Microsoft’s agreement to buy Skype for $8.5 billion may turn out to be a bad bargain, but that does not mean Microsoft CEO Steve Ballmer made a mistake. His company has all the upside, while you and I are on the hook for approximately half of any losses.
Our irrational tax laws made it rational for Ballmer to spend a fortune acquiring a company that makes no money.
Microsoft built an enormous cash hoard in the decades that its Windows and Office software dominated the personal computer industry. That dominance is coming to an end, but the cash is still sitting there. Much of it is overseas as a result of foreign sales.
When companies accumulate cash far in excess of what they need to operate, management comes under pressure to either return it to shareholders in the form of dividends or share repurchases, or to spend it on expansion and corporate acquisitions. It would be wonderful for shareholders if Microsoft could deploy its assets to produce another cash cow like Windows, or a hardware home run like Apple’s iPhone, iPad or iPod. But the company’s track record is unimpressive.
Windows made Microsoft a one-hit wonder. The Office software suite is a big commercial success that piggybacked on the success of Windows. Nearly everything else Microsoft has released for the past couple of decades is basically irrelevant to a company its size.
If it cannot constructively use its cash, Microsoft should return it to shareholders so they can reinvest it elsewhere. This is where the tax laws get in the way. To bring a single dollar of that overseas cash home, Microsoft would face a U.S. tax rate of 35 percent. This would leave 65 cents of that dollar to pay to shareholders. If the 65 cents is paid in the form of a dividend, another 15 percent federal tax, or about 10 cents, will be due. That leaves 55 cents for the shareholder. But some shareholders face state and local taxes up to about 10 percent, and they could pay another 10 cents on that dividend, leaving those unfortunate investors with only 45 cents of the repatriated dollar.
So Microsoft reached out to Skype. Skype happens to be incorporated in Luxembourg, so money invested to buy its stock is not considered repatriated to the U.S. No American taxes are due. If the deal turns out to be a big success, Microsoft can continue to keep Skype’s foreign-generated profits overseas, deferring American taxes indefinitely. If the deal is a disaster, Ballmer can tell shareholders not to feel bad, because the alternative of giving them the money would have caused half of it to be taxed away, regardless.
This logic helped Ballmer justify the very rich price he agreed to pay for Skype, whose specialty is transmitting video and voice calls from computer to computer for free, and to ordinary telephones anywhere in the world for very little money. Those pennies add up to millions of users and $860 million in annual revenue, but no profits for now. Microsoft hopes to change this through greatly expanding the Skype user base by integrating the service into everything from the Xbox game platform to Windows itself.
It is a gamble that just might work, because despite all our connectedness these days, there is still room for improvement. Consider my family’s situation this week.
My wife and elder daughter were traveling in Spain together, while I hopscotched the country on a business trip. Our younger daughter attends college in the Chicago area and was interviewing for a summer journalism internship. My mother was visiting friends in California. My wife’s father was visiting doctors in New York.
We had a lot of family news to share, and this week, our family did most of the sharing on Facebook. We made minimal use of cellphones in Europe, where AT&T would charge us about $2 per minute for voice calls. We could have talked for much less on Skype, but none of us use it. We could have had video chats using the software that came with our laptop computers, but we did not want to bother setting it up. A more smoothly integrated voice or video phone system could have captured our business.
Facebook and Google already know this. Both companies are interested in becoming a one-stop hub for people to stay in touch with everyone they know. If Facebook had an integrated voice or video chat system, our instant messages and wall posts this week would probably have included audio and video, even if we had to pay a modest fee. Facebook and Google, in fact, were both candidates to buy Skype, though they probably never considered paying anything close to what Microsoft agreed to spend.
Microsoft is at risk of becoming irrelevant in a world dominated by information aggregators like Google, social networks like Facebook and Twitter, communications companies like Verizon and AT&T, and the hybrid hardware-software-content business that Apple has built far more successfully than Microsoft. This ultimately justified Ballmer’s extravagance.
Especially when he could be extravagant on the taxpayer dime. Some will see this as a reason to close so-called loopholes in the corporate tax laws, making U.S. companies pay American taxes immediately on income they earn anywhere in the world. But doing so would only hand a major advantage to foreign firms, whose home countries tax them lightly or not at all, and never on earnings generated abroad. This leaves their companies free to repatriate foreign-source profits to expand business and payrolls at home.
We made it irrational for Ballmer to invest his company’s stockpiled cash domestically, and rational for him to overpay for a corporation based abroad. Don’t blame Ballmer for making a bad deal. Blame thoughtless tax policy for making a bad deal look good.