International taxation and ethics

1 Introduction

Chapter 13 dealt with the mechanics of tax: how a corporate income tax computation is built and how a capital gain is calculated. This chapter deals with the framework around those computations — where tax rules come from, how tax authorities administer and enforce them, and what happens once a business stops operating in one country and starts trading across borders.

The international part matters more than it once did. A business can now sell to customers in a country where it owns no building and employs nobody, which puts pressure on tax rules written when profits and premises went together. The syllabus expects you to understand corporate residence, the forms an overseas operation can take, double taxation and its relief, transfer pricing, and the difference between avoiding tax and evading it — together with the ethical questions each of those raises. One distinction to fix at the outset: the regulatory environment in this chapter is the regulatory environment of taxation — where tax rules come from and who enforces them. The regulatory environment of financial reporting (the IFRS Foundation, the IASB and the standard-setting process) is Chapter 1. They are separate systems with separate regulators.

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2 Background: sources of tax rules

Tax rules vary enormously between countries, but the sources of those rules are much the same everywhere. The balance between them differs; the list does not.

3 Background: the administration of taxation

3.1 Record keeping

Tax legislation requires businesses to keep records that support what they have declared, and to retain them for a specified number of years. What has to be kept follows the taxes the business is exposed to:

Record keeping is now largely digital. Many authorities require returns to be filed electronically, some require accounting records to be kept in a prescribed digital form, and a growing number require invoices to be reported to the authority in real time as they are issued. The obligation is the same as it always was; the medium and the speed have changed.

3.2 Deadlines, filing and penalties

Deadlines exist because governments budget their expenditure against expected tax receipts. If the money arrives late the government has to borrow, and borrowing costs. Penalties exist to make late filing and late payment unattractive enough that they do not happen.

Two broad models of assessment are found:

• Self-assessment – the taxpayer prepares its own return, calculates the tax it believes is due and pays it. The authority may enquire into the return afterwards and amend it.

• Assessment by the authority – the taxpayer submits information, and the authority calculates the liability and issues an assessment stating what must be paid.

3.3 Powers of tax authorities

Revenue authorities can normally impose penalties for offences relating to corporate income tax and sales tax, and in addition they generally have power to:

• review and query returns that have been filed;

• request special reports or returns;

• examine the underlying records, typically extending back a number of years;

• enter and search premises, usually under a warrant or similar authorisation;

• collect tax due, including by seizing assets or attaching amounts owed to the taxpayer by third parties;

• exchange information with tax authorities in other countries.

Information exchange has grown into a system rather than a favour. Under multilateral agreements, authorities now exchange financial account information automatically each year, and large multinational groups file country-by-country reports setting out revenue, profit, tax paid, employees and assets for each jurisdiction in which they operate. A group can no longer assume that what it tells one authority stays with that authority.

4 Tax evasion and tax avoidance

The awkward territory is between the two. Claiming a relief for the purpose it was created for is uncontroversial tax planning. Building an elaborate structure with no commercial purpose other than to produce a tax result is what is usually meant by aggressive tax avoidance: legal on its face, but contrary to the intention of the legislation.

4.1 How authorities respond

• Reduce the opportunity – deduct tax at source wherever possible (employment income, interest, dividends paid abroad) and simplify the tax structure, since complexity is what creates the gaps.

• Increase the perceived risk – audit returns and payments, and require schemes to be disclosed to the authority before they are used, so that the legislation can be amended quickly.

• Reduce the gain – review the penalty structure regularly, and legislate a general anti-avoidance rule that allows the authority to counteract arrangements whose main purpose is to obtain a tax advantage.

• Change social attitudes – build an honest, equitable and accessible tax administration, and use transparency (public tax strategies, country-by-country reporting) so that aggressive behaviour carries a reputational cost.

4.2 The ethics of taxation

The professional accountant sits between the taxpayer and the authority, and the ethical principles you met in Chapter 2 apply directly to tax work:

Beyond the accountant’s own duties, boards face a genuine judgement. The argument in favour of minimising tax is that directors have a duty to shareholders and are entitled to use the law as it stands, and that a business contributes to the economies it operates in through employment, employment taxes and sales taxes as well as through corporate income tax. The argument against is that tax funds the infrastructure, education and legal system the business relies on; that what is not paid by large multinationals falls on individuals and smaller companies; and that arrangements the public regards as unfair damage the business’s reputation, its customer relationships and ultimately its licence to operate. Both arguments are examinable — the ability to set them out is worth more marks than a view.

5 Corporate residence

Corporate income tax is usually charged on the basis of residence: a country taxes companies resident in it, often on their worldwide profits, and taxes non-resident companies only on profits arising within its borders. The test of residence varies:

A permanent establishment typically includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, and a building or construction site that lasts more than a specified period. Purely preparatory or auxiliary activities — a warehouse used only for storage, a display facility — normally do not create one.

Because different countries apply different tests, a company incorporated in one country but managed from another can be resident in both. That is the origin of double taxation, and it is why treaties contain tie-breaker clauses that assign residence to one state — usually the state of effective management — where the domestic rules of two states conflict.

6 Branch or subsidiary?

An entity expanding abroad usually chooses between two structures, and the tax consequences differ sharply because one is the same legal person as the parent and the other is not.

7 Double taxation and its relief

Double taxation arises when the same profit is taxed twice — because two countries both claim the company as resident, or because one country taxes the profit where it arises and the other taxes the same profit in the hands of a resident recipient. Left alone it would make cross-border trade uneconomic, so relief is given in one of three ways:

Most relief flows through double taxation treaties modelled on the OECD Model Tax Convention. A treaty allocates taxing rights between the two states, breaks residence ties, defines what constitutes a permanent establishment, and reduces or eliminates withholding taxes. The Model’s general principle for trading income is that business profits are taxable only in the state of residence unless the enterprise trades through a permanent establishment in the other state, and then only so much of the profit as is attributable to that establishment.

7.1 Withholding tax

Many countries require a payer making a payment abroad to deduct tax at source and account for it to their own authority. Interest, dividends, royalties and some capital payments are the usual targets. The recipient receives the payment net, and the amount withheld is normally creditable against its home liability. Treaties commonly reduce the withholding rate, sometimes to nil.

7.2 Underlying tax

A dividend is paid out of profits that have already borne corporate income tax in the paying company’s country. That corporate tax, to the extent it relates to the dividend received, is called underlying tax. Where the recipient holds a substantial shareholding, relief is often given for it as well as for the withholding tax:

Underlying tax = Gross dividend × (Tax paid by the overseas company ÷ Profit after tax)

8 Transfer pricing

When two companies in the same group, in different countries, trade with each other, the price they charge is set within the group rather than by a market. Move that price up or down and profit moves from one country to the other — and if the two countries tax at different rates, the group’s total tax bill changes without anything real changing at all. The same applies to intra-group interest, management charges and royalties for the use of brands and technology.

The international answer is the arm’s length principle: related parties must price their transactions as independent parties dealing at arm’s length would have priced them. Where they do not, a tax authority may substitute the arm’s length price and tax the profit that would have arisen.

Establishing that price is the practical difficulty. The OECD Transfer Pricing Guidelines set out methods, of which you should recognise:

• Comparable uncontrolled price – use the price charged in a comparable transaction between independent parties. The most direct method when a comparable exists.

• Resale price – start from the price at which the goods are resold to an independent customer and deduct an appropriate gross margin.

• Cost plus – start from the supplier’s costs and add an appropriate mark-up. Common for services and manufacturing on contract.

• Transactional net margin – compare the net profit margin earned on the controlled transaction with margins earned on comparable uncontrolled transactions.

• Profit split – where both parties make unique and valuable contributions, split the combined profit between them on an economically sensible basis.

Groups are generally required to keep contemporaneous documentation justifying their transfer prices, and large groups file country-by-country reports as well. Where two authorities disagree, the treaty’s mutual agreement procedure exists to prevent the same profit being taxed twice; some groups obtain an advance pricing agreement with one or more authorities to settle the method in advance.

9 Taxing the digital economy

The residence and permanent establishment rules described above were built on a simple assumption: to sell substantially into a country, you needed premises and people there. Digital business breaks that assumption. A platform can have millions of customers in a country, earn revenue from them, and hold data generated by them, while owning nothing there and employing nobody. On the traditional rules there is no permanent establishment, so there is nothing for that country to tax.

Two further features sharpen the problem. Value increasingly sits in intangibles — brands, algorithms, user data — which are mobile and hard to value, so they can be located wherever the tax rate is lowest. And user participation itself creates value, which the traditional rules do not recognise at all.

The responses you should be able to describe:

• Unilateral digital services taxes – a number of countries introduced turnover-based taxes on revenues from digital advertising, online marketplaces and data sales generated from their users. They are quick to implement but sit outside the treaty network, tax revenue rather than profit, and invite retaliation.

• The OECD/G20 base erosion and profit shifting (BEPS) project – a coordinated programme of measures against artificial profit shifting: limits on interest deductibility, rules against treaty abuse, neutralising hybrid mismatches, a broader permanent establishment definition, and country-by-country reporting.

• Reallocation of taxing rights – reallocating a share of the profits of the largest and most profitable multinationals to the market jurisdictions where their customers are, whether or not the group has a physical presence there.

• A global minimum tax – requiring large multinational groups to pay an effective rate of at least 15% in every jurisdiction in which they operate, with a top-up charge collected elsewhere in the group if a jurisdiction taxes below that. The point is to remove the benefit of shifting profit to very-low-tax jurisdictions in the first place.

10 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.