By Craig A. Sharon, Esq.
Bingham McCutchen LLP, Washington, DC
Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.
Judge Learned Hand, Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934)
No quotation about taxation is more famous than Judge Hand's comment above. As a matter of general principle, it has long been accepted that a taxpayer need not pay more tax than is required by the law. As a practical matter, however, it is sometimes difficult to distinguish between lawful "tax minimization" and improper "tax evasion," especially when the legal rules are vague or their application is based largely on a facts-and-circumstances analysis. The distinction is further complicated in the international context, where taxpayers must satisfy multiple tax authorities with competing interests and often conflicting views. No technical issue challenges the distinction more directly than transfer pricing, where previously accepted tax minimization strategies are now under attack, based in substantial part on aspirational arguments not founded specifically on past or current interpretations of the arm's-length standard.
The long arc of transfer-pricing enforcement reflects the perceived inability and increasing frustration of tax authorities, individually and collectively, to police taxpayers' application of the arm's-length standard. Starting with the adoption of specified transfer pricing methods in the late 1960s, evolving to upfront documentation and penalty rules in the 1990s, and moving more recently toward increased taxpayer transparency and bilateral collaboration, tax authorities have sought continually to balance better the mix of policies designed to encourage greater upfront taxpayer compliance, reduce controversy, and punish overly aggressive planning. Each new enforcement phase followed a new round of "incriminating" disclosures about taxpayer efforts to minimize their global tax liabilities, indignant public reaction, and increased political scrutiny, leading tax authorities to implement new initiatives to combat the latest perceived abuses. Historically, these new initiatives have focused on improving the effectiveness of traditional tax enforcement processes, with only occasional changes in the underlying substantive rules (e.g., the addition in the United States of the commensurate-with-income rule to §482 in 1986).
Recent events make clear that the global enforcement environment is changing again, but this time with a new, extra-legal dynamic, accompanied by populist rhetoric and unprecedented political pressure. Whether this is the beginning of the end of the arm's-length standard, a preview of an emerging consensus among tax authorities about an application of the arm's-length standard that focuses on "people functions,"2 or short-term political expediency to manage voter frustration with ongoing fiscal austerity measures, the immediate effect is to create new compliance challenges for multinationals.
"As Anger Over Alleged Tax Avoidance Rises, British MPs Vow Action on Multinationals"
Bloomberg BNA Transfer Pricing Report (11/29/12).
"U.K. Vows Transfer Pricing Crackdown … Against `Tax Dodgers'"
Bloomberg BNA Transfer Pricing Report (12/10/12).
"Senate Committee Says Reforms Needed to Stop Tax Avoidance by Multinationals"
Bloomberg BNA Transfer Pricing Report (10/4/12).
"India Assesses Google … Blasts `Double Irish' Maneuver"
Bloomberg BNA Transfer Pricing Report (11/15/12).
"Allegations … Prompt Italy to Revise Transfer Pricing Rules"
Bloomberg BNA Transfer Pricing Report (12/10/12).
The above headlines manifest a new call to arms against the tax minimization strategies of global companies. The news articles: (1) describe legislative hearings and executive branch pronouncements in the United States, United Kingdom, Italy, and other countries; (2) single out specific companies, such as Google, Amazon, Starbucks, Forest Laboratories, Oracle, Microsoft, and Hewlett Packard,3 for special condemnation; and (3) describe transfer pricing in pejorative, provocative, and often misleading terms, e.g., as loopholes, maneuvers, paper transactions, secret pacts, systematic abuse, evil, immoral, and scandalous, to name a few.
Here's the great irony though: None of the "offending" conduct was or is alleged to be unlawful under applicable local laws or current mainstream transfer pricing practice.4 Indeed, most of the conduct was and is fully consistent with, and was in fact contemplated by, tax and economic policies enacted by one sovereign government or another. In some cases, there may be legitimate disputes about a transfer pricing valuation, but that is not exclusively driving the debate and is not true in all cases. For example, lost in the criticism of Microsoft is the fact that three low-tax affiliates made $28 billion in total buy-in payments to the United States when they first joined the company's cost-sharing arrangement and it was those purchases that entitled the affiliates to earn the IP-related income in their respective territories in subsequent years. Whether or not the buy-ins were arm's length - all were presumably subject to potential adjustment - their implications (and justification) for Microsoft's post-buy-in results have been effectively ignored.5 Similarly, Google is under attack in various foreign countries because of a transfer pricing structure - the so-called Double Irish, Dutch Sandwich structure - that was and still is permitted under the local laws of the affected countries and that followed an early-stage IP migration from the United States to Ireland that was blessed as arm's length in near real-time by the IRS in an APA, which has since been described in conspiratorial terms as a "secret pact."6
Have Microsoft and Google been engaging in acceptable tax minimization or improper tax evasion since their respective restructurings years ago? Under the emerging paradigm, it does not matter. According to critics, both are guilty of engaging in unacceptable (even if legal) tax minimization because the resulting tax consequences are too favorable. This normative judgment appeals not to applicable legal rules, but instead invokes "eye-of-the-beholder" notions of fairness, social responsibility, and corporate ethics. As invoked, these concepts ignore and effectively reject the arm's-length legal standard (or any legal standard).
Should taxpayers not be allowed to take advantage of preferences made available to the public at large by tax jurisdictions trying to influence economic behavior? Should such taxpayers be publicly shamed into paying more tax than is legally required (or making voluntary payments) in one tax jurisdiction because they took advantage of preferences available in another jurisdiction? Shouldn't a changed legal standard be applied only after the change is made through normal, carefully crafted legislative and administrative processes?
In answering these questions, consistency is apparently not required at least in the U.K.:
The Patent Box is part of the Government's growth agenda (as detailed in the Plan for Growth document published in March 2011). The aim of the Patent Box is to provide an additional incentive for companies to retain and commercialise existing patents and to develop new innovative patented products. This should encourage companies to locate the high-value jobs associated with the development, manufacture and exploitation of patents in the UK and maintain the UK's position as a world leader in patented technologies.
Why is the Patent Box acceptable to Parliament, but not the policy choices adopted by Ireland (or other jurisdictions) to attract similar economic activity there? Should the IRS go after U.S. companies that try to take advantage of the Patent Box? Is there a principle here, or is it only the tax results that critics find so objectionable?
Today, we're taking action to pay corporation tax in the United Kingdom - above what is currently required by tax law.
Kris Engskov, Managing Director, Starbucks Coffee Company U.K.7
After being harshly criticized by Parliament and the U.K. Treasury,8 Starbucks agreed to pay about $16 million more in U.K. corporate taxes in 2012 by foregoing available tax deductions for royalties, coffee purchases, interest on intercompany loans, capital allowance deductions, and loss carryforwards. Starbucks expects to make similar, negotiated "extra-legal" tax payments in 2013 and 2014.9
I'm not in a position to second guess Starbucks' decision to pay additional tax voluntarily to HMRC. Presumably, it made a hard-nosed business judgment based on tax, business, and other considerations. Indeed, the company's statement makes clear that it was acting primarily to protect its reputation: "Since Starbucks was founded in 1971, we've learned it is vital to listen closely to our customers - and that acting responsibly makes good business sense."
I wonder, though, whether Starbuck's "goodwill" gesture will be lost on the IRS and other tax authorities:10
- Does the payment represent an admission of improper transfer pricing? Starbucks says "no," but try explaining that to other tax authorities in a position similar to the HMRC. Why won't they go after their "fair share"?
- How much extra-legal tax represents a company's "fair share"? What are the criteria, if any, for determining the right amount?
- Whatever the amount, how should the payment be characterized - as additional income tax, as a marketing expense, as a gift to the people of England?
- If HMRC characterizes the payment as an additional tax, will the amount be creditable in the United States for foreign tax credit purposes? That seems unlikely, given the payment's non-compulsory nature.11
- Finally, what does the Irish tax authority think about this? What about the IRS (or the U.S. government more broadly), especially since it seems like only U.S. companies are being targeted?
The foregoing questions represent food for thought for other taxpayers thinking about anteing up additional revenue to satisfy public opinion. For the rest of you, buckle up, because the compliance road ahead is unmarked and may take surprising turns.12 To navigate, you may need to broaden your thinking about tax compliance to encompass not only the technical tax rules, but also public policy, public relations, and government relations. Following the current legal rules may not be enough when your reputation is increasingly at risk.
This commentary also will appear in the February 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.
2 As evidence of this thinking, see the OECD Discussion Draft, "Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions," at pp. 12-17 (issued June 6, 2012). See also note 4 below.
3 The complaints about Hewlett Packard relate not to transfer pricing, but to a short-term intercompany lending program designed to avoid Subpart F income under §956. For additional background, see the Senate Permanent Subcommittee on Investigation Memo on Offshore Profit Shifting, dated Sept. 20, 2012.
4 But see Chapter 10 of the recently updated U.N. Transfer Pricing Manual for emerging "developing country" views about transfer pricing that could serve as the basis for challenging tax structures such as the Double Irish, Dutch Sandwich. The OECD is studying the same issues (see note 2 above), but has not yet incorporated the developing country views into its transfer pricing guidelines. If the OECD were to revise its guidelines, such changes would not have the force of law (presumably on a prospective basis) unless and until they are formally adopted by individual countries.
5 The payment of the buy-in amounts was relegated to a footnote when the Senate investigated Microsoft's practices. See the Senate Permanent Subcommittee on Investigation Memo on Offshore Profit Shifting, at note 69 and accompanying text (Sept. 20, 2012).
6 For additional information, see the following Jesse Drucker articles: "Google Revenues Sheltered in No-Tax Bermuda Soar to $10 Billion," Bloomberg (12/10/12); "Google Questioned by SEC over Earnings in Low-Tax Countries," Bloomberg (3/21/11); "Google 2.4 Rate Shows How $60 Billion Lost to Tax Loopholes," Bloomberg (10/21/10), and "US Companies Dodge $60 Billion in Taxes with Global Odyssey," Bloomberg (5/13/10).
8 Less than a week after the hearings in Parliament, George Osborne, head of the U.K. Treasury, observed that "[i]t is simply not fair that at a time when most people are making a contribution to balancing the nation's books, there is a small minority of taxpayers who are trying to escape their responsibility." Quoted in Bloomberg BNA Tax Management Transfer Pricing Report, dated Dec. 13, 2012.
9 Whatever you think about President Obama's desire to increase taxes on corporations and the wealthy, at least he is pursuing the idea the old-fashioned way, i.e., through the legislative process on a prospective basis.
10 Of course, during the recent Presidential campaign, Republican candidate Mitt Romney raised the bar for all of us by "generously" forgoing roughly $1.75 million in charitable deductions on his 2011 federal tax return.
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