Friday, October 14, 2016

Facebook responds to IRS court filings

Back in July we briefly looked at court filings the IRS had made into Facebook’s 2010 tax return in the US.  At the time Facebook had yet to respond; but they have now.

Earlier this week Facebook filed their own petition and there is a useful summary here.

Although the additional tax claimed by the IRS for 2010, $1.7 million, is relatively small there are a number of offsetting factors that give rise to the net figure.  Central to the case is the transfer of economics rights of  intellectual property owned by Facebook Inc. to Facebook Ireland Holdings in September 2010 after which date the two companies entered a cost-sharing agreement (CSA) for the continued development and licensing of Facebook’s technology.

As a result of the transfer and the cost-sharing agreement Facebook Ireland Holdings is granted the license to use Facebook’s technology outside of North America.  The IRS make some minor quibbles about the treatment of payments under the CSA but their major issue is the valuation of the IP that existed at the time the CSA for future developments was entered into.

Facebook Inc. put a net present value of $6.7 billion on the intangibles and calculated royalty payments on the basis of that.  The IRS meanwhile have assessed that the intangibles had an NPV of $13.9 billion at the time.  There is quite a substantial gap. In a separate filing related to discovery Facebook claim that their answer was “overly generous”:

Facebook explained that once the IRS errors were corrected, the IRS economic model yielded essentially the same value that Facebook used to prepare its tax returns, or even that Facebook’s tax return position was overly generous to the IRS.

The rights to the intangibles were transferred to Facebook Ireland Holdings on September 15, 2010 and the IRS estimate that an additional royalty payment based on their valuation of $85 million should have been made to Facebook Inc. for the remainder of the year.  Over a full year this would equate to additional payments of around $300 million, assuming payments on a straight-line basis.

So the IRS have revised up Facebook Inc.’s gross royalty income for 2010 by this $85 million (and will likely seek upward revisions of $300 million for a number of years after if the case is upheld).  One would expect that this would have led to a larger tax bill for Facebook Inc. for 2010 of around $30 million (assuming the 35% US CIT rate applies) but the IRS made a number of other adjustments.

Most of these were minor but the biggest of them was that the IRS increased Facebook Inc.’s deduction for Net Operating Loss by around $700 million.  The use of this deduction almost fully offset the additional tax due on the increased royalties.

The IRS adjustments mean that Facebook Inc. will not have the Net Operating Loss deductions applied to 2010 available for future periods and will face higher tax in the US due to the increased royalties that Facebook Ireland Holdings will have to pay. And this latter point highlights the key aspect of many of the global tax strategies used by US MNCs - getting the economic rights to IP developed in the US into entities outside the US (or at least considered ‘offshore’ for US tax purposes).  In this instance ‘offshore’ seems to be Grand Cayman but mentions of that in all the filings to date: nil.

Anyway, if the IRS require much larger payments to Facebook Inc. for the technology developed in the US then Facebook will have much larger US tax payments.  As the company itself says:

On July 27, 2016, we received a Statutory Notice of Deficiency (Notice) from the IRS relating to transfer pricing with our foreign subsidiaries in conjunction with the examination of the 2010 tax year. While the Notice applies only to the 2010 tax year, the IRS states that it will also apply its position for tax years subsequent to 2010, which, if the IRS prevails in its position, could result in an additional federal tax liability of an estimated aggregate amount of approximately $3.0 - $5.0 billion, plus interest and any penalties asserted. We do not agree with the position of the IRS and will file a petition in the United States Tax Court challenging the Notice. If the IRS prevails in the assessment of additional tax due based on its position, the assessed tax, interest and penalties, if any, could have a material adverse impact on our financial position, results of operations or cash flows.

In theory, of course, this is tax that Facebook would have to pay anyway.  But it has set up a structure, as many other companies have, to defer the tax due on earnings made outside the U.S. until those earnings are “repatriated” to a U.S.-registered entity in the company.  Facebook does not make a provision for this deferred tax in its accounts (one reason being that it does not intend to repatriate the profits) so actually paying this tax will have a “material adverse impact” on its operations.

Thursday, September 1, 2016

Why tax campaigners should be aghast at the Apple ruling

The European Commission ruling that Apple should pay €13 billion of Corporation Tax to Ireland has been met with approval in some quarters.  But one problem is that many of those who are approving have a completely different view of how companies should be taxed when compared to the broad logic used by the Commission to reach the €13 billion figure.  It is as if the ruling should be welcomed for the simple reason that it involves more tax (or at least appears to involve more tax).

Would other companies like to replicate the outcome that the ruling reflects?  Absolutely. And particularly for non-US companies as US companies are subject to US tax on their worldwide earnings.  But what about a company in France or Germany?  Would they like to have 60 per cent of their profits taxed at 12.5 per cent in Ireland. You bet they would.

So how can they achieve that?  If we follow the logic of the EC ruling it would be relatively straightforward.

Let’s take a company in France as an example.  The company should aim to have as much of its profits accumulated in a single subsidiary as possible using transfer pricing to maximise the difference between the prices it pays and receives.  There will tax due on the profits on other subsidiaries but the company should be looking for a central ‘hoover’ type subsidiary where as much of the profit as possible is located. 

It could be a company that buys off manufacturing units and then sells on to distribution or retail units or even final customers.  It doesn’t really matter just as long as it captures the maximum amount of profit possible.

This subsidiary can be in France, it can hold intellectual property (which may be how the profit is allocated to it), it can record sales on its accounts, its board of directors can stay in France, its accounts can be maintained in France and its financial assets can be kept in France.  It is crucial though that the company has no employees or physical assets in France.  The company must exist in France “on paper only” (leaving aside the fact that this is  is actually how companies exist).

This subsidiary should then set up a branch in Ireland where the only employees of the subsidiary are located.  The Irish employees implement the decisions of the board of directors.  They can deal with production units within the company and external suppliers.  The can do inventory management on the output to be produced.  They can oversee the logistics of the transport and delivery of the product.  And they can manage the invoicing and payments with customers.

How much profit should be attributed to the Irish branch that undertakes these functions?  Here is the Commission outlining position in the case of the Apple subsidiaries which had their head office in the US and a branches in Ireland with their only employees:

The Commission's investigation has shown that the tax rulings issued by Ireland endorsed an artificial internal allocation of profits within Apple Sales International and Apple Operations Europe, which has no factual or economic justification. As a result of the tax rulings, most sales profits of Apple Sales International were allocated to its "head office" when this "head office" had no operating capacity to handle and manage the distribution business, or any other substantive business for that matter. Only the Irish branch of Apple Sales International had the capacity to generate any income from trading, i.e. from the distribution of Apple products. Therefore, the sales profits of Apple Sales International should have been recorded with the Irish branch and taxed there.

The "head office" did not have any employees or own premises. The only activities that can be associated with the "head offices" are limited decisions taken by its directors (many of which were at the same time working full-time as executives for Apple Inc.) on the distribution of dividends, administrative arrangements and cash management. These activities generated profits in terms of interest that, based on the Commission's assessment, are the only profits which can be attributed to the "head offices".

Per the EC ruling ALL of the profits of this subsidiary should be “recorded with the Irish branch and taxed there”.  The tax to be allocated to France is nil – except for the interest earned on French bank accounts.

If the company can set up this structure they can get a good chunk of their profits taxed at Ireland’s 12.5 per cent and may not have to pay any more corporate income tax on those profits.

How big a chunk depends on the structure of the company and what it does.  Apple is an unusual case in that so much of its profit is derived from IP – design, brand, reputation, innovation etc.  Its central hoover subsidiary had about 60 per cent of the companies profit accumulating in it.  And per the Commission ruling this 60 per cent of Apple’s profits will be subject to Ireland’s 12.5 per cent rate of Corporation Tax. 

This isn’t much of a gain for Apple as US companies are liable for the US 35 per cent federal corporate income tax on their worldwide earnings (though obviously they can defer this).  But France operates a territorial system.  In theory, at least, this means that French companies are only taxed on their profits earned in France.  Profits earned abroad are not subject to French tax.

So our example company could set itself up with a French subsidiary that has a branch in Ireland and have all the profit of that subsidiary taxed in Ireland as long as the only employees of that company are in Ireland.  And it doesn’t matter how many employees. Just a few will do. 

Now we really have Ireland acting as a tax haven.  Think of the possibilities.  Companies all over the world can set up this central subsidiary that hoovers up as much of their profit as possible (within the confines of transfer pricing regulations).  This subsidiary maintains its board of directors in the home country but sets up a branch in Ireland that has the subsidiary’s only employees.  As long as this is the only “operating capacity” of the subsidiary then ALL of the profits will be allocated to the Irish branch and taxed in Ireland.

This would lead to huge profit shifting and significant exploitation of Ireland’s 12.5 per cent Corporation Tax rate.  Countries with territorial system would see large parts of their tax bases shifting to Ireland.  There is no other country in the world where this would be possible but the application of the EC ruling means that this is what Ireland should do. 

Any time the Revenue are faced with a non-resident company with an Irish branch then 100 per cent of profits of that company should be taxable in Ireland if Ireland is the only country that company has employees in.  This is being a tax haven on a grand scale.

How would the authorities in France react if one of its companies tried to pull this stunt?  They would be up in arms.  And rightly so.  There is no way they would accept Ireland taxing 100 per cent of the profits of that subsidiary just because Ireland was the only country it had employees in. 

They would say to Ireland to look at the branch operating there and collect tax based on the risks, functions and assets in the branch and leave the residual profit with the “head office” for the French to tax.  France will only allow Ireland to collect tax based on what happens in the Irish branch.

But this would put Ireland in contradiction to the EC ruling.  The two paragraphs quoted above clearly state that if the subsidiary only has employees in an Irish branch ALL of the profits are taxable in Ireland.  The Revenue Commissioners are between a rock and a hard place.  To avoid falling foul of further state-aid inquires all branches should be treated as the EC ruling requires but France will only allow Ireland to levy tax on the functions that the Irish branch actually undertakes.

This is why there have been many people saying that the EC ruling “flies in the face of international tax practice”.  But not only does it do that it opens the possibility of Ireland becoming a tax haven of grand proportions.  Maybe we should scrap the IDA and set up an agency with the tagline “set up a branch in Ireland, pay all your tax here”.  For companies in countries that have territorial tax systems it would be hugely attractive.  There could be tens of billions in revenue in it for us (if it was possible, which it is not!).

This is all a bit whimsical.  And although what the Commission have done in the case of Apple goes against all principles of taxation what is here is not enough to say they are wrong on the particulars of that case.  We will come back to that.  But it does highlight the inconsistency of some of the reaction to the ruling. 

If other companies set up structures to try and avail of what the ruling offers they would be accused of tax avoidance by many of those welcoming the ruling.  And they would be right. So, rather than welcoming this ruling, if anything, campaigners should be aghast at what this ruling means.  Do they really want the tax system to function as implied by the two paragraphs quoted above?    

Does the arithmetic behind the €13 billion stack up?

In a word: yes.  This is from a post last March which looked at ASI in detail.

But what if the profits of ASI were to be deemed taxable in Ireland?  All the noises are that this is a determination that the European Commission could make.  There seems little basis in fact to support it but I guess there are arguments that could be made.  These may be that:

  • ASI should be deemed tax resident in Ireland
  • ASI is an Irish-registered company
  • ASI has employees in only one country – Ireland
  • ASI only has substance through its Irish branch which is enough to deem the parent, which has no substance, taxable in Ireland
  • Such is the nature of the activities of the Irish branch that ASI’s sales should be considered to be fully completed by it

What happens if all of ASI’s profits are deemed taxable in Ireland? Without the exact calculations it is difficult to tell but if it does happen we will be really at the races and the talk will be of billions not millions.

Assuming ASI performance in 2013 tracked that of the overall company then the cumulative profit earned by ASI over the ten-year period from 2004 to 2013 is somewhere around $113 billion.  If we just do a crude approximation and apply a 12.5 per cent tax to that you get $14 billion.

And you can’t just rock up to the Revenue Commissioners in 2016 and say you want to pay tax due for 2004.  At the very least interest will be applied and the interest rate used by the Revenue Commissioners since 2009 has been the equivalent of eight per cent per annum.   If we apply eight per cent interest to this notional $14 billion of tax due over the ten years then the total liability reaches $19 billion.

The calculation was from 2004 to 2013 and is based on the figures in the table below showing ASI’s profits and taxes.  Convert to €, add in the amounts for 2014 and interest for another 8 months and you get around €13 billion of tax and around €6 billion of interest.  There is nothing wrong with the Commission’s arithmetic.

The table below also shows some of the effective rates used by the Commission in their press release. 

ASI Tax Outcomes

Getting the arithmetic right is one thing; getting the logic right is another.  As shown above we suggested five possibilities through which the Commission might conclude that the entire profits of ASI could be deemed taxable in Ireland.  They went for a variation of the fourth:

  • ASI only has substance through its Irish branch which is enough to deem the parent, which has no substance, taxable in Ireland

Essentially what the Commission have said is that because the parent – which the Commission describe as the “head office” and with the quotation marks! – has no substance (in their view) all the profit allocation within the company should be zero to the “head office” and 100 per cent to the Irish branch (bar some interest income).

So while they have the arithmetic right the key question is do they have the basis for the logic behind the arithmetic right.  We only have the press release to go on so far so it can be hard to tell what the exact justification is.  The government and Apple have the full 130-page ruling so they are in a better position to assess what the Commission have done.  But once the smoked has cleared it is something we will come back to over the next while.

Tuesday, August 30, 2016

Some take outs from the Apple ruling

Lots to muse over in the €13 billion tax ruling from the European Commission in the Apple case today.  And that’s just the tax.  Add the Revenue Commissioner’s 8 per cent per annum simple interest bill on top of that you’re probably looking at something close to €19 billion.  I didn’t think they’d do it but they have. 

Here are some extracts from the Commission Press Release in the order they appeared:

These profits allocated to the "head offices" were not subject to tax in any country under specific provisions of the Irish tax law, which are no longer in force.

This seems to be a bit of a contradiction to what follows later and also a bit of a stretch of what Irish tax law can achieve.  I doubt Irish tax law can be used to argue that profits in other countries are not subject to tax there.  And if these specific provisions of Irish tax law deemed that the profits of the head offices were not subject to tax in Ireland how is that state aid?

This selective tax treatment of Apple in Ireland is illegal under EU state aid rules, because it gives Apple a significant advantage over other businesses that are subject to the same national taxation rules.

Not sure I get this.  If what Apple did was under “specific provisions of the Irish tax law” why couldn’t other companies do it.  I guess some probably did!

This tax ruling was terminated when Apple Sales International and Apple Operations Europe changed their structures in 2015.

Well I guess that confirms where the 26% GDP growth rate in 2015 came from!

Apple set up their sales operations in Europe in such a way that customers were contractually buying products from Apple Sales International in Ireland rather than from the shops that physically sold the products to customers. In this way Apple recorded all sales, and the profits stemming from these sales, directly in Ireland.

Hmmm. I’m not sure that’s true.  Some customers, such as online customers, may have bought from ASI but anyone going to a shop bought the product from that shop – especially when they bought from non-Apple stores such as Currys, Carphone Warehouse, Dixons etc.  These retailers may have bought from ASI but that’s a bit different to saying the customers did.

And even for Apple stores it’s not clear that the customers were buying from ASI.  Apple Retail UK Ltd which runs Apple stores in the UK had £900 million of sales in 2014 (accounts here).  The shops might have bought the devices from ASI but the customers bought them from Apple Retail UK Ltd.

Only the Irish branch of Apple Sales International had the capacity to generate any income from trading, i.e. from the distribution of Apple products. Therefore, the sales profits of Apple Sales International should have been recorded with the Irish branch and taxed there.

And this is the contradiction.  We have “specific provisions in the Irish tax law” in the first extract saying the profits are not subject to Irish tax and the factual position set out by the Commission that only the Irish branch has substance.  The Commission are going for substance over law.

The "head office" did not have any employees or own premises. The only activities that can be associated with the "head offices" are limited decisions taken by its directors (many of which were at the same time working full-time as executives for Apple Inc.) on the distribution of dividends, administrative arrangements and cash management.

I’m not sure “limited decisions” is how best to describe the activities of the board of directors.  They signed the cost-sharing agreement with Apple Inc. which the Commission highlight as being key to the profit earned by ASI.  They negotiated and signed the contract manufacturing agreements with the manufacturers in China.  And they set the price at which ASI could sell the products.  All the key elements of ASI’s costs and revenues were controlled by the board of directors and not the responsibility of the Irish branch.

These activities generated profits in terms of interest that, based on the Commission's assessment, are the only profits which can be attributed to the "head offices".

So the EC are attributing 60 per cent of Apple’s global profits to what goes on in Hollyhill in Cork because the “limited decisions” of the board of ASI only generate interest income.  Everything else is down to the staff in Cork. That’s serious productivity!

This is only a first run through the ruling and this is only from the press release.  In a couple of months we’ll get the full 130-page decision (minus some redactions) so we’ll see then if the Commission have their ducks in a row. 

And if you want to look through the finer details of Apple Sales International they are in this previous post which showed that the approach proposed by the Commission gives a tax bill of $14 billion for 2004 to 2013.  Add 2014 and you get to in and around the €13 billion figure the Commission have come out with.  And the interest probably comes to another €6 billion or so (if we apply the Revenue Commissioner’s 8 per cent simple interest rate).  €19 billion. Who’d have thunk? Not me!

Tuesday, August 16, 2016

The latest Corporation Tax pot of gold

Ireland’s Corporation Tax generates a huge amount of domestic debate.  There are a couple of common themes that run through it.  One of them is that “we would collect X billion in extra tax if only we did Y.”  The latest of these relates to companies who have no liability for Corporation Tax under the headline “68% of companies paid no Corporation Tax in 2014”.

There is, of course, a pretty simple reason why most companies don’t pay Corporation Tax: they don’t make a profit.  This is because they have never started trading, stopped trading or are trading but didn’t generate a taxable profit.  There a several reasons why companies are established with trading for profits being only one of them.

However, the story doesn’t end there and goes on to say that companies with no Corporation Tax liability actually had earnings of €17 billion in the period from 2009 to 2014.

The Irish Corporation Tax regime is actually relatively straightforward.  Once a company’s taxable income is determined it is multiplied by 0.125 (or 0.25 in some cases) to get the gross tax due.  There are then a limited number of credits and reliefs available which give the ultimate calculation of tax payable.  Here is an aggregate calculation using 2011 data.

So if there are €17 billion of earnings out there that results in a tax payable of zero it shouldn’t be too difficult to work out what is going on.  And it isn’t.  First here are the annual figures:

Companies wth no CT liability

The average amount of net taxable income per company with no Corporation Tax liability is just under €32,000.  But the distribution is probably highly skewed because it requires the use of the limited credits and reliefs we have to get the gross tax due from the €16.8 billion of net taxable income to a tax payable of zero.  And indeed those making the queries were told as much:

The Department of Finance says there is a range of tax reliefs available to companies which explains much of this, such as double taxation relief, which prevents companies being taxed on profits they have already paid tax on elsewhere or tax reliefs that apply to research and investment.

But that didn’t stop some heroic conclusion jumping been made:

Sinn Féin says vital public services have suffered as a result. Employers, however, say Irish businesses already face high taxation.

TD Louise O’Reilly said: “Our estimation is that from 2009 there could potentially be 2.1 billion euro in tax revenue that has been forgone by the State through whatever means. I think when you’re looking at figures that size though, you’re not talking about simple loopholes. You’re talking about government policy.”

Yes, €16.8 billion multiplied by 0.125 is €2.1 billion but wouldn’t it be helpful to actually understand why the tax payable on this net taxable income is zero and propose to remove the provision that results in it rather than just shooting off blindly.

Here are the reliefs and credits used by the companies with nil or negative Corporation Tax liabilities over the six years in question.

Companies wth no CT liability reliefs and credits

And there is the €2.1 billion reduction of the €2.1 billion gross tax due to give tax payable of zero.  Almost 95 per cent refers to Double Taxation Relief.

Ireland operates a worldwide Corporation Tax system whereby Irish-resident companies owe Irish Corporation Tax on their earnings no matter where earned and can owe Irish Corporation Tax on dividends from subsidiaries and other passive income receipts.

However, if an Irish-resident company earns profits through a branch or subsidiary in another jurisdiction it will pay corporate income tax on those profits in that jurisdiction.  In Ireland these profits will be included in the company’s taxable income and the gross tax due will be calculated including foreign profits.  To avoid double taxation the company can apply for relief of the gross tax due in Ireland based on the corporate income tax paid in the foreign jurisdiction. 

It is fairly obvious that in this instance we are dealing with a small set of companies who have no domestic profits (which would trigger a tax liability excluding them from the above table) and have foreign earnings where the foreign tax paid exceeds the amount of gross tax due at Ireland’s Corporation Tax rates thereby giving a tax payable figure of zero.  These companies are not avoiding tax; they have already paid it.  If the amount of eligible foreign tax paid was less than the amount of Irish tax the company would have to pay the balance to make up in the difference.

So, in theory, we could have collected €2 billion of extra Corporation Tax over the last six years if we had abolished Double Taxation Relief from 2009.  And the figure would be even higher as this €2 billion only includes companies who have nil or negative Corporation Tax liabilities.  Over the past six years the total amount of Double Taxation Relief granted to all companies has been almost €4 billion (and was almost €1 billion in 2014 alone).

But getting at this latest pot of gold depends on these companies with foreign profits continuing to be Irish resident which would subject them to an additional 12.5 per cent (or 25 per cent) tax on top of the corporate income tax paid where they earned their profits.  Would companies stick around for such double taxation? And if Irish-resident shareholders move away with them we would lose the income tax collected from distributed dividends.

Double taxation relief is not just “government policy” it is international best practice in taxation around the world.  And it is probably going to get more attention in Ireland as inversions and re-domiciled PLCs increase the number (and size) of companies who are eligible for it.