For years, tax payers around the world have watched as multinational corporations employed elaborate schemes to stash their profits in low-tax jurisdictions out of reach of tax collectors in their home countries. Now multinational institutions, such as the Organisation for Economic Co-operation and Development (OECD) and the EU, along with governments such as the US, are taking action to combat such activity, and the incentives they create for distorted FDI decisions.
The OECD has weighed in with far-reaching guidelines to prevent losses of tax revenue through base erosion and profit-shifting (BEPS) by multinational corporations. The OECD estimates that $100bn to $240bn is lost to national treasuries each year because of multinational tax dodges. That equates to between 4% and 10% of global corporate income tax revenues being lost because of loopholes “that allow corporate profits to ‘disappear’ or be artificially shifted to low/no-tax environments, where little or no economic activity takes place”, the OECD stated.
The scale of the BEPS problem globally is huge. Using data from the International Monetary Fund, a recent report by the US Congressional Research Service showed that the nine most popular direct investment destinations globally are all tax haven or tax preferred countries, with an average inward FDI position equal to 961% of their own GDP in 2013.
Establishing a base
The OECD’s new 15-point 'action plan' was endorsed by the G-20 in October 2015, with signatories from 90 countries, and others joining later. Although the measures are not legally binding, the signatory governments are expected to implement them. Some measures can be implemented immediately, including rules to curb transfer pricing abuses by making it more difficult to shift profits from high- to low-tax jurisdictions. Others will require changes to tax treaties, and some will need domestic legislation.
“From the US perspective, country-by-country reporting is the most current issue under BEPS,” says Donald Moorehead, a partner in the Washington, DC offices of global law firm Squire Patton Boggs.
That is because, effective from January 1, 2016, tax authorities have had to have, for the first time, a global view of the operations of multinationals with annual revenue exceeding €750m, through a system of country-by-country reporting intended to expose artificial arrangements to minimise taxes. These reports will be automatically shared with other treaty partners.
Mr Moorehead says companies are concerned about the type of country-by-country data they will be required to report, and whether this information will be kept confidential by tax authorities. The change will also alter the way most companies collect information internally, and will be challenging to implement, he adds.
A permanent challenge
The question of what constitutes a 'permanent establishment' is another major challenge, says Bernhard Gilbey, a partner at law firm Squire Patton Boggs’ London office, who cites the example of a UK company with a handful of sales people in Germany. If the activities of those sales people are sufficient to create a 'permanent establishment', the company will have to pay taxes in the UK on its worldwide profits but also in Germany on profits generated by its sales activities there, raising the group’s overall tax bill. As a result, companies have been very inventive in trying to evade the permanent establishment label for their foreign operations.
The new BEPS rules will restrict their options and will have a significant impact on companies whose effective tax structure is based on not having a permanent establishment in another country, according to Mr Gilbey.
The BEPS plan also aims to “limit the toxicity of patent boxes”, says Pascal Saint-Amans, director of OECD’s centre for tax policy and administration. Patent boxes are devices created by some governments to allow income from intellectual property (IP) to be taxed at lower rates than other types of income. Since IP may be a company’s most valuable asset, patent boxes have been effective in attracting FDI. However, under BEPS, the tax benefit will only apply to profits generated from IP developed in that country – the 'nexus' approach.
For its part, in January the European Commission (EC) announced its Tax Transparency package to shed light on the secret deals some governments have struck to lower the tax rates of individual companies through 'tax rulings'. The legislative proposal requires member states to automatically exchange information on their tax rulings every three months, along with other initiatives.
In October 2015, the EC clamped down on Luxembourg and the Netherlands, member states that issued secret tax rulings that enabled Fiat and Starbucks, respectively, to reduce their tax by shifting profits abroad or deliberately underestimating them – rulings the EC considered unlawful state aid. The companies were ordered to pay a respective €20m to €30m in unpaid tax – a decision the Dutch government said it will appeal. Apple’s tax structure in Ireland is also under EU investigation – with a potential $8bn bill for back taxes, according to a Bloomberg Intelligence analysis, which Apple is lobbying against – as are Amazon’s and McDonald’s in Luxembourg.
In addition, the EC has concluded that Belgium enabled 35 multinationals to discount their corporate tax rates by between 50% and 90%, and ordered the country to claw back $700m from these companies' "excess profits". In January, the UK extracted a tax settlement from Google’s parent, Alphabet, to recover £130m ($185.9m) in taxes on profits that had been diverted since 2005 through Google’s Irish subsidiaries.
As a member of the OECD, US legislators are mulling decisions about implementing the BEPS proposals, some of which are opposed by some trade groups.
However, the US also faces the problem of its multinationals resorting to the practice of inversion, by which a US corporation buys a company in a foreign jurisdiction with a low corporate tax rate then adopts the domicile of its new acquisition. The proposed $20bn merger of Wisconsin-based Johnson Controls with Dublin’s Tyco International is the latest inversion to hit the headlines, following New York-based Pfizer’s proposed acquisition of Dublin-based Allergan.
The reason for the exodus is clear: multinationals consider the US corporate tax rate, at 35%, too high. And it is one of the few countries to tax a company on its worldwide operations. In addition, US companies can defer paying taxes on income earned abroad until it is brought home. As a result, US corporations are estimated to hold some $1900bn in offshore tax havens, with no intention of repatriating it.
In November 2015, the US Treasury announced yet another set of rules to try to curb the outflow. But there is consensus that until policymakers change the tax structure, the trend will continue.
Indeed, Mihir A Desai, a finance professor at Harvard Business School, argues that if the government addresses the problem only through anti-inversion regulations – without reform of the tax rate and without implementing a territorial tax system – it will be counterproductive. Mr Desai says it will draw a line that defines some transactions as inversions and others as genuine mergers. “The winners will be larger non-US firms that can buy US firms and have the deal not be characterised as an inversion,” he says.
Meanwhile, the Australian tax office has already taken aggressive action to name and shame domestic and multinational companies that paid little or no tax by, in 2014, publishing the tax details of 1500 large corporations. Tax commissioner Chris Jordan warned that some foreign-owned entities operating in Australia “are overly aggressive in the way they structure their operations".
“Large corporates now have to consider the impact of their tax information as a factor in managing their reputation with the markets, their shareholders, their consumers and in the Australian community,” Mr Jordan said. It is a lesson multinationals in other jurisdictions may well take to heart.