February 2016 (157) – MAYHEM

My work day begins with seeing the familiar Google logo in my browser window. I take for granted the ability to find a local restaurant or to explore a city I want to visit. I rarely stop to think about the magic that goes on in air conditioned data centres in the other hemisphere, let alone about how Google pays for electricity to keep them running.

In the beginning, I used to be bemused when for weeks after looking for a place that serves sea bass I would keep seeing local fishmonger adverts in my search results. This was until I learnt that Google studies my browsing patterns and sends me targeted adverts, which it monetises to form the bulk of its multi-billion revenue. In Google’s own words:

“We generate revenue primarily by delivering relevant, cost-effective online advertising.”

Despite embodying capitalism at its purest form, for a long time Google’s guiding principle had been “Don’t be evil”. Since Google’s recent transformation to Alphabet, it replaced the motto with a broader statement that Alphabet’s employees and affiliates “should do the right thing — follow the law, act honourably, and treat each other with respect”. Judging by the latest assessments emanating from various tax administrations, Google’s declared principles have been put to the test.

In January 2016, Google reached an agreement with HMRC to pay £130 million in UK corporation tax and interest as a result of HMRC’s investigation which started in 2010. The agreement has been dubbed a “sweetheart deal” largely because, to the Government ministers and to the general public, the UK tax liability seemed paltry compared to Google’s total £4.6 billion of sales to UK advertisers. In response the company argued that it traded through its 5,000-strong workforce in Dublin and, in the absence of a UK permanent establishment, was not liable to UK’s corporation tax.

Those of our readers who want to be reminded about the traditional concept of a permanent establishment are welcome to read our December 2009 newsletter (click here), which discusses it in depth.

On 9 February 2016 HMRC published a factsheet where it professed a dedication to collect tax revenue within the scope of the existing national and international tax principles (click here). Unusually, HMRC spoke in defence of Google stating that it was incorrect to judge the tech giant by its group profit margin, which when applied to its sales to UK customers, resulted in an effective tax rate of around 3% on the group’s profit’s arising in the UK.

HMRC went on to explain that instead, under international tax rules, Corporation Tax applies to profits created from economic activities carried on in the UK, not to profits from sales to customers in the UK. Many elements contribute to a multinational business’s economic activity and thus generate the profits, including the work that staff do, the technology used by and driving the business, intellectual property and other assets as well as where those assets are developed and actively managed. However, HMRC avoided confirming or disagreeing with the fact that Google’s activities constituted a permanent establishment in the UK, simply stating that it took all relevant circumstances into account in arriving at the calculation of the right amount of corporation tax that Google duly paid.

In one of our newsletters (click here) I spoke of difficulties of marrying taxation and morality. In May 2013 Margaret Hodge MP, the chair of the Public Accounts Committee (PAC) attacked Google by accusing the company of being “calculated and unethical” over how it pays tax in the UK and in fact calling it “evil” despite not finding evidence of formal breaches of law.

Now in February 2016 we see how the stand against international companies’ taxation has developed from personal incursions to the call for the review of the international tax system in general. The PAC assessed the “sweetheart deal” I refer to above and concluded that it is not possible to judge whether a £130 million tax settlement agreed between Google and HMRC is fair to taxpayers (click here) . The Committee still found that the sum paid by Google “seemed disproportionately small when compared with the size of Google’s business in the UK, reinforcing its concerns that the rules governing where corporation tax is paid by multinational companies do not produce a fair outcome”. However, instead of pushing Google to contribute more to the public coffers, the Committee in its recommendations to Government calls on HMRC to “lead the way in pressing for changes in international tax rules to prevent aggressive avoidance by multinational companies”, particularly in the area of international exchange of information.

Google’s perils do not end in the UK, which is its second largest market after the US. Its £130 million tax assessment is a tip of the iceberg compared to what it may have to pay to other countries. The Italian tax authorities have recently announced their belief that Google evaded 227 million Euro in taxes, and now we have heard that the French tax authorities have issued an assessment of 1.6 billion euro in back taxes. Furthermore, the French Government officials ruled out striking the same deal with the search company as HMRC did, saying the sums at stake in France were “far greater” than those in Britain.

Even if we discount Google’s bona fide affirmations as part of their PR campaign, it simply cannot afford being too “evil” on the tax front in light of public scrutiny, which a company of its stature attracts worldwide. And I am sure that Google employs the best tax and legal minds, which help the company stay within international legislative boundaries. Yet it seems that we are witnessing a global shift in the same boundaries where long-established principles — those founded when a stall with brussels sprouts at a market square would constitute a permanent establishment as explained in my December 2009 newsletter — are no longer appropriate to help collecting tax revenue in the modern age.

Readers may recall my review of the OECD BEPS project in our October 2015 newsletter (click here). Of particular relevance to this discussion are my views on the digital economy, which is driven by companies that do not require physical presence to trade and that can easily shift revenue from high tax to low tax jurisdictions. This leaves many developed economies — in this case the UK, Italy and France — at a disadvantage, particularly because of the slow adoption of legislative changes to combat what they perceive as abuse for their tax systems. This brings us to the UK lawmakers resorting to human terms when talking about corporations in their attempt to collect tax. Admittedly, though, neither French nor Italian tax authorities have yet published details of their investigations into Google’s affairs.

The BEPS’s action points are subject to implementation by each OECD/G20 country individually although the OECD has just announced (click here) that it will establish a framework to allow any interested country to join in efforts to update international tax rules for the 21st Century. In OECD’s own words “to help the governments to close the gaps in existing international rules that allow corporate profits to «disappear» or be artificially shifted to low or no tax environments, where companies have little or no economic activity.”

The main difficulty with the BEPS project lies in the fact that despite the good intentions behind it, the initiative is only as good as the laws that are passed by the countries that want to adopt the action points, and until then it remains declaratory, albeit highly influential. On 28 January 2016 the EU Commission announced (click here) its intention to introduce a pan-European implementation of the BEPS recommendations and I cannot overstate the importance of this announcement.

The Commission announced in a useful factsheet the following:

1) It would introduce legally-binding measures to block the most common methods used by companies to avoid paying tax;

2) Make a recommendation to Member States on how to prevent tax treaty abuse;

3) Introduce a proposal for Member States to share tax-related information on multinationals operating in the EU;

4) Recommend actions to promote tax good governance internationally; and

5) Create a new EU process for listing third countries that refuse to play fair.

Points 1, 2 and 3 are particularly important for Google and a host of other international companies, such as Starbucks and Amazon that have attracted flak in the recent past. They will be embodied in the Anti Tax Avoidance Directive that will contain six legally-binding anti-abuse measures, which all Member States should apply against common forms of aggressive tax planning. These include:

1) Controlled Foreign Company (CFC) rule: To deter profit shifting to no or low tax countries;

2) Switchover rule: To prevent double non-taxation of certain income;

3) Exit Taxation: To prevent companies from re-locating assets purely to avoid taxation

4) Interest Limitation: To discourage companies from creating artificial debt arrangements designed to minimise taxes;

5) Hybrids: To prevent companies from exploiting national mismatches to avoid taxation; and

6) General Anti-Abuse Rule: To counter-act aggressive tax planning when other rules don’t apply.

Once the European Parliament and the Council adopt the new measures, they will become part of the Member States’ legislation arming domestic tax authorities across 28 countries.

Despite the EU’s harmonised legislative scheme and considering the absence of such unification outside the EU, it is expected that the number of international tax disputes between two or more States (often with a taxpayer caught in the middle) will increase significantly as a result of the OECD BEPS initiative. Tax administrations may claim the existence of permanent establishments, or deny treaty claims, or simply claim a greater share of widely available reporting obligations. Mutual agreement procedures (MAPS) have not yet been adequately developed to protect taxpayers from the prospect of expensive and lengthy disputes with tax administrations. What can be done to improve this? How to advise those caught up in these proceedings? These issues will be discussed at the IBSA workshop on 12th April as explained in the introduction to this newsletter.

Join this IBSA workshop (click here), which is privileged to have secured a representative of HMRC, along with leading dispute resolution professionals, and the tax director of a global industry leader, to examine these issues, share thoughts on what organisations are doing to prepare for the changes ahead and discuss how the professional community should protect its clients.

On the subject of the IBSA, we are holding a branch discussion group on Wednesday 2nd March at Farrer & Co (click here) where we will consider how companies can best utilise the value of their intellectual property on their balance sheet and structure international expansion. We will examine how to protect IP – cost v benefit – valuation and tax considerations with experts in the field. The meeting is open to IBSA members but those IFS newsletter readers who have not previously been to an IBSA discussion group are welcome to attend as my guest. Simply register your attendance and add IFS Newsletter Reader.

This is the first newsletter of 2016 and I hope the year has started well for all our readers. Our next newsletter will review the implications of Brexit and how some of the issues mentioned in this newsletter will be affected by Brexit, if it happens. We now have 4 months of discussion, manoeuvring, back-stabbing and general mayhem before 23rd June! If you want to know the derivation of mayhem as I did, I suggest you Google it and see what adverts come your way on the topic of violent destruction!

With kind regards

Roy Saunders and Dmitry Zapol