The score at half time: OECD 7, Tax Avoidance ??

Today the OECD announced the deliverables on seven of their fifteen planned actions to tackle global corporate tax avoidance. (for background, see here). 

So what’s in today’s release? Quite a bit, actually. Work will continue on the digital economy, which is a good thing, as they are taking a broad holistic approach to this rather than confining their focus to techie firms. As the interim report says – digital economy is the economy now, and almost all sectors including health, education, media and financial services are impacted by the issues of mobility, reliance on data, user-created content, flipped supply chains and business models, near-monopolies and a pervasive virtuality that makes the old-fashioned taxing questions of who, what and especially where very challenging. 

There are concrete proposals on hybrid mismatches and on harmful tax practices which promise to tackle patent-box regimes. There are new proposals on preventing tax treaty abuse, but more interestingly, they’ve moved on the feasibility of a global multilateral tax treaty to replace the thousands of bilateral ones now in place. That in itself would be a game-changer. There is a lot more by way of country-by-country reporting, particularly for those patent-box regimes. The devil will be in the detail here, and of course this all poses massive challenges for developing countries who may lack the ICT infrastructure to cope. 

That and other issues will be addressed next year when the OECD report on the remaining eight actions on their original list of fifteen. This includes a lot more on aligning transfer pricing, and on data methodologies. In the meantime, because of the very public and comprehensive nature of today’s disclosure, we may see a lot of quiet tweaking of individual countries’ tax rules, in anticipation of more imposed changes. 

There are issues of democracy and mandate in all of this. None of these rules can officially be imposed on the world – they have not been voted in democratically anywhere yet. The OECD can change their model rules and the member countries will abide by them. The G20 are on board in general terms and together, they control 90% of the world’s economy (as Pascal Saint-Amans pointed out happily today). So there is an economic mandate, but not a democratic one. Developing countries are consulted, and the UN can observe, but what they are observing is a small group of rich nations acting in concert. But act they have, and next year, when the remaining eight proposals are brought forward, we will see a significantly-changed corporate tax landscape. Winners, losers, yet to be determined, but certainly some companies will pay some more tax. Somewhere. 

Sheila Killian

@sheilakillian

OECD and tax avoidance: the story so far ...

In a webcast from Paris this afternoon, the OECD updated the world on progress on the BEPS project to date. Pascal Saint-Amans stressed the process was on track to be presented to finance ministers in September 2014. Four discussion drafts have been issued over recent months, covering country-by-country reporting, the abuse of the international network of tax treaties, the rather more technical question of hybrid mismatches, and more broadly the challenges posed by the digital economy.  This article summarises where the OECD is on each of these four areas, and then makes some general observations on the process. 

The Digital Economy

The current thinking here, sensibly, is that it is neither possible nor useful to ring-fence the digital economy. Everything is digital now. So what the draft does is focus on the key features which warrant attention from a tax point of view. These are mobility of assets, customers, employers; the way new business models rely on data, sometimes very large banks of personal data; the multi-faceted nature of these new business models with value being created by customers as well as by vendors; and network effects in general.

So the working group will focus on questions such as how to restore source and residence taxation in this new context. How can value be attributed to data, given that it is created by a wide network of individuals? How can cloud-based storage be attributed to a single or even to multiple jurisdictions? What about consumption taxes?

These are complex questions. Taking just that last one as an example, VAT has traditionally been imposed in a particular jurisdiction based on the concept of place of supply;  if I sell you a car, for example, it is not difficult to decide where that transaction takes place. If, on the other hand, I download music produced by some Californian indie band from the cloud, to an ipad, while transiting through Manchester airport, where is that sale made? Do we look at where the customers are located? Where the service providers are headquartered?  Where the company making the sale says its sales force are? Each of these methods would give a very different tax outcome, with fairly profound implications for both companies and countries. 

Hybrid mismatches

This is a more technical area, fascinating to tax planners and tax nerds generally, almost certainly less so to the general public. It refers to any arrangement that exploits the different tax treatment in different jurisdictions of the same instrument, so for instance a financing instrument that obtains a tax deduction in one place, but is tax free in another. 

Achim Pross clarified some important issues of scope; the OECD are not looking at mismatches between tax and law, for instance, only at international tax mismatches. They are seeking rules wich are clear and easy to apply ,and which can be easily or automatically imported into domestic law without the need for taxing authorities to form a judgement about intent .  They want the new rules to be comprehensive – there is no  point in closing down one type of abuse only to let it open elsewhere in a slightly different guise. The mechanism they will probably apply is to neutralise the tax mismatch without disturbing the regulatory consequences, so the tax treatment in one state will be based on the tax treatment in the other, restoring the symmetry to the international situation that would have applied had the transaction been domestic. This raises the implementation question of which country’s rules to adapt? Whether to apply this only to group transactions or also to parties acting in concert and structured arrangements more generally? How to deal with accidental hybrid instruments? It is clear that widely-traded financial instruments which are hybrid in some way will probably be outside the scope, but there are lots of questions still to be addressed on this one. 

Tax Treaty Abuse

This is a big one, and has generated a great deal of public comment already on the discussion draft issued last month. The approach is interesting. First the purpose of treaties is established, and in particular the fact that they are intended to be bilateral, and not to create conduits. Next there are specific anti-abuse rules being developed such as tie-breaker rules on dual-residence companies, and minimum holding periods for dividend transfers. Finally, they are talking about a general provision, more or less like an anti-avoidance rule, which denies treaty benefits if the main purpose of the transaction is to obtain the treaty benefits, AND the obtaining of the benefits is contrary to the purpose of the treaty. 

This is potentially a game-changer, depending on how widely the new general provision might be applied. 

Transfer pricing and country by country reporting

Here is where things slow down a little. On transfer pricing, the OECD remain firmly committed to the principle of arms-length pricing, despite protests from many groups such as the tax justice network. Similarly on country by country reporting, the latest changes seem to limit the recommendations to high-level reporting on a country level rather than on a company level, and only to taxing authorities rather than to the general public. It is likely that companies will only need to report income, profit, tax paid and accrued in each country as well as details on the numbers of employees, tangible assets and retained earnings/capital. 

Overall points

The emphasis is on saving the system, not rebuilding it. In particular, the arms-length principle remains a staple of the current thinking. In answer to a question at the end, Pascal Saint-Amans said “So let’s fix the existing system. Which will allow us to save the arms-length principle, which will provide the certainty that countries and companies need.” 

Developing countries have other concerns on international tax, especially about commodity mispricing and tax incentives, which are less reflected in the current work programme of BEPS. The OECD have had a series of regional  consultations with developing countries, and have promised to take their views into consideration. 

BEPS is not all-embracing. For instance, a question from an Australian journalist revealed that aggressive tax planning based on after-tax hedging, is not currently under scrutiny. However, for particular structures, such as the infamous Double Irish, the writing is clearly on the wall. Asked specifically about that structure, Pascal Saint-Amans said that yes, they expect and encourage the ending of the Double Irish, and that for companies to anticipate such changes and adapt their actions in advance of proposed changes “”would be a smart move”

So change continues, with some measures such as country by country becoming more conservative, and others such as the treaty abuse measures holding out real possibility of reform. They promise more webcasts, so watch this space. 

Dr Sheila Killian

@sheilakillian

Ethics and regulation: complements, not alternatives

Last week former Taoiseach and President of IFSC Ireland, John Bruton, said that the banking industry needed "to focus on ethics rather than regulation". As someone who strongly supports the idea of ethical codes and a more central role for ethics in business, I found this remark and the casual way it was accepted unhelpful on many levels. Ethics are not an alternative to regulation; rather regulation is needed to support ethical behaviour. 

First, what do we mean by ethics in business?  There are many approaches; to illustrate why ethics are not an alternative to regulation, consider just three. 

You can take a deontological approach, like that that of most religions, and impose an absolute moral code.  Something is either right or it is wrong, no exceptions. You can see aspects of this in some corporate codes of conduct: some things such as fraud, insider trading or forced labour are simply prohibited, regardless of the consequences at the time. These things are unethical – everything else is OK. Because of the inflexibility of prohibiting an action, the list tends to be a short one, and not very useful for complex “grey area” situations. 

In contrast, a utilitarian or consequentialist approach hinges on the idea that the morality of any action is completely determined by its consequences.  So in its purest form, faced with a decision, you could weigh up the impact on all parties and choose the course of action that minimises harm or maximises good. So while stealing might be “wrong” under a deontological approach, utilitarian ethics might allow it under some circumstances, such as the theft of food from a profitable business to save the life of a starving child. This is pragmatic and useful, but depends on the person making the decision having been really well trained; unless business schools and professional institutes put serious weight behind teaching the process of ethical decision-making, it is unreasonable to expect individual employees to respond in the best possible way when making snap decisions in a fast-moving and high-pressure environment.   

As a final example, a virtue-based approach to ethics comes from Aristotle’s ideas of how to be, rather than what to do.  A decision on a particular situation could be reached by asking, “Am I the sort of person who would ...?” or, “Are we the sort of organisation that ..?” This can work really well for individuals, but won’t work in business unless everyone in the organisation is aware of and supports the sorts of virtues or values that the firm as a whole espouses.  Since these values are not based on rules, they must be embodied by the leaders within the organisation – a kind of ethical role-modelling which be either positive or negative, depending on who’s in charge and how they behave. 

Now the question is: which of these approaches, bearing in mind that they are only three of a myriad of ways of describing and understanding business ethics, could credibly act as an alternative to regulation in an industry as cut-throat and prone to moral hazard as banking? 

The absolute moral code of deontological ethics is barely compatible with capitalism, and would be either limited or diluted by its application to profit-seeking financial innovation. The utilitarian approach is pragmatic but time-consuming, and depends heavily on training. Virtue-based ethics comes close to a personal ideal, but depends on individuals to an unsustainable degree.   

They are all good to have in an industry, but will never work alone.

The trouble with ethics in isolation is that unless they seem coherent with the overall climate in which an individual is working, he or she will lack the confidence to “do the right thing” even where the “right thing” is clear.  I might know that stealing is wrong, for example, but if all of my peers are routinely cleaning out the stationery cupboard and falsifying expense claims, then my personal belief is constantly challenged by the daily experience. This is where regulation – clear rules of law with penalties and consequences for non-compliance – will support ethical standards, reinforcing rather than replacing them.  

Of course regulation also has the happy advantage of being effective even for people who would never embrace an ethical code. Even sociopaths fear the law. In that sense, regulation has a wider impact than business ethics, and is a baseline if we are to expect better corporate behaviour. Without punishments, some people will never obey rules.  But most employees are not sociopaths, so training in ethical decision-making will also have a useful effect, enhancing the impact of regulation, and ensuring that it is implemented in spirit as well as in statute. 

What the industry needs is not "to focus on ethics rather than regulation," but to enforce regulation and resource ethical training. Then we might see the change we need. 

Sheila Killian

@islandtotheleft

Multinational tax avoidance and international responses (1 of 2)

Ahead of tomorrow’s release by the OECD of what promises to be an interesting report on their plans to address multinational tax avoidance, this post is a primer on the issue and on the role of the OECD. I’ll follow up tomorrow with some analysis of the report itself.

What’s the issue

Multinational Corporate Tax avoidance: the perfectly legal but shockingly complex process of arranging special purpose companies and capital flows in artificial ways so that the group as a whole pays as little tax as possible worldwide. It’s a huge problem – the IRS figure for profits offshored by US corporations is 1.7 trillion dollars - and that’s just American firms. The problem is that while taxes are imposed by individual countries, multinational firms roam the world in search of advantage, setting up a management firm here, a registered office there. Individual tax authorities find it difficult to see the whole picture. These days too, most of the value in large companies comes from intangible things like brand and intellectual property, which are far harder to trace than physical sales or factories.

Avoiding tax is a game as old as tax itself, but lately opposition to multinational tax avoidance has gathered momentum and political support.

Why is this a problem ?

That $1.7 trillion kept offshore by American firms is not just a loss to the US exchequer – profits it might reasonably have expected to tax. It also makes an uneven playing pitch for American companies. The bigger multinational ones can avoid tax more easily than smaller, domestically-centred firms. That gives them an immediate advantage that biases against entrepreneurship, growth, and all the things needed to kick-start the economy.

A wider problem is that it’s not just the US that is losing tax: as discussed here, the loss in relative terms to countries in the global south is even greater. A recent Action Aid report details the case of a Zambian sugar company routing interest and dividend payments through Ireland and the Netherlands in order to avoid tax in Zambia; this in a country where 45% of children are undernourished, and 90% of rural dwellers live in poverty. Lives are, quite literally, at stake here.

It’s hardly surprising in this context that US President Obama harks back again and again to the need for corporate tax reform. Indeed, politicians the world over are excited about this issue now. South African leaders have spoken out about this for years. It’s debated in the UK parliament, makes primetime news in France, home of the OECD. This media coverage drives more political debate, which in turn puts pressure on the big international bodies to do something about this.

So who are these international bodies?

In this part of the world, the three international bodies shaping international tax are the European Commission (EC), the UN and the OECD. The EC has been working for the last seven years on the Common Consolidated Corporate Tax Base (CCCTB), of which more here.  Basically, this is a way of allocating the taxing rights on profits earned in the EU across the member states, depending on where the company has located its assets, its employees or its sales. It’s an idea that bubbles steadily under the surface, but for now, and as long as unanimity is required for big tax changes like this, it is not an immediate prospect.

The UN is obviously the most representative of the three bodies. It’s also the most focused on the global south, and last October produced a detailed Practical Transfer Pricing Manual for Developing Countries.  Like the OECD, its focus is on the tax rules in place between countries – tax treaties and transfer pricing arrangements. The UN models tend to favour developing countries by allowing tax to be withheld on royalty and interest payments of the kind documented in the Action Aid report mentioend above. However, while the UN may have the mandate, and the EU the immediate proximity, the OECD has the resources, and now, spurred on by increased political pressure, is developing new strategies to tackle the issue.

What has the OECD been doing so far?

The OECD is the body behind the dominant model tax treaty, which forms the basis for most bilateral treaties negotiated worldwide. It has fairly standard clauses on who has taxing rights in cross-border transactions, and aims at eliminating double taxation. They started looking at tax havens, or harmful tax competition in the 1990s. They developed a three-part test whereby a country with low or zero tax rates ring-fenced to a subset of companies and with a general lack of transparency would be regarded as a tax haven. The penalty effectively was to lose the benefits of the tax treaty network. Around this time, Ireland’s switch from a 10% rate in Shannon and for manufacturing, to a 12.5% rate for all neatly sidestepped the new rules. We have a low tax rate, but we’re not a tax haven as defined because we have no ring-fencing of the low rate to a particular subgroup of companies.

As well as identifying countries with harmful practices, the OECD focuses on transfer pricing, of which more here. Simply out, a transfer price is the price at which goods are sold between sister companies. It can be abused as a way of shifting profit from high-tax to low-tax locations by manipulating the prices or more commonly the level of royalty or management charges paid. Such transactions should be at “arms length”, meaning that the same rates and conditions should apply within a group of companies under common ownership as between unrelated firms. This is straightforward enough to police if you are looking at the selling price of something tangible, like cars or computers. It’s virtually impossible in the case of royalties for which there is no benchmark price outside of the group.

As if this wasn’t challenging enough for taxing authorities, there has been a raft of new and very complex tax structures adopted and mimicked by multinational firms in recent years. The best known locally is The Double Irish.  As reported by Bloomberg , this is a now-infamous means used by large US firms to channel royalty payments through Ireland on to Bermuda, reducing their overall tax bill to negligible levels. Ireland is not the only country whose tax system is used in this way. Even without a detailed knowledge of the particular techniques used to shift profit, there are signs plainly to be read: the number of companies now headquartered in The Netherlands, for instance; the levels of investment flowing in and out of Luxembourg. The issue is enormous, complex and difficult to tackle. How do you establish an arms-length price for something which is only sold to one related company? How can you determine where a company has operations if its product or service is as nebulous as the very cloud in which it hosts its files?

The way in which business is done by multinational firms has changed dramatically, and tomorrow the OECD reports on how it will change its approach to multinational tax evasion in response. A blog post here will analyse their new approach, and some of its implications.

Sheila Killian

@islandtotheleft

Changing the way companies are taxed

Sheila Killian: As reported by the Irish Times, yesterday, the European Parliament approved a resolution proposing amendments to the CCCTB (the common consolidated corporate tax base). So what is this all about? Well, the CCCTB aims to streamline the basis on which companies pay tax in the different countries in the EU, and to allow companies established in any EU country to make a single tax return covering all EU states. The tax base would then be allocated among the countries on the basis where the assets are located, where the payroll bill is, or where the sales are made. So if a company made most of its sales in France, for example, and had all its assets and payroll in Ireland, then France would be entitled to tax some of the company’s tax base at French rates, while Ireland would tax the remainder at Irish rates.

This is a fundamental change from our current residence rules, which allow a company resident and operating here in Ireland, but making sales all over the EU to pay all of their tax in Ireland. The idea behind it is to streamline administration for companies operating in the EU, eliminate double taxation and double non-taxation more efficiently than bilateral treaties would, and essentially make irrelevant intra-group transfer pricing arrangements within the EU.

Not surprisingly, the CCCTB is seen in Ireland as a threat to our ability to raise taxes from companies operating here. More significantly it’s seen as damaging to our policy of seeking foreign direct investment on the basis that our 12.5% rate will apply to all their profits.

Up until now CCCTB has been proposed by the European Commission as a voluntary system: companies could opt-in to the system at their discretion. Furthermore there was a sense that the relatively slow process of decision-making at EU level would mean a long lead-in to the operation of the CCCTB. Yesterday, however, the European Parliament passed a vote to make the CCCTB mandatory for all but the smallest companies within the next five years.

The resolution passed by the Parliament also had three other interesting aspects, which were less widely reported. Most importantly, they recommended a change to the weighting between the three factors – assets, payroll and sales. The European Commission's original idea was that these three would be equally weighted. The Parliament proposes putting a 45^ weight on each of assets and employees, and only 10% on sales. This amendment would be good for Ireland, and seems fair in the sense that most profit is generated through the workforce and assets. http://www.blogger.com/img/blank.gif

Parliament also proposed that if some countries were not ready to embrace CCCTB, then others could move ahead without them. This is an idea that would have seemed far more radical a few years ago, before the Fiscal Compact. Finally, the parliament’s amendment specifically includes a review of the usefulness of corporate tax harmonisation when the CCCTB comes up for review after five years.

The vote means that the interesting times promised by the CCCTB are more immediate than before. A focus on the relative weightings of the three criteria for apportioning the tax base – assets, workforce and sales – is now of critical importance. There may be scope for making the CCCTB both more politically palatable and more fair with an increase in the weightings of assets and workforce.

The clouding effect of international tax avoidance

Sheila Killian: In the Central Bank’s most recent Quarterly Bulletin, released today, Mary Everett does a good analysis of the impact of multinational investment in Ireland. It includes a really useful discussion of the difficulties in extricating the real underlying economic activity from the tax-based money-moving of multinational firms. There’s a particular focus on the Shire effect – the way some multinational firms moved their headquarters here in order to avoid adverse taxes elsewhere.

Everett notes that:
“While these types of companies have large balance sheets, their contribution to the local economy in terms of employment tends to be limited.”

While it’s well worth reading in full, one highlight to ponder is the depressing statistic that 15% of inward direct investment and 21% of outward direct investment moves between Ireland and Bermuda. Hardly a traditional trading partner, this is a strong indication of the sort of aggressive tax planning outlined here, and indicates that for all serious purposes, our GDP is a far less realistic measure of real economic activity than GNP.

Irish Bonds Tempt Buyers Again After Banks Blow Up: Euro Credit

Sheila Killian: There’s an interesting article on Bloomberg, by Dara Doyle and Cormac Mullen. Interesting, that is, in the Confucian sense of living in interesting times.

The initially rather bizarre gist of the article is that for potential bondholders, the banks that we have bailed out are now a far more attractive investment proposition than the Irish government which guarantees them. They are producing a higher yield, which is counterintuitive if you take the view that they have the same risk, since we are underwriting them.

Here’s a quote from the article:
“Essentially, you are getting more than twice the yield for the same amount of risk,” said Fergal O’Leary, a director at Dublin-based fixed-income firm Glas Securities. “The government bond is undoubtedly more liquid than the guaranteed bank security, but that just doesn’t justify the current scale of the yield premium.”

Indeed not. So what does? Well, perhaps the market, in its anthropomorphised all-knowingness doesn’t actually “think” they have the same risk. Perhaps it “thinks” that for some reason Irish bank bonds are riskier than Irish government bonds, despite the government’s willingness to guarantee them. Another quote, this time from a billion-pound fund manager based in the UK:

“I don’t see how they will be able to maintain that guarantee, or at least there’s a risk that they won’t, and certainly the chances of a default on the bank debt are significantly more than on the sovereigns,” Bathgate said by e- mail yesterday. “The risk return just doesn’t add up.”

So it looks as though investors don’t really believe that the government will ensure that all the bank bonds are repaid. It looks as though that might already be priced into the yields of these bank bonds. In which case, perhaps, we should look again at the unguaranteed bonds coming up later this month, and consider what’s really to be gained or lost, by paying them.

Guest post by Sheila Killian: An Audit of Irish Debt

Dr Sheila Killian is head of the Department of Accounting and Finance at the University of Limerick and lead researcher on the debt audit project. The results of the audit, commissioned by AfRI, the Debt and Development Coalition and UNITE, were released yesterday.
An Audit of Irish Debt is the result of 5 months of research from my colleagues Frances Shaw and John Garvey and myself, which has been an interesting journey that we hope has led to a useful picture of the current situation. The banking crisis and the decision in September 2008 to support all of the Irish banks has brought our debt far beyond sustainable levels. Through the Celtic Tiger years, our total long-term bonds increased, but remained comfortably below 40billion. Now they stand at over 90billion, or roughly twenty thousand euro for every woman, man and child in the country. We can add to this our contingent liabilities: the debts of the banks that we have guaranteed, the NAMA bonds, promissory notes, emergency overnight lending and guaranteed deposits. These potential liabilities come to 279bn euro, over three times the already inflated total for government bonds.

The Audit report spells out in clear language where these different categories of debt have come from, how they are inter-related, and discussed the nature of the anonymity that surrounds the names of bondholders. We also discuss other market activities which impact on the risk of Irish debt, such as Credit Default Swaps and short selling. We are grateful for the support of Afri, Unite and the Debt and Development Coalition, and we hope that the report is useful to all concerned people who want to learn more, and forms a foundation for future work in the area.