Tax planning in letter and spirit
By R. Subhashree
The media, in recent months, has been focussing extensively on tax planning, tax avoidance and aggressive tax planning. All ingredients that go into a good story- big monied corporates funnelling money to low-tax jurisdictions, abusing the legitimate means and incentives , the shocked ordinary tax payer with no resources to plan or effect similar savings… have been used to the hilt. Of course, there was no allegation of actual breaking of any law, or of ‘tax fraud’ as with seized assets or falsified documents. Thus, the companies observed the law in letter but perhaps not in spirit. The victims were, surprisingly, developed countries with elaborate tax laws, sizeable number of transnational entities and experience with international taxation. The recent G8 meeting pledged greater information sharing and coordinated efforts to curb abuse of legal arrangements.
Interestingly, post questioning and public outbursts threatening to boycott goods in UK, Starbucks agreed to pay around 10 million pounds in taxes in succeeding years irrespective of profit or loss. It had been reporting losses in the previous years. Taxes are not voluntary payments or donations. The question is not about duty to pay taxes or the freedom to arrange one’s financial transactions or economic affairs. It is one of fairness and certainty to both parties – the tax payer and the state.
Leveraging differences in market price, tax rates, manufacturing costs is not a new phenomenon. But, the size of evasion alleged, coupled with the fact that instead of avoiding double taxation, double non-taxation resulted, has revenue authorities in Europe and the US urging reform and correction.
The entities being investigated set up subsidiaries with little or no operations in tax favourable jurisdictions and transferred earnings. By applicable definitions of permanent establishment (PE), business connection, earning, taxable income etc, the countries where most of the transactions happened or earning arose received no tax on them. One method was to create a subsidiary as a licensee or owner of intellectual property and transfer huge payments towards royalty, marketing advice etc. In the case of companies engaged in e-commerce, raising invoice on overseas subsidiary and location of servers in low tax havens, enabled companies to avoid paying tax on advertising or other revenues earned in the country where the actual transaction took place.
So this brings us to the basic question - what should be taxed? The reason for collecting taxes is said to be that every person enjoying the infrastructure and stable political/economic environment to earn the income should contribute his share to the government that has enabled it. Income – received, arising, accruing, deemed to be received/arise/accrue would be subject to tax. Income is more than just cash inflow and could cover gains, benefits, appreciation in value and so on. Different jurisdictions exempt certain items like royalty, capital gains, dividends, etc., based on policy considerations. In the said cases of abuse, the concept of income has become hazy and subject to varied interpretations. Further, tax rules based on territorial limits seem inadequate to take care of digitalisation of commerce. For instance, in ITO v. Right Florists Pvt. Ltd. [ITA No. 1336/Kol./2011 decision dated 12-4-2013 (ITAT Kolkata)], it was held that a website (virtual presence) cannot constitute PE and the servers hosting the website should be in taxable territory to constitute PE.
The concept of permanent establishment is defined in different ways in different treaties. For instance, as per a 1996 decision of the German Federal Tax Court, a pipeline running through Germany using which a Dutch company transported oil, was held to be a PE though there was any personnel stationed /engaged to operate the line within Germany nor did it have a place of business. A PE can be a fixed place of business, service PE, dependent agent, installation PE and so on.
Harmonising all definitions across jurisdictions or even within a country is idealistic but impractical. For instance the Authority for Advance Rulings (India) held that no inference can be drawn from the India-US treaty MOU in order to interpret terms in the India-Netherlands treaty (see end note 1). Each country arrives at its own point of resolution between ceding tax base, reducing rates and remaining an attractive investment destination. Tax laws will be peculiar to the State, its level of development, demography, advantages of natural resources, scarcity of labour and so on. Other suggestions have been to simplify the rules, have a flat rate of tax or attribute earnings on basis of operations.
Aggressive tax planning
A European Commission recommendation in December 2012 states that while signing Double Taxation Avoidance Agreements (DTAAs), the parties must draft the terms so that an item is exempt only if it is subject to tax in the other contracting state or states. While this may result in greater scrutiny of transactions and exchange of information, it does not solve the problem of structuring. As in the case of Apple which negotiated a low tax rate with Irish Authorities (see end note 2).
General anti-avoidance or anti-abuse rules (GAAR) are said to empower the authorities to look into the substance of a transaction in order to determine whether a transaction is genuine or not. However India’s experience in framing and trying to implement the same is enough indication that it is not an easy option. Britain has brought in GAAR but the task of proving that an ‘arrangement’ is abusive or ‘one of its main purposes is to attain a tax benefit’ can be cumbersome.
When governments need revenue and particularly during times of recession, they will resort to every tool at their disposal, as Greece did with ‘presumptive taxation’- which works more like wealth tax and is payable on the basis of assets owned even when a person does not have ‘income’. Tax planning and structuring to the point of over-leveraging may not work. As in the case of companies trying to push up return on equity by having a small equity base and rest of the funds through fixed-charge bearing funds (say debentures). The model works as long as rate of earnings far exceed the fixed charges. Perhaps erecting zero-tax mazes is reaching a saturation point. Companies need to be able to substantiate their choices. For this, they need an enabling environment where the tax regime is perceived as fair and both law and its implementation are certain.
‘It’s a cup of coffee. It’s not an internal combustion engine. I take the point about branding and advertising, but the generic coffee-making process is not that difficult’ (see end note 3) – the Public Accounts Committee observed on being told that the value creation happens outside UK – to serve coffee in UK, premium beans are bought through a Swiss entity and the recipe is obtained from a Dutch entity.
[The author is a Manager, Knowledge Management Team, Lakshmikumaran & Sridharan, New Delhi]