Thought leadership from our experts

Tax Structuring Post BEPS

"We are not interested in your stories", the tax auditor claimed. Decades of audit experience had taught him to be weary of business narratives. "Hong Kong is a tax heaven." His right arm thrust up a fancy paperback on tax saving for dummies. He pushed it high above the founder's head as if posting a battle flag. "What we want is the beef, and that is the profits you have shifted to Hong Kong. Look at these numbers!" he lowered the paperback halfway as if waiting to thrust it up again, and pointed his left index to an untitled flip chart with half a dozen numbers supposed to show millions of Euros. "This is what we found in public data bases, and if you don´t show the Hong Kong company financials, you have something to hide!" The founding shareholder felt struck by the flash of lightning. He could barely read the numbers on the flip chart but he clearly felt rolled over and disregarded. These guys had their sentence ready, before he could even explain his case. And had this well paid civil servant, who had never made a single dollar in the market, not called him a story-teller, thus denouncing decades of hard work out of New York and Hong Kong? Why on earth, he wondered, had he journeyed here to explain the tax men live and fresh how he and his team ran the business, if, at the blink of an eye, he was cut short and treated like a perpetrator ? The founder was determined not to be deprived of his dignity nor of a his money by giving in to this kind of tax extortion.

Leaving this authentic snapshot of a modern tax audit, it is still safe to say that many tax audits end amicably. But something has changed, after 2013, OECD/G20 leaders had called to life the project to fight against BEPS (Base Erosion and Profit Shifting): Business models and transfer price systems which have gone unnoticed or were even accepted by previous audits are now dismissed, tax auditors apply post-BEPS rules to pre-BEPS years such as global profit transparency (called CbC-Reporting), and officials feel ethically obliged to suspect groundless base shifting (or even worse) in every unusual transaction. Politicians had found a new reason for the bleak state of public budgets: Multinational enterprises were constantly hunting for tax savings engaging hoards of highly paid attorneys. These international giants shrank their effective tax burden to unnaturally low rates by using tax savings schemes, tax rulings and artificial structures. They failed the public by shortening tax payments which the ordinary guy in the street had to make up for. And did LuxLeaks, Panama Papers and earlier Swiss Banking disclosures not overwhelmingly show that undue tax reduction was pervasive and ubiquitous in all segments of the business? Nobody needed hard proof when stories and emotions abounded.

Ironically, politicians and legislators, some the very same individuals who now demonised "aggressive tax planning", had created the very same incentives use of which they now denounced. Media eagerly snapped up juicy stories of real or reported tax evasion. Journalists, "activists", "civil society" and NGOs made a sport of unearthing unethical tax savings. Apparently low tax payments or unusual group tax rates often seemed evidence enough for immoral tax dodging.

Since then much has changed in international tax practice. Hundreds or thousands of tax laws, tax conventions, supra-national rules and administrative instructions were introduced or exacerbated. The international exchange of information on tax matters has reached new dimensions as regards the number of participating countries and the breadth of information transmitted. This wave has just begun and will swell.

Tax auditors have adapted their mode of operation when checking tax compliance. They rely even more on IT tools and large scale data analytics, in some countries even accessing company data live. Tax officials feel heartened by updated OECD and UN publications to be less believing towards taxpayers' facts and to supersede them with their own view of how businesses should be run. Even three million digit tax reclaims do not necessarily make it to the headlines, anymore. Royalties and service charges paid to foreign affiliates are routinely dismissed. A taxable transfer of "something of value" is easily identified. Inter-company revenue from foreign subsidiaries is often adjusted upwards. Permanent establishment profits and taxable VAT sales may also be attractive honey pots. The threat or start of criminal investigations can be used neatly to maximize taxpayer's concessions. Previously taxpayers could regularly assume that serious investment in time and documentation to explain the realities of business could change the tide. Today tax auditors are convinced they have a public obligation to be tough and unbelieving, while taxpayers long for open minds and unbiased assessment of facts and figures.

To be clear, there are certainly cases when authorities and public prosecutors have to enforce the law with determination, and this certainly includes the lawful prosecution of criminal tax evasion. At the same time, as deplorable as it is, criminalizing taxpayers for little or no grounds becomes more and more the fashion. Even if the criminal charge should finally prove unfounded, the prospect of long and winding investigations nicely softens taxpayers' grips on their purse. Beside the mental stress, the possible damage to the company's reputation in public, media and the business community can hardly be underestimated. Sadly, these negative reputational effects are nurtured by the age-old idea that tax authorities and prosecutors merely apply the law and nothing but the law. In personal income tax and monthly paychecks, salary paid multiplied by tax rate makes (wage) tax owed. It is easy for the public to think that complex international tax questions are just as clear to determine. Yet, it is a fallacy and finding "the" true tax is often the result of art and subjective assessment (albeit method based), rather than simple calculus.

Against this background, it is no surprise that the enforcement drive of tax administrators and state prosecutors does not go down. Frequency and complexity of national and international tax controversies appear to be rising strongly whereas effective and fast relief from double taxation has largely become a bottle neck of tax dispute resolution. Thus, more and more businesses feel they have no choice and feel forced to seek relief in tax courts. Among taxpayers and courts like, there is less reluctance to deal with transfer pricing and other economic issues in court. When politicians believe that "the public" can be a force for proper taxation of profits where profits are really earned, they put the application of the law into the hands of lobbyists – be they aligned with international business or with private activists. Neither of them are qualified or do have the democratic legitimacy to decide on the amount of tax due in a certain country. Under classical Western democratic thinking, the application of the law has to be in the hands of a skilled and neutral administration, separate from both legislation and the public mood. Emotionalizing, moralizing and maybe even publicizing taxes, thus, poses a challenge to democratic systems based on the separation of power and the rule of law. Ironically, these trends induce more and more taxpayers to apply for unbiased application of the law in court.

What do these trends imply for decision making by investors, supervisory boards and management?

1. As dry as it seems, management and supervisory board have to deal with the company´s tax position and develop their own understanding of its major factors. Responsible management requires having an informed view of the company's international tax strategy and on its fit with law and business reality.

2. Tax and transfer pricing risks can often not be avoided (such as other business risks). But, they never ought to be big. Tax strategy and transfer prices must not be inconsistent with the reality of the business. This calls for open communication between headquarter functions (tax, PR, IR) and line management (board and management). Never must management allow a tax or transfer price controversy to become a bet-the-company issue. If a tax controversy has become unavoidable, the company will only successfully conclude it if it shows stamina and persistence.

When tax planning is publicly condemned and taxpayers are molested with suspicions of tax evasion, the question arises what the relative position of tax reduction in the total spectrum of company objectives should be. Some of us may never have mentally accepted the historic victory of capitalism and market economy (preferably in socially responsible moderation as in Ludwig Erhard's "social market economy"). But even those critical of "big business tax dodging" should recognize that businesses are under the fundamental imperative of market economies to seek best use of their money at their own risk – thereby ultimately contributing to public wealth. This is not to deny externalities of the market and social inequality. But emotionalizing and moralizing individual company tax policies is simply not democratically legitimate and fit for purpose. Rather, rule based changes of tax and state aid laws are the prerogative of democratically elected legislators. Tax structuring of course has to observe democratically legitimized (post BEPS) tax rules, but also continues to have its role in the spectrum of business management objectives – and this is morally okay. As a general statement, one may hardly dispute that tax structuring should be consistent with business. Yet, the famous political mantra of taxing profits where value is created has its limits where tax law itself uses formal, legal trigger points for tax rather than economic value creation as such. Transfer pricing is probably the one area of tax structuring where fiscal declarations and business reality can and should be brought to closest or perfect overlap. In sum, tax structuring will go on – not only as an unavoidable result of never ending tax competition, but also as a legitimate part of productive enterprises privately contributing to public wealth.