Models That Multinational Corporations Use To Avoid Tax

Excerpt from the book ‘Loophole Games: A Treatise on Tax Avoidance Strategies’, by Smarak Swain; (WoltersKluwer, 2019).

Tax avoidance, as opposed to tax evasion, happens within the boundaries of law and constraints imposed by accounting standards. For a corporate entity, the taxable profit is usually related to the net profit. Hence, a corporate entity keen to reduce tax incidence tries to reduce its annual profits. A few ways of doing this are profit suppression (by using strategies such as deferral of revenue to a future year), profit shifting, and tax base erosion.

Profit shifting is a rampantly-used strategy in many multinational corporations, in which profits derived by the Indian entity are pushed to sister concerns in low tax jurisdictions (such as Mauritius, Singapore, Cayman Islands, Cyprus, Hong Kong, etc.). By doing this, the profits in India are reduced. Base erosion, on the other hand, refers to models in which the multinational corporation manages to escape taxation in India on its India-sourced profits. Such models have been popular among digital businesses due to the foot-loose nature of their business. Some popular models detected are discussed here.

IP Structuring

Under this strategy, the business is structured in such a way that all valuable patents and technical know-how are owned by a subsidiary in a low tax jurisdiction. In its simplest form, all IP rights of the MNC group are centralised in an entity registered in a tax haven.

Group companies have to pay a royalty (usually as a percentage of sales) to the intangible principal. This reduces profits of group companies and thus their tax incidence. This also increases profits of the intangible principal, which does not have to pay any tax since it is located in a tax haven jurisdiction.

This kind of structure is also (mis)used by domestic companies to reduce their tax incidence. The domestic company opens a company in a low tax jurisdiction and sells all its IPRs to the low tax jurisdiction company. Sale of IPR to related parties in low tax jurisdictions is often referred to as IP migration.

This structure is also misused by companies in the consumer goods segment; some of these companies register their brands in low tax jurisdictions and pay a royalty to the low tax jurisdiction company for using the brand. Royalty is expensed from the domestic company’s profits. Brand promotion and marketing expenses are also deducted from the domestic company’s profits.

Thin Capitalisation

Another strategy is to concentrate capital in tax havens. Capital is required by operational companies in high tax jurisdictions (such as India, the United States, United Kingdom, France, etc) to purchase assets and grow business. However, capital is concentrated in tax havens and the group companies in tax havens fund operational companies by way of debt.

Operational companies have to pay interest to the tax haven companies. The interest received faces no or nominal tax in tax haven jurisdiction. So the capital of tax haven countries further increases. The profit declared by operational companies reduces. Thus tax incidence reduces.

Thin capitalisation is a vicious circle. When an Indian company takes a loan from a related party situated in a tax haven, the interest payment further increases the capital of the shell company in the tax haven. The interest payment further decreases the profits of the Indian company, and so the Indian company cannot build capital from profits.

The Double Irish

More complex structures to effect profit shifting are provided as schemes by some tax havens. One such tax haven is Ireland. Ireland is ranked 26th in Tax Justice Network’s ranking of tax havens in 2018. This is a significantly low rank, indicating that Ireland does not behave like a typical tax haven. However, Ireland provides schemes, and facilitates structures, that help corporate entities avoid corporate income tax.

The famous Double Irish Dutch Sandwich tax avoidance tool arose in Ireland. The tool uses a strategy called treaty shopping. Ireland made some amendments in 2010, which helped eliminate the Dutch intermediary. Since then it is called the Double Irish tax avoidance tool. A majority of technology and life sciences multinationals have been known to use the Double Irish tax avoidance tool. This tool is used to re-route profits from high tax jurisdictions to tax havens. Many high tax jurisdictions do not enter into exhaustive tax treaties with havens such as Bermuda and Malta. The Irish government allegedly saw an opportunity here. The declared tax rate in Ireland is 12.50 percent. So Ireland managed to enter into treaties with high tax jurisdictions.

Apple has been allegedly using the Double Irish BEPS tool since the late 1980s. It was only in 2016 that the European Union levied a fine of €13 billion on Apple. It is touted to be the largest tax fine in history and covered the period from 2004 to 2014, during which Apple shielded €111 billion in profits from tax in high tax jurisdictions.

Subsequent to its investigations on Apple, the EU forced Ireland to close the Double Irish schemes. The former, however, gave the later a time of five years for already existing Double Irish users (till January 2020) to shut down.

Interestingly, Ireland had already started two substitutes when EU forced it to close the Double Irish: the Single Malt and the Green Jersey. The Single Malt tool is similar to the Double Irish, except that it routed profits shifted from high tax jurisdictions to Malta and not Bermuda. Tax abusers moved to Single Malt tool as soon as the Double Irish closed. Ireland resisted, for some time, attempts to shut-down the Single Malt tool. It opted out of Article 12 of the OECD’s anti-BEPS Action Plan to protect the tool. But it had to finally close the tool in 2018. Existing users have been given time till September 2019 to shut down.

But now tax abusers can use the Green Jersey tool, also called Capital Allowances for Intangible Assets, to shift profits to Ireland and use it as a terminus to divert profits to tax havens.

Base Erosion

Base erosion refers to strategies that help an entity do business in India without having any business establishment in India. As a result, they escape India’s territorial jurisdiction and don’t have to pay tax in India. This erodes the tax base of India.

Businesses running in the digital economy run on models that make base erosion possible. A typical example is the structure used by aggregators. As per a report of the Vidhi Centre for Legal Policy, the payment Uber users make through the Uber application goes to Uber Netherlands directly. The Uber app has no physical presence in India (technical term used is ‘permanent establishment’); hence Uber Netherlands is not taxable in India. Uber Netherlands enters into a contract with drivers, and directly pays to the drivers. The profits of Uber Netherlands are not taxable in India. A subsidiary in India provides ‘support services’ and is reimbursed for its expenses with a nominal mark-up.

Validity Of The Schemes

These schemes are open secrets in the field of tax consultancy. Economists consider such structuring a side-effect of globalisation. Governments have, in recent years, introduced anti-abuse provisions to counter these schemes. As a result, litigation risk and reputation risk in indulging in such schemes have increased manifold in the last decade.

Sovereign governments have, however, found it difficult to make local laws for global strategies. As a result, sovereigns are now cooperating under the aegis of the Organisation for Economic Cooperation and Development and the United Nations to develop global jurisprudence to counter base erosion and profit shifting.

Smarak Swain is a Joint Commissioner of Income Tax, in the Department of Revenue, at the Ministry of Finance. Views are personal.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.