The Most Famous Tax Planning Technique - Essay Example

Executive Summary

This work represents a detailed analysis and investigation of different financial techniques being applied by modern multinational corporations with an aim to enhance their overall profitability. At the beginning of the body, there is thorough description of international trade in terms of commercial relations. The explanation consists of advantages and disadvantages of international trade, as well as opportunities and risks that it provides. Thereafter, the main financial techniques of profit shifting, such as transfer pricing, intra-group licensing and intra-group debt financing, are considered in details. The paper gives much prominence to transfer pricing; thus, there are described its main regulations, pros and cons of this technique. Furthermore, the work represents and precisely explains different types of transfer pricing. Eventually, in order to show how might transfer pricing and intra-group licensing affect the international trade strategy of an organisation, there was described the most famous tax planning technique called “Double Irish Dutch Sandwich”.

International Trade

Nowadays, the world has experienced the rapid development and prosperity. In turn, a process of Globalization has significantly facilitated international relations among countries and businesses. As a result, there emerged transnational corporations aimed at maximization of their profits and facilitation of the economic development by means of integrating their operations to different emerging markets. International trade signifies extra opportunities and threats over and above trading and financial cooperation in one state. The management of profitability is a perfect example of how different organisations capitalize on openings and avoid threats. Thus, the purpose of this paper is to investigate and analyse how various organisations apply some financial techniques, which are available in terms of international trade, in order to legally enhance their overall profitability.

International Trade. Risks and Opportunities

Primarily, it would be appropriate to determine international trade as a term. Drawing on Reem Heakal, “international trade is the exchange of goods and services between countries. This type of trade gives rise to a world economy, in which prices, or supply and demand, affect and are affected by global events” (2015). To be more specific, a political or economic alteration in Asia or Africa can considerably affect the labour and manufacturing cost for an American multinational corporation, which produces some products in African and Asian countries. Consequently, it will definitely increase the price for these goods in the US and other countries. In an opposite way, if a labour and manufacturing costs decrease, it will result in a reduction of the price for the product in other countries. International trade allows people around the world to consume goods and services that may not have been available for them without such a global economic cooperation. Moreover, it provides different companies with an ability to expand their activities to other countries and markets in order to increase their profitability, avoid stagnation and ensure the future growth. As a result, customers are able to pick among various goods taking into account factors such as a quality, price, and origin. Due to international trade, the global competition always intensifies and contains more competitive prices.

There are many types of international trade participants. For instance, multinational companies are a perfect manifestation of commerce at the global market. These companies are a massive and influential form of business organizations, which carries out their manufacturing and distribution of goods or services in two or more countries. “Their ownership and management are scattered around the countries wherever they operate. They are incorporated in one country as parents company of multinational companies can be viewed as a holding company and the branch companies as its subsidiaries” (Nedobour 2010). At this point, it signifies that a parent company is to plan, organise and control financial management of all subsidiaries and outsourcing companies so as to ensure its effectiveness and maximize the incomes. According to Mihir A. Desai (2008), “Rather than simply make aggregate capital-structure and dividend decisions, for example, they also have to wrestle with the capital structure and profit repatriation policies of their companies’ subsidiaries”. Therefore, multinational corporations can perfectly get benefit from the opportunities provided by international trade in terms of management of profitability.

Undoubtedly, it is necessary to count benefits and risks that faced by organizations participating in international trade. The first benefit is growth of the business caused by an increase of consumers, suppliers and employees. Better margins are the second benefit. It signifies that the company can enhance its profitability by a difference in currency value and price levels. The last benefit is flexibility in terms of taxation. The reason is that corporations can transfer and allocate their profits taking into account taxation policy of various countries. As a result, they can capitalize on a positive difference in taxes by usage of an appropriate financial technique.

Nevertheless, there are some risks that organisations can face trading internationally. The first is risk of diversity. It means that there are a significant amount of factors affecting a market. This variety includes political and economic instability, different disasters and the like. To clarify, it is extremely risky to invest all resources in a single currency (Rosevear 2013). The second is misunderstanding the local legal framework. It is obviously that laws in other countries are distinguished from that in the United Kingdom. “The reality is laws differ in every country which means it is essential for companies to spend sufficient time educating about the legal framework of the country it is doing business with” (Hines & Rice 1994, pp. 151). The third risk is unstable profits. To be more specific, trading at an international level, organisations are expected to consider a great number of aspects affecting their profits. For instance, currency exchange is an exceedingly important factor. Unfortunately, there is a risk of not getting the best exchange rate which, in turn, could have a negative impact on a company’s profit as an organisation from the UK are to exchange anything it exports or imports into sterling. It signifies that (Heckemeyer & Overesch 2013, pp. 10) “between setting a budget, buying the goods and then paying for them, if a company does not plan ahead, the market’s volatility could always change the worth of the sterling, and not always for the best”. Thus multinational organisations should give much prominence to financial allocations, distribution of incomes and management of profitability.

Financial Techniques

Unconditionally, it is necessary to explain some financial techniques that are available for organisations trading internationally. It means techniques that enable multinational companies to legally increase their profitability. According to Maffini and Mokkas (2011), “profitability management involves employing one or more techniques for optimizing, not just maximizing, returns to meet strategic objectives”. For instance, in some circumstances, an appropriate approach to achieving a long-term strategy of a company can involve lowering short-term margins for rising volume for some businesses, products or services. Multinational organisations can apply and adopt activity-based costing or other approaches of marginal-cost so as to determine the economic cost of goods and services. In addition, they can adopt an absolutely new tactic. For example, pricing optimization is aimed at extracting higher prices from customers desiring to pay more. It signifies a relocation a company’s operations to a country with a higher quality of life, price level, and customer income. In other words, companies are to create and develop a consistent and focused approach to management of profitability. It consists of four elements such as analytics, strategy, people and information technology. The main goal is to balance and align the trade-offs necessary for functional groups.

Transfer pricing

There are a great number of profit shifting techniques that provide organisations operating internationally with various opportunities and benefits in terms of the enhancement of overall profitability. For instance, transfer pricing is a widespread method of profit allocation and avoiding taxation. “A transfer price is the price at which divisions of a company transact with each other, such as the trade of supplies or labour between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities” (Jacob 1996, pp. 308). In terms of managerial accounting, various groups of a multi-entity organisations are to manage their profits. Furthermore, these divisions are responsible for own return on invested capital. Consequently, when this business units need to make transactions with each other, they employ transfer price so as to determine costs. Transfer pricing is applied in order to attribute net profit of a transnational corporation to countries in which it operates before taxation (Janeba 1993). It is an extremely beneficial financial technique enables corporations to reduce taxes; thereby increase profits. To be more specific, during transfer pricing, organisations are able to book incomes of transactions in some countries with a lower tax rate (Peralta, Ypersele & Wauthy 2003). In addition, the transfer of goods or services among countries within an interrelated organisation transaction enables companies to avoid tariffs and taxes on products and services that are exchanged on the international area.

There are several types of transfer pricing. The first is Transfer at Cost, which signifies that organisations applying this method have no profits on transfer sale; however, the expectation is that a subsidiary would make profit by means of resale. This approach significantly minimizes duties (Blouin, Robinson & Seidman 2012, pp. 32). The second type of transfer pricing is Cost-Plus Pricing, which means that companies seek to make a profit shown for any product or service at each stage of transfer across the corporate system. The third type is Market-Based transfer price, which is derived from the competitive price on the global market. The only limitation of such a price is cost. This method provides a company with an ability to establish a franchise or its name in a market avoiding investments in bricks and mortar. It is necessary to mention that Arm’s-length transfer pricing can be also considered as a type of transfer pricing.

Intra-group debt financing

The second financial technique, which is available for organisations trading internationally and can enhance their overall profitability, is intra-group debt financing, which is so-called intercompany loan (Blouin, Robinson & Seidman 2012, pp. 43). In spite of transfer pricing, international corporations are able to improve their opportunities regarding tax planning by means of internal and external funds so as to control their structure of capital. It provides multinationals with an ability to arbitrage more effectively around various lending markets, as well as gives various tax planning opportunities through intra-group loans. To clarify, “borrowing from affiliates located in low-tax countries and lending to affiliates in high tax locations will allow the latter to deduct interest payments from profits and save taxes” (Mintz and Smart, 2004). There can be a few purposes for intercompany loans. The first means that employing of such loans would be impacted by a local tax rate. The second purpose signifies that intra-group loans will depend on differences in the tax-rate between the borrowing and the lending firms inside a multinational corporation.

Intra-group licencing

The third financial technique allowing to enhance overall profitability of a multinational organisation by means of reducing tax liability is intra-group licensing. This technique signifies that a parent company transfers the rights to use its property outside the country of its location to countries where tax legislation is more flexible (Heckemeyer & Overesch 2013, pp. 13). Thereafter, this property, which is owned by a subsidiary, moves throughout a long chain of the organization’s subsidiaries to branch office, which is located in a country with the lowest taxation rate, in order to be distributed. In general, such a technique is used for profit-shifting through Intellectual Property. Eventually, the product may be sold by means of the Internet to customers from another country almost without taxation. Then, the profits are transferred as royalties and dividends to the parent company avoiding high taxes.

Regulations and limitations

Obviously, in different countries are implemented some regulations on this kind of activity in order to ensure correctness and fairness of transfer pricing among related business units. The close attention to financial techniques, that enable multinationals to bypass taxation, bears some legal and non-legal risks for multinational corporations. For instance, an arm’s-length rule was enforced by regulations. “It states that companies must establish pricing based on similar transactions done between parties not of the same related company but at arm’s length” (Wien 2016). Transfer pricing must be strictly monitored in financial reporting of an organisation by means of specific documentation including various documents of financial reporting for regulators and auditors. The Organization for Economic Cooperation and Development (OECD) regulate the international tax laws while various auditing firms in different countries around the globe audit financial statements of multinational corporations in accordance with the rules. The main legal threat of transfer pricing is that the necessary documents are scrutinized and, in a case, if they inappropriately composed, a company can experience additional expenses through restatement fees, fines or added taxation. It may cause significant losses damaging the overall profitability of a corporation. In general, the governments and responsible institutions of developed countries precisely monitor and control all activities related to transfer pricing. The main aim of these institutions is to ensure that all incomes are booked accurately in order to guarantee a corresponding payment of associated taxes. Moreover, the usage of the financial techniques for profit-shifting has some negative non-legal consequences. For instance, the government may confront a multinational company through defamation of the organization’s character in the media and society. Accordingly, such an actions can cause a drop in sales and deterioration of a corporate image. Currently, a similar case is present in Australia where the government is highly concerned about an erosion of the Australian tax base (Williams 2016). The reason is that a few large multinational entities have applied contrived and artificial agreements to avoid a permanent establishment of a profit attribution in Australia.

How financial techniques affect the international trade strategies

As a result, an existence of different useful financial techniques, such as transfer pricing, intra-group debt financing, and intra-group licensing, as well as different regulations aimed to control and lower effectiveness of these techniques in terms of tax reduction, encourage multinational organizations to create, develop and adopt various approaches to and strategies of international trade. It signifies that each corporation possesses its own scheme of internal interaction among interrelated business units and external cooperation with partners and customers. Certainly, the main goal of these strategies and approaches is a decrease of losses by means of ensuring effective tax rates on profits made abroad. To clarify, a corporation is to allocate its subsidiaries properly so that each of them would be able to contribute effectively to a minimization of the overall tax rate of the corporation. For instance, in 2014, tax rates on foreign profits of Google and Apple have been less than 3% and 1%, respectively (Wien 2016). In turn, in 2014, the revenue of Apple Inc. was $233.7 billion while Google’s revenue was $66 billion. It is obvious that operating such amounts of money, corporations are aimed at avoiding each percentage of taxation so as to utilize their capital more efficiently and ensure subsequent growth. These figures directly point to the fact that Apple Inc. and Google have implemented efficacious and relevant international trade strategies. Therefore, it can be concluded that a well-designed international trade strategy is an essential part of successful international commerce. In addition, it can provide an extremely positive impact on the development and growth of organisations by means of the considerable savings of funds.

It would be appropriate to precisely describe how might transfer pricing, intra-group licensing, and intra-group debt financing can affect the international trade strategy of an organization. In the course of international trade development and establishing of transnational corporations, there have been created and implemented a great number of strategies aimed at an enhancement of profitability through bypassing taxation. The companies have deployed different approaches in many countries in order to research and elaborate highly effective schemes of avoiding taxation. One of the most famous tax planning techniques is called “Double Irish Dutch Sandwich”. It is widely applied by different IT corporations from the United States of America, such as Google, in order to reduce their tax liability on foreign profits (Sandell 2012, pp. 871). The scheme includes a Conduit Company incorporated in Holland, Intellectual Property-Holding and Operating Company, both incorporated in Ireland, as well as Parent Company located in the US. According to Clemens Fuest and Christoph Spengel (2013, pp. 4), in general, “the IP-Holding Company is a direct subsidiary of the U.S. Parent Company and the single owner of the Irish Operating Company and the Dutch Conduit Company”. The Holding is controlled and managed in Bermuda. As a result, for Irish tax purposes, it is considered resident in Bermuda. On the contrary, the US considers the IP-Holding as a corporation from Ireland due to tax residency, which is based on jurisdiction of incorporation according to U.S tax assessments act (Clemens Fuest and Christoph Spengel 2013, pp. 5). This strategy would provide a corporation with a set of the following advantages.

- Low payment of taxes on the primary Intellectual Property transfer;

At this point, the IP-Holding Company (Grubert 2003, pp. 214) should make a buy-in-payment and conclude a cost-sharing agreement on the prospective enhancement and modification of the IP with the Parent Company incorporated in the US. Thereafter, the IP-Holding Company possesses rights of the non-US IP established under the cost sharing agreement. As a result, periodic license payments would not be made to the U.S. Parent Company. Usually, it is sufficiently difficult to determine the arm´s length price for the buy-in payment due to the fact that at the moment of transfer, the intangible is only fractionally developed (Kadet 2009, pp. 36); thus, future earnings are associated with risk. Finally, corporations can avoid high rate of exit taxes as they obtain considerable leeway in setting the price.

- Due to e-commerce, there would be almost lack of taxation in a country of final intake;

Multinational corporations applying the ‘Double Irish Dutch Sandwich’ frequently sell goods and provide services by means of the Internet. In turn, the Operating Company incorporated in the Ireland functions as a contractual partner of all customers located outside the United States who purchase these products and services. Consequently, there is not physical presence in a country of final consumption; therefore, the incomes must not be taxed. Functions such as the manufacturing, marketing or delivery of activities and products are usually appointed to companies of low-risk group located in the states of customer residence (Huizinga & Laeven 2008, pp. 1168). These providers of services operate on a cost-plus basis retaining the tax base low in the country of final destination.

- Implementing high payments of royalty would reduce taxes at the scale of the Operating Company;

The incomes from the sales made by the Operating Company must be taxed in Ireland. Nevertheless, the Operating Company’s tax base is near to zero as the company pays high royalties that are tax deductible for the usage of the IP. It is necessary to note that the IP held by the Holding Company. As in Ireland are only transfer pricing rules that do not apply to terms and contracts agreed before July 2010 (Gravelle, 2015), the majority of organisations deploying a strategy called ‘Double Irish Dutch Sandwich’ are capable of setting the royalty payment prices as high on their own accord.

- Dutch Conduit Company’s Intermediation for avoiding withholding taxes on incomes of royalties leaving Europe;

The royalties should be passed by means of a Conduit Company incorporated in Holland instead of being paid directly to the Holding Company. The reason is that the Conduit Company sublicenses the IP. Therefore, this company does not undertake any economic actions. It is inserted due to residence of the Holding Company in Bermuda for tax objectives of Ireland. Then, Ireland imposes withholding tax on the royalty payments directed to Bermuda. Through channelling the royalties over the Conduit Company in the Netherlands, “withholding taxes can be completely circumvented as royalties paid from Ireland to the Netherlands are tax-free under the EU Interest and Royalty Directive and the Netherlands do not impose withholding tax on any royalty payments, irrespective of the residence state of the receiving company” (Murphy 2008). The fiscal compliance of the Dutch Conduit Company only includes a moderate fee payable for the usage of the tax system of Holland

- IP-Holding would face no taxation in Bermuda and Ireland;

The Holding Company is neither object to tax in Bermuda nor in Ireland as in Bermuda, taxes are not levied on corporations, as well as Ireland treat the company as a non-resident. Therefore, the incomes obtained in the Europe leave it actually untaxed.

- U.S. CFC rules are outsmarted through check-the-box election

In turn, the U.S. does not tax the external income upon condition it is not qualified as Subpart F Income or reallocated as dividends. To avoid taxes on Subpart F Income, the Operating Company from Ireland and the Conduit Company incorporated in the Netherlands file a check-the-box election in order both subsidiaries from Ireland and the Conduit Company from Holland to be treated as one single corporate organization incorporated in Ireland. As a result, their profits would be combined for tax purposes of the US. The payments of royalty between the companies are unheeded. The only thing, which is considered from the perspective of the US, is revenues from customer transactions that do not constitute Subpart F income.

Conclusion

The paper represented the investigation and precise analysis of how different companies can apply the financial techniques so as to legally enhance their overall profitability. Primarily, international trade was explained in terms of terminology, main aims, and regularities. The main advantages and risks provided by international trading were considered in details. Subsequently, there were described various financial techniques of profit shifting that can legally enhance overall profitability of organisations. This variety includes transfer pricing, intra-group debt financing, and intra-group licensing. A particular attention was paid to transfer pricing. There were explained its main regulations, pros and cons of this technique. In addition, different types of transfer pricing were counted and precisely considered. Finally, there was provided an example of how transfer pricing and other financial techniques can shape an international trade strategy of modern corporations.