At some level it makes sense. A multinational company, with subsidiaries all around the world and therefore subject to a host of different corporate tax rates, will look to mitigate its tax burden by efficiently structuring how – and where – it pays its taxes.
"By their nature, companies always try and ensure they stay within the law – but they don't want to overpay tax," says Joe Tynan, an international tax partner with PwC, noting that corporation tax rates can vary from 10-12.5 per cent at the lower end to up to over 40 per cent at the higher end.
“This means companies will take a ‘can we ensure we earn profits in lower-tax jurisdictions rather than higher-tax jurisdictions?’ approach,” says Tynan.
However, under the Organisation for Economic Co-operation and Development’s (OECD’s) base erosion and profit shifting (BEPS) project, new rules on transfer pricing mean this is about to become a lot more difficult.
As Conor O'Sullivan, partner with KPMG, says: "Multinationals face increased transparency and risk of challenge to their intra-group pricing and need to be prepared for this by thoroughly assessing their alignment of profits with economic substance."
The rules on transfer pricing
Transfer pricing relates to how companies set the prices companies, within the group, pay each other for goods, services, the use of money, intangible assets and similar transactions.
Multinationals have used it to their significant benefit to allocate income to lower tax jurisdictions and expenses to higher tax countries.
However, the OECD is looking to prevent companies from allocating too much value to low-tax countries, where they do not have many employees, and too little value to countries where they may employ lots of people and sell their goods or services.
Under BEPS, the OECD wants to get companies to align where they have substance, ie employees/activities, with where they pay their taxes.
Areas addressed by the BEPS project include intangibles, such as intellectual property (IP), risk, commodities, low value-adding services, such as back-office functions and documentation, including so-called country-by-country reporting (see previous page).
For multinational companies, the rules mark a significant change in approach.
“There will be greater transparency on business for the transfer pricing and increased risk of challenge where a jurisdiction’s profitability is not sufficiently aligned with economic substance,” says O’Sullivan.
“There will be greater focus on the attribution of profit to capital and intangible and more emphasis on aligning profits with key decision-makers.”
Focus on documentation
The new regime places a heavy emphasis on documentation, and requires a three-tiered approach, which includes a detailed country-by-country overview and specific transfer pricing information for each relevant country of operation.
“Documentation requirements will be focused on providing as much transparency as possible to tax authorities of a company’s total supply chain and how profits are aligned with tangible economic substance – with more emphasis on tangible assets and employees,” says O’Sullivan.
However, it has sparked some fears about the sheer intensity of the work required to comply with the rules, as well as the confidentiality of what might be commercially sensitive information.
“Every revenue authority will know what profit you make in different countries,” says Tynan.
“So, if you’re a phone manufacturer and your distributor in Italy makes a 7 per cent return, but the local distributor in Germany makes 10 per cent, the authorities in Italy may question why that’s the case.
“So you will have to have documentation to back up your decisions,” Tynan adds, saying most companies will have different approaches in different regions and will now have to justify all of them.
“In the past, you had to justify to the Italian tax authorities what your approach in Italy was, but you didn’t have to justify it compared with other countries.” He says it is going to be a very big challenge for companies.
It already is. Indeed, country-by-country reporting is already technically in place since January 1st this year, with filing due at the end of 2017 and revenue authorities due to look at the information by 2018. As such, it is one of the first elements of BEPS that taxpayers across the world have to get to grips with.
“There is some time to prepare for it but not much,” says Tynan. “Companies need to be thinking can they get this information.”
BEPS also marks a significant departure for how intangibles, such as intellectual property (IP) will be taxed in the future.
Under the current version, a company typically has IP in locations with few employees, such as in the Caribbean, Switzerland or Luxembourg.
“This is no longer feasible,” says Tynan, adding that brass- plate operations will not be allowed under the new regime and companies will have to have people where the IP is based – and people who can make decisions as well.
“There is no benefit to just having IP here; a brass plate gives you no benefit. The only way to get benefit out of IP [for a company] is if they also have employees,” he adds.
So it is a significant change for companies, which may have to think about moving this IP. One option is to simply spread it around where they already have very senior people based, but these countries may have very high tax rates.
The other option is to move people to lower tax jurisdictions – such as Ireland – where their IP may already be based.
“They will try and ensure they hold their IP in a competitive location where they have employees and where they can manage that,” says Tynan, adding that Ireland would like to position itself as just such a location.
However, it will be competing with the likes of the UK, where corporation tax is just 20 per cent, and other jurisdictions such as Switzerland.
“It’s positive for Ireland because of this connection between IP and employees; if the IP is moved here, then it creates a foundation for ensuring there is greater permanence around employees,” says Tynan,
O’Sullivan agrees that the move could ultimately benefit Ireland.
“Ireland’s tax regime which emphasises transparency and substance is well-aligned – the key issue going forward is whether Ireland can continue to attract senior talent and decision-makers to locate here,” he says.
“Already, we are seeing companies deciding to increase their economic substance in Ireland largely because of the transparency and relative certainty of our tax policy”.
Another element of the BEPS project is Action 9, which aims to ensure transfer pricing outcomes are in line with value creation, by preventing profit shifting through the transfer of risks among, or the allocation of excessive capital to, group members.
BEPS also has a view on high-risk transactions and is looking to develop rules to prevent abusive transactions which would not, or would only very rarely, occur between unrelated parties.
The US approach
While there may be divergence when it comes to IP (see following page), for now, at least, both the US and Europe appear to be on the same track when it comes to transfer pricing.
"The US did not dissent from the OECD's BEPS reports on the transfer-pricing action items. Thus, in theory at least there should be no significant divergence of approach on transfer pricing on the two sides of the Atlantic," says Washington based Nick Giordano, tax leader with EY.
However, there has been a view, expressed in some US quarters, that the OECD’s BEPS project is really about getting US companies to pay more tax in Europe.
“And if they pay it in a European country it’s definitely not getting paid in the US,” Tynan says.
This means countries may potentially implement the new rules in different ways, so we’ll see slightly different versions of the same thing.
This could potentially dilute the project.