In the context of Action Point 11 of the BEPS Project, the macroeconomic effects of BEPS were reviewed. In its final report on Action Point 11, the OECD emphasized that the available indicators were of merely preliminary nature, necessitating heavy qualification when drawing any conclusions. One of the main difficulties in evaluating the magnitude of BEPS found by the OECD is disentangling real economic activity from BEPS behavior – which is one reason why macroeconomic assessments estimating profit shifting based on responsiveness to tax rate differentials are conceptually less suitable to measure BEPS as firm-level data. Irrespective of its own cautionary remarks, the OECD did put forth a rough estimate that between 4 percent and 10 percent of global corporate income tax revenues are lost to BEPS. These estimates were readily adopted by those advocating stricter regulations and have (too seldom) been critically questioned. Similar, highly questionable estimates are now being presented on firm-level data and utilized to lobby for large-scale tax harmonization and higher tax rates.
One recent example of the potential misuse of CbC-type data for assessing tax avoidance on the microeconomic (MNE) level can be seen in the case of the Zara group (Inditex). The respective study was commissioned by the Greens/EFA Group in the European Parliament – published in December 2016 (the “study” ). Based on financial statements of the retail subsidiaries of the Zara group in Austria, Belgium, France, Germany, Greece, Italy, Spain and the U.K., which are publicly available in the national Business Registries, comprehensive data on sales, royalty expenses, net income and corporate tax paid were obtained. Building on this data, key ratios were calculated, most notably net income per employee. Respective ratios were presented as proof for a drastic disconnect between profit allocation and “real” economic activity, highlighting the aggressive tax planning strategies pursued by the Zara group. The study focused specifically on the entities located in the Netherlands, Ireland and Switzerland performing centralized group functions (financial management, branding management and purchasing). The main hypothesis of the study was that the higher profit margins of these non-retail entities located in low tax jurisdictions, when compared to the profit margins of retail branches located in high tax jurisdictions, reflect that the Zara group takes advantage of the lowest tax rates and the lack of harmonization of tax systems at the European level. The conclusion presented by study was, unsurprisingly, that the Zara group saved substantial taxes (“at least” €585 million) during the period 2011-2014. The conclusion was widely echoed by the media (Bloomberg) and various NGOs (Oxfam), which castigated the Zara group as being a tax dodger.
Do the estimated tax savings really reflect aggressive tax avoidance schemes? Does the case of the Zara group support the claim of the Greens/EFA Group that application of the arm’s length principle as paradigm of international taxation “has generated endless opportunities for multinationals, while making it difficult for Member states to challenge abuses, except in the most egregious cases”?
When taking a closer look at the most substantial individual “avoidance point” identified by the study, amounting to € 378,42 million in the 2011–2014 period, namely the royalty payments received by a dutch entity (ITX Merken), it becomes clear that the estimated tax savings in no way reflect immoral or abusive tax dodging behavior. Retail subsidiaries pay a percentage (5 percent) of their sales as a royalty fee to ITX Menken, which is the legal owner of the respective intellectual property rights – realizing a net income of € 1,95 billion in the 2011–2014 period (paying €290 million of corporate taxes in the Netherlands). Three aspects are noteworthy from a transfer pricing perspective. First, the study does not present any indication that the royalty rate is not commensurate with the arm’s length principle.
Considering that the tax authorities in the jurisdictions of the retail subsidiaries (among them notoriously aggressive tax authorities such as Germany and Italy) are perfectly willing and capable of challenging the arm’s nature of the royalties, it is reasonable to assume that the royalty rate is indeed commensurate with the arm’s length principle. In other words, the Zara group does not engage in profit shifting based on aggressive transfer pricing (i.e. excessive royalty rates). Second, ITX Merken employs 203 people. Even when applying the post-BEPS transfer pricing guidelines on intangibles, it appears at least conceivable that ITX Merken is capable of performing most value adding (DEMPE) functions and assuming all risks relating to the intangibles. In other words, there is no apparent disconnect between profit allocation and “real” economic activity in the Netherlands. Third, ITX Merken acquired the intangibles for the sum of € 1,47 billion on which an exit tax of € 360 million was paid (yes, these are tax revenues for the Spanish tax authorities!). Again, the study does not refute that the purchase price reflects market prices.
With (abusive) transfer pricing eliminated as the cause of the tax savings, one should wonder what the origin of the € 378,42 million so prominently featured in the study is? The calculation performed by the study is revealing: As ITX Merken is “only” taxed at 15 percent in the Netherlands, the difference compared to the higher tax rate in Spain (30 percent) is considered as “taxes avoided” – that is €295 million. The remaining € 84 million are considered as taxes avoided due to the fact that (acquired) branding rights would not produce deductible tax amortization in Spain.
The estimates for the other (comparatively minor) avoidance points (involving Irish and Swiss entities) follow a similar “logic” and also do not expose any abusive tax dodging behavior by the Zara group.
The scale of tax avoidance is thus solely estimated based on the notion that higher tax rates are sacrosanct, while earning profits in low tax jurisdictions, however legitimate and in line with real (value adding) economic activity this allocation might be, are inherently immoral and must be eliminated. In order to further emphasize (in bold font) the abusive nature of the profit calculation, the study computes that ITX Merken has a profit/employee rate of €2.4 million per employee compared to the group average of €0.018 million per employee. But what can this ratio signify? Is only an equitable distribution of profits to be considered “fair” as acolytes of formulary apportionment like to argue – i.e. an allocation of profits which is solely based on quantitative inputs without taking into account economic reality such as the fact that complex business activities as well as intangibles will create a higher value added compared to routine functions?
The above illustrates that such CbC-type ratios can be highly misleading and must be interpreted with utmost care. From a policy perspective, the recent OECD initiative in regards to a peer review process relating to the utilization of CbC-data by tax authorities is welcome, as any use exceeding basic risk assessment (i.e. justifying tax adjustments) will be considered as improper. A mere peer review, however, could prove to be insufficient to prevent misuse of CbC reports. In any case, it is of the essence to wake up to the fact that estimates such as those featured in the study Greens/EFA Group are instrumentalized for promoting an agenda for tax harmonization (centralization of political powers) and higher tax rates – as illustrated by the policy prescriptions of the Greens/EFA Group:
- A public CbC Reporting
- Publication of tax rulings obtained by large companies
- Adopting a Common Consolidated Tax Base (CCCTB) in Europe
- A minimum corporate tax rate in Europe.
For those tax practitioners and economists wishing to preserve at least some degree of tax competition, it is time to weigh in and challenge the questionable tax gap estimates and put the scale of BEPS into a more somber perspective. Crunching the numbers is essential for exposing the tax grabbing agenda of those lobbying for CbC reporting and formulary apportionment.