A Moral Crusade with a Hollow Core

Double taxation treaties (DTTs) were created by governments to facilitate cross-border trade. Usually negotiated bilaterally and with guidance from international organisations, their essential purpose is to ensure companies are not taxed on the same income in multiple locations, which could impede overseas expansion. Offshore financial centres serve as conduits for these capital flows, essential links in a chain that extends from the US, through Europe, into Asia, and back again.

DTTs often come with incentives to encourage use – such as tax breaks on certain forms of passive income – but the key points of attraction from a corporate perspective are cost efficiency and certainty over tax treatment. And it works both ways. One of the reasons governments offer incentives for using DTTs is they encourage companies to operate through official channels that require an element of disclosure as opposed to completely in the dark.

More is achieved through the presence of these treaties than would be in their absence, yet in recent months they have been demonised. Western politicians, notably in the US and UK, have drawn DTTs and the offshore financial system in which they operate into a war against multinationals that are perceived as tax evaders.

It has not been established conclusively that laws have been broken, but that does not really matter. This is a war being waged on a moral basis: through the use of offshore structures, multinationals are shortchanging governments – and by extension eating into the budget for schools, roads, elderly care and social security – and squeezing out competition from smaller players that do not have the resources to engage in complex financial engineering. As such, the targets are large, with Apple and Google front and centre.

What is most troubling about this is not the witch hunt per se as its potential impact on DTTs, information exchange, and by extension efficient business practice. And, gallingly, the principal actors in this farce - the US and UK - are among the jurisdictions that have yet to put their house in order in terms of security and transparency (as the Edward Snowden case illustrates, the two are not mutually exclusive).

The political lightning rod, in Apple’s case for example, is that the company paid US$six billion to the US Treasury in federal tax in 2012. A memorandum published before a Senate Permanent Subcommittee on Investigations hearing in May claimed the company had avoided US taxes on US$44 billion in otherwise taxable offshore income over a four-year period.

Apple CEO Tim Cook went before the subcommittee to defend his company, stressing that it paid its taxes in full and does not rely on financial misdirection. “We don’t move intellectual property offshore and use it to sell products back into the US to avoid US taxes,” he said. “We don’t stash money on some Caribbean islands. We don’t borrow money from our foreign subsidiaries to fund our US business in order to skirt the repatriation tax.” No, Apple relies on a network of DTTs endorsed by the Organisation for Economic Cooperation and Development (OECD).

Google was taken to task even more fervently by the UK House of Commons Committee of Public Accounts - last November and again in May.

The company generated US$18 billion in revenue from the UK between 2006 and 2011 yet paid the equivalent of US$16 million in UK corporation taxes during that period. The vast majority of Google’s non-US sales are billed in Ireland, the company’s local entity recording revenues of GBP396 million in 2011 and paying just GBPsix million in corporation taxes. “Google relies on the deeply unconvincing argument that its sales to UK clients take place in Ireland, in Ireland, despite clear evidence that the vast majority of sales activity takes place in the UK,” the committee’s report, published last month, concluded.

This conclusion was in part based on whistleblower evidence and media investigations that threw doubt on an earlier assertion that none of Google’s 1,300 employees in the UK were involved in the sales side of the business. Under the Ireland-UK DTT, an Irish company is only subject to UK tax on its UK earnings if it has ‘permanent establishment’ in the country. This would be triggered by employees of the UK company who are authorised to close sales contracts on behalf of the Irish entity.

If Google has indeed violated the DTT then the committee’s claim that the Ireland operation “has no purpose other than to avoid UK corporation tax” would warrant further investigation. The credibility of the treaty system relies on its proper use and transgressors should be punished. Publicly traded companies have mechanisms to address such issues – just as the board has a fiduciary duty to shareholders to operate in a tax-efficient manner, it must also abide by international laws and internal governance standards. Failure to do so can result in removal.

In this sense, there is also merit in OECD-led efforts to clean up the system. Yes, the more nefarious elements of offshore financial services should be curtailed, whether that means taking a closer look at transfer pricing techniques, allowing regulators to have greater visibility on the ultimate beneficiaries of structures, or ensuring that companies have ‘substance’ in a jurisdiction rather than just using it as a postbox.

But by over-politicising the debate, governments risk shooting themselves in the foot. DTTs were conceived to facilitate trade and going after the offshore financial centres that underpin this system is counterproductive. For example, information exchange works and that is why the clause appears in most DTTs. Automatic information exchange, where an investigation might be based on little more than speculation and its target has no recourse, is hardly a boon for international commerce. Neither is hunting for the scalps of large corporations that abide by the laws as they stand.

An interesting postscript is Apple’s explanation as to why it only paid US$six billion in tax last year. As Cook noted in his testimony, it doesn’t reflect the full weight of the company’s earnings because 70 per cent of its cash is held overseas. This is because the DTT network that allows Apple to operate efficiently overseas stops short at the US border – crossing it would incur a sizeable tax bill.

“Unfortunately, the tax code has not kept up with the digital age,” Cook said. “The tax system handicaps American corporations in relation to our foreign competitors who don’t have such constraints on the free flow of capital.”

It is a nuanced observation, throwing light on the fact that Western governments are wading blindly into an international battle without addressing the weaknesses closer to home. On one hand, they call on offshore financial centres to disclose client information while collecting none of it themselves; on the other, they rage at taxes forgone but have yet to create collection systems suited to a global economy.