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The Problem with Profit Shifting, Part 1

Mimi Song: Doug, we’re super excited to have you on today and clearly you and I we’ve been in transfer phrasing for many years now. And when we think about this idea or this, this notion of profit shifting right profit shifting through transfer pricing, what do you think? What does that make you think of when you hear profit shifting? I’m curious. Can we start there? 

Doug Darling: Sure. No, absolutely. Cause I definitely have some thoughts on this, and to be fully transparent and this might put me in somewhat of a radical or extremist…? In that yes, it is profit shifting, but it’s such a negative connotation. You’re shifting it away from where it should be. I kind of distinguish that from putting profits where you have the appropriate DMPE functions, if you will. And even if that means in areas of lower tax rates than higher tax rate, it seems that the terminology profits shifting just assumes that’s wrong, 

Mimi Song: That’s implied. 

Doug Darling: I think that’s implied that any type of profit shifting, it’s “not fair” is … 

Mimi Song: Yeah! 

Doug Darling: … is the tone behind that. I really take issue with that concept. 

Mimi Song: I agree with that. I mean, I think that’s why, you know, I wanted to start with that definition of the term of what does it mean? Or, what does profit shifting mean to us, transfer pricing practitioners? Who’ve been doing this for many years because I believe the connotation right now when people hear profit shifting is automatically that negative connotation because it goes hand in hand with base erosion, profit shifting. 

What is that? Well, that’s the OECD BEPS Action Plan. And that’s sort of where the landscape has evolved to. So understanding that a lot of tax authorities are thinking profit shifting is this negative connotation, how are they actually focusing on cracking down on this negative aspect of profit-shifting through transfer pricing or improper profit shifting through transfer pricing? 

Through implementation of the action items, particularly I take Action item 13, I point to, and more specifically to CbC reportingAnd the transparency that’s supposed to provide, but I don’t think this point they’re effectively cracking down on anything. I think it’s still too early in the process. I’m not saying it won’t eventually, but I think that’s the vehicle — or *a* vehicle.  

But I think as transfer pricing, auditors are becoming more technical and they’re seeing the general pricing and they’re asking certain questions in the audits that they might not have that kind of aligned with that notion of the CbC, I guess I can’t say, as I’ve noticed a lot more cracking down in terms of an effect. Sure. 

Yeah. I mean, I think that’s the operative word there, going back to the idea that the Tax Justice Network, their report had over $1.3 trillion shifted into tax havens, right? There’s a significant amount that is being considered to be improperly shifted.  

Now, definitionally, going back to what you were saying before: there could actually be a reasonable explanation or business rationale of why these profits are, in fact, shifted to these other jurisdictions. 

Doug Darling: Yeah, absolutely. And first off, anytime somebody throws such a big precise number out there, I kind of got to go,  

Mimi Song: … “Where did they get that?”  

Doug Darling: Where did that come from? And what’s the motivation behind it?” Right. So giving it, given that it may be accurate, right. Give them that.  

Mimi Song: I think that it’s accurate, right? Yeah. 

Doug Darling: Assuming that it is how my doubts, but assuming that it is, it’s this idea that it’s being shifted, that it’s the idea that it was in the right place in the first place.  

And that you’re taking it away and properly. That isn’t necessarily the case. I mean, do you could have these, the tax or transfer pricing structure or your paradigm in place and it’s been a place for a long time, but somebody is now just now seeing maybe as a result of the CbC, that somebody that was a low or tax rate jurisdiction is getting residual profits. 

Mimi Song: Well, I think, that’s the key there.  

Doug Darling: It shouldn’t be there.  

Mimi Song: I think that’s a key point you’re making because operating or having profit in a low tax jurisdiction automatically makes tax authorities a little bit more suspicious that there’s improper profit shifting happening. 

Doug Darling: Right. Agree completely. That’s the assumption. And again, again the words used ‘Tax Haven’ has such a – again – that negative connotation, it’s a ‘haven.’ What you think ‘haven,’ you think of … criminals, you know, it’s a safe place, pirates, whatever… it’s a ‘haven’ [that] protects them improperly, I guess.   

I guess that’s where I’m trying to go with. And as simply as a set of low tax jurisdiction is what it is. You’ve just labeled it a ‘Tax Haven’. And that assumes that there are improper things going on with it. So it’s just the way the wording is set up in the first place is you’re already having to overcome a great deal to dispute that. 

Mimi Song: Well. And besides operating in these low tax jurisdictions, right, we’ll properly label them from our perspective. What else do you think makes tax authorities more suspicious of potential profit shifting activity. 

Doug Darling: What we do see [is] transfers of value, particularly IP and intangibles, right? When they see a US company and they sell their IP, for example, to Ireland or Switzerland, dad immediately assumes that that’s a heads up you’re right. That’s an absolute heads up and it’s a red flag to them and that this needs to be investigated.  

So even though it may be proper, you may have all the DMPE substance you need in that lower tax jurisdiction. Again, it’s a red flag. That’s what it triggers, that you’re now shifting those profits in properly. And we’re gonna assume you don’t have that DMPE until you approve. 

Mimi Song: Right. There are these very complicated tax planning structures that were deliberately put into place to take advantage of these very esoteric tax structures. I think Whirlpool is a really good example here that they were able to create a structure that apparently they weren’t taxed in three different tax jurisdictions. It’s phenomenal what could be happening. And I know that –  

Doug Darling: Now, that’s really impressive. That’s very impressive. And I’m sure there is a business reason behind it.  

Mimi Song: That’s the question. I think, I mean the OECD though, they understand that a tax authority should not necessarily automatically assume that these multinationals are seeking to manipulate their profits. It’s this concept of being guilty before being innocent, being proven innocent, right? 

Doug Darling: Got to prove your innocence, right? Yeah. Not prove you’re not guilty. You’ve got to prove you’re innocent. And that shifts the burden. 

Mimi Song: Yeah. And I think, I feel like we’re, we’re in that state right now, a transfer pricing perspective, transfer pricing [means, practically, that you are] already guilty. And then we have to prove her innocence. And what are some of the circumstances today? And maybe even some of the temporary situations that we see that are increasing this level of profit shifting suspicion. 

Doug Darling: COVID-19 weaves into that… pandemic. Right? Because generally companies are seeing reduced profits due to the pandemic. Some are seeing increased [profits]. That’s not all are — apparently companies like Facebook and such, Amazon… pizza delivery places are doing well. So it’s not a constant, but I sit back and I try and wonder how that weaves into it. Now I’m not really sure, but it’s got to be somehow impactful. 

Mimi Song: Well, I mean, I think that’s also part of the motivation behind the accelerated or continuous accelerated pillar one pillar, two initiatives by the OECD. This whole concept of how as a global community, are we going to tax this digital economy that we never even anticipated could be reality, right? 

Doug Darling: Yeah, no. You make the great point that that’s a, that’s obviously sticking out there like a sore thumb, but as a measure, a reaction is the Pillar One and the Pillar Two in the current buying environment [for one thing]. And digital has always been difficult anyways in the tax world. Right. It’s, you know, the sales tax issue is the most common one is where, you know, where is that money earned? And so that’s always been a tax issue, anything digital or software related. Yeah. 

Mimi Song: Well, challenges that definition of what constitutes a taxable nexus.  

Doug Darling: Right. It’s all about the nexus in that, in that instance, also that concept w weaves has some relevance to the pillar one and the pillar two, but I think you’re right in that’s a double-down attempt, it’s another enforcement tool to address the profit shifting they’ve gotten specific because all actually on 15 was kind of generic. I mean, kind of wishy-washy without much substance and this has given it that substance, I think it’s trying.  

Mimi Song: Right. Real life sort of application. 

Doug Darling: That’s right. Real life application. Now we’re going to get serious. We’re not effectuating the change we want necessarily about slowing down, stopping profit shifting. So here’s, this is the next step we’re going to take to control that [or] stop it. I think that’s, that’s an absolutely spot on example. 

Mimi Song: From an MNE perspective. I mean, you know, we, we were just joking about this earlier, right? Doug, the transfer pricing community is such a small world. Everyone knows everybody. What do you think the general sentiment is? You know, what are the general attitudes, at least from a transparent pricing, MNE perspective, in-house tax professional perspective about profit shifting? Are they concerned about this feeling like they’re really doing something guilty and then they have to prove their innocence?  

Doug Darling: I think that’s the prevalent attitude that most definitely under the microscope unfairly. 

Mimi Song: Right. And do you think that the pandemic has heightened this awareness and concern right. Because all of a sudden we’re talking about different issues, having an impact to your overall transfer pricing framework and policy. 

Doug Darling: I take the pandemic can have several effects. And that is most, certainly one where I think it can be seen that everybody’s working remotely. And so it goes back to, it’s not the same as a digital economy, but I think it just the increased use of the technology, the [Microsoft] Teams, whatever has also increased awareness of that is this falling within that Pillar One, Pillar Two [framework]. I still think a lot of tax professionals in-house are just still focusing on what they have to do day-to-day. And I mean, they’re not dwelling on it. I mean all the time. The issue is raised, especially, a third-party consultant type they’re there to remind them. 

Mimi Song: That’s an interesting point because, I’m wondering, this whole attitude about profit shifting and this whole mindset of, of being concerned that the tax authority is putting the burden of proof on the taxpayer to really prove their innocence. Right. Is that in any way, driving a change in the behavior of these internal tax professionals? 

Doug Darling: In my opinion, no, not really. No, it’s it, you know, it’s a heightened awareness. Uh, they think about it for five or 10 minutes and then, “Oh, I’ve got this to do, I get back to there, it’s floating there, but it’s always pushed aside by just what has to get done.” 

Anyway. It’s interesting. It’s not like it’s not like this huge, huge concern. It’s a concern, but it’s not overwhelming and not all invasive. 

Mimi Song: Well, I think it depends, Doug, because I do think that there are probably many professionals out there where transfer pricing is one aspect of their day-to-day job. And they’re worried about 10 different things. And TP tends to get de-prioritized, let’s just say as a compliance exercise and in that case, I probably agree with you that maybe it’s not changing their current behavior in terms of what they need to do.  

But for more of the sophisticated transfer pricing professionals like you and myself, I think it’s – if I’m not mistaken, correct me if you have a different opinion here, Doug – but I think that transfer pricing professionals are now much more concerned about this: the shift in attitude about transfer pricing, this idea that transfer pricing is only applied in a manipulative situation.  

I constantly find myself almost feeling attacked. It’s like … I’m not doing something bad. I’m actually doing something that governments have put forth from a regulatory perspective, from a legislative perspective, to prove that the company is not manipulating profits. 

Doug Darling: Absolutely. I’m just using their rules and regulations. And they made the laws, not me. I’m just using them maybe more to my benefit in a way they didn’t anticipate, but it’s not in violation of them. 

Mimi Song: It’s not in violation of any rules. Right. I’m doing what makes sense for the business, for the organization. I’m looking for, I’m looking for opportunities to make sure that this profit attribution aligns with value creation. 

Doug Darling: Yeah, no. And I think you make a point in that when you carve out people like you and myself, I mean, sure. Transfer pricing professionals that have been in it for quite a while. It is more of a concern, I think. And I guess, when you talk about the general tax department, or even, you know, you’re keeping staff, like I think it’s not so much on their radars.  

It is in the C-suite probably or VPs of Tax and stuff. They’re quite aware of it, but they’ve got a lot of other issues as well. But I certainly think people like you and me and just eat, breathe, and sleep transfer pricing, I do feel that I’m being… 

Mimi Song: … targeted. 

Doug Darling: … targeted in everything I do has to be, to prove, I have to prove [I] did it right. As opposed to somebody else having to prove it’s wrong. And that’s just the paradigm we’re used to, or at least it shouldn’t be here. 

Mimi Song: And I think it especially becomes much more of a challenge. If you operate in a multi-national that does have a ‘Tax Haven,’ then that’s – let’s be realistic here – I think most companies operating on a global basis have at least one or two legal entities and jurisdictions that could be and would be considered tax havens. But some of them have very legitimate business reasons for operating there.  

And some of them have substance for being in those particular jurisdictions. Now, in your own personal experience, how do you think that businesses with legitimate rationale for operating in those jurisdictions should mitigate their risks now. The whole, how do they prove their innocence? 

Doug Darling: I think the first and foremost way is documentation, documentation, documentation. And I don’t mean just, TP report, although that that’s part of it, but any way to document that you have the required substance, the board of directors meetings, you have to hold those in those jurisdictions. Everything has to be documented somehow that you have the required substance. And what I say, obviously I say DMPE, but the effort to substantiate every, every letter in DMPE has to be done. It’s an increased cost. It’s an increased burden. But if you’re going to operate in that manner, in that structure, then that’s about your only defense, right?  

What else are you gonna do? You’re gonna cave to it? But the best defense you have is documenting that it exists in every conceivable and imaginable way. I would not really hesitate to operate with that type of structure. If I felt that those substance requirements were satisfied. I’m of the opinion, “Okay, I’ve done all I can. I’m doing the right thing here, come get me!”… It’s all you can do! 

Mimi Song: That’s true. So, here’s the thing. I mean, then, then we would agree that this is one of those situations where maybe you want to address it head on, right. Anticipating that his tax authority is going to challenge you in this particular situation…. 

Doug Darling: Absolutely. 

Mimi Song: You’re going to go ahead and just put it out there up front and say, “Okay, we have operations here. Let me tell you why.” 

Doug Darling: Absolutely. It’s one area where I think being proactive is critical. I think the rest of the tax world, and I know we affect taxes, aren’t our biggest concern, but we certainly have an impact on taxes, transfer pricing. Does I think there it’s more often than not so reactive, active area and to be as proactive as possible is always a goal. But this is one area where I think you have to, I absolutely agree the open Komono transparent. 

Mimi Song: Cause they’re going to find out anyway. And if you’re not proactive about it … I think there’s perhaps a… little bit more suspicious. 

Doug Darling: Yeah. 

Mimi Song: They will infer that you might be doing something wrong. 

I have a, this is a true story. So when I was at MEFG union bank, my boss there, he used to work for another financial organization and he was physically based in Bermuda and they would wear Bermuda socks to their board meetings. They would wear their Bermuda shirts and he said, it was an amazing job. 

It’s April. We’re here. That’s, that’s funny. That’s, that’s almost mocking it, which I kind of like, well, but, but he was physically there.  

Doug Darling: He was physically there and he could prove that, I’m sure. But that’s almost taken it to turning it back on them and then kind of being Lower Reverend and mocking them and “Look, you know, I’ll even wear Bermuda socks!” [Mimi laughs.] 

I actually, I think that’s funny. But you’re right. You’ve got to have the decision makers there and that a lot of times that’s the board of directors, they at least at a minimum what I’ve seen, they have to have their meetings there. 

Mimi Song: Yes. Yes. And in which board of directors doesn’t want to hold their meetings in a.. beautiful…  

Doug Darling: Going to go to Malta. So yeah, I think that, those are the minimum requirements, right. But if you at least meet the minimum requirements, but you, you, you meet them. It wouldn’t change my structure. I wouldn’t alter it just because of the imminent fear of being asked about, being questioned, being attacked. Because if you do, that’s all you can do. If you do it right. You have the substance there, you document it, you can’t entirely change the way people do business just because of BEPS.  

Mimi Song: Yes.  

Doug Darling: And I say, that’s, I think that’s the assumption that did it will, that’s what they want. 

Mimi Song: Changing behaviors that they feel are behaviors that were manipulating the profit allocation. Whereas exactly. And it is BEPS in fact, changing behaviors to avoid the perception of profit manipulation and in fact, creating some other types of challenges. It is interesting to say… 

 Doug Darling: ‘Seen a lot of behavior changing. No, I haven’t seen a lot of behavior changing.’ I mean, the behavior that changes is maybe the documentation of it, or supporting it, go into the extremes, if you will, to substantiate it and audit-proof it. 

Mimi Song: Yes. And then and create a consistent narrative. 

Doug Darling: Not the transactions, but not the transactions. 

I think this is a good point too, to discuss a little bit further. That a lot of multinationals now operating on a global basis, the documentation clearly is a key component to be able to controlling the perception from the tax authority. So there are many multi-nationals that, pre-BEPS, would have taken a very unilateral approach to the documentation and that, “Hey, if it’s above the range in the UK, HMRC is not going to care, I’m not worried about it.”  

But in this environment, we are much more aware of this heightened sense of global transparency. And so inconsistencies become much more of an issue. 

Doug Darling: Absolutely. I think you’re right. In the pre-BEPS that counterparty to your UK, that’s making above the range, let’s say it’s US, may never know it. But the transparency and the CbC, I mean, you’re right. Given all that, they have more visibility. 

Mimi Song: There’s much more visibility and there’s tax inspectors without borders that are doing joint audits. 

Doug Darling: Yep. And that’s that, that’s an absolutely good point that while before this information wasn’t known or made known, it wasn’t as much of a risk, clearly those that dynamic has changed. And so the things like the documentation just to come all that more important because as I like to say, and I think it’s my philosophy and I think it’s also CrossBorder’s philosophy and I feel free to say so is: documentation is your first chance a lot of times to tell your story. 

And so why not make it the story you want to tell, that’s accurate, that is compliant locally as possible. Because that’s always can be a stumbling. That’s an immediate invitation. If it, if it’s not, you know, locally and hyper local compliant. And then in that documentation, tell your story… and maybe it is a way to weave in, especially in the master file, your world value chain and business strategy and why you are operating in that jurisdiction. 

Mimi Song: How important is that particular entity with respect to the value chain, why that entity… 

Doug Darling: Right. And you’re starting to be proactive right there in your documentation. And especially, I think that obviously the master file is a good place. You get into that and keep going. 

Mimi Song:  It gives that holistic view of the organization. 

Doug Darling: … the whole value chain and why it makes sense for this entity to be where it is.