These methods could actually apply to any reasonably large corporation and in some cases much smaller companies as well, but I'm going to use Starbucks as an example to keep things simple in this case.
Introduction:
1. Tax Avoidance Vs Tax Evasion
Tax avoidance is legal. Tax Evasion is illegal. This is not a point directly linked to Starbucks, but it's essential to understand that Starbucks were not doing anything wrong in a legal sense (they may have been in a moral sense, but that's not my prerogative to discuss).
Tax avoidance is the process of reducing one's tax bill by utilising multiple tax jurisdictions, holding companies within these jurisdictions and multiple other inter-company transaction based techniques. Generally speaking, avoiding tax is the process of looking at the rulebook and asking "What can we get away with looking at these rules?" and "What loopholes may exist within these rules that we can utilise?".
Tax evasion on the other hand is the illegal process by which a company or individual reduces their tax bill by utilising illegal methods. These methods could involve having a cash-in-hand business (if you're an individual), where you don't declare your real income to your tax authority, or by utilising foreign bank accounts (if you're a company) for investments based in other countries, so you can avoid paying high capital gains tax rates on the disposal of assets, etc.
2. Holding Companies:
A holding company is a company that's only purpose is to own stock in other companies and by this form a corporate group. Under normal circumstances they will not create goods or services itself and are usually formed in various tax haven authorities in order to utilise varying rules and legislation which help to reduce a company's tax exposure.
3. Profit and Loss:
For tax purposes profits must be low. For shareholders profits must be high.
Profit = Sales Revenue - Costs.
This is a very important point to understand, because when all of this kicked off about Starbucks there were a few journalists at the time who were mistakenly saying that tax was paid on sales, when it is intact paid on profits.
This is a pretty obvious idea to many, but just in case some of you have missed this idea, tax is paid on the profits that a company makes. In order to reduce your tax bill you want your profit to be made (in technical accounting terms) in jurisdictions that have the lowest levels of tax, but as investors we are looking for good strong profits. Although this initially sounds counterintuitive, a company isn't going to become unprofitable just to avoid paying tax. Instead, they move their profits into low tax regions and their losses into the higher tax regions. This way shareholder value is retained with high profits after tax (which dividends are paid from) and the company also benefits by paying overall less tax.
4. Types of Tax:
The first point to make here is that we are discussing the ways in which Starbucks may avoid paying corporation tax - a tax on companies. We're not discussing how it may avoid paying tax in all senses. So, for example, in the UK Starbucks employs around five-thousand people and will pay national instance contributions for those employees and business rates, etc.
5. Where Tax is paid:
This is another very simple point, but UK corporation tax (the tax that Starbucks were paying very little of) is obviously paid in the UK. Therefore, Inland Revenue don't care about tax they may be avoiding elsewhere in the Starbucks global empire, but just tax that should be paid in the UK. Now, because I live in the UK I am going to discuss how the UK corporation tax bill was reduced by tax avoidance techniques and not about how Starbuck may be avoiding tax elsewhere in the world.
6. Tax Negotiations:
It's worth noting that any tax for companies is more of a negotiation than a checklist filled out between Inland Revenue and the company in question. Often there will be teams of expensive tax lawyers negotiating between the two parties and the governing tax authorities reserve the right to call the company on certain points of their tax strategy.
The Methods:
There are three main methods that you could use (they're not necessarily methods that all large corporations will use).
1. Increasing Costs:
As we know from point three of the introduction, Profit = Sales Revenue - Costs. Now, lying about how much sales revenue you're making would be tax evasion and it would also be very easy to check, making it not a great idea for companies who want to legally avoid tax.
On the other hand, bringing up your costs so that they effectively wipe out profits within the jurisdictions with the highest tax rates is a way forwards - Inland Revenue won't make you pay loads of tax in the UK if you don't make loads of profits in the UK.
Now, really we need a diagram here, but instead you need to imagine the following set up:
Debt
USA----------------------------------------------->UK
<----------------------------------------------
Interest
This method works on the basis that head office of Starbucks (which we'll put in the USA for this example) funds the UK operation. So debt is effectively transferred to the UK from the Starbucks head quarters in the USA and then the UK branch of Starbucks pays interest to the head quarters in the USA.
Now, what's great about this method is that interest paid within a company group is set by the company group's worldwide finance director, who probably lives in the USA near the Starbucks head quarters. This means that the interest rate can be set at a level that begins to absorb some of the profits that the UK operation maybe making and thus reducing their corporation tax bill in the UK.
There are issues with this method however:
One issue is that you can't say set and interest rate within the company group of fifty or one-hundred percent. In other words, Inland Revue are not daft enough to believe and accept that you would have an utterly uncommercial business and reserve the right to call you up on it (in the open market no one pays fifty percent on a loan).
Also, the interest income would still have to be paid in the USA, where the Starbucks head quarters reside (in this example), so while you can use this method to decrease your tax bill in one jurisdiction (the UK) you still have to pay the tax elsewhere, even if it may possibly be at a lower rate.
2. Franchising Costs:
This is the idea that the Starbucks brand has value and that in order to set up a Starbucks franchise I need to sign a licensing agreement. I can't turn my house into Morley's Micro Starbucks for example.
Again for this we will need a little diagram:
6% of Sales
UK-------------------------------------------------->Holland
<----------------------------------------- Licensing Office
Brand
This works on the basis that you charge the UK operations to be able to make and use the Starbucks brand and it works by having your licensing office in a very low tax jurisdiction (Holland for example). This means in the example above the six percent of the total UK sales for Starbucks would be sent to Holland and paid as tax there (where the tax rates are a lot lower than in the UK), but more than this, it also incurs a cost to the UK operation and can reduce the UK profits of Starbucks, thus reducing their UK corporation tax bill.
This has become a very popular method for companies that have very highly valued, unique intangible assets, as it allows a lot of potential for very high rate licensing payments to reduce taxable profits substantially.
Again, as with method number one this can't be set at an astronomical rate. Starbucks would have to negotiate with the UK authorities for a number they could get away with and in order to do this they would discuss brand value, unique value they may have, etc.
3. Past Losses:
This is the idea that you can net past costs against current profits. This simply works on the exact same basis that capital gains tax does in the UK.
So, for example, I have a business and it makes a fifty million pound loss in the first year, but then it makes a fifty million pound profit in the second year. Those two figures can be netted against each other so that for the second year in which I made that fifty million pound profit I don't have to pay any tax.
50 million - 50 million = 0
This method is handy to begin with for many companies, but it begins to become redundant once the business beings to become substantially profitable. In order for it to be of use, the business has to incur a huge operating loss to fully offset income.
To sum things up, we can see a few methods that companies may chose to use to avoid corporation tax in the UK. The methods can often be used to avoid tax in other jurisdictions as well and often companies will employ a wide variety of these techniques in order to reduce their total tax bill across their global empire.
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