Part of an occasional series in which CIOT tax experts explain the background to topical issues
How is a company’s tax bill calculated?
A company’s Corporation Tax bill (most companies will pay other taxes too) is calculated as a percentage of their profit in a given year. (For this year the UK rate is 20%.) For a company resident in the UK this is in theory all its profits globally, however where the company has to pay tax in other countries on its profits in those countries it is either exempted from UK tax on those profits or allowed to use these payments to offset its UK tax.
Put simply, profit is what is left after you subtract a company’s costs (raw materials, wages and so on) from their revenue. Profit is calculated before any dividends are paid out to company shareholders.
There are complications to these rules, such as that losses made in a particular year may be carried forward to offset profits made in future years. But let’s keep things simple for now.
What about companies not resident in the UK?
A non-UK resident company must pay UK Corporation Tax on the portion of its profits attributable to the UK if it has a UK ‘permanent establishment’. A company has permanent establishment in a country if either it has an office, factory or other fixed place of business there, or if it has someone there acting as an agent of the company with the authority to do business on behalf of the company.
How do you calculate what portion of a multinational company’s profits are attributable to the UK?
It's important to realise that mostly, tax is calculated on a company-by-company basis rather than on the group as a whole. A multinational company may well have several different parts of the business operating in the UK through different companies; e.g.
- A call centre, taking calls from customers on their bills or problems with services provided to them, set us as a company in the UK;
- A “back office” function, providing book-keeping services to the worldwide operations, set up as a separate company;
- A sales team, in a third entity
Each of these entities has its own profit calculation.
Many critics believe this is highly significant and would like to change to a profit based on the group as a whole . Our view is that this would create as many problems as it would solve - for example, what would happen with joint ventures? - and would not affect the fundamental drivers of international negotiations on tax.
Broadly the principle is that the profits attributed to the UK operations are those which the UK operation would have made had it been a separate unrelated company dealing with the non-UK parts of the company on arm’s length terms.
Is this the same as assuming profits from all the sales in the UK are attributable to the UK operation (and so should be taxed in the UK)?
No. For example imagine an Italian car manufacturer, who make all their cars in Italy, and do all the research and development in Italy and manage it all in Italy, but have a UK branch office who market and sell the cars to UK customers. Let’s imagine they sell each car for £40,000 and they cost half that to make, leaving the other half of the sales revenue as profit. Is all of that £20,000 profit attributable to the work of the UK staff, or might some of it be due to the engineers, developers, managers and everyone else involved in designing and building the car in Italy?
Or to put it another way, following the ‘arms length’ principle, imagine the UK branch office was a completely separate company who signed a contract giving them the sole rights to market and sell the cars in the UK. Would the Italian manufacturer sell them the cars for £20,000 a time, leaving themselves with no profit? We can be pretty sure they wouldn’t. We guess that, say, 80-90% of the profit would be taken by the Italian company who are doing 80-90% of the work and the UK sales company would be left with a profit of at most a few thousand pounds on each car they sell.
Unfortunately because a lot of the time we don’t have arms length real world examples to work from this process involves a fair amount of economic analysis and discussion between companies and tax authorities about what the right division of profit is.
Of course nowadays, it is unusual even for a manufactured product like a car to be designed and built entirely in one country. And there are issues, for example around how much profit should be attributable to the manufacturing and how much to the consumer finance activity as well as to sales and marketing. Nowadays, both taxpayers and tax authorities will look to undertake a Value Chain Analysis, to allocate the profits between different functions However, the example does illustrate the principle that profits on a product not developed in the country of sale are likely to largely belong somewhere else.
So where does Google fit into this?
Google Inc is an American company. It was founded in the US, it is headquartered in the US and so far as we can tell most of its staff and development work are also in the US. Its only presence in the UK appears to be a subsidiary, Google UK Ltd. Google’s European headquarters – and where it appears all their advertising contracts are signed – is in Dublin.
What does Google UK do?
According to media reports Google UK Ltd has just over 2,300 staff. Their work is described by the company as “the provision of marketing services to Google Ireland Limited and the provision of research and development services to Google Inc.” In other words they provide services to Google’s central operation in the US and European headquarters in Dublin, for which they receive payment from Google centrally. They don’t have a separate income stream. They may market to UK businesses to encourage them to take out adverts but when the business comes to sign the agreement the arrangement is with Google Ireland. The UK staff appear to provide sales and marketing support, but they (and their UK employer) don’t actually sell to customers.
How much tax does Google pay in the UK?
Following the recently announced settlement with HMRC reports are that Google is paying about £30 million a year in tax. (Based on reports that Google is paying £46.2m in taxes on UK profits of £106m for the 18 months to June 2015.)
Why is it not paying more?
It is based on the amount of profit that Google UK makes, which appears to be about £70 million a year, but maybe with a notional 'arms length' royalty from Ireland substituted for the actual one.
It is not based on the amount of profit Google makes on its services to UK customers. This would be a much higher figure – probably about £1 billion (estimate based on Google’s UK revenue of about £4 billion having the company’s global profit margin of 26% applied to it). If corporation tax of 20% was levied on this amount then Google would get a bill for roughly £200 million from the UK Government.
Is this where the ‘3% tax rate’ claim comes from?
Yes. £30 million is 3% of £1 billion.
So is £30 million the right figure?
Without access to all the figures we can’t be sure, but HMRC appear to think so.
It is possible to do some guesswork. One researcher, Maya Forstater, has done some ‘back of an envelope’ calculations based on how Google’s global costs divide up and worked out that if you take the category (sales and marketing) which constitutes most of Google’s activity in the UK and extrapolate from that that 16% of the company’s profits from UK sales are generated by its UK activity then you end up with £160 million of profit being taxable in the UK which, at a 20% tax rate, comes to £32 million. Of course this is an illustrative calculation by an outside commentator, we don't know on what basis Google and HMRC came to what they agreed.
Why shouldn’t Google be paying tax based on all its UK profits?
Arguably it is. The issue is, what is a UK profit? How do you decide what profit was made here and what was made somewhere else, in a global business?
There is a distinction between profits a company makes in the UK and profits generated by a company’s activity in the UK. Corporation tax is based on the latter.
Expanding upon that a little, Google makes £1 billion a year profit on sales to UK customers, but it is deemed that only a fraction of the value of that is generated by its UK staff, assets and their activities. As with the example of the Italian car manufacturer (see above), the product is being developed and managed elsewhere (mostly at the Googleplex in Mountain View, California, presumably). The UK marketers/researchers/salespeople are promoting it to UK customers – an important job undoubtedly, but without the impressive product Google have invented in the USA there wouldn’t be anything to market. So on that basis it shouldn’t be seen as unreasonable that most of the tax on the company’s UK sales profits is allocated to the US Government.
Would it make a difference if Google UK actually booked sales to UK customers?
Unless this was accompanied by other changes in what Google did in the UK, no it wouldn’t; exactly the same amount of value would be being created in the UK. What would change is that Google in the UK would report a large amount of sales revenue, matched by a large amount of additional cost, being the cost of the products it would have to buy in from other Google companies to fulfil its customer needs.
Is Google paying its fair share of tax globally?
Hard to answer definitively. The company is certainly paying a lot of tax. Google’s (technically Alphabet’s since the central holding company had a name change) accounts for 2014 provide for just over $3.3 billion of tax on corporate income on the profits of that year. (It is understood that this is overwhelmingly paid in the US.) That is about 20% of the company’s profit of just over $17 billion (from revenue of $66 billion), significantly less than the US’s 35% corporate tax rate, but still a pretty sizeable contribution. Why is it less than 35% of profits? The US famously has a high corporate tax rate but many, many corporate ‘shelters’ that multinational companies can take advantage of. Google is taking advantage of some of these. There has been no suggestion from the US tax authorities that they think Google is underpaying them.
It has, though, been widely reported that the Google group has reduced its effective tax rate on profits on non-US sales through various techniques including holding the part of the value of its intellectual property (all developed in the United States) attributable to non-US sales in Bermuda and routing its royalties there, rather than to the United States. This makes use of the soon to be abolished ‘Double Irish’ loophole (explained in the link above). Analysis of such techniques is beyond the scope of this article. Google has stated that its Bermuda operation does not impact the tax it pays in the UK; this is understandable, as these techniques would not be expected to affect the value created in the UK. However, these techniques will have significantly reduced the group’s tax bill in the United States. The Chartered Institute of Taxation is a supporter of international initiatives to ensure tax is paid where value is really created, ensuring a level playing field for all taxpayers, wherever they come from and whatever their size.
It is of course, a coincidence, that Google's effective tax rate is 20pc, the same as the UK headline rate for the relevant year. The key drivers are, on the one hand the higher headline rate in the US system, and on the other hand, the opportunities to reduce its US tax bill through structures in third countries. Because of the political deadlock in the US, whatever happens to particular structures like the 'Double Irish', these key drivers may not change soon, whatever approach the UK or other countries take.
Should the system be changed to one where companies are taxed on all the profits they make from their sales in the country?
There are a few downsides to this.
First of all it would be very hard for one country to switch to such a system without getting the rest of the world to do it too. If we did it unilaterally it would open up more differences between national tax regimes and so create, rather than reduce tax avoidance loopholes.
It is also far from clear the UK would gain from such a change. We might gain from some of the big US-based multinationals paying more tax here, but we have plenty of multinationals of our own and they would generally end up paying less here. The biggest losers could well be poorer developing countries, especially those reliant on extractive industries such as mining. If they could only tax companies based on their sales to their residents in that country that would bring in a lot less than taxing them on the share of the economic value of the products generated in that country. The UK itself still generates between 8 and 9 percent of Government revenues from corporation tax, which is pretty respectable internationally, despite being a very open economy exposed to competition.
There is also an economic question as to who ultimately bears the burden of taxes on a company - is it the shareholders, the customers, or the workers, and if the workers, is it the highly-paid top management or the people at the bottom? The answer is not certain, but it does seem likely that a shift to sales-based tax would be at the expense of the customers. In other words, by taxing internet-based suppliers more, we could be more heavily taxing ourselves.
But the strongest argument against is fairness. If a product is invented / developed / mined / refined / built and potentially even marketed and sold all round the world entirely from country X, making use of staff educated in country X, who use country X’s health care system and transport network, often with tax breaks from country X to encourage its growth, and maybe even wage subsidies from country X for its employees, who deserves to be able to tax the company’s profits? Is it country X, or every country that has someone in it who buys a product from the company? Of course if a country wants to tax sales it can, and sales taxes such as VAT are a perfectly reasonable and sensible part of a country’s tax mix; though in the EU, this is governed to a considerable extent by EU rules.
Are there other changes that should be made?
The key is for governments to work together, with tax authorities sharing more information and agreeing frameworks that eliminate loopholes like the ‘double Irish’. That is what the G20/OECD project on Base Erosion (companies reducing their taxable profit) and Profit Shifting (companies routing their taxable profits to low or no tax jurisdictions), which reported recently, aims to do. It is about filling in the gaps in the system.
There is a perceived issue with the internet making it easier than ever for companies to ‘sell into’ a country with little or no presence in that country, and therefore offering little or no taxable base for the government of that country to tax the profits of. Sales taxes can be part of the answer to this. Ultimately though we need to recognise that companies like Google are very successful US exporters and we need to work harder to encourage more companies of our own to take them on and earn further tax revenue for the UK. But note the Italian car manufacturer example above - sales into one country generated by activity in another are as old as the existence of internationally traded goods, and did not just come about with the internet.
John Cullinane, Tax Policy Director, Chartered Institute of Taxation
With research by George Crozier, Head of External Relations, Chartered Institute of Taxation
Tuesday 2 February 2016