Businesses deliberately loaded with debt rob the country of future tax income

Debt-fuelled buy-outs replace taxable profits with onerous interest burdens

 

It is extraordinary the extent to which the banking sector is behind so many of the woes that litter the business pages of newspapers across the Western world.

The issue of increased taxation is a similarly prominent story, not least because so many people are incensed at having to shoulder more tax so as to pay off the cost to society of the perfidious banking sector.

Benjamin Franklin said the only certain things in life are death and taxes but people could be forgiven these days for tweaking the quote.

Debt as equity
What is particularly interesting about the issues of debt and taxes is how they are connected by the way a business can use its finance costs to reduce its tax bill. The Financial Times commentator, Martin Wolf, has proposed that debt should be treated like equity, by which he means – as I understand it – that you should pay your bank interest from your after-tax profits.

People in charge of large, successful cash-generating businesses can be tempted to load them up with debt.

By doing this, they can take the future profits of a company out now, (and bank them), and leave it to the business to pay off the debt that it has been assigned.

The risk that is associated with the business is in this way switched from the owner to the lender.

The owner has already banked the future profits and, if unforeseen events lead the business to crash, it is the bank that will take the hit. So the owner of the business gets his future profits, the bank executive who processes the loan gets his fees and the risk is left floating somewhere in the international banking system which, as we have seen, can be viewed as being the responsibility of the general population.

All of this may sound somewhat academic, but consider the history of Telecom Éireann/Eircom.

The following paragraph is from the 2002 accounts of Valentia Telecommunications Ltd: “Under the terms of the €2.4 billion facilities entered into between Valentia Telecommunications Ltd and Goldman Sachs International, Deutsche Bank AG London, Barclays Capital, The Governor and Company of the Bank of Ireland, and Allied Irish Banks plc and pursuant to which Valentia Telecommunications Ltd had financed its acquisition of the shares in Eircom, Valentia Telecommunications Ltd agreed to procure that Eircom would enter into an accession agreement pursuant to which Eircom would agree to become an additional borrower and a guarantor under the Facilities Agreement.”

Valentia’s annual return for 2002 includes shareholders based in some of the world’s best-known offshore locations. Sir Anthony O’Reilly’s Lionheart Ventures had an address in the Irish Towers, Nicosia, Cyprus. Other shareholders were in the Cayman Islands and Bermuda.

Such is often the case with large companies involved in such transactions. The companies’ profits, which formerly were taxed, now go towards servicing debts, while dividend and capital gains income goes to owners who have organised their affairs so they pay little or no tax.

The point this column would like to focus on is the loss of tax involved. The sale of Telecom Éireann in 1999 netted the State €6.3 billion.

But in the years since then, the eventually unsustainable levels of debt placed on its shoulders meant that the State’s largest telecoms operator, which was otherwise a profitable operation, paid very little tax.

The State’s plan for dealing with the current crisis includes the intended sale of State assets with a view to raising €3 billion.

It is not hard to imagine the type of corporate and financial structures that will lie behind any such purchase. An offshore entity buys a valuable State asset using a large amount of bank debt which is placed upon the shoulders of the asset purchased.


Struggling to survive
Untaxed income by way of dividends or capital gains accrues to the offshore entity or entities behind the purchase, while the actual business struggles to survive under the burden of its debt and all but ceases making any bookable profits that can be taxed by the State.

No one is asking Enda Kenny’s Government to redesign the way the world works, but in deciding to sell off valuable assets, it should include in its calculus not just the loss of future profit but also the inevitable loss of future taxation that will arise.

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