Civilians not enlisted in the armies of lawyers, accountants, and economists who battle over multinational taxes for a living must wonder, "Why is it so difficult for governments of advanced economies to prevent profit shifting to tax havens?" Part of the answer lies in the fact that long ago, governments willingly hard-wired into the system certain principles that have now evolved in a way that has made life easy -- and proftable -- for corporate tax planners.
One of the problems is described in a recent paper by professor Bret Wells of the University of Houston Law Center and Cym Lowell, a partner at McDermott Will & Emery. Widely accepted transfer pricing methods allow multinationals to claim that affiliates in high-tax countries perform largely routine functions that are comparable to those performed by independent companies. Therefore, the profits allocated to those subsidiaries should be routine returns, like those earned by comparable independent companies.
That may all seem logical enough. But these so-called one-sided methods effectively require tax authorities to ignore that multinationals often generate enormous profits in excess of routine returns. Under one-sided methods, these residual profits are, by default, assigned elsewhere. Multinationals have set up structures that ensure that "elsewhere" is a relatively small operation or even a pure holding company in a tax haven.
Wells and Lowell explain that these methods of determining profit were originally given prominence before World War II, when dominant economies like the United Kingdom and United States were the home of most of the world’s leading multinationals. The idea was that the subsidiaries of UK and US parent companies would receive a routine return, and the corporate headquarters would be assigned the residual return that was usually many times larger than the routine return. The authors write that “it is a matter of great situational irony, that [multinational corporations] have used this earning stripping paradigm that was put into place by the developed nations after World War I to base erode those same developed nations today. A cynic might think the developed nations find themselves hoisted on a petard of their own making.”
Another problem is that under long-standing tradition, governments give a great deal of deference to contracts that one subsidiary of a multinational enters into with another -- even though these contracts have little economic substance. That allows multinationals to transfer the rights to valuable intangibles to holding companies in tax havens. More recently, clever attorneys have devised contracts that allow them to assign risks and the corresponding profits to principal companies in low-tax jurisdictions. Nobody describes it better than my colleague Lee Sheppard. Here is an excerpt from one of her many brilliant articles on the topic ("Is Transfer Pricing Worth Salvaging?" Tax Notes, July 30, 2012, p.467):
- The frightening thing about the shifting of income from relatively simple manufacturing operations to tax haven principal companies is how cheap it is. Contracts are redrafted, lawyers baby-sit, and a few people are assigned to mind things in Switzerland. The OECD transfer pricing guidelines tell tax examiners to respect these self-serving contracts.
In the ongoing great debate about multinational base erosion and profit shifting (known as BEPS by those of us in the biz), the OECD, under pressure from the G-20, has begun to take a stand against multinationals’ tax planning. In its discussion drafts, its technicians are making a lot of noise about requiring greater use of profit-split methods. Those are “two-sided" methods that use a company’s worldwide profits as their starting point and are therefore far more likely to assign residual profits to high-tax countries. The technicians are also suggesting that where physical activity actually takes place, not where contracts assign risk and ownership, should determine where profits are allocated.
But nothing is settled, and the OECD is being heavily lobbied by powerful multinationals and their representatives in the tax planning business. These interests are advocating minimal use of profit splits and continued respect of related-party contracts. If they succeed on those critical points, which leave fundamental problems under current law unsolved, profits shifting to tax havens will only be slowed down temporarily -- that is, -- until multinationals get over the speed bumps the new rules will put in their path.