Monday March 11, 2013

Reining in cross-border profit shifting

Comment by Kang Beng Ho

An employee of Amazon putting packages onto a conveyor band at the logistics centre in Bad Hersfeld, Germany. Amazon revealed to the UK’s Parliamentary Committee that all its European sales, including those to UK customers, are made by its affiliates in Luxembourg. — EPA

A RECENT statement by George Osborne, the British Chancellor of the Exchequer, was given wide media coverage in the United Kingdom and elsewhere when he said that he wanted to see “international action” taken against multinational companies which engaged in “profit shifting”.

This was in response to the public outcry against Starbucks, Amazon and Google when it was found that the tax they paid on their UK business activities was a mere fraction of the overall profits they made from such activities.

Osborne's statement gives rise to a number of pertinent questions:

How do these companies shift profits in light of prevailing rules which are designed to obviate such acts?

Why international action when it is British tax shortfall he should be concerned with?

Why the exhortation now when global companies have been subject to these rules for almost a century?

The case of Amazon highlights how profits are “shifted” and the international tax rules that are in play.

Amazon revealed to the UK's Parliamentary Committee that all its European sales, including those to UK customers, are made by its affiliates in Luxembourg.

Its UK affiliate operates the order fulfilment, customer support and logistics services and earns a margin for these services. Since these are low-margin businesses, the profits earned bythe UK entity are understandably low.

The bulk of the profits from its substantial sales volumes are attributable to the Amazon affiliates in Luxembourg, a low-tax location.

Amazon's business model thus exploits fully a number of key international tax rules.

The first is the “separate entity” principle, which treats a company within a global group as separate and distinct from other companies in that group.

By locating its server and website in Luxembourg entities, Amazon is ensuring that profits from sales to UK customers are attributed to these entities. Thus the separate entity rule legitimises the dichotomy of Amazon's business when the reality is that its high sales volume would not have been possible if it did not have the warehouses and other facilities in the United Kingdom.

The separate entity rule, therefore, has the perverse effect of permitting the fiction of separate businesses.

The second is the arm's length rule, which operates to complement the first rule. It requires that transactions between companies in a group are made at arm's length i.e. as if they are made with third parties.

Amazon had not been accused of breaking the law so that they would have adhered to these rules in arriving at profits for each of its entities in the United Kingdom and in Luxembourg. Having done so, “it is difficult if not impossible to challenge the attribution of low profits to Amazon UK and high profits to Amazon Luxembourg” in the words of Sol Picciotto, an emeritus professor at Lancaster University and adviser to the Tax Justice Network, an activist group calling for greater transparency and fairness in tax systems.

Chancellor Osborne's call for “international action” is because he knows that the rules he wants changed have become international tax standards. Taking unilateral action would not only be ineffective but could find global companies shunning the United Kingdom.

It is somewhat ironical that the Organisation for Economic Co-operation and Development (OECD) has been tapped to drive this initiative by the G20 countries. Current international tax standards owe much to policies and rules initiated by the OECD and over the years substantial efforts have been made towards ensuring their wide acceptance.

A cynic would regard to the accusation of “profit shifting” as incoherent since the OECD arm's length transfer-pricing principle had been designed to prevent just that.

The OECD first issued its transfer pricing rules, termed guidelines, in 1979 with the current guidelines being issued in 1995/1996. Since then, they have been tweaked several times and today, some 60 countries have generally followed these rules.

The global spread of these rules stems in part from the process of globalisation as well as the realisation that transfer pricing is a zero-sum game. Transfer pricing issues are really issues involving the split of taxes between two countries one where the selling company is located and the other where the buying company is; both being companies in the same group.

Adherence to the universal arm's length rule will tend to avoid double taxation of profits on multinational companies operating in more than one country. This explains why it is in the interest of a country to adopt this rule if it does not want to be viewed unfavourably by investors.

It is also a reason why multinational companies find it incumbent on them to play by these rules, but in a way which benefits them.

They do this by locating subsidiaries in low-tax jurisdictions (the Amazon model) and justify this by claiming that they have a responsibility towards their shareholders legally to reduce the taxes their companies pay.

Questions arise on whether these entrenched rules can be re-jigged in a way that will provide clarity and avoid giving greater discretionary powers to tax authorities. Clarity and certainty are what business investors look for and will turn their backs on where these are absent.

Professor Picciotto, clearly thinks not and through the Tax Justice Network, strongly advocates the adoption of Unitary Taxation to replace the current international system. The unitary system first came into the limelight in the late 1990s and is still part of the California state tax system.

Under unitary tax, a company operating a business line globally, as in the Amazon example, will have to report a single set of worldwide consolidated accounts to each country where it has a business presence. The overall global profit is then apportioned to the various countries according to a weighted formula reflecting say payroll, assets and sales. Each country will levy tax on its part of the world-wide profit so carved out.

This system reflects the economic reality that multinational companies are usually “oligopolies based on distinctive or unique technology or know-how: they exist because of the advantages and synergies that come from economic activities on a large scale and in different locations.

Treating each affiliate as a separate entity for tax purposes is impractical and does not correspond to economic realty”, so says the good professor in his paper arguing his case. However, he also believes that the vested interest of the many specialists of the current complex system will make it politically difficult to bring in unitary taxation.

What is clear is that the major economies, which at this time are all finding their tax coffers emitting the familiar twang of emptiness, are looking for quick fixes. It has been reported that the OECD is to draw up detailed action plans within the next six months.

If the current international tax rules took almost a century to be accepted virtually worldwide, it will be left to the eternal optimist to think that radical changes will be quickly and widely accepted.

Kang Beng Hoe is an executive director of Taxand Malaysia Sdn Bhd, a member firm of Taxand. The views expressed do not necessarily represent those of the firm. Readers should seek specific professional advice before acting on the views. The writer can be contacted at kbh@taxand.com.my

More News

Business

Monday March 11, 2013

Reining in cross-border profit shifting

Comment by Kang Beng Ho