By Peter Wells From The Sydney Morning Herald

Income shifting by multinationals is making a big dent in governments’ tax take.

Some companies artificially structure transactions to avoid tax.

A major challenge facing the Australian Government and governments around the world is how to protect their tax revenue.

One response has been to target people who transfer assets or divert income to tax havens such as the Cayman Islands to avoid paying tax. In Australia, the Tax Office has targeted wealthy individuals with its Operation Wickenby.

However, these responses only target pickpockets, while bank robbers operate with impunity.

A far bigger challenge to tax revenue is income shifting by multinational corporations such as Apple. These businesses pay virtually no corporate tax, and have been defiant in the face of criticism.

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A recent Organisation for Economic Co-operation and Development (OECD) report addressed these issues and came up with an “action plan”, which was endorsed by the finance ministers of the world’s richest nations, ahead of the G20 leaders’ summit in September.

OECD Secretary-General Angel Gurría said international tax rules were aimed at ensuring businesses don’t pay taxes in two countries. “This is laudable, but unfortunately these rules are now being abused to permit double non-taxation,” he said.

How do some companies manage to pay little or no tax? It is achieved by artificially structuring transactions so there’s little relation between the economic substance and legal form of the transactions.

Let’s take a simplified example of a company manufacturing devices in China, shipping them directly to Australia and selling them to customers in Sydney. If the transaction were structured in a way reflecting its economic substance, the taxable income would be equivalent to the sale amount received from the customer less the costs of manufacturer and other “real” business expenses.

The sale amount might be $300 a device, with “transfer pricing” rules dictating how much of that is recognized in Australia and China respectively.

But, to avoid paying tax, extra “paper” transactions could be recorded. First, the devices would be sold to a company in Ireland before being resold to a company in Australia. Second, the company in Ireland could make “royalty” or “licence” payments to a second company registered in Ireland but resident in a tax haven such as the Cayman Islands. These payments could be $275 a device. Now there’s only $25 in taxable income to be recognized in Australia, China and Ireland.

Most of the income is recognized in the Cayman Islands and tax is avoided. Ireland doesn’t limit payments to the tax-haven company through transfer pricing rules, it allows a company registered in Ireland to be resident for tax purposes in a tax haven and it has a very low corporate tax rate.

Some in Ireland might call this being “tax competitive” and argue that significant employment is created in operating these shell companies. Maintaining the bank robbery analogy, others might call this driving the getaway car.

Why has so little been done? Tax treaties between countries constrain the ability of governments to respond and this has emboldened multinationals.

These treaties were intended to provide clarity about where income should be taxed and prevent the taxation of income in more than one country. However, differences in tax laws have been exploited so income is not taxed anywhere.

Governments must act to either modernize the treaties or act unilaterally to ensure income is taxed appropriately. The aim should be to ensure income is recognized on the basis of the economic substance of transactions.

Peter Wells is head of Accounting at UTS Business School.

Photo: Thinkstock

This story written and produced by the University of Technology, Sydney, for Brink, a publication distributed monthly in The Sydney Morning Herald.

For more on this story go to:

http://www.smh.com.au/business/global-giants-slip-through-tax-net-20131011-2vdx5.html