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It would have been impossible over the past six months to have read a newspaper without reading about the taxation challenges faced by some of the world’s largest multinational companies (“MNCs”) and iconic brands, including Apple, Google and Starbucks. This has resulted in, amongst other things, tax audits worldwide for Google, an appearance before a Senate Hearing by Apple’s CEO to defend the company’s tax arrangements, and a public boycott of Starbucks stores in the UK leading to a “voluntary” tax payment by the company to the UK Revenue.
Whenever an MNC faces such a challenge the reputational damage to such companies - that typically pride themselves on being good corporate citizens with a social responsibility – is immense.
This article will provide some insights into some of the issues underpinning the tax structures used by the above companies and many other multinationals (“MNCs”) globally, with an emphasis on what this means for intangible asset planning from a transfer pricing perspective.
The Google Example
The Google model – which is by no means unusual or unique amongst MNCs – is based on the following:
- Non-US intangibles are owned/ licensed by a group entity outside of the US (in this case in Ireland);
- Local country entities operate as marketing service providers, identifying and managing the relationships with customers (advertisers); and
- Advertising contracts for all non-US customers are with a group entity also in Ireland
In simple terms, the local marketing service providers derive a routine return for their arguably routine marketing services, while the majority of non-US advertising revenue is initially recognised in the Irish advertising entity.
This entity then pays a royalty to a related party in Bermuda via a second Irish entity and a Netherlands entity. This has been referred to as the “Double Irish Dutch Sandwich” and has been effective in avoiding withholding tax as well as ensuring a large share of the profits end up in Bermuda with a 0% tax rate. It is reported that Google cut its global taxes by some US$ 3.1 billion in the period 2007-2009 through the adoption of this structure, apparently reducing its non-US tax rate to 2.4%.
As complex as this sounds, the above transaction structure is held to be consistent with the arm’s length principle that governs related party transactions and is compliant with the letter (although arguably not the spirit) of the tax laws of the various countries involved.
Implications for intangibles planning
These structures encompass a whole range of tax planning concepts that have been elaborated elsewhere. The focus here is on what this means for locating your intangible assets and building a robust and defensible tax structure around those intangibles.
MNCs often have opportunities to design a business/transfer pricing model that optimises their overall effective tax rate. Various functions can be shifted around, for example, key decision makers can be relocated to a low-tax hub such as Hong Kong/ Singapore to drive the company’s marketing and sales efforts. Hence, a relatively low tax rates is applied to the residual profits, while leaving higher tax jurisdictions with a routine level of profit only. However, the above all involves substantial planning, restructuring and movement of key functions and people.
As an alternative, or in addition, the traditional view is that intangible assets are considerably easier to shift across borders, at low cost and without the emotion and transition costs of, for example, moving senior executives and their families to a new location or moving a factory to a new site.
However, it is important to understand that this is a greatly oversimplified view of the world today. It is no longer simply possible to shift, for example, your brand or product intangibles to a new country to take advantage of lower tax rates. In order to support such an arrangement, you would need to consider the following:
- Which party developed the intangibles i.e. incurred the marketing cost or R&D cost associated with the intangible? This party is typically the economic owner – irrespective of legal ownership – of those assets and entitled to a return for them. If they are shifted one would generally need to determine an appropriate exit charge through a valuation exercise, having regard to the profit potential of that asset. Such an exit tax – imposed in various countries such as Germany, US and China - can in many cases eliminate any tax benefit that can be achieved from there-structure.
- Regardless of the asset’s location, it needs to be remunerated – probably through a royalty or licence fee paid by those utilising the asset – on an arm’s length basis. Part of the concern in the arrangement of Starbucks was that the UK entity was paying a royalty to a Netherlands entity (the owner or licensee of the Starbucks brand) that appeared to be excessive, particularly given it was not sufficient to enable Starbucks UK – with stores seemingly constantly full of coffee drinkers - to generate enough sales to earn a profit in the UK.
- Further to point 1, in order to own an asset from an economic perspective, it is no longer sufficient to merely bear the cost of developing the asset. The current view is that you must be able to show that you have significant day to day control over the asset. For example:
- In a contract R&D arrangement, in addition to making key decisions such as what to research and develop and who to hire to do the work, you need to demonstrate day to day oversight, quality control and active participation in the business. Merely having your head of IP or R&D fly to Bermuda once a quarter to sign off on some company documents is not going to be sufficient to support leaving your intangible assets there, if in reality the contract R&D team sitting in a low cost location is running the R&D function.
- Similarly, having someone with the title of Head of Marketing and Sales in Singapore does not mean in itself that the brand and customer lists and all revenue associated with them can be recognised in Singapore. The reality may be that local staff are driving the sales and marketing on the ground in various locations, and that country’s claim on residual profits should not be overlooked.
In short, in the two examples above, genuine economic substance is critical, including active decision making, oversight and control over risks, in addition to merely the legal ownership or funding of intangible creation.
From the above points, the inherent risks in intangible planning from a tax and transfer pricing perspective should be evident. Although the structures of Google, Apple and Starbucks may well technically be within the law, it is evident that the days of aggressive shifting of intangibles to tax havens or low tax jurisdictions, without building up the appropriate level of economic substance, are long over.
However, this is not to suggest that tax and transfer pricing planning opportunities cannot be realised, just that careful and professional design, documentation and implementation is needed. For tax authorities, faced with growing budget deficits and unpopular austerity measures, auditing an MNC that is seen to be avoiding tax obligations is an easy way to pick up some revenue without upsetting voters. It is advisable to seek advice from independent transfer pricing and valuation specialists. Proper and timely design of a robust transfer pricing model will ensure you can avoid becoming the next target. Furthermore, you will be seen by your customers and the public as a responsible taxpayer and good corporate citizen at the same time.