Archive for Controversy

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.

A New Arena for Transfer Pricing Disputes

You may have seen last week’s news that the tax treatment of Amazon by the country of Luxembourg is being examined by the European Commission as a possible violation of EU competition rules.This follows the opening of similar investigations by the EU into the tax arrangements of Apple, Starbucks, and Fiat.

This is interesting for a variety of reasons.  First of all, this marks one of the first times that transfer pricing arrangements are being actively and specifically scrutinized not by any national tax authority, but by a multinational body with no direct financial stake in the outcome.  Secondly, the tax authorities of Ireland and Luxembourg — i.e., the tax authorities that stand to gain tax revenue if the EU rules against the companies in each case — are actually in the position of defending those companies, even though if they lose the legal battle with the EU, they stand to gain billions of dollars in tax revenue.

But perhaps the most fascinating aspect of this development is that transfer pricing is now being explicitly and directly addressed as an aspect of competition policy, rather than simply as a tax matter. The Economist put it thus (subscription required):

[T]he European Commission has been exploring those dark recesses to establish whether multinationals’ arrangements with tax-friendly Ireland, Luxembourg and the Netherlands amount to illegal subsidies. For the three companies targeted so far (Apple, Fiat and Starbucks), and for the many others that routinely engage in complex tax-planning, the probes have taken the crackdown on cheeky tax avoidance into uncomfortable new territory…

Citing minutes of meetings between Apple’s tax advisers and officials, the commission suggests they reached a quid pro quo in which the company was allowed to shelter profits from tax in return for maintaining jobs. The suspected mechanism was “transfer pricing” agreements that deviated from international accounting guidelines, which require transactions between group subsidiaries to be priced at market rates. The costs attributable to one Irish subsidiary appear to have been “reverse-engineered” to arrive at a certain level of taxable income with “no economic basis”, says the commission.

These investigations and the resulting legal fallout could have substantial implications well beyond the companies and countries in question. If transfer pricing arrangements become subject to anti-competition investigations in addition to scrutiny from tax authorities, the regulatory landscape suddenly has the potential to look very different from what we’re used to.  Stay tuned.