Corporate debt and greed are going to sink the British economy, writes Prof Prem Sikka.
Corporate addition to high debt threatens to destabilise the world economy. Not my words – those of the International Monetary Fund.
A recent report by the IMF says that “in a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk could rise to $19 trillion —or nearly 40 percent of total corporate debt in major economies—above [2008] crisis levels.”
In other words, in an economic slowdown, many firms will be unable to cover even their interest expenses with their earnings. Countries most at risk are US, China, Japan, Germany, Britain, France, Italy and Spain.
One study estimated that in 2018 UK s FTSE 100 companies alone had debt of £406bn.
Sinking in debt
Low interest rates have persuaded companies to pile-up debt in the belief that they will be able to use it to maximise shareholder returns. The key to this is tax relief on interest payments.
Ordinary folk don’t get tax relief on interest payments for mortgages or anything else because successive governments argued that such reliefs distort markets and encourage irresponsible behaviour.
However, corporations get tax relief on all interest payments. Currently for every £100 of interest payment, companies get tax relief of 19%, the prevailing rate of corporation tax, which reduces the net cost to £81. The tax subsidy enables companies to report higher profits.
Companies do not necessarily use debt to finance investment in productive assets. The UK languishes near the bottom of the major advanced economies league table for investment in productive assets and also lags in research and development expenditure.
British companies appease stock markets by paying almost the highest proportion of their earnings as dividends. BHS famously borrowed £1 billion to pay a dividend of £1.3bn. Carillion used its debt to finance executive pay and dividends. Thomas Cook had at least £1.7bn of debt but that did not stop lavish executive pay and bonuses.
Fatal effects
Corporate debt facilitates profiteering and tax avoidance. Water companies have long used ‘intragroup debt‘ to dodge taxes. Typically, they borrow money from an affiliate in a low/no tax jurisdiction. The UK-based company pays interest which qualifies for tax relief and reduces the UK tax liability.
Many a tax haven either does not levy corporation tax or exempts foreign profits from its tax regime. As a result, the affiliate receives the interest payment tax free.
It is important to note that the company is effectively paying interest to another member of the group and no cash leaves the group. The inclusion of interest payments in the paying company’s cost base can also enable it to push up charges to customers, especially if has monopoly rights on supply of goods and services.
Thames Water is an interesting example here. From 2006 to 2017, it was owned by Macquarie Bank and operated through a labyrinth of companies, with some registered in Caymans.
During the period, Thames’ debt increased from £2.4bn to £10bn, mostly from tax haven affiliates, and interest payments swelled the charges for customers. Macquarie and its investors made returns of between 15.5% and 19% a year.
For the period 2007 to 2015, the company’s accounts show that it paid £3.186bn in interest to other entities in the group alone. Tax relief on interest payments reduced UK corporate tax liability. For the years 2007-2016, Thames Water paid about £100,000 in corporation tax.
Private equity entities use debt to secure control of companies and engage in asset-stripping. A good example is the demise of Bernard Mathews, a poultry company.
In 2013, Rutland Partners acquired the company and loaded it with debt, which carried an interest rate of 20%. This debt was secured which meant that in the event of bankruptcy Rutland and its backers would be paid before unsecured creditors.
In 2016, Bernard Matthews’ directors, appointed by Rutland, decided that the business was no longer viable and sought to sell it. However, they only sold the assets of the company which realised enough to pay secured creditors, Rultand and banks.
The big losers were unsecured creditors, which included employee pension scheme, HMRC and suppliers. The purchaser of the assets told the House of Commons Work and Pensions Committee that it offered to buy the whole company, including its liabilities, but the offer was declined by Rutland because by dumping liabilities it collected a higher amount.
What needs to change
There is some recognition that corporate addiction to debt poses a threat to the economy. Following recommendations by the Organisation for Economic Co-operation and Development, the UK has placed some restrictions on the tax relief for interest payments, but that is not enough.
An independent enforcer of company law is needed to ensure that companies maintain adequate capital. Companies need workers on boards to ensure that directors do not squander corporate resources on unwarranted dividends and executive pay.
The insolvency laws need to be reformed to ensure that secured creditors can’t walk away with almost all of the proceeds from the sale of assets and dump liabilities.
And finally, tax relief on debt needs to be abolished altogether.
Prem Sikka is Professor of Accounting at University of Sheffield and Emeritus Professor of Accounting at University of Essex. He is a Contributing Editor to LFF and tweets here.
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8 Responses to “Prem Sikka: How companies use debt to line their pockets”
nhsgp
So no mention of the 13,000 bn the UK government has racked up.
Or the 42,000 bn the French government has created.
But what the heck lets make companies more unprofitable, so they go bust, and those pensioners lose their pensions.
Nice – not.
The accounting fraud by the public sector is going to come home to roost.
Chester Draws
Companies do not necessarily use debt to finance investment in productive assets.
Sure. But largely they do.
You can see we’re off to a bad start when instead of talking about profit we are treated to “lining their pockets”. The aim of business is to make a profit, and we shouldn’t stigmatise them for doing so. Unless you are a full on Communist, the market won’t work without the profit motive — it’s a necessary feature.
Meanwhile borrowing money is a cost to business. So it makes sense that they can treat it as a cost. How are people going to get into a small business of their own if it is too costly to borrow?
We have to be very careful that aggressive treatment of large scale borrowers doesn’t make things worse, and drive small businesses out of operation. In the end businesses that over-borrow will be over-taken by those that don’t.
Higher interest rates would help prevent the issue Sikka wants to be cured by more tax (no surprise) and more regulation (no surprise) rather more quickly and effectively than his suggestions.
For the years 2007-2016, Thames Water paid about £100,000 in corporation tax.
Well, yes, because they have had a massive amount of investment, over £1 billion per year. Normally the Left rail about how the utility companies don’t invest sufficiently for the future — but when they do, they cop it for that as well.
Dave Roberts
Well put Chester. Nothing else to say really.
Marian Lawrence
All the above comments are nit-picking. The IMF report is very clear levels of debt are leaving companies vulnerable. On a practical note I rely on dividends to supplement my pension. 30% net gearing is the highest I am comfortable with. I got out of Kier with a very healthy profit as a result of monitoring debt
Dave Milner
I think the comments miss the point. Regardless of where you stand politically, to have companies claim tax relief when their funds are off shore, means the people of the country in which the company is operating are subsidising a private organisation. This is not healthy as it encourages business people of ill intent to exploit these loopholes. Unfortunately we seem to live in an age where many businesses take short term profit over long term, healthy operation….and then the big boys run off with other peoples’ money.