Offshore profits can mean a tax headache

Jill Storey explains why transfer pricing is a boardroom issue for companies with international operations.

We have all seen the recent surge of interest in tax and, in particular, transfer pricing around the world following extensive press coverage. If you are a main board director, do you need to be concerned? Do you need to ask: What will our response be if we find ourselves on the front page of a major newspaper under a heading related to “tax avoidance”?

Before answering the question it may be worth heading back to basics.

Transfer pricing occurs when two companies that are part of the same multinational group trade with each other. For example, an Australian subsidiary of an imaginary company, Distillers Pty Ltd, may buy bottles from the Irish subsidiary of Distillers Pty Ltd. The act of the two parties negotiating a price for the bottles is known as transfer pricing. Current international tax and transfer pricing rules provide the opportunity for companies to modify their supply chains, such that their profits are moved and taxed in countries with low tax rates.

Transfer pricing itself is not illegal or necessarily abusive. In fact, there is strong evidence that in the vast majority of cases reported in the headlines, companies have not acted illegally. However, directors need to be aware that merely being legally compliant may no longer be enough.

The debate around taxation has shifted. As economic conditions have toughened for individuals and governments around the world, there has been growing public anger at cases of corporate tax avoidance. Although companies may be operating within the law, they are often now subject to the “morality” or “good corporate citizen” test.

You may recall reading about the campaign to boycott a chain of 350 coffee shops in the UK after it was reported to the House of Commons that it had paid no UK tax on earnings of $650 million. Following protests on the streets and falling sales, it was reported that it volunteered $35 million of tax to the UK authorities in an “attempt to deflect public pressure”.

So should you be concerned about transfer pricing? Could negative headlines adversely affect your reputation?

As Warren Buffet said: “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you will do things differently.”

A starting point is to consider the scale and structure of your international operations. If you have a purely domestic group structure then transfer pricing is not a concern. Notwithstanding this, merely having international operations and various overseas subsidiaries does not necessarily mean that transfer pricing is a concern or justifies a place on your board agenda.

If you have an international group structure then some questions you may want to ask include:

• What is the significance and scale of our international operations relative to our domestic operations and does the profit allocation correlate?
• How does our effective tax rate reconcile with the statutory tax rate?
• Do we have entities in low-tax jurisdictions or tax havens?
• How does our effective tax rate compare to our industry peers?
• Are our inter-group transactions commercially viable?

If you decide that your organisational structure justifies putting tax on the board agenda, then a carefully considered approach is required.

The board’s remit is to act legally and in the best interests of shareholders. However, this does not mean minimising the corporate tax bill at all costs. There must be a balance between taking advantage of legal means to reduce the organisation’s tax bill in an effort to improve shareholder value and being viewed by customers as a good corporate citizen by paying an appropriate level of tax.

For your business, what would be the likely reputational damage from negative headlines? What impact would they have on your efforts to create a highly publicised, strong corporate social responsibility ethos?

To answer these questions you will need to decide whether your industry’s consumer demand is highly sensitive to the media focus on tax. In the coffee shop example, consumer demand was visibly sensitive. It is arguably less clear whether some of the technology companies who have been in the headlines recently have been affected to the same degree.

However, it may be dangerous to reach the conclusion that industries focusing on business-to-business transactions do not need to be concerned. Ethical investors are starting to step up their focus on tax avoidance, with some ethical funds excluding companies with overly aggressive tax reduction policies.

Tax is now a boardroom issue, given the potential reputational effects. However, whether it justifies a place on your board agenda will very much depend on your organisation. In any event, the board should be aware of the global push for greater tax transparency, the likely increase in media scrutiny and the move led by the OECD/G20 to better align transfer pricing outcomes with value creation in the global digital economy.