How US tax planning works through Ireland

I quoted Robert Peston’s piece on about Apple in my blog on 22 May 2013. Given some conversations, I thought it would be useful to spell out how the generic US tax planning works and what the building blocks are. The Public Accounts Committee in the UK have said publically that  they wanted some clarification of this difficult area.Because this involves negotiating ones way round a number of tax regimes it is complicated, but I think it can be explained.

The objective of the planning is clear. Taxable profits are transferred from European businesses (as that is what I will focus on) by a US owned group, and parked in an offshore location ( Bermuda). The parking in Bermuda is key as no US tax is due because the money is not “remitted” to the US. The economic justification for the payments is the intellectual property owned in Bermuda and how that comes to be located in Bermuda is a US tax planning issue (which I’m not going to address here). But there are some other key tax issues to address to get this structure to work.

For US tax purposes, the profits which arise in Bermuda will be taxable if they are remitted (or paid) to the US and because they have low amounts of non-US tax the US tax would be substantial if treated as remitted. Remittance for tax purposes includes loaning the money to the US but there are let outs for short term loans which mean that if the money is loaned in rotation by a number of Bermuda corps the loan isn’t treated as a remittance and the income is not subject to US tax. In short, its possible to remit the money in Bermuda to the US without it being treated as being remitted for US tax purposes and with no tax in either Bermuda or the US.

But this is only the US part of the tax planning and a key element arises in Europe in transfering the income from Europe through the use of hybrid companies which avoids withholding tax on the transfer of income to Bermuda. A hybrid company is one which simply is viewed in different ways by different tax authorities.

The structure has involved the following:

EU operating company (located in any European country say Germany)

Irish company 1 – Irish incorporated, tax resident in Ireland (carries on activities in Ireland and employs Irish staff)

Irish company 2 – Irish incorporated, tax resident in Bermuda does nothing in Ireland

Netherlands  company

Bermuda company (parent of Irish 2)

So what is an Irish incorporated non resident company? Its an Irish-incorporated company which is under the ultimate control of a person or persons resident in an EU member state or in a country with which Ireland has a double tax agreement, or which is, or is related to, a company whose principal class of shares is substantially and regularly traded on a stock exchange in an EU country or a treaty country AND which carries on a trade in Ireland or is related to a company which carries on a trade in Ireland will continue to be able to be non-resident under the management and control test. (‘Related to’ means that either one of the two companies owns at least 50% of the other, or that both are owned at least 50% by a third company; ‘Control’ is interpreted within Irish rules that attribute the rights of shareholders to related parties and associates.)

The flows work as follows:

Germany co pays royalties to Irish co 1 (no withholding tax is paid as both companies are within the EU), this moves  most of the profits out of Germany.

Irish co 1 pays the royalty (the German profits less a small charge for services and a mark up) on to Netherlands co (again no withholding tax is paid as Netherlands is an EU company under the royalties directive) after retaining a small profit for the services provided in Ireland. If the royalty was paid direct to Bermuda, it would be subject to Irish withholding tax of 20%. However the Irish tax authorities issued a practice statement as part of a suite of incentive measures to increase Ireland’s attractiveness as a location for intellectual property. The practice statement, which takes effect from 26th July 2010, allows patent royalties to be paid by an Irish tax resident company to a foreign company, including an entity that is resident in a non-treaty jurisdiction, without Irish withholding tax, ie patent royalties can be paid to Cayman/ Bermuda Companies free of withholding tax.

The previous requirement was that 20% withholding tax was required to be operated on payment of patent royalties where it was being paid to a patent holder who was resident in a non EU/DTA State.This change, which was introduced by administrative practice, directly follows the change in the Finance Act 2010 which exempted Irish companies from having to deduct withholding tax on paying patent royalties to a company resident in an EU/DTA State. Accordingly, this removes the requirement to rely on a treaty provision and, in some cases, can produce a better result than a specific treaty provision.

Netherlands co then  pays the royalty to Irish Co 2.  No withholding tax is due as the Netherlands does not impose withholding tax on royalties.

As a result of these three steps, the royalty income has been paid from Germany to Ireland to the Netherlands and finally to Bermuda (because that’s where Irish Co 2 is tax resident) and no withholding tax has been paid . Or in a post 2010 structure it could be paid Ireland to Bermuda.

Ireland views its payment as a payment from Ireland to the Netherlands and the Netherlands isn’t concerned about the payment to Irish co 2 .Irish Co 2 isn’t tax resident in Ireland for corporate income tax purposes. Irish Co 2 is the key hybrid company in the structure.

From a US tax perspective, the “check the box” rules allow the US to ignore Irish Co 2 even though it is tax resident in Bermuda, it looks at the Irish group of Irish 1 and 2 . Because of this, the US controlled foreign company rules don’t apply and therefore don’t tax the income arising in Bermuda in Irish Co 2.

So most of the European profits arise in Bermuda and a small amount of tax is paid by Irish Co 1 in Ireland. This tax structure facilitates the tax which isn’t paid in Europe. Why does the Irish tax system facilitate this? What is the policy purpose for the Irish non resident company? Why did the Irish Treasury agree to this (and continue to agree) and who lobbied for this in business? And why did go further and relax the rules in 2010. The key that makes the structure work is the different tax treatments of Irish Co 2 by the three tax authorities involved. An interesting question is , what is the commercial purpose of Irish Co 2? As a non tax person who read this article asked, does it have any other purpose than tax avoidance? If so, what is it and how does it fit into the commercial structure of the US group?

Based on the above, one might wonder why this structure is acceptable under the EU Code of Conduct on Harmful tax practices? How does the structure comply with the “letter and spirit of the law” under the OECD multinational guidelines from the  perspective of the multinationals which use it? The Dutch don’t think they have any responsibility for the structure, the Irish maintain its US tax which is being avoided and the US sees the result as being due to the weakness of European tax systems – so no country is responsible for the success of the structure! The low or non taxation of European generated profits in Bermuda thus appears fine to all involved!

I don’t believe that many tax authorities were aware of the total scale of shift of taxable profits from Europe to Bermuda before the recent publicity. They are now and one would expect to see some action. Also, how does this structure work with developing countries, does it shift profits in the same way and reduce tax in developing countries?

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