The Economics of Offshore Trading Corporations

Recently there has been a huge outcry related to offshore income being collected in low or no tax jurisdictions.  There has been some moral angst attached to this outcry.  It is said that the tax savings are achieved at the expense of domestic taxpayers. 

First, there is no moral component to paying taxes.  You either owe what’s assessed or you don’t.  Cheats will be dealt with by either the tax or criminal courts.  If a taxpayer enters into a contract with its offshore subsidiary to collect offshore income in a foreign jurisdiction and, that is a legitimate legal obligation (and not a sham) then the only contentious issues are (a) if the legal obligation is real, (b) if the separate existence of the offshore entity is real and (c) if there is any inter company pricing between the domestic and its offshore subsidiary, that the pricing between them is fair. 

Tax is just another expenditure for companies.  Optimizing tax is as important as optimizing purchases, salaries or other costs.  Increased taxation hurts reinvestment of resources in capital equipment, inventory and accounts receivable. Reinvestment of after tax earnings means more jobs.  If excess funds are paid out to shareholders then Canada receives the tax on these dividends and the shareholder’s net after tax income is either spent in the economy or contributed to the economy as additional investment.

Most OECD countries allow after tax earnings of offshore companies to be repatriated to the domestic parent free of tax.  The only country of any significance that does not conform to the norm is the US.  The US charges a tax of 35% of repatriated offshore income.  If, for example, the offshore company pays tax at the rate of 35%, then the total tax load for repatriated income would be about 70%.  This has caused US companies to hold about $1 trillion offshore instead of repatriating it to the US with resulting harm to the recovery of the US economy.

Most tax programs are there because the government wants to reward or subsidize certain behavior.  Depletion allowance reward mining and petroleum companies because Canada is a raw material exporter and rewarding this sector is a subsidization of the price of the product.  A tax credit for charitable donations is a subsidization of the charities sector of the economy.  Allowing a credit for medical expenses is a subsidization of the health industry.  And so on. Canada is a small trading country.  Canadian companies need to export to larger markets.  The subsidization of offshore trading companies makes Canadian companies more price competitive.  Lastly, I would argue that the subsidy is not much of a subsidy but rather a timing adjustment in collecting taxes.  This is because dividends from the Canadian parent will be fully taxable in the hands of its shareholders.  To the extent that the Canadian parent can delay taxation by simply holding the funds is also true for the domestic Canadian corporation. 

The huge outcry is mostly political.  No one in government seriously believes that the US model would be better for Canada.  If this were the case many Canadian companies would simply hold offshore profits offshore or leave Canada as its main taxing jurisdiction. 

Hewers of Wood and Drawers of Water

In a recent article in the New York Times, Thomas Friedman argued that bringing Vladimir Putin to heel was a matter of turning off the demand for Russian oil and gas. Since Russia is basically a petro state, a significant reduction in demand will cause severe economic stress.  The inability of Putin’s close associates to use money market facilities in New York, London and the Continent will also isolate Russia. 

There is a lesson here to be learned for Canada.  Canada is very much a petro state.  Much of our future has been linked to the oil sands and to exports to either the United States or the Far East.  If that was not bad enough much of the rest of the economy is linked to other extractive industries.  If world markets for such commodities fall (as they did during the last recession) Canada becomes the canary in the mine.  If America becomes more energy self-sufficient, Canada will lose one of its prime customers.  A report this morning from one of the banks indicates that manufacturing represents just 14% of the GDP in Canada.  This down from 16% pre recession and up from 12% during the recession.  To make matters worse (or better?) this feeble sector of our economy depends on a cheap dollar for it to be competitive at all.  A dismal picture. 

The old canard that Canada is just too small an economy to foster an indigenous manufacturing industry belies the fact that countries smaller than Canada do just that.  The Scandinavian countries, the Benelux countries and even a city-state such as Singapore do very well indeed.  In Canada much of our manufacturing is linked to American countries that can, on whim or otherwise, terminate their existence in Canada.  Leamington has been decimated by closures of US food processing plants.  The London-GTA corridor depends largely on the US auto manufacturers.  We live, largely on US manufacturing handouts and job creations wax and wane at the whim of US manufacturers.  If cars can be made more economically in Kentucky, then that’s where Korean carmakers put their plants.

One of the functions of governments is to create a global view of our economy.  I know that our Prime Minister has been trying to forge trade relationships with Europe and Southeast Asia and that will help.  However, that is not enough.  There is the patchwork of job creation programs that involve both federal and provincial governments but that’s not enough.  Canada’s unemployment rate remains stubbornly above 7% and we treat that as the new normal.  We need policies that foster companies that can manufacture goods that are consistent with the size of our market and our need to export surplus inventories.  It needs a bigger picture and that’s what none of our political parties can and want to do.