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US tech sector valuations threatened by tax moves at home and abroad

The U.S. and EU are on a collision course over how best to tax the biggest multinational technology companies, and the resulting impact will wallop the corporations and their investors, tax experts said.

U.S. technology giants top the list of companies that are hoarding about $1 trillion in cash, most of it parked overseas in jurisdictions with better tax rates than their home country. The leader is Apple Inc. with $246 billion, or almost 94% of its cash and cash equivalents overseas, according to S&P Capital IQ data.

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EU Competition Commissioner Margrethe Vestager says the bloc is ready and willing to formulate its own approach to taxing tech companies. Source: Associated Press

The other top five tech companies in order of the amount tucked away in overseas venues are Microsoft Corp. $127.9 billion; Cisco Systems Inc. $67.5 billion; Oracle Corp. — $58.3 billion; and Google parent Alphabet Inc. $57.9 billion, according to the data.

The latest U.S. tax reform effort includes provisions meant to encourage the tech industry and other sectors to bring that money home and, theoretically, invest it in the U.S., especially to hire more Americans.

At the same time, the EU is pushing ahead with an attempt to tax the multinationals where their revenue is generated. That move is an effort to correct the advantage that U.S. digital companies hold over their European counterparts, which must pay taxes in the countries where they are domiciled. U.S. companies can avail themselves of lower-tax jurisdictions.

The EU and the U.S. still have to deal with the question of what, exactly, they are trying to tax; specifically, where do companies make money on things that take no physical form. That issue aside, valuations of tech companies, which have been at an all-time high, are likely to take a hit when the taxmen come calling. The S&P 500 Information Technology Sector Index hit a record 1,124.85 on Nov. 28, before losing nearly 46 points, or 4% by Dec. 4, the next trading day after the Senate pushed through its tax proposal. The bill is not final, but investors are taking notice.

Not waiting for consensus

The Organization for Economic Cooperation and Development began a project in 2015 to address attempts by multinational entities to shift profits to low- or no-tax jurisdictions. Last month the OECD launched a project to gather consensus from its global member countries about how to proceed. But it is having a hard time getting agreement on how to go about it, said Channing Flynn, EY's global technology tax leader.

However, the EU is not going to wait for that consensus to gel. Last month, Competition Commissioner Margrethe Vestager said that if the OECD did not come up with an answer by the spring, Europe would move ahead with its own recommendations.

France has been a vocal backer of a coordinated EU approach, with President Emmanuel Macron saying in a speech at the Sorbonne earlier this year that he wanted to see "the taxation of value created, where it is produced, which will allow us to overhaul our tax systems and to stringently tax companies which relocate outside of Europe for the specific purpose of avoiding tax."

Last year, the European Commission told Ireland it had to collect $15 billion in back taxes from Apple, under the theory that giving the iPhone maker a tax break was illegal state aid. Apple agreed to hand over the money to an escrow account while the company and Ireland appeal the decision.

Italy has proposed its own plan — a 6% equalization tax that would be imposed on Italian entities that advertise on digital platforms like Google or Facebook.

U.K. finance minister Philip Hammond said in his budget speech last month that Britain would begin to tax royalty payments tech companies make to affiliates in lower tax jurisdictions, an action that he said should raise about £200 million annually.

Britain last year got Google parent Alphabet to agree to pay £130 million in back taxes for a period covering the prior 11 years. However slight £12 million a year might seem for a company that reported nearly $28 billion in revenues last quarter, it no doubt emboldened the U.K.'s attempts to "raise revenue from digital users that generate value from U.K. users," Treasury said in a November position paper.

While it said the government supported the OECD initiative, it also said it "stands ready to take unilateral action in the absence of sufficient progress on multilateral solutions."

US plays catch-up

Competing proposals from the U.S. Senate and House differ somewhat in how technology companies' tax bills are calculated, but they both have an overriding principle: Trying to get U.S. multinationals to bring back, and then keep, more of their assets in-country, where they will supposedly invest and help the local economy grow.

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French President Emmanuel Macron delivering a speech at the Sorbonne in which he called on the EU to "stringently tax companies which relocate outside of Europe for the specific purpose of avoiding tax." Source: Associated Press

In fact, the economic expansion argument was crucial to get deficit hawks on board with a tax bill that the Joint Committee on Taxation estimated would increase the deficit by $1 trillion. Or, as President Donald Trump claimed in a recent speech, the tax bill would pump "rocket fuel" into the U.S. economy.

One provision of the Senate proposal would require companies to pay 12.5% on half of their "high return profits," which is the legislature's way of trying to describe assets, like intellectual property, that do not have a physical presence, and, therefore, whose value has to be calculated in some other way.

The good news for the tech industry is that it is a lower rate than even the 20% corporate tax rate being proposed, said EY's Flynn.

The bigger issue for the sector is that different jurisdictions are going after the same pile of money, but with different rationales. So if Europe pursues a revenue-based tax system, while the U.S. adopts a model based on valuing the intellectual property, there is a risk of double taxation, said Claude Stansbury, tax partner with law firm Freshfields Bruckhaus Deringer.

EU finance ministers meeting in Brussels this week said they would ask the European Commission to look into whether U.S. proposals would violate international agreements against double taxation, according to news reports.

Which does not mean that the EU will back down from going after revenues found within constituent member's borders.

"While a coordinated approach on OECD level would be the most suitable way forward, the EU should be ready to go it alone if the United States keeps blocking the OECD work in order to protect their internet behemoths," Markus Ferber, European Parliament member from Germany said in a Dec. 5 statement.

Also, for companies that have been able to take advantage of their size and dominance to keep their tax bills relatively low, proposed changes could affect their valuation, Stansbury said.

"To the extent that the proposals result in a minimum tax on worldwide income that's currently not being taxed so that the effective tax rate goes up, it will have an effect on earnings per share," he said.

Still, Toan Tran, founder of technology-focused hedge fund 10 West Advisors, said that if Europe were to become more stringent in its tax policies, at the same time as the U.S. enacts tax cuts, it wouldn't necessarily concern investors.

Big tech "will be able to repatriate the money, bring it home and do a capital return to shareholders," through share buybacks or dividends, he said.

Indeed, "past experience has suggested that any money brought back to the U.S. won't be put back into the economy through investment," said Joseph Song, senior economist at Bank of America Merrill Lynch.

The irony that tech companies are more likely to reward shareholders than create jobs is not lost on EY's Flynn, especially when the companies already cannott find the right people to fill highly skilled jobs.

"They make it about jobs and U.S. competitiveness when, at the end of the day, there aren't enough people trained with sufficient competencies to fill those jobs," he said.