Monday, November 07, 2005

Tax Avoidance 2.0

It's no secret that the Republic of Ireland has an extremely advantageous corporate tax system for multinationals. Nor is it a secret that the Republic's corporate governance rules tend to be in the "and whatever you're having yourself" spirit. We've noted this before, such as here and here. But Monday's Wall Street Journal European edition (subs. req'd) lays out in fascinating detail how it works, using the example of Microsoft.

The more traditional form of tax avoidance used by multinationals in the Republic was to manage the accounting so that the most valuable part of their chain of production would show up in the country and be taxed at a low rate. This meant that there was at least some physical production taking place in the country, which would show most of the company's profit (e.g Coca Cola). But now the real action is not in the actual production, but in the intellectual property to software and pharmaceuticals. So Microsoft, for example, structures its operations so that its physical manufacture and sales outlets don't make much money, because they are paying huge licensing fees to company subsidiaries -- and those subsidiaries happen to be located in the Republic. Example:

Round Island One Ltd., has a thin roster of employees but controls more than $16 billion in Microsoft assets. Virtually unknown in Ireland, on paper it has quickly become one of the country's biggest companies, with gross profits of nearly $9 billion in 2004.

Ireland's citizens may not have heard of Round Island One, but they benefit greatly from its presence. Last year the unit handed the government of this small country of four million citizens more than $300 million in taxes ... Microsoft routes the license sales through Ireland and Round Island pays a total of just under $17 million in taxes to about 20 other governments that represent more than 300 million people.

But Microsoft does some real stuff in Ireland, so at least you can drive by one of their facilities and see the buzz of activity at Round Island? Errr.. No:

Round Island's legal address is in the headquarters of a Dublin law firm, Matheson Ormsby Prentice, that advertises its expertise in helping multinational companies use Ireland to shelter income from taxes. It represents other U.S. technology companies including Google Inc., which recently set up an Irish operations center that the firm credits in its SEC filings with reducing its tax rate. A Google spokesman said the company set up in Ireland to be close to its European customers. "Because that business is done outside of the U.S. it is taxed according to international law," he said.

It does seem that concerns in Ireland about losing tech business to Rummy's "New Europe" are overblown, because the government was quick to see that the real action was in tax rules for intellectual property as opposed to factories:

In the past four years, Ireland has stepped up its effort to woo U.S. high-tech firms by piling on new tax breaks for technology transfers, leading a string of major U.S. companies to announce research facilities here. The trend poses a quandary for U.S. regulators and policy makers in the face of a skyrocketing federal deficit and widespread tax shelters.

Irish officials say U.S. companies aren't exporting their intellectual wealth to Ireland, just sharing it. "This isn't about sucking knowledge out of the U.S. This is about building up capability elsewhere," says Enda Connolly, a manager at the Industrial Development Agency of Ireland.

The IRS is fighting intellectual-property migration in court, and the Treasury Department has issued a draft of new rules to limit it. Their efforts have done little to slow the trend

Amongst the people on the downside of this arrangement: Gordon Brown --

Microsoft's ability to avoid reporting large profits in the United Kingdom relies on its position that its U.K. sales -- $1.8 billion in fiscal 2004 -- are actually conducted from Ireland.

To avoid U.K. corporate-profits tax, a company must show it has no "permanent establishment" in Britain through which it makes sales. Microsoft has a large U.K. operation (owned by Round Island) that it calls marketing and a tiny Ireland-based sales staff.

It helps that those pesky regulations about timely annual reports are enforced in a business-friendly manner:

Round Island ... filed its annual report in Ireland on Oct. 27, some seven months late. When asked, Microsoft attributed the delay to the need to finish routine audits of subsidiaries. In the U.S., such a late filing would require an explanation to regulators and possibly large penalties. In Ireland, regulators don't even ask. The penalty for late filing: $3.60 a day.

Notwithstanding the bus fare sized penalty for a late report, Microsoft understands the need to keep the local chieftains happy -- and they reciprocate:

Last year Microsoft also helped cover Ireland's costs in its six-month turn in the EU presidency, donating software and forgiving some $60,000 in royalties. Bertie Ahern, the Irish taoiseach, a title similar to prime minister, spoke at Microsoft events twice this year. "The growth and success of Microsoft Ireland has coincided with, and played an important role in, a dramatic transformation in the Irish economy," he said at an event at Dublin Castle last month.

One other thing; the article explains why the Republic is better at this than small tax haven rivals -- because the country is just big enough for companies to plausibly make the case to the Internal Revenue Service that substantive economic activities take place there:

The Matheson Ormsby law firm in Ireland promotes its expertise in setting up tax-sheltered structures, in a glossy booklet available at its Dublin office. As the global economy changes and technology develops, the firm notes, it is getting easier for multinationals "to unbundle the traditional value chain and locate appropriate profit generating functions in Ireland," including "ownership and exploitation of intellectual property." The law firm has an office in the heart of Silicon Valley, in Palo Alto, Calif.

The booklet sheds light on how Ireland has beat out smaller locales like Bermuda and the Cayman Islands in the competition for U.S. firms' intellectual property. The answer involves the IRS. As Matheson notes, small, sparsely populated and largely undeveloped havens like Cayman lack "the necessary economic infrastructure to which value and ultimately profits can justifiably be attributed." But Ireland has the people and physical infrastructure to permit "construction of profit-generating centres defensible by reference to functions, risks and tangible assets of the Irish operation."

This is too easy but we're going to do it anyway: "construction of profit-generating centres defensible by reference to functions, risks and tangible assets of the Irish operation"

Was it for this the wild geese spread
The grey wing upon every tide;


UPDATE 17 NOV: The New York Times editorialises: American Ingenuity, Irish Residence . And [22 NOV] the WSJ story has sparked several in the Irish Times; for instance this one (subs. req'd) notes that the Internal Revenue Service is contesting a $500 million tax reduction achieved by Synopsys through an Irish subsidiary.

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