How Laws Meant to Close Tax Loopholes May Open Them Even Wider

Thanks to a change in Irish law, Google in the U.S. will do something it hasn’t in years: own outright its intellectual property, including patents, trademarks, branding, and more.

For years, Google and other companies employed a legal tax avoidance strategy called the Double Irish, Dutch sandwich. Here’s how it works: Using complex multi-national structures, they transferred ownership of intellectual property to wholly owned subsidiaries in low- or no-tax regions and then licensed the material back to the rest of the company. Profits turned into “license fees” and thus avoided taxes.

One of the Irish laws that made the tactic possible expired on Jan. 1, 2020 due to international pressure from many countries—the U.S., France, the U.K., and Spain, for example—that were tired of losing tax revenue to low-tax Ireland, among other havens.

Some of the pressure came through political organizations as well like the EU and Organisation for Economic Co-operation and Development (OECD). Other efforts have been unilateral.

France went the furthest, introducing a digital tax last year, a “stick” that targeted the likes of Google parent Alphabet, Facebook, and Uber to pay up. On the “carrot side” side of things, Congress in the U.S. used the 2017 tax overhaul to create incentives for companies to repatriate overseas profits and expand U.S. operations, including job creation and investment in equipment and facilities.

However, corporate ingenuity and the law of unintended consequences blunted—sometimes completely—many of these attempts.

Best laid plans

It all comes down to, of course, money.

“Back in the 90s, the U.S. was much more cavalier about letting U.S. companies move their intellectual property offshore,” says Jay Darby, a tax partner at Sullivan & Worcester. But once American companies found that “intellectual property and money are interchangeable,” they found ways to license their own property and legally shift profits.

Companies in other countries took notice, and the race was on.

“Companies will always engage in aggressive tax strategy,” says Maureen Monaghan, a partner in the international tax practice of law firm Fox Rothschild. “They have to because if they don’t do it, their competitors are going to do it [and gain an advantage from lower costs]. And they’re run by people, and all people like to reduce their taxes.”

Such countries as Ireland, the Netherlands, and Luxembourg enabled the shifts and made money from fees and increased economic activity from all the accounting and tax work that came their way. “It was a numbers game,” says Jason Gerlis, global head of consultancy solutions for TMF Group—Americas. Those countries made their income on volume.

Eventually, elected officials on the other end of the loophole, facing challenging economic times and a dwindling tax base, began to challenge the tax dodges popping up around them in the hopes of bringing the revenue back to their countries. To remedy the situation, they needed revised laws across all countries. Soon enough, the European Commission, the OECD, and the U.S. all began to apply pressure.

“The 39 members of the [OECD] are treaty-bound to … enact the given regulatory reform,” says L. Burke Files, president of risk management firm Financial Examinations & Evaluations. Similarly, EU members must implement their own versions of European Commission decisions.

Results began to take hold around 2014. “Ireland has been an enthusiastic participant in the OECD process,” says James Farrell, head of strategic policy at IDA Ireland, a government agency that courts foreign investment. That process goes by another ancronym—BEPS, or base erosion and profit shifting. “Changes were made to Ireland’s corporate tax residence rules to…shut down known structures, such as the so-called ‘Double Irish,’ which were designed to exploit gaps in U.S. anti-avoidance rules.”

The Netherlands also reformed its rules in the face of European Commission pressure, as the TMF Group’s Gerlis notes in slightly less delicate phrasing.

“The Dutch effectively changed their legislation because they didn’t believe they could any longer get away with it,” Gerlis says.

So what happened?

The end of the sandwich

Less than a month since the end of its Double Irish, Dutch sandwich strategy, it’s unclear exactly what Alphabet’s tax strategy will be. A statement sent by the company to Fortune read: “In line with the OECD’s BEPS conclusions and changes to US and Irish tax laws, we’re now simplifying our corporate structure and will license our IP from the US, not Bermuda.” The company said over the last ten years, its “global effective tax rate has been over 23%, with more than 80% of that tax due in the US.”

But that statement has some misdirection, perhaps inadvertent, built in. Alphabet is weighting its calculation largely to before the tax changes, which dropped statutory rates from 35% to 21% and required the company to pay a $7 billion one-time transition tax.

Finding a replacement for the sandwich, as many other companies have already done, will be critical. As the company has explained in every 2019 quarterly earnings statement so far available, one of the primary reasons its effective tax rate remains below statutory levels in the U.S. is “foreign earnings taxed at lower rates.”

Apple began a transition to a new tax strategy several years ago, as revealed in the notorious Paradise Papers. The company shifted one of its subsidiaries to the Channel Island of Jersey, 12 miles off the coast of Normandy, France, which had a 0% tax rate for foreign corporations—a move nicknamed the “Green Jersey,” Monaghan says. That subsidiary owned rights to some of Apple’s intellectual property, as the BBC reported in November 2017.

The Jersey subsidiary sold the rights to another Apple Irish subsidiary, according to Monaghan, which could now license the IP both within and outside Apple. The cost of “buying” the IP would offset years of profits—which, when talking about licensing IP to Apple, were really shifted its other businesses. The Irish subsidiary will also be able to deduct interest payments to the Jersey one, which financed the transaction.

“So, you have very low-taxable profits,” Monaghan says—and lots of money being made. “By April 2018, economists estimated Apple onshored [to Ireland] $300 billion of intellectual property from Jersey in Q1 2015, apparently the largest recorded BEPS action in history.” With it shifted $40 billion in profits. “This was equivalent to over 20% of Irish GDP,” says Monaghan.

Apple did not respond to a request for comment. The company did address the 2017 story in a blog post, claiming, among other things, that “no operations or investments were moved from Ireland” and that it “pays every dollar it owes in every country around the world.” The same blog post did note that the company changed the “residency of our Irish subsidiaries.” Also, a company holding ownership of IP might not be considered an operation or investment.

Unintended consequences

While designed to raise tax revenues, the 2017 U.S. tax rules could have some unexpected—and undesired—consequences.

“The effects of the 2017 reform are still going to take a while to be measured,” Monaghan says. “The international provisions are completely new and unprecedented. Since the reform was enacted, it’s estimated that Treasury has issued a thousand pages of regulations.”

Some provisions could unwittingly do the opposite of what legislators originally intended. For example, the 2017 U.S. law created a 13.125% tax on foreign income from intellectual property—Foreign-Derived Intangible Income (FDII). Under FDII rules, companies are taxed on all income beyond a certain percent of their tangible assets, like machinery and facilities, held overseas. The more tangible assets overseas, the higher the deduction.

“There is a bit of a perverse incentive to put your tangible assets abroad” to lower the ultimate taxes on intangible asset income, says Monaghan. Some manufacturing companies could shift even more jobs and operations to other countries as a result, she notes. “Various features of the Tax Cuts and Jobs Act [of 2017], if not corrected, may actually enhance Ireland as a U.S. corporate tax haven,” Monaghan adds. It will take time to see the size of any effect.

But not everything promises a rosy future for corporations. Further progress on the OECD front is “precarious,” according to Brian Jenn, a tax partner with law firm McDermott Will & Emery and former deputy international tax counsel for the Department of Treasury. When the OECD took up digital taxes—like those of France on such companies as Amazon and Facebook—U.S. Treasury secretary Steven Mnuchin sent a letter on behalf of the Trump administration in opposition.

“That letter really froze the process,” Jenn says. “Theoretically all the countries but the United States could agree to something, but that doesn’t seem like anything more than a theoretical possibility.”

Instead of one clear set of international rules, corporations could suddenly face a world without a coherent agreement and, instead, find unilateral actions by many nations. “I think the risk is that companies will be double-taxed,” Jenn says, which isn’t what countries were suggesting.

In other words, a sandwich of quite a different sort.