Having spent the last 40 years studying international tax systems in most of the developed countries around the world, I want to offer those in charge of fiscal policy and raising tax revenues some alternative ideas for their consideration. But first, they need to face the truth. It’s their responsibility that the tax revenues are neither adequate for their needs nor properly reflect the profitability of their taxpayers.
Without using Starbucks as a scapegoat, let’s take a look at their annual accounts, a matter of public record and which serve as the basis for submitting tax returns to the tax administrations. In the UK, for example, Starbucks shows losses from 2008 to 2011 of £26 mn, £52 mn, £34 mn and £33 mn respectively, despite being the second largest restaurant/coffee chain in the world after McDonald’s, and despite having first opened in the UK in 1998. Hardly a newly created organisation that needs to penetrate the market before making profits, especially when it reports coffee sales in excess of £3 billion during this period. Who at HMRC was responsible for allowing such losses to pass unnoticed until now? Who at HMRC has accepted a 6% royalty payable to Starbucks Netherlands when other companies including McDonald’s charges royalties at a lower rate? And who at HMRC has accepted huge payments made to Starbucks Amsterdam for its Dutch roasting operation, or ascertained why Starbucks Switzerland has made such enormous profits from buying coffee beans and selling them to its UK operation? And finally who at HMRC has accepted interest payments at a higher rate than current low rates dictate?
It is clear that Starbucks itself is responsible for its intercompany pricing and trading arrangements, and its advisors should have known that regular losses would inevitably trigger a backlash if the public is being told at the same time by its management that Starbucks is a very profitable organisation. But HMRC and therefore the Government has to take its share of responsibility for this furore. It’s no good complaining about the coffee if you can’t count the beans!
It is abundantly clear that subsidiaries and affiliates within multi-national groups have relationships with each other, either as regards trade or perhaps licensing or financing activities, and artificial pricing structures as a means of profit diversion are well known in all developed countries. And the Dutch ‘royalty route’ has been around even longer than I have been practising, which is a rare phenomenon! I thought it may be interesting therefore to see how other countries consider the tax consequences of intercompany pricing arrangements.
For example, in Germany, Section 1 of the Foreign Tax Act deals with adjustment of inter-company profits requiring a normal return on capital, and the German tax administration has published ‘administrative principles for the examination of income allocation of international affiliated enterprises’ (the so called Verwaltungsgrundsätze) in an attempt to create uniformity within the German tax administration.
Thus, each taxpayer is obliged to prepare documentation on transactions between the German taxpayer and related parties, the scope and contents of this documentation being defined in a decree on the documentation of profit allocation; the documentation must be presented to the tax authorities within 60 days upon request with non-compliance of this time limit causing heavy penalties.
The basic premise followed by the tax administration in Germany with these administrative principles is that no company should work for a profit less than that which can be expected to be earned in that industry under prevailing market conditions. Low profits or actual losses may only be admitted under the following circumstances:
(a) losses incurred in introducing products in a new market previously untried are accepted, since the cost of establishing the new product, e.g. advertising, may be high;
(b) losses incurred because of management error may be accepted, or may be attributed to a foreign parent company, if the error is the parent company’s responsibility; in other words, an adjustment is then made to the domestic German company’s losses;
(c) a newly founded company may take five or six years to be profitable, an effect recognised by the tax authorities; and
(d) finally, losses incurred may be accepted because of general market conditions, bad debts or other extreme circumstances.>
However, if the losses are not incurred as a result of the above points, then the German tax authorities will investigate the reasons behind such losses and, if they result from artificial pricing manoeuvres or other artificial transactions, adjustments will be made.
As with other tax jurisdictions artificial pricing policies may also apply to interest payments, royalty payments, management fees etc. The administrative principles consider whether loans are constructive capital contributions with the result that interest payments are constructive dividends; in any event interest rates are to be comparable to market conditions, or if the loans are denominated in a foreign currency, then the rate obtaining in the currency area of that foreign currency is the appropriate rate. Royalty payments will only be allowed if they leave the licensee company with an acceptable commercial profit from the licensed product.
The above underscoring is an emphasis I have made in connection with the Starbucks exposure. Is it too much to conclude that the natural German efficiency in following these guidelines generates greater tax revenue than their counterparts in the US, UK and elsewhere? And yet all developed countries have so called transfer pricing legislation which permits the same penetration of accounting profits to establish the appropriate return on which taxation may be levied.
The United States has an interesting alternative basis of assessment where a company’s taxable income within a group consolidation is proportionately less than the total income reported by the group. The ‘unitary’ basis of taxation used to be on a global basis, but is now restricted to States within the US only.
These State taxes are assessed on taxable income pursuant to normal accountancy principles, even in those States whose internal tax legislation allows them to impose taxation on the unitary principle. For these latter States however, where a corporation has affiliates, parents or subsidiaries, the unitary method of taxation may be adopted as an alternative basis of assessment.
Under this principle, the taxable income of a corporation within a State is arrived at by aggregating the national (previously worldwide) profits of the group of companies of which the corporation is a part and, under this combined reporting method, allocating the profit of the corporation on the basis of, for example, the turnover, payroll and property within the State, compared to the total combined turnover, payroll and property. Passive income is not apportioned under the unitary principle which is only applicable to business profits.
At present, approximately 22 states operate such a system; however, they have agreed a restriction to the “water’s edge” approach and there seems to be a growing body of opinion against the operation of unitary taxation. The arguments against this basis are that the compliance costs are high and a US corporation can be assessed to taxable income in one State even when an overall commercial loss has been made. The arguments in favour of unitary taxation, however, are that the State obtains a current tax yield without having to consider whether the locally reported profits are correct, taking into account the traditional principles of inter-company pricing.
Multinational corporations have attempted to challenge the right of individual States to tax them on a unitary basis, but in June 1983, the US Supreme Court held in the case of Container Corporation of America v Franchise Tax Board (California) that California did not violate the Constitution by computing tax under the unitary system. Similarly, the US Supreme Court ruled on June 20, 1994 in the cases of Colgate-Palmolive Plc and Barclays Bank Plc against the California Franchise Tax Board that the US Constitution was not violated by the imposition of unitary tax, so that the State of California need not refund taxes already paid as computed under the unitary tax method.
It may be interesting to see whether developed countries around the world could benefit from using this system, not necessarily as a basis of assessment, but as a calculation to see whether domestically reported profits appear to reflect the global business profitability of the enterprise. If they do not, then further investigation should follow as to whether transfer pricing manoeuvres have affected reported profits.
Taking California as an example, and limiting the unitary tax to a water’s edge approach within the US, it would appear that the unitary method of apportionment of total profits will only be applied if three tests are met:
(a) there must be unity of ownership, i.e. more than 50 per cent of a US corporation’s voting stock is owned by the group; and
(b) there must be unity of operation as evidenced, for example, by centralised purchasing, substantial inter-company loans whether interest bearing or not, mutual transference of employees, common internal audits, and the provision of central administrative services; and
(c) unity of use in the centralised executive force, for example common directors of US and overseas subsidiaries.
It is possible, therefore, to avoid unitary taxation of a Californian corporation (and this can serve as an example for other States) if there is in fact no unity of operation; if the Californian operation is totally self-sufficient from the parent company and is locally managed and controlled, then no unitary taxation should be imposed, taxation being based instead on normal principles of accounting. However, in the case of Starbucks UK to revert to the focal point of this article, the inter-relationship between the franchising of the name and other intellectual property as well as the purchase of the coffee beans within the group as a whole may well create this unity of operation.
The following example shows the way in which unitary taxation would work, at least to demonstrate whether normal profit allocations between related parties has occurred.
Example
Frisko Inc is a California based corporation which is part of a US group. It has sales of $25 million on which it achieves a net return of 8 per cent, which should be subject to tax in California at 9.3 per cent under normal accountancy rules. It employs 200 people costing a payroll of $3 million pa and has property valued at $10 million.
The US group of which it is a member has sales of $150 million but achieves a higher net return of 10 per cent on average. Productivity of the 1000 employees is slightly higher at a lower total wage cost of $13 million, and total US property is valued for balance sheet purposes at $50 million.
The unitary tax calculation is:
| Frisko Inc: Total | Percentage | |
| (a) Sales | 25:150 | 16.67% |
| (b) Payroll | 3:13 | 23.08% |
| (c) Property | 10:50 | 20.00% |
The average of the above three percentages is 19.92 per cent which, as a percentage of total US profits of $15 million (10 per cent of $150 million) is $2,988,000 which will be subject to California tax at 9.3 per cent.
The comparison that must be made is therefore:
| Taxable Profits | Tax Payable | |
| (i) Normal accounting principles | 2,000,000 | 186,000 |
| (ii) Unitary principle | 2,988,000 | 277,884 |
Two conclusions may be drawn from this example. The first is that taxable profits may vary greatly under the two methods of computation of profits (almost 50 per cent higher in the above example); the second is that the final tax bill may not be significantly different bearing in mind that any additional State tax payable as a result of a unitary re-allocation should result in a correspondingly lower State tax elsewhere, subject to similarity of State tax rates (which is not always the case).
Moreover, although the State has an option to impose taxation on the unitary method if it considers that the taxpayer is part of a unitary concern, if the State adopts such an attitude but subsequently finds that its tax revenue is smaller than it would be if the taxpayer were assessed only on local profits, the State then has to prove that the taxpayer is not part of a unitary concern. As an example of this ironic twist in unitary taxation, California, which for years has assessed British American Tobacco on the unitary basis now wishes to take the opposite view to increase its tax revenue and this is being resisted by BAT!
This alternative basis of taxation may indeed add a layer of both complexity and administrative burden, yet it may throw up anomalies in tax returns such as Starbucks, Google and Amazon, where locally reported taxable profits are far lower than those achieved on a consolidated worldwide basis.