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Cliff Taylor: Has Ireland found the secret sauce that will keep public finances buoyant?

Smart Money: Corporation tax has surged following major FDI inflows and corporate restructurings. But the scale of increase is now astonishing

Is Ireland at risk of repeating the mistakes of the financial crash, relying too heavily on a transient source of revenue? Or has the State found the magic elixir – the secret sauce that will keep the public finances buoyant for years to come?

The likelihood is that the corporation tax take will approach €20 billion this year. Ten years ago it was €3.5 billion. The Department of Finance is crying wolf again after another 50 per cent plus rise in corporation tax in the first half of the year, warning that we can’t rely too heavily on this tax to fund ongoing spending plans.

They are right to do so, because the exposure is now growing – the top 10 multinationals pay one euro in every eight of all taxes. UCC economist Seamus Coffey told The Irish Times Business Podcast this week that Ireland may now be the second-highest recipient of all US corporate tax payments after the US itself.

But nobody can explain exactly what is going on, making analysis of this difficult. Here is why.

1: What we know – and don’t know

Corporation tax payments rise because companies are reporting more profits in Ireland. A huge inflow of foreign direct investment (FDI) in recent years is part of the story – the more straightforward part.

Employment in Industrial Development Authority (IDA) firms is up by 96,000 since 2014, perhaps explaining one third of the tax increase, if we assumed profit per employee was constant.

And it seems that profits have also risen. So a significant part of the surge in corporation tax receipts is explained by the activity of big multinationals here – real economic activity producing pharmaceuticals and medical products, information and communications technology (ICT) products and selling digital services across the world.

A lot of the resulting profits get booked here because Ireland is typically the European or international (outside the US) headquarters for the companies involved.

However, the Irish Fiscal Advisory Council has said a significant part of all corporation tax payments here – between 30 per cent and 60 per cent of the total revenue – is not explained by activity in the Irish economy.

The Central Bank weighed in this week, warning that more than half of all corporation tax – or €8 billion in cash terms – “might” be unsustainable.

The Department of Finance is doing a similar study and while it indicated this week that its estimate of the unexplained element would not be as high, it will also be very significant.

2: Explaining the surge

Changes in international tax rules led to significant restructuring of many big US multinationals after 2015. This resulted in many moving what is called their intellectual property (IP) assets to Ireland – in other words the copyrights, patents, licences and so on underlying very valuable products.

These were previously held in offshore tax havens such as the Cayman Islands and Bermuda, but international tax rules moved to make it difficult to locate these assets in places where multinationals do not have big physical operations. Ireland was the obvious new location, as many had big plants here and employed a lot of people.

Moving IP around the world is essentially a legal exercise, actually executed on paper and key to often-controversial tax planning. The value of these assets was so big in terms of cash – particularly in the case of big companies such as Apple which moved entire balance sheets to Ireland – that they affected the national economic figures.

Remember the “Leprechaun economics” controversy when GDP soared by 26 in 2015? There must also be a link to corporate tax revenue growth, though here things get a bit murky and hard to explain.

The IP assets are big earners as other parts of the multinational chain pay royalties to the Irish operations in return for the use of the IP in overseas markets.

However, these earnings are largely sheltered from tax because when the Irish part of the multinational operation invests in bringing the asset here, it gets a tax allowance – similar to what it would get from investing in a machine or a new factory.

The vast bulk of the direct earnings from IP located here since 2015 will still be sheltered by these allowances – though the rules changed in 2020 so for IP relocated after that, only 80 per cent of annual profits can be sheltered.

Now we don’t know how multinationals are claiming these allowances – they have some leeway and some may choose to spread out the allowances over a longer-term frame and thus pay some tax on IP profits in the early years.

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However, something else changed as multinationals moved their IP assets here. Because the international tax rules now oblige them to have " substance” – in other words significant senior management, decision-making and key functions –where their IP is located, a whole cadre or senior people moved to Ireland and new investments followed.

This in turn means more activity managed and directed from Ireland and more profits declared here. How much of this is stable and how much is purely tax-driven is impossible to judge.

Meanwhile, US tax changes introduced by former president Donald Trump – the Tax Cuts and Jobs Act 2017 – were designed to bring investment back to the US. However, US economist Brad Setser and others have argued that it may in some cases have incentivised pharma companies to invest in countries such as Ireland to manufacture high-margin products for sale back to the US.

Setser said the legislation might be called the “Tax Cuts and (Irish) Jobs Act”. Certainly pharma companies seem central to the tax payment surge. According to Revenue data, the manufacturing sector, dominated in profit terms by pharma, but also including ICT manufacturers, reported a profit increase of around a third in 2021.

There had been speculation these profits, some related to a Covid bounceback or profits flowing from pandemic-related activity, might ease this year.

But the latest figures show strong tax payments in June, a key month. These largely reflect full-year earnings estimates for 2022 and despite fears for global growth receipts remain strong.

“This augurs well for corporate tax receipts in the crucial later months of year,” according to Peter Vale, tax partner at Grant Thornton.

3: What could go wrong?

There are a few clear risks. The Department of Finance has underlined the so-called concentration risk – the reliance on a small group of companies for a large amount of tax, particularly in a scenario where a large chunk of the tax is not related to activities in Ireland.

Ireland is thus vulnerable to decisions in a small number of corporate headquarters, or to the fortunes of these companies, some of which have been caught up in the big US stock market sell-off which has seen their valuations fall sharply. With the possibility of a global – and US – recession, profits, and thus taxes, could fall.

The department points out that had corporate tax remained at 2019 levels, then the exchequer would be in deficit this year and next to the tune of about €7 billion, on current forecasts.

There are also risks from the ongoing programme of international tax reform – the Organisation for Economic Co-operation and Development’s (OECD) base erosion and profit shifting (BEPS) process – though it is not clear if or when this might be implemented. Previous estimates had put Ireland’s annual exposure at €2 billion plus.

In a malign scenario, the IDA inward investment figures we are now seeing could be the peak of the current investment wave. This, together with any difficulties in the big taxpayers here – who are also big payers of income taxes – could hit the exchequer hard, as could corporate restructurings by these companies which removed key functions or assets from Ireland.

4: What could go right?

It is also possible to imagine a rosier scenario. In this one, inward investment remains strong and the big tech and pharma companies ride out the looming downturn. Sources say that for now the FDI pipeline remains strong, boosted by the UK’s woes and nervousness about investment in eastern Europe.

As tax write-offs on the original IP investments run out, more of the profits from these assets could be taxed here. Could these IP assets be moved away from Ireland when the current tax advantages run out?

They could. But doing so now and keeping within tax rules is not as easy as in the past. And if the assets have increased in value, then capital gains tax could be payable in Ireland on their disposal, or there could be some clawback of old reliefs on IP which came here before 2020.

The IP could still move, of course, but it remains to be seen if there are compelling reasons for this to happen. Ireland’s competitiveness will be one of the factors, given that physical investment and employment are also associated with these assets.

But complex international tax rules could also play a part. So while an international slowdown will also certainly affect corporate tax revenues here in the next few years, the basis for the recent growth could remain in place.

At this stage it looks more likely that the part of the BEPS process which could benefit Irish revenues – the increase in the corporate tax rate – could go ahead before the part which would cost Ireland, which is the reallocation of taxing rights.

5: The bottom line

Corporate tax revenues have been a huge boon for Ireland in recent years, helping to plaster over other problems, like health sector overruns.

Some mechanism to set some of these funds aside is likely to be announced in the budget. The sensible solution is to rely on the excess cash for once-off spending, either capital investment or as a fund to help Ireland if serious trouble hits.

The mistake is to use the excess to pay for ongoing day-to-day spending. As we have seen, judging exactly how much of the payments are “excess” is difficult, but the Department of Finance is working on the calculations. With corporate tax now representing close to one in four of every tax euro collected, its conclusions will be important.