Multinational enterprises and design of a tax-aligned global supply chain
I. Globalization and technological development: new opportunities and challenges for businesses The combination of economic globalization and the digital transformation led, for businesses, to an unprecedented scenario in terms of both opportunities and challenges.
Businesses have been enabled to achieve enormous operational advantages in terms of value creation and minimization of production and distribution costs. New technologies have indeed triggered a drastic reduction - and in certain cases the complete elimination - of the traditional intermediate steps.
Furthermore, digital transformation, automation, and free markets have allowed not just large businesses but also small and medium businesses to become multinational enterprises (MNEs) and thus effectively operate in multiple markets different from their jurisdiction of establishment.
The same circumstances – i.e. the reduction or elimination of intermediate levels in the supply chain and the internationalization and interconnections of markets – have led, in turn, to a drastic increase in the degree of competition between businesses operating in the same field. This gave rise, again, to further opportunities of growth and development, but also to dangerous challenges for businesses. Indeed, while, on the one hand, more competition between businesses provides consumers with a broader offer of products and services meeting their demand, on the other hand it leads to a race to the bottom in terms of minimization of production and distribution costs induces enterprises to constantly look for new solutions which often imply lower salaries, outsourcing and off-shoring of entire business functions to low-cost jurisdictions and, more recently, reliance on artificial intelligence with severe consequences in terms of unemployment.
All of the above circumstances necessarily triggered substantive adjustments to the supply chains of MNEs.
From country-based structures – according to which the various functions aimed at the production, sale and delivery of the products and services had to be replicated in approximately any jurisdictions where the enterprise had a market presence – MNEs have been able to turn into global structures, characterized by, on the one hand, centralization, at the headquarter level, of the main managing functions and risks, and, on the other hand, the establishment of subsidiaries and branches dedicated to the implementation of a single function of the global supply chain in the interest of the entire group (the so-called vertical integration of business activities into so-called key supply chain processes). [1]
II. Tax implications and need for a tax-aligned supply-chain management The today most profitable businesses are characterized by a high degree of mobility, due to their reliance on intangible sources of income (such as IP). In the past two decades, we have observed how, in order to attract such businesses (and especially their headquarters), several jurisdictions have used tax incentives which have on some occasions been qualified by the OECD as harmful tax competition. [2] More recently, some of these tax measures have been deemed by the EU Commission to be in violation of the EU State Aid legislation. [3]
The implementation of such measures has been favoured by the outdated international tax legal framework – mainly constituted by tax treaty law and domestic laws dealing with cross-border transactions. Indeed, the increasing importance of mobile sources of income such as intangibles, combined with the possibility to manage global businesses remotely, has showed how the main traditional criteria to identify a taxable presence in a certain jurisdiction – i.e. residence and a fixed place of business or a dependent agent – result being inadequate. MNEs, especially the ‘champions’ in the Digital Economy, have certainly took advantage of such circumstance in order to reduce their production and distribution costs and thus increase their profit margins and their competitive advantage. Practically, they structured their supply chains in such a way that a) prevented the identification of a taxable presence in those high-tax jurisdictions which coincided with the main markets where most of their business took place, and b) enabled them to qualify for the most appealing tax breaks granted by governments all around the world.
As a response to such aggressive tax planning, governments of the most industrialized countries reacted initially through unilateral twofold measures: on the one hand, they strengthened their anti-avoidance rules and their tax audit and assessment activities; on the other hand, they also introduced tax incentives for new investments by MNEs.
Subsequently, such governments agreed on the necessity to adopt multilaterally-designed anti-avoidance rules, such as, for example, those designed at the OECD level within the framework of the so-called BEPS (“Base Erosion and Profit Shifting”) [4] project, and at the EU level through the enactment of the Anti-Tax Avoidance (“ATAD”) Directive. [5]
In light of all of the above, it emerges how today the design and management of MNEs’ supply chain need to be oriented not just toward the legitimate exploitation of operational advantages, internationalization opportunities and cost reduction offered by the recent technological improvement and the integration of markets, It should also be oriented towards the selection of the most appealing tax opportunities offered by the various jurisdictions, and, at the same time, the minimization of the risks arising from the application of the many anti-avoidance domestic and internationally-designed tax rules introduced in the past years. In such regard, we refer to tax-aligned supply chain management. [6] The implementation of a tax-aligned supply chain by a MNE is particularly complex as it requires the knowledge of tax rules in as many jurisdictions as those in which the enterprise conducts its business.
III. Tax opportunities The main tax opportunities MNEs need to take into account when designing their global supply chain consist of lower tax rates, tax credits or exemptions, boosted depreciations for newly acquired capitalized assets, IP box regimes, and advance rulings.
III.A. Lower tax rates Obviously, the first thing multinational businesses look at when dealing with taxes is the applicable tax rate. In the past decades, there has been a general trend towards a decrease in the corporate income tax rates. Indeed, the average OECD nominal corporate tax rate has shifted from being close to 30% in the late ’80s and ’90s to being around 25%, with many countries being way below such level (e.g. 12.5% in Ireland) [7]. And such trend is very likely to continue, as a result of competition between governments to attract businesses. Although the effective tax rate, and not the nominal rate, is what actually matters, a decrease in the latter necessarily trigger a decrease in the former as well. III.B. Tax credits, exemptions, and boosted depreciations
Significant incentives are provided to MNEs also in the form of tax credits which can be used to offset, and thus lower, the tax due. Among the many tax expenditures provided in the form of tax credits, the most recurrent and significant ones are those granted by many jurisdictions for R&D activities, which also stimulate an increase in the level of innovation.
Further tax incentives of special interest for MNEs are constituted by boosted depreciation of capitalized tangible and intangible assets – i.e. allowing corporations to deduct an amount which is higher than the actual purchase price of these assets. Various countries have conditioned such tax breaks to the acquisition of assets which are deemed to be critical for economic growth and innovation (such as, for example, investments in AI).
III.C. IP Box regimes
A special type of tax expenditure initially adopted by certain European countries (such as Ireland, the UK and the Netherlands) and currently implemented by many jurisdictions around the world, is the so-called IP Box regime.
The IP Box regime substantially consists of granting – through various mechanisms - a significantly lower taxation on income arising from direct or indirect exploitation of intellectual property. Some countries grant such benefit in the form of a tax credit, others in the form of a tax exemption or a lower tax rate.
The ultimate goal of countries implementing the IP Box regime is, obviously, to attract the IP holding companies within their territory, given the importance of such assets in the modern digitalized economy.
As of today, over 15 OECD countries have adopted an IP Box regime. It is up to the tax directors and the top managers of MNEs to assess which jurisdictions offer the best treatment and therefore is more appealing for the establishment of their IP holding companies. A certainly decisive role is played by the EU membership, which, through the application of the so-called Interest&Royalty Directive, entitles IP holding companies to benefit also from the exemption, in the source countries, from withholding taxes on royalties – i.e. the main type of income arising from the indirect exploitation of IP.
III.D. Advance rulings
Finally, a tax opportunity which has been extremely appealing to MNEs is represented by advance tax rulings granted by tax authorities. Advance rulings do not constitute, per se, a tax expenditure aimed at lowering the taxable base. Their main goal is actually to grant advance legal certainty about the tax treatment of certain transactions, and thus avoid the cost of uncertainty and ex post assessments. For this reason, the use of advance tax rulings has been strongly recommended by the OECD as a decisive tool for the change in the paradigm of the tax authorities-corporate taxpayers relations. [8]
Advance tax rulings have in fact been used by several jurisdictions as a powerful instrument to attract MNEs’ headquarters. Recently, advance tax rulings concerning the determination of transfer pricing in intra-group cross-border transactions have been the subject of challenges by the EU Commission, based on the argument that they were in violation of the EU State Aid legislation. The EU Commission has issued six decisions through which it deemed rulings granted by the Tax Authorities of Ireland, Luxembourg and the Netherlands to be in violation of EU State Aid law and thus required those countries to recover a total amount of about €14 billion. [9] Such decisions will have eventually to be evaluated by the European judges, since they have been appealed by the interested Member States. However, in light of this EU Commission’s approach, tax directors and top managers of MNEs will have to pay a particular attention to the features of the advance tax rulings they will obtain, as the advantages provided by them may be offset by the re-characterization of such rulings as State aid and therefore be subject to the recovery procedure set forth in the EU law.
IV. Tax risks As anticipated, any time a restructuring of the supply chain which involves cross-border aspects takes place an efficient tax-aligned supply chain management should take into due consideration the anti-avoidance rules and practices in force in both the outbound jurisdictions (the jurisdictions from which certain functions or assets depart) and the inbound jurisdictions (the jurisdictions where certain functions or assets are relocated).
IV.A. Outbound perspective On the outbound jurisdictions’ side, the attention should be focused, primarily, on:
the transfer of residence of the headquarter itself or of certain branches of businesses (especially those businesses whose main assets are intangible assets);
the incorporation of foreign controlled entities in charge of carrying out certain activities previously conducted by the headquarter or of being the holders of intangible assets;
intra-group cross-border transactions.
IV.A.(i) Exit taxes The transfer of residence to low-tax jurisdictions has been, in the past decades, a quite widespread phenomenon concerning, especially, financial and IP holdings. The main issue arising from the transfer of residence of such entities is related to the fact that it implies the transfer of assets on which capital gains may have accrued (although not yet monetized). As a result of the transfer, indeed, the country of origin loses its entitlement to tax such accrued capital gains when they will be monetized and thus realized. They will be taxable only by the new country of residence. Furthermore, it should be noted that very often MNEs relocated the financial and IP holdings to jurisdictions which recognised a step up in the value of the transferred assets, regardless of the payment of any tax on capital gains in the country of origin. Such transfers, therefore, resulted in extremely beneficial tax planning for the interested enterprises, which ended up achieving double non-taxation in regard to capital gains over transferred assets.
Many OECD countries (including Italy, Spain, Germany, the Netherlands etc.) reacted to such impairment of their taxing rights by introducing a so-called exit tax, consisting of treating the transfer of residence as a taxable event – i.e. deeming the accrued, although not monetized, capital gains to be realized for tax purposes. [10]
The application of the exit tax gives rises, for the transferred entities, to a potential cash flow disadvantage, as they are required to pay taxes on capital gains which have not been monetized yet. Furthermore, the application of the exit tax is suitable to trigger double taxation in the case the country of relocation did not grant a step-up in the tax value of the transferred assets.
As a result, one of the key elements to take into account even before the incorporation of a company in a certain jurisdiction is whether such country would apply an exit tax upon the transfer of the entity to a different jurisdiction. Symmetrically, before a supply chain restructuring, it is necessary to assess whether the potential country of destination will grant a step up in the value of the transferred assets.
IV.A.(ii) CFC legislations
With regard to the incorporation of foreign subsidiaries, MNEs need to pay a special attention to the potential application, by the country of residence of the headquarter, of the so-called CFC legislation. This legislation provides a tool for governments to prevent MNEs from shifting income from high-tax countries to low tax jurisdictions by means of foreign entities.
As of today, over 25 countries have passed CFC regulations. Despite significant differences arising from the various domestic contexts and tax policy perspectives, an overview of the CFC regulations shows that their application is generally triggered by three “triggering factors”: a) the existence of a controlling participation interest in a foreign corporation; b) the “passive” nature of the controlled foreign corporation’s income, meaning that most of its income arises from intangible assets; c) the (low) tax burden in the jurisdiction where the controlled foreign corporation is established.
When the application of the CFC legislation is triggered, the income of the controlled foreign corporation is fictitiously attributed to its controlling shareholders, regardless of the circumstance that such foreign-sourced income
has actually been distributed or not.
Over the last years, CFC legislations – especially those implemented by EU Member States - have been significantly strengthened.
IV.A.(iii) Transfer pricing
In the past years, OECD countries have observed a significant increase in tax assessments against MNEs based on transfer pricing (“TP”) regulations. TP regulations are rules aimed at preventing the profit shifting from high-tax jurisdiction to low-tax jurisdictions that may arise from intra-group cross-border transactions’ prices which are deemed to be not in line with the so-called arm’s length values, that is, the prices which would be normally charged between independent parties. [11] Under such regulations, national tax authorities are entitled to re-determine, for tax purposes, those intra-group prices. Specifically, the (high-tax) jurisdiction which deems that a specific transaction did not take place at the arm’s length value will issue a tax assessment through which an upward adjustment to the taxable base of the entity resident within its territory will be made. It is fair to expect that such type of assessments will further increase in the next years due to larger amount of information about intra-group transactions that MNEs are now required to provide.
In light of this, and of the fact that TP evaluations are exposed to a high degree of discretion,
an advisable strategy, for MNEs, is to enter into so-called Advance Price Agreements (“APA”) with the tax authorities of the various countries where they operate. Such agreements grant advance legal certainty about the determination of intra-group cross-border transfer prices and eliminate the risk of harmful ex post assessments.
V.B. Inbound perspective
On the inbound jurisdictions’ side, the focus should be, specifically, on:
the consistency of the remuneration of subsidiaries with the arm’s length principle;
the alignment between the market presence and the taxable presence.
IV.B(i) Transfer pricing
In regard to point 1), the same considerations on the application of TP rules already illustrated above apply.
IV.B.(ii) Permanent establishment assessment As for point 2), it is worth recalling that, according to the general international tax rules – set forth in the double tax treaties and in domestic law – foreign sourced business profits of an enterprise are taxable only in the country of residence of that enterprise, unless it has a permanent established in the source country. [12] Therefore, source countries are not entitled to tax profits of a foreign enterprise unless the existence of a permanent establishment of that enterprise in the source country can be identified. According to the relevant and traditional tax treaty provisions, a permanent establishment consists of a fixed place of business through which an essential core business activity is carried out or of a dependent agent having the power to conclude contracts in the name of the foreign enterprise,
In the past years, many MNEs have carefully designed their supply chains in order not to have a permanent establishment in the in high tax jurisdictions where significant portions of their profits were generated. As a result, despite the fact that they had a strong market presence in such countries, they ended up not paying income tax on most of their profits therein. MNEs were able to achieve such result by taking advantage of the fact that the concept of permanent establishment currently included in the existing tax treaties is outdated, as it refers, as anticipated, to physical presence in the source countries.
This is the main reason why OECD countries – and others – decided to work together on the amendment of the concept of permanent established included in the existing tax treaties. Over 80 jurisdictions signed the so-called Multilateral Instrument (“MLI”) [13], i.e. an agreement through which several parts of existing bilateral tax treaties for the elimination of double taxation, including the concept of permanent establishment, will be amended at the same time and made more fit to the current digitalized economy. Furthermore, other proposals for the adoption of a concept of digital permanent establishment or significant economic presence are being discussed at the international level. As a result, MNEs will become increasingly exposed to the risk of assessment of a permanent establishment in high tax jurisdictions and therefore of being taxed therein. MNEs therefore need to take such risk into account when re-designing their global supply chains.
IV.B.(iii) New types of taxes Finally, in designing their tax-aligned supply chains, MNEs cannot disregard the recent or forthcoming introduction, by an increasing number of countries, of new types of taxes targeting MNEs and their transactions. I refer, in particular, to the various equalization levies on digital transactions enacted in certain countries (e.g. India or Italy) or advanced in other countries (such as Spain and France) or by the EU Commission [14]. The common features of these taxes are that their application is not conditioned to the existence of a permanent establishment in the source countries, and that their taxable base is constituted by the gross revenues and not by the net profits. Such latter aspect is particularly relevant, because it makes these taxes potentially applicable also to businesses which are not profitable, and leaves them outside of the scope of application of the treaties for the elimination of double taxation.
V. Final remarks
In light of all of the above considerations, it emerges how for MNEs it is of critical importance to design and manage their global supply chains based not just on business and financial evaluations, but also on the multifaceted tax opportunities and tax risks that can be encountered in the various jurisdictions where they operate. In such regard, not just the existing tax rules should be taken into account but also those measures which are likely to be implemented in the near future and which aim to realign the market presence with the taxable presence. For these reasons, the involvement of tax managers and tax directors in the decision-making process concerning the supply chain design and management is expected to significantly grow.
Notes
[1] Mies H., 2014. "Cross-Border Outsourcing – Issues, Strategies and Solutions", Bulletin for International Taxation, 68(11), 573-85.
[2] OECD, 1998. Harmful Tax Competition: an emerging global issue, OECD Publishing, Paris.
[3] G. Allevato, The Commission’s State Aid Decisions on Advance Tax Rulings: Criticisms and Potential Impact on the Future of Direct Taxation within the European Union, in “Combating Tax Avoidance in the European Union: Harmonization and Cooperation in Direct Taxation“ (Ed. J.M. Almudí, J.A. Ferreras Gutiérrez, P. Hernández González-Barreda), Wolters Kluwer, 2018, 483-95.
[4] OECD, 2012. Addressing Base Erosion & Profit Shifting, OECD Publishing, Paris.
[5] European Council, 2016. Council Directive (EU) 2016/1164 of 12 July 2016.
[6] Mies, supra note 1.
[7] OECD, 2017. OECD Tax Database Table II.1 – Corporate income tax rates, available at http://stats.oecd.org/index.aspx?DataSetCode=TABLE_II1.
[8] OECD, 2013. Co-operative Compliance: A Framework. From Enhanced Relationship to Cooperative Compliance, OECD Publishing, Paris.
[9] Allevato, supra note 3.
[10] Prebble J., 2006. "Controlled Foreign Company Regime and Double Taxation", Asia-Pacific Tax Bulletin,12(1), 3-5.
[11] On the methods to determine the arm’s length value, please see OECD, 2017. Transfer Pricing Guidelines for MNEs and Tax Administrations, Preface, OECD Publishing, Paris.
[12] OECD, Model Tax Convention on Income and on Capital, OECD Publishing, Paris (November 2017), available at oecd.org, Artt. 5, 7.
[13] Multilateral convention to implement tax treaty related measures to prevent base erosion and profit shifting (2016), available at http://www.oecd.org/tax/treaties/multilateral-convention-to-implement-tax-treaty-related-measures-to-prevent-BEPS.pdf).
[14] European Commission, Proposal for a Council Directive on the common system of a digital services tax on revenues resulting from the provision of certain digital services, available at https://ec.europa.eu/taxation_customs/sites/taxation/files/proposal_common_system_digital_services_tax_21032018_en.pdf
About the Author Giulio Allevato is Professor of Tax Law at IE University Law School. He is also Affiliate Professor of Tax&Law at SDA Bocconi School of Management in Milan. Before joining IE University, he was Hauser Global Fellow at New York University (NYU) School of Law, and Lecturer of Tax Law at SDA Bocconi School of Management. In the past, he has also been Ernst Mach Scholar at the Institute for Austrian and International Tax Law of the Vienna University of Economics and Business (WU). He regularly teaches at undergraduate and post-graduate programs and conducts research and training projects with important national and multinational enterprises, and has published on various taxation topics in international journals. He also practices as a certified international tax attorney for the Baker McKenzie’s Milan office.