The Shape of Water
Assessing tax disputes in the age of intangible value.
The shape of water
Tax disputes in the age of intangible value
Turning the tide
New data and insight from Baker McKenzie quantifies the increase
in tax disputes and explores how companies can best manage those
disputes in an increasingly digitized economy.
Foreword
Simone Musa
Chair - Global Tax Practice Group
Across the globe, corporate tax is at the top of the agenda in newsrooms and boardrooms alike, owing to a marked rise in the number of cases being contested. New research from Baker McKenzie shows that the amount of tax under dispute is so large to wipe out more than half of profit growth in the Fortune 500. With disputes predicted to continue rising in the coming years, how can corporate taxpayers effectively manage the load?
Media coverage of corporate tax matters focuses almost exclusively on claims of avoidance and abuse, but our data shows that the rise in disputes actually reflects fundamental shifts in how and where organizations create value.
In the past, there was a clear connection between physical market activity – such as sales and manufacturing – and taxable value. Today, companies and regulators struggle to attribute profit neatly to particular activities and jurisdictions, as organizations routinely work with digitized networks and dispersed workforces and customer bases. Intangibility of value creation is the main challenge nowadays not only for lawmakers, but certainly also for tax authorities and taxpayers.
In addition, we foresee controversies that involve or affect multiple jurisdictions arising as a result of the increased transparency and new global compliance obligations. Tax authorities are now capable of interpreting information using technology and can exchange information on a real time basis.
Indeed, there are no longer simple answers on tax. As digitization accelerates and technology evolves, taxable value can substantially depart from physical means, and global information on multinationals flows rapidly to tax authorities. In this new environment, supporting a consistent tax position worldwide and preparing for tax disputes demands more sophisticated approaches from tax directors in all industries.
In this report, we provide data and insight for tax leaders as they build their tax management and litigation capabilities to cope with the significant rise in tax disputes.
About the research
This report charts the rise in disputed tax and investigates the drivers behind this new wave of disputes. Opinion research was conducted in Summer 2018 amongst 150 respondents from Fortune 500 companies. Study participants include a representative sample of tax leaders (Finance Directors, CFOs and Heads of Tax) in five sectors (Healthcare & Pharmaceutical; Financial Services; Industrial, Mining and Transportation; Technology, Media & Telecoms; and Consumer Goods & Retail).
The threat to profits
New research from Baker McKenzie shows that the amount of
tax under dispute is so large that it threatens to wipe out more
than half of profit growth in the Fortune 500.
The scale of current tax disputes presents a significant threat to hard won profit growth in the Fortune 500. Among the 150 respondents interviewed by Baker McKenzie, up to $22.6bn of tax is under dispute. If the entire Fortune 500 is managing tax disputes in similar proportions, that equates to an eye-watering $75.3bn.
To put that figure in perspective, it would be equivalent to 7.5% of the profit made by the Fortune 500 in 2017. In the same year, average profit growth in the Fortune 500 stood at 12.4% and in 2016 it was as low as 6%.
Among hyper growth organizations – those with annual turnover growth of more than 20% – exposure to rising tax disputes is higher still. They face up to $5bn greater exposure than lower growth peers, owing to a challenging combination of unique value generation models and less mature compliance and disputes management experience.
Unsurprisingly, the majority (60%) of tax leaders said that this represents an increase in tax disputes over the last 5 years, but in more unsettling news, two thirds (63%) predicted that the amount of tax under dispute will continue to rise over the next 5 years.
According to respondents transfer pricing is the most common source of disputes, according to respondents, with issues arising from conflicting valuations of assets and disagreement on the location and scope of value-generating activities. In response to renewed public attention, authorities are applying greater restrictions to transfer pricing activity.
Transfer pricing disputes
Corporate activities are under the spotlight and regulations are being implemented where there had previously been little guidance. But this explains only part of the ubiquity of transfer pricing disputes. The amorphous nature of value created by digitization is perhaps the most significant contributor to the high number of transfer pricing disputes we see today, and that are predicted over the coming five years.
Transfer pricing is inextricably tied to matters of value. For example, when value is created by unique intellectual property, technology and personnel – or a combination of these elements – it is more difficult to price, split and assign that value.
Transfer pricing also requires organizations to consider potential as well as actual value, creating further room for authorities to challenge the calculations made by tax leaders. When a challenge from authorities is inevitable, early consideration and preparedness is critical.
So how can organizations succeed in transfer pricing disputes?
Elsewhere, indirect tax emerges from the research as another significant source of disputes, particularly in connection with digitized business models and services. It’s now possible to operate in a jurisdiction without any physical presence, which makes the job of accurately calculating tax hugely challenging. It also creates troubling inconsistencies in how value is calculated country-by-country, as Mark Delaney, Head of UK Tax, explains:
If regulators come out on top in the majority of tax disputes, the impact will be keenly felt in the wider economy as well as by multinationals. Two thirds (65%) of tax leaders say that a continued rise in tax disputes will lead their company to retrench and centralize in future – risking global trade growth and calling into question the viability of continued cross-border activity and expansion.
Meanwhile, the consequences of rising tax disputes for multinationals can also extend to reputational and liability issues, as financial and ethical transparency become increasingly intertwined. More than half the tax leaders we surveyed (56%) said that they have lost revenue as a result of public awareness of tax disputes and 61% say there has been some sort of negative consequence. At the same time, 65% fear endemic customer, employee and investor mistrust if they don’t get tax right.
The shift in value
Locating and isolating the source of corporate value is the
single greatest challenge facing organizations and authorities,
according to nearly three quarters (72%) of tax leaders.
It is the leading cause of contention between companies
and regulators and the key driver for tax disputes.
While media coverage of tax disputes focuses heavily on perceived efforts by multinationals to reduce their tax bills, two thirds (65%) of tax leaders say the rise in disputes has more to do with seismic shifts in how corporate value is defined.
The digitization of business is creating particular complexity for a broad spectrum of businesses: technology companies are selling customers digital solutions; consumer goods organizations are digitizing traditional delivery models; financial firms are using AI to create new customer value and innovations like 3D printing are revolutionizing the manufacturing sector. Value flows freely across multiple jurisdictions, without the need for customs or local operations, and it draws on highly technical or specialist knowledge. In this context, accurately capturing the true scale and location of taxable liability is hugely challenging.
It has also become close to impossible to delineate ‘digital’ companies from others. Business as a whole has been digitized – from operating structures and supply chains to customer interaction and service delivery. The challenge of capturing amorphous taxable value is therefore relevant to multinationals in all industries – not just digital pure plays.
Tax authorities have been slow to respond to these changes, though efforts are being made to implement new guidance in the form of BEPS. But seeking to realign taxation with economic activities and value creation has opened up new issues for corporations. Where tax structures were once led by national legislation, some authorities are now interpreting and adopting various elements of BEPS. However, they are taking a piecemeal approach, applying concepts not yet incorporated into law and retroactively imposing them on past tax filings, leaving organizations reeling.
Certainly, the new digitized reality is significantly outpacing tax regulation – leaving much open to discussion, interpretation and uncertainty. A clear majority (72%) of tax leaders say that current tax regimes are not fit for purpose.
Today, value drivers are more likely to include codes, systems and platforms, but global tax authorities are more familiar with sales, headquarter locations or key personnel. This lack of fluency with modern generators of value is raising the risk of exposure and double taxation for multinationals, as enforcement bodies make broad requests for information and operate unilaterally.
The struggle to keep pace
The complexity and volume of tax disputes is taking a toll on multinationals’ ability to manage them efficiently. More than half (57%) struggle to clearly articulate their tax calculations and liabilities and two thirds (64%) worry about their ability to meet the demands of global authorities.
Timelines for resolving disputes are growing ever longer, owing to global divergences between regulatory regimes and the difficulty in unravelling the source of taxable value. With more issues to settle and greater scope for negotiation, extensive consultations between tax leaders and multiple authorities are commonplace. Two thirds (67%) of tax leaders say it’s taking longer than ever to solve cross-border disputes.
At the same time, costs are rising, draining the resources of in-house tax functions in the process. Organizations are deploying greater internal and external resources to tackle ambiguous or contentious tax calculations and reach fair agreements with authorities. More than three quarters (77%) of tax leaders report that the cost of litigating cross-border disputes is escalating and half (52%) say that their budget is insufficient to manage the pressure of global tax regulation.
As well as becoming more aggressive, tax authorities are simultaneously becoming smarter in how they pursue cases. In more and more instances, authorities are sharing information across borders, leading to an increase in multilateral audits. As a result, it becomes increasingly difficult for tax payers to maintain control, as Partner Jessica Eden explains:
Traditional mechanisms for dispute resolution are also becoming less effective as complexity increases. Litigation is falling out of favor with multinationals, as it fails to provide sufficient control and certainty. Meanwhile, negotiated settlements have grown in popularity. From arbitrated settlements to advance pricing agreements, complexity is creating a greater need for discussion, consideration and partnership between tax leaders and authorities.
A new course for effective dispute management
While multinationals consult with authorities and governments to build a new corporate tax model, they must simultaneously develop more effective and scalable dispute resolution processes.
It will take time to implement the regulatory change required to meet the demands of the new tax environment. But while revisions are underway, multinationals must act now – building scalable and effective dispute management systems that are better designed to capture corporate value. Tax directors will be held professionally and personally accountable for reaching accurate tax calculations, regardless of the difficulty of reaching an objectively correct figure in today's environment.
Tax directors must be aware of new trends in enforcement – particularly audit digitization and hiring practices – that will affect how they interact with authorities. Innovations in electronic invoicing and data capture now provide global tax authorities with an unprecedented view of the ‘digital footprint’ of corporate value – emboldening them to conduct increasingly far-reaching investigations. Some authorities even recruit in-house tax professionals to improve their understanding of modern value generation.
Tax leaders must also consider a broader definition of success – financial figures negotiated and paid are just one aspect of successful dispute resolution. Bypassing costly litigation, avoiding penalties or criminal action and protecting information throughout the process are all similarly valuable outcomes. Reaching a timely and positive resolution, while minimizing negative consequences, now requires a more balanced outlook and cooperative approach.
Baker McKenzie’s model for effective dispute management in the digitized economy
Be prepared for a desire for information: Tax authorities have an increasingly demanding appetite for facts and documentary evidence. Time spent building a clear understanding of the facts and the availability of evidentiary support is often invaluable in putting the company on the front foot in later settlement negotiations. The powers of tax authorities to obtain information and documents vary from jurisdiction to jurisdiction and are often extensive. It is important in responding to any tax authority request for information to be clear on both the taxpayer's rights and obligations.
Cooperation and redlines: Reaching a negotiated settlement requires both parties to the negotiation to have trust in the other party. Creating an atmosphere of cooperation and transparency is often critical to building this trust. At the same time it is important to stand firm on the technical merits of the case and to be clear on your redlines, those points that will not be conceded for the purposes of reaching a negotiated outcome. Knowing your alternative routes to resolution, including the formal litigation process, and what would be involved in following through on a threat to litigate increases the strength of your bargaining position.
Global complexity and the importance of consistency: For cross-border matters involving international taxation, and in particular, transfer pricing, when agreeing a settlement in one jurisdiction consideration should be given to how that settlement might impact on the ability to reach settlements in other jurisdictions. Documenting differences in facts and any aspects of a settlement specific to a particular interpretation of the OECD guidance can be used in future audits to differentiate settlements reached in another jurisdiction. Equally, it is increasingly important to be alive to the increasing complex interaction of different tax and the volume of new international rules and regulations.
Negotiate or play to win: Tactics for reaching a negotiated settlement or litigating for a successful outcome tend to diverge. While it is possible to run these tactics in parallel it is of key importance to ensure that the impact of all decisions made in the negotiations on the litigation track are considered and vice versa. Know your appetite for litigation.
Key contacts
and information
Simone Musa - Chair - Global Tax Practice Group
María Antonia Azpeitia - Chair - EMEA Tax Dispute Resolution Steering Committee
Jorge Narváez-Hasfura - Global Tax Dispute Resolution Steering Committee
George Clarke - Chair - North America Tax Dispute Resolution Steering Committee
Steven Sieker - Chair - Asia-Pacific Tax Practice Group
Antonio Russo - Chair - EMEA Tax Practice Group
Nigel Dolman - Partner
Mark Delaney - Head of UK Tax
Patrick O'Gara - Partner
David Jamieson - Partner
Jessica Eden - Partner
Richard Fletcher - Chair - EMEA Transfer Pricing Steering Committee
