My recent newsletters have reflected the public debate about tax morality, but as the months have unfolded, the debate becomes less relevant. It is now a definitive factor that multi-nationals have to take into account to appease the public opprobrium lavished on them through the media and via governments themselves.
As readers of my ITSAPT launch letter released last week will have read, it is no longer APT to plan aggressively with the aim of avoiding paying tax where income is sourced, particularly if this means that profits are transferred to low or no tax countries. In fact, item 2 of the Lough Erne Declaration from the G8 Summit 2013 says:
“Countries should change rules that let companies shift their profits across borders to avoid taxes, and multinationals should report to tax authorities what tax they pay where.” (click here)
This statement is buttressed by extensive disclosure and tax information exchange obligations envisaged under the Declaration. At G8’s request the OECD has also issued a new report “A Step Change in Tax Transparency” (click here). The report suggests four concrete steps needed to put in place a global, secure and cost effective model of automatic exchange of information, which will put an end to many aggressive tax planning techniques.
Regular readers of our IFS newsletters will recall our April newsletter entitled “Aggressive tax planning: the view from Brussels” which discusses the EU and OECD recommendations on profit shifting where in one country, payments are tax deductible whilst they may be effectively exempt from tax in the other country through legislation or structural design (click here).
Part of the programme for this year’s ITSAPT conference at the Mandarin Oriental hotel in London on 7 November (click here) is to expose ideas and recommend how businesses can adapt to new concepts in taxation, finance, law and regulation, showing them how they can navigate through a very uncertain future world. Economists, financiers and entrepreneurs as well as officials from the OECD and HMRC will consider how the next decade is going to significantly change the ways in which international businesses will both operate and report their taxable profits.
This newsletter focuses on my individual field, international taxation, and what governments will do to use their existing legislation in order to ensure that tax is paid where profits are earned. There is no need to re-invent the wheel of already complex and voluminous legislation; tax administrations merely need to use the considerable fire power of the arsenal of tax law that exists. Some countries, such as the US, have created additional laws to ensure a certain level of taxation is paid, such as the ‘alternative minimum tax’. This is aimed at preventing individual and corporate tax payers from avoiding income tax through tax shelters, adding back most of the tax preferences otherwise provided under the standard method of computing taxable income. The unitary system of taxation in the United States is a further alternative basis of assessment whereby the taxable income of a corporation within one State is arrived at by aggregating the national (previously worldwide) profits of the group of companies of which the US corporation is a part and, under this combined reporting method, allocating the profit of the corporation on the basis of, for example, the turnover, payroll and property within the State compared to a total combined turnover, payroll and property. This could potentially answer the debate on tax morality if adopted worldwide, but this is as unlikely to happen as permanent stability within the Eurozone area. And these additional methods of creating a fair spread of tax revenue throughout all territories in which a multinational corporation operates creates further problems, not only administratively through the burden of submitting hugely complex returns but may create tax liabilities for companies which clearly are not profitable for one reason or another.
What is certainly appropriate is to focus more on inter-group relationships and what is understood by the term ‘transfer pricing’. In my opinion, the balloon of the media fury and governmental censure of certain companies could be pierced by tax administrations insisting on reviewing the relevant group’s ‘transfer pricing memorandum’. In future, governments may insist on being informed of global profits of a group of companies in which one of the companies is located in its jurisdiction, and then reviewing the transfer pricing memorandum to see what level of profits should be reported locally.
Basically, a transfer pricing memorandum illustrates the functionality of every entity within a group and the risks undertaken by such entities for which relevant profits should be acceptable. Thus, if a company in say the UK has a significant payroll cost, a substantial asset base and is able to achieve a considerable level of turnover, then in a similar way to the unitary approach to taxation, the tax administration would rightly consider that there are significant trading risks for such a company. If the group as a whole earns profits, it is unlikely that the local company would also not create a similar level of profits.
Auditors should be obliged to review the company’s transfer pricing memorandum when reporting on the accounts of a company and should provide the tax administration with a detailed statement (with appropriate schedules) showing how the local company is reporting profits in line with the relevant transfer pricing memorandum. So concluding this part of the newsletter and what is likely to be a feature of the next decade, all clients with international activities should ensure they have prepared a transfer pricing memorandum which meets their objectives and is unlikely to be challenged by tax administrations.
This does not mean, however, that tax planning cannot be legitimately arranged for international businesses, and there is probably no single asset capable of appropriate arrangements for such purpose than intellectual property. My March 2012 newsletter (click here) details very fully all of the types of intellectual property and how their valuation and licensing can achieve significant tax benefits whilst at the same time providing control of IP within one entity, and allowing such IP to be used as collateral to finance the development of the business.
There is so much intellectual property that is spread throughout a group and may even be totally unrecognised by the management team. The intellectual property may be marketing related, such as trademarks, brands, trade names, internet domain names, etc.; customer related such as customer lists, contracts with restrictive covenants, etc., artistic related such as copyrights; as well as the more commonly understood technology based IP, often protected through patents which may also include computer software, databases, etc. What companies may be less aware of is the degree of know-how that exists in running their particular business, and if this know-how could be written into appropriate modus operandi, it may be capable of being licensed at the appropriate level of royalty income.
What is APT for today’s world is to capitalise on the value of IP within a separate entity located in an appropriate jurisdiction which provides incentives to such companies, either in the form of low taxes, tax holidays, grants or other tax credits. Personnel employed by such companies can manage the IP rights, perhaps transferring such rights from disparate entities within the group at relatively low market valuations. Collectively, however, the value of such combined IP is considerable and its value to the group in potential royalty income enormous. The personnel will ensure that all rights are protected internationally on an annual basis, as well as in jurisdictions in which the business wishes to expand. They can create all of the contractual arrangements to license the full package of rights including know-how rights with the minimum of tax consequences, collecting the royalty income and fulfilling the substance requirements which are of paramount importance to ensure that management and control is within that particular entity. If these licensing agreements can minimise the value of the IP remaining within high tax jurisdictions, on exit via a trade sale or IPO, the maximum value can be achieved for the group as a whole. This control of value can be achieved through limiting exclusivity, length of agreements, territorial rights, etc., and require specialist skills who understand valuation concepts in intellectual property.
And so we come back to the transfer pricing memorandum discussed above. Where it is clear that significant costs have been incurred in developing IP within the relevant entity, it is justifiable to expect a reasonable return to that entity via licensing agreements in the form of royalty income. Double tax treaties may ensure that the licensing entity, if located in the appropriate jurisdiction, is able to receive such royalty income without foreign taxation at source. However, if the royalty rate is too high, profits remaining in local companies will be artificially lowered, resulting in the debate over certain multinational corporations which has so enraged the public at large. An appropriate transfer pricing memorandum would have revealed that it is not only the IP company that has taken risks and should be rewarded through profits, but also the trading entities, and the allocation of group profits on a global basis should be split between those companies who are assuming risks for their role in the global business. As I have said, transfer pricing memoranda are essential, but transfer pricing legislation is not new, it exists within the anti-avoidance armoury of all developed countries. It is through transfer pricing memoranda, however, that tax administrations can be provided with all relevant information to enable a fair split of profits to be declared for tax purposes, and the provision of such information by auditors and management is likely to be the most important development in the next decade.