A great many people suffered during the Great Recession of 2007-2009. Unemployment soared in both the United States and Europe. Millions lost large chunks of their savings. Who was to blame? In the court of public opinion, big, “financialized” business was placed in the dock.
Big business, the public felt, had been gaming the system. While the economy recovered ever so slowly and people searched for hard-to-find jobs (frequently at lower wages than they had earned previously), big business appeared to be pocketing huge profits and (people read and believed) not paying their fair share of taxes in the countries in which they operated and earned their revenues and profits.
With the public clamoring for redress, politicians (and governments) began looking into corporate tax policies and practices.
The first stage in this evolving process involved public shaming. Amazon, Apple, Google, Starbucks and other large U.S. multinationals were held up as examples of tax miscreants. In May 2013, the U.S. Senate’s Permanent Subcommittee on Investigations released a report that alleged that Apple had reduced its corporate income tax by approximately $10 billion a year for the previous four years in succession by locating its income in jurisdictions where taxes were lower than the United States’ 35 percent corporate tax rate. In the UK, it was revealed that Starbucks, which had 2012 sales of £400 million in Great Britain, had paid no corporate tax there at all. And the storylines were similar for other companies. However, while this publicity caused these corporations a measure of reputational damage, it had limited impact on their revenues or valuations or generally, to date, on many of their corporate tax policies — which were legal. While tax evasion is a crime, tax avoidance is not.
However, the rules governing corporate tax policy are changing in both the United States and Europe. Reputational difficulty soon may turn into penalties and fines if companies do not revisit not only their tax strategies and policy but the thinking and processes that go into devising them.
Tax Policy: The Narrow View
Companies have long regarded international tax policy purely as a matter for their legal, tax and finance functions. And many of these functions have been incentivized in one direction: to pay less tax. As a result, some companies have established a policy intended to minimize their tax liabilities, and corporations have created a variety of sophisticated strategies to do just that.
Furthermore, companies have had national partners in advancing these tax minimization structures as countries have competed to attract multinationals (and the jobs and investment that follow) by offering certain tax-related incentives if these large corporations locate their operations in certain jurisdictions. And, again, all this has been legal.
Consequently, companies have felt no need to develop a new tax policy to harmonize with the growing public and political dissatisfaction with current corporate tax regimes. Nor have corporations felt the need to communicate the reasoning behind their tax policy to their public stakeholders.
This, however, is changing. Right now, governments and policy organizations are increasing their attacks on corporate tax avoidance strategies and structures, proposing changes to their tax policy and regulations that will make the old schemes difficult and/or impossible to implement. Therefore, companies must develop new tax strategies, structures and policy — and the optimal way to do so is to bring together functions such as the C-suite, human resources and communications that previously played a very small part (if any) in devising tax policy. Not only that, it behooves companies to ensure tax policy is reappraised at a board-level as, with the coming era of greater tax transparency, companies now must decide how they want to present themselves to the world and determine what the goal of their tax strategies should be beyond mere minimization.
As the World Turns, Swiftly
Even as some multinationals were being pilloried in the press for their tax behaviors, a wave of tax inversions (in which large corporations acquire smaller companies in order to change domicile and take advantage of a lower tax rate in those new jurisdictions) was sweeping the markets. These inversions involved companies such as Ohio’s power management company Eaton re-domiciling to Ireland after acquiring Cooper Industries in 2012. And there were many other inversions, either proposed or concluded.
These inversions, the acquiring companies argued, were necessary to open new markets and remain globally competitive. However, with some exceptions, these actions were not viewed that way by the public; they were seen as schemes to avoid paying the U.S. corporate tax rate, which, at 35 percent, is the highest in the developed world. This public perception put pressure on Congress and the Obama administration to reform the U.S. corporate tax system and, at the same time, discouraged many companies from following through on planned inversions. For example, the acquisition of Shire plc by Chicago- based AbbVie Inc., intended (in part) to take advantage of lower corporate tax rates outside the U.S., was abandoned.
In September 2014, the Department of the Treasury released Notice 2014-52 that (among other things) prevented formerly U.S. domiciled companies from accessing the cash of the acquired foreign company without repatriating it (that is, bringing it back to the United States), thereby exposing it to U.S. taxes. On July 8, 2015, a report was filed with the U.S. Senate Committee on Finance that, among other recommendations, urged lowering the tax on foreign-earned income — that is, proposing a more territorial approach to corporate taxation. That would remove the incentives for U.S. companies to keep and invest their overseas profits offshore. Given the now almost endemic gridlock and partisan divisiveness in Congress, it is unlikely any tax reform measures will go forward in advance of the 2016 presidential election, except perhaps a narrow reform of international taxation to help pay for some domestic infrastructure spending. The next few months will show whether the U.S. government can make a down payment toward tax reform while undertaking some much needed domestic spending.
In contrast, today, the European Union ("EU") is moving swiftly to address these and other tax avoidance practices by multinational corporate entities.
Moreover, the 2014 G20 Summit stated its determination to address Base Erosion and Profit Shifting ("BEPS") to "ensure that profits are taxed where economic activities generating the profits are performed and value created." To accomplish that, the summit mandated the Organisation for Economic Co-operation and Development ("OECD") to overhaul the global corporate tax system. The G20 also endorsed a template for country-by-country reporting of tax revenues.
In other words, every company now would have to report what it earns in every country.
This move toward transparency will come as a shock to many Corporate Tax departments, and they must file their reporting no later than the end of their first fiscal year in 2016.
The OECD defines BEPS as tax planning strategies "that exploit gaps and mismatches in tax rules to artificially shift profits to low- or no-tax locations where there is little or no economic activity, resulting in little or no tax being paid." Companies shift profits, in the OECD’s evolving understanding, because uneven global tax rates have led them to shop for domicile and nexus in jurisdictions with a low corporate tax rate such as Ireland, where the rate is 12.5 percent. The OECD’s BEPS project is intended to be completed, and to make its final recommendations, by the end of 2015.
On another front in the tax revolution, in June 2015, the European Commission announced a new Action Plan to make corporate taxation fairer, highly efficient and more transparent in the EU.
The Action Plan is intended to improve the EU’s framework for transfer pricing (in which divisions of a company transact with each other, allowing the parent company to record revenues in the most advantageous tax jurisdictions), patent boxes (that offer a reduced tax rate on revenues derived from intellectual property ("IP") located in jurisdictions with a lower tax rate even if the IP was developed elsewhere) and a variety of shelter practices. Many of these latter practices were revealed in the so-called "Lux Leaks," which disseminated information about Luxembourg helping companies (such as Disney and Koch Industries) establish complicated, corporate structures in Luxembourg. These structures allowed companies to funnel profits through those often paper entities to take advantage of the country’s 2015 value-added tax of 17 percent (the lowest in Europe) and its 22 percent corporate tax rate (as compared with Germany’s almost 30 percent or France’s 33 percent). Largely as a result of the controversy arising from the Lux Leaks report, the European Commission reportedly is looking into the tax structure of more than 100 companies.
Included among the European Commission’s proposals to promote a growth-friendly taxation policy is the relaunch of the Common Consolidated Corporate Tax Base (“CCCTB”) concept, first proposed in 2001. The CCCTB proposal, which will be published in the first quarter of 2016, would provide a mandatory single set of rules to calculate taxable profits for all companies operating within the EU. And the commission says it will go beyond the OECD’s BEPS measures to demand greater transparency on transfer pricing designed solely to reduce tax liabilities. But corporations need not wait until next year to appreciate the seriousness of the commission’s intentions — or the impact it’s already having.
For example, as of January 2015, all companies registered in Ireland also had to be a resident — that is, they had to maintain significant materials, operations and workforce there — to qualify for the country’s lowest-in- Europe corporate tax rate.
In June 2015, the commission published a list of what it deemed to be the top 30 non-cooperative jurisdictions, including Bermuda, the British Virgin Islands, the Cayman Islands and Hong Kong. And the commission said it will consider possible aggressive measures within three years if those nations, where many multinationals maintain entities (some only existing on paper, to be used when and if needed), do not comply with good governance standards. The commission will define the technical aspects of those standards in its Platform for Tax Good Governance, slated to be published by the end of September 2015.
This focus on corporate taxes is not limited to the United States and Europe. Countries around the world are exercising sovereign powers in new ways, taking on bigger countries and large companies. Mexico, for example, with the lowest tax revenues in the OECD, reportedly has been investigating 270 companies (the majority of them U.S. firms) for allegedly attempting to avoid taxes by recording Mexican-derived profits in lower tax jurisdictions. (The UK recently announced in its 2015 budget that £5 billion will come from a crackdown on tax avoidance and loopholes.)
The aggressive pursuit by governments of what they deem to be their deserved portions of tax revenues soon could become a hurricane blowing through the boardroom of multinationals, overturning decades of tax strategy, threatening business models and putting profits at risk. According to a Financial Times report, JPMorgan Chase has estimated, for instance, that Apple could be on the hook for about $19 billion if the European Commission rules that it has violated international tax avoidance rules already in force through its arrangements in Ireland over the past 10 years. According to the Financial Times, Apple has warned its investors that it could suffer a material hit if Ireland is forced to claw back that money.
But corporations have been slow to react to these global changes. In particular, Government Affairs departments have been late in recognizing the need to engage in the political process if they wish their company’s voice to be heard in the policy debates and decisions going on right now.
In this new, somewhat anti-business global environment, engagement is necessary, and developing a transparent tax policy, practices and strategies is becoming more and more critical.
Toward a Broader View of Tax Policy
It certainly is no crime for a company to attempt to limit or even reduce the taxes it pays. Doing so is a legitimate business endeavor, and governments recognize that. However, it is becoming increasingly clear that a political consensus has gelled that holds that strategies designed for no other purpose than avoiding or mitigating tax liabilities run counter to the best interests of the interconnected, interdependent global economy. Governments and policymaking bodies appear to be intent on enforcing the concept that corporations have a responsibility to pay taxes in the jurisdictions where their income is earned. The G20 and OECD are also committed to levelling the playing field to reduce the practice of jurisdiction shopping from which benefits often are retrieved unevenly and unequally. For example, the practice of locating IP in tax advantageous jurisdictions — such as Ireland and Luxembourg, where the tax rate for royalties derived from that IP is 0 percent to 1 percent — is, seen by many as a species of state aid, which, under EU rules, is barred. In an interview with the BBC, the Director of the OECD Tax Policy Centre was quite explicit in condemning multi-national behaviour in tax planning, referring to it as "extremely aggressive" and "pushing the boundaries of what is legal."
To thrive in this new environment, companies need to broaden their understanding of their business interests as they relate to tax policy. Based on substance, on the real-world implications of their policy, companies should incorporate into their strategic thinking the impact their business has on the communities in which they operate. For example, if a company chooses to locate operations in a foreign jurisdiction to reap legitimate tax policy benefits, it should return the favor by contributing to the welfare of that jurisdiction: creating jobs, building infrastructure and improving the nation’s overall quality of life. Companies need not do this to appear angelic, and they need not do anything that runs counter to their business interests. But those interests may be broader than formerly assumed. Today, they may include avoiding reputational damage that could impair future earnings — certainly a legitimate business concern.
Among other actions, this requires that businesses examine their global footprint to review potential vulnerabilities in their tax structure. For instance, many multinationals in the United States hold structures in Bermuda, the British Virgin Islands and the Caymans. Many times these structures are dormant but are held open to park future revenues or to serve as convenient tools for doing deals later on. However, these structures are red flags. Maintaining them may be a risk greater than any benefit that could be retrieved from their potential use. Companies must realize that if they are doing something improper somewhere, anywhere, it could jeopardize their operations everywhere. From a tax policy perspective, the totality of an organization’s operations should be considered holistically.
Reviewing a company’s global footprint also should include an assessment of its IP practices. Corporations that sell products derived from IP in high-tax jurisdictions but which locate that IP in more advantageous locations for the purpose of taking tax advantages on revenues should review this practice. Increasingly, it is being viewed as a distortion of the competitive landscape even when enabled by a cooperating government. This, in effect, is another red flag, an additional risk. The European Commission’s 2011 review of the Interest and Royalties Directive amended it to state clearly that EU nations can grant the benefits of the directive only when "the interest or royalty is not exempt from corporate taxation."
Again, the intent of the commission is to enforce substance in corporate tax policy to bring taxation closer to where profits are generated.
Finally, to devise and implement these changes to corporate tax policy, all stakeholders should be brought to the table. Tax policy no longer can be left to a company’s legal, tax and financial functions. Tax policy should be made in concert with the board of directors, the C-suite, human relations and communications. Today, a company’s tax policy is part of the face it shows the world. Surely, that is the concern of all stakeholders especially the leaders.
Beyond the P&L
Today, the traditional role of tax policy — a way to limit expense and maximize shareholder return — has become outdated, overwhelmed by forces beyond any one company’s control. Tax policy now needs to be regarded as an instrument of a corporation’s global strategy that embodies how a company wishes to be considered in the markets in which it does business. Ideally, one would wish to be viewed positively. That’s good business. While it may not optimize shareholder value for a particular quarter, in the long run, proper tax policy burnishes the company’s reputation as a positive force in those markets, ensuring revenues and profits. And along with those returns, it ensures future growth.
The lesson for companies is not that they should act counter to their business interests; it’s that those interests must be understood to extend beyond the P&L.