THE RISE OF TRANSFER PRICING PRACTICES AND
THE FALL OF SOCIAL RESPONSIBILTY
Ms. Jin Cui - School of Accounting, Economics & Finance, University of Wollongong
Dr. Corinne Cortese - School of Accounting, Economic & Finance, University of Wollongong
Dr. Graham Bowrey – School of Accounting, Economics & Finance, University of Wollongong
Abstract
Purpose: This paper explains how transfer pricing is used by multinational corporations (MNCs)
to shift profits into low tax jurisdictions.
Design/methodology/approach: Using Google as a case study, the ‘Double Irish Dutch
Sandwich’ technique is used to illustrate a particular transfer pricing technique used by MNCs to
shift profits.
Findings: We argue that transfer pricing practices such as the Double Irish Dutch Sandwich
enable MNCs to avoid their corporate social responsibilities, with digital economies being
particularly vulnerable to these practices.
Originality: This paper highlights the importance of identifying the underlying substance of
economic transactions in the analysis of transfer pricing practices.
Keywords: transfer pricing, corporate social responsibility, digital economy, tax havens
1
Introduction
The purpose of this paper is to explore the use of transfer pricing techniques by multinational
corporations (MNC). This accounting technique has been used at a growing rate over the past two
decades to increase the profitability of MNCs while simultaneously enabling them to turn their
backs on their corporate social obligations. One of the social obligations that MNCs often fail to
fulfil is to pay a fair share of tax in both host and home country (De George 2010) which in turn
deprives society of the benefits of the application of these tax revenues (Sikka & Willmott 2010).
For example, Apple disclosed in their 2012 annual report that ‘we are incredibly proud of all
Apple’s contributions … [we] pay an enormous amount of taxes, which help our local, state and
federal governments… in the first half of fiscal year 2012, our U.S. operations have generated
almost $U.S. 5 billion in federal and state income taxes, including income taxes withheld on
employee stock gains, making us among the top payers of U.S. income tax’. However, Apple’s net
income for 2012 was $U.S. 41 billion, making their $U.S. 5 billion tax bill just 12 percent of its
earnings (Apple Press Info 2013) Further, this $U.S. 5 billion included the taxes withheld on
employee stock gains, in other words personal tax liabilities of employees. So, while Apple is,
without doubt, a significant employer, and its employees pay significant amounts of tax, the
company itself is mis-claiming its corporate social responsibility as a tax paying citizen (Duhigg
& Kocieniewski 2012).
Companies cannot claim that they have discharged their social
responsibility when in fact their claims are either fictitious or unsubstantiated by facts. The
United Nations Conference on Trade and Development (UNCTAD), a United Nations agency, found
that, in 2003, 64,000 MNCs had a total of 870,000 subsidiaries (an average of 14 for each MNC)
up from an average of five for each MNC in the early 1990s (The Economist, 2004).
Correspondingly the total MNC intra-company trades values increased threefold from $U.S. 5.1
trillion in 1995 to $U.S. 18.3 trillion in 2012 (UNCTAD 2014). The increase in subsidiaries and
the value of MNC’s intra-company trades is consistent with the MNCs applying a number of
contemporary corporate development strategies such as transfer pricing.
2
Historically, transfer pricing was a means used by MNCs to cost goods transferred between the
parent entity and their domestic or international subsidiaries (Cravens 1997; Gox 2000; Rugman
& Verkebe 2003; Bernard et al., 2006; Cools & Emmanuel 2008; Fjell & Foros 2008). Today,
transfer pricing is applied as a means of routing MNC’s profits between different tax jurisdictions
in order to minimise corporate tax liability (Bartelsman & Beetsma 2003; Desai et al., 2006;
Christian-Aid 2008, Adams & Dritna 2010, Sikka & Willmott 2010; Krautheim & SchmidtEisenlohr 2011). For instance, the Chinese tax authorities claimed that the country approximately
lost $U.S. 3.6 billion tax revenue every year (China Daily, 2004); Papua New Guinea was estimated
of a tax loss around $U.S.100 million a year due to the international timber companies (Forest
Trends, 2006); Africa lost $U.S. 25 billion tax revenue while Philippines lost $U.S. 8.1 billion (Kar
& Freitas, 2011). Not surprisingly, transfer pricing arrangements through complex corporate
structure is becoming the main reason for the tax revenue losses (Bartelsman & Beetsma 2003,
Bernard et al 2006, Christian-Aid 2008, 2009, Hong & Smart 2009, Sikka 2010, Sikka & Willmott
2010). Using transfer pricing arrangement as a means of tax avoidance and evasion has been
enabled by the existence of tax havens which offer low or zero corporate tax rates (Christian-Aid
2008, Hong & Smart 2009, Sikka 2010, Sikka & Willmott 2010), and the mobilised exchange of
services and payment facilitated by information technology (Evans and Wurster 1997, Lee 2001).
The information technologies and web-based communication have been widely adopted and used
by technology-centric companies that operate in international markets (Oviatt and McDougall
1994, Tapscott 1996, Knight and Cavusgil 1996, Samuelson 1999, Castells 2001, Britton and
McGonegal 2007). By using these technologies, companies are able to utilise more affordable and
greater electronic connectivity infrastructure which facilitates cheaper and easier business
operation and information exchange (Castells 2001, Zekos 2005). Hence, this enhances the
mobility of companies that rely on cyberspace to deliver their digitalized products and services
(Anderson, 2001). As a result, the rules of competition change and facilitate the transformation
of a new form of the economy: digital economy (Lee 2001, Zekos 2005). Companies establish
virtual presences at a global level which are remote from customers but able to deliver products
3
digitally through cyberspace. Such electronic trading often becomes part of a complicated and
structured production and value creation processes under transfer pricing arrangements (Lee
2001, Zekos 2005, OECD 2013a). As a result, it is now more difficult to determine the jurisdiction
in which value creation occurs and hence leads to the situation in which companies can stay far
beyond the reach of tax and customs authorities (Anderson 2001, Haltiwanger and Jarmin 2000,
Li 2004, OECD 2013b).
To address the growing concerns of transfer pricing mal-practices, the Organisation for Economic
Co-operation and Development (OECD), acting as an independent entity providing a forum where
governments can work together on international issues, released a set of guidelines to assist in
addressing some of their concerns regarding the application of transfer pricing strategies by
MNCs. These guidelines, Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administration, which were initially approved by the OECD Council in 1995, have been added to
and substantially revised over the period to 2010 (OECD 2010). A key aspect of these guidelines
is the application of the ‘arm’s length principle’ in determining cross-border transactions within
associated entities. This principle requires that any intra-company trades should be valued as if
they had been carried out between unrelated parties (OECD 2006). The OECD guidelines also
determined the criteria for ‘Permanent Establishment’, which creates the taxable jurisdiction for
corporate entities. Once an entity specifies a particular location as its ‘Permanent Establishment’,
any income earned in this jurisdiction is subject to the corporate tax applicable in that country.
However, the determination of a Permanent Establishment is an increasing challenge in the
current economic environment, particularly in the digital economy. The operating practices of
web-based companies that operate in international markets transform the rules of competition
and lead to difficulties in determining the jurisdiction in which the value creating activities occur
(Anderson 2001, Haltiwanger and Jarmin 2000, Li 2004, OECD 2013b). This problem is
exacerbated when companies seek to deliberately obfuscate the reality of their transactions
through transfer pricing mechanisms for the purposes of avoiding tax liability.
4
An example of on such technology-oriented MNC is Google. Google, with its large amount of
intellectual property and flexible service delivery channels, has been criticized for using the
‘Double Irish Dutch Sandwich’ technique to reduce its tax liability on non-U.S. generated income
by taking the advantage of digital economy through its various subsidiaries (Main 2012). The
company reduced its non-U.S. tax bill by having their customers across Europe transact directly
with an Irish subsidiary through transfer pricing arrangements, which condensed its taxable
profit by paying royalty fees to an affiliate in Bermuda, where corporate tax is zero (Bergin 2014).
In Bergin’s earlier report (2013), he pointed out that Google Ireland Ltd reported sales of $U.S.
16.4 billion in 2011 with profits of $U.S. 31.4 million and an Irish corporation tax bill of $U.S. 10.4
million. Similarly in Australia, Google Worldwide made net profit of $U.S. 4.22 billion, $U.S. 6.52
billion and $U.S. 8.5 billion for the years 2008, 2009 and 2010 respectively while at the same time
Google Australia recorded losses of $U.S. 5.4 million, $U.S. 3.9 million and $U.S. 3.1 million
respectively. These financial losses correspondingly led to very low tax payments. For instance
in 2011 Google Australia had $201 million ($U.S. 196.9 million) revenue but recorded a loss of
$3.9 million ($U.S. 3.8 million) and paid a mere $74,176 ($U.S. 72,629) in Australian taxes (Butler
& Wilkins 2012, Dearne 2012). Furthermore, a significant amount of $1.3 billion ($U.S. 1.3 billion)
revenue from the lucrative AdWords program, which is an online advertising service that places
advertising copy around customer search results was not recorded in its Australian operational
revenues (Smith 2013). Similar to Google, other information technology and communications
corporations also recorded revenues outside the locations where they provided a wide range of
products and services (Jarach 2012). For example, EBay was billing out of Switzerland, Yahoo’s
search marketing operations were billing out of Ireland, and Facebook and Microsoft were using
an Irish subsidiary (Commonwealth House of Representatives 2012). This loophole in the tax
systems were exploited by these MNCs, which causing a significant taxation concern for the
relevant governments.
MNCs' tax avoidance is now a priority issue for the British government (Public Accounts
Committee 2013a). The UK market is Google’s biggest foreign market and has been listed
5
separately in its financial report. From 2006 to 2011, the UK government was only able to collect
$U.S. 16 million of corporate taxes from Google’s $U.S. 18 billion UK-based revenue (Public
Accounts Committee 2013a). This was due to ‘the complex British tax system and as well as a
complex international framework governing where global companies pay tax’ (House of Lords
2013, p7). This increased the opportunistic behaviours used by digital economy enabled MNCs to
reduce or avoid corporation tax using loopholes in tax system. An in-depth investigation on
Google’s tax avoidance was launched by the House of Public Accountants Committee requested
from HM Revenue and Customs (HMRC) based on the facts that Google UK generated significant
income but pay little tax (House of Commons 2013b). Later, a report called Tax Avoidance –
Google (2013), which examined the evidence provided by John Dixon, Head of Tax in Ernst &
Young, and Matt Brittin, Google’s Vice-President for Sales and Operations, Northern and Central
Europe, was released as an outcome of the investigation. The report revealed that the disparity
between high revenue generated and low tax payment was due to Google's lack of a Permanent
Establishment in UK According to Matt Brittin, Google UK did not perform any service
transactions other than promotion and providing tech support to its UK customers. Other service
transactions were executed by a Google subsidiary based in Ireland. The Irish subsidiary would
be liable for paying UK corporate tax only if it earned a profit from UK activities through a UK
Permanent Establishment (United Kingdom/Ireland Double Taxation Convention 1976).
Therefore, it is vital to lift the veil of the corporate structures to determine the purpose to create
a complex corporate structure. The challenge for the HMRC in its further investigation is to
determine whether the dominant purpose of establishing an offshore subsidiary (by companies
such as Google) is tax avoidance.
In the following section, an analysis on how companies use the ‘Double Irish Dutch Sandwich’
corporate structure to shift profits to tax havens is provided. Then, a further investigation on
Google’s implementation of the ‘Double Irish Dutch Sandwich’ is illustrated. In the last section, we
discuss the implications for corporate social responsibility when transfer pricing practices are
used to avoid tax liabilities and consider potential solutions offered by the OCED.
6
Double Irish Dutch Sandwich
The technique known as the Double Irish Dutch Sandwich was developed in earlier 2000
(Simpson 2005). Used predominantly by U.S. information technology companies, this strategy
enables entities to takes advantage of corporate classification rules in U.S. tax laws, whereby
foreign base company sales income made by a controlled foreign corporation1 is not liable to U.S
tax law. This technique also relies on the attractive low corporate tax rates in Ireland of 12.5
percent (Department of Finance 2013). In this way, a hybrid structure is developed which allows
these companies to make sales through an Irish subsidiary to customers in non-U.S. jurisdictions
while greatly reducing Irish, U.S. and worldwide taxation (Darby and Lemaster 2007). In order to
take advantage of Irish law, which enables exemptions from withholding tax and royalty payment
between Irish and Dutch based entities, a Dutch based subsidiary also needs to be established.
This complex structure is known as Double Irish Dutch Sandwich (Loomis 2010).
As an example, assume that a parent company P is located in the United States, which is the
headquarters of the group focuses on research and development of products. As suggested by its
name ‘Double Irish Dutch Sandwich’, two companies are established in Ireland. One is an
intellectual property holding company, A, and the other is intellectual property operations
company, B. Company P transfers its intellectual property to company A at a very early stage
when the value of the intellectual property is very low, thereby, reducing the taxable gain
occurred in company P. Furthermore, with this transfer arrangement comes a cost sharing
agreement which entitles company A to own the intellectual property rights without any payment
of royalties to company P (OECD 2012). Company A is established as a shell company without
physical properties and staff but is managed by a company located in Bermuda or Caymans
Island; company H, where corporate tax is zero. Due to the central management and control of
company A is in Bermuda or Caymans Island, company A is regarded as a tax resident in Bermuda
A controlled foreign entity is any foreign corporation which has more than 50 percent of either (A)
voting power of all classes of stock, or (B) the total value of all outstanding stock owned by ‘United Sates
shareholders’ at any time during the taxable year (Internal Revenue Code § 957 (a)).
1
7
or Caymans Island. Company B is set up for intellectual property operation purpose, therefore, it
pays the royalty to company A which can be deductible expenses for company B. The remaining
profits in company B are taxed at the Irish corporation tax rate of 12.5%.
As company A and B are both in the group, the payments between two related Irish companies
might be charged for U.S. tax purpose. In order to avoid this, company B is set up as a fully owned
subsidiaries to company A and claimed as a ‘disregarded entity’ when made entity classification
election by filling Internal Revenue Service Form (Internal Revenue Manual 1997). This means
that as long as company A has a single owner, company B can be treated as part of the single
owner which eliminates the impact on the intra-group transactions for U.S. tax law as they are
regarded as one entity (Internal Revenue Manual 1997).
Company N is set up in the Netherlands to further reduce cross-border withholding for tax
avoidance purposes. Company B purchased intellectual property rights through company N
rather than from company A directly. Company N applies cost-plus method to price this service
and pays a royalty to company A. According to Netherland’s taxation rules, there is no
withholding-tax between certain European Union countries (in this case, Ireland and the
Netherlands), therefore, the profits in company B finally transfer to company A.
This complex corporate structure has been used by a number of MNCs for the explicit purpose of
reducing their tax obligations. Well-known companies such as Starbucks and Amazon have
implemented similar corporate structures and, like Google, have been investigated by the House
of Commons Public Accounts Committee. For example Apple ‘booked about $U.S. 100 billion in
sales through its Irish subsidiaries in 2013’ (Hennigan 2014) to avoid its tax obligations in the
UK. Another example is Caterpillar, which was able to sidestep ‘$U.S. 2.4 billion in U.S. taxes over
13 years by shifting profits to Switzerland’ (Wood 2014). This paper illustrates Google as an
example of those MNC who use Double Irish Dutch Sandwich structure as a shell to route its UK
profit away from its tax jurisdiction.
Google’s Double Dutch Irish Sandwich Structure
8
Google Inc. founded by Larry Page and Sergey Brin in 1998 in United States was initially listed in
NASDAQ in 2004 (Google 2014). The two founders had built a search engine called BackRub,
which was the predecessor of the current google search engine. The company is mainly a service
provider which offers their clients an easy way of finding information. The main source of income
for the company is advertisement revenue and hardware revenue. The research and development
operations of the information technology and innovation that drives Google, this is
headquartered and managed out of the U.S. parent entity, Google Inc.
In Google’s early years of operation, two Irish-based subsidiaries were established by Google Inc.
One, Google Ireland Ltd has more than 3000 employees, and the other, Google Ireland Holding
which does not have a physical office. After establishing the Irish companies, Google Inc
transferred its Intellectual Property assets to Google Ireland Holding. At the time of transfer, a
cost sharing agreement was established whereby Google Ireland Holding would maintain the
right to use the Intellectual Property assets but would not have to pay royalty fees to Google Inc
for the use of the assets. Google Bermuda was later established in Bermuda which is known as a
corporation tax haven due to its zero corporation tax. Google Ireland Holding is managed by
Google Bermuda. Because the central management and control of Google Ireland Holdings is
located in Bermuda, the profit will be taxed on income made by Google Bermuda rather than
Google Ireland Holdings. As Google Ireland Holding and Google Ireland Ltd are both in the group,
the payments between two the Irish companies could potentially be subject to U.S. tax. In order
to avoid this, Google Ireland Ltd was set up as a fully owned subsidiary of Google Ireland Holding
and is claimed to be a disregarded entity when made entity classification election by filling the
U.S. Internal Revenue Service Form. This means as long as Google Ireland Holdings has a single
owner, Google Ireland Ltd can be treated as part of the single owner which eliminates the impact
on the intra-group transactions for U.S. tax law and they are treated as one entity.
Google also set up Google Netherland Holdings B.V. to further reduce the tax liability of Google
Ireland Ltd by avoiding the tax withholding that would otherwise be required between two
9
Ireland companies for Irish tax law purposes. According to Netherland’s taxation rules, there is
no withholding tax between certain European Union countries; therefore, the profits in Google
Ireland Ltd can be transferred to Google Ireland Holding. Figure 1 shows the routing of funds that
this structure enables Google to minimise tax obligations.
Customers
Sales
Royalty
Support,
marketing,
etc.
Google Ireland Ltd
Google
Netherland
Holdings B.V.
Google
London
Cost
Royalty
Manage and control
Google Ireland
Holdings
Google Inc.
(Headquarters
of the group
research and
development)
Google Bermuda
Unlimited
Intellectual Property
Figure 1 – Double Irish Dutch Sandwich of Google.
When customers purchase services from Google, the sales will be offered by Google Ireland Ltd
rather than Google UK Ltd which claims that it only provides marketing support digital consultant
not the services. This allows Google to avoid any tax liability in UK as the sales activities occur in
Ireland. Google Ireland Ltd purchases royalties from Google Netherland Holdings B.V which a
pays royalty to Google Ireland Holdings. By applying the cost-plus method on this service, the
ultimate profit is transferred from Google UK Ltd to Google Bermuda which owns Google Ireland
Holdings. This complicated corporate structure has been investigated by the Committee of Public
Accountants appointed by UK tax authority HM Revenue & Customs (HMRC). The investigation
highlights that Google generated a significant amount of income in countries like UK, however its
10
profit was out of reach of the UK’s tax system due to lack of a Permanent Establishment in UK
(House of Commons 2012). The web-based business model facilitates e-commerce but at the
same time it opens a loophole for shifting the source of revenue and therefore tax liability in the
context of the digital economy.
Discussion
Corporate social responsibility has drawn significant attention in recent years as academic
research seeks to reconcile the existence of profit making conglomerates alongside populations
experiencing employment, gender, economic, political, investment and other social problems
(Cooper 2004, Vogel 2005, Hawkins 2006, Solomon 2007). The concept of corporate social
responsibility is much broader than the compliance with laws and regulations; it also deals with
ethical and social behaviours (Christian-Aid 2008, 2009, Hong & Smart 2009, Sikka 2010, Sikka
2010, Sikka 2013). In this vein, the payment of corporate tax is a company’s ‘return to society on
the investment of social capital’ (Sikka & Willmott 2010, p344) rather than ‘a pure tax on
corporate capital’ (Hong and Smart 2009, p84). Companies play an increasingly crucial role in
contemporary economic, political and social development with corporate tax revenue often the
main financial source of a government's income (Korten 2001). Governments collect tax revenue
and use it to facilitate infrastructure development including education, social security, healthcare,
legal systems and urban development in order to improve social welfare for citizens. If a
government is not able to collect adequate tax revenue, the social infrastructure development will
be hindered (Christian-Aid 2008, 2009, Sikka 2010, Sikka & Willmott 2010, Sikka 2013).
In terms of its tax payment practices, during the investigation into Google UK Ltd, Vice President
Matt Brittin stated that Google had complied with the tax rules of all the countries in which it
operates and had therefore not broken any laws (House of Common 2013). This raises the issue
of whether compliance with the law can be regarded as satisfactory for the discharge of corporate
social responsibility. Transfer pricing practices enable companies to comply with the letter of the
11
law without necessarily complying with its spirit. The existence of tax havens further facilitates
socially irresponsible practice.
In 2000, the OECD issued its Fiscal Affairs Committee report listing 35 tax havens which offer low
or zero corporate tax and very limited corporate disclosure requirement (OECD 2000). However,
when corporations see taxes as a cost of doing business and tax haven territories do not recognise
themselves as problematic, responsibility for socially acceptable behaviour of corporations is
weakened. For example, Bermuda Finance Minister Bob Richards claimed that the territory ‘does
not intentionally facilitate profit shifting, and gains little from the Bermuda-registered affiliates’
(Bergin 2013). In addition, he pointed out that it would not be practical for Bermuda to change
its tax rules to stop corporate profit shifting, arguing that corporate taxes were not important to
the territory’s economy which instead relies on consumption and employment taxes (Bergin
2013).
In March 2014, the OECD initiated a Base Erosion Profit Shifting (BEPS) program, which discusses
a series of tax planning strategies that exploit gaps and mismatches in tax rules that make profit
‘disappear’ for tax purposes or that shift profits to locations where there is little or no real activity
but the taxes are low resulting in little or no overall corporate tax being paid (OECD 2014). This
will potentially address the dilemmas around tax sovereignty being that MNCs operate on a global
basis by that tax authorities operate and collect tax nationally (Samuelson 1999, Li 2004). In
Google’s case, the U.S tax authorities were arguably owed tax liability from Google Inc because
the company’s core operations, including innovation, design, and top level management decision
making was performed in the U.S. The UK also had a claim to tax revenue from Google UK Ltd
because sales transactions were managed by UK staff. However, the Double Irish Dutch Sandwich,
coupled with the Bermuda tax haven, meant that the company was able to significant avoid its tax
liabilities in either country. As noted above, Bermuda subsequently denied responsibility for the
tax obligations of corporate entities. The case of Google Inc. and its subsidiaries brings to light the
urgency of matters relating to transfer pricing and tax havens in the digital age and the need for
international regulations to combat these socially irresponsible corporate practices.
12
13
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