Taxed beyond all reason

Minimising taxation yet staying on the right side of the moral and legal aspects has become an inflammatory issue for business. Darren Baguley investigates

It is a truth universally accepted that a company that does not work to maximise shareholder returns is seen as cavalier in attitude and neglectful of its duty to investors. Yet when high-profile firms such as Apple, Microsoft and HP do just this - by minimising tax - they are increasingly excoriated.

Many argue that companies which benefit from public goods such as an educated workforce, all manner of infrastructure, and law and order should contribute by paying tax. It is not just a UK issue; Apple has been asked to explain in the US, the UK and Australia why it only pays tax in the millions, despite making profits in the billions.

The first thing to clarify is the distinction between tax evasion and tax avoidance. Evasion is quite simply illegal and usually involves a criminal act or omission on the part of the taxpayer - such as mis-stating (lying about) your income.

Avoidance or tax minimisation are both terms for legal escapes from the tax code, and may be the result or objective of tax planning.

Governments started waking up in the 1990s to how much revenue they were losing through tax avoidance, and have been on the case ever since. HMRC estimated the figure in 2010-11 at £9bn. Furthermore, the line between avoidance and evasion is blurring, with the grey area between the two dubbed "avoision".

Often, schemes in that grey area are legal until HMRC decides otherwise. "The difference between the two can be the thickness of a prison wall," said Denis Healey, James Callaghan's chancellor of the exchequer, many years ago.

Kept at arm's length
One of the most commonly used tax avoidance strategies among large companies - and according to taxation justice blog Tax Research UK, transactions between multinationals could account for as much as 70 per cent of world trade - is transfer pricing.

Lobby group the Tax Justice Network describes this practice thus:
"If two unrelated companies trade with each other, a market price for the transaction will generally result. This is known as ‘arms-length' trading, because it is the product of genuine negotiation in a market. This arm's-length price is usually considered to be acceptable for
tax purposes.

"But when two related companies trade with each other, they may wish to artificially distort the price at which the trade is recorded, to minimise the overall tax bill. This might, for example, help it record as much of its profit as possible in a tax haven with low or zero taxes."

As the vast proportion of companies on the FTSE 100, Dow Jones 200, ASX 200 et al have foreign subsidiaries, it is not hard to see the practice could be rife among developed nations.

As an example of how this may work with a technology company, take a multinational called World Inc, which produces hardware in China and sells the finished product in the US via three subsidiaries: China Inc, Haven Inc (in a tax haven, with zero taxes) and America Inc.

If China Inc sells the product to Haven Inc at an artificially low price, it follows that China Inc will have very low profits, and a very low tax bill in China. Then Haven Inc sells the product to America Inc with virtually no margin at all. You guessed it: the
result is that America Inc also has very low profits and a very low tax bill in America.

Haven Inc, however, has done what every company tries to do - buy low and sell high - and reaped very high profits as a result. And because it is based in a tax haven it pays no taxes on those profits.

John Chown (pictured, right), principal of UK-based international tax adviser Chown Dewhurst, though, argues that it is becoming increasingly difficult to avoid tax using transfer pricing - at least in the UK and the US.

"It is easy enough to set up a subsidiary in a tax haven but has for many years been very difficult to avoid tax this way. There is legislation on transfer pricing and also to bring into charge profits accumulated in Controlled Foreign Corporations (CFCs).

"If companies are avoiding tax by transferring profits from the UK to lower tax jurisdiction, it should be caught by transfer pricing, but the subsidiary should then be caught by the US CFC rules."

Professor James Sharman of Griffith University, Australia, and co-author of a Lowy Institute for International Policy paper G20: Rebutting Some Misconceptions, has drawn the same conclusions.

"Especially since 2002, the OECD and a group of three dozen tax havens had agreed in principle to share tax information on demand, a major reversal for the previously secretive havens.

"The problem, was that in the interim the agreement in principle had not translated into signing many specific agreements by which tax information could actually be exchanged. A particular sticking point was that the havens refused to budge unless Switzerland agreed to the same terms, which the Swiss - veto-wielding members
of the OECD, but not the G20 - resolutely refused to do."

Within weeks of the 2009 G20 summit, however, not only Switzerland but every other country on the list dropped their objections and began signing bilateral tax exchange agreements. Hundreds of such agreements have been reached since 2009, Sharman says.

Sandwich loophole
While such measures may be putting a crimp in the tax minimisation efforts of hardware companies, software companies selling products that increasingly exist only on servers are able to avail themselves of transfer pricing to an even great extent by using a loophole that goes by the name of the "Double Irish with a Dutch Sandwich" loophole.

Writing on the FindLaw blog, tax lawyer William Peacock Esq explains: "It's a complicated corporate tax loophole, exploited by tech companies and others with intellectual property, pioneered by Apple and used by many to save billions of dollars in taxes.

"It all begins with the licensing of patents and IP to an Irish subsidiary. When products are sold in the US, taxes are reduced by paying royalties to that subsidiary. Under Irish law, if the subsidiary is managed by foreigners, profits skip along, Irish-tax-free, usually to a Caribbean tax haven.

"When products are sold outside the US, profits are directed to another Irish subsidiary, which forwards the profits to the Netherlands under a tax-free treaty, which kicks the profits back to the initial Irish subsidiary, which exploits the same foreign-manager tax loophole to send money to the Caribbean."

CEOs of large multinationals like to quote Nobel Prize-winning economist Milton Friedman to defend such aggressive tactics.

"There is one and only one social responsibility of business: to use its resources and engage in activities designed to increase its profits, so long as it stays within the rules of the game - which is to say, engages in open and free competition without deception or fraud."

While such structures are within the laws of the UK and the OECD guidelines that many countries follow, such aggressive corporate behaviour is coming to the notice of the media and the people.

"Citizens with no choice but to pay tax increasingly resent multibillion-dollar businesses - such as Apple and Google - they see as not playing by the rules of the game.

More pragmatically, John Chown believes that many developed country's regimes are riddled with tax traps and loopholes. When a company must take expensive advice to avoid even more expensive traps, its advisers will inevitably look for loopholes as well.

"All my working life, governments have claimed to ‘balance' their budgets by bringing in anti-avoidance legislation which they estimate will bring in a large amount of money. It never does," says Chown.

"A simple, broad-based, relatively low-rate tax system not full of loopholes and traps is far more effective."