Today we unveil a potent thesis on multinational tax avoidance by Michael Hibbins, formerly an executive of a global oil major operating in Australia.
Tax avoidance, says Hibbins, is rife. Multinational directors and executives, along with regulators and the Big Four accounting firms are in denial.
Multinationals in Australia – the household names we know so well – no longer operate as “body corporates” in the traditional sense and according to the intention of corporations and tax laws. They are virtual puppets which dance to the jig of their foreign overlords.
Executive pay in these satellite “branches” is no longer struck on incentives to maximise profits in the local offshoot. Instead, executives have become officers of the parent company, rather than the subsidiary. They are expected to transfer profits offshore while accepting the transfer of group costs into Australia. So it is that billions of dollars wend their way to tax havens every year rather than benefit the communities in which the multinationals operate.
Their subsidiaries should be deemed by governments and tax authorities as “undisclosed agents”, says Michael Hibbins. Their myriad “related party transactions”, that is, their profit-shifting deals with other entities of the global group, are a sham.
From the time they rolled out their “global authority delegation structures”, the likes of dividend payments from local puppet company to parent company, as well as inflated interest on artificial loans from overseas, should have been treated, not as dividends or interest, but as mere cash.
Presently, these deals are touted as legal and “arms-length” but they should be seen for what they are; invalid contracts; rubbish, unenforceable.
Story by Michael Hibbins
“We’ve paid our taxes in accordance with the laws of Australia and have done nothing illegal”. This is the refrain so often heard by apologists for corporate tax avoidance. Its hollowness though is not merely a factor of repetition.
It also swings on the simplistic assertion that illegality is the only basis on which the behaviour of multinational corporations should be judged. This focus on the legality is consistent with strategies designed to distract the public and regulators from a much more fundamental question of whether or not the related party contracts struck by multinationals have established enforceable rights and obligations that are tax effective.
From the perspective of managing their tax affairs, multinationals have taken their eye off the fundamentals and most such contracts have been “hollowed out” by the corporations themselves.
While individual elements of multinational tax and royalty minimisation strategies may not be illegal, there is a big difference between being legal and being effective. This article has been written to assist in understanding: 1. why multinational related party contracts have been rendered ineffective, and 2. how multinationals have been (almost) successful in hiding the problem they created.
“Some multinationals have been “getting away with it” for decades. Others were slow to introduce these structures, but were forced to join in to remain competitive”
First a little background on contract doctrines. All multinational tax schemes rely on the use of related party contracts. They rely on the common law doctrine of “privity of contract”. This doctrine provides that a contract can only confer rights or impose obligations arising under the contract on the parties to that contract and not on any other person or agent.
It highlights the concept that a valid contract requires at least two persons, neither being an agent of the other or an agent for the same principal, before rights and obligations under the contract are effective. If one or more parties are acting as agents then, in the main, no rights or obligations under the contract are conferred upon those agents.
These contracts also rely on another doctrine that separates the legal person of the company from its owners (in this context, a multinational parent from its subsidiaries and these subsidiaries from each other).
Multinationals argue that contracts between their related parties are legal and therefore allow profit shifting, providing that, for tax purposes, the contract terms are at arm’s length.
We are all aware that multinationals have been funnelling profits to tax havens. If you followed the recent Senate hearings into multinational tax avoidance you would have heard senior executive after senior executive (often the foreign senior tax counsel) offering similarly worded rhetoric to the effect they have done no wrong.
It is the “nothing to see here” strategy. Some executives may even believe their own rhetoric, but their frame of reference has been corrupted.
Senators were guided to focus on arms-length considerations, as required under tax legislation. Unfortunately though most senators lacked the detailed knowledge of the internal workings of a multinational which was needed to ask the right questions and expose diversionary tactics.
“Local boards became functionally redundant, but often a bare minimum of local directors were retained to rubber stamp decisions made by officers of the parent company”
The watering down of corporate law and external reporting obligations over recent years also made it virtually impossible for the senate committee presiding at the inquiry to expose the fact that multinational global governance frameworks, while arguably efficient for their businesses, have irreparably compromised the foundation of their tax avoidance strategies.
Surely the guardians of our financial system would have picked up the fact that changes in global governance structures have brought fundamental changes to the status of the Australian-incorporated subsidiary companies they were charged with regulating.
Unfortunately, these guardians and enforcers, the Australian Securities & Investments Commission (ASIC) and the Australian Tax Office (ATO) have let us down.
How could this happen? Have the regulators been too lazy, too inept, or did they fall prey to the conman’s claim “nothing to see here folks”?
We can see the effect of this type of strategy in nearly all large-scale corporate scams. Even in the US, the financial system guardians (the Securities & Exchanges Commission (SEC), the legal profession, the Big Five accounting firms (which then included Arthur Andersen), tax authorities and industry regulators) were all fooled by the conman’s blind during scandals such as Enron, Bernie Madoff’s Ponzi Schemes and the global financial crisis.
In each case, regulators were also guilty of not listening to warnings and ignoring the fundamentals. The same thing is happening again in relation to the changes to the global governance of multinational corporations.
Multinational tax scams continue to provide tax advantages that are being used against taxpaying competitors in Australia to undermine the level playing field. While regulators and politicians have been warned about the problem, they seem ill prepared to realise they are being exploited and have consequently failed to explain how that exploitation works to the benefit of their citizens.
To paraphrase author Harry Markopolos – the man who exposed Bernie Madoff’s Ponzi schemes – “No one is listening”. The multinationals and their tax advisors know it, so they continue to obfuscate.
The fact is, if you are a multinational and you have implemented a global authority delegation structure as most have, then your profit shifting via related party contracts is probably ineffective. How is this possible?
Changes to multinational governance and delegated authority structures have been a creeping evolution. The internet and increasing effectiveness in communications have sped up the process.
The boards of multinational parent companies became seduced by the idea that new computing and communication technologies would allow them to directly control marketing, supply chain, capital allocation and treasury functions of their subsidiaries.
Pursuing business efficiency then, they started to replace local board authority structures with global authority structures under which all authority within the group was delegated by the parent company board across legal and sovereign boundaries (as if they did not exist) directly to the lowest level of officers within their subsidies.
In effect, they absorbed their subsidiary body corporates into one global body corporate. Local boards became functionally redundant, but often a bare minimum of local directors were retained for legal compliance purposes; that is, to rubber stamp decisions made and often already implemented by officers of the parent company.
Tax advisors quickly realised the new authority structure would allow them to manipulate group tax exposure by both shifting revenue out of – and pushing (often artificial) costs into – high tax regimes such as Australia.
While some subsidiaries retained the façade of local authority delegation structures, local employees are under no illusion that the local version, while legal, is no more than window-dressing in the real world. Global business heads have been delegated authority over their businesses globally. They set policy which Australian employees, including subsidiary directors, must follow.
“Subsidiary directors in Australia have themselves become officers of the ultimate parent”
Perversely, in Australia, directors and officers, including shadow directors (who may be senior executives or even directors of the ultimate benefiting parent) have been aided and abetted in overlooking their legal obligations as directors of an Australian company – and merely therefore do the bidding of the ultimate parent – by the CLERP amendments to the Corporations Act of 2001, which were enacted in the name of business efficiency.
Given the strong support for these amendments by multinationals, such outcomes may not have been unintended. If the offending amendments were repealed, directors of multinational subsidiaries might be less inclined to breach their obligations with current levels of impunity but, in any event, one layer of state-sponsored obfuscation would be removed.
By accepting the ultimate parent’s cross-border authority delegation structure and then acting in accordance with directions from senior officers of the ultimate parent, subsidiary directors employees in Australia have themselves effectively become officers of the ultimate parent.
They have effectively assumed a fiduciary obligation to the parent (as the subsidiaries’ actual mind and management), to cause their subsidiary legal entity’s name, legal status, assets and business platform to be used in accordance with directions from the board and officers of the ultimate parent for the benefit of the ultimate parent.
Now, subsidiary employees are conflicted in representing the subsidiary as a body corporate separate from its shareholders.
Corporations law is enacted to regulate incorporated bodies for the economic benefit of society. Legal entities that ASIC registers as companies are assumed, under the tax laws, to be independent corporations. However, under global authority delegation arrangements, the subsidiary no longer has the capacity to function as a body corporate in its own right.
Executive structures have been stripped out of subsidiaries. There is no treasury function and what is left of finance, tax and back-office functions report directly to the parent, not to the local board. Financial statements are consolidated down rather than up (that is, the parent controls what is reported locally, not the local board). Local governance arrangements either don’t exist or are subservient to parent authorities in practice, even if not at law. In practice, many boards of multinational subsidiaries now lack the capacity to set policy.
Remuneration is key. Subsidiary employees are now told little about their employing company because their goals are global and set by the parent.
Key Performance Indicators (KPIs) for subsidiary employees now have the “controllable revenue” and “controllable cost” focus of the parent instead of a legal entity profit focus. This is because related party transactions imposed by the parent include terms that have tax minimising, profit shifting objectives. Local employees must accept these contracts, but they have no control over content.
It is therefore impossible to reward such employees based on profitability at the local level when they know profit is being eroded and shifted offshore to tax havens. Reward systems based on “getting away with it” expose their internally fallacious logic.
What all this amounts to is that foreign multinational subsidiary companies have effectively handed control of their businesses and assets to the parent. They have become agents of the parent. They retain legal title to the parent’s assets in an agency capacity. Officers of the parent now directly control and operate subsidiary businesses and also act as shadow directors of these subsidiaries.
The establishment of undisclosed agency arrangements created by global governance structures means that related party agreements, including related party loans, IP transfers, marketing and service agreements and so forth are no more than legal facades which attempt to conceal from the public and regulators, the reality of the parent doing business with itself. Such contracts became, and continue to be, ineffective from the date these new global governance structures were rolled out.
The outcome is that multinationals have hollowed out clearly defined legal and sovereign boundaries (that are the very foundation of related party contractual relationships) while convincing themselves, their auditors and other commercial guardians that there is “nothing to see here”.
The parent, as one body corporate, has actually been running branch operations in Australia (and other countries) from the date it rolled out its global authority delegation structures. As such, the parent was required, from that date, to register with ASIC as a foreign company doing business in Australia using the business names of its subsidiary companies. That is assuming ASIC would accept the parent’s use of those business names, as not being misleading.
One suspects Australian creditors would want to know they are now dealing with an entity that has the asset backing of the entire group, globally, not just the assets of the Australian subsidiary. It appears that many Australian creditors and corporate regulators (both state and federal) are currently being misled.
Unsurprisingly, multinational parent companies have not registered their Australian operations as branch operations and consequently have not complied with ASIC’s disclosure and reporting obligations; obligations which apply to registered foreign companies.
Instead, they have continued to conceal their self-created problem with denials and obfuscation. They have an incentive to do so because their funnelling of revenue offshore is rendered ineffective. Hiding that reality has become an imperative.
Some multinationals have been “getting away with it” for decades. Others were slow to introduce these structures, but were forced to join in to remain competitive.
“Ordinary people, taxpaying citizens, have been the ones footing the bill and we will continue to do so if the government fails”
The problem now impacts every common law and most civil law countries in which multinationals operate. The accumulation of income taxes avoided in these countries over decades has been a significant commercial advantage for multinationals versus their local competitors.
In aggregate, it has also resulted in an inestimable value of unrecognised liabilities for income tax. Not all taxes evaded may be recoverable, but in Australia there is no time limit for the ATO to recover these unpaid taxes, if it can prove fraud or tax evasion. Proof will depend on the facts in individual cases.
What is clear is that multinational executives, the Big Four and their legal advisors have vested interests in maintaining the status quo. Executives have exposure to the market value of the parent company via their remuneration arrangements, both current and deferred.
Tax accountants and lawyers also have a vested interest in preserving the tax avoidance industry from which they benefit. While upheavals may evolve into new opportunities for advisors, they need not be sanguine. For some, the learning curve is a big obstacle. Mostly it will be shareholders that suffer, but class action lawyers are sure to take an interest.
As for the multinationals themselves, most big tech, big mining, big oil and big pharma groups have unnecessarily paid tax in low tax countries to which their ineffective related party contracts purport to have transferred income. It seems unlikely that these tax payments will be recoverable, even though the contracts that supported the purported transactions were invalid.
Profits which were sourced from Australia should now be correctly taxed in Australia. The result will be double-taxation plus penalties rather than tax avoidance. Dividend payments will now be treated as cash transfers to head office. Artificially inflated Interest payments will be disallowed and also treated as cash transfers, but deductions should be allowable for some part of actual group interest payments to third parties.
It is unclear what should happen to the withholding taxes deducted, given the parent should have been entitled to a credit in its home country for those withholdings.
The obfuscation strategy is unravelling. Ordinary people, taxpaying citizens, have been the ones footing the bill and we will continue to do so if the government fails to hold its regulators and others in the financial guardian community to account.
We of course need to hold the government and its advisors, which include the Big Four, which plays both sides of the street, to account. All need to acknowledge the damage done in failing to monitor and audit the fundamentals on which the financial system is based. It highlights the importance of putting an immediate halt to the migration towards corporate opaqueness. The level of self-deception that occurs behind this screen has only resulted in illusory gains and increased risk for shareholders.
Greater transparency is more likely to result in better risk mitigation strategies and greater economic benefits for both investors and the communities in which multinationals operate.