Chinese ADRs: Not (Yet) At Risk From The Clampdown

by Thomas Kirchner

• Legal uncertainties rekindled by Chinese clampdown.

• VIE structures have been found to be illegal by Chinese courts.

• Nuclear economic option unlikely except in major geopolitical conflict.

After Chinese regulators clamped down recently on tutoring companies and some online services, which is said to have wiped one trillion dollars off stock market valuations [i] some investors have expressed concern about further regulatory action. Especially at risk are Variable Interest Entities (VIEs), the structure used by all U.S.-listed Chinese companies because these structures are merely allowed by administrative action, and no law specifically allows them. With such weak legal underpinnings, a simple administrative measure could declare the VIE structure illegal and would wipe out $1.6 trillion in equity of all 248 U.S.-listed companies[ii]. The question is not whether, but on what occasion Chinese regulators will wipe out foreign shareholders.

Chinese VIEs and their risks

When Sino Forest went bankrupt after fraud allegations were revealed in June 2011, the complex structures of Chinese companies listed in the West became known widely. Because foreigners are not allowed to own companies in industries on China's 'restricted' list, a workaround was developed: Chinese nationals own the assets in China and then assign their economic interests to a holding company, often based in Cayman or the BVI, whose shares or ADRs are then listed on foreign exchanges. For example, Alibaba and ANT Financial are actually majority owned by co-founders Jack Ma and Simon Xie. The IPO prospectus states clearly how it works:

Due to PRC legal restrictions on foreign ownership […] we operate our Internet businesses and other businesses in which foreign investment is restricted or prohibited in the PRC through wholly-foreign owned enterprises, majority-owned entities and variable interest entities. The relevant variable interest entities, which are 100% owned by PRC citizens or by PRC entities owned by PRC citizens, hold the ICP licenses. [...]These contractual arrangements collectively enable us to exercise effective control over, and realize substantially all of the economic risks and benefits arising from, the variable interest entities.[iii]

The key risk of this complicated arrangement is also disclosed in plain English:

If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations. […] It is uncertain whether any new PRC laws, rules or regulations relating to variable interest entity structures will be adopted or if adopted, what they would provide. [iv]

In other words: nobody knows how solid the structure is.

There seem to be two schools of legal thought here: not surprisingly, law firms writing legal opinions for IPO prospectuses hold the view that the VIE structure is legal. This view is bolstered by their tacit endorsement by Chinese bureaucrats, who would probably take action if hundreds of large, public financial transactions were gross violations of the law.

Skeptics counter that contracts written to circumvent the law are unenforceable under Chinese law. There have been several cases in which Western shareholders have tried to enforce VIE contracts in Chinese courts, all of which failed. In the 2012 Chinachem case, the People's Supreme Court ruled after 12 years of litigation that Hong Kong-based Chinachem could not enforce the VIE contracts for shares of Mingsheng Bank because the contracts were designed to circumvent the law. However, the court ordered compensation be paid to Chinachem in the amount of 40% of the value of the shares, so the investor did not suffer a complete loss. In Gigamedia, the local nominee owner of the business, Wang Ji, simply transferred the assets to himself. When VIE shareholders attempted to recover their investment through arbitration, the tribunal took a similar rationale as the People's Supreme Court in Chinachem and declared the VIE contract unenforceable. [v] [vi] It is notable that a private arbitration tribunal came substantially to the same conclusion as a court of law. We take that as an indication that the favorable legal opinions of law firms in IPO prospectuses may be overly optimistic.

It appears to us that VIEs are tolerated by Chinese regulators mainly because they bring in foreign investment. Regulators maintain the upper hand and have a free option to enforce Chinese law any time it becomes convenient for them to expropriate foreign shareholders quietly.

How serious is the VIE risk?

To gauge the risk that Chinese regulators may take action against VIEs and wipe out U.S. shareholders, it helps to look at another precedent in which an emerging market dictatorship seized a company and wiped out foreign shareholders: the 2003 arrest of Russian oligarch Mikhail Khodorkovsky and subsequent breakup and forced bankruptcy of oil company Yukos over allegedly unpaid taxes.

As Russia's richest man at the time, Khodorkovsky had challenged Vladimir Putin's ascent to power and was openly contemplating entering politics. The ferocity of Khodorkovsky's prosecution and seizure of Yukos should not be mistaken as capricious acts of a mad dictator, but were carefully calculated to set an example and dissuade others from challenging Putin. In that sense, the strategy worked very well, because numerous other Putin-critical oligarchs promptly went into exile.

We believe that China's current clampdown follows a similar logic of power preservation by a dictator who is still consolidating his position. This view is consistent with the suspension of Ant Group's IPO in October 2020, which is reported to have been ordered by President Xi Jinping personally [vii], a clear indication the decision was political in nature. The widely reported explanation for the suspension concerns Jack Ma's October 24 criticism of regulators during a conference in Shanghai. However, a decision taken at such a high level points to another reason: Jack Ma was close to former Premier Jiang Zemin, whose vision of free enterprise is on the opposite end of the spectrum compared to Xi's stone-age communist emphasis on state ownership. Many Zemin associates are said to have been investors in a private equity fund run by Zemin's grandson, which was heavily invested in ANT Financial. The IPO would have given Zemin's circle a multi-billion dollar windfall, which would have been a substantial war chest in any future power battle, an outcome Xi prevented by stopping the IPO.

We believe that we can extrapolate this precedent and that an eventual clampdown on VIEs is inevitable, but it will not come as a result of domestic policy considerations, much less due to random, capricious regulatory actions. Wiping out $1.6 trillion in wealth from foreigners is not something the Chinese government would take lightly. It is an economic nuclear option whose use makes sense only under overwhelming foreign policy considerations. For example, should China attempt to invade Taiwan and should the United States actively support Taiwanese resistance, a cancellation of all VIE contracts would be a possible form of economic warfare. Similarly, should the trade war escalate, disputes over mineral right in the South China Sea intensify or should the West become more serious about human rights violations in China, retaliation against VIEs could be a policy option for Xi.

The market, of course, recognizes the risks inherent in Chinese companies listed in the West. That is why many trade at a discount to what they would be worth in the Chinese market, which opens the door for management to take them private for a low valuation and relist them shortly thereafter in China at a much higher valuation, pocketing the difference.

[i] “Investors Lose $1 Trillion in China's Wild Week of Market Shocks” bloomberg.com, July 30, 2021.
[ii] Noriyuki Doi, Takenori Miyamoto: “Crackdown on US listings: Will China close $1.6tn VIE loophole?” Nikkei Asia, July 14, 2021.
[iii] Form F-1 filed with the Securities and Exchange Commission by Alibaba Group Holding Limited on May 6, 2014.
[iv] ibid.
[v] Brandon Whitehill: “Buyer Beware: Chinese Companies And The VIE Structure.” Council of Institutional Investors, December 2017.
[vi] Charles Comey , Paul McKenzie, Y. Michelle Yuan, Sherry Yin: “China VIEs: Recent Developments And Observations.” Morrison and Foerester, August 19, 2013.
[vii] Jing Yang, Lingling Wei: “China’s President Xi Jinping Personally Scuttled Jack Ma’s Ant IPO.” The Wall Street Journal, November 12, 2020.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

Camelot Portfolios LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B255
Disclosures:
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Portfolios, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Portfolios, LLC’s disclosure document, ADV Firm Brochure is available at www.camelotportfolios.com

Copyright © 2021 Camelot Portfolios, All rights reserved.

Morningstar Alts Categories Catch Up

by Thomas Kirchner, CFA

• Better match with hedge fund categorizations.

• Performance comparable between similar categories of hedge and mutual funds.

• Liquid alts have tax benefits over LPs..

At the beginning of May, Morningstar reorganized its categories for alternative mutual funds in the U.S.[i]. The result is a closer alignment of alternative mutual fund classifications with hedge fund classifications, which are the gold standard for alternatives. It has been a slow road to get these asset classes to match up. Even though the strategies are often identical, they were classified differently for hedge funds and alternative mutual funds, making comparisons difficult. Especially investors with access to both types of funds were impacted and may often have ended up investing in higher priced hedge funds when equivalent mutual funds with lower cost and better tax efficiency were available.

The U.S. has lagged international markets in the adoption of hedge fund strategies in formats accessible to the public. Morningstar has often been the catalyst for change in the industry, and the recent reclassification is likely to accelerate an expansion of hedge fund strategies in '40 Act format.

All this comes amid a background of strengthening performance of alternative '40 Act mutual funds, which are competitive with hedge funds albeit with a far superior liquidity and operational risk profile.

Limitations of the '40 Act Space

We have come a long way since Morningstar first introduced a long/short category in 2006. Mutual funds that used shorting had been around since the 1980s, but had been lumped in with traditional style boxes. This led many in the hedge fund industry to make the false claim that mutual funds were not allowed to sell short – a powerful, albeit completely false marketing argument.

Since then, many alternative strategies have been launched, but unfortunately, not always for good reasons. Large fund complexes sometimes started funds that appear to have been driven more by marketing considerations than the availability of a good strategy run by a competent manager. Whenever Morningstar creates a box, fund marketing departments feel a need to offer a fund in that box.

Despite the growth of alternative mutual funds, the sector remains far behind true hedge funds in the U.S. The situation is different internationally, where the UCITS structure has attracted both assets and hedge fund managers. Originally, UCITS were created in the EU but these vehicles have been such a success that they are now recognized by and can be distributed in many non-EU countries from the middle East to East Asia and Latin America.

The key to success of UCITS, and the reason for the comparatively marginalized existence of U.S. mutual funds, is the difference in performance fees. While U.S. mutual funds allow only watered-down versions of performance fees, UCITS allows managers to charge such fees in the same way as they do in their flagship hedge funds. The result is that many leading hedge fund firms were willing to launch versions of their strategies in UCITS funds, but not in U.S. mutual funds.

In turn, the availability of brand name hedge fund managers in UCITS vehicles made this structure acceptable to investors, including institutions, while alternative U.S. mutual funds continue to suffer from investor snobism.

The new categories

These are the new Morningstar category classifications for alternative mutual funds, along with similar HFRI categories and their respective 5-year annualized returns:

Morningstar retired a number of other categories. Unfortunately, this includes the bear market category, so that short-selling funds no longer are easy to find. We question whether this decision was driven more by performance considerations of the underlying funds. The result is that hedge fund classifications remain better for short-selling funds.

As can be seen from the performance in the table above, the perception that hedge funds are superior to their mutual fund peers is no longer true. In a few categories, mutual funds even outperformed hedge fund over the last five years. This is even more remarkable considering that leverage tends to be higher in hedge funds, which also have the benefit of locking up their investors for long periods of time, whereas mutual funds give their investors daily liquidity.

Tax efficiency

Limited partnerships benefit from pass-through taxation, which sounds great until you look at the details. Generally, pass-through taxation is inferior to Subchapter M taxation of mutual funds, which is similar to how REITs are taxed. The problem with pass-through taxation is that, as the name suggests, all incomes and expenses are passed through to the taxpayer. Once they show up on the taxpayer's tax return, they are subject to limitations on deductibility. For example, management fees can only be deducted to the extent that they exceed 2% of the taxpayer's AGI. Therefore, you could be in a situation where a fund passes through short-term capital gains of 2%, which are fully taxable at income tax rates (over 50% in NY or CA), resulting in a net return of 1%. Once you factor in a 2% management fee, the net after-tax return of the fund is negative, approximately -1%. In contrast, a mutual fund, as in a REIT, the management fee and all other expenses are deducted from gains, resulting in a net after-tax return of zero, which outperforms the hedge fund structure solely because of the hedge fund's unfavorable pass-through tax treatment.

[i] Erol Alitovski: “Introducing the New Alternative Morningstar Categories.” morningstar.com, April 29, 2021.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B245
Disclosures:
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

Quiet Macro, But Significant Shifts Brewing

by Paul Hoffmeister, Chief Economist

• Some Covid case numbers stopped improving.

• The Federal Reserve began to telegraph a shift away from its current easy money policy.

• A concerted effort is underway to raise corporate tax rates around the world.

• Following Vice President Kamala Harris’s trip to Central America, her political prospects in 2024 took a notable turn for the worse in betting markets. However, President Biden’s probability of being the 2024 Democratic nominee improved.

From our perspective, it’s a relatively quiet and positive market environment these days. The CBOE Volatility Index reached a Covid low; the S&P 500 is up over 15% year-to-date; credit spreads such as the Moody’s Baa-Aaa spread is tighter than it was in at the beginning of 2020; and the number of Americans filing for unemployment benefits has reached its lowest levels since the start of the pandemic.

Despite the steady, favorable trends and it being the middle of summer, a number of significant events occurred during the last month that may have larger implications in the coming months. Some Covid case numbers stopped improving. The Federal Reserve began to telegraph a shift away from its current easy money policy. A concerted effort is underway to raise corporate tax rates around the world. And, Vice President Kamala Harris’s political prospects took a turn for the worse following her trip to Central America.

Covid

Since mid-June, the 7-day moving average of new Covid cases each day around the world has increased from approximately 360,000 to 420,000 – according to Johns Hopkins. This comes after the steep decline in daily case counts from over 800,000 since late April. Based on the Johns Hopkins data, the increases are primarily coming from the UK, South Africa, Russia, India, and Indonesia.

Similar to what happened in March after confirmed cases increased, many expect the death toll to increase in the coming month. For the most part, lockdown restrictions around the world have eased; but if the current trend in the Covid numbers continues, it certainly raises the risk of extended or reimposed lockdowns.

Fed Policy

On June 16, following its two-day policy meeting, the FOMC raised its inflation forecast from 2.4% to 3.4%, and a number of members conveyed that they expect at least two quarter-point rate increases by the end of 2023. In March, no officials expected a lift off from today’s zero interest rate policy until 2024.

While the news sparked a slight weakness in equities during the afternoon of the announcement (the S&P fell about 70 basis points at one point), the most pronounced moves occurred in the Treasury and gold markets.

The last time that the Fed attempted to normalize policy was 2018, and the market panic at the time strongly argued that the Fed failed in both implementing the correct policy course and effectively telegraphing central bank policy. This and the unique pandemic circumstance today don’t leave a lot of room for error for the FOMC today.

For now, the FOMC is telegraphing a change in policy more than 2 years from now. And Chairman Powell stated in the post-meeting press conference, “This is an extraordinarily unusual time, and we really don't have a template or any experience in a situation like this.”

It appears that the Fed communication strategy is to give itself significant lead time to communicate a policy change while being transparent that it simply doesn’t know its policy path, at least with a high degree of conviction.

Tax Outlook

The tax outlook remains uncertain after the Biden Administration failed during the spring to convince its entire Democratic Senate caucus to support its corporate tax plan. Senators Manchin (D-WV) and Sinema (D-AZ) were the key holdouts, by opposing major tax increases via the budget reconciliation process which requires a simple majority vote in the Senate. Note, too, that many House Democrats from high-tax states criticized the White House’s plan to not increase the $10,000 cap on state and local income tax deductions.

But the Biden team isn’t done. Thanks to negotiations led by Treasury Secretary Yellen, there appears to be an agreement being reached between most G20/OECD countries on a global tax deal. The OECD/G20 Inclusive Framework has two key elements. “Pillar One” appears mainly aimed at preventing major, multinational technology companies from avoiding taxes, by looking to tax profits based on the location of customers. “Pillar Two” would establish a minimum global corporate tax rate of 15%.

There are still some holdouts, and some of those countries’ ascent will be crucial to reach an agreement; and many technical details remain. But the White House is hoping that progress here will help persuade legislators in Washington that raising corporate tax rates in the US will not put American companies at a major competitive disadvantage… The threat of a higher US corporate tax rate remains; its probability appears to be 65% at the moment. We expect Senate Majority Leader Schumer to make a strong push in the coming weeks to pass a tax bill before the August recess.

U.S. Political Outlook

Three months ago, the Predicit betting market was giving Vice President Harris a 40% probability of becoming the 2024 Democratic Presidential Nominee, and President Biden 37%. But Harris’s political future took a significant blow in June, falling from 38% on June 1 to 30% as of July 9. The turn for the worse appeared to correlate with her trip to Central America on June 6.

Last week, Axios reported on significant concerns about Harris from inside the White House. According to Hans Nichols: “Some Democrats close to the White House are increasingly concerned about Harris’s handling of high-profile issues and political tone deafness, and question her ability to maintain the coalition that Biden rode to the White House.”

President Biden has mostly captured the points that Harris has lost in the betting market. But will Biden really run for re-election at the age of 81?

If Biden and Harris aren’t the nominees in 2024, there doesn’t seem to be an obvious alternative today. Every other Democrat is polling at 6% or less on Predictit. Will it be another Establishment Democrat or someone more aligned with the Progressive wing -- led by Senator Bernie Sanders and firebrand Congresswoman Alexandria Ocasio-Cortez, who leads the small group of House members called “The Squad”.

Harris’s performance in June elevates the importance of the special election on August 3 for an open congressional seat in Ohio. Progressives are backing Nina Turner, a former state senator and co-chair of Sanders’s 2020 presidential campaign; while the establishment is supporting Shontel Brown, chair of the Cuyahoga County Democratic Party… At the moment, Predictit is giving Turner a better than 80% probability of winning. If Turner wins, it forces the question: what will that do to the longer-term Democratic policy agenda? A more concerted effort toward higher taxes and Medicare for All?

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

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Disclosures:
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
• Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

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A Global Minimum Tax Will Intensify Trade Disputes

By Thomas Kirchner, CFA

• 15% minimum corporate tax decided at G-7.

• Subsidies to replace tax incentives.

• Trade wars will intensify over subsidies.

• Implementation in the U.S. is unlikely...

The introduction of a global minimum tax rate may sound like a really good idea if you are a head of a cash-strapped government at a G-7 meeting where everyone has been concerned about their eroding tax base. However, new tax rules can have unintended consequences. Their proponents often have no experience with business decisions and are more focused on vague notions of tax fairness rather than the hard practicalities of decision-making when facing conflicting international tax regimes. Of the seven core nations at the G-7, only one is represented by a leader with private sector experience worth mentioning: Italy's PM Mario Draghi spent three years at Goldman Sachs and a few years as a consultant at the World Bank. We put little value in terms of private sector business expertise on UK PM Boris Johnson's decade as a journalist, apparently without any management responsibilities, or President Biden's two years as a public defender in the 1960s. Therefore, a tax regime heavy on pathos and light on practicalities should be expected.

With the new U.S. Administration seeking to increase corporate taxes, the U.S. withdrew its long-lasting opposition to the OECD proposal for a global minimum tax, paving the way for its adoption by the G-7. In fact, Treasury Secretary Yellen has her own 15% minimum tax rate proposal, which could be even more draconian than the OECD one.

How the new minimum corporate tax works

The global minimum tax framework proposed by the OECD and adopted by the G-7 has two pillars [i]:

1. The first pillar seeks to reallocate profits to markets where the economic activity occurs. This seeks to eliminate the creation of intellectual property holding subsidiaries (aka “patent boxes”) in countries with low tax rates, and thereby reducing the profits in high-tax countries via license payments to the patent boxes.

2. The second pillar is the actual minimum tax. It acts as a tax equalization: if a company pays less than a 15% tax rate in its foreign subsidiaries, then the home country will charge an extra tax so that the total tax increases to 15%. This is meant to reduce the incentive for moving subsidiaries to low-tax jurisdictions.

The tax would apply only to the largest companies who have more than a 10% margin. “Large” appears to refer only to the largest 250 companies – at least for now, rules tend to expand once in place, after all.

What the margin is on is unclear – net margin on sales, EBITDA margin on sales, return on equity, return on invested capital? Whatever the metric, one company that has caused the ire of many politicians for its creative use of low-tax jurisdictions will not be included: Amazon.com does not make 10% on those metrics. The only way to have Amazon included would be to apply the minimum tax to each business segment. That is something under serious consideration and, if actually implemented, would make such a minimum tax a bureaucratic nightmare.

The main difference between the OECD and Secretary Yellen’s minimum taxes are their scope: Yellen's minimum would apply to all companies; the OECD proposal only to the world's largest companies, with a disproportionate, if not exclusive, burden borne by U.S. tech giants.

The devil is in the details

The tricky question is what taxes exactly count toward the minimum. After all, tax rates themselves are always secondary considerations, exemptions and calculation methods are the main drivers of the taxes effectively paid. And as one may expect, the minimum tax already has a number of pet peeves excluded.

Most notably, the Digital Services Tax (DST) that Europeans want to impose on U.S. tech giants would not count toward the 15% minimum. Therefore, the effective minimum for tech giants will be higher than 15%. Europeans propose to abandon the DST in exchange for the minimum tax but experience shows that a tax, once proposed, will eventually be implemented.

Other taxes, such as real estate taxes, labor-related taxes, business activity taxes, value-added taxes, franchise taxes and the like also would not count. This matters a lot, because by some estimates, profit taxes only represent one quarter of the total tax burden of large, global enterprises, with the rest coming from such other taxes that generally are ignored in the debate about “fair” tax burdens [ii]. Therefore, charts that have circulated recently showing a steady decline in corporate taxes over the last five decades are misleading because they ignore the simultaneous increase in other forms of taxation.

The second pillar in particular can have severe impacts depending on how poorly it is implemented. For example, does each foreign subsidiary have to pay a 15% minimum tax, or can losses in one country offset profits in another, so that foreign subsidiaries pay the 15% minimum in the aggregate? This is more than a technical detail – it can make the difference on whether or not entering a foreign market makes sense or not. If each subsidiary has to pay a 15% minimum tax, it could make more sense for companies to not enter markets through subsidiaries but to use foreign partners. Effectively, this rule alone can lead to a severe de-globalization of global enterprises.

The Biden Administration currently supports a country-by-country minimum tax calculation. We believe that one of the unintended consequences might be the further export of U.S. jobs. Long-term investments outside of the U.S. will become less attractive for U.S. firms compared to locally-based firms that can fully utilize the initial tax losses such investments entail. Therefore, crucial elements of the supply chain that are currently owned and controlled by U.S. firms will slowly fall under the control of foreign firms, with eventually entire supply chains being expatriated and U.S. firms becoming mere importers of finished goods.

Another uncertainty is the treatment of REITs and investment funds. Alone the suggestion that a fund-level corporate tax might be imposed shows how little economic sense is in the minds of policymakers. It is only a matter of time until someone discovers mortgage-backed securities, CLOs or other securitizations as potential targets for a corporate tax.

Tax incentives become pointless, shift revenue from one country to another

Tax incentives are a powerful instrument used by governments to attract business. A global minimum tax will negate any such incentives. For example, if the state of Georgia tried to attract investment by a foreign sports car manufacturer in Atlanta through tax abatement, any such benefit would be offset by the Federal government which would collect a higher tax. In fact, the tax revenue would simply shift from the State to the Federal government. A similar shift in tax revenue would also occur internationally should the Federal government offer similar incentives. The car company's home country would then increase its taxes to the minimum and collect the tax incentives offered by the U.S.

In particular, Biden's proposed 10% “Made in America” investment tax credit would end up in the coffers of foreign tax authorities if paid to a foreign company investing in a U.S. plant and if that company is then hit with the 15% minimum rate in its home country.

Rethinking subsidies

Such an international shift of tax revenues is probably not what the G-7 leaders have in mind, but it is an inevitable consequence of the proposed minimum tax regime. The implications are widespread, because tax incentives are used widely to support investment in favored areas: accelerated depreciation for energy investments in the U.S., tax support for renewables pretty much everywhere, favorable tax rates or exemptions for agriculture. Traditional tax incentives will become appealing only for domestic enterprises.

But governments are creative, too, and if they cannot attract foreign investment through the traditional tax incentive schemes, they will create new incentive schemes. The most obvious coming to mind would be subsidies masked as social spending: for example, rather than making employers pay for health care and other social taxes, the government might pick up the cost disguised under welfare programs. This will lead to a reduction in unit labor costs, which can then be used through the clever use of transfer pricing rules to shift profits elsewhere.

The possibilities are endless, and it is clear that the winners will be the lawyers and tax advisors, for whom a new era of record billings is likely to begin. Whether any country will be better off remains to be seen.

Why trade wars will escalate

With tax incentives gone and governments coming up with with new and inventive subsidies, others will push back over such “unfair” trade practices. Both the WTO and European Union have rules about state aid. In fact, it's ironic that the 40-year battle between the EU and U.S. over subsidies to Airbus and Boeing is winding down just as governments are creating a tax framework that would make such subsidies more appealing in the future. This war intensified after a 2019 WTO ruling that authorized the U.S. to levy tariffs on the EU and at the same time authorized the EU to levy tariffs on the U.S. The absurdity of this ruling appears to have been grasped even by policymakers, who are now ready to do a deal [iii]. We note that while the press pins the beginning of the dispute to 2004, when the current case at the WTO was filed, the disputed subsidies actually go back as far as the 1980s. Most of the key decision-takers from back then are not even alive any more, and none hold public office.

We believe that the Airbus/Boeing trade debacle is a template for what lies ahead. As governments slowly come to grasp what their minimum tax decision has done to their ability to incentivize investment, they expand the use of subsidies, many of which will run counter to WTO rules. But elected officials benefit from the immediate political support that such subsidies create, while the cost in the form of punitive tariffs will be borne by future administrations and taxpayers decades later. No mechanism exists to address this conflict of interest. Therefore, it will happen.

The result will be violations of WTO rules, retaliatory tariffs followed by more rule violations and compensatory tariffs. We may have changed the tone of international trade relations, but the substance is at risk of sliding into an escalating trade war.

Good news: it won't happen

The fanfare surrounding the announcement of the minimum corporate tax stands in sharp contrast to the low likelihood of its implementation. The City of London and Switzerland are already trying to find ways for an exemption or circumvention. Even in the U.S. it is far from certain that it will be implemented. The agreement might be considered an international treaty, which would be subject to two thirds approval by Congress, a near impossibility. If the U.S. does not participate, it is likely that many other countries will also refuse to implement it. While the EU is very likely to implement it, we expect that it will dilute the impact through rulemaking if the U.S. does not participate.

The main problem with the global minimum tax is that it is designed to target U.S. tech companies. The U.S. will lose tax revenue to other countries as a global minimum tax shifts tech giants' taxes to other countries, but it will not have the opportunity to recover the lost taxes from foreign companies operating in the U.S. because they shift profits less frequently to patent boxes. Congress is likely to recognize this asymmetry and reject the OECD proposal.

Things get really complicated if Congress passed Secretary Yellen's 15% minimum tax proposal but rejected the OECD’s. In that case, U.S. firms face a double disadvantage: companies of all sizes would be faced domestically with the Yellen minimum, and the tech giants would be hit internationally with the OECD minimum. Firms domiciled outside of the U.S. do not face such a double disadvantage. It would be unfortunate if the asymmetry that the U.S. faces in international trade would now be replicated in international taxation. It is clear that if a future administration took a similarly tough line on asymmetries as the previous one, the global minimum tax regime will make such a confrontation only worse.


[i] “KPMG report: Analysis and observations about tax measures in G7 communique.” KPMG, June 7, 2021.
[ii] Natalia Drozdiak, Alberto Nardelli, Bryce Baschuk: “U.S. and EU to End for Good Trump’s $18 Billion Tariff Fight.” Bloomberg News, June 8, 2021.
[iii] Andy Agg, Andrew Packman: “2020 Total Tax Contribution survey for the 100 Group.” pwc for The 100 Group, December 2020.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

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