The ongoing investigation by the US Internal Revenue Service into Facebook’s 2010 tax return attracted some renewed attention last week when the IRS filed a court petition in California looking for further documentation from Facebook.
The investigation relates to the most crucial aspect of the international tax structures used by US MNCs – getting the global rights to their intellectual property outside the jurisdiction of the US. In 2010, Facebook Ltd transferred the global rights to its IP to Facebook Ireland Holdings. The IRS are investigating the nature of this transfer and whether the correct price was paid for the assets transferred.
We know that Facebook has a trading company here, Facebook Ireland Limited, and that this company collects substantial revenue from selling advertising and other services on the Facebook platform. However Facebook Ireland Limited doesn’t own the rights to the IP and must pay royalties for the right to use the Facebook platform. These royalties are paid to Facebook Ireland Holdings who obtained the rights from Facebook Ltd.
We know that other US companies (Google, Apple etc.) have somewhat similar structures and that these companies have R&D cost-sharing agreements whereby their offshore subsidiaries are granted the non-US rights to their IP in return for making contributions to the cost of their development.
It is likely that Facebook has a similar arrangement in place but this can really only apply to new or ongoing IP development. When the transfer was made in 2010 the Facebook platform was already in existence and Facebook Ireland Holdings would have to pay based on the value of this existing technology at the time rather than the historical cost of its development. Although few details are available it seems that it is this price paid in 2010 that the IRS is investigating. It is also possible that the outcome will affect subsequent tax years if the R&D cost-sharing agreement is found to be inappropriate.
From an Irish perspective almost all reports on the court petition state that the rights to the IP were transferred to Ireland. However, this is not correct. Facebook has its international operating company in Ireland but the holding company is not based in Ireland – even though it is called Facebook Ireland Holdings.
Facebook Ireland Holdings is registered in Ireland but it is not managed and controlled in Ireland nor has it any risks, functions or assets in Ireland so it is not liable for Irish Corporation Tax. They have been some reports linking Facebook Ireland Holdings to the Cayman Islands but with no corporation tax or filing requirements there it is hard to tell. And, of course, as we have seen in the case of Apple this holding company could be managed and controlled in the US and still generate the same tax outcome.
Anyway the central element is to get the global economic rights to Facebook’s IP outside of the US. If the holding company has to pay a high price to the parent then the profit becomes subject to the US corporate income tax. However, even if the price is low it shouldn’t really matter as the US has a worldwide corporate income tax regime with all profits of US companies being subject to US tax regardless of where they are earned so a bit more than just getting the IP outside the US is required.
For this we look to the the deferral provisions in the US tax code where the payment of the corporate income tax due on foreign profits does not become due until the profits are formally repatriated to a US-registered entity in the company’s structure. There is a general deferral for trading profits. This means the profits earned by Facebook Ireland Limited are not subject to US tax until they are repatriated.
However, Facebook Ireland Limited is not a massive profit generator. It collects large revenues (€4.8 billion in 2014) but most of this is paid out in royalties as it is granted to rights to sell on the Facebook platform through a cost-plus agreement with Facebook Ireland Holdings.
Facebook Ireland Holdings receives significant royalty payments from Facebook Ireland. There is no general deferral provision from the US tax due for passive income so, in theory at least, Facebook would have to pay the 35 per cent US corporate income tax on the royalties received by Facebook Ireland Holdings.
There are, however, a number of exemptions that grant a deferral of the US tax due on passive income. One of the most crucial of these is the “same-country exemption”. Under this provision passive income transfers between companies in the same country do not trigger the payment of the US tax due on the profits from such transfers.
The US tax system judges this on the basis of country of incorporation. Thus if two companies are registered in the same country a passive income transfer between them does not trigger a US tax payment until the profits are repatriated. Both Facebook Ireland Limited and Facebook Ireland Holdings are Irish incorporated so the transfer between them is eligible for this exemption.
The IRS are not investigating this transfer and the cost-plus arrangement between the Facebook subsidiaries would be a matter for our Revenue Commissioners (while the European Commission have taken up investigating some of the cost-plus arrangements entered by Apple). The IRS are investigating how much money gets from Facebook Ireland Holdings (possible in the Cayman Islands) back to the parent in the US.
This is the crucial component of the tax structure. If Facebook Ireland Holdings pays most of the profit back to Facebook Ltd in the US then the rest of the structure is largely moot as the US tax becomes due anyway. But if Facebook Ireland Holdings pays a substantially lower price relative to the royalties it receives then the structure can successfully defer the payment of significant corporate income tax payments to the US. And it does!
It is the IRS that matters in all of this and they are clearly not satisfied with the size of the transfer between Facebook Ireland Holdings and Facebook Ltd. There isn’t really a lot that other countries can do about it. Countries can look at the activities US companies carry out in their jurisdictions and determine whether they are taxed appropriately. In the UK, HMRC completed a six-year audit of Google earlier this year and accepted the basic principles of Google’s structure. And no matter how many times it is erroneously linked the location of customers is not a taxable activity of a company!
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