Sunday, April 24, 2011

Why 'double taxation' of corporates is justified

Irrespective of the country, one common complaint from business chambers is the seeming double taxation of legal entities-initially on the income they earn, and then on the dividends distributed to their shareholders. The argument used is that substantially, these entities should be viewed as pass through vehicles, and so their shareholders should be taxed on their share of the income from the entity, similar to how partnership firms are taxed.  For good reasons, the tax authorities do not yield to this argument. And the reason boils down to(in my view) externalization of social costs.

Except a partnership firm/individual entity/LLP, all other business forms ringfence the other assets of their investors. In case of insolvency/lawsuits etc, if the business cannot pay its liabilities, shareholders will not be called upon to pay its dues(unless of course they have personally guaranteed the obligations or unless law casts obligations on them like in India where private company directors are liable for unpaid tax dues under certain circumstances). If an entity desires a legal form allowing ring fencing, it should pay its social dues for this service('taxation'). We could of course have an explicit bankruptcy levy on all companies to pay this cost, in lieu of tax. But something tells me that would not go down well either. So we are stuck with this system, which is equitable albeit seemingly logically unsound.

No payment for failure-an absurd proposition

Last year(2010), Gordon Brown's phrase 'no payment for failure' seems to have latched on to the UK financial services regulator(FSA) and UK headquartered banks(Standard Chartered/HSBC etc). Read their Pillar III disclosures and this phrase jumps out at you. Considering all the public outcry over bankers getting fat bonuses despite their bank being bailed out, it only seems reasonable that bankers are not rewarded for failure(of their institution) at a group level, or even individually(if they do not meet their targets).

But from the public disclosures(in Pillar III), what I gather about the implementation is that
  1. Stringent performance targets will be set covering profit, risk, people etc. These targets will be mostly in number of shares/options.
  2. The performance bonus will be adjusted for 'risk'(any adjustment to be DOWNwards only)
  3. Even after that, the vesting of the options/shares will be subject to clawback, deferral and overall group criteria in terms of total shareholder return, economic profit etc. 
  4. And finally, a significant number of people will be awarded Zero bonuses. 
 So those days of hitting a purple patch and then quitting the industry are gone. Even if a banker(trader/structurer/investment banker etc) is eligible for a $10MM bonus, chances are
  1. Immediate cash component will be capped at 10%(viz $1MM-for RBS it is 2000GBP!!!!)
  2. The rest will be paid out in terms of restricted shares-subject to market price risk and insolvency risk
  3. The bonus can be clawed back for N number of reasons-including quitting the organization etc
 Given that top bankers are somewhat like top athletes(in terms of peak earning years), this does seem unfair to cap a lottery type payout. And then awarding zero bonuses for average performers is also hard to justify-if the base pay is not increased accordingly.