Transfer pricing has always presented a problem for companies. Previously there were physical trails and invoices for physical goods, but in the global and virtual economy nobody can be quite sure where the value added lies. This makes nonsense of the idea of a value added tax, but that doesn’t stop authorities from trying to tax what is nearly impossible to work out. That’s why corporate treasurers are already facing a huge challenge working out where value lies globally.
But if governments, international agencies and regulators get their way, there will be a rewriting of the fundamental rules of multinational income tax. Treasurers and CFOs who ignore it in the belief that it will be derailed by complexity and international infighting are sorely mistaken.
As Pascal Saint-Amans, director of the Organisation for Economic Co-operation and Development’s (OECD) centre for tax policy and administration, says: “The golden era of ‘we don’t pay taxes anywhere’ is over.”
There is a worry that global authorities will have a mentality to exert pressure and ‘squeeze the lemons until the pips squeak.’
What is the revolution?
The revolution comprises a series of international initiatives to clamp down on tax avoidance. By far the most significant is the OECD’s ‘Action Plan on Base Erosion and Profit Shifting’ (BEPS), according to John Forry, international tax adviser and director of tax programmes at the University of San Diego’s School of Law.
BEPS is a wide-ranging and profound attack on the cornerstones of international corporate tax. It seeks to re-impose the intended effects of tax legislation that have been altered partly by changes in the global economy (digital business, globalisation) and partly through complex crossborder tax schemes. This requires a new look at concepts of companies’ ‘sources’ of income which globalisation, the digital economy and multinationals’ exploitation of key tax concepts have often rendered meaningless.
It also seeks fundamentally to redraw the transfer pricties ing landscape to prevent abuse. It addresses specific tax ploys based on clever interpretation of particular definitions or products. So it attacks hybrid income mismatch arrangements, abuse of controlled foreign company rules, abuse of the concept of arm’s length transfer pricing among related par- ties – especially with respect to intangibles, as well as treaty shopping, capital allocations to entities in low tax jurisdictions, the definition of economic activity, commissionaire arrangements – the list goes on.
And perhaps most aggressively of all, the plan seeks to redress the information balance between corporate and government in tax affairs. Global multinationals have long had the upper hand. They, not national governments, have a full picture of their global affairs. They exploit this information asymmetry to their advantage. And they spend more money on developing tax avoidance schemes than governments can on countering them – usually well after they have had the desired effects.
So the plan requires companies to disclose their aggressive tax planning arrangements by providing all relevant governments with information on their global allocation of the income, economic activity and taxes paid among countries according to a common template. In other words, for the plan to work, country-by-country reporting to governments will be essential. This is a big deal.
“Country-by-country reporting looks innocent,” says Forry. “But it will give countries the opportunity to see and claim a larger allocation of total profits.” And even if some countries refuse to adopt it (the US for example says it applauds this move towards greater transparency, but in reality is resisting), other countries will. Forry believes that it will help to give countries a clear picture of where corporate profits arise and therefore is an attractive proposition particularly for emerging markets to adopt. US and other developed country resistance to the OECD proposals may lead to false complacency for companies whose tax base is in one of those jurisdictions. This is a mistake. “Any country may be able to insist a company use multi-country reporting if it wants to do business there,” Forry says.
EU on the warpath
The next element of the revolution comes in the form of the EU’s competition commission. Its contention is that countries offering tax sweeteners are effectively distorting competition by offering what amounts to state aid.
It wages its war partly through the increasing attacks on low-tax jurisdictions made via the route of tax investigations into highprofile multinationals, and partly through direct pressure on countries themselves.
So, in July 2014 the commission demanded that Luxembourg hand over sensitive documents concerning the tax affairs of Amazon’s mai European operating company. Other big names to have come under the commission’s glare are Apple, Starbucks and Fiat Finance, with the regimes in the Netherlands and Ireland also under scrutiny.
Another example is the pressure that has been put on Switzerland long before the OECD announced BEPS. In Switzerland, the key issue is the advantageous tax treatment of holding and mixed companies as well as the Swiss fiscal practices for ‘principal companies’ and Swiss financial branches. Holding companies, domiciliary and auxiliary companies (mixed companies) are ring-fenced and their foreign profits are subject to lower taxation compared with Swiss source revenues.
The EU considers such preferential regimes unauthorised state aid which violates the 1972 Free Trade Agreement. However, these regimes have attracted many foreign companies to Switzerland. The Swiss Federal Government proposes to replace the holding, domiciliary and mixed company regime in the next five to seven years with potentially huge impact on foreign treasuries.
US attacks inversions
In the US, among many tax initiatives, there are aggressive moves towards ending specific tax abuses identified by politicians seeking to appease voters fed up with corporation tax manoeuvres. The key concerns in the US are offshore cash piles and so-called ‘inversions’, in which a US company shifts its tax home base to a lower-tax jurisdiction by merging with a company based in that country. The offshore cash issue is a perennial point of tension. According to a study of 14 of the largest tech and pharma firms by the Financial Times, the strategy of pushing profits offshore has enabled some of the largest US corporations to cut their tax bills by a quarter, on average, while boosting their annual earnings by up to 24%. Between them, the 14 held $479 billion of cash and similar assets offshore – more than half of the $947 billion of total offshore cash that Moody’s estimated was held by US non-financial companies at the end of 2013.
US companies deny that their strategy is a deliberate ploy to reduce tax and boost earnings and say they only hold assets offshore because of the punitive tax rates on funds repatriation. They are calling for a temporary tax amnesty to encourage them to bring their profits home. However, although this has been done before, political goodwill towards big business seems to have waned because the last amnesty did not bring about tangible economic benefits.
The US Joint Committee on Taxation, which provides non-partisan analysis for Congress, has warned that US companies were incurring extra costs from keeping their profits outside the country. It cited research showing a ‘ballooning’ of company balance sheets, as multinationals chose to borrow more for spending purposes, rather than repatriate their offshore cash and pay US tax on it.
And in 2013, the Congressional Research Service, the research arm of Congress, warned that the process was continuing as US companies moved more profits out of high tax countries, including the US, into ‘tax preferred’ countries, such as Bermuda, Ireland, Luxembourg, the Netherlands and Switzerland.
Inversions have been around for while, but again they have provoked politicians to demand legislation against tax avoidance. Treasury Secretary Jacob Lew is urging Congress to legislate quickly, with laws retroactive to May 2014 to discourage US companies from moving their tax domiciles abroad to avoid federal taxes.
Nowhere to hide
Treasurers should be under no illusions. These changes will not simply affect large companies. They will not simply affect companies who rely largely on the digital economy. And they are not simply targeted at companies with huge offshore cash piles or the most complex tax avoidance structures. They are aimed at any companies whose tax planning shifts taxable income to low tax jurisdictions.
In a May 2014 report on international tax, the IMF confirmed that the plan would have a significant impact on corporates. It called the OECD initiative “an unprecedented effort to address major avoidance opportunities that arise under current international tax arrangements, and one that is already having some effect on national tax policies and, perhaps, the behaviour of [multinational companies].”
Fundamentally, there are two issues that treasurers should be thinking about. First, there is the question of the ‘location’ of corporate profits. Low-cost manufacturing, multinational group synergies, and local marketing intangibles can give rise to additional profits that existing local income tax systems often do not capture.
Second, currently ‘sales’ or ‘services’ alone may not create much corporate income tax liability in a jurisdiction if valuable ‘intangibles’ are held abroad. So regulators are formulating new rules to attack transfer pricing that overvalues the contributions that such intangibles make to the final value of the products and services in question.
The effects on treasury
All these global changes will hurt companies where it hurts the most: on the bottom line. That’s because, if successful, the OECD-led move should narrow the gap between statutory and effective corporate tax rates worldwide. This will have negative implications for corporate earnings prospects.
There will also be very significant compliance and treasury costs. The reporting requirements by themselves will be onerous (as well as making many current tax strategies unviable). Current reporting requirements for segment reporting under International Financial Reporting Standards and other Generally Accepted Accounting Principles (GAAPs) generally do not require the reporting of income on a country-by-country basis.
So what should treasurers do about it? First, they can’t assume it won’t happen. While no one underestimates the difficulties, one good reason for believing that some form of profound change will happen is the overwhelming support that exists across a broad range of institutions for anti-tax avoidance policies.
Investors are also starting to worry that the positive effect of tax-cutting strategies on companies’ earnings could go into reverse. Many companies have achieved significant improvement in net margins by reducing their tax bills. And the ratings agencies are becoming concerned about some of the other knock-on effects of taxdriven policy. The strategy of leaving vast cash piles offshore is often accompanied by heavy borrowing in the US. This has led Moody’s to describe the growth in offshore cash as “an emerging credit challenge” for some technology companies.
There are those in business, consulting and the law who say big changes to tax regimes won’t happen. They say it’s too complicated and governments will fight to gain competitive advantage or to retain status because their tax regimes are a key part of their economic success.
But while it is true that getting agreement will be hard, all that this means is that we may end up with a series of unilateral moves, which not only bring about the disruption that a unified new model would deliver, but, worse, a moving carpet of ad hoc changes that would be even more damaging and difficult to manage.
Where is the juice?
Treasurers and their boards must begin to think about a new world order.
“We know big changes are likely to happen,” says the treasurer of a large US multinational that uses aggressive tax planning structures. “But inevitably there is almost nothing we can implement until it happens. But it could mean the dismantling of the core infrastructures we have put into place globally because they will be obsolete.”
Forry advises: “Treasury should be meeting with tax regularly. I have clients that schedule those meetings several times a year but then often schedules get conflicted and the meeting isn’t seen as essential.” It is more than essential, it is crucial, Forry says.