Looking Where the Light Is

A colleague recently came to me with a question about where to find a specific type of data needed for a transfer pricing analysis. That got me to thinking about how dependent our work is on the type of data that we have available to us. And the issue of data availability helps to explain one of the great paradoxes of transfer pricing analyses: most transfer pricing studies actually say nothing about actual transfer prices.

The goal of a transfer pricing study is to ascertain whether the transfer prices applied to transactions between two related companies are consistent with the “arm’s length standard”; that is, whether the prices are consistent with what we would have observed if the two companies had been unrelated. In theory, therefore, one would think that a transfer pricing analysis should involve the identification of market (or “arm’s length”) prices against which to benchmark the transfer prices applied to transactions between related companies.

20163348_sYet in practice it is indeed quite rare to see such direct price comparisons in a transfer pricing analysis. Instead, most transfer pricing studies take a “profits-based” approach in which it is the overall profitability of a company that is examined in detail; actual transfer prices are often never even mentioned in our studies.

This is largely due to data constraints. Many transactions between related companies are transactions that we never actually observe between unrelated companies. And even if similar transactions do take place between unrelated companies, it’s typically impossible to obtain price data that’s detailed enough on transactions that are comparable enough to make direct comparisons.

So instead, we are forced to do what economists have always done: we look where the light is.

While we don’t have data on the specific prices that Company X obtained for selling its goods and services to customers, we do often have very good data on the revenue, costs, and profitability of Company X – particularly if Company X is a public company. And since we have good data on profitability, that’s where we typically focus our attention in a transfer pricing analysis. If the related companies that are transacting with each other each demonstrate profitability similar to what we observe among independent companies, that provides indirect evidence that those related companies were not using transfer prices to shift profits between them.

So it turns out that the data that we have available to us plays an enormous role in determining the methods and types of transfer pricing analyses we can do. It’s not a coincidence that transfer pricing economists end up spending a ton of money – tens or even hundreds of thousands of dollars per year – just to obtain good data. In transfer pricing, as in so many other types of economic studies, the data is the driver’s seat.

Cross-posted at the WTP Advisors blog.

Cost or Value?

Last week the famous (infamous?) BEPS project released a discussion draft on the topic of how activities that create intangibles should be remunerated. According to existing guidelines and practice, when multiple entities work together to create an intangible, each entity is rewarded according to its share of the costs incurred during that process. However, the BEPS group working on this issue is now suggesting that each entity should instead be rewarded based on the “value” it has contributed rather than its share of costs. This suggestion has some problems…

The full post, Value Creation and the Lightbulb, can be found at the WTP Advisors transfer pricing blog, where I will be posting regularly.

Transfer Pricing and the Regulatory Climate in India

16530988_sWhen Barack Obama met with Prime Minster Narendra Modi in India last week, one of the items discussed was rather unusual for presidential summits: transfer pricing. But it seems that this attention from the highest levels of government may be having results.

First of all, the US and India seem to have reached agreement on a number of transfer pricing-related issues, including resolving a huge number of competent authority cases involving the transfer pricing of US firms such as IBM, Cisco, Microsoft, and Yahoo.  The Times of India reports:

NEW DELHI: India and the US have agreed on a “broad framework” for resolving transfer pricing disputes involving America companies, paving the way for increasing business ties between the two countries. Sources said the two sides reached the agreement after several rounds of negotiations…The pact also includes the promise to adhere to bilateral advance pricing arrangements (APAs) which would help US firms determine their tax liability in advance and create certainty on tax issues.

Over 150 US companies have applied for APAs in India, but these have all been for unilateral APAs, given the absence of a framework to negotiate bilateral APAs between the US and India. So there’s a lot of potential for US firms to dramatically reduce the uncertainty, at least on the tax side, of doing business in India.

Obama and Modi also met with a number of CEOs to discuss how to improve economic relations between the US and India. During the session Ajay Banga, CEO of Mastercard, specifically singled out transfer pricing as a major impediment to US firms that want to do business in India. Interestingly, yesterday the White House announced that Mr Banga is being appointed to the Advisory Committee for Trade Policy and Negotiations. This presumably means that transfer pricing will continue to receive attention at a very high level of the US government.

Finally, it’s worth noting that the day after Obama’s visit the Indian government announced that they were going to drop a half-billion dollar transfer pricing case against Vodafone.  From the Wall Street Journal:

“The [cabinet’s] decision gives a message to investors,” said India’s telecommunications minister, Ravi Shankar Prasad, after a meeting of the cabinet on Wednesday. “The government—led by Narendra Modi, the prime minister—wants to convey a clear message to investors world over that this is a government where decisions will be fair, transparent and within the four corners of the law.”

Time will tell, but as of now it appears that the present Indian government has reached the same conclusion as many other observers: India’s tax authorities are hurting the country more than they are helping it. So we could be witnessing the start of a new kind of climate change in India.

The EU Commission’s Problematic Reasoning on Amazon

Today the EU Commission released a document detailing its reasoning behind its decision to consider Luxembourg’s tax treatment of Amazon to be a violation of EU competition rules. The full document can be found here (pdf).

The crux of the EU Commission’s argument is that Luxembourg gave Amazon permission to set up a transfer pricing structure that was inconsistent with the arm’s length standard, and that in so doing it conferred a “selective advantage upon Amazon in so far as it results in a lowering of its tax liability in Luxembourg.” And that’s where the problems start in the EU’s reasoning.

EU v AmazonTo begin with, one might think that in order for Amazon to have received a “selective advantage” it must be the case that Luxembourg would have rejected the same structure for another taxpayer. But there’s no evidence presented that Luxembourg would have interpreted its own tax code differently for any other taxpayer.

But even putting that issue aside, how does the Commission believe that the Amazon structure was inconsistent with the arm’s length standard? Its argument is based on the following points:

  1. Luxembourg did not provide the Commission with Amazon’s transfer pricing analysis supporting its transfer pricing policies.
  2. The method used to calculate Amazon’s transfer prices in Luxembourg (specifically royalty payments to the owner of the Amazon IP in Europe) “does not seem to correspond to any of the methods listed in the OECD Guidelines”.
  3. Amazon’s calculation of the royalty payments “is not related to output, sales, or to profit.”
  4. Luxembourg accepted a margin of 4-6% over cost for the Amazon entity without a comparability analysis, and that margin may be too low.
  5. Luxembourg also accepted a floor on the Amazon entity’s profitability of 0.45% of Amazon’s EU sales revenue, along with a cap equal to all of Amazon’s European profits.

There are problems with each of these points. Taking them in turn:

1. The fact that Luxembourg did not provide the Commission with Amazon’s transfer pricing analysis says nothing about whether or not the arrangement is inconsistent with the arm’s length standard.

2. The method described in the Commission report is easily recognizable as the income method (i.e. the TNMM as specified in the OECD Guidelines) for the calculation of payment for intangibles. The income method is a frequently used approach in determining an appropriate level of royalty payments, and in fact is the method preferred by many tax authorities, such as those in the US.

3. Amazon’s calculation methodology is in fact directly related to sales and/or profit. This is obscured somewhat by the two-step nature of the calculation, in which the royalty payments are calculated such that they leave Amazon’s Luxembourg entity with profits equal to either 4-6% of its cost base or at least 0.45% of total Amazon sales revenue in Europe. But it’s clear that as Amazon’s sales and profitability in Europe go up, the income attributable to Amazon’s Luxembourg entity will also rise. So it’s hard to see where the Commission arrived at this particular conclusion.

4. The 4-6% range of profitability for the Amazon Luxembourg entity is not obviously too low; a 5% margin is considered very typical for a wide range of service providers. Whether or not it’s the right range in this case depends on the specific functions performed by the Luxembourg entity. A full functional analysis and set of comparable companies would be necessary to form a final opinion on this issue, but given the widespread use of 5% margins for intragroup services it seems oddly ill-informed to pick on this figure. Regardless, this point is largely irrelevant due to the second portion of the calculation methodology, in which the profitability reported by the Luxembourg entity actually depends on Amazon’s European revenues, not its cost base, as discussed in the next point below…

5. Yes, Luxembourg accepted Amazon’s rather unusual policy of having its Luxembourg entity’s taxable income depend not just on its cost base, but on total sales revenue in Europe. But there are two important points to be made about this. First, it’s not at all unusual to see arm’s length licensing arrangements where two or more alternative calculations are used to arrive at the amount of the payment, so this is not an obvious flag that the arrangement is inconsistent with the arm’s length standard. Second, given reasonable assumptions it’s entirely possible that the second, sales-based condition could actually increase Amazon’s tax bill in Luxembourg over what it would otherwise pay. Consider that Amazon’s sales in Europe were around €13.6 bn in 2013. Applying the 0.45% floor on the Amazon entity’s taxable income means that it must have declared income of at least €60m in Luxembourg in that year. Amazon’s Luxembourg entity has about 1,000 employees, suggesting that its direct operating expenses are probably in the neighborhood of a few hundred million euro. Even if its operating costs were €600m in 2013, it would have earned a margin of 10% over its costs – arguably significantly more than would be expected in an arm’s length arrangement. The point is that it’s not at all clear that Amazon’s transfer pricing policy yields a lower-tax result than would be expected in an arm’s length arrangement.

More fundamentally, the weaknesses in the EU Commission’s argumentation remind us that the EU competition authority is taking on a vast new area of inquiry with its recent push to address transfer pricing issues. Are the EU’s competition regulators now going to try to seriously assume a new role as a review body for each member country’s interpretation and enforcement of transfer pricing policies? If so, they have a lot of work in front of them.

 

UPDATE: For a bit more on the issue of “selective advantage”, take a look at this post by Renata Ardous. In it she points out that the General Court of the EU has recently taken issue with the Commission’s attempts to characterize aspects of national tax laws as providing selective advantage, and that similar reasoning may apply to this case.

The Most Aggressive Tax Authorities in the World?

Earlier this week there was a court ruling in India related to transfer pricing. As reported by Business Standard:

3087367_sThe Bombay High Court on Tuesday ruled in favour of Shell in a transfer-pricing order that sought to tax the energy giant’s 2009 investment in its Indian subsidiary. The order will have an impact on other multinationals fighting the tax department on similar grounds.

The income-tax department had sought to add Rs 15,220 crore to Shell India’s taxable income after Shell Gas invested in its local arm at Rs 10 a share. The tax department valued Shell India’s shares at Rs 180 apiece in January 2013 and charged it with undervaluing those to evade tax… The court rejected the tax department’s argument that the Shell case was distinguishable from Vodafone’s case, which won a similar reprieve in October.

In a narrow technical sense this verdict matters simply because it means that the tax authorities in India can no longer try to apply Indian transfer pricing regulations to capital transactions such as the issuance of new shares. This will make life a bit simpler for many companies in India (including some of my clients) that have recently felt obliged to prepare transfer pricing documentation to support balance sheet transactions.

But the broader implications are more interesting. To my knowledge, India was the only country in the world that even attempted to apply transfer pricing rules to capital transactions. And that is just one of many ways in which the Indian tax authorities have very aggressively interpreted and applied transfer pricing rules to multinationals doing business in India. In transfer pricing circles, India has a reputation. This ruling is the latest in a string of court decisions that indicate that the Indian judicial system thinks that the Indian tax authorities have been overstepping their bounds.

This is a good illustration of how subjective transfer pricing can be. The fundamental principle behind every transfer pricing analysis – whether conducted on behalf of a company or a tax authority – is clear enough: transactions must be consistent with the arm’s length standard, meaning that the prices applied to intra-group transactions should be the same as market (or arm’s length) prices. But in practice, it’s often impossible to determine exactly what prices or rates of compensation would be agreed upon between unrelated parties, because such transactions are never actually observed in the real world.

As a result, there’s frequently no obviously correct arm’s length price to apply, and multinationals as well as tax authorities often have substantial latitude in how they interpret and apply the arm’s length standard to intra-group transactions. And just as some multinationals are particularly aggressive in how they approach transfer pricing, so are certain tax authorities, like those in India.

What effect does the behavior of the Indian tax authorities have on the business climate in India? Many companies (as well as some politicians in India) would argue that they effectively view the Indian tax authorities’ harshly aggressive transfer pricing enforcement as an extra tax that companies must pay to do business in India. Many are willing to pay that tax in order to reap the advantages that they get from being in India, but it is a real effect nonetheless, as it probably does dissuade some firms at the margin from undertaking certain economic activity in India.

And I find that very interesting. As a student of economics one learns a lot about how to analyze the effect of explicit taxes on behavior. Some students even learn about the importance of institutions and organizations in facilitating or hindering economic transactions (though generally I think such subjects are woefully under-taught in most economics programs).  But relatively little emphasis is paid to qualitative, subjective phenomena such as differential enforcement of transfer pricing regulations from country to county, or the broader category of “business climate”. To me this serves as a useful reminder that even such hard-to-measure economic forces or behaviors can have very real economic effects.

Attacking the Cash Box

A colleague of mine yesterday highlighted comments made recently by Robert Stack, deputy assistant secretary for international tax affairs at the US Treasury Department: “We are determined to put a big dent in the ‘cash box’ because countries cannot afford large piles of untaxed income.”

4871276_sBut what is a “cash box”, anyway?  The concept is pretty simple: it’s a company within a multinational group located in a low-tax jurisdiction that owns some sort of valuable asset. That company may not even have any employees, but since it owns the asset it is legally entitled to the profits that are generated by the asset, thereby ensuring that a portion of the multinational group’s income gets taxed at a very low tax rate.

But for tax authorities, restricting the use of such arrangements is trickier than it might seem. Let’s use an example to illustrate. Imagine there’s a company called SuperTech USA that develops a fantastic new product. SuperTech USA sets up a subsidiary on a lovely tropical island that happens to have a corporate tax rate of zero, and then has SuperTech Island Co purchase the designs and technology underlying that product. SuperTech Island Co hires a contract manufacturing company in China to make the product, and contracts other SuperTech affiliates around the world, possibly including SuperTech USA, to essentially act as local sales agents.  From that time onward, whenever SuperTech products are sold to consumers the local sales affiliates get some sort of arm’s length compensation for their services (maybe a sales commission), but SuperTech Island Co gets the rest of the revenue. If it’s really a good product with fat profit margins then it’s likely that the bulk of the group’s profits will actually belong to SuperTech Island Co and be subject to zero corporate income tax.

If you are interested in stopping this type of arrangement, how would you go about it? Perhaps you might consider blocking the initial purchase of the asset by SuperTech Island Co. But companies buy and sell assets all the time for perfectly reasonable business reasons, so any sort of simple rule prohibiting that won’t work. What about requiring all of SuperTech’s sales revenue to belong to the local sales affiliates rather than to SuperTech Island Co?  Allowing the owner of an asset to claim the income generated by that asset is a basic element of our notion of property rights, so we can’t easily tamper with that.

The OECD seems inclined to address the issue in a different way: require SuperTech Island Co to pay much more compensation to SuperTech’s local sales affiliates. That’s a transfer pricing issue, and would depend on making the argument that SuperTech Island Co is paying its sales affiliates less than what it would have to pay to unrelated sales agents. Given the abundance of sales people in this world eager to have a good product to sell, it seems likely that would be a difficult argument to make. Trying to tweak existing transfer pricing rules to address this particular situation would likely open an entirely new can of worms.

Instead, Stack indicated that the US government thinks a better approach would be for an international agreement to allow countries to tax income earned by companies domiciled outside their jurisdiction. In other words, Treasury would like to get other countries to agree to allow the US to tax the profits of SuperTech Island Co even though that company is not located in the US. Needless to say, however, reaching such an international agreement could be extremely difficult.

But the economist in me wonders if the root cause of this sort of arrangement is really something else: incorrect initial valuations of the asset.  If the price that SuperTech Island Co had to pay to acquire ownership of the asset fully reflected the future stream of income that could be expected from that asset, then it seems likely that there would not be much of an incentive to move the asset in the first place. With the transaction described above SuperTech USA would record a large amount of income in the year of the asset sale – on which it would pay US tax rates – in exchange for a stream of tax savings in future years.  It strikes me that a correct initial valuation of the asset should take this into account. And if it did, then perhaps the cash box problem would not be so much of a problem after all.

Simplifying the Rules. A Bit.

Last week the OECD released a discussion draft about how “low value-adding intra-group services” should be treated for transfer pricing purposes (pdf). This document is part of the OECD’s ongoing BEPS project, and represents a substantial piece of output by the group working on action item #10 (out of 15 total): “high risk transactions”.

8161291_sBy way of background, it’s important to understand what is meant by the term “intra-group services”. Nearly all multinational groups have entities that perform services that benefit entities in other countries. Perhaps the group has an R&D center in a country that helps to develop new products for the entire company. Or maybe a local affiliate helps to develop marketing materials for a parent company. Even the performance of order processing, call center, logistics, or other “back-office” type functions by an entity in one country to assist a related entity in another country count as intra-group services. Given the complex web of functions distributed around the world in today’s typical multinational, the scale and scope of such intra-group services are enormous.

Since such transactions are between related parties, they are subject to transfer pricing rules. That means that every time a company or facility in one country performs a function that benefits a member of the corporate group in another country, the service must be paid for in a manner consistent with the arm’s length standard – i.e. as if the transaction had happened between two unrelated companies.  The associated administrative burden to calculate and substantiate that can be substantial.

That’s where the OECD’s latest draft document comes in.  While the primary aim of the BEPS project is to make it harder for multinationals to shift their worldwide income to low-tax jurisdictions and thus reduce their tax bills in ways that are perceived as being unfair, this document actually takes a step toward making life a tiny bit easier for multinationals to meet their transfer pricing regulatory requirements.  The document proposes that there be a simplified way for multinationals to calculate the correct prices to apply to certain intra-group service transactions.

The proposed simplified approach will be very familiar to transfer pricing practitioners in the US, as it is substantially the same as the Services Cost Method (“SCM”) that has been a part of US transfer pricing regulations for several years. The essence of both the SCM and the OECD’s proposed simplified method is to pool the cost of the center providing services, allocate those costs in a reasonable way among the various entities that benefit from the provision of those services, and then possibly add a small markup (in the case of the OECD proposal) or no markup at all (in the case of the US’s SCM).  Importantly, this simplified method is only applicable to services that are considered “routine” and not central to the company’s business.

From my perspective, this makes all kinds of sense. I don’t see any reason for companies to waste time and resources to perform extensive economic analyses supporting their transfer pricing on routine services.  Transfer pricing practitioners have seen so many of these intra-group services (after all, pretty much every multinational company has them) that we can usually tell you exactly what transfer prices the economic research will support even before we’ve crunched the first number.

But this also touches on a couple of larger interesting issues.  First, I think that this marks another step on the path of simplifying transfer pricing by focusing more on outcomes rather than individual transactions. In other words, to me this seems consistent with the continued ascendancy of profits-based approaches over transaction-based approaches to verifying that a company is adhering to the arm’s length standard.

Second, it puts renewed attention where it really should be: on the role and treatment of intangible assets (including their creation, maintenance, and management) when it comes to tax strategies employed by multinational companies.  After all, when you think about today’s most profitable companies, what is the ultimate source of their profitability?  It usually lies with their IP. Most other intra-group transactions are little more than a sideshow and distraction by comparison.

Finally, it’s interesting to note that this may be yet another way in which the US’s transfer pricing rules appear to have foreshadowed developments around the world. The US was one of the first adopters of formal transfer pricing regulations. The US began emphasizing profits-based approaches over transaction-based approaches before most other countries. And now the US’s simplified approach toward low-value intra-group transactions seems to be earning wide-spread acceptance as well.

I think this is simply a reflection of the fact that the US started regulating transfer pricing before most other countries. As a result, the US has had over 20 years to slowly build up a cadre of transfer pricing professionals and a body of institutional knowledge among the IRS, taxpayers, and consulting firms. And with that has come a gradual improvement in our understanding of what works and what doesn’t from a practical point of view.  So it’s worth thinking about how this latest product from the BEPS project may be another small but positive step in the gradual convergence of transfer pricing rules around the world… and to consider that the end result may end up looking more like the US’s transfer pricing rules than one might have expected.

German Wishes for Irish Taxes

Ireland has long been a favorite country for multinationals to set up shop in, thanks in part to its 12.5% corporate tax rate – one of the lowest in the world. A typical situation would be for a multinational based in the US or Asia to set up an Irish subsidiary as the principal entity from which to run its European business, thereby allowing it to legally record a significant portion of its European income in Ireland.

But this low tax rate has not been so popular among other European countries, as it is seen as making it difficult to compete with Ireland in their ongoing quiet contest for tax revenues from multinationals. So with the visit of German finance minister Wolfgang Schäuble to Dublin this week to deliver some low-interest loans, The Irish Times posed an interesting question: why hasn’t Berlin demanded that Ireland raise its corporate tax rate in exchange for its assistance?

German officials mystified by inaction on Irish corporate tax rate

German finance minister Wolfgang Schäuble is in Dublin tomorrow to help Ireland’s Halloween party with a €150 million loan from Germany’s KfW state development bank. Matched by the European Investment Bank (EIB), this is the starting capital for Ireland’s Strategic Banking Corporation of Ireland…

As on previous occasions where Ireland was looking for something from Berlin – the prom note reconfiguration, or the bailout itself – Berlin demanded something in return, having already given Dublin what it wanted first…

Given the regular German swipes at Ireland’s 12.5 per cent tax rate, it’s interesting that Berlin never followed the Cyprus strategy. Last year, Nicosia was “encouraged” to make a sovereign decision to raise corporate tax rates as a precondition for the required assistance.

It’s a good question, though I’d like to rephrase it slightly: why does Germany treat Ireland so differently from Cyprus when it comes to providing financial assistance? One possible explanation is that the corporate tax rate in Cyprus, which had been set at 10%, was seen by Germany as being more egregious than Ireland’s rate. But it may also be a subtle symptom of the north-south divide in Europe that has emerged so strongly in recent years. The distrust and hostility between northern European nations and southern Europe has been displayed in many ways since the Eurozone crisis began in 2009-10. Perhaps this is another one.

What Is This ‘BEPS’ Thing, and Should I Care?

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You have almost certainly seen news stories recently about how global companies like Apple, Amazon, and Starbucks reduce their tax bills through clever use of international tax planning. You may also have come across the term ‘BEPS’ sprinkled liberally through the business news over the past month or two. If so, your eyes probably glazed over at the time. But since a number of my non-transfer pricing specialist friends have been asking me what ‘BEPS’ actually is and whether they should care, I thought I would take a moment to try to connect the dots and explain what it’s all about.

As these stories about global companies paying little or no tax in certain jurisdictions have become regular front page items in the business press, the issue has drawn the attention of the world’s political leaders. For better or worse (and I think it’s probably for the better – the system is sort of a mess in my opinion), corporate tax policy has become a hot political topic in recent years, as noted by the OECD:

 downloadThe debate over base erosion and profit shifting (‘BEPS’) has reached the highest political level and has become an issue on the agenda of several OECD and non-OECD countries… The G20 leaders’ meeting in Los Cabos on 18-19 June 2012 explicitly referred to “the need to prevent base erosion and profit shifting” in their final declaration. G20 finance ministers, triggered by a joint statement of United Kingdom Chancellor George Osborne and German Finance Minister Wolfgang Shaüble, have asked the OECD to report on this issue by their meeting in February 2013. Such a concern was also voiced by US President Barack Obama in his Framework for Business Tax Reform, where it is stated that “the empirical evidence suggests that income-shifting behaviour by multinational corporations is a significant concern that should be addressed through tax reform”.

In other words, governments around the world have decided that it’s time to consider reforming corporate tax policy.  But since global corporations are, well, global, it is widely recognized that such a project really needs to be internationally coordinated if it’s going to be successful.  That’s where the OECD and its BEPS project comes in.

The BEPS project is essentially a bunch of working groups, composed of officials from the world’s largest economies, that are tasked with the job of trying to figure out how the international tax landscape for corporations should be changed.  They are focusing on a few specific areas, including but not limited to:

  • Tax avoidance by digital companies: Do different rules need to be created to specifically address the digital economy?
  • Financial loopholes: What changes need to be made to prevent companies from using financial instruments like intercompany loans to avoid paying tax on some of their income?
  • Intangibles: Should international transfer pricing norms be revised to make it harder for companies to reduce their taxes simply by moving their intangibles to low-tax jurisdictions?
  • Documentation: What sort of international reporting standards could be imposed to make it harder for global companies to shift their income into low-tax jurisdictions?

In a nutshell, the BEPS project is the attempt by the world’s major economies to try to rewrite the rules on corporate taxation to address the widespread perception that they don’t pay their fair share of taxes.  So despite its opaque acronym, and even though they don’t know it, BEPS is actually something that millions of people around the world feel strongly about.

In future posts I’ll address some of the questions you might be asking yourself at this point, like:

  • Will any of the BEPS agenda items actually result in higher tax bills for global companies, and if so, which ones?
  • Do different rules really need to be created to specifically address the digital economy?
  • Is BEPS a good way to address the issue of corporate taxation?

In the meantime, keep your eyes open for mentions of BEPS in the news.  And the next time you come across that obscure acronym, hopefully you’ll be able to see through it to the substantial international effort to address corporate tax policy that it represents.

Fighting Over Tax Revenue in Europe

There’s been a burst of news recently about how multinational companies (“MNCs”) use corporate structures (and of course the transfer pricing that goes with it) to reduce their tax bills. Starbucks, Apple, and most recently Amazon have all been getting lots of unwelcome press about their European tax planning strategies.

This is nothing new, of course. But there does seem to be a slightly different flavor to the criticism this time around. In the current round of attention it seems that national tax administrations are coming under as much scrutiny as the companies involved, with certain countries being accused of essentially colluding with MNCs to facilitate their tax minimization. Last week we learned that the EU has commenced an anti-competition investigation against Luxembourg related to the tax treatment that the country applies to MNCs.  And this week it was announced that Ireland will, under pressure, revise its tax regulations to eliminate one type of corporate structure that MNCs can use to reduce their tax liabilities.  The Economist reports:

20141018_fnd001

BONO may front one of the world’s most popular rock bands, but the U2 singer did not earn many new fans when he recently defended Ireland’s controversial tax policies, which are widely seen as helping multinationals to avoid paying their fair share. Even Ireland’s government seems to be having doubts. On October 14th it announced plans to close the country’s biggest loophole, the “Double Irish”.

The Double Irish allows companies to shift their profits from high-tax countries to havens… Users can thereby cut their effective tax rate—perfectly legally—far below Ireland’s already low 12.5% rate, in some cases down to less than 2%…

From January all new companies domiciled in Ireland will also have to be tax-residents there, making the Double Irish impossible. Ireland is acting under pressure from America, the European Commission and the OECD, which are working on multilateral reform of international tax rules to curb avoidance.

On one level focusing attention on the countries involved, rather than MNCs, makes perfect sense.  After all, MNCs are simply doing the best that they can for their owners, given each country’s tax rules as they are written. (The degree of involvement that MNCs have in the writing of those tax rules is an interesting but separate question that we’ll have to leave for another time.) So if you think that MNCs should pay higher taxes, you really should be directing your criticism at the creators and administrators of tax regulations, not the taxpayers.

But why now?  And why does the attention seem to be falling not on those stereotypical sunny, shorts-wearing, palm tree-fringed, tropical island tax havens, but instead on respectable (if rather more gloomy, weather-wise) northern European nations like the Netherlands, Luxembourg, and Ireland?

I think a couple of factors are contributing to this.  First of all, I don’t think it’s a coincidence that the countries in question are EU members. In case you hadn’t noticed, the EU has been going through a bit of an economic rough patch over the past few years. The eurozone financial crisis that began in earnest in 2010 has highlighted and contributed to dramatic differences in economic performance and budget policy between EU member nations. Suspicion and resentment between European countries over economic and financial issues has probably never been greater since before the second world war.

But more specifically, I think that the troubled economic landscape in Europe over the past several years has brought to the forefront something that usually lies unseen in the background, but which transfer pricing practitioners are constantly reminded of: the world’s major countries are engaged in a constant, usually quiet battle with each other for tax revenue from MNCs.  It’s not quite true that MNC tax payments are a zero sum game, but as a first approximation that idea captures how tax administrations view the problem.  Each MNC has a pie of global tax payments. And each tax administration wants to capture as large a slice of that pie as they can.

So as many European countries feel the accumulated burden of years of economic and financial struggle, it’s not surprising that they have become more aggressive with each other in their battles over the share of the tax revenue they can claim from the world’s largest MNCs. I think this phenomenon will help keep the pressure on the participants in the OECD BEPS project to make sure that the new rules that come out of those negotiations are quite strict. And I’m sure we haven’t heard the last of how Europe’s low-tax jurisdictions help the world’s MNCs to reduce their overall tax bills.