It’s all about Google – but is it about Ireland?

The taxation of Google’s activities are capturing the attention this week.  Although a party to what is going the attention isn’t really on Ireland – the attention is rightly on the taxation by countries of activities that take place within their jurisdiction.

Closest to home we had the conclusion in late January of the six-year audit of Google’s activities in the UK by HMRC.  By and large HMRC seem to have accepted the premise of Google’s structure as it is generally understood and the rough position is outlined in the Supplementary Written Evidence that HMRC provided for the House of Commons Public Accounts Committee when they convened a hearing on this matter a few weeks ago.

Under the structure Google’s sales are booked by Google Ireland Ltd in Dublin.  Google Ireland contracts with a subsidiary, Google UK Ltd, which provides “marketing services” to Google Ireland and liaises with Google’s largest customers in the UK. 

A critical part of the audit was whether the activities of Google’s staff in the UK are close enough to the sales to mean that Google Ireland had a permanent establishment or branch in the UK.  This would accept that the sales are booked by Google Ireland but that this activity actually happens in the UK rather than Ireland.

HMRC have concluded that Google Ireland does not have a permanent establishment in the UK and therefore Google Ireland does not owe UK Corporation Tax on sales made to the UK.  The parent company’s most recent 10-K filing for 2015 in the US shows that based on the billing address of customers Google generated $7.1 billion of sales from the UK.

Another part of the audit involved analysing the remuneration of Google UK for the activities it undertakes.  The 2006 accounts of Google UK include the following note:

Turnover represents the total intercompany cost plus at 8% charged to Google Ireland Limited for sales and marketing and cost plus 10% for research and development charged to Google Inc. during the year, excluding value added tax.

The most recent accounts show that in the 18 months to June 2015 Google UK had revenue of £1,178 million with £890 million coming from Google Ireland and £288 million from Google Inc.  The reported operating profit of £123.7 million suggests there has been a small uplift in the margins used in the transfer pricing arrangement but not significantly so.  Although not broken out it seems that part of the outcome of the HMRC audit relates to the treatment and deductibility for Corporation Tax purposes of share-based staff remuneration rather than the remuneration of the activities of Google UK per se.

Anyway the political reaction has been as expected.  The PAC state that:

The lack of transparency about tax settlements makes it impossible to judge whether HMRC has settled this case for the right amount of tax.

before going on to declare that:

The sum paid by Google seems disproportionately small when compared with the size of Google’s business in the UK, reinforcing our concerns that the rules governing where corporation tax is paid by multinational companies do not produce a fair outcome.

A crucial aspect was whether Google Ireland had a de facto branch in the UK and HMRC have determined that it does not.  But the PAC are sure to be interested in how this is being viewed by other tax authorities – namely in France and Italy.

In essence, the French and Italian tax authorities are following the same approach as that undertaken by HMRC in the UK.  In a similar fashion Google Ireland has subsidiaries in France and Italy, Google France and Google Italy, and these also provide “marketing services” to Google Ireland and get their revenues from Google Ireland.

In 2014, Google Italy had revenue of €54 million and reported a profit of €4 million.  Over 60 per cent of expenses were personnel costs. For 2013, Google France had revenue of €225 million with a profit of €20 million.  Again personnel costs made up over 60 per cent of expenses.  Given the profit levels the (relatively small) amount of tax paid can be roughly discerned.

France and Italy might quibble with the remuneration by Google Ireland for the “marketing services” provided by Google France and Google Italy respectively but that is not where the pot of gold is.

France and Italy are also looking at whether Google Ireland has a permanent establishment in their countries.  Again what is at issue is whether the activities of the staff are sufficiently close to the sales of Google Ireland that they constitute a branch of Google Ireland in those countries.  We don’t have figures for Google’s revenue from customers with billing addresses in France or Italy but the suggested figures are that it is around €1 billion per annum in France with a somewhat smaller figure originating from Italy.

Although final assessments have yet to be made the tax amounts involved are significant – apparently €1.6 billion in the case of France and €227 million in the case of Italy.  It appears around one-third of the €1.6 billion figure for France arises from interest and penalties for not declaring a tax presence but the potential tax sum is large.

However, there does appear to be a bit of leap here to arrive at these tax figures.  As it stands the sales are booked in Ireland but this doesn’t result in massive taxes falling due in Ireland.  How are Italy and France (allegedly) determining much higher tax bills by claiming the sales of Google Ireland are booked in branches the company has in their jurisdictions?

Google Ireland’s accounts for 2013 show revenue of €17 billion.  The companies main expenses were “cost of sales” of €5.1 billion and an “administrative expense” of €11.7 billion.  The cost of sales is the money to third-party websites which host ads from Google and this is around 30 per cent of the ad revenue. “Administrative expense” includes around €0.4 billion of costs in Ireland and also the fees paid to the subsidiaries of Google Ireland in the various countries for “marketing services” but the main component of this expense is the royalty paid for the license to sell advertising on the Google platform.  This fee was €8.5 billion of Google Ireland’s “administrative expense” in 2013.  The deduction of the cost of sales and the administrative expense from revenues leaves a profit in Ireland of around €200 million and Corporation Tax due in Ireland of around €25 million for sales in all of Google’s European markets.

So how can the tax due in France, in particular, and Italy be a multiple of this?  One avenue could be that they are challenging the royalty fee paid by Google Ireland.  Even if they determine that Google Ireland has a branch in their country the taxable income remaining could be negligible after the royalty fee is deducted.  For the company as whole Google Ireland’s costs are almost 99 per cent of revenue. What reason is there to believe that this would not be similar for a branch of the company undertaking the same activity?

The size of the royalty fee can be challenged but it is possible that they are not going down the route but looking at the tax treatment of it and, in particular, whether it is subject to a withholding tax.  The report on the Italian audit says:

In addition, some 600 million euros of royalties should have been revealed to the tax authorities and would have faced a tax demand for some 200 million euros.

Google Ireland does report that it pays some “foreign withholding tax” but the amounts are small with €8.5 million paid in 2013 and €17.5 million in 2012.

As we know the royalty fee incurred by Google Ireland is paid to The Netherlands.  The most recent accounts for Google Netherlands Holding show that it received €9.2 billion of royalty income from Google Ireland in 2014. This payment, or a variation thereof, would still be due if sales are not booked in Dublin but are booked by branches of Google Ireland in the various countries.

At present, the Revenue Commissioners do not subject this outbound payment from Ireland to a withholding tax.  One justification for this is that the payment is made to a company in another EU Member State and such payments are exempted from withholding tax under the EU directive on the taxation of interest and royalties.  Besides those arising from the EU directive there can also be exemptions from a withholding tax in  other provisions of domestic law.

However, even if the provisions of the EU directive have been transcribed into domestic law there are a few bases on which it can be argued that the royalty payment could be subject to a withholding tax.  It could be said that Google Netherlands Holding does not qualify as a “beneficial owner” per article 1(4) given that it transfers 99.9 per cent of the royalty it receives to Google Ireland Holdings in Bermuda (or apparently it does).  Alternatively it could be argued that the withholding tax should apply so as to prevent “fraud or abuse” under article 5 of the directive. 

These are possibilities but it is not clear that any them would actually apply.  And for these countries to impose a withholding tax it first of all requires the determination that Google Ireland does actually have a permanent establishment in their jurisdiction.  In the only known audit concluded to date on this matter HMRC have determined that Google Ireland does not have a permanent establishment in the UK.  But that doesn’t mean that France or Italy can’t determine that Google Ireland has permanent establishments in their jurisdictions – this can be through a difference of facts or, maybe more likely, a difference of interpretation.  And just because HMRC have concluded their audit doesn’t mean they are right.  Truth be told there is no “right” but let’s not go there.

Even if other countries can show permanent establishment they would further need to establish that a withholding tax can be applied to the outbound royalty payments of that permanent establishment (with the possibility of challenging the size of the royalty also an option – again a matter of interpretation). If the royalty payment was paid direct to Google Inc. in the US (as it possibly should) then it is likely that no withholding tax would apply.  But the payment isn’t made to the US so there doesn’t seem any leeway for someone from the US Treasury to try and intervene by arguing that EU Member States have no right to tax these monies.  This is about countries exercising their right to tax activities that take place within their jurisdiction and because of the countries involved US tax treaties do not apply.

Anyway, one first-round statistical implication of attributing the sales of Google Ireland to branches in the various countries is that the flows would no longer be recorded as imports and exports in Ireland’s Balance of Payments. And for these countries there would be a reclassification of the current computer services import as a patent royalty import.  The GDP effects in both  cases would be negligible (provided the royalty paid by the branch is of a similar magnitude to that currently paid by Google Ireland).

How will the Revenue Commissioners react? Will they be passive and say “after you” to countries who deem Irish-resident companies to have permanent establishments within their jurisdiction?  If such branches are deemed to exist would they argue that the royalty fee should be paid from the branch to the parent here without being subject to a withholding tax?  Would they be prepared to challenge the transfer pricing parameters of such arrangements?  Do they have the resources to do any of this?  Should they be charging a withholding tax?

And what of the implications for Google? Well the implications in the UK seem slight in comparison to the (alleged) potential outcomes in France and Italy.  What about the implications for the infamous “double-irish” structure that Google uses?  In essence, this is not a relevant feature of the various audits being undertaken.  What the tax authorities are concerned with is establishing the activities that take place within their jurisdictions and the remuneration and taxation of same.  The place of incorporation of the companies is a bit of a side-show – except, that is, for US tax reasons.

The main reason for putting in place a “double-irish” structure is to engineer a deferral until repatriation of the US corporate income tax that would be due on these profits.  The US has a general deferral for sales company profits but if there are profits from royalties, rents, interest or dividends the anti-avoidance measures in Subpart F of the US tax code for passive income kick in and the US tax becomes due for payments regardless of whether such profits have been repatriated or not.

Well, that was the original intention of Subpart F when it was introduced in the early 1960s but it has been significantly watered down since then with various provisions and exemptions.  The structures are all multi-layered and include many methods through which a deferral of the US tax due on passive income can be achieved.  Even if one fails there will be another to step in.

The principle exemption that a “double-irish” structure is designed to avail of is the “same-country exemption”.  That is, the transfer of passive income between two companies in the same country does not trigger a payment of the US corporate income tax due under Subpart F.

Of course, the US judges “same country” on the basis of place of incorporation so we have two Irish-registered companies, Google Ireland Limited and Google Ireland Holdings, being classed as being in the same country even though one is in Dublin 2 and the other in Hamilton, Bermuda.  [Google uses “check the box” to have Google Netherlands Holdings assessed a disregarded entity in this instance.  The royalty payment does not go direct from Ireland to Bermuda as Ireland would have levied a withholding tax on such transfers to a non-treaty country.]

What would happen to the “same country exemption” if the royalty payments originate in branches of Google Ireland in other countries?  From this remove it is impossible to tell.  And with provisions like the “look-through rule”, “check the box”, and others there are multiple ways of achieving the same deferral outcome. 

And we don’t know if all of this is just idle speculation.  HMRC have completed their audit and concluded that Google Ireland does not have a permanent establishment in the UK under the Irish-UK tax treaty.  There isn’t anything sufficiently different in our tax treaties with France and Italy to suggest that the definition of permanent establishment used will lead to a different outcome.  Of course, the facts may be different or, even if the same, France and Italy may apply a different interpretation to the PE provisions.  And it is also the case that this tax risk has been obvious to Google for some time – one would imagine from the time the structure was put in place - but knowing the risks and avoiding them are not the same.

Is there any take-out point from all of this. Maybe not!  But it does show that countries are not trying to unravel the “double-irish”.  It is a part of the story but they are not hugely interested in what goes on in Ireland – or more precisely they are interested in what does not go on in Ireland.  They are interested in the activities that are carried out in their countries.  What they are doing is looking at the structure and wondering if the nature of the activities that happens is such that they can dip into the flows that begin with customers in their jurisdictions and capture some tax revenue from them.  All sides are generally acting as they should; let’s see how it plays out.

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Google before the PAC in the UK

Last week Google appeared before the UK’s Public Accounts Committee for the third time in four years.  Once again it was a wasted opportunity.  The Committee Members were more interested in point scoring then in getting to the heart of the matter in hand. 

The first topic addressed to the Google executives was that of Matt Brittin’s and the first issue for the staff of HMRC was the cost of the audit into Google’e tax affairs.  Google’s pay rates is not a public accounts issue and HMRC undertook the detailed investigation that the PAC Members had been loudly clamouring for. 

There are some nuggets of information in the transcript but all in all it makes for frustrating reading with lots of weak questions and the Google executives cut off whenever they seemed set to give a useful answer to the few good questions asked.  The supplementary written evidence from HMRC on the Google audit is helpful.

When the results of the audit were published there were numerous claims that Google was engineering a 3% corporation tax rate in the UK.  The crude calculations usually go something like this:

• Google has worldwide revenues of $70 billion or £40 billion
• Ten per cent, £4 billion, of Google’s revenue comes from UK customers
• Google makes an annual profit of around £10 billion
• Thus, Google profit margin is around 25% of revenue
• Therefore, Google’s profit from sales to UK customers is £1 billion
• Google pays £30 million of UK Corporation Tax a year
• Ergo, Google pays 3% tax on its UK profits.

This is all well and good and the arithmetic is correct but it is not how the current system of Corporation Tax works.  Maybe it is how it should work but arguing that the amount of Corporation Tax that Google pays in the UK is “wrong” based on such a calculation can only be the result of ignorance of how Corporation Tax works or dishonesty.  Neither reflects well on those making the claims.  Here is a good reply.

Corporation Tax is not paid based on the location of sales or customers; it is paid based on the value-added of the activities a company has in a country.  If a company has no presence in a country and makes sales to customers in that country it will face no liability for corporate income tax in that country. 

Of course, the problems arise when a company has a presence in lots of countries.  The first problem is determining whether that presence is significant enough to be deemed a taxable presence.  This is the concept of permanent establishment.  A storage facility will not be a permanent establishment whereas a manufacturing facility will be.  The next problem is determining how to allocate a company’s taxable income across these permanent establishments.  The current approach is to try and resolve this using transfer pricing based on the arm’s-length principle.   This allocates profits to permanent establishments based on the risks, functions and assets that they have.

The staff of HMRC tried to explain this to the Committee Members but they weren’t fully for listening. They heard what was being said but didn’t follow through on it.  Below the fold are some extracts from the hearings. 

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Who will be footing the bill if Apple pays more tax?

The following exchange took place at a recent hearing of the US Senate Finance Committee.

Mr Warner (D): I wanted to ask as well, I know Senator Wyden raised the question of the European Union state aid cases and the overall impact because of potential targetting of American companies and what that impact is for American taxpayers.

Mr. Stack could you kind of walk through that just of terms if a taxpayer was sitting in front of you, how does it affect me ultimately or how could it potentially affect that taxpayer.

Mr Stack: Sure Senator.  When a US company pays a tax in a foreign jurisdiction and then they bring money home they get a credit for the tax paid in a foreign jurisdiction up to a certain limit. 

Now, in the normal case that means you are actually doing some business in Germany, let's say, and you had some tax and you brought it home and you got your credit.  In this fact pattern, the EU is coming along and they're saying "Oh we think when you cut your deal with Ireland or Luxembourg or the Netherlands that in fact you, the company, should have been paying more tax to those jurisdictions." 

Now if we were to determine that those payments are in fact taxes and we were to determine that they are creditable under our rules, now when that money comes home from those companies in addition to the credit they got for the tax they originally paid in those jurisdictions they get an extra credit. And that credit to this taxpayer you asked me about means in effect the US Treasury got less money and in effect made a direct transfer to the European jurisdiction that is getting the ruling from the Commission. 

So if these turn out to be creditable taxes it is the US taxpayer that are footing the bill for these EU investigations.

The reply was given by Robert Stack, Assistant US Treasury Secretary with responsibility for international tax affairs and can be viewed beginning from timestamp 1:17:20 in the video on this page.

Here is a very very simplified set up of what Robert Stack is describing.

In both scenarios the company has foreign earnings outside the US of 1000.  In scenario ‘A’ it pays foreign tax of 100 on those earnings, while in scenario B the foreign tax is 200.

In both cases the gross US tax due is the same (35 per cent of foreign earnings) but to avoid double taxation companies get a tax credit for foreign corporate income tax.  If a US company pays more corporation tax abroad it gets a larger tax credit to offset its US tax liability.

This means that the net tax due to the US falls from 250 to 150 – there is less tax due in the US by an amount equivalent to the extra foreign tax paid.  The total amount of tax remains the same and the company’s post-tax profit is unchanged.  The increased foreign tax paid results in less US tax being due.

Of course, this is highly highly simplified and excludes one key complication – the ability of US companies to defer the US tax due on their foreign earnings – but the impact on the tax that could be paid to the US is the same.  More foreign tax paid means less tax due to the US even if it is deferred.

Naturally, this was always known but as the EU state aid investigations have progressed the US has become ever more vocal on this issue.  Maybe they felt they did not want to interfere with matters in other jurisdictions but it’s also likely that they felt the EU would not interfere with international agreements to allocate the taxing rights to corporate earnings.

Here’s Robert Stack later in the same hearing on this:

Mr Stack: We were faced with a choice as to whether speak up now before multi-billion dollar judgements are rendered against our companies or wait until the decisions have been handed down so we have been raising this issue today.

From my personal observation of these cases and study it appears to me that the Commission is attempting to tax income that really under international standards doesn't belong to any member and, I agree with you, my perception is that they are tring to tax the income that they perceive as untaxed because it has been deferred for US tax and they see it as something that is there for the taking because our system has let it set offshore without being taxed. So that's my perception of the substantive state of those cases.  They have ways to go; I could be wrong. But that's the way I see them today.

So all those suggesting that Apple should pay more tax in Ireland (with some saying we should just force them!) need to back that up with reasons why the US Treasury and US taxpayers should foot the bill.  And it needs to be more than “but the US doesn’t collect the tax”.  That is true but the US has the right to tax that income – on what basis can we take that right from them?

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Corporates in the Institutional Sector Accounts

The previous post looked at some developments in the household sector in the Q3 release of the Institutional Sector Accounts.  There we concluded that the pattern of employee compensation received by the household sector was now more plausible but there seem to be unusally large increases in mixed income (+22%) and net property income (+55%).

Here we will look briefly at the corporate sector which is divided into Financial and Non-Financial.  First the table. Click to enlarge.

What are the take-out points?  First we can see in line 7 that the increase in Corporation Tax receipts is reflected in the account.  In line with the Exchequer Statements there is an increase of more than 40 per cent in the first three quarters of 2015 compared to 2014.

There has been a lot of debate about this increase with the Department of Finance attributing it to “improved trading conditions”.  We see some evidence of that here.  Gross Operating Surplus (line 4) is up 19 per cent year-on-year.  Gross Operating Surplus is akin to earnings before income, tax, depreciation and amortisation (EBITDA) which in turn is a relation of taxable income.

But how do we reconcile a near 45 per cent increase in tax payments with a 19 per cent rise in operating surplus?  What profits are the companies paying extra taxes on?

The increased taxes could be due to non-trading factors such as the exhaustion of previous losses carried forward or the taxation of capital gains rather than trading profits.  Based on a letter from the Chairman of the Revenue Commissioners to the Minister for Finance we can rule out capital gains (as almost all of the surplus is expected to be repeated this year) but the increase in Corporation Tax seems too large to be explained by the exhaustion of previous losses (even with a 20 per cent rise in operating surplus).

A second issue is one that is in the detail behind the above table.  Line 5 gives net property income.  For the non-financial sector this is dominated by the outflow of profits earned by foreign-owned MNCs with operations in Ireland.  But the figure above is net and the constituent elements are worth looking at.  Again click to enlarge.

It can be seen that the net figure results when property income received is offset with property income paid.  In the first three quarters of 2014 the NFC sector in Ireland received €10 billion of property income and in the first three quarters of 2015 this increased to €11.5 billion.  Almost all of this is re-invested earnings on direct foreign investment, i.e. it is profits earned abroad by “Irish” companies. 

This is counted as an outflow from the countries where the profits are earned (just as MNC profits are usually counted as an outflow here) and is counted as an inflow to Ireland.  As the money remains reinvested abroad it will be counted as an outflow in the financial account so the net overall effect is nil.  This money never comes to Ireland but for ownership purposes is counted as an inflow of profits (income) and an outflow of investment (FDI).

The pattern of these reinvested earnings paid to the Irish NFC sector are worth recalling.

We know what has caused this – redomiciled PLCs with inversions from the US likely to play an even greater role in furture time periods.

What do we get from this “inflow” to Ireland? Very little.  It is unlikely that the companies are paying any additional Corporation Tax to Ireland on these profits.  As stated above the money never passes through Ireland. It is retained profits earned abroad that stays abroad.  If the companies ever decide to distribute these profits as a dividend then it will count as an outflow from Ireland (assuming the shareholders are non-resident) but that is unlikely to happen as companies do retain substantial profits for reinvestment.

Is there a cost to Ireland of this? Yes, there is.  These “inflows” are counted as part of our Gross National Income.  In a sense because of these redomciled PLCs the GDP-GNP gap is smaller than it otherswise would be. [This income also makes the current account of the Balance of Payments appear better.]  Is there anything set based on GNI? Yes, contributions to the EU.  We are paying more because of these profits.

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Compensation of Employees revisited

A recent post wondered why compensation of employees isn’t increasing in the national accounts.  The CSO have now published the Q3 2015 update of the non-financial sectoral accounts and the question seems moot – primarily because of data revisions.

In the chart above there is now a two-year upward trend which was not evident in the last version of the data.  All of the revisions relate to data before the first quarter of 2014 so it is possible the changes are result of the switch to ESA2010. 

Anyway now that we have what we would expect – rising compensation of employees – it is worth looking at the broader household sector accounts.  Click to enlarge.

For the first three quarters of 2015, gross disposable income is almost €6 billion (9.2%) higher than in the equivalent period of 2014.  This is driven by three key factors:

• a €3.5 billion rise in self-employed and mixed income
• a near €2 billion rise in wages received, and
• a €1 billion improvement in net property income (mainly dividends)

These are partially offset by a rise in social contributions paid (both to the government and financial corporations) and a reduction in social benefits paid by the government.

Although there was a €6 billion increase in gross disposable income the figures show that there has been a €2.5 billion increase in household consumption expenditure.  This means there has been a big jump in gross savings and the household savings rate for the first three quarters of 2015 stands at 12.2% compared to 7.8% in the first three quarters of 2015.

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