How to pay less corporate tax

Profits shell game.

The price of a Frappuccino is high in the U.K., as is the corporate tax rate (Photo: Kerim Okten/Newscom)

Given the small fortune Londoners fork over for a caramel Frappuccino, a Starbucks coffee outlet might seem a licence to print money. Yet, after 15 years in the U.K., Starbucks can’t eke out a profit there. Some British politicians whinge the losses are deliberate. “You’ve run the business for 15 years, you’re losing [money] and you’re carrying on investing here,” veteran MP Margaret Hodge told CFO Troy Alstead at a hearing in November. “It just doesn’t ring true.”

It’s an odd accusation—until one recalls profits are subject to corporate taxes. There are perfectly legal ways of reducing taxes payable, some of which involve “transfer pricing.” That’s the exercise of determining what amounts subsidiaries of the same multinational parent located in different countries should bill each other. Starbucks must decide this for everything from roasted coffee beans to fees for using its brand. The considerable latitude in setting such prices creates an opportunity to shift profits from a division in a country with high corporate taxes to a division in a country where taxes are lower. The importance becomes clear when one considers that according to the Doing Business database, the U.K.’s total tax rate on corporate profits is on the high end, at 35.5%.

Tax authorities sometimes protest where transfer pricing deviates significantly from transactions negotiated by non-related parties. They face rising pressures to intervene. In 2010, the IRS established a special practice to target transfer pricing, and this September the U.S. Senate Permanent Subcommittee on Investigations held hearings on avoidance schemes. “The massive offshore profit-shifting that is taking place today is doubly problematic in an era of dire fiscal crisis,” said its chair, Michigan Sen. Carl Levin. “The transfer pricing process is widely abused.” Levin accused Microsoft of transferring intellectual property rights at knock-down prices to Singapore and Ireland to dodge taxes.

Meanwhile, in November Australia proposed revisions to transfer-pricing rules intended to thwart alleged avoidance by multinationals. The issue is particularly emotional in Britain, a nation ravaged by fiscal consolidation following massive bailouts. “The potential for tax authorities worldwide to generate significant cash from [transfer pricing] audits is resulting in their adopting ever more bullish attitudes,” lawyers from U.K.-based CMS Cameron McKenna warned clients.

Starbucks’ troubles began after Reuters published a news report in October noting that while the U.K. division regularly reported losses for tax purposes, executives regularly told investors it was profitable and performing well. (Starbucks denied avoiding taxes.) The report prompted a parliamentary investigation, which is why Alstead and senior executives from Amazon and Google found themselves before Hodge’s Public Accounts Committee. The committee found them “unconvincing, and in some cases evasive.” Its report, published in early December, blasted tax authorities for “not taking sufficiently aggressive action” against avoidance. “We believe that this practice is widespread,” it claimed. Chancellor George Osbourne added £77 million to the enforcement budget. Starbucks said it was “looking at our tax approach in the U.K.”

Starbucks, Google and other impugned companies might take solace from Canada’s longest-running transfer-pricing saga. GlaxoSmithKline is a Canadian subsidiary of pharmaceutical giant Glaxo Group. Its blockbuster ulcer drug, Zantac, was at one time the world’s bestselling prescription drug. In the early 1990s, GSK bought the active ingredient, ranitidine, from a Swiss subsidiary, paying more than US$1,200 per kilogram. The Canada Revenue Agency noticed Canadian generic manufacturers paid less than $250 per kilogram, and concluded GSK overpaid. It reassessed GSK for the years 1990 through 1993, causing a sharp spike in taxes owing.

GSK protested it wasn’t merely buying ranitidine: the price included the right to manufacture Zantac, and Glaxo’s ranitidine was also specially granulated. GSK appealed to the Tax Court of Canada but lost. But GSK appealed again, and the higher court sided with GSK. “In the real business world, presumably an arm’s-length purchaser could always buy ranitidine at market prices,” its decision noted. “However, the question is whether that arm’s-length purchaser would be able to sell his ranitidine under the Zantac trademark.” The CRA then appealed to the Supreme Court of Canada where, two decades after the offending payments, it suffered ignominious defeat in October.

The lesson is clear: policing transfer pricing consumes swaths of manpower, time and money. Hodge and Alstead could be long retired by the time her accusations against Starbucks are resolved.