Market leading insight for tax experts
View online issue

Multinationals and the great tax debate: a view from industry

printer Mail

Colin Garwood, head of group tax at InterContinental Hotels Group, provides an industry view on BEPS related issues and responds to a recent call for a top-up tax.

Tax Journal has kindly published a paper I have written concerning the BEPS process and related issues (this is available to view here). My particular focus is on issues associated with the digital economy and intangibles. That includes consideration of some related withholding tax and foreign tax credit issues, which are outside the scope of the current BEPS review. I link the analysis with consideration of the more fundamental principles and concepts which underlay the current international system and consideration of whether those principles can still produce outcomes which align with subjective public expectations of where taxing rights should arise.

The paper was prompted by a paper by John Watson concerning the current tax debate. That paper set out and commented on the key reports and suggestions over the years concerning what the best design is for a well-functioning international tax system for taxing corporate profits. It set the current context as a problem of tax-avoidance by multinationals and the need to consider what system is best able to counter that problem. After considering various alternatives for more fundamental reform (for example, unitary tax systems and a pure form of destination tax), he suggests the retention of the current system but supplemented by a destination based top-up tax. As I understand it, that is seen as a means of addressing avoidance which results in supplies being able to be attributed to low-taxed supplier jurisdictions and also incur little or no tax in the customer jurisdiction.

It struck me that we have (at least) two parallel processes and mind-sets here. Firstly, there is a BEPS process whose objective is to address avoidance via base erosion and profit shifting (BEPS), but which sees the existence of BEPS as primarily a function of gaps and inconsistencies in the current international tax framework, rather than as suggesting either that the fundamental framework is wrong or that the problem is to do with all pervasive moral failings in the business community. Secondly, we have a number of sources (in the UK at least) suggesting that the whole system is broken and we need a new one, while perhaps also suggesting that it is avoidance by business which has broken it.

Where I would hope that there is common ground is that international trade and a thriving business community is a good thing which, within the framework of a well-functioning system, makes a major contribution to the well-being of societies generally. The common challenge therefore is to arrive at a well-functioning system. Part of that challenge, and of meeting the second challenge below, is trying to get more intellectual consensus as what is the right broad framework, and why that is to be preferred to more radical alternatives.

The second area of common ground is that public trust in the system and in business has been damaged, and that a sustained loss of trust will have harmful effects for both business and for society more broadly. We therefore need to rebuild that trust. That probably involves not just fixing the system in a way which passes the tests of intellectual and practical coherence for those who have to work with them, but which also produces outcomes which, without the need for complex explanations, pass a public smell-test as reasonable.

My paper approaches the subject by a consideration of the OECD’s BEPS review; of what we might expect that to deliver in the key action areas linked to the digital economy, intangibles and transfer pricing; and of whether that is likely to deliver outcomes which meet the subjective expectations of both tax professionals and the broader public (concerning both the existence of profits which should be taxed and concerning the allocation of taxing rights between jurisdictions).

One of my fundamental factual contentions is that there is not a discrete economy which can properly be ring-fenced and described as the digital economy. There is rather the technological development of digital functionality which pervades all modern businesses to a greater or lesser degree and which enables functions to be carried out remotely and carried out more rapidly. One consequence of that is that it is questionable whether tax rules can be designed which target companies whose core profit sources come from that digital functionality without having an unintended and punitive impact on digital functionality used within a cost centre function or used for a lower margin peripheral profit centre function.

I conclude from that that the right sequence in which to approach the tax problems arising from this digital functionality  is not to try and immediately jump to a ‘digital’ solution but to first test how far solutions are likely to get which follow the more traditional permanent establishment and transfer pricing approaches. That means BEPS Actions 7, and 8 to 10, in particular. It appears that the OECD (and HMT and HMRC in their position paper released on Budget day) have come to the same conclusion.

I suggest that whereas that is likely to be the best analytical sequence, we should not lose sight of the fact that the technological capability which now exists to perform functions from a distance is not something which would have been anticipated when the current international tax rules were developed. The current rules thus almost certainly assumed that customer jurisdictions would receive a share of tax on profits from sales in the jurisdiction. This is because it was assumed that business practicalities would mean that there would have to be sufficient nexus to generate one.

There is therefore a need to subsequently come back and sense check whether the ‘post BEPS’ allocation of taxing rights does meet more subjective expectations and tests (and practical tax raising needs). I suggest that that sense check should follow a concept which is closer to ‘value derivation’ rather than ‘value creation’ so as to encompass not just capital and production functions but also contributions made in the customer jurisdiction- including perhaps by the customers themselves. This may be justified because another feature of the modern digital world is that customers are not passive recipients of goods and services but perform active and inter-active roles with suppliers, whether as inputters or as information providers.

When considering BEPS Action 7 permanent establishment issues I suggest that  focus needs to be placed on existing tests and concepts concerning whether a function, or combination of functions, are preparatory and auxiliary or not. Under the existing OECD model and commentary that is not just a matter of whether those functions fit a description on a given list, but is a question of whether, when viewed in the context of the particular business concerned, the function is preparatory and auxiliary or not. For example, a function of finding customers, where the securing of contracts with those customers is sufficient in itself to deliver a pretty much certain profit, does not seem preparatory and auxiliary. In contrast if resultant profits are uncertain and significantly dependent on matters of performance and delivery under the contract then the function probably is preparatory and auxiliary.

It is important to remember that the existence of a PE will not in itself generate taxes if, after taking into account associated arms' length charges to the PE there would be no attributable profit. The existence of additional tax is thus dependent on transfer pricing considerations. It is however reasonable to assume that arms' length charges for local activities performed by associated local subsidiaries which are not preparatory and auxiliary should be higher than those for services which are. Thus one way or another a reasonable tax charge in the customer jurisdiction should  result.

When considering intangibles I contend that the current international tax rules are generally based around the premise that intangibles are passive assets generating pure income profits. The tangible asset comparable would be to a building generating rental income. Whereas there are still classes of intangibles which meet that profile the more general profile nowadays is of active assets whose development, maintenance and exploitation play a dynamic role in a business, and which have significant functions and costs associated with them.

The BEPS process starts to catch up with this profile. In particular, Action 8, concerning transfer pricing of intangibles, might be seen as helping address excessive allocations of profit to legal ownership based on a failure to properly reflect and compensate functions which support many modern intangibles. Its backdrop is still shot through however with implicit assumptions that the profile will be of a few long life intangibles which go through a process of development and then have a long static life of royalty generation-rather than the active profile of continuous creation, modification and replacement which may often apply.

I contend that the result of digital functionality, this modern intangible profile, and its taxation in accordance with the principles of Action 8, has double taxation consequences which the current international framework does not address, and that continuing developments in all these areas will exacerbate the problem.

This is firstly because the income arising from many intangibles is now far from being pure income profit. The application of royalty withholding tax rates which assume it is therefore produces, at best, a lop-sided allocation of taxing rights to the source jurisdiction. Secondly, whereas the taxing rights with respect to the profits concerned are now increasingly fragmented amongst the jurisdictions contributing to supporting the intangibles, credit for the withholding tax is only available in the direct counterparty of the source jurisdiction. The domestic tax liability of that party will thus often be less than the foreign withholding tax it has suffered. Additional tax will however be payable, without credit offsets, in supporting jurisdictions.

I suggest that this double taxation problem should be correctable via standard provisions to allow flow through of credits on a pro-rata basis – and should be addressed by the OECD as a follow on action from the BEPS review process.

My conclusion from my review of BEPS Actions 7 and 8 (and also 9 and 10, which I do not go into here) is that the types of corrective actions under consideration in the BEPS process should go a long way towards correcting any misallocation of profits resulting from digital functionality or otherwise. If, however, it is concluded that that would still not leave an equitable allocation of taxing rights to customer jurisdictions, then I suggest a system which may give some workable mechanics  for making additional charges in the customer jurisdiction. That would not, however, solve the problem touched on earlier of how to draw appropriate boundaries for applying such a system without unintentionally penalising the broader use of digital functionality.

The system I suggest is one which would make revenue based charges in the source jurisdiction (on a tax return rather than withholding tax basis) where revenues from the jurisdiction exceed a suitably high de minimus threshold. That revenue based tax would then be creditable in the same way as withholding tax is (including on an extended basis down the value chain as described above). The rate of revenue based charge should be set at low rates suitable to allocate an additional proportion of taxing rights to customer jurisdictions - but not more than is justifiable based on fundamental principles.

EDITOR'S PICKstar
Top