Following King.com’s recent decision to move its tax base to Ireland and public discussions about the tax arrangements of tech giants including the likes of Facebook and Google, we looked for some much needed clarity on the issue.
In his first guest column for Tech City News, Machiel Lambooij, a tax partner based at Freshfields in Amsterdam, explains the current state of the issue .
Consider where your IP is created
For companies that have a top market position through technological advances and creativity, the value of the business tends to rest in Intellectual Property (IP) rights, like patents, copyrights, trade marks or know how.
Startups in this kind of business can choose where they set up their headquarter and R&D functions, locate their customer services people and host their servers.
The headquarter function is often limited to internal services such as accounting, financial, HR and legal services. That is not where the business makes its profits. The location of such functions is therefore often much less decisive for tax purposes than where the IP rights are created and located.
Tax paid on the basis of each entity in each country
Many such businesses ultimately operate on a highly integrated global basis. Taxes, however, are still very much levied on a per-country basis as per the legal entities located in each country.
Local tax authorities face the challenge of determining which part of the overall global profits of a group should be taxed locally. Businesses do not want the same profits to be taxed multiple times. They also feel a duty to their stakeholders to maximize their profits, and that means minimizing taxes.
Planning is legal, evasion is not
Tax planning in most countries is legal and generally considered acceptable. Tax evasion is not. The borderline between the two is a grey area, and in the public debate the distinction is sometimes lost.
Tax planning in most countries is legal and generally considered acceptable. Tax evasion is not
Global businesses organize themselves in corporate structures, organized by country, regionally, or by business line. Their structure is driven by a mix of factors, such as the best way to manage the group generally, market focus, legal and regulatory concerns, and of course the tax factor.
How the overall profit of such a business is divided over the various countries in which the group has a presence is determined by complex international tax rules, which have been created over many years and reflect a broad level of consensus between countries on how to divide the available “tax cake”. These rules operate by reference to the “arm’s length principle” (i.e. taxing intra-group transactions as if they were priced on the same basis as transactions with third parties).
Countries can apply their own tax rules and rates on that part of the total tax cake that is allocated to them under these rules. The principle is that value drivers in a multinational group need to be properly remunerated in the country where these drivers are located.
Where important value drivers are creativity, innovation and know how, deciding where such functions are exercised also may substantially influence the global tax bill of a group.
Global competition for lower tax rates
Many countries currently compete against each other to attract such functions. They do so by offering lower general tax rates (such as Ireland, with its 12.5% corporate tax rate) or by offering tax incentives for R&D activities (such as the UK, but also many other European countries that offer a special low tax regime for income from IP rights).
Whether this form of competition between countries is desirable is currently the subject of debate at the OECD and the European Union.
Relocating to a brass plate company will not work in practice
If startups establish new R&D activity and the “brains” that manage that activity (and therefore also their resulting IP rights) in a location that is attractive due to incentives granted by local government, there is nothing wrong with that. That is a normal business decision and taxes are – and should be – a factor in such decisions.
Companies may also consider relocating some or all of these function to such places. Again, a mix of factors will determine what locations are suitable, of which the local tax treatment is one. Just relocating on paper to a brass plate company will not work in practice. Tax authorities generally tend to look at “substance” rather than at the form.
Recent activity by the G20 and the OECD further reinforces that notion as stricter rules are being considered to combat pure paper based relocations. When a valuable function can be run by a limited number of people (such as some forms of R&D and the management of IP rights) , it should be possible to relocate that function to a more attractive location.
The price to be paid for such relocation is that the tax authorities where these activities were previously located may charge a tax on the value of that activity upon emigration. In that way, they receive their share of future profits that are moved elsewhere. Those are the current rules.
An ongoing debate
If the effect in practice of these current rules does not match the expectations of the general public and the politicians, then new rules could be agreed for dividing the tax cake, e.g. by reference to local sales (or other factors such as personnel or assets). That is what the G20 and the OECD are currently debating.
The OECD is also specifically looking at whether and how international tax rules should be adapted to the Digital Economy. Given differing economic interests between technology importing and exporting countries, it will be a challenge to reach interenational consensus.
However, if these new rules are not based on wide international consensus, double taxation (to the detriment of businesses) or double non-taxation (to the detriment of tax authorities) will arise.
Such new rules can divide the cake differently, but they should not increase the cake to more than 100%! That is what could happen if countries unilaterally changed their rules. Alternatively, countries may introduce new forms of taxation for digital businesses (as has occurred already in the US, Italy and France).
Uncoordinated taxation of international business is, however, not good for business and ultimately not good for society.
Freshfields’ Murray Clayson also contributed to this guest column.
Freshfields tax experts will be discussing these issues in more depth at one of a series of upcoming tech roundtables in Palo Alto, find out more details here.