Recently newspapers and broadcasters have become very keen on investigating and exposing tax practices of multinationals, but this is nothing new. The practice of minimising tax liabilities has been going on for decades. We hear explanations with multinationals citing contributions via employment tax (National Insurance in the UK) and VAT. This is a lame excuse dreamt up in the Multinationals PR departments which indicates the level of desperation at Multinationals HQs and their desire to limit the damage to their brands. Governments have been complicit in this and are being caught out by the speed and ferocity of the public response.
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This article aims to clarify and add an insight into these practices. Additionally, in my view, these practices not only deprive governments of tax revenues but are fundamentally distorting the principal of free market and threaten local manufacturer, suppliers, and jobs. In simple terms, if you are a local supplier that only operates in one country, then your multinational competitors have an unfair competitive advantage. They can transfer their taxable revenues (profits) to a third country, enjoying higher operating profits than their local competitors. Multinationals can use this additional margin to cut prices to a level where local competition can no longer compete effectively, putting local companies out of business (Starbucks strategy). Alternatively, they can retain this margin to make hyper-profit on their goods and services, enabling them to invest more in marketing and R&D (Apple, Amazon & Google strategy). This fundamentally undermines the mechanics of free market, does away with the concept of a level playing field, costing local jobs, and depriving host governments of tax revenues. Given that a large proportion of most governments' tax receipts derive from corporation tax, when a government has shortfall of tax receipts it will be forced to impose higher taxes on its citizens, which means you and me. These practices are morally and fiscally unacceptable.
Before we go any further, let me explain that I am not an accountant but spent nearly two decades working for multinationals with a large part of my time being responsible for "Pricing" and "Margin Management"! This insight can help demystify the practices and methods deployed by Multinationals as well as suggesting practical ways that these practices can be stopped. With the exception of the section on what government should do, the content of this article will not be a surprise to any CFO, Accountant or Tax Planning Professionals. The basic philosophy of margin streamlining and the mechanics used may surprise some readers who are not familiar with corporate taxation. My suggested ways to stop these practices will appear surprisingly simple to readers but horrifyingly effective to CFO of any Multinational. I shall leave the accounting part of this debate to the professional accountants and tax experts.
So how do Multinationals manipulate costs and pricing?
In this case semantics are incredibly important, it is critical that we understand and discuss the issues with a common language for reference points. Multinationals, lawyers and politicians are adept in misusing semantics to confuse the public and push their own agendas. In order to avoid misunderstandings and to comprehend tax avoidance practices it is necessary to use simple language and explain the semantics used.
Creative Transfer Price
To get a clear picture of the web of confusion created by the Multinationals and their tax experts, we simply need to follow the money! Following the Margin Chain as well as the Supply Chain are the two best ways of discovering what is really going on, and the only means to backward-engineer prices to arrive at the real Cost of Goods (COGS) and profits made.
Cost of Goods (COGS) is very tricky as it is used to mean many things but within the Multinational operations it very rarely means the real costs. Cost of goods can include allocation and arbitrary costs loaded into the system which makes costs appear higher than they really are.
For manufactured goods to get to the true COGS, it is necessary to establish the Bill of Materials (BOM). This is actually very easy to do even if you are not an insider. There are companies and experts that can take a product apart and give you a fairly accurate view of the costs. For example, COGS and the margins of Microsoft's Surface device were calculated by experts using this method within 5 days of its public launch! Manufacturers do this to their competitors all the time, so why the tax authorities have not bothered with this method defies comprehension.
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From this base line you can easily calculate the absolute margin, providing the real profitability of the goods. Notice I have said "Profitability of the Goods" and not the company. Companies have varying levels of costs, but in general you can easily calculate their operational profitably from their financial filing with the authorities. Of course this is where the fun starts with Multinationals.
In principal Multinationals work on "Loaded Costs" rather than the real costs. Loaded costs are where a range of arbitrary internal costs are loaded into the real COGS. These are usually hidden under "Allocations" and "Transfer Costs".
How Subsidiaries can help mask profits
For Allocations and the Transfer model to work properly, Multinationals have to create subsidiaries in each country of commercial activity. These organisations are purely sales organisations with no administrative, manufacturing or other value-added functions. In theory, they are there solely to sell their products or services in the local market. This appears to make perfect sense both operationally, and to the consumers as they feel the company is making a commitment to the local consumers. Usually any announcement of opening a new operation in a country by a Multinational, is hailed by the government concerned as proof that their policy to attract investment is working. This in reality is just a side show; as you can serve your customers equally well by using reputable local Distributors who can support your products locally.
The reasons for setting up sales subsidiaries in individual countries are many but the tax upside makes this a compelling and irresistible proposition.
Firstly, the multinational can set transfer prices between the HQ and the subsidiary under the "Loaded Cost" principal. This means the company can overcharge the subsidiary, therefore ensuring that it will never make a profit in the country of consumption or host country. In fact, the more hand-over between subsidiaries the better, helping to create a web-of-deceit which no tax authority can break through.
Secondly, by running own operations, Multinationals retain the margin they would have been sharing with a Distributor, which more than compensates for the additional operational costs they incur in a direct distribution model. Typically Distributors demand margins between 15% to 30%. A well-run operation combined with smart "Transfer Pricing" will make it less costly than using Distributors, who need to cover their operational costs, as well as make a profit on the sales of the goods. The producer only needs to cover its operational costs in the host country, as it has plenty of "Margin/Profits" upstream. Also retaining total control of the margin chain enables multinationals to repatriate profits to the lower taxed countries.
Take the case of Apple in the UK (or any other European country), where it sells all its products through a myriad of channels including retailers such as Curry's, PC World, John Lewis, etc. as well as from 100s of web outlets. Then Apple opened up its own shops, competing with its own channel (a sin in an indirect sales model), and follows on to declare virtually no profit from its retail operation. If a company doesn't make any money, why on earth would it get involved in the retailing of its products? Why not invest and support Apple's channel to help them sell more? Why not educate & train Apple's channel so that they can support Apples products more effectively? Apple does it because they are managing their transfer pricing and allocations effectively, so that they can show a loss locally even when they are making massive profits upstream.
Finally, and rather ironically, multinationals charge Corporate Taxation on their subsidiaries. This is also known as "Fully Loaded Cost" or "Fully Allocated Cost" and is supposed to include general costs such as R&D, IT systems, HR, Legal Services, Marketing Services, Distribution Costs, etc., which allegedly shares the costs of centrally supplied or supported services amongst the subsidiaries.
Take Amazon for example, as per evidence given to the UK's MP Select Committee. Amazon sales are handled through a Luxembourg Subsidiary, whilst the UK Company acts as a Service Provider to handle warehousing, shipping and other aspects of the operations for all European sales! This is clever cross-charging and re-cross-charging of the same sales $. So Amazon sells a product from its subsidiary to another, then another subsidiary charges the original subsidiary to deliver and service it. These multi-level transactions will suck the paper profits dry, so Amazon ends up paying zero taxes in the country that consumes the product, and then declares all its profits in the country with the lowest tax rate in this case Luxembourg. This is modern day piracy.
Another example is Google, with 700 Sales personnel in the UK, who sell advertising in the UK to UK companies targeting UK consumers. However, the sales are processed at Google's sales operations in Ireland, so that the revenue is actually booked in Ireland rather than the UK. The corporate tax saving is over 16% just in this one cross-transaction level, and before consideration of loaded costs with allocations and so called corporate internal taxes. Google admits that until as recently as 2012 it also charged the Irish subsidiary "Service Charges" via their Dutch subsidiary in order to reduce their Irish tax liabilities further.
Acquisition or just clever tax planning?
Now if the Multinational is really clever, instead of setting up a new company in a country, they will acquire a company. Why? I hear you ask! Well this is even a better scheme than above, because now they can charge their subsidiary for the cost of acquisition over a 10 year period receiving handsome tax relief to boot! When "Investment Incentive" was put in place by the government, it did not intend it to be used as a means of tax avoidance. Under the current system, if a Multinational spends $100m in acquiring a company, it can then set aside $10m per annum tax write-down as "Acquisition Write-Off" over a 10 year period! So now, the acquired company is in fact paying for its own acquisition through its own revenues and profits, whilst the tax payers in the host country are subsidising the acquisition with tax write offs. This is just a tax Punzi scheme.
Let me illustrate this with an example. Let us say we are "Widgets R Us" the leading manufacturer of "Widgets" in the world. Being a multinational "Widget R Us" have factories in Taiwan or China where they can minimise the cost of manufacturing by an average of 30%. The COGS of the "Widget" is $100 with the loaded cost of $130. The Widget is sold at retail price $260 (Don't be shocked this is a very modest mark up -check on your Smartphones' real margins, and you will have a heart attack!). Transfer this to your local subsidiary at $200, your subsidiary now only has $60 to pay for all its overheads and operational costs. The chances of the subsidiary making a profit is pretty low, but if they do get near making any profits you whack them with "Allocations" and/or charge them 10% corporate tax (in this example $26 per unit off the bottom line). So now your subsidiary only has $34 of margin or 13%. If you have acquisition costs you can load them up on the accounts too, which means your subsidiary now makes about 1cent on every $260 of sales! Good luck taxing that one.
A local competitor who has been naïve enough to keep its manufacturing and operations onshore has no way of creating an internal transfer market. Local companies not only have to compete with lower manufacturing costs, but also have to compete against the Multinationals profit repatriation programme. So if anyone is wondering why there is practically no manufacturing left in our country, do not blame the Chinese or other low labour cost countries. The real blame lies in the taxation system and Government (of all flavours) allowing this kind of "Gaming-of-the-System" to go on for nearly 40 years. It is the tax system that is bankrupting local manufacturers or suppliers and not cheap labour abroad. Manufacturing or production cost differential can be matched by efficiency, just look at Nissan, Jaguar, and Land Rover in the UK, despite one of the highest wage levels in the international car industry. No amount of efficiency locally can help you win against creative tax planning by Multinationals, unless of course you are a Multinational yourself.
How to stop the Multinationals gaming the system?
The answer is very simple, namely break the chain. Taxation should be paid at the country of consumption and based on benchmark costs. Tax authorities should benchmark COGS (in case of service industry cost-of-service-delivery) which is not that difficult. Tax authorities can then impose taxation based on estimated true costs of goods, irrespective of the declared margin or local subsidiary P&L. As reported by the BBC on 12 November 2012, using this exact method the French tax authority has presented Amazon a tax demand of over €200m.
In order to cut off the acquisition write-off practice tax authorities need to firstly distinguish between "Acquisition" and "Investment in new operations". Once this distinction is made within the tax system, acquisition tax write-offs can then be rejected by the host country tax authority. This will force multinationals to claim tax write-off in their home country, under usual business expenses and costs. This means any cost of acquisition has to be written off in the country where the HQ of the Multinational resides, and not be subsidised by the host country's tax payers. This will not penalise genuine investors with genuine intentions, but will stop acquisitions that end up being subsidised by the tax payer. This will also become a disincentive for some of the more controversial acquisitions such as the acquisition of Cadburys by Nestles.
These two simple actions do not require international agreements, consensus, or long drawn out negotiations. Countries can unilaterally put these actions in place, including those within the EU, without contravening free movement principals within the Maastricht Treaty.
There is also no need to worry about these companies exiting your market, as we all know they are not stupid. Apple, Amazon, Starbucks, or Google will not leave the UK or any other major European market just because we called time on their creative pricing and tax management. It just needs political will and positive consumer action such as local boycotting. There are plenty of locally owned coffee shops, even if you prefer swanky chain outlets with undrinkable coffee, other Smartphone manufacturers, or even alternative search engines. We just have to break the habit and put our country first rather than paying lip service to patriotism.
Ali Zartash-Lloyd is Managing Partner at Cognisant Associates ( http://www.cognisantassociates.co.uk ) a business consulting partnership. He is a management graduate from the University of Leicester and was European Director for major US and Korean multi-nationals for over a decade. Cognisant Associates helps businesses grow profitably and create value ethically.
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