'Permanent Establishment' Becomes Tax Authorities' Weapon Of Choice in Attack on Corporates
Facebook became the second major tech company to announce a significant change to its UK tax policy this past month, when it said it would start recognizing advertising revenue initiated in Great Britain locally instead of routing the sales through its international headquarters in Ireland. I predicted this last May when Amazon announced a similar move. It’s just the beginning.
A perfect storm of global tax reform, bad publicity about corporate tax avoidance, and increased scrutiny of corporate balance sheets is putting corporations under a microscope and making it harder than ever for them to manage their international tax operations with certainty. Increasingly, many multinational corporations are coming to the conclusion that costs associated with lengthy conflict resolution and years of having their names tarnished with the stigma of corporate tax avoidance isn’t worth the trouble and are simply succumbing to higher taxes to avoid the drama.
In the short-term, this looks like it could be a win for lawmakers and tax authorities. But it’s not quite that simple. Longer-term, this heightened level of enforcement will create a drag on corporate earnings and enormous administrative hurdles for large corporations that could create a range of negative ripple-effects.
To truly understand the issue, it’s important to first understand the current state of global tax reform. While there are several factors at play driving this evolution, including the Organisation for Economic Cooperation and Development’s (OECD) Action Plan on Base Erosion and Profit Shifting (BEPS) initiative, along with hundreds of localized corporate tax reform efforts, the real lynchpin driving these high-profile corporate tax policy shifts in the UK right now is the concept of permanent establishment. Central to several new tax laws, such as the diverted profits tax in the UK and the expansion of Australia’s general anti-avoidance provisions, the permanent establishment concept stipulates that any entity conducting business operations from a fixed place of business in a jurisdiction should (subject to certain limited exceptions) pay tax in that jurisdiction.
Though it sounds simple enough in theory, interpreting what exactly constitutes a permanent establishment in a particular location is very much a grey area, and it’s increasingly becoming one where companies cannot afford to miscalculate. For some guidance on how permanent establishment is currently being interpreted, I turned to Tom Lickess, Director, International Tax at Radius Global Growth Experts. Having spent the last dozen years in Australia with Deloitte, where he helped companies wrangle the Australian diverted profits tax, he’s now based in the UK and advises corporations on multinational expansion plans, specializing in international tax.
Lickess explained a pretty typical permanent establishment scenario through the eyes of a U.S.-based technology company:
“Let’s say you have a U.S.-based tech company with an international headquarters in Ireland. Its European server is based in Ireland, so, technically, if the company uses the server to contract with customers in Great Britain and there is no fixed place of business or sales force on the ground locally in Great Britain, the company could argue that it does not have a permanent establishment there, with the result that the source of the company’s taxable profit is Ireland. Therefore, the company would pay tax on its UK sales at the 12.5% Irish corporate tax rate as opposed to the 20% rate in the UK.”
It’s rarely that simple in the real world, though. As Lickess explained, tax authorities are well-aware that some companies may use the differences in jurisdictional tax laws to game the system and have designed their laws to make it harder to do that.
“The new UK law requires certain taxpayers to notify the UK tax authority should they determine that they have conducted their activities in such a way that they were designed to stop just short of having a physical presence in the UK. So, for example, if a UK-based employee with a seemingly innocuous-sounding title like ‘Business Development Officer,’ has income generation or sales responsibilities in their remit, that employee may give rise to the offshore taxpayer having a permanent establishment in the eyes of UK tax authorities.”
Ultimately, what’s happening is that gradual reform of tax laws is giving tax authorities more latitude to pull back the veneer of seemingly auxiliary activities and categorize them as direct sales activities that justify local taxation at local tax rates. It’s also giving them the authority to investigate deep into the details of the corporate structure to prove their case. Companies can fight this, of course, by challenging the tax authorities’ definition of what constitutes a permanent establishment, but, as Lickess points out, it may not be worth the pain for most.
“The real problem arises when this occurs five years down the line. You’ve already paid taxes in Ireland and the UK and the tax authorities in the UK say you owe more. Now, you have to enter into a lengthy, perhaps very public, tax fight that could result in a double-taxation scenario where you owe the UK government tax on revenue that has already been taxed in Ireland. The only way to remediate a problem like this is to bring both tax authorities to the table and work out an agreement. A time consuming and administratively burdensome process. Many companies are realizing that they are better off cutting this potential problem off at the pass by seeking certainty (from tax authorities) now, and / or restructuring their cross-border tax arrangements.”
This, of course, is just the beginning. The BEPS country-by-country reporting mandate will give local tax authorities even more ammunition to challenge corporations on the grounds of permanent establishment. Many companies will follow in the footsteps of Amazon and Facebook and adjust their tax policies to avoid the issue. Others, like Chevron in Australia, are likely to take on the challenge, come what may.
Will it all go down as a win for lawmakers and tax authorities? While early evidence is clearly pointing toward more companies abandoning aggressive profit shifting strategies, others are getting even more aggressive and reincorporating their entire operations into lower tax regimes through tax inversion deals. Right now, it looks like multinational corporations are paying the biggest price, but that could also trickle down to shareholders, customers and, ironically enough, tax authorities.