(Bloomberg) International Business Machines Corp. has reduced its tax rate to a two-decade low with help from a tax strategy that sends profits through a Dutch subsidiary.
The approach, which involves routing almost all sales in Europe, the Middle East, Africa, Asia and some of the Americas through the Netherlands unit, helped IBM as it gradually reduced its tax rate over 20 years at the same time pretax income quadrupled. Then last year, the rate slid to the lowest level since at least 1994, lifting earnings above analysts’ estimates.
IBM is aiming for $20 a share in adjusted earnings by 2015, up from $11.67 in 2010—a goal made more difficult as the company posted seven straight quarters of declining revenue. To stay on target, IBM has bought back shares, sold assets, and fired and furloughed workers. A less prominent though vital role is played by its subsidiary in the Netherlands, one of the most important havens for multinational companies looking for ways to legally reduce their tax rates.
“They’ve got a lot of ways to beat earnings and they definitely take advantage of it,” said Josh Olson, an analyst at Edward Jones & Co. “It’s part of how IBM operates.”
IBM ended 2013 with a tax provision $1.84 billion lower than it initially projected, thanks to a tax rate of 15.6 percent— compared with its forecast of 25 percent. Without the lower rate, the company’s earnings per share would have fallen from the previous year instead of rising, and net income would have missed analysts’ estimates by about 14 percent instead of 2.9 percent, according to data compiled by Bloomberg.
Michael Fay, a spokesman for Armonk, New York-based IBM, declined to comment on the company’s tax structure.
Attracted by the Netherlands’ policies and extensive network of tax treaties, IBM joins companies such as Yahoo! Inc., Google Inc. and Cisco Systems Inc. that have used Dutch subsidiaries to cut taxes.
Offshore tax strategies like the one used by IBM are coming under increased scrutiny. In the past year, the tax-avoidance techniques of companies including Apple Inc., Google and Amazon.com Inc. have been the subject of U.S. Senate and U.K. Parliament hearings. Meanwhile, the Organization for Economic Cooperation and Development, a government-funded think tank, is developing a plan to fight so-called profit-shifting at the direction of the Group of 20 nations.
IBM International Group BV was incorporated under Dutch laws in 1999, according to filings in the Netherlands. The subsidiary acts as a holding company for more than 40 IBM-owned companies worldwide, including its operations in Ireland, a corporate tax haven where IBM has thousands of employees. The Dutch group had three employees in 2008, a number that has since swelled to about 205,000 as of the end of 2012— only 2 percent of whom actually work in the Netherlands. IBM overall has about 430,000 workers worldwide.
As of the end of 2012—the latest year for which filings are available—IBM had accumulated $44.4 billion of offshore profits on which it hasn’t paid U.S. taxes, the sixth-highest total of any American company, according to data compiled by Bloomberg from securities filings. Since IBM International Group’s incorporation, its parent company’s tax rate has fallen in 12 of the past 14 years.
“No company is better than IBM at managing their annual effective tax rate,” said Ed Outslay, an accounting professor at Michigan State University.
The lower costs have helped IBM free up funds for its $65 billion in share repurchases since 2010. By reducing the amount of stock in circulation, the buybacks increase earnings per share—even when revenue is falling.
IBM has stumbled during the technology industry’s transition to the cloud, where information is stored online instead of onsite. While the company’s sales from cloud services are growing, the trend has spawned a new crop of competitors and eroded demand for traditional hardware and services.
Even as that technological shift affects the business, Chief Executive Officer Ginni Rometty has stuck with IBM’s profit goals. To stay on track for her $20-a-share earnings target, the company spent $1 billion last year to restructure its workforce—shedding 3,300 employees in the U.S. and Canada, according to employee group Alliance@IBM. It also sold businesses, getting $505 million for a customer-service unit last month and agreeing to let Lenovo Group Ltd. buy its low-end server business this year for $2.3 billion.
Last year’s tax rate was lower than expected partly because of a “more favorable expected geographic mix” of earnings, the company said in an October filing. The company declined to provide further details. In the last three months of the year, an audit of IBM’s U.S. taxes from 2008 to 2010 went in the company’s favor, helping reduce the rate to 11.2 percent, the lowest for any quarter since at least 1994. A retroactive 2012 U.S. tax credit for research and development also helped cut the rate last year.
From 2010 to 2012, IBM attributed $34.1 billion of its pretax income to its non-U.S. operations, according to the most recent data from tax footnotes in the company’s annual reports. During that period, IBM consistently cut about a third off its tax rate as a result of those overseas earnings, saving about $6.5 billion compared to what it would have reported if all its earnings had been in the U.S. The company’s effective tax rate of 15.6 percent in 2013 was down from 28 percent in 2007.
“They have always looked at the tax rate as a potential lever to drive earnings growth,” David Grossman, an analyst with Stifel Nicolaus & Co., said in an interview.
Even with the cost cuts, IBM hasn’t been able to convince some investors to hold onto its shares. The stock was the only member of the Dow Jones Industrial Average to decline in 2013, and it trailed the Standard & Poor’s 500 Index by 32 percentage points.
Walter Todd, a chief investment officer who oversees about $960 million for Greenwood Capital Associates LLC, said his firm sold all of its holdings after IBM’s 2013 third-quarter earnings report.
“We were concerned about the revenue growth slowing,” Todd said. “You see this a lot of times with these big companies—there are a lot of ways to manage earnings.”
IBM has said it doesn’t expect its tax rate to stay at last year’s lows, meaning it will probably have to find other ways to keep expanding profits. The company has forecast a 2014 tax rate of 23 percent—7.4 percentage points higher than where it ended up last year—though it’s possible other unforeseen items could affect the number, Chief Financial Officer Martin Schroeter said last month.
Revenue growth would help. IBM is increasing its bet on cloud services with a plan to invest $1.2 billion in its SoftLayer Technologies Inc. network-infrastructure business. The company is also spending $1 billion to build a new division around its Watson supercomputer, which can analyze large volumes of data and answer questions in conversational language.
It’s becoming more difficult to find other areas where IBM can cut costs, making it hard to see how IBM can meet its earnings targets, Toni Sacconaghi, an analyst at Sanford C. Bernstein & Co., said in a note to investors.
“The model is increasingly strained,” he said. “IBM risks being tethered to its road map to the detriment of its longer-term financial health.”
—With assistance from Richard Rubin in Washington. Editors: Crayton Harrison, Nick Turner