Profit shifting aspect

Levan Lomtadze Tbilisi, 31.01.2018 Tbilisi, Georgia, 0194 Profit shifting aspects of intra-group financing: challenges of Georgia and International Practices. Master s Thesis Master s Program Public Administration Ivane Javakhishvili Tbilisi State University in Co-operation with German University of Administrative Sciences Speyer Supervisor: Prof. Dr. Thea Kasradze Module VIII (Budget Planning and Program 2015 2017 Management; Funding Public Expenditure) i Table of Content Table of Content ...............................................................................................ii List of Acronyms..............................................................................................iii I. Introduction ......................................................................................................... 1 II. BEPS and its impact ............................................................................................. 2 1. Base Erosion and Profit Shifting ........................................................ 2 2. Profit shifting behavior of MNEs .................................................... 11 III. Prevention of tax motivated debt financing..................................................... 26 1. Arm s Length principle ............................................................................... 26 2. Pricing of Intercompany loans .................................................................. 29 IV. Georgian Legal Framework and its Enforcement............................................. 37 1. Transfer Pricing rules and Anti-avoidance provisions.............................. 37 2. Administrative Challenges.......................................................................... 40 V. Conclusion ......................................................................................................... 42 Bibliography....................................................................................................................... 45 Annex 1.............................................................................................................................. 51 Annex 2.............................................................................................................................. 52 Annex 3.............................................................................................................................. 54 ii List of Acronyms BEPS - Base Erosion and Profit Shifting CFC - Controlled Foreign Corporation CPM - the cost plus method CUP - comparable uncontrolled price method EBIT - Earnings Before Interest & Tax EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization ETR - Effective Tax Rate EU - European Union FDI - Foreign Direct Investment GDP - Gross Domestic Product IMF - International Monetary Fund MNE - Multinational Entity OECD - Organization for Economic Co-operation and Development PSM - transactional profit split method R&D - Research and development RSM - the resale price method SPE - Special Purpose Entity TNMM - the transactional net margin method UNCTAD - United Nations Conference on Trade and Development UNDP - United Nations Development Programme iii I. Introduction In modern world government increases its role in many directions. Its fiscal policy became one of the enablers of economic activity and also source for securing provision of public goods, such as defense, general order and social welfare. To ensure fulfillment of those obligations main tool is public budget, overtime share of social spending has increased in Georgia, the biggest part of budgetary spending comes to health-care and relevant services. Georgian government is very active in financing startups and infrastructural projects, to promote economic activity and so, it reduces poverty in the country. In reaching this goal the importance of having steady tax revenues increased substantially. Georgia being open economy and its strategic location attracted many investors, subsequently integration of economy with other countries increased dramatically. Increased integration to global economy has definitely its benefits, but on the other hand it possesses some threats to fiscal stability, particularly tax base erosion. There is global concern about how MNEs use their structural and financial advantages to reduce its overall tax burden. For instance EU commission investigation on corporate tax compliance of Apple, Starbucks and Fiat.1 In case of Fiat s subsidiary in Luxembourg, which provided intercompany loans to affiliates, it paid 20 times less tax than it would pay, if prices would have been at market conditions.2 1 European Commission, Press release, State aid: Commission investigates transfer pricing arrangements on corporate taxation of Apple (Ireland) Starbucks (Netherlands) and Fiat Finance and Trade (Luxembourg), to be found on: http://europa.eu/rapid/press-release_IP-14-663_en.htm, researched at 20th of November 2017 at 15.23h. 2 European Commission, Press release, to be found on: http://europa.eu/rapid/press-release_IP-15-5880_en.htm, researched at 20th of November 2017 at 15.50h 1 Primary goal of this thesis is to assess current position of Georgia within international tax framework, what are determinants of its tax base erosion and possible impact of it. In that regard thesis aims to examine local and international practices preventing of those harmful arrangements. Scope of the thesis is profit shifting through intercompany loans and transfer pricing treatment of it. It seeks to identify current loop holes regarding the scope. Based on it, researching questions are as follows: • What are the main incentives for tax base erosion? • What is the impact of profit shifting through internal debt financing? • What is the most relevant method for pricing of intercompany loans? • What are legal and administrative deficiencies of Georgia regarding transfer pricing? Method of this thesis is critical analysis of current Georgian legislation and comparing it to international practices, besides of that it employs empirical data obtained from public sources and received from government bodies to estimate scale of issue or find indication of it. Thesis structure follows sequence of research questions and each question is discussed in following chapters. II. BEPS and its impact 1. Base Erosion and Profit Shifting Tax revenues comprise major part of budgetary revenues. In Georgia for 2016 fiscal year it amounted 90.8% of total budgetary 2 revenues and 10.9% out of it was Corporate Tax revenue.3 Thus corporate tax plays important role in public revenues. Fiscal Policy is one of the main policies to ensure delivery of public services and promote economic activity. It stays within sovereignty of the State and only interacts with other countries policies through bilateral tax treaties. Early in 20 th century it was recognized that the interaction of domestic tax systems can lead to overlaps in the exercise of taxing rights that can result in double taxation .4 Principles of international taxation dealing with double taxation were devised by the League of Nations in the 1920s, to address legal and economic impediments and consequently promote cross border transactions. These principles were efficient in avoiding double taxation, although as concrete findings suggest, it leads also to low or zero double-non taxation, which is not intention of these international standards. Reason of it is interaction between domestic tax rules of treaty parties, e.g. hybrid mismatches5 or interposition of the third country residents within treaty jurisdictions. Within domestic tax system coherence of tax policy to economic transactions is achieved through so called matching principle payment of one party is deductible and at the same time it is included in the recipient s income, or if income is exempted 3 Annex 1. OECD, Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris, 2013, p. 5, to be found on: http://www.keepeek.com/Digital-AssetManagement/oecd/taxation/addressing-base-erosion-and-profitshifting_9789264192744-en#.WnGXK66Wb4Y, researched at 20th of November 2017 at 17.24h. 5 OECD, Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues, OECD Publishing, Paris, 2012, p. 7, to be found on: http://www.oecd.org/ctp/exchange-of-taxinformation/HYBRIDS_ENG_Final_October2012.pdf, researched at 30th of November 2017 at 11.15h. 4 3 then there might be limitation of deduction for payer. In international level there is no such coherence, because tax policy is sovereign policy of a state and might significantly differ country by country. Tax systems are divided into two main concepts: worldwide and territorial. The first system taxes the residents on their local as well as worldwide income and non-residents local income. The second system taxes residents as well as non-residents on local income. It is general classic features of those two systems and not is established in pure form in none of majority of countries. Therefore, interaction between different tax systems makes overlap and leads to double taxation, which is solved by treaties, but also this interaction often makes gaps for tax evasion. Free movement of assets, particularly intellectual property and capital, from high-cost to low-cost locations (low labor and raw material costs), removal of trade barriers and disruptive development of information and communication technology has changed not only people s lives but also the way business is carried out, especially global business processes. Enterprises grow from local actors to Multinational organizations with centralized functions assigned to certain subsidiaries in different countries, for instance manufacturing base in low cost countries, distribution entities on country or regional scale and centralized treasury or R&D in financial hubs or tax havens. Such structures often exploit wide variety of treaty networks and legal arrangements to shift profits from high tax to low tax jurisdictions and consequently pay low or even zero tax on global scale. Those developments raised questions regarding effectiveness of current international taxation standards which were devised in 4 past century when such level of globalization, integration of economies and cross border activities weren t occurred as nowadays. In modern economy at stake on the one hand are raising tax revenues and on the other hand attract foreign investment, which is crucial for country s economic development. Thus governments are under pressure to establish competitively lower taxation to attract FDI. However it is recognized that a race to the bottom would ultimately drive applicable tax rates on certain mobile sources of income to zero for all countries, whether or not this was the tax policy a country wished to pursue .6 At the same time countries employ certain anti avoidance measures to fight against tax evasion, these include: Antiavoidance rules, e.g. in cases where is lack of economic substance of the transaction; Controlled foreign company rules, under which income derived by a non-resident controlled entity is attributed to, and taxed currently to the domestic shareholders, whether it is repatriated or not; Thin capitalization rules limiting interest deductions, e.g. the debt-to-equity ratio where of the debt is considered to be excessive; Anti-hybrid rules, which link the domestic tax treatment with the tax treatment in that foreign country, thus eliminating the possibility for mismatches; Anti-base erosion rules, which impose higher withholding taxes on, or deny the deductibility of, certain payments.7 Often anti-avoidance measures are set out in treaties to prevent unduly assignment of treaty benefits, e.g. conduit companies and making emphasize on economic substance of transaction rather than legal arrangement. 6 7 OECD, (Fn. 4), p. 28-29. OECD, (Fn. 4), p. 38 5 International Profit shifting raises several issues, first is tax revenues, as already mentioned corporate income tax plays important role in forming state budget. Within OECD countries it amounts, on average, 3% of GDP,8 approximately the same proportion is in case of Georgia, where since 2006 it has been the same 3% of GDP and 10.6 % of total budgetary revenues.9 Second issue relates to competition between local and multinational enterprises, i.e. big multinational enterprises (MNE), who exploit sophisticated legal tools to avoid taxes through complex cross country structures gain competitive advantage over local companies in terms of higher liquidity, which allows them to set lower competitive prices on goods or services and attract additional capital because of better financial indicators (less tax rises profit and thus certain investment indicator such as EBIT). The third issue derives from taxation fairness within jurisdiction; it harms voluntary compliance when other taxpayers see that MNEs can legally avoid tax, subsequently undermines whole taxation system of a country. By tax administrations and international bodies were observed different types of tax avoidance schemes from all over the world. MNE can reduce taxable income of high tax jurisdiction resident subsidiary, by granting loan, licensing for intellectual property utilization or management services provided by group entity located in low tax jurisdiction. Actually service provider might also be located in high statutory tax rate country, but reached low effective tax treatment by means of local taxation rules or treaty with subsidiaries country, for instance exemptions 8 9 OECD, (Fn. 4), p. 15. Annex 1. 6 on foreign income, low or zero withholding tax in source country, deduction right in source country for deemed interest on capital. Also different treatment of an entity organizational form in different, treaty party, countries make available to avoid taxes, e.g. service provider in its residence is treated as transparent entity (i.e. Entity is not treated as taxpayer; instead of it profit is taxed at entity members level) and non-transparent in income source country, thus source country levies zero tax on income and its resident subsidiary claims deduction against profits, while income receiver company does not pay tax in residence country because members of entity are non-residents and even residents of tax heaven jurisdiction. Tax avoidance can be reached by using hybrid instruments, for instance if in one country certain financial instrument is treated as capital contribution/equity and in other country it is debt and subsequently debt receiver can claim deduction against profit, thus reducing tax. There is also opportunity reducing tax by setting up of a conduit company in treaty partner country and providing service (debt) to another subsidiary through it. Consequently, subsidiary reduces tax claiming deduction on interest payments made to Conduit Company, at the same time there is low or zero withholding tax on payment because of treaty rules, subsequently Conduit Company will make deduction on corresponding payments to actual lender thus offset the income. Thus income will be effectively repatriated to actual lender located in low tax jurisdiction as a result of domestic exemptions on outbound payments in intermediary country or another treaty with low tax jurisdiction. Another way to avoid taxes is to shift gross profit using different trade strategies, using intermediary entities located in low 7 tax jurisdictions, by mispricing of goods and services provided through such arrangements, i.e. charging non arm s length prices. It relates to transfer pricing issue. According to arm s length principle the more extensive the functions/assets/risks of one party to the transaction, the greater its expected remuneration will be and vice versa .10 Therefore MNEs tend to shift those functions/assets/risks to low tax jurisdictions, particularly risks and ownership of intellectual property, which are easy to shift rather than functions. All above mentioned creates incentives to employ such arrangements and finance operating group companies through centralized treasury conduit companies by debt rather than equity and reduce taxes on global scale. 2012 G20 countries meeting11 called for relevant actions by member countries and relevant international organizations, particularly the OECD. In 2013 the OECD carried out a complex work to identify all issues regarding international tax evasion and developed comprehensive Base Erosion and Profit shifting Action Plan.12 It was acknowledged that unilateral measures would lead to chaos in international taxation and to double taxation; which subsequently will make impediments for cross border trade. Therefore, BEPS action plan formulated multilateral measures for developed as well as for non OECD developing countries for taking part in project. The BEPS project has several objectives in 10 OECD, (Fn. 4), p. 42. G20, G20 Leaders Declaration, Los Cabos, 2012, p. 9, to be found on: http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/131069. pdf, researched at 2nd of December 2017 at 10.26h. 12 OECD, Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris, 2013, to be found on: http://www.oecd.org/ctp/action-plan-on-baseerosion-and-profit-shifting-9789264202719-en.htm, researched at 2nd of December 2017 at 11.45h. 11 8 elimination of tax avoidance on global scale, it is: refining international taxation standards by making relevant changes into model tax convention and tax treaties to avoid abusive interpretation and emphasize economic substance of actual transaction as well as align its provisions to digital economy features; increasing of coherence of domestic tax rules on international level to avoid gaps and mismatches caused by their interaction; establish anti avoidance standards; setting up effective framework of the exchange of information regarding harmful tax practices and cross border tax risk issues; elaboration of relevant measures regarding transfer pricing, emphasizing real value creation and profit drivers rather than legal arrangement of transaction.13 The main actions which deal with base erosion matter through excessive debt financing are action 4 - Limit base erosion via interest deductions and other financial payments ,14 action 6 Prevent treaty abuse 15 and action 9 Risks and capital .16 These actions aim to establish international standards regarding limitation of interest deduction caused by excessive debt financing, also refine treaty framework to prevent abusive cross country legal arrangements and simultaneously develop transfer pricing guidelines17 to emphasize on economic substance/rationality of 13 OECD (Fn. 12). OECD (Fn. 12), p. 17. 15 OECD (Fn. 12), p. 19. 16 OECD (Fn. 12), p. 20. 17 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD Publishing, Paris, 2010, to be found on: http://www.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-formultinational-enterprises-and-tax-administrations-2010_tpg-2010-en, researched at 5th of December 2017 at 13.30h, OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD Publishing, Paris, 2017, to be found on: http://www.oecd14 9 transaction and give more clear guidance regarding application of guidelines. This study is focused on may be the most challenging and controversial part of Issue, Transfer Pricing, where legal measures interact with economic principles and particularly, finance. In 2017 OECD issued updated Transfer Pricing Guidelines, which are discussed in this study. From inception of BEPS project tremendous work was carried out by parties and specific goals have been already achieved. Under the EU Council s Anti-Tax Avoidance Directive (2016/1164/EU), all EU countries are required to introduce rules based on Action 4. Since then it was identified that BEPS poses significant threat to public financial revenues, revenue losses could be varied within 4% to 10% of global corporate income tax revenues, which amount 100 to 240 billion annually.18 According to surveys conducted by Big 4 accounting firms, it is seen that many MNEs have adapted their transfer pricing arrangements co be compliant with BEPS developments. Some of the MNE have even changed functional profile their subsidiaries and transferred more substantial functions regarding development, enhancement, maintenance, protection and exploitation of intangibles. Because The need to align tax and the business models is critical - tax authorities are already questioning and seeking to ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinationalenterprises-and-tax-administrations_20769717, researched at 5th of December 2017 at 13.35h. 18 OECD, Inclusive Framework on BEPS, Progress report July 2016-June 2017, OECD Publishing, Paris, 2016, p. 16, to be found on: https://www.oecd.org/tax/beps/inclusive-framework-on-BEPS-progress-reportjuly-2016-june-2017.pdf, researched at 5th of December 2017 at 16.12h. 10 understand the alignment as a starting point of inquiries, audits or from proactive discussions .19 All above mentioned emphasizes the need for revision of current international taxation framework and past bad experience should be reflected in future s standard. In this regard international cooperation and coherence of domestic tax rules to international principles play crucial role. For correct set up of relevant objectives and final success, the first step is to examine extent of problem and its features; it can be achieved through specific empirical as well as methodological data. 2. Profit shifting behavior of MNEs There has been carried out many surveys and empirical research about profit shifting. Some of them are based on Foreign Direct Investment data and specifically country positions in that regard; others employ data regarding Effective Tax Rates of MNEs on country by country context. From those studies we see some indications of aggressive tax planning but because of the fact that they use different methodologies and data is not sufficient, these studies only support already presumed conclusion rather than achieve independent conclusion on basis of research. The IMF Coordinated Direct Investment Survey (CDIS) shows that in 2010 from tax haven countries such as Barbados, the British Virgin Islands and Bermuda received and made more FDIs than Germany. In 2010 the British Virgin Islands (14%), after Hong Kong(45%), were the second largest investor in China, Mauritius made biggest investment in India (24%), Cyprus, the 19 OECD, (Fn. 18), p. 19. 11 British Virgin Islands, Bermuda and the Bahamas were top investors into Russia (combined 53% of total FDI).20 There is big issue regarding usage of certain developed countries jurisdictions for channel investment purpose, when there are established special purpose entities (SPE). These Entities don t have material presence in economy, a few employees and tangible assets, all assets comprises of investments into associated companies, in another countries. Their main purpose is to benefit from large network of tax treaties and domestic tax rules of that jurisdiction and make investments from other countries into third countries. In 2011 the Netherlands received 3 207 billion USD investments, through SPEs it amounted 2 625 billion. Outward investments from the Netherlands in the same year amounted 4 002 billion USD, 3 023 billion USD through SPEs. Similar picture is in case of Luxembourg 93% out of total inward FDI was made through SPEs and for outward investment 90%.21 According to the National Statistics Office of Georgia emerge similar observations. In 2007 the Netherlands was top investor in Georgia (14.9%), the British Virgin Islands (9.3%) Cyprus (7.4%) the third, and the fifth. After worldwide financial crisis 2008 and war between Russia and Georgia, the total FDI as well as economic activity decreased in country, only from 2011 we see recovery and in this year the Netherlands is still top investor with 21.6% out of total FDI. In subsequent years the Netherlands and Luxembourg are among top five investor countries in Georgia22 and in some 20 OECD, (Fn. 4), p. 17. OECD, (Fn. 4), p. 18. 22 Annex 2 21 12 years they are only surpassed by close neighbors of Georgia and its strategic partners Turkey and Azerbaijan. Studies based on Effective Tax Rate (ETR) of MNEs arrive at very different conclusions. There is distinction between statutory tax rate and effective tax rate. The first one is tax rate set up by national tax law of a country; the second is actual ratio of tax paid by enterprises to their pre-tax measure. As usual ETR is far below to statutory tax rate, because it implies variety provisions of domestic tax law, such as accelerated depreciation rule or exemption on certain types of income. Thus ETR is more reliable measure than statutory tax rate for BEPS risk assessment, but it is hard to evaluate main drivers of low ETR, whether it is aggressive tax planning or intended country policy to attract investments through favorable tax framework. Some studies using ETR find evidence for increased profit shifting behavior, citing on huge amount foreign retained earnings of US MNEs.23 Others on the contrary concludes that United States-based companies face an average ETR of 27.7% compared to an average ETR of 19.5% for foreign-based companies included in the analysis .24 Thus argues against existence of such behavior by MNEs. As regards to tax evasion in developing countries there is a few studies due to lack of statistical information, reliability and difficulties in methodology. 23 The Greenlining Institute, Tech Untaxed Tax Avoidance in Silicon Valley, and How America s Richest Company Pays a Lower Tax Rate than You Do, Berkeley, 2012, p. 6, to be found on: http://greenlining.org/wpcontent/uploads/2013/02/TechUntaxedReport.pdf, researched at 14th of December 2017 at 20.44h. 24 OECD, (Fn. 4), p. 62. 13 OECD also elaborated BEPS indicators and updated them since starting of project. According to these indicators in 2013, 45% of total income was accounted by highly profitable MNE affiliates in low-tax countries, on the other hand only 12% was reported by low-profit affiliates in high-tax jurisdictions. At the same time the average profit rate of affiliates in low-tax jurisdictions was 2.3 as high as groups average. Another BEPS indicator is debt concentration. MNEs use debt to reduce tax burden in high-tax countries. According to indicator there is more percentage of debt lent to high-tax country affiliates, 55% out of total interest payments was made by them and had on average 30% interest-to-income ratio. On the other hand low-tax country affiliates paid 7% of total payments and had on average 2% interest-to-income ratio.25 These figures show broad indication of BEPS issue and its significance on global scale. The main incentive of MNE is to reduce expenses for profit maximization, as far as tax is one of the most significant expenses for business, MNEs seek to reduce its tax burden. The main driver which tempts business to shift profit to low tax country and thus reduce overall tax expense, is the difference of effective tax rates between countries of residence26 and also level of sophistication of taxation rules against profit shifting, as well as capacity of national tax administrations to effectively enforce those law provisions and availability of interposition of third low tax country through treaty network. 25 OECD, (Fn. 18), p. 42-43. Bartelsman, Eric J., Beetsma, Roel M. W. J.: Why pay more? Corporate tax avoidance through transfer pricing in OECD countries, Tinbergen Institute Discussion Paper TI 2000-054/2, June 2000, to be found on: http://www.rrojasdatabank.info/wir2006/pricetransfer.pdf, researched at 10th of January 2017 at 09.37h. 26 14 Provided that most of MNE s parent entities are residents of developed countries (mainly OECD) and CIT is much higher than in other countries, indirect financing, through conduit entities in another country, of subsidiaries might be more cost effective rather than directly by ultimate parent entity, because it provides opportunity to shift tax burden to conduit low tax jurisdiction. Some jurisdictions typically are conduit entities, primarily due to tax laws, bank secrecy or corporate governance .27 Governments try to prevent such tax arbitrage by domestic rules on interest deductibility and withholding tax; however, those rules are not too much strict and allow some level of availability of indirect financing.28 It might have another reason, for governments attraction of foreign direct investment is also very important, therefore it might make tolerable such forms of indirect financing to some level. Research conducted in this field is based on various sources of data, some of them uses a micro-level dataset for German multinationals (MiDi) provided by the Bundesbank, to asses correlation of the debt-to-asset ratio of affiliates of German MNEs to tax rate change in host country29 or to tax differential within 27 Mintz, Jack: Conduit Entities: Implications of Indirect Tax-Efficient Financing Structures for Real Investment, International Tax and Public Finance, 2003, p. 4, to be found on: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.195.2884&rep=rep1&t ype=pdf, researched at 15th of January 2017 at 13.35h. 28 Mintz, Jack: (Fn. 27). 29 Mintz, Jack, Weichenrieder, Alfons J.: Taxation and the Financial Structure of German Outbound FDI," CESifo Working Paper Series, No. 1612, CESifo Munich, 2005, to be found on: https://www.cesifogroup.de/DocDL/cesifo1_wp1612.pdf, researched at 15th of January 2017 at 13.45h. 15 MNEs all country jurisdictions.30 It is also widely used AMADEUS database, which contain financial information of European companies, or ORBIS database similar to AMADEUS, but on worldwide scale, to estimate the impact of earning shocks of parent company over its subsidiaries both in high and low tax countries31 and profit shifting intensity according to economic and institutional development of country.32 By one study it was employed the meta-data sampled from the past from 25 empirical studies To evaluate the importance of intercompany financing as profit shifting channel comparing to other non-financial channels.33 It was established clear sensitivity of capital structure and leverage of high tax affiliates to local tax changes34 as well as to tax 30 Buttner, Thiess, Wamser, Georg: Intercompany Loans and Profit Shifting Evidence from Company-Level Data," CESifo Working Paper Series, No. 1959, CESifo Munich, 2007, to be found on: http://www.cesifogroup.de/DocDL/cesifo1_wp1959.pdf, researched at 15th of January 2017 at 13.55h. 31 Dharmapala, Dhammika, Riedel, Nadine: Earnings Shocks and Tax-Motivated Income Shifting: Evidence from European Multinationals, CESIFO Working Paper, No. 3791, CESifo Munich, April 2012, to be found on: http://www.cesifogroup.de/DocDL/cesifo1_wp3791.pdf, researched at 16th of January 2017 at 15.25h. 32 Wier, Ludvig, Torslov, Thomas, Johannesen, Niels: Are less developed countries more exposed to multinational tax avoidance?, United Nations University, WIDER Working Paper 2016/1, March 2016, to be found on: https://www.wider.unu.edu/sites/default/files/wp2016-10.pdf, researched at 16th of January 2017 at 12.15h. 33 Heckemeyer, Jost H., Overesch, Michael: Multinationals Profit Response to Tax Differentials: Effect Size and Shifting Channels . ZEW Working Paper 13045, Mannheim: ZEW, 2013, to be found on: http://ftp.zew.de/pub/zewdocs/dp/dp13045.pdf, researched at 16th of January 2017 at 13.45h. 34 Buttner, Thiess, Overesch, Michael, Schreiber, Ulrich, Wamser, Georg: Taxation and Capital Structure Choice - Evidence from a Panel of German Multinationals,"CESifo Working Paper Series, No. 1841, CESifo Munich, November 2006, to be found on: http://www.ifogeschaeftsklima.info/DocDL/cesifo1_wp1841.pdf, researched at 15th of January 2017 at 12.25h. 16 differential within countries if residence of affiliates.35 Particularly it was seen in case of wholly owned affiliates, because as it seems introduction of tax effective strategies within partly owned ones are more difficult to achieve, because of different interests of shareholders. Also it was observed that German multinational groups totally rely on intra-group financing rather than their peers in U.S., where tax rate change was more sensitive to external debt ratio.36 However because of high cost of adjusting the capital structure for means of profit shifting 37 and thus low effectiveness of such policy, MNEs would probably use other strategies for tax avoidance rather than inter-company loans. Furthermore as it seems capital structure depends on not only local tax rate, as well as to MNE worldwide structure and tax difference between jurisdictions where MNE operates. A 10 percent overall tax increase in one country is found to increase the leverage ratio in that country by 2.44 percent, while the leverage ratio in the other country decreases by 0.6 percent .38 It supposes that strong tax incentive in one jurisdiction affects on local firm capital structure as well as the leverage of other subsidiaries , because MNE seeks to rebalance its leverage strategy on global scale to maintain proper level of overall indebtedness. It also supposed influence of source level tax change rather than tax rate 35 Buttner, Thiess, Wamser, Georg: (Fn. 30). Mintz, Jack, Weichenrieder, Alfons J.: (Fn 29). 37 Buttner, Thiess, Wamser, Georg: (Fn. 30). p. 25. 38 Huizinga, Harry, Laeven, Luc, Nicodème, Gaëtan: Capital structure and international debt shifting, IMF Working Paper, No. WP/07/39, February 2007, p. 4, to be found on: https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Capital-Structureand-International-Debt-Shifting-20074, researched at 15th of January 2017 at 14.45h. 36 17 of multinational s ultimate parent country,39 because repatriation of income can be effectively deferred and thus avoided tax in ultimate parent residence country. At same time relevant capital adjustment costs and costs incurred because of deviation from optimal capital structure must be considered. According to one study firms with risk profile of above average are more involved in profit shifting activities rather than low risk firms and rely mostly on internal funding, whereas low risk firms rely more on external funding.40 This fact may be explained by two reasons, one is that for high risk firms to receive external funding is too expensive compared to internal, because internal related party lender has reduced information asymmetry and therefore can charge lower interest rate. Thus profit shifting might not be the determinant, but on the other hands MNE can misuse high risk profile of Subsidiary to charge higher interest rate, subsequently be formally compliant with transfer pricing, but simultaneously achieve profit shifting. There was also utilized different method and assesses the impact of earning shocks of parent company over its subsidiaries both in high and low tax countries. It was assumed that if MNE was engaged in profit shifting activity, it would shift its fraction of increased earnings to low tax affiliate in another country. Study finds the prove of such behavior as far as low tax affiliates income react significantly to the positive earning shocks of parent 39 Huizinga, Harry, Laeven, Luc, Nicodème, Gaëtan: (Fn. 38). Dischinger, Matthias, Glogowsky, Ulrich, Strobel, Marcus: Leverage, Corporate Taxes and Debt Shifting of Multinationals: The Impact of Firmspecific Risk, University of Munich, January 2010, to be found on: http://www.ecpol.econ.unimuenchen.de/downloads/publis/dischinger_publis/dischinger_2010_lev.pdf, researched at 17th of January 2017 at 18.15h. 40 18 company, moreover only their financial income shows positive effects, such as interest payments and not other operating income. At the same time parents debt-to-asset ratio reacts also positively.41 All above mentioned might be indication of intense profit shifting behavior and in case of outward profit shifting from parent jurisdiction to middle low tax country, debt motivated financing is widely used. For the purpose of assessment of outward profit shifting, in case of Germany, given the fact that Germany is high-tax country and shifting from subsidiary to parent in Germany is less expected, research focuses on inter-company loans between subsidiaries and calculates the spread from the lowest tax rate (statutory) within MNE subsidiaries. Study finds significant elasticity between change of differential and increase of internal loans, supporting profit shifting probability. However according to assessment the magnitude of tax effects is rather small, so that internal debt seems to be a rather unimportant vehicle for German rms in shifting pro ts ,42 because of existing strict CFC rules in Germany, which makes taxable the shifted profits in Germany whether is it repatriated or not, but in U.S where CFC rules are more flexible and MNEs can circumvent it, it is expected that U.S MNE might be engaged more in this type of profit shifting.43 For the purpose of establishing effective policy against profit shifting practices it is crucial to evaluate the importance of 41 Dharmapala, Dhammika, Riedel, Nadine: (Fn. 31). Buettner, Thiess, Wamser Georg: Internal Debt and Multinational Profit Shifting: Empirical Evidence from Firm-level Data , In: National Tax Journal, March 2013, p. 84, to be found on: https://www.ntanet.org/NTJ/66/1/ntjv66n01p63-95-internal-debt-multinational-profit.pdf, researched at 17th of January 2017 at 11.15h. 43 Buettner, Thiess, Wamser Georg: (Fn. 42). 42 19 intercompany financing as profit shifting channel from other nonfinancial channels such as transfer mispricing of goods and services, including licensing on R&D. Specifically conducted research compares the tax sensitivity of pre-tax profits, capturing shifting activity via both routes, with the tax sensitivity of earnings before interest and taxes (EBIT) which are only affected by nonfinancial shifting mechanisms .44 According to findings EBIT indicator has much more elasticity with tax variables than pre-tax profit, thus suggests more significance of non-financial profit shifting methods rather than tax motivated internal lending. There was a lack of studies regarding profit shifting in developing countries. Where tax revenues play crucial role in delivery of public services and raising prosperity through promotion of economic activities by public spending in infrastructure, prevent base erosion has substantial importance for developing countries. In recent years, development of statistical information and accessibility of data from developing countries provided opportunity to conduct comprehensive exploration in this direction. Inter-company loan to asset ratio of developing country residents affiliates is twice more sensitive to changes in the host country than in developed countries.45 Thus it showed that developing countries are more vulnerable to profit shifting. This might be explained by several causes, one is less sophisticated anti profit shifting rules in developing countries, for instance transfer 44 Heckemeyer, Jost H., Overesch, Michael: (Fn. 33), p. 3. Fuest, Clemens, Hebous, Sha k, Riedel, Nadine: International Profit Shifting and Multinational Firms in Developing Countries, International Growth Centre, January 2011, to be found on: https://www.theigc.org/wpcontent/uploads/2014/10/Fuest-Et-Al-2011-Working-Paper.pdf, researched at 17th of January 2017 at 10.35h. 45 20 pricing rules, thin-capitalization rules, or lack of its enforcement capacity by local tax administration. Also for profit shifting purposes more important is the tax differential within MNE rather than having affiliate in tax haven and shift profits through it.46 It might be explained by vide range of anti avoidance rules in different countries dealing exceptionally with tax haven, for instance in Georgia interest paid to resident of tax haven country is levied by 15% of withholding tax, which is equal to corporate income tax rate and thus makes no sense using tax haven channel investment solely for profit shifting. According to some studies revenue losses from profit shifting is higher for developed countries than for developing, but on the contrary in terms of tax to GDP it is much substantial for developing countries and might vary around 1.3% of GDP.47 At the same time tax incentives for profit shifting have much higher impact in developing countries and states that : a 10 percentage point decrease in foreign affiliates tax rates is found to decrease reported profits by 10 20 per cent 48 in Eastern Europe (including Georgia). Fuest, Clemens, Hebous, Sha k, Riedel, Nadine: (Fn. 45). Crivelli, Ernesto, de Mooij, Ruud, Keen, Michael: Base Erosion, Profit Shifting and Developing Countries . IMF Working Paper WP/15/118. Washington, DC: IMF, May 2015, to be found on: https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Base-ErosionProfit-Shifting-and-Developing-Countries-42973, researched at 17th of January 2017 at 13.25h. 48 Wier, Ludvig, Torslov, Thomas, Johannesen, Niels: Are less developed countries more exposed to multinational tax avoidance?, United Nations University, WIDER Working Paper 2016/1, March 2016, p. 3, to be found on: https://www.wider.unu.edu/sites/default/files/wp2016-10.pdf, researched at 16th of January 2017 at 12. 46 47 21 According to UNCTAD World Investment Report estimated annual tax losses are 100 billion for developing countries.49 The report does not cover all routes of profit shifting, only those, which are linked to FDI from offshore hubs and mostly but not solely implies those related to shifting through financing. In offshore hub are considered tax haven jurisdictions and also SPEs in developed countries like Netherlands and Luxembourg. According to simulation of report, there is correlation between the share of FDI from offshore hubs in total inward FDI and reported rate of return (taxable) generated by inward FDI. Particularly On average, across developing economies, every 10 percentage points of offshore investment is associated with a 1 percentage point lower rate of return .50 Provided numbers emphasizes significance of profit shifting for developing countries through internal financing structures. Subsequent research followed UNCTAD FDI driven approach, extended it by new and more comprehensive data from the IMF s Coordinated Direct Investment Survey (CDIS) and corporate tax rates for each country.51 As well as UNCTAD, it implies those profit shifting schemes which relate to internal debt. According to results in absolute terms developed country tax revenue losses are higher than developing ones, but in terms of 49 UNCTAD, World Investment Report, Geneva: United Nations, 2015, to be found on: http://unctad.org/en/PublicationsLibrary/wir2015_en.pdf, researched at 17th of January 2017 at 14.35h. 50 UNCTAD, (Fn. 49), p 200. 51 Janský, Petr, Palanský, Miroslav: Estimating the Scale of Corporate Profit Shifting: Tax Revenue Losses Related to Foreign Direct Investment, Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, 2017, to be found on: https://editorialexpress.com/cgibin/conference/download.cgi?db_name=EEAESEM2017&paper_id=1029, researched at 17th of January 2017 at 16.45h. 22 share of GDP, developing country losses are much more significant. For instance according to estimation annual loss for Georgia is 71.64 million US$ comparing to Germany France 1802.9 US$, 1335.72 US$ and UK 1684.24 US$ or Turkey 438.34 US$, at the same time relative to GDP Georgia s 71.64 million US$ amounts 5.12% of GDP comparing to above mentioned countries which amount 0.53%, 0.56%, 0.58% and 0.61% respectively. Georgia takes tenth position in top ten countries with highest tax losses relative to GDP, and among lower middle income countries it is the fourth after El Salvador, Honduras and Zambia. All above results are based on assumption that the higher share of offshore investment in total inward FDI the lower is rate of return on FDI,52 but the profitability is not only affected by profit shifting practices and depends also on other external economic events, such as increased competition by domestic firms or high import duties or downturn in product market. Therefore it cannot only be assigned to profit shifting, but on the other hand it indicates existence of such practices and significance for developing countries. EU Commission estimated EUR 19.3 billion tax losses for eight European countries in 2015.53 It assessed results of schemes based on leaked information of only one law firm Mossack Fonseca, revealed by Panama papers. For the all EU 28 countries estimation amounts almost EUR 237 billion. For U.S. according to recent research based on data from the Bureau of Economic 52 Janský, Petr, Palanský, Miroslav: (Fn. 51). European parliament, The Impact of Schemes revealed by the Panama Papers on the Economy and Finances of a Sample of Member States, Study for the PANA committee, 2017, to be found on: http://www.europarl.europa.eu/RegData/etudes/STUD/2017/572717/IPOL_STU( 2017)572717_EN.pdf, researched at 16th of January 2017 at 22.00h. 53 23 Analysis, estimated CIT revenue loses amount between $77 and $111 billion annually by 2012.54 To examine the data provided by the National Statistics Office of Georgia,55 research of this thesis employed some methodology used in UNCTAD and supplemented it by own classification, to group inward FDI by countries. Countries were grouped in following categories: A countries, which provide favorable rules for offshore investment, self-declared SPE ; B other SPE ; C - tax haven countries recognized by Georgian legislation as well as UNCTAD; D- tax haven countries recognized only by Georgian legislation; E - tax haven countries recognized only by UNCTAD (it was only Malta); F countries with whom Georgia has signed DTT before 2013, because provided data is from 2014; G countries with no DTT with Georgia before 2014. Then countries, which have less than USD 1 million combined FDI, were excluded. Then is estimated debt to equity ratio. In many cases it is seen negative equity flow; it might be, because of repatriation of equity in certain year, which where invested in subsidiaries in earlier years. Also there is many cases of negative flow of debt; it might be, because of payments of principal by subsidiaries to their parents, but in one case with Netherlands this negative debt flow is substantial (764.911 million USD), which as then was identified, is because of capitalization of loan interests into principal amount in 54 Clausing, Kimberly A.: THE EFFECT OF PROFIT SHIFTING ON THE CORPORATE TAX BASE IN THE UNITED STATES AND BEYOND, Department of Economics, Reed College, Portland, 2016, to be found on: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2685442, researched at 16th of January 2017 at 21.15h. 55 Annex 3. 24 2016.56 It was presumed that countries falling in groups A, B, E would have higher debt to equity ratio, where there is zero withholding tax on interest payment and those jurisdictions provide favorable taxation regimes for channel investment and even one of them is tax haven (but not recognized by Georgia), comparing to other groups C and D, tax havens recognized by Georgia, because there is 15% withholding tax (equal to CIT),57 and groups F and G, which have higher statutory tax rate than Georgia. Initial presumption was not proved, instead of it research shows significant amount of debt, the ratio above 20%, in majority of cases in any group of countries (37 out of 50). It may be indication of profit shifting through tax motivated debt, particularly in case of Netherlands (group A SPE) significant amount of accrued capitalization, because of, according to Georgian tax law interest accrued on foreign loan, is only deductible when it is paid or capitalized, at the same time it should be considered that according to new tax reform (so called Estonian model distribution tax)58 from 2017 deduction is not anymore relevant for tax purposes and based on these circumstances, in case where debt financing of subsidiaries were motivated by only tax matters, it would lose its relevance for future and might be used for reduction of CIT in 56 National Statistics office of Georgia, (2017 III , ) (Foreign Direct investments, 2017 III Quarter, preliminary), Tbilisi, 2017, p. 3, to be found on: http://www.geostat.ge/cms/site_images/_files/georgian/bop/FDI_2017Q3-GEOwith%20cover.pdf, researched at 20th of January 2017 at 15.55h. 57 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 134, Paragraph 11, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 58 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 97, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 25 2016. These implications are more valid if it is considered the absence of thin-capitalization rule and thus opportunity for MNE to exploit such techniques. As findings show Channel investment from tax havens and SPEs hubs is ordinary practice for both, developed and developing countries, which is consistent in Georgian case also. It is sometimes hard to evaluate the exact amount of issue, particularly in developing countries, but by development of publicly available data it can be reached to some extent and picture for Georgia, might not be so good. Therefore having relevant measures against this issue is necessary and one of them definitely is transfer pricing. III. Prevention of tax motivated debt financing 1. Arm s Length principle OECD member countries agreed on Arm s length principle as international standard for transfer pricing purposes, subsequently overtime other non-member countries appreciated this standard and incorporated in its legislation, including Georgia. Arm s length principle addresses issues regarding pricing of goods delivered or services rendered (controlled transaction) between associated entities. On an open market terms and conditions (such as prices, but not only) between independent enterprises are affected by external market forces and thus determined in accordance, in contrast between associated companies those terms and conditions might be determined by very nature of their relationship and other non-market considerations, such as tax matters. In this case market price would be distorted and so taxation of relevant entities. But it should be considered that prices might be distorted by another reasons rather 26 than tax matters, for instance because of imposed governmental measures about customs valuations or anti-dumping duties .59 At the same time it must not be expected that prices would be per see distorted, because of the mere fact of association. The Arm s length principle is embodied in Article 9 of the OECD model Tax convention and implies the approach of treating associated companies as separate entities as if they were independent entities .60 To assess whether pricing of transaction between associated parties are at Arm s length, the principle employs comparability analysis and seeks to identify whether the conditions of transaction deviates from the conditions between independent parties in comparable circumstances on an open market. Consequently, the approach eliminates tax considerations from economic decisions of related parties. There are several difficulties in applying of the principle. Associated enterprises may engage in such transaction which wouldn t do independent parties, since they face different economic circumstances because of very nature of their relationship and it might not be motivated by tax matters. In this case it might be difficult to find comparable independent transaction and to apply arm s length principle through comparability analysis. However the fact that comparable transaction may not be found, doesn t mean that terms and conditions between related parties are not at arm s length61 and key 59 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD Publishing, Paris, 2017, p 34, to be found on: http://www.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-formultinational-enterprises-and-tax-administrations_20769717, researched at 5th of December 2017 at 13.35h. 60 OECD, (Fn. 59), p. 35. 61 OECD, (Fn. 59), p. 37. 27 question here is to assess economic rationality of transaction.62 Other problem arises in obtaining the data suitable for comparability analysis; often such data is hard to obtain because of confidentiality concerns, lack of comparable transaction in certain geographical location or the lack of systematization of such information. Therefore it is developed some indirect methods and relevant adjustments to tackle such obstacles. Otherwise deviation from the arm s length principle is viewed to lead to double taxation63 and subsequently it will harm cross-border economic activity. As noted above the determination of arm s length conditions of controlled transaction is achieved through comparability analysis. In that regard crucial is to accurately identify all comparability factors which have material impact on transaction and on its price. Those factors are: the contractual terms; functions undertaken by the parties, including assets employed and risks borne within transaction; the characteristics of goods delivered or services rendered; broad economic and market circumstances, which materially affect parties and the value of transaction; and the business strategies pursued by parties, for instance market penetration and marketing strategies.64 Usually identifying contractual terms is the first step for delineation the transaction, but it might happen when all actual functions performed or risks be not formalized in contract, for instance when MNE sells goods to its limited risk distributor, which according to contract has only to sell products to third 62 OECD, (Fn. 59), p. 79. OECD, (Fn. 59), p. 38. 64 OECD, (Fn. 59), p. 45. 63 28 parties, but actually performs substantial marketing on local market; or when actual conduct substantially differs from terms of contract, in these cases all actual facts and circumstances must be considered in delineation of transaction rather than only contractual terms. All above comparability factors are considered to the extent how materially impacts each of them have on controlled transaction. In case of intercompany loans contractual terms are the starting point; second is characteristics of service i.e. amount of a loan, collateral, term and so forth; in the end the most important factor in which a functional profile and broad economic factors affecting borrower is reflected in credit rating of entity. After considering all above mentioned factors precise delineation of transaction is to be made and then has to be researched relevant transaction to make comparable independent comparability analysis (uncontrolled) and reaching conclusion about suitability of transaction with arm s length principle. If material differences occur within researched comparable, it must be considered possibility of making relevant adjustment to increase comparability65 or change transfer pricing method for which those difference has less importance, for instance switch method from CUP to TNMM. 2. Pricing of intercompany loans Transfer pricing principles of intra-group financing falls within broad concept of Intra-Group Services. The service might be provided by parent company or one of the members of MNE, 65 OECD, (Fn. 59), p. 46. 29 i.e. centralized provider of certain type of service within MNE, in case of lending it might be central treasury often located in favorable taxation jurisdiction for financial activities. According to guidelines for Intra-Group Services, there are two main aspects which must be considered, first it must be determined that service is actually provided, only after determination of the fact of transaction, second aspect is what should be the charge for services, considering arm s length principle.66 To identify that service has been provided, it depends on the assessment whether service provides benefit to receiver and enhances its commercial value. To be clear, whether an independent entity would agree to receive and pay for that activity to non-related enterprise in comparable circumstances or would perform it in-house for itself. If independent entity would not agree to pay for the activity, then the service cannot be considered to be provided, according to arm s length principle.67At the same time all relevant documentation must be provided to tax administration, which proves the fact of service provision, such as contract, invoices and so forth. In case of intercompany loans this requirement may be fulfilled by having in place all relevant documentation and proving the economic rationality of loan, i.e. purpose of loan, otherwise it might be considered as equity and accrued interest deduction will be rejected by tax administration. Also incidental benefits obtained by only mere fact of being part of MNE cannot be regarded as provision of service, for example there is no service when company has higher credit rating only because 66 67 OECD, (Fn. 59), p. 320. OECD, (Fn. 59), p. 320-321. 30 of its affiliation and no guarantee fees paid to Parent should be recognized.68 But in that regard it must be made distinction of implicit support, which was discussed above and explicit support, where MNE parent or other member provides legal instrument to lender and thus increases credit rating of borrower, on later case the service provision is recognized, but for credit rating with above implicit support.69 If the fact of provision of service is determined, second step is assessment of price for service i.e. interest rate for loan at arm s length. For this purpose OECD guidelines formulate five methods: Traditional Transaction Methods comparable uncontrolled price method (CUP), the resale price method (RSM), the cost plus method (CPM); and Transactional Profit Methods the transactional net margin method (TNMM), the transactional profit split method (PSM).70 The CUP method it is compared price of controlled transaction with price of uncontrolled transaction, i.e. interest rate on intercompany loan is compared with interest rate on loan between independent parties. If prices differ, it can be indication that association of parties had effect on transaction and price must be adjusted to arm s length price. In application of CUP, highest comparability requirements must be met, as minor differences between controlled and uncontrolled transactions might affect prices substantially and thus distort comparison. Application of CUP is very rare of its nature of strict requirements and lack of reliable comparables, however in case of intercompany loans CUP 68 OECD, (Fn. 59), p. 324. OECD, (Fn. 59), p. 93. 70 OECD, (Fn. 59), p. 97. 69 31 can be widely used, because of systematized data is available, for instance on Bloomberg Terminal, and also reliable adjustments between comparables can be achieved. The RSM and the CPM methods employ gross profit margins for determination of arm s length price, these methods in general are similar, and difference is that RSM is used for marketing and distribution activities,71 comparing controlled transaction provider resellers margin to uncontrolled ones; and CPM for manufacturing, comparing gross margin calculated on direct and indirect production costs with uncontrolled transaction s same margin.72 Rationales behind these methods are that for similar functions performed by different providers similar remuneration is expected, expressed in similar gross margin, therefore for these methods functional comparability has much significance and minor differences in product is bearable. It has to be noted that these methods are used to service provider with little functional profile, for instance limited risk distributor, agent/commissionaire (RSM) or toll/contract manufacturer (CPM), otherwise when entity conducts variety of different functions gross margin can t be comparable, e.g. manufacturing and distribution with marketing or contribution in making of intangible property (R&D), in these case TNMM or PSM has to be used. Weakness of RSM and CPM is also that difference in accounting practices and in treatment of direct and operating costs makes comparability not reliable, thus these method are very rarely used and most it is, when internal comparables are available, i.e. when associated entity supplies the 71 72 OECD, (Fn. 59), p. 106. OECD, (Fn. 59), p. 111. 32 same product or provides the same service simultaneously to associated company and third party. The TNMM employs net profit indicator, e.g. return of sales, return on assets. TNMM might be most widely used method because transactional differences have less impact on net profit than on gross margin or on price and some degree of difference in function is more tolerable, from comparability perspective. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but still broadly similar levels of net operating profit indicators .73 Also when using external comparables and particularly regional comparables from different countries, differences in accounting practices across countries and the lack clarity of provided financial information in databases, makes net profit indicator more reliable, for instance Earnings before Interest (EBIT) or EBITDA. For the selection purpose of profit indicator must be considered functional profile of company, i.e. return on sales for distributor or return on assets for manufacturer,74 in particular it should reflect the allocation of risks between the parties . 75 When it comes to such an activity as conduct of R&D and contribution in making of intangible property, TNMM only cannot be used, and it is required PSM method. Previous methods are so called one-sided methods, because they examine only indicator of one side of controlled transaction, i.e. tested party. Tested party should be the party for whom chosen 73 OECD, (Fn. 59), p. 119. OECD, (Fn. 59), p. 123. 75 OECD, (Fn. 59), p. 125. 74 33 method can be applied in most accurate manner and to be found most reliable comparables.76 Usually it is considered to be party, who performs less complex functions within transaction than counterparty, because with limited variety of function, e.g. contract manufacturer or limited risk distributor, establishment of higher degree of comparability is assumed. On the contrary where parties of transaction contribute in value creation rather than just conduct routine functions, for instance one is involved in development of intellectual property (R&D) and other (or others) conduct strategic marketing for development of product brand, or all parties are involved to some degree in conduct of those functions, two sided method is required for pricing such activities, i.e. PSM method. The PSM this method is two sided method, it assesses contribution and relevant expected remuneration of all parties. Under the transactional profit split method, the combined profits are to be split between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm s length .77 Basis for division of combined profit might be total expenses on such activities and profit can be split relative to share in total costs.78 There is also second approach, where the first step is to remunerate parties for their routine functions using one sided method and then use PSM for residual profit. 79 However there are difficulties in using this method, it requires much information about current and historical costs/activities, in many 76 OECD, (Fn. 59), p. 153. OECD, (Fn. 59), p. 135. 78 OECD, (Fn. 59), p. 136-137. 79 OECD, (Fn. 59), p. 137-138. 77 34 cases tax administration might not obtain such information, moreover it might not obtain information about combined revenue, because of the fact that transaction involve at list one foreign party and its financial information may not be accessible. This method requires also very specific knowledge about variety of economic factors which affect parties, thus utilization of this method is difficult. For the selection of an appropriate method must be considered several factors: the nature of controlled transaction determined based on functional analysis of transaction and involved parties, available data on comparables, the degree of comparability and the reliability of relevant adjustments. 80 According to guidelines the first group method is preferable to the second group method; moreover if all requirements of guidelines are met for reliable application of CUP, this method is the most preferred method, because it assumes highest degree of comparability between controlled and uncontrolled transactions,81 thus ensures preciseness of estimation of transaction. There is no requirement of application of more than one method, but second can be applied as supportive evidence of reached conclusions through the first method,82 e.g. CUP and TNMM, and again relevant comparability requirements for both methods must be met. Besides mentioned five methods MNE is allowed to apply another method, but in this case the arguments must be provided why OECD method is less appropriate and why the chosen another 80 OECD, (Fn. 59), p. 97. OECD, (Fn. 59), p. 98. 82 OECD, (Fn. 59), p. 100. 81 35 method is more consistent with arm s length principle, considering the nature of transaction.83 Since RSM and CPM are suitable to certain types of commercial activities, other than intercompany loans, whereas TNMM focuses on almost whole scale of activity of entity, considering different type of commercial functions and PSM is employed in very complex and integrated cases, based on all rules and assumptions, CUP method seems to be more straight-forward and most precise method for estimation of interest rate on loan. Providing that rationality of a loan is proved, next step is pricing of interest rate on intercompany loans. For the purpose of delineation of transaction and relevant comparability analysis following factors should be considered: contractual terms of the loan, such as the date of issuance of the loan, maturity, amount, currency, type of interest (fixed or floating), payment schedule, seniority or subordination, collateral, embedded options; creditworthiness of borrower; guarantee provided by the third party.84 In conclusion for the purpose of limiting of profit shifting through intercompany loans exist two broad policies first is thin capitalization rules, which addresses limiting principal amount of loan on which accrued interest is allowed for deduction, and second is transfer pricing of loans, limiting interest rate. Both policies supplement each other in preventing base erosion and are 83 OECD, (Fn. 59), p. 99. Bakker, Anuschka J.: Transfer Pricing and Intra-Group Financing:LowHanging Fruit? In: DERIVATIVES & FINANCIAL INSTRUMENTS, IBFD, March/April 2013, p. 28, to be found on: https://www.ibfd.org/IBFDProducts/Journal-Articles/Derivatives-and-FinancialInstruments/collections/dfi/html/dfi_2013_02_int_2.html, researched at 6th of January 2017 at 10.05h. 84 36 viewed as effective tool for this purpose, but only in combination, because if one policy is missing MNE have opportunity exploit it, for instance if transfer pricing is not introduced, MNE can speculate on interest rates and if thin-capitalization is not effective, profit shifting may be simple achieved by increasing debt ratio in total funding of affiliates. IV. Georgian Legal Framework and its Enforcement 1. Transfer Pricing rules and Anti-avoidance provisions Transfer pricing rules in Georgia has been incorporated since 2011, when new tax code went into force85. These rules formulates legal basis for Transfer pricing, such as terms for determination of the association between local and foreign entities,86 they slightly differ from provisions defining association between domestic entities87 and set higher threshold of association than in later one; it sets so-called market principle, comparability terms,88 and methods for assessment of transaction between associated entities, which are generally consistent with above mentioned principles and provisions of OECD Guidelines. That legal provision does not 85 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 126-129, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 86 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 126, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 87 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 19, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 88 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 127, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 37 contradict with OECD Guidelines; moreover according to the decree of the Minister of Finance89 OECD guidelines are applicable in line with local legal provisions, however there is one issue since issuance of new OECD guidelines in 2017, which are more refined and concretized version of earlier one, issued in 2010. Subsequently if new guidelines contradict to earlier version, in Georgia provisions of earlier guidelines are applicable. More concrete and also procedural provisions are introduced by the decree of the Minister of Finance.90 Besides this, transaction between Georgian entity and resident of favorable tax jurisdiction, falls within Transfer Pricing provisions and its terms and conditions has to be consistent with arm s length principle, whether they are actually affiliates or not. The list of favorable tax countries is defined by the Ordinance of the Government of Georgia91 and mainly reiterates OECD classification of tax havens. This regulation might be one of the anti-avoidance regulations, which seeks to prevent profit shifting of income into tax haven. Second anti-avoidance regulation with same goal is withholding tax of 15% on payment to tax haven 89 Decree #423 of the Finance Minister, 2013, (On the Approval of the Instructions on International Transfer Pricing), Tbilisi 18 of December 2013, Article 1, Paragraph 3, to be found on: https://matsne.gov.ge/ka/document/view/2078069, researched at 22h of January 2017 at 16.25h. 90 Decree #423 of the Finance Minister: (Fn 89). 91 Ordinance of the Government of Georgia 615, (On the determination of the list of favourable taxation countries), Tbilisi 29 of December 2016, to be found on: https://matsne.gov.ge/ka/document/view/3523434#DOCUMENT:1;. researched at 23h of January 2017 at 12.25h. 38 resident,92 and it is equal to corporate income tax in Georgia, thus it makes no sense for shifting profit into tax haven which will be taxed on source at same tax rate as corporate income tax. There is no statutory requirement for transfer pricing documentation; it can be only requested in case of ongoing tax audit and its provisions are too general.93 There is also no requirement in corporate tax returns for disclosure of transaction between associated parties. Such deficiencies might harm both sides, tax payer, as well tax administration. For tax payer not knowing concrete documentation requirements might lead to confusion and lack of tax compliance, where for tax administration it might lead to misunderstanding and in result in incorrect assessment of transaction. Also such kind of deficiencies may hinder for effective tax enforcement, in terms of low quality of risk assessment and subsequently dedication resources to less risky transactions. All of discussed problem will probably harm effective tax enforcement of transfer pricing legislation and legal certainty for investors. Georgian tax legal framework lacks also one important component, which plays crucial role in prevention profit shifting through inter-company financing; it is absence of thin capitalization rule. Thin-capitalization rules limit taxpayers intercompany debt ratio and principal amount provided by related entity to Georgian resident. Thin-capitalization rule existed in tax 92 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 134, Paragraph 11, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 93 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 129, Paragraph 1, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 39 code but was never actually effective, because it was being delayed every year and finally abolished in 2016.94 Without such regulation and only being rely on transfer pricing, might be risky, because MNE can change leverage of subsidiary increasing debt to equity ratio and effectively shift profits to abroad, being in compliance with transfer pricing regulations, which mainly addresses interest rate and not the principal amount. 2. Administrative Challenges Transfer pricing is relatively new subject for Georgian tax authorities, in spite of being made relevant provisions introduced in 2011 in new tax code, only in 2015 was established transfer pricing division.95 Since then some success has been achieved, but it seems there are some obstacles for effective transfer pricing enforcement. These challenges are follows:96 • Lack of personal and qualification capacity, • Absence of specific documentation statutory requirements, • Gaps in transfer pricing risk assessment, • Low degree of awareness from tax payers and disputes in results, • Lack of publicly available financial information of private companies, • Low amount of comparable transactions. 94 (the tax code of Georgia), No. 3591, Tbilisi 17/09/2010, Article 123, to be found on: https://matsne.gov.ge/ka/document/view/1043717, researched at 22h of January 2017 at 10.10h. 95 Interview with the Head of Transfer pricing division at Revenue Service Mr. Avtandil Svanadze, Interview about administrative challenges in Transfer pricing, Tbilisi, 14 of January 2018. 96 Interview, (Fn. 95). 40 To above mentioned challenges may face every developing country s tax administration, but it can be overcome, for instance to tackle capacity constrains, the OECD and UNDP common project Tax Inspectors without Borders97 might be suitable solution. The project deploys retired tax officials from developing countries share their experience and take part in on going tax audit.98 Another solution is strengthening cooperation with foreign tax administrations99 on international tax matters, such as share of information about members of MNE. To deal with the absence of specific documentation statutory requirements, OECD developed certain guidance about this issue and included in new updated guidelines. Specifically it develops a three-tiered approach consisting of (i) a master file containing standardized information relevant for all MNE group members; (ii) a local file referring specifically to material transactions of the local taxpayer; and (iii) a Country-by-Country Report containing certain information relating to the global allocation of the MNE s income and taxes paid together with certain indicators of the location of economic activity within the MNE group . 100 This documentation provide understanding to taxpayer specifically what kind of information may be required by tax authorities, make common understanding between them about issue and 97 The Platform for Collaboration on Tax, Enhancing the Effectiveness of External Support in Building Tax Capacity, July 2016, p. 14, to be found on: http://www.oecd.org/ctp/enhancing-the-effectiveness-of-external-support-inbuilding-tax-capacity-in-developing-countries.pdf, researched at 8th of January 2017 at 15.23h. 98 OECD/UNDP, Tax Inspectors without Borders annual report 2016-2017, Paris, 2017, p. 10, to be found on: http://www.tiwb.org/resources/publications/taxinspectors-without-borders-annual-report-2016-2017-WEB.pdf, researched at 10th of January 2017 at 21.34h. 99 The Platform for Collaboration on Tax: (Fn. 97), p. 38. 100 OECD, (Fn. 59), p. 233. 41 avoids to certain level undesirable disputes. It also provides opportunities for tax administration to build its tax risk assessment framework through integrating this information it assessment system. Low amount of comparable transactions in small economic such as Georgia is objective fact and it might not be resolved by tax authorities. However, it can be overcome by using comparables on regional level, for instance there is databases provided by Bureau van Dijk, contain public financial information of European companies (AMADEUS) or on worldwide scale (ORBIS), also specifically for financial transactions there are two main databases Bloomberg terminal and Loan connector. But when using such databases, must be considered reliability of information and relevant adjustments to increase comparability, which lies in the core of arm s length principle, because on comparables from different countries influence variety of macroeconomic factors and this should be considered. V. Conclusion To summarize, the lack of international tax standards, which were devised in past century and obviously could not catch up developments of modern economy; also interaction of sovereign domestic tax rules between countries and lack of coherence; at the same time countries unilateral measures of favorable taxation for attraction FDI made opportunities and incentivized MNEs to use loopholes in international taxation, for reduction overall global tax burden by segregation actual economic activities from places where its income is reported, mainly shifting from high to low tax countries. 42 Existence of problem was observed by many tax authorities and scientists. Variety of studies, often basing on previous experience, employs different methodologies and overtime has delineated different features of such practice from MNEs. Some of them reach contradictive results, but in general the majority supports presumed profit shifting behavior through intercompany loans. It seems that on such behavior affects not only host country taxation, as well as they are in correlation to other jurisdictions changes, where MNE operates and it is constant process. As it was observed aggressiveness of tax planning increase by degree of sole ownership in affiliate, which reflects that different shareholders might have different views other than tax avoidance, therefore achieving consensus on illegal action becomes hard, which indirectly proves such consideration of profit shifting; also level of sophistication of local laws and its enforcement capacity are substantial factors. One important feature is that profit shifting strategies are used interchangeably and in combination, considering relevant adjustments costs and opportunities costs derived by deviation from rational economic arrangements. Consequently it harms all countries and maybe nobody, besides MNEs shareholders, benefit from it. Harmful effect is not only confined in decreasing of tax revenues, it also harms competition between MNE and domestic companies, as well as undermines whole taxation system of a country, by denouncing the core principle, voluntary compliance, from the point of view of local players, such as local small and medium enterprises. It also must be noted that because of different legal rules in different countries, there is very thin frontier between the two terms tax avoidance and tax evasion , where the former one is reduction 43 of tax burden by legally allowed loopholes, the later one is illegal action. It happens because of variety of reasons, for instance intention of government to attract FDI or lack of sophistication of anti-avoidance rules, certain action is legal while in elsewhere it is prohibited and is treated as tax evasion. There are definite measures against tax base erosion; they have become more comprehensive, varying from international cooperation of tax authorities to coherent domestic rules, such as transfer pricing and thin-capitalization. Study intended to examine maybe most complicated one of those two, whose principles goes far beyond just ordinary law and interact with finance, it is transfer pricing. It reached conclusion about relevant factors and methods for pricing intercompany loans. However it is realized that having just one arm to Defeat Dragon is not enough and another tool, thin-capitalization rules or its more refined version, is essential. In case of Georgia it is proved by small empirical review and other foreign studies. Unfortunately numbers are no so good, by one estimation total revenue loss, mainly because of tax motivated debt financing, is significant relative to total annual CIT. 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