Taxing the intangible: How tax authorities are taking on the likes of Facebook

A California federal judge this week ordered Facebook Inc to explain why it hasn't complied with at least seven Internal Revenue Service summonses seeking information on how the social media giant transfers rights from its worldwide business through Facebook Ireland.

The United States tax enforcement agency three years ago opened an investigation into Facebook over arrangements between its California parent company and its Irish subsidiary.

The tax office is calling out multinationals, telling them 'enough is enough', to stop gaming the system and to pay their fair share of tax.

The IRS is examining the company's tax liability for 2010, when Facebook's tax return reported royalty income from transfers of intangible property to Facebook Ireland Holdings.

Facebook, which has repeatedly claimed that it "complies with all applicable rules and regulations in the countries where we operate", could owe taxes worth somewhere between $US3 billion to $US5 billion, plus interest and penalties.

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The issue at hand is whether the transfer of intangible property to low-tax countries - in itself not illegal - has happened at an "arm's length basis".

That is, are the goods and services transferred for the same price as they would have been had these parties been unrelated?

In a world where goods and services are physical - say property - the answer to this question is relatively easy.

But in the digital age, where goods and services such as IP are intangible, it's a harder puzzle to solve.

It's this question that has kept tax authorities around the world, including Australia, struggling to claw back revenue from multinationals.

When Facebook and Airbnb send profits to Ireland, Uber sends profits to Netherlands, or BHP Billiton sends them to Singapore, all claim it is legitimately being done on an arm's length basis.

These companies are aggressive and have the best lawyers at their disposal. Up until now tax authorities, including the Australian Taxation Office, were prepared to sit down and do deals.

But a combination of tougher domestic and global laws, and growing consumer discontent about the lack of taxes multinational giants pay, has made revenue agencies more willing to head to the courts.

Some [multinationals] are sailing too close to the wind with these manufactured arrangements.

ATO Deputy Commissioner internationals Mark Konza

This week the ATO issued a series of alerts, cautioning large companies and multinationals that they could face penalties if they use "contrived arrangements" to avoid paying tax.

Without naming companies, the ATO has gone into detail about some of the arrangements high on its watch list.

The ATO is feeling confident after recent court wins with companies including Chevron (under appeal) and Orica, and with the introduction in January of the Multinational Anti-Avoidance Law, which allows the ATO to hit companies with hefty penalties and interest charges if they don't comply.

Many companies are restructuring to avoid being hit by the new laws. But others will be willing to battle it out in the courts.

"The ATO will try to test the limits of the new rules through the courts," Clayton Utz tax partner Niv Tadmore says.

"You will see more and more disputes between taxpayers and revenue authorities, but you will also see more disputes between revenue authorities [in different countries] as the limits of laws are tested."

The first area of concern for the Tax Office is multinational groups using offshore "permanent establishments". This, like the Facebook case, relates to where the intangible goods and services - such as IP - are located.

"Through these arrangements groups may be understating their true Australian income and claiming deductions incorrectly," says ATO Deputy Commissioner public groups and international, Jeremy Hirschhorn.

"Taxpayers need to ensure the taxable income returned properly reflects the economic substance and significance of operations carried on."

Another area the ATO is looking into is structures developed by companies which are designed to reduce the amount of GST payable.

Deputy Commissioner internationals Mark Konza says companies found to have done so will have to pay back liabilities and may face penalties of up to 75 per cent of tax owed.

"We're also looking closely at intermediaries who encouraged these arrangements and may consider them promoters of tax exploitation schemes," Mr Konza says.

A third area of concern is companies trying to claim higher debt deductions than they are entitled to under "thin capitalisation rules" which limit the amount of debt companies can claim.

Mr Konza says "some [multinationals] are sailing too close to the wind with these manufactured arrangements".

The ATO also this week issued a consultation paper, which multinationals have until October to respond to, on the use of offshore marketing and service hubs.

Senate hearings last year focused on multinationals such as Google, Apple and Microsoft, as well as mining giants such as BHP Billiton and Rio Tinto, using marketing or services hubs located in low-tax nations such as Singapore to lower their Australian tax bills.

The ATO now lists the factors it will use to place taxpayers into risk categories, ranging from a "low-risk green zone" to a "very high-risk red zone" and the consequences of such placement.

The ATO spokesman said about a third of the 30 largest miners and energy companies with marketing hubs fall green and blue ratings, which required minimal reporting and involved less than $5 million in potential tax. These companies were likely to face lighter penalties for complying.

But "the rest are likely to be in the yellow, orange and red zones", meaning they are non-compliant and could face tougher penalties.

ATO warns multinationals on "contrived arrangements"

Areas under watch:

Offshore hubs: Senate hearings last year focused on large multinationals´┐Ż using marketing hubs in low-tax nations such as Singapore and Ireland that are used to lower their Australian tax bills.

'Permanent establishments': In the old days determining a company's PE, or permanent establishment, was easy. They usually had a physical location. In the digital age, that is harder to determine, and companies often claim their PE is offshore, so Australia has no taxing rights. The ATO is disputing this.

GST avoidance: Companies often use structures deliberately designed to reduce the amount of GST payable.Companies found to have done this will have to pay back liabilities and may face penalties of up to 75 per cent of tax owed.

Debt deductions: Some companies try to claim higher debt deductions than they are entitled to. Under "thin capitalisation" rules companies are limited in the amount of debt they can claim.

Source: WA Today