Sunday, March 9, 2014

Who is to blame for ASI’s effective tax rate of 0.1%?

The current OECD-led network of tax treaties is about conferring the rights to tax income that is earned across borders.  The purpose of the treaties is to avoid double taxation so the right to tax is determined by the rules that underpin the treaties.

Under the current system the rights to tax Apple’s profits (earned from US research and development) lie with the US.  The fact that the US, through its deferral provisions, doesn’t exercise that right when the profit is earned but allows a deferral until the profit is “repatriated” is an issue for the US and the US alone.

Neither Ireland, Australia nor any other country have to right to tax those profits.  Ireland can affect the rate levied on profits earned in Ireland but Ireland has no jurisdiction over the profits of non-residents earned in other countries.  There is nothing that can be done here to change that.  Ireland has no right to tax the profits of non-resident companies earned outside of Ireland.

Is Ireland to blame for the US not collecting US taxes? No, but it suits Capitol Hill that Ireland is blamed. 

The current corporation tax system could be changed so that the right to tax the profits is conferred differently but that requires a change of the source, residence and transfer pricing principles currently used.  The OECD’s BEPS programme which change things but the debate is around the system as it is now.

Ireland’s corporation tax regime is deliberately attractive for foreign investment.  In general, however, these deliberations have given more thought to what not to change as opposed to what to change. 

A major part of the attraction is stability.  Things don't change - or at least they didn't up to last October.  Ireland’s corporation tax rate and regime get a lot of attention but what elements can be changed to change the outcome - the amount of tax paid either here or elsewhere?

There is no change that can be introduced in Ireland that will result in more corporate income tax being collected in say, Australia.  Australia could move to impose a greater tax on Apple for the “profits” it earns there but that would violate every tax treaty Australia has entered into which sets out what should be taxed where (source and residence) and how much should be taxed (transfer pricing).  Apple doesn’t earn profit by selling to customers in Australia; it earns profit by designing a product in the US that Australians want to buy.  The current rules attribute the profit to the activity in the US.  If Australia wants to collect more tax from the sale of Apple products there it can do so via an increase in sales taxes.

There is also no change that can be introduced in Ireland that will result in more tax being collected in the US.  There are a huge range of structures that can be put in place to allow US companies to defer the payment of their US corporate tax liability on their foreign-source income.  The “double-Irish” and “stateless income” have got some public attention but many more are possible.

Why do companies engage in these particular strategies? Stability.  Companies don’t like having to change and reorganising their structure is time-consuming and costly.

The “double-Irish” (so-called even though it would work in numerous countries) is based on residency and, crucially, on the “same-country” exemption in Subpart F of the US tax code which allows the transfer of passive income between two related companies without triggering a US corporate tax payment.  Companies use the “same country” exemption because it is a permanent feature of the US tax code – it needs a vote in Congress to be repealed.  And the US law won’t change.  The other part involves finding a country that with appropriate residency rules.  There are lots of possibilities.  The US companies want a country that determines residency on the basis of the test of management and control.

Here is the company residency rule for Malaysia:

A company is resident in Malaysia if at any time during that basis year the management and control of its business is in Malaysia.

Legally that is all that is required to set up a “double-Irish” type structure.  The US company can establish two Malaysian-incorporated companies but have the management of one in another country – such as a Caribbean Island.  The US parent company can transfer passive income between the two companies and use the “same-country” exemption to avoid triggering a US tax payment.  Malaysia won’t tax the second company, the one holding the profits, because it is managed in another country.  This is the “double-Irish”, Malaysian style.

Why don’t US companies use Malaysia instead of Ireland?  There are many reasons but stability is an important one.  They don’t want to have to reconfigure their arrangement because the country changes its rules.  They want stability.

The residency rules in Ireland are actually more restrictive than those in Malaysia. Historically, the residency rule was (from

All companies whose central management and control is exercised in Ireland (whether it is incorporated in Ireland or not) is regarded as resident in Ireland for tax purposes.

This was revised in the Finance Act, 1999, and now:

in general, companies incorporated in the State are resident in the State.

However, there are exceptions to this is.  One is a ‘relevant company’ that is ultimately controlled by persons resident in the EU or in a country with which Ireland has concluded a double taxation treaty and is related to a company that carries on a trade in the State  - the “trading” exemption.

This is a key feature of the Irish corporation tax regime.  It allows the residence of some companies to be determined by their ultimate control – the test of management – but only for companies that are related to companies that trades here.  You can only trade if you have employees.  A “brass-plate” operation is not sufficient; companies need a presence of substance, i.e. employment, to be able to avail of this provision.

Could we change our tax residency rules to make all companies incorporated here resident here?  Of course we could.  That would definitely end any reputation for stability and it would end the opportunity for US companies to avail of the “same-country” exemption here.

We could do this and it is the case that the US companies don’t need the Irish residency rules (or equivalent based on management and control) to achieve the same tax outcome.  In fact using the “look-through” rule they don’t need any residency rules at all to facilitate the passive income transfer to a related company in a low/no tax jurisdiction.  Certain related companies in any two countries will do. 

The “look-through” rule is far less restrictive than the “same-country” exemption and could be considered the “any country” exemption.  Under the “look-through” rule hierarchical subsidiaries of a US company can be treated as a single entity by looking through the lower level to reach the higher level.  Using this, passive income transfers can be made between subsidiaries in different countries as the transfer is considered to have happened within the same entity, so in essence is not considered to have happened at all.

Ostensibly, this was introduced to allow US companies to redeploy their foreign earnings in one country for re-investment and expansion in another country without triggering a US corporate tax payment.  This is true for the majority of companies who use the rule but a small number of hugely profitable companies can use the rule to accumulate profits in low/no tax jurisdictions without triggering a US corporate tax payment.

So why don’t companies use the flexible “look-through” rule instead of the more restrictive “double-Irish”?  Many do but the “look-through” rule is only a temporary feature of the US tax code.  Unlike the “same-country” exemption which requires a vote in Congress to be repealed, the “look-through” rule requires a vote in Congress to be continued.  It actually expired at the end of the 2013 tax year but there is still plenty of time for it to be appended to any bill for it to apply for the 2014 tax year and beyond.

The “look-through” rule gave legislative effect to the “check-the-box” election introduced by the IRS in 1996/7.  “Check-the-box” is little more than an administrative process in the IRS (but obviously one that has huge implications).  “Check-the-box” allows US companies to determine if an entity in their structure should be treated as a taxable entity on its own right or combined with several subsidiaries to form a single taxable entity.  By combining subsidiaries in a single tax entity the company can make passive income transfers between them without triggering a US corporate tax liability – the tax is deferred.

The “check-the-box” provision can be changed at any time.  The IRS actually proposed doing so in both 1998 and 2003 but a non-binding resolution was passed in Congress asking the IRS not to change the provision – the IRS complied.  And anyway, Congress went ahead and partly formalised “check-the-box” with the introduction of the “look-through” rule in 2005.

However, there is sufficient doubt around the provision such that companies will seek a structure that is not dependent on it.  They use it but if “check-the-box” changes they will ensure they can achieve the same result without it.  The “same-country” exemption offers that security hence the use of “double-Irish” type structures.

The “stateless income” scheme of Apple was also based on stability.  First was the certainty that the US would not change its company residency rules. They didn’t.  And certainty that ‘stable’ Ireland would not change its residency rules.  But we did!

Although it was a very small change, and will have no effect on tax outcomes, the knock-on consequences of Ireland changing have yet to be determined.  It is likely that a significant amount of thought went into the decision and as stated above more thought in Ireland goes to determining what not to change rather than what to change.

Apple’s “stateless” income strategy only works if the relevant company is not managed and controlled in Ireland otherwise it would be resident here.  But everything ASI does happens in the US.  Here is the company residency rule, Article 2.8, in the Ireland-France tax treaty:

A company shall be regarded as a resident of Ireland if it is managed and controlled in Ireland. It is agreed that this provision does not prevent the application, according to Irish law, of the corporation profits tax in the case of a company incorporated in Ireland which is not managed and controlled in France.

A company shall be regarded as a resident of France if it is managed and controlled in France.

That is pretty clear.  The residence of a company is based on the test of management and control.  There is no possibility of setting up a “stateless company” between Ireland and France; it has to be managed and controlled somewhere. 

US law does not recognise management and control.  It is a US judgment that a US company which carries out all its operations in the US is not tax resident in the US.  Who is to blame for that?

Ireland’s rate and regime undoubtedly play a role in determining the very low effective tax rates attributed to some US companies but not one that is overly significant.  The 12.5% rate is nice but that only applies to profits earned here (the companies will be subject to making up the balance at the 35% US rate anyway – if the US wants to collect it).  The regime has its attractions but none are so significant that if they were removed the same tax outcomes could not be achieved by US companies.  The government are trying to foster a reputation for transparency and cooperation.  That sort of reputation doesn’t concern the companies; a reputation for stability does.  On the tax side companies use Ireland because they don’t like change.

Yes, we have a low rate.  Plenty of other countries do too.  Yes, we have favourable residency rules for US companies. Plenty of other countries do too.  We have a reputation for stability, not many countries have that.  Britain’s “patent box” is unlikely to form a major part of MNC tax strategies until it becomes embedded as a part of the UK tax system that is unlikely to change (which will take a couple of years of Labour in power).

If Ireland is guilty of anything in the international application of corporation tax, it is stability. A good reputation is hard won but easily lost.  A bad reputation can be hard to shake off.  In any debate if you are explaining you are losing; Ireland is losing.

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