Where should MNC profits be taxed?

Proinnsias Breathnach03/03/2017

The role of intellectual property (IP) rights in the tax avoidance strategies of multinational corporations (MNCs) in general, and Apple in particular, appears to have received little media coverage.

The role of intellectual property (IP)

This role has assumed major significance in two particular ways. Firstly, intra-corporate royalty charges for the use of corporate IP have, in many cases, superseded intra-corporate transfer pricing (the prices charged within companies when goods are traded between subsidiaries which ideally should be at arm’s length) strategies as a means of moving untaxed profits surreptitiously between jurisdictions.

Secondly, at least some MNCs are arguing that tax on global profits should be paid where research and development (R&D) is conducted and associated IP is created. We will return to the question of royalty charges as a tax avoidance vehicle in a future post; here we will focus in particular on the question of where the global profits of MNCs should be taxed.

In opposing the European Commission (EC) ruling that €13bn in tax should be paid to the Irish government, Apple Corporation has argued that profits passing through Ireland should be taxed in the USA, as this is where the firm’s R&D is conducted and its IP resides. According to a company press statement released last December: “Because our products and services are created, designed and engineered in the US, that’s where we pay most of our tax”.

Bizarrely, the Irish government appears to agree with this argument. According to a report in the Irish Times (February 3 last), Finance Minister Michael Noonan told the Oireachtas Committee on Finance, Public Expenditure and Reform that the Government insists that the tax the EC believes that Ireland should collect from Apple is owed in the US, where the firm’s IP, R&D and management functions are based. This is bizarre because, for decades, the Irish government has been collecting tax on profits moved into Ireland through transfer-price manipulation by MNCs with an operating base in this country.

Collect very little tax?

Most corporation tax in Ireland is paid by high-tech foreign firms managed from abroad and utilising proprietary technology sourced from abroad. If Michael Noonan’s argument relating to Apple were to be applied across the board, the Irish government would collect very little tax from these firms. As pointed out by Pádraic Neary in a letter to the Irish Times on December 22 last: “If the location of IP production or IP rights residence were to be accepted as the location where tax should be paid on profits, then TNCs based in Ireland would pay little tax”.

The Apple press statement is itself bizarre, since Apple actually pays little or no tax in the USA on the profits which it generates abroad. Such tax is only payable when profits are actually repatriated and Apple routinely keeps foreign-earned profits outside the USA. By July of last year, the company had a cash pile of $215bn in accumulated unrepatriated profits stashed overseas.

Role of R&D in tax reduction.

R&D is a production cost factor and is paid for from revenue in the same way as other cost factors such as plant and equipment, materials, fuel and power, transport and administration costs. Apportioning the share of overall profits attributable to each of these cost elements is a difficult, if not impossible. This is particularly the case with large MNCs which operate integrated global “value chains” in which production operations, R&D, marketing, logistics, other support operations, and sales are spread over numerous jurisdictions.

Many MNCs have become very adept at developing means of shifting revenues around within these value chains in order to minimise their global exposure to tax liabilities. Such profit-shifting has now reached such a scale that the governments of the world – many cash-strapped in the wake of economic stagnation occasioned by the 2007-8 financial collapse – have finally begun to take concerted action to tackle it.

Tackling global tax-avoidance strategies

The result has been two major international projects designed to tackle multinational global tax-avoidance strategies viz. the OECD’s base erosion and profit shifting (BEPS) and the EU’s common consolidated corporate tax base (CCCTB) projects. The BEPS project seeks to “ensure that profits are taxed where economic activities take place and value is created” through tackling various devices used to shift profits between jurisdictions in ways which undermine this objective. The BEPS documentation is not very precise about defining “economic activities”: according to the OECD document Addressing base erosion and profit shifting (2013): “business activities are generally identified through elements such as sales, workforce, payroll and fixed assets”.

The document acknowledges that value is created in the different stages of production (which may be located in different countries), but provides no guidance regarding how total value added should be allocated to each stage. However, in noting “a tendency for firms to associate a growing share of profit with legal constructs and intangible rights and obligations, with a reducing share associated with substantive operations”, the OECD hints at a certain abritrariness in how firms make this allocation. Clearly, the Apple argument against the European Commission is based on asserting almost exclusive value creation functions for intangible rights (IP), which is highly contestable.

The EU’s common consolidated corporate tax base (CCCTB)

The CCCTB proposals are more specific regarding how profits should be divided between different activities, but are still quite arbitrary. There are two elements to these proposals. The first is to determine the overall level of profits arising from a firm’s activities within the EU. The second is to allocate these profits in accordance with that firm’s different activities within the EU. These profits would then be taxed in accordance with the tax regime of the different member states in which these activities are located.

The CCCTB proposes that a firm’s profits would be allocated among member states on the basis of three equally-weighted factors: the firm’s assets (e.g. buildings & machinery), employment (or payroll costs) and sales in each member state. This is (at least in principle) a straighforward formula which recognises the roles of sites of both production and consumption in value creation (albeit giving greater weight to the former). Given that Ireland accounts for a tiny proportion of EU sales for most products and services, but contains substantial production and/or administrative multinational operations, this formula is relatively favourable to this country.

The formula is arbitrary

At the same time, the formula is arbitrary, both in allocating equal weights to the three factors listed and also in failing to differentiate between the productive capacities (and therefore contribution to value creation) of different forms of assets and work forces. For example, a lot of recent foreign investment in Ireland has been in marketing, sales and administrative functions which, it could be argued, contribute less to value creation than functions directly involved in the production of goods and services.

There is also an argument that value is only realised at the point of sale and that therefore all profits should be assigned to where sales occur. There is a related equity argument that taxes on profits should be paid where sales occur so that consumers get some payback for their expenditure (in the form of government spending of tax revenues). Of course, allocating all profits on the basis of the distribution of sales would have very serious implications for Ireland.

Many, if not most, MNCs selling products and services in the EU operate through global value chains many of whose links may be located outside the EU. Thus, a key question facing the CCCTB is how value-added is divided between those parts of the chain located within and outside the EU, which in turn determines the level of profits deemed to arise within the EU.

CCCTB is hand in hand with BEPs

The CCCTB, therefore, goes hand-in-hand with the OECD BEPS project which is global in scope. Key objectives of BEPS are to get MNCs to give detailed country-by-country financial reports and to devise measures to prevent unjustified or surreptitious shifting of profits between jurisdictions. This will require the project to devise acceptable formulae for allocating value-added between different functions (and corresponding locations) within MNC value chains (perhaps along lines similar to those proposed by CCCTB).

While the Irish government has, at least formally, backed the BEPS project, it has voiced implacable opposition to the CCCTB even though, as suggested above, both go hand-in-hand. If the BEPS project receives sufficient international support when it gets to the nitty-gritty (a big if, perhaps), the days of competing for inward investment on the basis of facilitating profit-shifting (hitherto a key attraction of locating in Ireland) could be numbered. In that situation, MNCs will have to accept that they must pay a higher share of their profits in tax than is the case at present.

Under the CCCTB proposals, Ireland will still be able to offer a low corporate tax rate, while the formula for profit allocation offered by these proposals will mean that MNCs with substantial operations in Ireland will be able to declare the bulk of their profits in this country. Indeed, this would also encourage future investment in substantial employment-creating activities in Ireland.

Country-by-country financial reporting

Furthermore, in a system of (truly) transparent country-by-country financial reporting, Ireland could – or will have to – charge the full 12.5% tax rate on MNC profits declared in Ireland. Even though some of the profits currently channelled through Ireland will become taxable elsewhere in the EU under the CCCTB proposals, the fact that most of these profits currently are subjected to only minimal levels of tax should mean a substantial boost to government revenues here post-CCCTB (as will be the case if Apple is forced to pay 12.5% tax on the vast sums of untaxed profits moved through Ireland over the last 25 years).

On these grounds, it appears to me that the Irish government would be better served in the long run by supporting the CCCTB proposals rather than resorting to a knee-jerk negative reaction to them.

 

Dr Proinnsias Breathnach

Proinnsias Breathnach

Proinnsias Breathnach joined the Geography Department at Maynooth University as its second member in 1972. Officially retired 2010, he remains research active with Emeritus status.

His research interests are economic geography, national and regional economic development, transnational investment, informational economy and dairy cooperatives.


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