Tuesday, July 17, 2012

What is a circular sale?

With increasingly different supply changes and procurement models I thought I would do a quick post about circular sales. A circular sale is when a buyer purchase an item from one supplier and sells that item to a supplier and the supplier then sells the item back to the buyer either in its original state or a part of value added they provide. There are a number of ways and reasons why a circular sale can occur. A buyer may purchase items from Supplier B and sell them to the Supplier A because:
1. Supplier B will supplier will not sell to Supplier A for a variety of reasons (past history, credit, etc.)
2. The Buyer may have competitive pricing with Supplier B that it wants to mask from Supplier A.
3. The Buyer may have excess inventory on hand that it wants to liquidate by sale to free up the cash.

There is nothing wrong with circular sales as long as those circular sales are not being used to avoid the payment of income taxes. For it to not be an illegal circular sale, the cost the Buyer sells it for needs to be without overhead and profit, or the cost of the purchase of the item by Buyer from Supplier needs to be adjusted to reflect any overhead and profit the Buyer made on that initial sale.

Here’s an example of how an illegal circular sale would work.
The Buyer makes a purchase of a product from Supplier B in a tax free location.
The buyer sells that product to Supplier A at a rate that includes both overhead and profit.
Supplier A sells a higher level product back to the Buyer.
The cost of Supplier’s product includes their value added plus the cost of their purchase from the Buyer. If the Buyer treats that purchase cost from Supplier A as their cost of good in their sale of that product to a customer, that cost reduces the taxes the Buyer will pay on those sales.

The tax authorities look upon that as an illegal circular sale with the purpose of avoidance of taxes. The profits and overhead they added to the selling price in the sale from Buyer to Supplier A cannot be used to reduce the taxes. For example if the Buyer added a $100 profit to the sale of the product in its sale to Supplier A and that was allowed to flow through as a cost in its purchase back from Supplier A, at the U.S. Corporate Tax rate of 35% for corporations, that profit on which they paid no tax would generate a reduction of $35.00 on their U.S. income tax on that product. Tax authorities don’t want un-taxed profits to be used to reduce their U.S. taxes when it comes time to pay income tax on the customer sales profit. If the sale occurred in the
U.S., the company would have to pay taxes on the profit they made in the sale to Supplier A so it wouldn't be considered a circular sale to avoid taxes as the taxes would need to have been paid.

America Job Loss

It’s another election year in the U.S. and once again the politicians are playing the blame game. If you listen to the Obama campaign you will hear them place the blame on companies like Bain Capital who was run by Mitt Romney his opponent. They are claiming that companies like Bain destroy companies and drive jobs off-shore. While I’m no fan of either candidate I believe that people need to understand facts.

What is Bain Capital? They are a private asset management firm. This means that they make investment on behalf of their customers. When an asset management company buys a firm much of the time the company was troubled and losing money and asset management firms take the gamble that they can turn the company around and make a profit on their investment by either making the shares more profitable where they either hold or sell off those shares. In a way its not much different than someone that purchases a foreclosed home that needs in a number of repairs and makes those investments in an attempt to make a profit. If the business can’t be made profitable, it is only then that they will do a liquidation of a company to recover some of its investments. Like any other investor they have some wins and they also have losses that have affected jobs. When there are wins, the companies they invest in grow and expand and generate new jobs. When they don’t win, jobs are lost. What people fail to consider is that without the infusion of their investments, the troubled company probably would have have lost those same jobs earlier without the infusion of cash investment. One of the things that has harmed American companies is the high U.S. Corporate tax rate of 35% when they compete against companies based in locations with lower corporate tax rates. Only Japan has a higher corporate tax rate.

They also want people to believe that it is companies like Bain that are the cause of the problem. The root cause of the problem is something that could be resolved by the current administration and house and senate, but no attempt has been made to solve it. In business when you have a problem you don’t try to treat the symptoms, you look for the root cause. In this case the root cause for the decline of manufacturing and service jobs in America rests with the U.S. Corporate Tax Rate and tax laws. It is those rates and laws that have allowed both individuals and companies to implement aggressive tax management programs to avoid paying U.S. Taxes. If companies like Bain helped drive offshoring and outsourcing, it was fueled by aggressive tax management that has been enabled by the U.S. Corporate tax rate and tax laws that only congress and the administration can change.

How pervasive is aggressive tax management? An article in the New York Times last year said that 55% of the U.S, Corporations paid nothing in one or more years over a seven-year span. In an article http://coupons.org/pages/tax the author describes what they call the Nine Trillion Dollar Loophole and lists only a limited number of countries that help companies manage their avoidance of U.S. Income taxes. There are plenty more. How did companies like Cisco get forty billion dollars in off-shore accounts? How did Apple get sixty-four billion in off-shore accounts? How does Google pay only a 2.5% effective tax rate in the U.S.. Why do we allow over 8,000 hedge funds who can manipulate the cost of what Americans pay for everything to be domiciled in the Cayman Islands where there is no tax. It is the tax rate that has driven companies to outsource and establish off-shore companies where profits are made outside the U.S. and as such are not taxed. In doing aggressive tax management jobs have been lost and its all been perfectly legal.

The question voters should be asking the incumbents is why haven’t they done anything to change this and change the tax rates and close the loopholes that would help bring jobs back? All the rhetoric about taxes that they roll out every four years only talks about personal taxes when you have major U.S. corporations that make Billions of dollars pay a far less percentage than individuals. For individuals that use these legal loopholes I don’t blame them, I blame the Congress and administration for allowing such loopholes to exist in the first place and to exist for as long as they have existed.

What do I mean when say “tax management strategies”? Here are a few examples:

A company has products produced in locations where the labor is lower cost. They will have a subsidiary company based in a tax haven or low tax country purchase those products. That subsidiary adds significant overhead and profit to the product so the majority of the profit the company will make accrues in that low or no tax country. They then sell that product at what’s called the “transfer price” to all the company’s subsidiaries around the world including the company’s U.S. based sales subsidiaries. For the profits they make in those tax havens they pay no tax. To the U.S. Company the purchase of the product at the transfer price is a cost of the good. They will add their local overhead and profit as part of their selling price. This creates the situation where the net income on the sale of that product that gets taxed in the U.S. will only be a small portion of the actual profit that was made by the company. The remaining profit, as long as it’s held off-shore, is never subject to U.S. Tax. To repatriate that profit, a company is subject to a ten-percent tax. That tax is as high as some countries corporate tax rate. What that tax rate does is create a negative incentive for those companies to bring money back into the United States to invest. That is why U.S. Companies have approximately nine trillion dollars in profits sitting outside the U.S.

Companies will have services provided by subsidiaries based in tax havens or lower tax rate countries. For example Ireland has a corporate tax rate of only ten-percent versus the U.S.’s thirty-five percent. When they sell services to the U.S. subsidiary or other subsidiaries, they will include substantial overhead and profit on those services. That profit accrues in that country, not the U.S. or the other subsidiary countries. To the U.S, subsidiary the purchase of those the services is an expense. With the significant overhead and profited added to the service they purchase, this reduced the profits the U.S. company makes and that reduces the taxes they pay. That’s another way they drive down their effective tax rate.

For international shipment of commodities such as oil, the cargo may be sold a number of times while that item is in transit. All of the profits from those sales, since they are occurring in international waters, are international sales are not taxable. This means that companies and individuals that consume those items have the cost burdened by those profits upon which no taxes are being paid as long as the purchase and sales of those are by companies or subsidiaries based in tax havens. Maybe that’s why so many hedge funds are headquartered in the Cayman Islands where there is zero tax. The problem is the America consumers wind up paying for those profits that don’t get taxed so the tax burden or the American taxpayer is high.

If small business is one of the things that drives job creation, what the tax laws have done is create an un-even playing field where it’s harder for small businesses to compete and win. They have to compete against companies that by outsourcing and offshoring don’t have to pay the same effective tax rates. They don’t have to pay the same wages. Further, the company that outsources or offshores their business has a substantially less percentage burden placed upon by all the governmental programs that drive cost to the business. Did anyone consider the impact the recent health care bill will have on business?

How do politicians expect to keep and attract jobs when they do so many things to drive them away? Maybe they just don’t care.