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TFHPSA Working Group 2 – Item 1

TFHPSA Working Group 2 – Item 1. Capital injections / Superdividends / Reinvested earnings Philippe de Rougemont – Team leader TFHPSA WG II (Eurostat-C.3). Menu for today. Part I – Introduction Part II – Dividends, capital injections Guidance (Eurostat MDD – GFSM 2001) Assessment

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TFHPSA Working Group 2 – Item 1

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  1. TFHPSAWorking Group 2 – Item 1 Capital injections / Superdividends / Reinvested earnings Philippe de Rougemont – Team leader TFHPSA WG II (Eurostat-C.3) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  2. Menu for today Part I – Introduction Part II – Dividends, capital injections Guidance (Eurostat MDD – GFSM 2001) Assessment Part III – Accruing of profits/losses, Reinvested earnings (D.43) Part IV – Advanced option How does it work? Avantages Arguments Part V – Pending issues Part VI – Possible recommendations TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  3. Part I Introduction TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  4. Definitions • Capital injections: situations where the owner “recapitalizes” its enterprise by way of transferring assets or discharging it from its liabilities, to cover past losses (or likely future) losses. Is it a capital transfer (D.9) or an equity injection(F.5, transaction in equity)? • Superdividends: lumpsum distribution to equity owners in excess of the operating profit of the year. Isit a dividend (D.42) (a revenue of the owner) or a withdrawal in equity (F.5, transaction in equity)? • Reinvested earnings:profits not actually distributed to equity owners (and in some accounting systems, to be recorded as income, i.e., deemed to be distributed and reinvested by the owner into the company) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  5. The Government Finance issue: • Capital injections should generally be expensed, even though they are always net worth neutral for the corporation in question and also for government • Prudence: cover past or future losses of public corporations, which are not accrued as expenses in the books of government • Injections realized in a commercial context, with expectation of a reasonable return on investment, can be classified as transaction in equity • Distributed dividend recorded for a period should not exceed the income of the period • distributions of superdividends or lump sum payments should be classified as financial transactions (for the part in excess) • otherwise governments would be able to manipulate the timing of their revenues, irrespective of the time of the underlying event (the profit accrued) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  6. Guidance • SNA 1993 - ESA 1995 • Dividends / losses • Quasi-corporations • Reinvested earnings (RoW) • Eurostat’s Manual on Deficit and Debt (MDD) • Interpretation of ESA 1995, though not a legal act • 40% of the MDD (of 243 pages) is dedicated to Part II Relations between the government and public enterprises • GFSM 2001 • Compilation guide TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  7. Part II Superdividends / Capital injections TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  8. Dividends (1) • SNA - mixed message: • “it encompasses all distribution of profits by whatever name they are called” SNA 7.114 • “the level of dividend is not unambiguously attributable to a particular earning period....” SNA 3.99 • “income is often defined as the maximum amount that a household, or other unit, can consume without reducing its real net worth” SNA 8.15 • QC – “income that the owner of quasi-corporations withdraws from them is analogous to the income withdrawn from corporations by paying out dividends to their shareholder” SNA 7.89 • QC – amounts recorded under D.422 have to be explicitly identifiable (SNA 7.116) and will depend largely on the size of the entrepreneurial income (SNA 7.117) • QC – D.422 excludes withdrawal of funds realized by the sale or disposal of the quasi-corporations assets or of large amounts of accumulated of retained earnings or other reserves. SNA 7.118 TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  9. Dividends (2) • MDD II.1.2.1: • “Dividends arise from the government ownership of the unit. They, apply to payments that are funded from the unit’s income. Dividends do not apply to payments funded by asset sales, capital gains, orreserves accumulated over several years, even if they are called dividend.” • GFSM 2001 • “Dividends are payments a corporation makes out of its current income, which is derived from its ongoing productive activities. A corporation may, however, smooth the dividends its pays from one period to the next so that in some periods it pays more in dividends than it earns from its productive activities. Such payments are still dividends. Distributions by corporations to shareholders of proceeds from privatization receipts and other sales of assets and large and exceptional one-off payments based on accumulated reserves or holding gains are withdrawals of equity rather than dividends.” GFSM 5.87 TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  10. Capital injections (1) • 1993 SNA • Transfers from government units to publicly or privately owned enterprises to cover large operating deficits accumulated over two or more years are recorded as other capital transfer (D.99). SNA 10.141 • Regular transfers paid to public corporations which are intended to compensate for persistent losses—i.e. negative operating surpluses (B.2)—which they incur on their productive activities as a result of charging prices which are lower than their average cost of production as a matter of deliberate government economic and social policy, are recorded under D.319 Other subsidies on products. SNA 7.78c TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  11. Capital injections (2) • MDD • A capital injection made to cover expected future losses, as well as repetitive losses, should be recorded as capital transfer (D.9), even if shares (or equivalent) are issued. II.3.1.2.3. • GFSM • GFSM 6.60: “Subsidies also include transfers to public corporations and quasi-corporations to compensate for losses they incur on their productive activities as a result of charging prices that are lower than their average costs of production as a matter of deliberate government economic and social policy. If such losses have been accumulated over two or more years, the payments are classified as miscellaneous other capital expense (2822).” TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  12. Other issues • Central bank lumpsums • MDD • Debt assumption / cancellation • ESA 1995 inconsistencies: 3 cases not expensed: • Quasicorporations / Privatization / disappearing entity • GFSM 2001 Appendix II inconsistencies : • Notion of effective claim • 5 cases TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  13. GFSM 2001 Appendix II • In the case of debt assumption, “the assumption amounts to an increase in the equity owned by government” when the beneficiary is an on-going public corporation, whilst it gives rise to a capital transfer when it is a bankrupt public corporation (para 6). • In the case of debt payments on behalf of other units, an expense (subsidy) is booked when the beneficiary is a corporation (para 8). • Debt forgiveness is the cancellation of debt by mutual agreement. It always involves an expense (Para 9). • Debt-for-equity swaps are cases where the abandoned debt is exchanged against an equity stake. The difference in market value between the debt and the equity stake is recorded as a transfer where a debt forgiveness took place, or is not expensed otherwise (para 15). • A write off without bilateral agreement, such as in case of bankruptcy or when a public corporation is insolvent and is liquidated, is recorded as an Other economic flow (para 12). A unilateral write down is treated similarly to a partial write off. TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  14. Assessment (1) • MDD and GFSM 2001 usefully clarify 1993 SNA • They extend the 1993 SNA quasicorporation treatment to other companies • It has problems: • Asymmetry: superdividends not recognized as revenue but capital injections are expensed • Misrepresentation of income over the long run (superdividend) • Time of recording: for capital injection is unsatisfactory TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  15. Assessment (2) • Not in line with core 1993 SNA/GFSM 2001 principles: • Dividends/injections are net worth neutral: they do not meet the government’s expense/revenue definition • Dividends/injections’ time of recording does not respect the accrual principle. The time of event is the time of the profit / of the loss • Income / revaluation delineation is impure TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  16. Assessment (3) Principles: own funds / net worth neutrality • Superdividends = partial liquidation (more cash ; less equity) • Dividend distribution gives rise to a fall on the market at time of distribution • Value of shares = present value of future dividends • Capital injection = less cash ; more equity • So what moves the own funds? the profit / the loss (at time they occur/are announced) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  17. Assessment (4) Is it quantitatively important? • In the world: massive cases of “quasifiscal operations” + inequality of treatment • Algeria: over the past 10 years, debt assumption of 10-15% of GDP every 3 years; • Yemen: losses are immediately covered by budget/ most profits are immediately distributed • In Europe: • On average, less severe cases (0.2-0.5% of GDP but in some countries up to 2% of GDP yearly) // because of Eurostat MDD rules, most amounts are correctly recorded: remains the issue of the time of recording • EU targets can be impacted (EDP) • Equality of treatment between countries TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  18. Part III Accruing of losses/profits + Reinvested earnings TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  19. SNA ambiguous reading of some government operations Subsidies (D.3): to cover persistent losses incurred as a matter of deliberate government policy Tax (D.2):profits of fiscal monopolies Income of quasicorporations Capital transfers (D.9): to cover post losses Current 1993 SNA: reference in each case to transfers, to cover losses//of profits fiscal mono.//of QC income not in line with the accrual principle TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  20. 1993 SNA treatment of property income on FDI - D.43 • Direct foreign investment (DFI). • DFI enterprises encompass corporations where a foreign investor owns a sufficient stake to have effective voice in its management. SNA 7.119 • DFI enterprise is subject to control orinfluence by a foreign direct investor; the decision to retain some of its earnings within the enterprise must represent a conscious deliberate investment decision on the part of the foreign direct investor. SNA 7.121 TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  21. D.43 1993 SNA recognizes income flow: D.43 « reinvested earnings on FDI » With a counterpart entry: F.5 Shares and other equity TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  22. Importance of D.43 – a European experience • Governments’ contributions to Europe based on GNI/GNP (“GNI Committee”) • Relevant measure of relative national income/revenue • Reinvested earnings task force • Compilation of EU/Euro area sector accounts • Quarterly data: task force • Work on asymmetries, notably D.43/D.42 TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  23. Part IV Proposal for the new SNA : Extend the 1993 SNA treatment of reinvested earnings of FDI to earnings of public corporations TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  24. How does it work? (1) Example: Government owns a corporation that makes 15 of ‘operating’ profits during the accounting period, and distributes 5 in dividends The corporation’s assets/liabilities generate, during that period, 3 of holding gains/losses (to be excluded from operating profits) The equity stakes in the company starts at 100. It closes at 113=100+15+3-5 TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  25. How does it work? (2) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  26. Advantages – GFS (1)Improvement in fiscal data • Captures the impact of fiscal policy on the economy correctly • Time of recording issue (when the economy is stimulated) • Boosts transparency (quasifiscal operations) • Lowers manipulability • Eliminates cherry picking and asymmetry TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  27. Advantages – conceptual (2) • Solves the issue of superdividends and capital injections at the stroke: they become financial transactions • Purifies the government expense/revenue definitions • Implements accrual reporting • Aligns with accounting practices • Improves the income / revaluation delineation TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  28. Accounting practices – reminder • Consolidated financial statements • Treatment of equity stakes in accounting: • Controlled entities (above 50%): consolidate • Associates (20% to 50%): equity method • Below 20%: at historical cost • Equity method: • Equity reestimated on basis of shareholder equity • The profit of the investee is recognized, prorated, as profit of the investor • Therefore: dividend is not a revenue…….. TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  29. Argument (1) – Source data • Difficulties of recording D.43 in balance of payment: accuracy, reliability, timeliness issues • However: • Governments need keeping data on their corporations • Treasury at the board of corporations (central government) • Transparency issue for public finance • Flexibility in practice for local gov.s’ corpor. TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  30. Argument (2) – GFS issue: Volatility and 1st estimates issue • D.43 volatile? • In principle not: it is not the accounting profit/loss ; it is more the operating surplus – will hence mostly reflect the business cycle • Importance of quick/reliable estimates • Example in Europe: EDP data due by 1st March • Profits can be 1st estimated based on business cycle TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  31. Argument (3) – Symmetry of treatment • AEG decided to keep D.43 for S.2 • “If extension to S.13, then to all economy”. • But: • SNA encompasses sector specific rules • FISIM; assets recognition (durables)… • Should we also extend the agreed ad-hoc rules of MDD/GFSM to all units (superdividends/equity injection)? • Question: is the General Government sufficiently specific? • Any further extension is the prerogative of the AEG TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  32. Argument (4) – Savings issue • “Proposal will shift savings out of the corporate sector” • in part solely • This is an outstanding issue. • But is this so important? • Some units have zero savings (pension funds in SNA, and also mutual funds under ESA) • Proposal does not put profits at zero: profits should be measured beforedistribution • Savings = capacity to « self finance » out of income = can be measured by D.43 itself TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  33. Argument (5) – “Change in the definition of income” • Somewhat of a change on the face of it • But, the proposal restricts the extension to direct investment stakes of government • Real change to income definition would be to question the recording of dividend as such • In some respects the retreatment of superdividends as financial transactions changes also income (and possibly more) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  34. The case for dividends as financial transactions: the Microsoft example • Used to distribute no dividends • Superdividends of $ 32 billion to be paid on December 4st (3% of monthly GDP) • US households’ income for December 2004? (bill Gates ownership) • US GNI for December 2004? • The target price of option plans of staff will be reviewed (Board Decision) • Is the fall in value on 4th December a volume change or a price change? TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  35. Argument (6) – « An imputation » • Better to “limit imputations in the SNA” • Imputations are welcome when improving analytical relevance • Arguably, this more a delineation of flows (split of a change in value between a price component and a volume component) than an imputation • Signification of the “artificial” financial accounts entry? • Similar to interest accrued: the reinvestment on the instrument shows a gain in size, in volume TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  36. Argument (7) – Ownership versus economic unit • Reinvested earnings departs from SNA with an emphasis on ownership versus economic units • But, justified in case of government: • public sector / government delineation is based on the market/nonmarket criteria (fundamental economic behavior) • accountability requires reporting all public sector • reinvested earnings combines the two requirements TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  37. Argument (8) – Creditor’s view • « Reinvested earnings imposes the creditor’s view on the debtor » • This is true for all property income on equity in SNA: • equity seen as a liability, by convention • hence, dividend seen as a Use, by convention • The appropriate variable (for for-profit entities) is profit before distribution TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  38. Argument (9) – Consistency with market valuation • “Reinvested earnings is not consistent with market valuation” • Reinvested earnings delineates between an income flow and a revaluation flow (whatever the valuation rule of the asset) • For a quasicorporation, revaluation = those observable on the firm’s assets and on its other liabilities • For other shares (quoted), revaluation results from changes in the market conditions of the share itself TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  39. Arguments (10) – A GFSM 2001 footnote • Footnote 18 of chapter 5 of GFSM 2001 • Origin: • Treat income on direct investment same • Hesitation to depart too radically from 1993 SNA • GFSM experts’ position: reinvested earnings • Enhances transparency • Reduces manipulability • So GFSM 2001 will happily be changed if deemed to be acceptable in Reviewed SNA TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  40. Summary: it is about control • About control/influence: • Rational of the 1993 SNA FDI treatment • Rational for equity method in accounting (see IPSAS 7) • GFS: government takes not-for-profit actions and may act via corporations • Government is different from other sectors: it gives away value TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  41. Part V Pending issues TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  42. What definition of profit? • Definition of profit to accrue for D.43: • 1993 SNA: B.2+D.4r-D.4p+D.7r-D.7p-D.5p • Adaptation to government • Capital transfers • Loans write offs (for public banks) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  43. Question of threshold • No reinvested earnings • 100% ownership (straightforward) • 50% ownership (control established) • 20% ownership (associates in accounting) • 10% ownership (FDI – 1993 SNA) • 0% ownership (all equity) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  44. Various SNA review options TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  45. Other technical issues • Recording of losses (negative profits): • Expense or negative revenue of the investor? • Treatment of indirect profits • follow the BOP expertise? TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  46. Extension to other sectors / equity • To be decided by AEG (not GFS specific) • Extension to other sectors • ROW: applied / households: negligible / General Government: suggested / remains: financial-nonfinancial sectors delineation • Extension to other equities • Practice of share buybacks (USA) • Anomaly of the revaluation account • Notion of volume of instrument: profit reinvested allows the enterprise to grow in size. Like wine ageing, it is not a price change but a volume change. TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  47. Part VI Recommendations (tentative – not mutually exclusive) TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  48. Recommendation 1 • Change SNA to drop the reference to “transfers” • To cover losses.... • Of profits of fiscal monopolies • For quasicorporations TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  49. Recommendation 2 • Interpret SNA on the notion of income, to limit dividends to operating income of the period • Interpret SNA for expensing capital injections in all (most) cases • Clarify the treatment of debt operations in a consistent way: towards expensing • Recognize weaknesses of this approach TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

  50. Recommendation 3 • Adopt reinvestment earnings to GG holdings • Recognize conceptual superiority: • Control/influence of the shareholder • Accrual basis • Income / revaluation delineation ; Notion of volume • Look at useful thresholds • Look at the definition of earnings TFHPSA - WG 2 item 1 / Capital injections, superdividends, reinvested earnings - October 13, 2004

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