The rosy plan of the Biden administration to fight tax evasion was promoted heavily throughout the 2020 presidential campaign – and can be justified as fair and in the interest of the nation – much similar to how European policies generally work towards shielding the interest of the EU member states. The question arises, though, what would it take for Europe, to be as compact as the US, against tax injustice.
To work around this question, Cyprus and Delaware can be used as comparative case studies. Both regions have roughly the same population of approximately one million inhabitants, have economies largely dependent on exporting financial services, and are widely renowned for their preferential tax regimes. Taking a closer look at both regimes, one can identify a number of further similarities, as well as the effectiveness of transfer pricing (TP) restrictions.
For example, it could be assumed that (a) a Cypriot co. owns a subsidiary co. in Delaware which is invoicing US clients transferring profits back to Cyprus, (b) the exact opposite case, where the Cypriot subsidiary is invoicing European clients, (c) both satisfy the economic substance doctrine, and (d) withholding taxes are taken out of the equation.
A non-expert would be able to notice that tax dodging does not exist unless the transfer of profits is extreme, and that each contracting country is responsible through its own diligence to shield its taxable income against the interest of the other country. In other words, the ‘witch-hunt’ of any tax injustice is neither a cooperative action between the states, nor an equal one for the simple reason that the US is acting on a federal basis against all tax dodgers, or that Cyprus acts behind the European regulatory shield.
In theory, the OECD Transfer Pricing Guidelines are well structured to harmonise global practices. This could have been the case in the past but this will be insufficient in the future, to the extent that the affordable profit shifting is subject to a methodology, which is then subject to conditions, which are ultimately governed by guidelines. Thus, this leaves little protection against taking on a severe approach by any of its members.
Using TP technology in Europe
The existing supply chain of financial information is extremely potent. TP analysts, coming with a legal, corporate finance or tax background, are using benchmarking data two-dimensionally. This operates as expected when variables are set to make up a result, but would not operate correctly if the variables are making up themselves through a multi-variable approach.
The EU has the tools to access and collect financial data from all member countries and draw a parametric line as a target, with a core classification per the Nomenclature of Economic Activities (NACE) code. This would be very helpful for smaller countries such as Cyprus and set a benchmark for other regions in similar positions.
Benchmarking will not be able to cover the whole spectrum of cases given that some intra-group transactions cannot be validated on a profit margin basis. However, the number of such cases is not indefinite, and as uncertainty grows (e.g. in relation to intangible assets), there will be a greater need to set formal guidelines.
The European shield
In our view, tax evasion will be pushed on the top of the political agenda, as the world is departing from the pandemic. The wave will be coming from the US and will be tweeted with a slangy ‘tax dodging’. It will be brutal, and it remains to be seen if Delaware or Cyprus will get the bigger hit.
Europe has done some work to supervise itself. It is now time to arrange its tax affairs with the US.