Recent tax law changes have gone some way to justify the Government’s claim that the ‘UK is open for business’. But with many foreign jurisdictions still offering more competitive tax environments than the UK, Tim Brown investigates the feasibility of foreign profit attribution.
The coalition Government’s tax changes have included the well documented reduction in corporation tax to the baseline rate of 24%. Changes have also been made to the foreign profit rules so foreign subsidiary dividends, paid back to the UK, are tax exempt. Such amendments are unlikely to result in a frenzy of near-shoring of factories but they may help to stifle the largely one-way traffic of manufacturing operations leaving the UK.
With globalisation, the economic reality is that businesses are often comprised of large multinational groups with numerous subsidiaries.
The way in which profit is shared among those subsidiaries can have a big impact on gross profit margins. An article written by Bloomberg’s Jesse Drucker cited pharmaceutical giant Pfizer as an example of a company maximising profits through attribution of income to ancillaries in countries with lower tax rates.
According to Drucker, from 2007 through 2009 Pfizer posted almost half its revenues in the US, booking domestic pre-tax losses totalling $5.2 billion.
Over the same period a Dutch subsidiary reported pre-tax profits totalling $20.4 billion in 2007 and 2008 and was subject to a tax expense of 5%, a seventh of the top US corporation tax rate. Accordingly, the overseas tax savings helped increase the drugmaker’s net income by $1bn last year.
These are impressive figures that would make any company with an international base sit up and take notice. “While it is true to say that there are many jurisdictions with low or no tax,” says Tim Stovold, a partner at accountancy firm Kingston Smith, “the difficulties in actually being able to structure a business to take advantage of those low tax rates are huge.” How can companies such as Pfizer make such huge savings and what complications are involved?
Breaking it down
Profits from a multinational company have to be split in to the jurisdictions in which the group operates. For taxation purposes most countries view profits on a territorial basis and tax a company’s profits according to which transactions took place in that region.
In any multinational company, transactions also take place between group entities. For example, one company might buy the raw materials which are shipped to the manufacturing site. The product might then be moved again for subassembly or finishing and then be transported to market.
Transfer pricing laws prevent companies from simply manipulating the prices of goods sold within a group to allocate greater profits to a particular region with a lower tax rate. “The approach that most modern economies take to this is to use what is called ‘the arm’s length standard’,” says Deloitte’s tax partner Mark Stephenson. “This says that companies transacting between themselves in an intra-group situation have to, for tax purposes, charge the same price for a component good that they would normally sell to a third party, non-group company.” According to Deloitte, the most important piece of the profit attribution puzzle relates to the ‘intangibles’ or the elements of a business that don’t have an immediate monetary value.
These include items such as knowhow, brands, trademarks, research and development, patents and goodwill. In the case of a pharmaceutical company, the region in which it holds its intellectual property and therefore collects the related royalties is critically important. “The Netherlands has always been a favoured place for holding intellectual property,” says Stephenson. “This is because it is a modern regime with good legal protection but they also have a very generous tax regime.”
Intangible not untouchable
While intangibles don’t have an immediate monetary value, if a business attempts to transfer an intangible between companies in different countries, it is inferred that a gain has been made and the intangible will be taxed at ‘market value’. If a company decides to transfer a section of a business which has a value to a company in another country, it will have a tax liability on disposing of the goodwill and intangible assets, such as the IP, even though no earnings have been made.
Stovold says that patents and intellectual property are very easy to shift, ideally when they have no value. “While a company is developing a particular piece of IP, it might assign it to an overseas jurisdiction such as the Netherlands.” However, warns Stephenson, if a new invention is made and then transferred before having a true market value, “when all the cards are face up on the table and the Inland Revenue has all the facts, they would say that the original company which started the work owned an intangible and they would place a value on the transfer income.” Exit charges are often applied when businesses consolidate operations in different countries.
This happens because it is judged that profit has been shifted from one jurisdiction to another. If an existing contract is moved due to consolidation, a company may pay an exit charge on the value of the contract in the original country plus the tax on the profit earned in the new country. Stephenson says that although there are questions over the legality of exit charges within the EU, at present the duty to declare the provenance of an exit charge is unclear – suggesting it is worth trying to understand the liabilities of exit charges more fully.
Both Stephenson and Stovold add that the mantra applied by tax consultants is that commercial reasons should be the primary consideration when restructuring your global operations. “If your first reason for looking abroad to expand is tax, then it is unlikely that a move will be justified,” says Stovold. “The tax has to be a secondary reason, otherwise you will find that it either isn’t going to stand up to scrutiny or there are going to be more practical problems involving the cost of infrastructure or difficulties sourcing skilled labour.” However Stephenson says that “if a company is undertaking a reorganisation for purely commercial purposes then it is much more likely to be able to achieve that reorganisation without unforeseen tax costs… Those companies that have set up abroad a couple of years ago may now be looking at the corporation tax rate and foreign profit rules and thinking that the UK isn’t so bad after all. If you can live with a 24% corporation tax rate then the UK actually makes quite a lot of sense as a place to do business.”