International tax changes may have a major impact on multinational tech companies

International tax changes may have a major impact on multinational tech companies

Introduction Multinational technology companies face a swiftly changing international tax landscape. Monitoring the situation closely in multiple jurisdictions is important in order to avoid costly tax issues. At the forefront is a global trend by regulators to scrutinize multinational enterprises (MNEs) that shift earnings to lower-tax countries. Currently, base erosion and profit shifting (BEPS), the Foreign Account Tax Compliance Act (FATCA) and local law changes may directly affect technology companies. In this article, we look at the shifting tax landscape and the financial statement implications of foreign earnings.

The fight against base erosion and profit shifting BEPS is an initiative of the Organization for Economic Cooperation and Development (OECD) that is designed to address tax planning strategies that exploit the differences in tax rules between countries. In numerous countries, governments feel political pressure to generate short-term positive fiscal results. Finding additional revenue that doesn t hinder economic growth has led these countries to scrutinize certain tax planning strategies. The OECD released the first measures in September 2014 and intends to complete the full package of initiatives in 2015. BEPS will help individual countries to fairly tax MNEs based on the location of economic activities and value creation. For MNEs, the new rules are intended to reduce any conflict over the interpretation of international tax laws while reducing uncertainty and the risk for double taxation through global collaboration. In the end, the OECD hopes to produce a comprehensive and cohesive international tax framework, including domestic law recommendations and international principles under model treaty and transfer pricing guidelines. The digital economy The application of BEPS is especially important for those MNEs that engage in the digital economy, which is directly applicable to many technology businesses. The OECD is currently looking at several issues, including the definition of permanent establishment, how data drives value, implications of multisided business models, income characterization and potential options to address the broader tax challenges created by these issues in the digital economy. The goal is to ensure that these options are viable and fair, avoid double taxation, and can be implemented without increasing the costs of compliance and administration. The OECD Task Force on the Digital Economy, a subsidiary body of the Committee on Fiscal Affairs, released its first report related to Action 1: The Tax Challenges of the Digital Economy in 2014. The most important finding in the report is the agreement that it would be difficult, if not impossible, to fence off the digital economy from the rest of the economy for tax purposes. As a result, the issues identified above must be looked at in the context of the 15-point OECD BEPS Action Plan on Base Erosion and Profit Shifting. 1 Therefore, the committee for Action 1 will work to guide and support work of the other committees on issues relative to the digital economy. Their work in this area will be completed by December 2015 and a supplementary report reflecting the outcomes of the collaborative work will be finalized by that time. The application of BEPS is especially important for those MNEs that engage in the digital economy. Permanent establishment A permanent establishment (PE) is generally a fixed place of business. The OECD identifies three specific components that define a fixed place of business: 1. The business must be located in a fixed geographic location and be used for the purpose of a specific business. 2. The place of business must be used by a company to carry out its own business. 3. The company s business must be conducted in part or in whole at the fixed place. 1 Action Plan on Base Erosion and Profit Shifting, OECD, 2014. See www.oecd.org for details. 4 International tax changes may have a major impact on multinational tech companies 2015

Issues arise when countries do not interpret PE in the same way, and MNEs can be left out in the cold if there is a dispute. Another concern is that core activities may inappropriately benefit from an exception from PE status, and that artificial arrangements relating to the sales of goods and services can be used to avoid PE status. The OECD acknowledges that companies are able to have customers in a country without creating a PE and can communicate by phone, fax, mail and through independent agents. They agree that the resulting lack of PE is not a BEPS issue unique to the digital economy. However, the use of technology certainly facilitates conducting business remotely without creating a PE, and, when coupled with strategies to eliminate home country taxation, increases the opportunity for income to be taxed nowhere. They also recognize the impact technology has on a MNE s ability to bifurcate functions along the value chain such that each location falls below PE threshold and avoids taxation. Technology companies in the digital economy face a gray area when functions once thought of as preparatory and auxiliary may be increasingly significant components of a business. At what point do they become core activities? The OECD is actively seeking to modify the definition of PE to include significant digital presence and minimum levels of activity (for example, number of users, contracts, and/or levels of consumption in the market country). Another aspect of an updated definition could include the concept of significant presence, which could be tied to long-term customer relationships combined with a certain level of physical presence, localization of websites and local delivery/ support, and use of data-gathering in the local market to create value by the supply of goods or services. Transfer pricing of intangibles Many technology companies rely heavily on intangibles to create value and produce income, but the importance and mobility of intangibles generate substantial BEPS risks in the area of direct taxes. The unprecedented importance of intangible assets raises fundamental questions as to how companies in the digital economy add value and make their profits and how the digital economy relates to the concepts of source and residence or the characterization of income for tax purposes. For example, in the digital economy, a company can transfer intellectual property to low-/no-tax jurisdictions while using subsidiaries to perform various supportive services in highertax locations, thus separating the location of the business activity from the location of the taxable profit. Another area of growth and therefore concern is the increased value of data and data analytics, often referred to as big data. The 2015 BEPS enhancements may consider the relationship between work regarding the valuation of intangibles and the heavy reliance on collection, analysis and monetization of data. BEPS is also expected to address the appropriate use of the profit split method with regard to global value chains where functions and intangible ownership are spread out along the value chain in order to align income from intellectual property with the function/activity that gives rise to such income within the appropriate taxing jurisdiction. Did you know? Permanent establishment essentially refers to allocating the right to tax. The concept of permanent establishment goes back to a study in the 1920s by the League of Nations on avoiding double tax.

Further, BEPS may evaluate the need for greater reliance on functional analyses (assets used, functions performed and risks assumed) and on value chain analyses. This would enable OECD to address situations where comparables are not available due to the structures designed by taxpayers and the unique intangibles involved. In specific situations, the functional analysis may show that the use of profit split methods or valuation techniques (e.g., discounted cash flow method) is appropriate. For these situations, it would be helpful for the OECD to provide simpler and clearer guidance on the application of transfer pricing methods, including profit splits in the context of global value chains. Characterization of digital income New digital products and new means of delivering services may create uncertainties in relation to the proper characterization of payments, especially for cloud computing. For example, where a digital business is able to interact with customers in a market generating business profits without creating a PE, it will be difficult to determine which market jurisdiction has the right to tax such income. Modifying the PE threshold could by definition permit taxation in the appropriate source jurisdiction. Source taxation could also be ensured by creating a new category of income that is subject to withholding tax. The issues of income characterization and PE are complex and interrelated in the digital economy. 7 things MNEs should be doing now As countries target tax avoidance strategies, MNEs should: 1. Assume transparency with tax officials 2. Avoid commercial artificiality and treaty shopping 3. Ensure that tax/transfer pricing structures mirror substance 4. Expect local country audits subject to local country laws and interpretations of the arm s-length principle and treaty clauses (especially in non-oecd countries) and increased enforcement from all countries 5. Consider the use of Advance Pricing Arrangements as a riskmanagement tool 6. Investigate efficient documentation processes 7. Think governance and corporate reputation 6 International tax changes may have a major impact on multinational tech companies 2015

FATCA adds to the complexity The Foreign Account Tax Compliance Act (FATCA) was designed to identify taxpayers that may be hiding assets in offshore accounts or through interests in foreign corporations. FATCA requires U.S. individuals (including U.S. citizens living outside the country) to report certain financial assets (including financial accounts) held outside the country to the IRS. Further, FATCA generally requires U.S. persons making certain types of payments to non-u.s. entities to withhold 30% of the payment unless the non-u.s. payee provides the U.S. payor with documentation attesting to its FATCA status. Withholding and FATCA rules are very complex. The bottom line is that U.S. companies need to assess which payments are subject to withholding and ensure they fulfill documentation and withholding requirements. They also must understand the types of payments potentially subject to FATCA withholding (including intercompany payments), assess whether any exceptions apply and they must obtain and/or update any required documentation. FATCA takeaways FATCA affects all companies making payments. FATCA presents a good opportunity to run a systems check on withholding procedures. Withholding agents should analyze process and procedures that will be needed for identifying, withholding, paying, reporting and reconciling accounts. Foreign payees should analyze their FATCA status in order to position themselves to fulfill any FATCA obligations and provide the appropriate documentation to withholding agents or foreign financial institutions.

Financial statement transparency is critical The effect of accumulating foreign earnings without the need or intent to repatriate the earnings to the U.S.-based parent corporation, which is commonly referred to as indefinitely reinvested foreign earnings, is huge. Bloomberg News analyzed the securities filings of 307 corporations and found that the largest U.S.-based companies added $206 billion to their indefinitely reinvested foreign earnings in 2013. 2 Bloomberg s study also determined that MNEs have accumulated $1.95 trillion of indefinitely reinvested foreign earnings, up 11.8% from a year earlier. In the past three years, the amount of indefinitely reinvested foreign earnings has approximately doubled at Microsoft and Google and has nearly tripled at Apple. The transparency issue s magnitude There is a growing concern with the lack of transparency in financial statements regarding foreign earnings. The Financial Accounting Foundation 3 found that income tax information provided in financial statements may not be detailed enough for users to: Analyze earnings determined to be indefinitely reinvested in foreign subsidiaries Determine what the tax effects of foreign earnings deemed to be indefinitely reinvested would be if those earnings were repatriated to the U.S. parent company The Russell 1000 has over $2 trillion of indefinitely reinvested foreign earnings, with an average annual increase of $204 billion over the past 5 years (93% growth): Indefinitely reinvested earnings over time Year Number of firms with an accumulated indefinitely reinvested earnings (IRE) balance Total foreign IRE (billions) Year-to-year change in total foreign IRE Total assets for firms with an IRE balance (billions) Total IRE as a % of total assets 2013 547 $2,119.30 12.45% $24,320.77 8.71% 2012 533 $1,884.62 15.76% $23,223.97 8.11% 2011 516 $1,628.03 19.52% $21,590.54 7.54% 2010 491 $1,362.15 14.70% $20,567.44 6.62% 2009 472 $1,187.61 8.11% $18,935.52 6.33% 2008 487 $1,098.47 $18,935.52 5.80% 2 Rubin, Richard. Cash Abroad Rises $206 Billion as Apple to IBM Avoid Tax, Bloomberg News, March 12, 2014. See www.bloomberg.com for details. 3 The Financial Accounting Foundation s Post-Implementation Review Report on FASB Statement No. 109, Accounting for Income Taxes, Dec. 3, 2013. See www.accountingfoundation.org for details. 8 International tax changes may have a major impact on multinational tech companies 2015

Indefinitely reinvested earnings is a more prevalent issue for technology companies. In the aggregate, the 100 companies in the S&P 100 Index hold approximately $1.4 trillion of the estimated $2 trillion of indefinitely reinvested foreign earnings, with technology companies ($341 billion) and health care companies ($335 billion) having the most at stake. In the past three years, the amount of indefinitely reinvested foreign earnings has approximately doubled at Microsoft and Google and has nearly tripled at Apple. In addition, in the five-year period ending in 2013, the amount of indefinitely reinvested foreign earnings increased by 427.8% at 10 major technology firms (Apple, Cisco, Dell, ebay, Google, Hewlett-Packard, IBM, Intel, Microsoft and Oracle). 4 What the SEC is doing about transparency While the SEC staff want companies to make disclosures required by GAAP, it has been very active in encouraging more transparency in financial statements filed by public companies: The SEC s Division of Corporation Finance continues to closely review corporate disclosures on the tax implications associated with a company s foreign earnings. The SEC staff has seen a number of large companies with foreign earnings substantially more than half of their pre-tax earnings, which can vary significantly from foreign investment from one year to the next. This variability creates challenges for investors to understand whether past performance is indicative of future performance and generally requires more extensive disclosures. Recent SEC comment letters have, among other items: Requested more information when the company s indefinite reinvestment assertions for significant cash balances held outside of the United States appear inconsistent with the liquidity needs or disclosures elsewhere in the registrant s filing Requested information on why the company believes that foreign earnings are permanently reinvested, if the company has remitted some amounts in the past. Requested more details of the factors and specific plans considered in support of the indefinite reinvestment assertion Requested a further explanation if the company has not disclosed the appropriate reasons as to why it is not practicable to estimate the unrecognized deferred tax liability with respect to indefinitely reinvested foreign earnings Asked companies to provide clarity as to whether these funds might be subject to a significant tax cost upon repatriation 4 Engel, Russell and Lyons, Bridget. Trapped Cash in the Technology Sector: Accounting Disclosures of Permanently Reinvested Foreign Earnings & Foreign Cash Levels, Journal of Applied Economics and Business, vol. 16(6), 2014. See www.aebjournal.org for details.

What the FASB is doing about transparency The FASB met on Feb. 11, 2015, to review proposals to improve disclosures related to foreign earnings. It tentatively concluded that a reporting entity should be required to: Separately disclose income before taxes between domestic and foreign earnings (similar to the current SEC requirement). The entity should also be required to further disaggregate foreign earnings, whether indefinitely reinvested or not, by jurisdictions that are significant in relation to the total income before taxes. Transparency: What you can do about it Take a fresh look at existing Management s Discussion & Analysis (MD&A) and financial statement footnote disclosures Go beyond boilerplate language to provide as much clarity and transparency as possible to meet the needs of investors and analysts, including: How indefinitely reinvested foreign earnings affect reported earnings, foreign and domestic liquidity needs, and foreign asset composition (including cash) Even in advance of any FASB changes, consider a separate disclosure by jurisdiction, if considered individually significant, of (1) foreign earnings and (2) accumulated amount of indefinitely reinvested foreign earnings Disclose separately the accumulated amount of indefinitely reinvested foreign earnings for any foreign jurisdiction that represents at least 10% of the total accumulated amount of indefinitely reinvested foreign earnings. The FASB also tentatively concluded that a reporting entity should be required to disclose the following: Domestic tax expense recognized in the period for taxes on foreign earnings, e.g., the incremental U.S. tax expense resulting in the current period for foreign earnings not subject (or no longer subject) to the indefinitely reinvested assertion Amounts during the current period that are no longer asserted to be indefinitely reinvested with an explanation of the circumstances that caused the entity to no longer assert that the foreign earnings are indefinitely reinvested 5 The FASB s proposal would go beyond the current SEC requirement to disclose the domestic and foreign components of earnings; it would require a further disclosure of the foreign earnings in jurisdictions that are individually significant (a threshold not yet specifically defined). The proposal would apply irrespective of whether the foreign earnings are considered indefinitely reinvested. This project is still in the early stages and no date has been set for issuance of an exposure draft. It is important to note that all decisions reached at the FASB meetings are tentative and subject to change. The FASB decisions become final only after a formal written ballot to issue a final Accounting Standards Update. MNEs are putting themselves at risk if they do not actively monitor changes to how foreign earnings, whether indefinitely reinvested or not, are taxed. 5 The entity may also be required to provide separate disclosure of foreign jurisdictions that are significant in relation to the total amounts being disclosed. 10 International tax changes may have a major impact on multinational tech companies 2015

What technology companies need to do now The changes in the global tax landscape may pose financial statement risks and may ultimately affect the amount of taxes paid on profits being shifted to foreign countries with lower tax rates. MNEs are putting themselves at risk if they do not actively monitor changes to how foreign earnings, whether indefinitely reinvested or not, are taxed. Grant Thornton LLP recommends that MNE technology companies: Identify, evaluate and respond to the changes in the global tax landscape, including the managerial and financial reporting implications of: The BEPS action plan: Consider using this as a roadmap for the evaluation of current structures and strategies that have the effect of base erosion and profit shifting even if currently lawful Proposed legislation, which may require early warning to users of your financial statements New legislation and regulations: This may require adjustment to estimated annual effective tax rates and re-measurement of existing deferred tax assets and liabilities Noncompliance with FATCA requirements may result in exposures for missed withholding taxes, interest and penalties More aggressive enforcement, settlement experience and judicial decisions, which may change recognition and measurement of unrecognized tax benefits Have an effective internal control process with respect to the identification, evaluation and mitigation of resulting risks, including ongoing communications with the audit committee Have resource readiness to deal with the expected increase in cross-border tax disputes, the expected compliance burden relating to country-by-country reporting of transfer pricing, and the potential increase in scrutiny of foreign earnings by your audit firm Contacts Randy Free Partner West Region International Tax Practice Leader T +1 949 608 5311 E randy.free@us.gt.com Dean Jorgensen National Tax Partner Tax Accounting and Risk Advisory Services T +1 612 677 5230 E dean.jorgensen@us.gt.com Brandon Boyle Manager International Tax Washington National Tax Office T +1 202 521 1533 E brandon.boyle@us.gt.com

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