The Lough Erne Declaration, like most summit communiqués, is replete with bold statements of intent. G8 leaders have pledged to ‘fight the scourge of tax evasion’, with a focus on transparency and information sharing. However, the reality is that administrative reforms to international taxation will change very little – if anything – without substantive reforms to International Tax Law. And while the Declaration contains a statement of intent to ‘change rules that let companies shift their profits across borders to avoid taxes, and [make] multinationals […] report to tax authorities what tax they pay where’, with over 2,000 Double Taxation Treaties to amend, changing the rules in any substantive way is a herculean task.
How do firms avoid tax?
The key to reducing your tax liability is, rather obviously, to reduce your taxable profits in high-tax jurisdictions, and shift them to law-tax countries. While international tax rules, in theory, provide for taxation of business profits at source where a business has a ‘permanent establishment’ in that jurisdiction, it is possible to substantially reduce that liability through the use of – in particular – royalty payments and loan finance.
The Dutch Sandwich
Companies A and C are incorporated in Ireland. A is headquartered (and therefore taxable) in Ireland, C in somewhere like Bermuda. Company B is incorporated and resident in the Netherlands. All of these companies are ultimately part of Group X, probably incorporated and resident in the US. Tech firms domiciled in Ireland earn profits primarily from IP. The IP is owned (or substantially controlled) by Company C, but the operating arm is Company A. Company A earns a profit, but wants to shift that profit to a tax haven. Company A pays royalties to Company B (as there is no withholding tax in Ireland for royalty payments to EU countries). Company B then makes royalty payments to the ultimate owner – Company C – as there is no withholding tax between the Netherlands and Bermuda. Non IP-related profits can also be reduced through the use of loan finance funneled in the same way. For the purposes of Irish tax law, Company C is tax resident in Bermuda. For the purposes of US tax law, Company C is tax resident in Ireland.
The Double Irish
As above, except that, as Ireland has recently changed its rules relating to withholding tax on royalty payments, the Dutch company is no longer necessary. Payments can be made directly from Company A to Company C. The Double Irish, however, is only of use where profits from intellectual property are concerned. Where loan finance is used as a means of reducing profits a Dutch company is still necessary to channel profits out of the EU.
Where do these rules come from?
Current international tax rules find their genesis in the work of the Fiscal Committee of the League of Nations in the 1920s. Most of the principles that presently make up international taxation law were agreed by the four experts who were charged with drafting a set of model treaty articles – Professors Bruins, Einaudi, and Seligman; and Sir Josiah Stamp. Today, the rules as they are in force are contained in a network of over 2,000 Double Taxation Treaties (DTTs) – most of which are based on one of three models: The OECD Model; The UN Model; and the US Model. The OECD Model is the most prevalent, although the key clauses in the other models are fairly similar to that of the OECD.
Why not a multilateral treaty?
It was initially thought that agreeing a multilateral treaty would be nigh-on impossible. Instead, the League proposed model articles on which bilateral treaties should be based. It was hoped that once the principles of the model articles had been bedded-in by bilateral treaties, that states would eventually move to multilateral treaties – however few have ever emerged.
Why have they never changed?
Quite simply, because it would be too difficult. Agreeing even modest amendments to the Model Convention can take years – while the core principles of permanent establishment and arms length accounting have never been amended. Instead, the OECD has opted to amend their highly authoritative commentary on the Model Convention. Of course, even if amendments to the OECD Model could be agreed – it remains merely a set of model articles. The thousands of DTTs currently in force would then have to be amended – which cannot be assured of success. The dangers of having a patchy net of tax treaties are usually thought greater than the comprehensive but imperfect network that currently exists.
But these changes will work, right?
Doubtful. The focus of the G8 Summit at Lough Erne has been on information sharing and transparency. However the reality is that shedding light on companies’ tax arrangements will usually reveal that all is perfectly legal and above board. While it is the case that they may be forced to do in public what they formerly did in private, when it comes to a choice between pleasing tax campaigners and substantially lowering their tax bills, multinational corporations are going to elect to continue to do what they have been doing all along. What is needed is a genuine drive to alter the substance of international tax rules – rather than the manner in which they are administered.