The Organization for Economic Co-operation and Development (OECD), a group of 34 countries that embrace free-market economics, launched their review of how multinational enterprises (MNEs) moved their profits around the globe in 2015, under the banner of Base Erosion and Profit Shifting (BEPS).
A major part of the BEPS project looked at the way that MNEs priced transactions that take place between entities in their own groups—because this is how MNEs move their profits around the world.
I’m Not Asking You For 100, Not 50, But a Bargain at 10
To look at a simple example, when you go to buy a widget from the local shop, the shopkeeper, when he bought that widget, had to pay the price the wholesaler charged him, who in turn had to pay the amount the manufacturer priced them at, who had to pay the prices for the raw materials.
However, when you own the shop, the wholesaler, the manufacturer of the widget, the design of the widget and the brand under which the widget is sold, you can decide how much each entity charges so that the profit arises in the best place (i.e. the one with the lowest tax rate, preferably a zero tax rate). This is the “profit shifting” BEPS is concerned with, and the effect it has on the high tax countries is the “base erosion” (i.e. it is their tax base that is being eroded).
Most countries now have rules aimed at stopping this sort of activity, and they are, by and large, based around guidelines provided by the OECD (and those guidelines were drafted by officials or ex-officials of the tax authorities of the OECD members). These rules require the MNEs to price the transactions between members of their groups as if they were taking place between completely independent, uncontrolled parties. This is known as “transfer pricing.”
Turning back to our widgets, they sell to customers at 20 in a country where the tax rate is 25%. The retailer buys them from another country that has a tax rate of 5%. Independent wholesalers in this country sell them for 10, meaning that the retailer makes a profit of 10 that is taxed at 25%, and so receives a net 7.5. The wholesaler bought them from an independent manufacturer for 5, making a profit of 5, taxed at 5%, meaning it clears 4.75.
You WILL Pay Over the Odds
Now, consider what an MNE can do. The widget is still sold for 20, but they are now bought from a wholesaler that is also owned by the MNE. The wholesaler sells them for 18. The retailer now makes a profit of 2, taxed at 25%, meaning they receive 1.5 after tax. The wholesaler still buys them for 5 but now makes a profit of 13, taxed at 5%, meaning their after-tax profit is 12.35.
In the first scenario, using independent traders the total tax take is the retailer’s 2.5 plus the wholesaler’s 0.25 to make a total of 2.75. In the second, with connected parties, the retailer now pays tax of 0.5, whilst the wholesaler pays 0.65 to make a total tax take of 1.15, around 40% of the independent amount. The transfer pricing rules make the MNE adjust the sale price between the retailer and the wholesaler to that between the independent parties, here 10.
If the amounts in this example are increased to billions, it is evident why countries have been keen to address the problem. The problem (being transfer pricing) has been going on for years, but it was only when the tax affairs of the MNEs came under public scrutiny as a result of the Global Financial Crisis, and the countries really needed the cash, that they got serious about the subject, hence the BEPS project. It is worth remembering that U.S. companies have been using transfer pricing to park their profits offshore for years and the U.S. government could have stopped them at any time but chose not to—Something I will come back to.
The example set out above is only for “training purposes” as no real-life situation is that simple. The widget will have hundreds of parts, involve many patents and brands, and have a supply chain that goes around the world at least twice taking in dozens of countries. This complexity allows MNEs to lose amounts in the cracks between the rules in the different countries, exploiting lack of experience in revenue authorities and the information imbalance.
I’ve Hidden the Pot of Gold, Can You Find it?
A revenue authority will almost certainly have the right to know what is going on within its borders, but it will not normally have the right to know what is going on in other countries, or even if it has the right under its own domestic legislation, it will not have the power to enforce it. For example, consider the recent case of Jimenez v. First-tier Tribunal and HMRC  BTC4 where the Court of Appeal said that HM Revenue & Customs (HMRC) had the right to issue an information notice to a taxpayer resident in Dubai; however, HMRC will struggle to get compliance as they have no right to enforce the notice or collect any penalties in the United Arab Emirates.
This imbalance is, however, eroded by countries using exchange of information. Countries enter into double taxation agreements (DTAs) with each other to prevent double taxation but also to prevent tax avoidance. One of the ways DTAs help countries to do this is to allow them to ask for information held in the other country. For instance, using our example, the country of the retailer could ask the country of the wholesaler how much the wholesaler paid for the widgets to see if the profit was excessive.
There are checks and balances in the system to safeguard taxpayer confidentiality and to stop tax authorities “fishing” for information or sub-contracting their investigations to the other country (and using their resources and money to do so) but this a very valuable tool for cross-border inquiries and the U.K.’s JITSIC team (Joint International Taskforce on Shared Intelligence and Collaboration) have helped secure over 1 billion pounds ($1.3 billion) in tax.
The problem is that such exchanges are time consuming and the tax authority often has to know there is an issue to start with and what questions to ask. The information shoe is definitely on the MNE’s foot.
I’ve Found You!
Therefore, one of the outcomes of the BEPS project was country-by-country reporting (CbCR). This requires the largest MNEs (those with turnover over 750 million euros ($839 million) to provide information to their home tax authority showing their profits and activities for each country they operate in. That information is then shared with the tax authorities for those countries.
The information will then allow the relevant tax authorities to carry out risk assessments based upon the information in the CbCR. They can also use the exchange of information provisions mentioned above to ask for other relevant information in the report if they believe it is relevant to them.
From the reports in the mainstream press, it is clear that some pressure groups believe that this information should be made public in order to “name and shame” MNEs who they believe are not declaring profits in the countries where they (the pressure groups) believe the MNEs should.
This idea for public CbCR was picked up by the EU Council and the European Parliament and proposals were put forward to require both large MNEs headquartered in the EU and the EU subsidiaries of large MNEs from outside the EU to publish:
- a description of their activities;
- number of employees;
- net turnover;
- profit or loss;
- tax accrued for the year;
- tax paid in the year; and
- accumulated income.
This would be shown on a geographical basis for EU member states and for other countries.
No, You Haven’t
Most taxation matters within the EU have to be agreed unanimously by all member states and this was no exception. The proposal was tabled in 2017 and was voted upon by the Council at the end of November 2019. It perhaps came as no surprise that the proposal was vetoed, although the scale was perhaps larger than expected at 12. Nor would the names of some of the member states who vetoed the proposal raise eyebrows, with Ireland, Luxembourg, Cyprus and Malta all voting against—all jurisdictions that have well-developed financial sectors that are hugely important for the economy by attracting foreign MNEs to base themselves there.
However, very interestingly, Germany abstained. Germany has been a keen proponent of the common consolidated corporate tax base where EU based MNEs will use the same rules across the EU to calculate the tax due, publishing a paper (along with the French) in 2018 attempting to get the long-running project (it started in 2011) back on track.
You would expect them to be in favor of public CbCR, especially where, in their view, it might shine a light on multinationals, especially U.S. multinationals who are thought to be moving money out of Germany into other jurisdictions such as Ireland and Luxembourg. So why the abstention? Is public CbCR a step too far for them? If multinationals have to publish their details may the requirement creep down a level? Would German businesses, such as the family owned firms in the “Mittelstand” that power their economy, have to make information public that they would rather not?
Perhaps vetoing the measure was a step too far, but with a sigh of relief they were able to abstain, signaling to concerned domestic parties that the German government was not about to start making tax information public.
Andrew Parkes is National Technical Director at Andersen Tax, U.K.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.