As reported in the news in Reuters, big business was having none of it. In January 2013, a lobby group which represents the largest corporations in the world wrote a letter to the body that drafts the rules on taxing multinationals. The letter focused on a small change to an obscure document, but one that was significant enough to worry Will Morris, Director of Global Tax Policy at U.S. industrial giant General Electric Co.
The letter, which Morris wrote in his capacity as head of the Business and Industry Advisory Committee lobby, was addressed to Pascal Saint-Amans, head of the Center for Tax Policy at The Organization for Economic Co-operation and Development (OECD), a group of 34 mainly rich economies including the United States. It expressed concern about the proposed language in an updated tax convention. Morris wrote – 13 times in all – that his group was “concerned” about the proposal, but had been ignored. Submissions on the OECD’s website show that lobbyists, especially those representing tech firms, had been voicing such fears for more than a year.
With some reason. A Reuters examination of hundreds of corporate filings across a dozen countries shows the proposed changes – now part of an even further-reaching review – threaten tax structures that are used by most of the big tech companies in the United States to shield tens of billions of dollars of income from taxes each year. As Morris wrote then, the proposals could “have the effect of fundamentally changing” the basis on which multinationals are taxed.
The OECD – a forum in which governments work together to agree how to solve economic problems – is grappling with one of the toughest problems in the global economy. National tax rules are out of date and failing to keep up with multinational companies which split their activities across different markets and base themselves in the lowest-tax jurisdictions. Last week, the G20 group of countries backed an action plan drawn up by the OECD, which issues guidelines that most Western countries follow, to come up with ways to bring firms into the tax net.
A key area of concern is that the current laws on tax residency, known as the “permanent establishment” (PE) rules, allow firms such as Google to fix a tax base in a low-tax country – like Ireland – while generating lots of business in a country where tax rates are higher, like France.
The principle of the system now is that companies often pay tax not on the basis of where they do business, but on where they finalize their business deals with customers. With a contract-stamping operation in a low-tax country such as Ireland as its “permanent establishment”, a company can channel revenue from its major markets to be taxed at a lower rate.
The OECD calls that tactic “artificial avoidance of PE status”, and it wants to change things so the international tax system more closely resembles economic reality. It aims to tweak the guidelines – which countries including France want to change – so that countries where companies make lots of money can claim a commensurate share of tax.
At a conference in early July, Mike Williams, the director of business and international tax at the UK’s finance ministry, told tax professionals the existing rules led to outcomes that were “difficult to defend.” “It’s not right that groups can divorce their profits from the economic activity that gives rise to them and then shift those profits to tax havens where they pay little or no tax on them,” he said.
But GE’s Morris told Reuters that governments should be careful about changing a rule that works well “in most cases.” “We are concerned about wholesale changes to a rule whose certainty has, up to now, promoted cross-border trade and investment,” he said in an email. GE declined to say if it used such tactics; accounts for a dozen of its European subsidiaries show they have a tax residence in their main markets, so do not rely on the tax-cutting structures Morris was helping to defend.
But many firms do, especially in tech, where they can easily operate across borders. Reuters analyzed the accounts of the top 50 U.S. software, internet and computer hardware companies by market capitalization and found that PE structures that help them avoid tax are currently used by 74 percent of them.
Of the 37 companies that make use of such systems, those which responded to requests for comment for this article said they follow the tax rules in all countries where they operate; some said their arrangements were driven primarily by a desire to effectively serve customers, rather than tax reasons.
Chas Roy-Chowdhury, Head of Taxation at the Association of Chartered Certified Accountants, said managers had an obligation to investors to use legal means – such as electing where to declare a permanent establishment – to reduce their tax bill. “Corporation tax is another cost to the business,” he said. “Higher payments could mean lower wages for staff, higher prices for consumers and lower pension fund dividends received by investors.” Tax management is part of competition.
WHAT IS A SALE?
In principle, countries have the right to tax any economic activity that takes place on their turf. For that to happen, though, firms have to be resident for tax purposes within a country’s borders. The main factor determining whether a company has a taxable presence, or “permanent establishment”, in a country, is whether it sells there.
So when does a sale occur? In law, a sale is made not when it is negotiated and agreed, but when it takes on a legal nature with a signed contract. That’s the point some OECD members want to review.
Yet some companies want the existing system enshrined in law. In its January letter the Business and Industry Advisory Committee was suggesting draft clauses to add to the updated OECD document, entitled “Commentary on the OECD Model Tax Convention.” Those clauses would have allowed companies to continue to finalize deals in a low-tax country, and thereby avoid paying taxes in higher-tax markets even if that’s where most of the business happens.
“They tried to get us to clarify that their (current) deals work,” said Jacques Sasseville, Head of the OECD’s tax treaty unit. “Fair enough, but we were not prepared to do that.”
Business groups including the United States Council for International Business (USCIB), the main U.S. lobby group on international tax, say revising PE rules risks creating uncertainty. It could spark additional disputes with tax authorities. The risk that profits would be taxed more than once would hit trade.
“Moving to a standard under which a PE is created by mere negotiation of a contract would obviously be something that business would be concerned about,” Carol Doran Klein, Tax Counsel at USCIB, told Reuters.
But some European Union and U.S. officials said the Reuters analysis shows why the OECD needs to revisit its guidance on tax residence.
Reuters found that for 2012, the average tax charge on non-U.S. earnings published by the big tech companies which used such structures was 6.8 percent – less than a third of the tax rates in their main markets, and below the headline rate of 12.5 percent in Ireland, which has the lowest tax rate in Western Europe.
“People should find it surprising,” said Philip Kermode, Director of the European Union’s Directorate-General for Taxation and Customs Union. He said companies’ ability to do business in countries where they are not taxable is the real problem the OECD needs to get to grips with.
“It’s an illusion for some businesses to think that there shouldn’t be an examination of this.”
Much of the attention in the debate about PEs falls on U.S. firms. The United States has tough rules to dissuade companies from using such structures at home, but many tech companies use them abroad, the Reuters analysis found.
The accounts of the 50 biggest U.S. tech companies and their subsidiaries show that only 13 declare the bulk of their income for tax in the main markets where they generate it. The rest use mechanisms to channel some or all of their revenues to a central tax base in a country with a lighter tax regime.
Sixteen of the 20 biggest U.S. software companies by market value, including Microsoft, Adobe and Citrix, do not declare tax residences for their main businesses in their major European markets, their accounts show. Instead, they report software sales in Ireland, Switzerland and the Netherlands, countries which have smaller populations and offer lower corporate tax rates.
Microsoft told Reuters its Irish operation was “established largely in response to customer demand to consolidate shipments” and that it pays all the taxes it should. Adobe said it “pays the lawful amount of tax owed in the countries where we do business.”
Citrix said in its 2012 annual report that its effective tax rate was below the headline U.S. federal statutory rate “due primarily to lower tax rates on earnings generated by our foreign operations that are taxed primarily in Switzerland.”
A spokesman said: “Citrix companies fully comply with all tax laws, rules and regulations and we cooperate with the relevant tax authorities to ensure we continue to do so.”
U.S. computer hardware makers and internet firms use similar schemes. At least 13 of the 20 biggest hardware firms, including companies such as Dell, and eight of the 10 biggest internet service companies, including Google, Expedia and Yahoo, reduce their European tax burden by ensuring they do not create PEs in major markets. Companies can create PEs in as many markets as they like.
In Dell’s case, sales and other staff are employed in subsidiaries across Europe but sales are conducted on behalf of an unlimited Irish-registered company. That means it does not have to publish accounts, so it is not possible to see what if any taxes it pays. Dell declined comment.
Google said it chose Ireland as its Europe, Middle East and Africa headquarters for a variety of reasons including good logistics, an educated workforce and low tax. Expedia subsidiaries in countries like Germany supply services to a Swiss affiliate which does business with hotels and others who wish to sell through its websites, company filings and websites show. The company declined to comment.
Some companies that channel cash from their main markets to sales units in Ireland, Luxembourg and the Netherlands then send it untaxed to countries like Bermuda and the Cayman Islands, which do not levy corporate income tax. Microsoft and Google are among them.
Apple Inc uses companies that are registered in Ireland but say they are tax-resident nowhere. This incongruous mechanism was revealed by a U.S. senate panel in May, which called it the “Holy Grail of tax avoidance.” Apple declined comment, but its CEO Tim Cook said in May Apple pays all the taxes it owes and it did not depend on tax gimmicks.
In other cases it is unclear where the money goes, or what, if any, tax is paid on it, because the companies use set-ups that are not required to publish accounts. The unlimited company in Ireland is just one example.
ADOBE’S “LOWEST LEVEL … UNDER THE LAW”
A close examination of one company that does publish accounts – Adobe Systems Inc, one of the world’s largest software groups – gives a detailed insight into one way the centralized PE arrangement works.
Adobe markets products to create image-rich content such as the ubiquitous ‘.pdf’ format document. The United States is the company’s main center for research and development, and it operates large R&D facilities in Canada, Germany, Japan and India. But the firm also has an office at a business park landscaped with miniature waterfalls, sculpted shrubbery, trimmed lawns and rockeries, on the outskirts of Dublin.
Adobe said this office is too small to be included in the list of owned or leased “principal properties” that it must disclose in its annual filings. It houses two subsidiaries: Adobe Software Trading Ltd, and Adobe Systems Software Ltd.
According to Irish corporate filings, Adobe employs 120 people in Dublin, around one percent of its global workforce; three are engaged in software R&D.
Yet Adobe’s Irish operation generated 80 percent of its non-U.S. income in recent years – more than $500 million annually in 2010 and 2011, the years for which the most recent accounts are available.
Adobe paid only about $3 million a year in Irish income taxes on that profit, because most of it was earned by one of the subsidiaries, Adobe Software Trading Co Ltd – a company that is Irish-registered but which its accounts say is “not subject to Irish corporation tax.”
Adobe declined to answer any detailed questions about its tax affairs but added it “seeks to pay the lowest level of taxes owed under the law.” It said it paid “the lawful amount of tax owed” in the countries where it operates and believed in “a fair system of taxation.”
Adobe’s units around the world do have a tax residence in each of their markets, but not as sellers of software. Instead they are “service providers” to the second Dublin subsidiary, Adobe Systems Software.
Such an arrangement – where businesses in the main markets only declare profit on a support function – is known as the “Service PE” model. It’s one of several variants which arose in the 1980s but took off in the 1990s with the rise of e-commerce.
Regulatory filings show Adobe has managed an average tax rate on its overseas income of less than 7 percent in the past three years, which is a fraction of the rates in its main markets.
The Irish tax authority declined to comment.
Like Washington’s tax authority, Europe’s tax collectors can disregard PE schemes contrived to avoid tax. But French, Norwegian and Spanish attempts to exercise these rights have failed in court. Experts say civil law codes make judges reluctant to overrule contractual agreements, such as a sales deal.
This is why governments have asked the OECD to change the guidelines which will then form the basis of future tax laws. If the rules are changed, they hope, more companies will be forced to declare a PE in countries where they generate sales, rather than where the contracts are finalised.
A senior U.S. Treasury official involved in the OECD process said Washington understood concerns that these structures may help U.S. firms short-change other governments by not creating PEs in enough countries where they do business. “We are sympathetic to that,” the official told Reuters. “Because maybe … there ought to be more PEs.”
Back in January, discussion documents said OECD members were split on whether to support a change. Some officials and legal experts aren’t sure it will be possible to come up with a different legally enforceable definition of the moment of sale.
The OECD says it could take another two years before new proposals are drawn up. But the OECD’s Saint-Amans said firms have told him privately they know change is on the way.
He said that when he meets executives in the corridor, they say “‘We know it’s over, we need to fix it.'” (Additional reporting by Himanshu Ojha; Edited by Sara Ledwith and Will Waterman)