Chasing the Artful Dodger

Multinational tax avoidance

Now of course I am minimising my tax and if anybody in this country doesn't minimise their tax they want their heads read…

Kerry Packer giving evidence to the 1991 House of Representatives Committee of Inquiry into the Australian Print Media Industry1 when questioned about his tax payments.

For most of us, paying taxes is an unavoidable but necessary civic duty. Yet for the modern corporation it has increasingly become a voluntary matter, with a prevailing sense that a corporation's duty lies in avoiding tax, in order to maximise returns for shareholders. Milton Friedman (1970) famously dismissed views about the moral obligation of business when he said the duty of business is business, and ‘the social responsibility of business is to increase its profits'.

2 That view persists, yet fortunately it remains a minority position for most organisations and this paper attempts

to outline the nature of international tax avoidance together with the international and Australian responses.

Background

In Australia's case, the concern with international tax avoidance assumed greater importance in the context of the general debate on corporate taxation. Australia has a high level of foreign ownership and this high level of penetration, particularly in the retail sector, seems to have encouraged people to look at foreign corporate activity in Australia.

Perhaps most importantly, a lot of interest in the subject of corporate tax avoidance was generated by a paper from the Tax Justice Network,

3 which examined the tax minimisation strategies of corporations in Australia. There has also been a good deal of both domestic and international discussion of the exploits of Apple, Google and other mainly American technology companies, as well as the international strategies that take place via tax haven jurisdictions such as Luxembourg.

The most recent figures show that Apple paid Australian tax of $81.4 million on revenues of $8.1 billion for 2016-17. The low figure was a result of transfer pricing with Apple's Irish subsidiary.

In 2014, the Australian Financial Review reported on a number of Australian companies using complex tax avoidance schemes based on secret tax deals in Luxembourg, via accounting firm PWC. The article cited ‘hybrid debt

4 structures, total swap returns, royalty payments and intra-group loans to reduce taxes'. The article claimed that ‘the ability to move profits around the world purely by paperwork in return for what seems a minor fee to Luxembourg is a recurrent feature in the leaked tax agreements'.

Interest in international tax avoidance has probably been further aroused by the exotic forms tax avoidance takes. This is clear in the following comment from the US Congressional Research Service referring to Google's operations and the double Irish, Dutch sandwich:

Figures show that Apple paid Australian tax of $81.4 million on revenues of $8.1 billion for 2016-17.

An example [of tax avoidance] is the “double Irish, Dutch sandwich” method… which… has been used by Google. In this arrangement, the U.S. firm transfers its intangible asset to an Irish holding company. This company has a subsidiary sales company that sells advertising (the source of Google's revenues) to Europe. However, sandwiched between the Irish holding company and the Irish sales subsidiary is a Dutch subsidiary, which collects royalties from the sales subsidiary and transfer them to the Irish holding company. The Irish holding company claims company

International intrigue, exotic locations, and a hint of Dickens’ Artful Dodger.

management (and tax home) in Bermuda, with a 0% tax rate, for purposes of the corporate income tax. This scheme allows the Irish operation to avoid the even the lower Irish tax of 12.5%, and also, by using the Dutch sandwich, to avoid Irish withholding taxes (which are not due on payments to European Union companies). 5

This quote seems to have it all: international intrigue, exotic locations, and a hint of Dickens' Artful Dodger. People still like to cite the double Irish, Dutch sandwich but it is now no longer possible with Irish changes to the tax residence rules.

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The farcical nature of international tax avoidance is revealed in some Congressional Research Service calculations that show in 2010 Us-controlled Multinational Corporations (MNCS) claimed to have earned profits in Luxembourg worth 127 per cent of the GDP in that country. In plain English,

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US companies told US tax authorities that their profit in Luxembourg exceeded all the income earned by

WTO figures show total world merchandise exports of US$17.7 trillion and imports of US$18.1 trillion. Hence avoidance involving a small fraction of these is still a massive amount.

individuals, trusts, other companies, non-us MNCS and everything else in Luxembourg.

The farce continues; Us-controlled MNCS reported profits of 1,614 per cent of Bermuda's GDP, 1,804 per cent for British Virgin Islands, and 2,066 per cent for the Cayman Islands.

Types of multinational tax avoidance Transfer pricing

Tax avoidance involves shifting profit from high tax jurisdictions to low tax jurisdictions. At its most simple level, transfer pricing involves selling something at a low price to a subsidiary in a tax haven which then on-sells it at full price to the ultimate customer in a third country. These are effectively in-house transactions or intra-firm trade, except for the final sale to the customer. Taxable income is thereby minimised in the producing country and appears as high profits in a low tax jurisdiction.

An important Australian landmark in countering transfer pricing was a High Court decision involving aluminium exports with the profits accruing in Hong Kong. A more recent Australian example was BHP, which operated a Singapore hub that bought Australian commodities from BHP'S Australian subsidiaries and on-sold them to third parties at higher prices. BHP and the tax office agreed to a $529 million settlement.

The international scope for this sort of avoidance is still massive. World Trade Organisation figures show total world merchandise exports of US$17.7 trillion and imports of US$18.1 trillion. Hence avoidance involving a small fraction of these is still a massive amount. A variant of transfer pricing is the juggling of interest expenses to which we now turn.

Debt and interest

A simple avoidance strategy is to allocate debt to a low tax jurisdictions and claim interest payments in high tax jurisdictions. Suppose Aust office borrows from Haven office and Aust office pays interest of $100 million to Haven office. That interest income in Haven is not taxed but is a deduction worth 30 cents in the dollar for Aust office. The multinational group avoids tax of $30 million per annum. A slightly more complicated case involves Haven office borrowing at 2 per cent and charging Aust office say 6 per cent.

Tax office figures show that in 2015-16 Australian companies spent $17.0 billion on interest expenses payable overseas (ATO 2019). Like a lot of tax avoidance, it is virtually impossible to estimate the amounts avoided. We do not know if there is a needle or a crowbar in the haystack, but we can put a figure on the size of the haystack— the $17 billion.

Intellectual property

Payments for the rights to use intellectual property has been a growing issue, which no doubt reflects the increasing concentration of players in the digital industries. Today a good deal of the suspicious payments overseas appear as payments for the licensing of intellectual property. These may be classified as royalties, license fees, management fees, and so on. Intangible assets such as patents and other intellectual property are used by

a company to make profits just as they might use any other superior attribute to their advantage. The evidence is that the more valuable patents are strategically relocated to tax havens.

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A company such as Apple is not suggesting that any additional profit due to its intangible assets should be treated differently—it is just that tax law allows it to notionally allocate its intellectual property anywhere it wants and so it is going to be motivated to allocate it where company incomes are taxed most lightly.

Apple's proprietary technology is used to generate profit throughout the world and so, in that sense, its technology is stateless. The fairest thing seems to be to allocate the profit associated with the technology to the regions where it makes its profit and in proportion to that profit. That indeed is exactly what would happen if Apple did not attempt to earmark some profit for intellectual property and permitted itself to be taxed everywhere at the local tax rate.

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It is curious that intellectual capital can be attributed to a subsidiary that may have had nothing to do with its development and may have no business other than to collect payments on that intellectual property. In the same way, we think governments should ignore international arrangements through which intangible assets are held in other jurisdictions but within the same company or company group.

When Apple puts its assets in an Irish subsidiary it is not really alienating the profit on the licensing of the technology as it would (say) if it relied on technology from a third party. We would argue that the actual placement of its technology in a separate overseas division is not an arm's length transaction.

Australia's tax legislation used to have a strong anti-avoidance provision that required the tax office to ignore sham arrangements that were solely designed to avoid tax. The alienation of intellectual property should be treated as such a sham arrangement.

Tax havens

Multinational tax avoidance at the international level takes advantage of the fact that multinationals operate in more than one jurisdiction while taxation is normally a state-based activity and tax authorities have limited ability to obtain information from other jurisdictions. Tax havens can be regarded as those economies with no or low taxes, no or little exchange of information with other tax jurisdictions, a lack of transparency and no requirement that the entity concerned shows substantial activity.

Jane Gravelle from the Congressional Research Service has compiled a list of

Multinationals operate in more than one jurisdiction while taxation is normally a state-based activity.

countries that could be considered tax havens. These are listed in Table 1.

While these countries/jurisdictions have been included in the various lists compiled by researchers, many have agreed to reforms, such as the better provision of information, increased transparency and so on. Gravelle makes the point that countries such as the US, UK, the Netherlands, Denmark, Hungary, Iceland, Israel, Portugal and Canada all have some of the characteristics of tax havens.

The UK for example operates the ‘patent box' whereby foreigner companies that can organise their affairs to have intellectual property income attributed to the UK will thereby receive a very light tax rate.

Amounts involved

In 1999 there was evidence from America that more than 50 per cent of Us-based MNCS had a presence in countries considered to be tax havens. Official US data showed that about 40 per cent of net income of US firms derived from abroad was in tax havens. Reports over the last decade of tax avoidance by Google, Apple, Starbucks and Ikea provoked outrage with The Telegraph (UK) labelling them ‘robber barons'.

The OECD claims governments currently lose around US$240 billion

The OECD claims governments currently lose around US$240 billion through tax avoidance. An American estimate suggests the US alone lost $90 billion in 2008.

through tax avoidance. An American estimate suggests the US alone lost $90 billion in 2008, while UK official estimates suggest a ‘revenue gap' around 5 per cent of revenue.

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Amounts involved in Australia

In 2015-16 Australian companies claimed $27 billion in expenses involving royalties, licence fees, management and administration services, sales and marketing services, and technical services. Figures are available for 2016-17 but the ATO website explains that Australian companies were not required to provide as much detail for that year. Within that total, a large proportion would have been transactions by wholly and partially foreign-owned companies to related companies.

In addition, there is that previously mentioned $17 billion involved in foreign interest payments. Again, we can be confident that amongst that amount are some avoided taxes but it is impossible to know how much.

Base Erosion and Profit Shifting (BEPS)

Tax avoidance has motivated the OECD'S Base Erosion and Profit Shifting initiative, which now involves 125 countries that are collaborating to put an end to tax avoidance strategies ‘that exploit gaps and mismatches in tax rules to avoid paying tax'.

11 BEPS is the OECD initiative that seeks to combat international tax avoidance that takes place via, as the name suggests, erosion of the tax base and profit shifting to lower tax jurisdictions. The BEPS initiative follows earlier G20 efforts to improve things like secrecy and obscurantist structures in banking.

The OECD claims this has resulted in a 34 per cent reduction in bank deposits in international financial centres. The BEPS initiative is itself reported to have resulted in ‘massive changes'. The

12 achievements are listed as implying:

• Harmful regimes can no longer be used by countries to attract the tax base from other countries by targeting non-residents and foreign income only.

• Tax administrations are provided with access to extensive and consistent information on the largest foreign multinationals, which pose the greatest potential BEPS risk to their jurisdictions, given their size and potential revenues at stake.

• Country-by-country reports mean companies can no longer negotiate secret, sweetheart deals which would deprive other countries of their revenues. Despite the optimism of the OECD, this is not a finished process. We need only to consider the type of information the Australian Tax Office is going to

Tax avoidance has motivated the OECD’S Base Erosion and Profit Shifting initiative, which now involves 125 countries that are collaborating to put an end to tax avoidance strategies.

get from a country like Bermuda which itself collects little information. It is reported that the British Virgin Islands has 400,000 registered corporations but there are no requirements to identify shareholders or directors, and financial records are not required.

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Despite the OECD'S claims, it still recognises that there is a lot further to go in tackling multinational tax avoidance. Chief among the unfinished agenda are ‘the challenges of the digitalisation of the economy'.

There also remain the large differences in tax rates on companies (and other entities such as trusts) among economies, which range from zero percent to the thirties. In addition, there are practical matters such as the ability of some countries to actually administer a tax system in a sophisticated world economy.

Australia's own ability to administer the tax system has been called into question during periods of resource constraints. Countries still have incen

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tives, or governments think they do, to lower tax rates to attract business, even if what they attract is little more than a mail box and some registration fees.

Australia's efforts

As we argued earlier, we can measure haystacks reasonably well but we do not know if there are needles or crowbars in them. Equally, it is impossible to independently assess how well the Tax Office is doing against multinational tax avoidance.

The Tax Office established a Tax Avoidance Taskforce in 2016 to address MNCS and avoidance. It has also introduced new legislation, with significant penalties, to introduce some of the BEPS agreement action items. Budget Papers in the last few years and government press releases give optimistic projections on progress in collections from MNCS, but again these are impossible to verify. For example the government claims the Tax Avoidance Taskforce has raised $3 billion in 2017-18 without explicitly indicating whether this is a net figure.

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Arguably, the Tax Office has been extremely hampered in taking on new responsibilities in international tax avoidance while its staffing numbers have been cut. A report in 2017 suggested Tax Office staffing numbers had been cut by 4,600 in four years to 20,435 in 2016-17. The latest figures for 2018-19 show further cuts to 17,416.16 That gives a total staff reduction of around 7,600 – implying that just a few years ago staffing levels were 44 per cent higher.

The Community and Public Sector Union, which covers Tax Office workers, has given evidence that staff cuts have indeed harmed the government's ability to enforce collection and counter corporate avoidance. What we know

17 for certain is that tracking down tax avoidance is labour intensive.

It would be nice to conclude that international tax avoidance is on the run and that both international and Australian efforts have been beneficial. However, it is the tax avoiders who are taking the initiative. The double Irish, Dutch sandwich may have been addressed but new methods are being developed to replace it.

Like the Artful Dodger, it is the corporations that remain one step ahead.

A report in 2017 suggested Tax Office staffing numbers had been cut by 4,600 in four years to 20,435 in 2016-17. The latest figures

for 2018-19 show further cuts to 17,416.