How the US and UK could collect more tax from Apple and Google (if they really want to)

Ireland's corporation tax regime continues to be in focus but the reality is that some of the politicians from other countries making complaints are doing little more than engaging in misdirection away from the problems with their own tax systems.

In the example of Apple, which was highlighted at a US Senate Committee, it emerged that the companies Apple uses to manage its global tax affairs are fully based in the United States. These holding companies have accumulated close to $100 billion in assets built up from Apple's largely untaxed global profits.

These holding companies undertake all their activities in the United States. Their management decisions are made in the US; they hold their board meetings in the US; the $100 billion of cash is managed in the US; and the money is held in US banks. Everything these companies do happens in the US. The money never even passes through Ireland.

These companies can defer paying a massive US tax liability because the US tax code considers these companies to be 'offshore'. In general, the US tax code levies corporation tax on US-registered companies. Although entirely operated in the US the holding companies used by Apple are registered in Ireland.

Provisions in the Irish tax code allow the tax residency of some companies to be determined on the basis of a test of management, i.e. whether the company is managed and controlled in Ireland. Apple's holding companies do not satisfy this test of residence.

In the US tax code there is provision to allow for the taxing of offshore companies if the location of their activities and close relationship to the parent company means they should be considered part of the parent rather than a separate entity for tax purposes.

The Internal Revenue Service (IRS) in the US has accepted Apple's assertion that the holding companies are offshore. Following changes to the US tax code in the 1990s, Apple doesn't even have to prove that these companies are indeed offshore; Apple simply has to "check the box" with a tick on a form to avail of this loophole.

It is not the Irish tax code that allows companies which are functionally managed and controlled in the US to defer paying corporation tax to the US Treasury; it is the US tax code and the application of it by the US Internal Revenue Service that allows it.

In the UK, the activities of Google have come under the scrutiny of Westminster’s Public Accounts Committee. The tax strategies of Google UK are a good example of profit shifting.

Google sells billions of pounds of advertising to customers in the UK each year. Google avoids paying UK taxes on the profit it makes on these sales by telling Her Majesty's Revenue and Customs (HMRC) that these sales are made in Dublin and therefore not subject to UK tax. HMRC have accepted Google's take on this.

The investigation by the PAC has shown that the assertion that Google does not have a ‘permanent establishment’ in the UK is not supported by the evidence. Google has a large number of staff in the UK. These staff negotiate contracts with customers. Although Google has claimed that they only engage in marketing and promotion the online profiles of the staff clearly indicate that they are involved in sales.

Google's UK sales staff bring the customers right through to the point of signing the contract when responsibility for the transaction is transferred to Google’s operation in Dublin. By any normal definition it would seem that Google UK is fully dependent on Google Ireland. Google UK does not sell advertising for any other company. Google UK sells Google advertising in the UK and it is difficult to see how the HMRC have judged that this is not a permanent establishment of Google in the UK.

It is not the Irish tax code that prevents the UK Treasury from collecting taxes from Google's selling activities in the UK; it is the UK tax code and the interpretation of this by the HMRC that prevents it.

If the US wants to collect more tax from Apple and the UK wants to collect more tax from Google it is entirely within their remit to do so. Their politicians may point the finger at Ireland but the shortcomings are in their own systems.

That is not to say that Ireland is just an innocent bystander to the tax avoidance strategies of international companies. We are not. The Irish regime of corporation tax is deliberately designed to allow companies to take advantage of the loopholes and interpretations present elsewhere. Ireland did not create the malfunctioning system for taxing global companies, but we do set out to benefit from it.

Ireland has been attracting foreign companies to set up here with favourable tax rules since the 1950s. The tax provisions we have put in place are available to a specific set of companies - those with a presence of substance or trading presence in Ireland. In simple terms, the Irish tax regime is made attractive to MNCs as long as they create jobs here. The advantages cannot be fully exploited by companies who only set up a brass plate operation here.

The political hearings in the US and UK have led to calls that we should have a similar review process here. Attracting MNCs has long been a feature of Irish industrial policy. With 100,000 direct jobs from US companies alone it can be judged to be highly successful. But this success does not come without risks. A clear risk is that the companies will fold or move their operations elsewhere. The experiences with Digital in Galway and Dell in Limerick among others highlight this risk.

There is also the risk that the focus on foreign firms comes at a loss of development among indigenous firms. Until the EU ruled it anti-competitive in the 1990s Ireland had a dual system of corporation tax with two regimes operating side-by-side. One was for domestic companies and one was largely designed around attracting foreign manufacturing firms.

In 2003, the dual structure was abolished and a single rate regime at 12.5% was introduced. One problem with this is that, given the size and lobbying influence of companies in the MNC sector, the tax system will be designed with these companies in mind rather than indigenous small and medium-sized enterprises who employ a much greater number of people.

There is also the risk the countries will close the loopholes the Irish system allows companies to take advantage of. The key concern here is the US tax code and the large presence of US companies in Ireland. Almost all of the attention focuses on US companies because the Irish tax code has been made particularly attractive for them.

There are many complaints about lack of innovation and imagination in the officials who population government departments. This cannot be said of our use of the tax system to attract US companies. Of course, there are other advantages to locating here but the main attraction is how our corporate tax regime interacts with the US system.

This has been put in place by government officials with assistance of local accountants and tax practitioners who can provide services to companies to allow them to take advantage of the system. They get large corporate clients and the 100,000 well-paid jobs from US MNCs are a huge benefit for the country in general.

Will the US close the loopholes that make Ireland so attractive? This is unlikely as long as the US Congress remains as it is. Many Republicans will not vote for tax increases (which is what they will view closing the loopholes as) and many Democrats will not vote for tax reductions (which would make it less attractive to US companies to hold their profits offshore).

There is likely to be some moves to reduce the ability of companies like Google to engage in profit-shifting as described above. As this can only come from international agreement, through for example the OECD, the relative attractiveness of Ireland for MNCs will remain largely unchanged though the companies themselves may end up paying more tax around the world, as is correct.

In the current system Ireland does not benefit from a corporation tax windfall. Although Google transfers the profit from its UK sales to Dublin, the profits are in turn transferred from Ireland to Bermuda where the rate of corporation tax is zero. Ireland benefits from the thousands of jobs that Google create here.

The Action Plan on this issue published by the OECD presents few threats to Ireland.  Rules on transfer pricing will be tightened.  However, it is not the transfer to low-tax locations such as Ireland, where the MNCs have a presence of substance, that are being targeted.  It is the transfers to no-tax locations such as Bermuda, where the MNCs have no actual activity, that the OECD proposals are seeking to clamp down on, though there is no guarantee that anything substantial to reaching this goal will be delivered. 

It is right that the international system of corporation tax come under scrutiny. The system needs reflect the cross-border nature of modern businesses. Global corporations should pay a greater amount of tax on their profits which are only possible because of the legal and business environment that countries provide. Governments provide the foundation of these and corporations should pay for something they benefit hugely from.

Ireland should be an active participant in this debate but we do not need to take any solo runs. If there are going to be international changes let them be the outcome of negotiation and agreement. Ireland may not be a tax haven but we do use the tax system to our advantage. There is absolutely no point in giving that up because of some cage-rattling by foreign politicians (and by some misguided domestic ones).

S&P on Ireland

Although the change itself is not significant, the statement accompanying S&P’s adjustment of their outlook on Irish government debt from stable to positive is worth a read.  The statement is reproduced in full below the fold.  One of the more telling parts is the very last paragraph:

On the other hand, if the Irish economy remains sluggish, asset prices depressed, and debt reduction slow--or if banks are unable to reach NPL reduction targets--the ratings are likely to stabilize at the current level.

So even in the adverse case it seems that S&P would not bring the current BBB+ rating down.  In the S&P scale this is three notches above “junk status”.  From an Irish perspective the Moody’s Ba1 “junk status” rating with a negative outlook is the most notable and they have given no indication of a change, though this headline from the London Evening Standard did require a double take. It has since been rectified but is still wrong.  Anyway, S&P’s reasoning on their outlook change can be read below the fold.

OVERVIEW

In our view, there is a more than one-in-three probability that Ireland could over-achieve its fiscal targets and reduce its government debt 
faster than we currently expect.
We are therefore revising our outlook on the long-term ratings on Ireland to positive.
We are affirming our 'BBB+/A-2' long- and short-term foreign and local currency sovereign credit ratings on Ireland.

RATING ACTION
LONDON (Standard & Poor's) July 12, 2013--Standard & Poor's Ratings Services today revised the outlook on the long-term rating on the Republic of Ireland to positive from stable. At the same time, we affirmed our long- and short-term foreign and local currency sovereign credit ratings at 'BBB+/A-2'.

RATIONALE
The outlook revision reflects our view that Ireland's general government debt burden is likely to decline more rapidly, as a percentage of GDP, than we had previously expected. This is due to sustained budgetary consolidation, stabilizing domestic demand, and higher receipts from government asset sales. We base our expectation of improving budgetary performance on implemented cuts to the public sector wage bill, reduced interest expenditure as a consequence of the promissory notes exchange completed earlier in 2013, and a steady recovery in tax receipts. Since the start of the EU/IMF program in 2010, Ireland has not deviated from its stated fiscal goals.

Based on our current growth and fiscal assumptions, we expect net general government debt to peak at 122% of GDP in 2013 but to decline to 112% by 2016. Our estimate of Ireland's gross and net general government debt includes National Asset Management Agency (NAMA) obligations issued to purchase distressed assets from participating Irish banks at a discount. However, until these are sold, NAMA's loan assets are not considered liquid assets in our estimate of net general government debt. As a result, Ireland's net general government debt could reduce faster than we currently expect if NAMA monetizes its loan assets more rapidly, resulting in either repayment of its obligations or further accumulation of cash. The Irish government has pre-financed itself for 2014: we estimate the exchequer had a cash balance of €26.2 billion (15.6% of GDP) at end-June 2013. We also assess contingent liabilities from the financial sector, which are below 30% of GDP, as "limited", under our criteria.

The strong consensus among the country's largest political parties--for fiscal consolidation and policies aimed at economic flexibility, competitiveness, and openness--supports Ireland's policy and institutional effectiveness. In our opinion, under the IMF/EU bailout program, Ireland's government has improved the regulatory and legal framework.

Ireland's economic recovery is under way. Given still-weak external demand and Ireland's exports exceeding 100% of GDP, we expect growth to remain slow in 2013 and 2014. Nevertheless, Ireland's domestic economy is showing signs of stabilizing. Unemployment has started to decline while private sector employment numbers are improving. The seasonally adjusted standardized unemployment rate declined to 13.6% in June 2013 from a peak of 15.1% in early 2012. We also expect house prices to bottom out in 2013. We believe there is upside potential for Ireland to recover more rapidly, should external demand recover. We are also of the opinion that Ireland's potential growth rate is greater than 2%, benefiting from its favorable demographics, its openness, and its labor and product market flexibility.

Ireland remains vulnerable to external financing risks despite the current account being in surplus since 2010. Short-term debt by remaining maturity remains well above 100% of current account receipts (CARs). Because there are many international financial companies in Ireland, its external statistics are distorted by the large asset and liability positions of these entities. In our external debt analysis, we focus on the government's and Irish banks' external 
positions as they are the largest external debtors in the economy. While the government's international capital markets access has improved and the maturity extension of its European Financial Stability Facility and European Financial Stabilisation Mechanism official debt (as agreed in April 2013) has reduced its near-term financing needs, the banking sector has only recently re-entered the capital markets and issued unsecured debt. Given the uncertainties related to global liquidity, we view Ireland's private-sector access to external funding as still fragile.

Ireland's banking sector still has very high levels of nonperforming loans (NPLs), at above 25% of the domestic loan book, and rising. Most notably, mortgage arrears continue to increase (13.5% of accounts are more than 90 days past due). Recent government legislation has removed legal obstacles to repossession and introduced a new personal insolvency regime. A revised code of conduct that governs how lenders must treat struggling mortgage borrowers has also been introduced. Given these recent developments, we expect banks will now move more rapidly to try and resolve cases of long-term arrears following targets set by the central bank, which will likely lead to a large number of foreclosures in buy-to-let properties. Partly as a result, we do not expect Ireland's larger banks to return to profitability in 2013 and, in some cases, probably not until 2015. We also believe they will remain reluctant to lend to the domestic economy.

OUTLOOK
The positive outlook reflects our view that there is a more than one-in-three probability that we could raise our long-term ratings on Ireland in the next two years.

We could raise our ratings on Ireland if its growth performance suggests that fiscal outturns will surpass our forecasts or that banks' asset quality will materially improve.

On the other hand, if the Irish economy remains sluggish, asset prices depressed, and debt reduction slow--or if banks are unable to reach NPL reduction targets--the ratings are likely to stabilize at the current level.