Global tax crackdown will hit US firms

For a long time, tax avoidance (exploiting loopholes to pay less tax, entirely legally) by multinationals was considered a fact of life.

It's just what happens when countries have different tax regimes and they all want to attract business from big companies. If you crack down on it in one country, they'll just shift to another.

But that's changing now.

Cash-strapped governments are looking to raise money. And at a time when most people rightly or wrongly feel that they are suffering financially, the sight of huge companies managing to avoid paying any tax at all simply adds to the feeling that "we're not all in this together".

With the mood turning, governments have been emboldened. The European Commission (EC) has shocked everyone by taking on some of the biggest companies. Meanwhile, the rich country think tank, the OECD, has drawn up plans to make life harder for global firms.

Here's what that means for investors.

How global giants dodge tax

There are many ways to avoid taxes. However, one of the most common is through what is know as 'transfer pricing'.

Take a car firm. Say it makes the cars in a low-tax area, but sells most of its cars in a high-tax country.

To make sure it pays the least amount of tax possible, it will set up two subsidiaries, one for each country. It will then set up a series of transactions between the two that make it look as though all the profits are being made in the low-tax area, and that the firm is barely breaking even in the high-tax area.

So, even although the cars only cost $10,000 to produce, and end up being sold for $20,000, the accounts will show that the manufacturing subsidiary sold them internally for $18,000. If taxes are higher in the country of production, then the accounts will show that most of the revenue was made in the selling territory.

If neither territory offers an especially attractive rate, then there is always the possibility of opening some offices in a third country and using various deals to shift profits there.

But now Brussels is starting to strike back. There have been attempted crackdowns before. But this time Brussels is overruling national tax authorities.

The European Commission is to demand that various companies, including Apple, Fiat and Starbucks, repay taxes that they were able to avoid through a transfer-pricing scheme focusing on Holland and Luxembourg.

Now this is pretty punchy. You see, the firms involved had taken the trouble to get the authorities in Holland and Luxembourg to agree in advance that these deals were legit. They assumed (perhaps not surprisingly, given that they were dealing with apparently sovereign governments) that this would mean that the deal would not be challenged.

Yet the EC has declared that the transfer scheme pricing is abusive – approving the deal in exchange for promises of jobs amounted to illegal state aid. That's generally not allowed because it gives companies an unfair advantage in a single market.

Of course, both countries dispute this view and will fight it in the court. However, if the Commission prevails – as is likely – it will set an important precedent.

The rest of the rich countries are joining the clampdown

Meanwhile, the OECD is about to unveil a big anti-avoidance initiative agreed between its members. This scheme aims to make it much harder to take advantage of transfer pricing, by forcing subsidiaries within the same group to standardise the prices they charge each other.

The second part of the plan is to make it much easier for tax authorities in one country to find out what deals firms have agreed with other countries.

Around 90 countries – including most major economies – have signed up to the deal. Their combined economic power is likely to force the holdouts to comply.

Of course, some groups say that it doesn't go far enough. Others worry that it will meet so much resistance on the national level that it will be watered down.

But the OCED has already been successful in cracking down on the worst excesses of individual tax avoidance and money laundering. For instance, there are now few countries where individuals can hide their assets, with even Switzerland ending bank secrecy. So, while tax avoidance will clearly continue, the most blatant examples are set to disappear.

This is bad news for US stocks

OK – so what does this mean for investors? Well, it's worth noting that some of the worst offenders are American companies. Some estimates suggest that a falling effective tax rate (the tax rate a company actually ends up paying) has accounted for a third of S&P 500 earnings growth since the 1980s.

If that process stops and reverses, then US companies will face even more pressure on their already record-high margins. That might not matter if US stocks were cheap, but they're not.

The US market has a Cape (prices measured against a ten-year average of profits) of 23.3. It's only been that high before major crashes in the past. It's going to be even harder to justify those valuations now.

By contrast, Germany has a Cape of 16, while UK firms look even cheaper with a Cape of 12. It's another reason for investors to favour Europe over the US right now.