Proinnsias Breathnach

This is a revised and expanded version of the original piece with the above title published here, which contained a couple of errors.

 

The recent World Economic Forum at Davos brought the tax treatment of multinational firms operating in Ireland once more into the spotlight.  While there is much criticism of Ireland’s low corporation tax rate of 12.5%, the real issue is the way in which huge flows of revenue are allowed to pass through Ireland without being subject to any taxation at all.  An examination of the returns for 2016 filed by two major multinational firms which have bases in Ireland, Facebook and Google, helps to throw light on this controversy.

In that year, Facebook Ireland’s declared pretax profits amounted to an extraordinarily low 1.4% of revenues of €12.6bn.  This contrasts very starkly with Facebook’s total global profit rate of a whopping 45.3%, based on returns filed with the US Securities & Exchange Commission (SEC).  Thus, while Facebook Ireland accounted for over half (50.5%) of Facebook’s global revenues, its share of the firm’s global profits was just 1.5%.

In 2016 Google Ireland’s pretax profit came to a very modest 5.1% on revenues of €26.3bn.  This was less than one fifth of the company’s global profit rate of 26.8%. Google Ireland accounted for almost one third of Google’s total global sales, but just six per cent of global profits.

The very low relative profitability of the Irish operations of these two companies is attributable almost entirely to the royalties they are required to pay to the overseas branch of the company which holds the rights to the company’s global intellectual property (IP) i.e. rights over patents, brand images, etc.

These branches are located in the Cayman Islands (Facebook) and Bermuda (Google).  These are essentially brass-plate entities with virtually zero costs, so the royalties they receive are converted almost entirely into profits which are added to the bottom lines of their respective parent companies.

The returns which Facebook and Google make to the Companies Registration Office in Ireland do not detail these royalty payments.  Instead they are combined with various other cost elements in a single general/administrative costs category which, on its own, consumes 70% of Google Ireland’s revenues, with this figure rising to no less than 96% in the case of Facebook Ireland.

It is noteworthy that there is a much more detailed costs breakdown in the returns these firms’ parent companies make to the SEC.  One may ask why a similar breakdown is not required in their Irish returns which serve to hide royalty payments from public scrutiny.  There is no evidence here of the transparency which the Irish government routinely claims is a feature of the Irish corporation tax system.

However, one can get an idea of the scale of royalty payments being made by these firms by asking what level of profits their Irish operations would have made if their profit rate matched that achieved at global level.  This is justified by the high proportion of their global revenues accounted for by Ireland and the fact that there is no reason for expecting the non-royalty costs of the Irish operations to be substantially different from the non-Irish operations.

If Facebook’s and Google’s Irish operations had profit rates on a par with their global returns, between them they would have generated combined profits of €12.7bn in 2016, over eight times their declared profits.  If they paid corporation tax on this at the standard rate of 12.5%, the yield to the Irish government would have been €1.6bn, compared with the €193 millions actually paid.

In the past, royalties were generally charged where firms licensed technology or brand names to independent third parties, with the price involved being determined by commercial negotiation.  The development of in-house technology was considered a cost item similar to labour or transport costs and charged to the accounts accordingly.

However, multinational firms have increasingly employed the practice of charging overseas subsidiaries for the use of the firms’ own technologies in the form of royalties.  As firms can arbitrarily set the charges involved, this became a useful way of moving profits, disguised as royalties, from one jurisdiction to another.

The use of royalties in this way has a long history.  However, in the past royalties were mainly used to transfer untaxed revenues from Third World countries to hide the true level of multinational profits in these countries which in some cases were  astronomically high.

Up to recently, the main device used by multinationals for shifting profits between jurisdictions was to locate different stages of an overall production process in different countries, with one stage located in a low-tax jurisdiction.  By manipulating the prices charged for the movement of inputs and outputs between subsidiaries (so-called “transfer prices”), the bulk of the profits could be concentrated in the low-tax country, from which they were then extracted.

This has long been recognised as a feature of foreign investment in Ireland.  Such is the size of the foreign sector in Ireland that, in 2015, outflows of direct investment income (i.e. multinational profits) amounted to 23% of Ireland’s GDP.

The use of royalties as an alternative method of concealed profit shifting has grown dramatically in recent years, as multinational firms have developed accounting techniques for doing this without legal transgression.  It allows firms to avoid any tax at all on large portions of their global revenues, and is particularly important for services firms such as Facebook and Google which do not have the kinds of production systems which facilitate transfer-price manipulation of the type described above.

Multinational firms in services sectors such as internet services, software and financial services now account for one half of exports from Ireland.  Their rapid growth has been paralleled by a sharp rise in outflows of royalties from the country.  In 1998, the outflow of direct investment income (multinational profits) was three times greater than the outflow of payments for royalties and licences.  By 2016, the direct investment outflow was almost four times greater (in current terms) than in 1998 while the royalties outflow had increased almost 13-fold.  Thus, in 2016, the royalty outflow was 20% greater than that for direct investment income.

Between them, the outflow of royalties and investment income from Ireland amounted to €126bn in 2016.  This equates to almost one half of total GDP.  Multinational firms paid around €6bn in corporation tax in the same year. This indicates the scale of magnitude of the flow through Ireland of multinational profits which pay little or no tax en route.

It is no surprise, therefore, that the larger EU member states which are the source of most of this untaxed income wish to introduce measures which will allow them to obtain their fair share of tax on this income.  However, the EU’s proposals for a common consolidated corporate tax base (CCCTB) seek only to redistribute the profits currently declared within the EU by multinational companies.  As the Facebook and Google examples show, these represent only a small fraction of the real level of profitability of these firms’ activities in the Union. However, because of the high level of concentration in Ireland of these declared profits, redistribution under the CCCTB proposals seems likely to have a significant negative impact on Ireland’s corporation tax revenues.

The OECD’s proposals to tackle tax base erosion and profit shifting (BEPS) by multinational firms include the targetting of the global misallocation of profits generated by intangibles (i.e. the intellectual property on which royalties are based).  If successfully implemented, these proposals could lead to substantially increased tax revenues for EU member states, including Ireland.  However, there is considerable opposition to the proposals, and the prospects of their being implemented in any meaningful way in the foreseeable future are remote.

Anticipating slow progress in the development of the BEPS proposals, the European Commission is now proposing the imposition of a tax on the EU revenues of firms operating specifically in the digital economy, which are seen as the leading practitioners of profit shifting out of the Union.  This is presented as an interim measure pending the working out of more long-term arrangements for the effective taxation of global firms.  In this respect, the EC has recently suggested the EU might go it alone in taxing these firms on the basis of allocating to each member state a share of the firms’ global profit corresponding to that state’s share of global revenues.

Ireland has opposed the proposed “digital tax” on the grounds that it would reduce Ireland’s attractiveness as a location for multinational investment while offering litte counterbalancing compensation in terms of digital tax revenue due to the small size of the Irish market for digital sales.  However, the prospect has been raised of those countries advocating the tax (including the four largest post-Brexit economies – Germany, France, Italy and Spain) implementing it as a separate grouping, should unanimity among EU member states not be forthcoming on the issue.

The fact remains that Ireland currently acts as a major facilitator allowing multinational firms to avoid taxes which could contribute significantly to the revenues of other EU member states.  The argument that closing off these tax avoidance practices could undermine Ireland’s attractiveness as a location of multinational investment is alarmist.  These firms need a European base and Ireland has been performing more than satisfactorily in this respect in many ways other than in relation to corporate tax arrangements.

Ireland has been a major beneficiary of revenues transferred to Ireland from fellow EU member states since 1973.  Being part of an economic community involves give as well as take.  It therefore behooves the Irish government to support the EC’s attempts to secure a fair tax return from the profits being made by multinational firms within the EU.

 

 

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