Aggressive tax planning: noticing the signs

These primarily involve shifting profits between subsidiaries in different jurisdictions to book profits in lowtax jurisdictions, rather than where the business activity takes place.

An MNE may consist of hundreds of affiliates. These entities may be used to hold assets (such as intellectual property rights), issue/manage debt and receive/transmit payments such as interest or royalties.

Transferring assets (e.g. intellectual property)

A common strategy involves transferring assets (such as intellectual property (IP)) from a subsidiary in a high-tax jurisdiction to one in a low-tax jurisdiction.

Global tax rules require that these transfers be conducted using the arm’s length principle, which states that any internal corporate transaction must be conducted as if two unrelated parties were making the deal. This approach has been useful as a guide to evaluate transfer prices between associated enterprises in an effort to prevent double taxation; however, the application of the principle has proven highly vulnerable to manipulation. Abuses often arise due to information asymmetries between the company, which has a better sense of the long-term value of the asset, and tax authorities, who are not privy to that information. This is particularly problematic for sales of intangibles, such as IP, for which there are few reference prices available in the market.

IP rights can generally be sold to subsidiaries in low-tax countries in four ways: asset sale, sale of services, licensing and cost sharing. When an asset is transferred, the selling subsidiary (for example, a US subsidiary) earns income that is taxed in that subsidiary’s jurisdiction. The new owner (for example, an Irish subsidiary) then pays taxes over time on income from the asset. After the transfer, companies may allocate profits earned in numerous countries to the subsidiary in the low-tax jurisdiction where the asset now resides.

Conversations with tax advisors indicate that companies may abuse this system by not including expected future improvements to the IP (for example, an update to a particular piece of software) in their arm’s length economic value calculations at the time of transfer. In some cases, legal ownership of the IP asset remains in the original country and benefits from that country’s typically stronger legal system. The splitting of the legal and economic ownership of an IP asset creates a mismatch between the tax revenue needed to fund the strong legal system where the IP was developed and the tax revenue resulting from the income associated with the IP asset.

Changes in transfer pricing rules following the BEPS project will give tax authorities powers to characterise the terms of such licenses based on the actual functions performed, assets deployed and risks assumed by the parties, so that a function such as IP management would be assigned only a routine profit. Rules governing cost-sharing agreements will also be strengthened.

Intra-company debt

A subsidiary of an MNE in a low corporation tax regime can lend money to a subsidiary in a high-tax regime. The debt repayments and interest expenses are then offset against corporation tax in the high-tax regime, thus reducing tax payments (and the interest rates can be well above those paid by the corporation on its external debt).

Media stories suggest that in certain cases intra-company debt balances at certain companies may be many multiples higher than its external debt balances. Similarly, interest rates paid on intra-company debt may be multiples higher than interest rates paid on external debt (for example, see Chevron tax ruling in Australia which could be subject to appeal). Lack of disclosure over intra-company debt enables abuses and keeps investors from being able to assess any earnings impact of potential regulatory changes.

The OECD has highlighted the use of hybrid schemes, which use differences in the cross-border tax treatment of financial instruments to achieve (a) two interest expense tax deductions in different jurisdictions for only one interest income tax payment and/or (b) an interest expense deduction with no corresponding interest income tax payment. The latter strategy uses an instrument that is considered a debt in one country and equity in another.

Tax authorities are seeking to restrict the opportunities for debt-related tax minimisation by closely scrutinising the profit attributed to financial management functions, and limiting interest deductions by applying a fixed cap.

Marketing services and trading company structures

Companies can fragment functions (e.g. R&D, product design, logistics, transport, order fulfilment, or customer support) using marketing services or trading company structures, shifting profits from high-tax to low-tax jurisdictions.

In a marketing services agreement, an MNE designates sales staff in high-tax jurisdictions as “marketing” personnel. Although these marketing personnel maintain sales relationships, the company’s remote employees in a low-tax jurisdiction actually finalise the sale, so that the majority of the profit is then booked in the low-tax jurisdiction rather than in the high-tax jurisdiction where the real sales activity took place.

In a principal or trading company structure, the potential abuse comes when a company designates a subsidiary in a low-tax jurisdiction to control functions such as ordering from third-party manufacturers and inventory management for the whole group, despite the actual products and inventory in many cases never flowing through the country where this subsidiary is based. The company will then state that subsidiaries in high-tax jurisdictions, which generally account for the bulk of sales, are simply responsible for distribution, in spite of the physical products being held or services to end customers being provided, in that jurisdiction.

If headquartered in the United States, companies may be able to avoid taxation of passive foreign income (e.g. the payment of dividends or royalty payments between foreign subsidiaries) by exploiting certain rules like the “check the box” rule, which enables a company to require the Internal Revenue Service (IRS) to disregard certain entities for tax purposes.

Following BEPS, tax authorities are likely to closely scrutinise the profit attributed to such functions relative to the nature of the activities performed and value created. Several governments are seeking to unilaterally reduce these activities through regulations like the previously mentioned UK diverted profits tax.

Tax havens, shell companies and tax incentives

According to the OECD definition, a tax haven refers to a country which imposes low or no tax, and it can be used by corporations to avoid taxes which otherwise would be payable in a high-tax country. Most tax havens are characterised by opaque legislative, legal and administrative functions, few corporate governance requirements, and no effective exchange of information. Corporations often have very few if any assets or employees in tax havens and may only operate cash boxes in that jurisdiction to legally manage their affairs.

While definitions and classifications of tax havens vary around the world, research by MSCI has shown that a significant percentage of MNE subsidiaries are unquestionably located in recognised tax havens.

The presence of MNEs’ subsidiaries in tax haven jurisdictions through the use of shell companies (i.e. companies that do not have substantive assets, operations or employees, but serve as vehicles for transaction flows, or are set up for accounting purposes) may be a deliberate decision to take advantage of tax avoidance mechanisms.

Some jurisdictions with statutory tax rates that are in line with global averages will provide companies with individual incentives, to entice investment into the country. These incentives can include tax holidays, reduced tax rates and patent boxes. These arrangements can encourage companies to transfer substantial portions of their global income to that jurisdiction, regardless of the economic activity that is actually occurring there.

Many tax authorities and parliamentary oversight committees are concerned that incentives are overgenerous, and offered for short-term political reasons, which has increased media and societal attention on the use of these strategies. International organisations such as the IMF and the OECD are urging more stringent evaluation of their costs and benefits. The European Commission is applying state aid rules more actively.