better manage their stake in the company. They will be very active shareholders with highly concentrated investments, unlike those of the average listed company with wider stakeholders, as opposed to shareholder interests, to serve. The large publicly funded private company represents therefore a very helpful competitive threat to the public company, from which shareholders (including pension funds) the economy and its growth prospects can benefit.

It is thus no accident that the number of companies listed on all the US stock exchanges has declined dramatically over recent years, by between 40% and 60% over the past 25 years according to different estimates, as pension funds and endowments have increased their allocations to alternative investments and especially to private equity funds. Private companies may well, on a balance of full considerations, serve their owners better than public companies.

The competitive threat therefore should be encouraged and not discouraged (including by SARS). The objective of tax policies should be much wider than merely protecting the tax base. Private equity, by adding to the growth potential of an economy and especially adding to the willingness of the system to bear additional risks for the prospect of additional returns, deserves no less or more than equal tax treatment.

For its errors of commission and omission, Bain and the managers it chose for Edcon, were unable to improve its operating performance. How much this equity is now worth is a matter of conjecture that can only be resolved when, as is the intention, these Edcon shares are re-listed on the JSE. The sooner the current Edcon shareholders get to know what their shares are worth, surely the better and the sooner the shares can be listed and so could pass into the hands of perhaps more active investors, the better the company can be expected to perform. 27 September 2016

Some hope of an economic revival is in the spring air

The Reserve Bank, not before time, has changed its tone. It has suggested that the interest rate cycle may have peaked. From the pause in the trend to higher rates we now have talk of a longer pause in interest rate settings. If the exchange rate holds up better than R14 to the US dollar by the next time the Monetary Policy Committee (MPC) meets in November, interest rates may well be on their way down. The Bank’s inflation forecast (if not the year on year change in the CPI, headline inflation itself) will have had time to adjust lower and food price inflation will be in retreat from its extraordinarily elevated 12% plus base. How rapidly this occurs will depend on the rain. Prayers for rain are in order.

If all goes better on the inflation front, the Reserve Bank will be able to focus on something very important to the SA economy over which it does have considerable influence and that is domestic spending and lending. Its interest rate settings do predictably affect the willingness of households and firms to spend more; and the SA economy urgently needs the stimulus of more demand and lower interest rates.

These interest rates however have no predictable influence on the exchange rate, rainfall or on excise and other taxes, including fuel and sugar taxes. Nor do they affect the price of electricity except, perversely, should Eskom persuade Nersa, the regulator, that its higher borrowing and other costs are a good (actually bad) excuse for a higher tariff. Nor, as I would argue, though the MPC would disagree, do higher interest rates influence inflationary expectations for the better and/or wage demands for the better.

Inflation expected (which has remained remarkably stable and consistent around the 6% – the upper band of the inflation target level will follow inflation – not the other way round. Inflation leads and inflation expected follows, as will be further demonstrated should inflation come down because the rand has strengthened and long term interest rates decline relative to US interest rates, meaning less rand weakness expected and hence less inflation expected. This narrowing of the spread between RSA and US benchmark interest rates has been under over the past few days. It is a very helpful development.

With some help from global capital flows, the weather and the politicians (and also the rating agencies) we will see the rand hold up inflation and the inflation forecasts continue to recede. The question then will be how low can interest rates in SA go. I would suggest as low as it takes to get the growth in spending running at a sustainable 3- 4% per annum. The sustainability of such growth will depend upon support from capital inflows and so a stable rand itself. Faster growth itself will be very encouraging not only to capital expenditure by firms and the government – but to global suppliers of capital. Can we dare hope for a virtuous cycle of faster growth with less inflation? A reprise perhaps of 2003-2008, accompanied by much better control of money supply and bank credit?

Help or hinder?

GDP grew in the second quarter, despite very weak spending. Without a recovery in spending the SA economy will continue to struggle. Will the Reserve Bank help or hinder a recovery?

The SA economy, measured by GDP (the real output of goods and services) grew in the second quarter (Q2), at a satisfactory (annual equivalent) rate of 3.3%. In the first quarter (Q1) output had declined at a -1.3% annual rate. Hence the economy avoided a recession – defined conventionally as two successive quarters of negative growth. However an examination of the expenditure side of the economy reveals a much less satisfactory state of economic affairs. Total spending, Gross Domestic Expenditure (GDE) in real terms declined in Q2 by as much as GDP increased, at a -3.3% rate. The difference between GDP and GDE is by definition net exports: the difference between exports that add to domestic output and imports that substitute for domestic output. On a seasonally adjusted basis, export volumes grew very strongly in Q2, while import volumes declined enough to add a net 6.7% to the GDP growth rate.

Final demand makes up a large component of GDE. It aggregates the compensation spending by households and government and the expenditure by government agencies and the private sector on additional capital goods. This aggregate declined (by 0.1%) in Q2 – an improvement on the 2.8% decline estimated in Q1. The further component of GDE is inventories accumulated or run down. In Q2 inventories are estimated to have declined by a real R22.7bn, contributing a large negative (-3.2% p.a) to the GDP growth rate in Q2.

When the spending of households is aggregated with that of privately owned businesses on capital equipment, that is when government spending and investment in inventories are excluded from final demand, we find a similar reluctance of private households and firms to spend more. Private demand for goods and services has been growing at consistently slower rates in recent years appears and now appears to be in retreat, having declined marginally in Q2 2016, not quite keeping up with inflation, defined as the year on year increase in the GDP deflator. The supply of money and bank credit has been growing as slowly as private spending. This is clearly not co-incidental. The growth in spending and credit to fund spending tend to run together.

The performance of the economy in recent years indicates clearly that the increases in interest rates imposed on the economy since January 2014, while they have worked to reduce spending and so the growth in GDE and GDP, have not helped in any significant or predictable way to reduce inflation or inflation expected. Inflation in SA – that leads rather follows inflation expected – has been dominated by shocks in the form of a weaker exchange rate that has driven up the prices of imported goods and a drought that has reduced domestic supplies of food staples and increased dependence on imports. Higher regulated prices and taxes on expenditure have added to the supply side shocks that can drive prices higher – despite weak demand that only to a limited extent has helped to hold back prices. The exchange rate itself has taken its cue, not from interest rates set in Pretoria, but in Washington DC. It is not only the rand but all emerging market currencies that have depreciated as capital flowed to developed, rather than less developed markets, in recent years. Moreover wage rates and prices are determined simultaneously and interdependently in SA. Higher wages have come at the expense of employment opportunities as well as recent profit margins, when final demand is lacking and the firms lack a degree of pricing power.

The reality that the Reserve Bank finds so hard to recognize is that scope for an independent monetary policy to control inflation is very limited if the domestic authorities do not have any consistent influence over the exchange rate. This has been the case for South Africa as it is for most emerging market central banks with flexible exchange rates that respond to highly unpredictable capital flows. The figures below demonstrate that the common global rather than SA forces that have been responsible for almost all of the weak rand and the higher prices that have come with it. The EM Currency basket represents nine equally weighted emerging market currencies (The Russian ruble, Indian rupee, Hungarian forint, Mexican, Chilean and Philippine pesos, Turkish lira, Brazilian real and Malaysian ringgit). Though it must be added, the rand has been a distinct underperformer since 2012 – losing about 20% more than the EM basket Vs the US dollar. The current value of the rand is now (20 September) a little ahead of where it would be predicted to be – given the exchange value of the EM basket as its predictor – and so also taking into account the weaker bias against the rand.

The Reserve Bank, through its unhelpful interest rate and money supply actions, has significantly influenced the growth in spending. Higher interest rates may have reduced measured GDP growth by as much as 2% p.a. The limited feedback loop from interest rates to spending and so on to inflation has been dominated by the independence of SA interest rates and other highly unpredictable forces acting on the exchange rate and administered prices. The hope for a cyclical recovery of the SA economy and the lower interest rates that will be necessary to the purpose, rests on a degree of rand stability that will accompany a revival of capital flows into EM markets and currencies. A normal harvest will also help to hold down inflation in 2017.

It will take lower interest rates to encourage the demand for and supply of bank credit. It will take lower inflation and inflation expected to encourage the Reserve Bank to lower short term rates. It would seem self-evident, given the want of demand for goods and services and for the labour to help produce them, that the direction of SA interest rates should be downward rather than upward.

The highly competitive weak rand – now some 30% below its purchasing power equivalent value (see below) will continue to encourage exports (labour relations permitting) and discourage imports and may help sustain GDP, as it did in Q2 2016. However, given the importance of household spending for the economy, accounting as it does for over 60% of all spending and given also the further dependence of capital expenditure by private companies on the demands households make on their established capacity, any consistent recovery in the SA and the weak economy – will require the stimulus of lower interest rates. We can hope that a stable or better, a stronger rand and less inflation, makes this possible. We can also hope for a more realistic and helpful narrative from the Reserve Bank that recognises that interest rates influence growth much more than inflation and that maintaining growth rates is a highly appropriate objective for monetary policy – especially when controlling inflation is not within its control. 20 September 2016

 

The paradox of competition

The paradox of competition. You can lose because you have won the game.

When portfolio managers and active investors value a company, they are bound to seek out companies’ advantages that can keep actual and potential competitors at bay. Moreover, they seek companies with long lasting, hopefully more or less permanent, advantages over the ever likely completion, advantages that will not “fade away”, in the face of inevitable competitors.

The talk may be of companies protected by moats, preferably moats that surround an impregnable castle filled with crocodiles that keep out the potential invaders, that is the competition. Reference may be made to protection provided by loyalty to brands that translate into good operating profit margins; or to intellectual property that is difficult for the competitors to replicate and reduce pricing power. It’s a search for companies that generate a flow of ideas that lead to constant innovation of production methods and of products and services valued by customers; and those with good ideas that will receive strong encouragement from large budgets devoted to research and development that can help sustain market leading capabilities through consistent innovation that keeps competitors at bay.

Such advantages for shareholders will be revealed in persistently good returns on the capital provided by shareholders and invested by the team of managers – managers who are well selected and properly incentivised, and also well-governed by a strong board of directors, including executive directors with well aligned financial interests in the firm. Furthermore, the best growth companies will have lots of “runway” – that is a long pipeline of projects in which to successfully invest additional capital that will be generated largely through cash retained by the profitable company. By good returns on capital is meant returns on capital invested by the firm (internal rates of return: cash out compared to cash in) that can be confidently predicted to consistently exceed the returns required of similarly risky shares available on the share market, that is market beating returns.

Such companies that are expected to perform outstandingly well for long, naturally command very high values. Their high rates of profitability – high expected (internal) rates of return on the shareholder capital invested – will command great appreciation in the share market. High share prices will convert high internal rates of return on capital invested into something like expected normal or market-related returns. The virtues will be well reflected in the higher price paid for a share of the company. Thus the best firms may not provide exceptional share market returns, unless their excellent capabilities are consistently under appreciated. This is an unlikely state of affairs given the strong incentives active investors and their advisers have to search for and find hidden jewels in the market place.

Such excellent companies – market beating companies for the long run – are therefore highly likely to enjoy a degree of market dominance. Their pricing power and profit margins will be testament to this. In other words, they are companies so competitive that they prove consistently dominant in their market places.

But such market dominance – that has to be continuously maintained in the market place serving their customers better than the competition – has its own downside. It is bound to attract the attention of the competition authorities. The highly successful company – successful because it has a high degree of market dominance – may have to prove that it has not abused such market dominance. The fact that the returns on capital are so consistently high may well be taken as prima facie evidence of abuse that will be hard to refute. It may well be instructed to change business practices that have served the company well because they do not satisfy some theoretical notion of better practice. Such companies have become an obvious target for government action.

Foreign-owned companies that achieve market dominance outside their home markets may be particularly vulnerable to regulation. These interventions are designed perhaps to protect more politically influential but in reality less competitive domestic firms. Hence the actions taken by the European competition authorities against the likes of Google, Facebook and Microsoft who have proved such great servants of European consumers.

And so one of the risk of competitive success is that such success will be penalised by government action. A proper appreciation that market dominance is the happy result of true competition that has proved to be disruptive of established markets, through the innovation of products and methods, would avoid such policy interventions that destroy rather than promote competition.

Market forces and market dominance can be much better left to look after themselves, because innovation is a constant disruptive threat for even the best-managed and dominant firms. These firms will know that dominance may well prove to be temporary and so they will behave accordingly, by serving their customers who always have choices and by so doing satisfying their shareholders. 14 September 2016

The golden question

Gold and gold mining companies – is there a case to be made for including them in portfolios?

Gold mining companies listed on the JSE have been enjoying a golden year. The JSE Gold Mining Index (rand value) has gained over 200% this year (see figure 1 below). This outperformance of gold mining shares has much to do with improved operating results, gold mining specifics, more than with the gold price, though in US dollar terms the gold price has enjoyed something of a recovery in 2016. In figure 3, we show the daily price of gold in US dollars and rands going back to 2006. As may be seen the rand price of gold has risen more or less consistently since 2006 while the gold price rose very strongly and consistently in USD until 2011 where-after it fell back sharply – until the modest recovery of 2016.

We show in figure 3 below how far the performance of the gold miners so lagged behind that of the JSE All Share Index until 2016. The weight of gold shares in the JSE ALSI is now about 3.1% up from 1.45% at the start of 2016. In figures 4 and 5 we compare the performance of the gold miners to other sectors of the JSE. As may be seen, the JSE Industrials have been the outstanding performers over the longer run- but not in 2016. The higher rand price of gold clearly did not translate into higher operating profits in rends or USD. As may be seen investors would have done far better holding gold itself rather than gold shares for much of this period – until very recently.

As may be seen in figure 6 above, the JSE Gold Mining Index has been a distinct underperformer since 2005 – though it outperformed briefly in 2006 and again during the Financial Crisis of 2008-09 and then again, making up for some of the lost ground again this year. R100 invested in the Industrial Index on 1 January 2005 would now be worth over R771; and in the Gold Index about R152; while the R100 invested in the All Share Index would now be worth about R423. The rand price of gold rose by 7.7 times over the same period, gaining as much as the Industrial Index as we have shown in figure 3.

The Gold Index has also been twice as risky as the All Share Index. We show daily price moves in 2016 in 2016 in figure 7 below. When measured by the Standard Deviation of these daily percentage price moves, Gold Mining Shares listed on the JSE have been about twice as risky as the JSE All Share Index in 2016. The JSE All Share Index however has proved only slightly less risky than holding a claim on the rand gold price in 2016. The same pattern holds for much of the period 2005-2016, using daily price movements. On average the JSE Gold Index, on a daily basis, has been about twice as volatile as the All Share Index and the rand gold price. Thus the risk adjusted return expected from the gold mines would have to be significantly higher than that expected from gold itself, or from a well-diversified portfolio of JSE listed shares, to command a place in a risk averse portfolio.

Doing well out of gold shares surely would have demanded exquisite timing – both when to buy and when to sell. It is not a sector to buy and hold stocks for the long term. It is a highly cyclical sector of the market, with no long term growth prospects. And as we have illustrated, investing in gold mines, rather than in gold, is much more than an investment in the gold price. It is an investment in the capability of the mine managers to extract profits and dividends out of gold mines that are the quintessential declining industry.

Gold mines run out of gold as SA gold mines have been doing consistently for many years. Deeper mines are more costly and dangerous to operate and green field expansion is subject to more expensive regulation, to protect the environment as well as miners. All these considerations help make the case for gold over much riskier gold mines, though the stock of gold available to be traded will remain many times annual output over the long run. The market for gold is a stock market rather than a flow market. It is demand for the stock rather than extra supplies that drive the price.

It would appear easier to explain the price of gold than the value of a gold mine. Since gold does not pay interest, the cost of holding gold is an opportunity cost – income from other assets foregone when holding gold. Using US real interest rates – the real yield on a US Inflation Linked Bond of 10 year duration has done very well in explaining the US dollar value of an ounce of gold since 2006. The correlation between the daily level of the gold price and the real interest rates has been as high as a negative (-0.91) (see figures 9 and 10 below). In other words, as the cost of holding gold has gone up or down (as measured by the risk free real interest rate) the gold price in US dollar has moved consistently in the opposite direction. Real interest rates in the US fell consistently between 2005 and 2011 encouraging demand for gold – then increased to a higher level in 2013, where they stabilised until declining again in 2016, providing it would seem, a further boost to the price of gold. These real interest rates reflect the global demand for capital to invest in productive assets. They have been declining because of a global reluctance to undertake real capital expenditure and so to borrow for the purpose. Low real interest rates reflect slow global growth. And so gold has been a good hedge against slow growth, as well as insurance against financial disruption.

Inflation-linked US bonds have provided some protection against the S&P 500 – the daily correlation between the 10 year TIPS yield and the S&P 500 Index was a negative (-0.43) between 2006 and 2016 while the correlation between the S&P and the level of the gold price is a positive, though statistically insignificant (0.18). The correlation of daily moves in the S&P and the TIPS yield is a positive (0.23) and negative (-0.20) between daily changes in the gold price and the S&P. As important, the correlation between daily moves in the gold price and the S&P 500 are close to zero. Gold has been a useful diversifier for the S&P Index.

This past performance suggests that gold can be held in the portfolio as a potentially useful hedge against economic stagnation – stagnation that means low real interest rates – and also as insurance against global financial crises. The case for gold shares is much more difficult to make on the basis of recent performance. The problem with holding gold shares is the difficulty and predictability of turning a higher gold price into higher earnings for shareholders. Shares in gold mining companies comes with operational risks. If the gold miners could resolve these operational issues then gold shares could become a highly leveraged play on the gold price. The share price would then reflect the increased value of gold reserves: gold in the ground as well as gold above it.

Not all gold mines will be alike. The search should be on for gold mines with significant reserves of gold and highly predictable operating costs and taxes and regulations. The more highly automated a gold mine, the better the mine will be in this regard. Gold mines with these characteristics could give highly leveraged returns to changes in the gold price – in both directions – making them more attractive than gold itself for insurance and risk diversification.

 

Taking a bite of the Apple

The European competition authorities have ruled that Apple has wrongly benefitted from a tax deal with Ireland that allowed Apple to avoid almost all company taxes on its sales in Europe, the Middle East and Africa. The €13bn company income tax Apple is estimated to have saved on the taxes has been classified as state aid to industries. Hence illegally and to be refunded to the Irish government in the first instance- plus interest. No doubt other European governments and maybe even South Africa (assuming the Treasury is not otherwise engaged) will be looking to Ireland for their share of the taxes unfairly saved on the Apple income generated in their economies and transferred through their tax haven in Ireland.

The principle that taxes should be levied equally – at the same rate – on all companies generating income within a particular tax jurisdiction seems right. But it is a principle much more honoured in the breach than the observance. The effective rate of tax (taxes actually paid on economic income consistently applied) will vary widely within any jurisdiction, with the full encouragement of their respective governments. The company tax rate may vary from country to country – in Ireland it is a low 12.5% is levied on income that may be defined in very different ways from one tax authority to another from company to company.

A company may benefit from a variety of incentives designed to stimulate economic activity generally and capital expenditure in a particular location, perhaps in an export zone or a depressed region or blighted precincts of a city. They may utilise incentives to employ young workers or to train them. Investment allowances may far exceed the rate at which capital is actually depreciating to encourage capex. And governments may well collaborate in R&D that effectively subsidises the creation of intellectual property. A further important source of tax savings comes from the treatment of interest payments on debt. The more debt, the higher the tax rate, the less tax paid or deferred. And so every company everywhere (not just Apple) manages its own effective tax rate as much as the law allows it to do. It would be letting down its owners (mostly affecting the value of their shares in their retirement plans) if it failed to pay as little tax it can.

But then this raises the issue that Apple has already raised in tis defence as has the US government. How does one value the intellectual property (IP) in an Apple device? And who owns the IP and where are the owners of the IP located? In Europe – at the head office post box in Cork or in California where much of the design and research is undertaken? Operating margins are very large – maybe up to 90% of the sales price in an Apple store. What if Apple California charged all its subsidiaries everywhere heavily for the IP that accounts for the difference between revenues and costs? Profits and income in Europe and Africa could disappear and profits in the US explode given very high US company tax rates. The reason Apple does not or has not run its business this way is obvious enough; it has been able to plan its taxes and cash holdings to save US taxes.

The insoluble problem with taxing companies and determining company income is that company income is not treated as the income of its owners – or as it would be in a business partnership. In a partnership (which can be a limited liability one) all the wages and salaries, interest, rents, dividends or capital gains are treated as income and taxed at the individual income tax rates. Total taxes collected (withheld) by the partnership could easily grow rather than decline given that there would be no company tax to shield. And the value of companies absent taxes would increase greatly, calling for a wealth as well as a capital gains tax on their owners. The problem with company tax is company tax. The world would be better without it.1 September 2016