The Friendly Irish Skies for Transfer Pricing Games

My discussion of the Apple Structure promised to elaborate on a gem from Aidan Regan:

Wow! Exports are up 34%; Investment is up 27%; imports are up 22%. Wham, bam, the economy grew by 26%. Sensational. Per capita income per person in employment has increased from a whopping 88k in 2010 to 130k in 2015. I’m sure you can feel the booming economy in your pocket? Of course you can’t, the national accounts are a sham. So what’s really going on? The increase in investment, although you can’t see it in the national accounts, is being driven by airline leasing. My hunch is that this has increased by about 110%. Airline companies of the world are effectively transferring their financial activities (as new aircraft machinery) into Ireland for tax purposes….imagine all those massive Boeing planes flying around the world, then imagine them in Ireland, and hundreds of people working on them. Where are they? In truth. We couldn’t even fit these planes in Ireland. It’s just around 20 people managing a financial fund for tax avoidance purposes. Then using the generated money for profit redistribution. That’s what’s really go on.

Let me preface our discussion by noting this game is played by hotels in the U.S. who establish Real Estate Investment Trusts as well as oil drilling rig multinationals. After all those rigs in the North Sea off the coast of Norway and Scotland are formally owned by tax haven affiliates in Switzerland and the Cayman Islands. So how much income is being diverted to these tax havens? Let’s start with a discussion from Tom Bergin of Reuters:

The change, announced by Finance Minister George Osborne in March, caps the amount a UK company can deduct from profit for leasing drilling rigs from an overseas unit in the same group. The rig-leasing units are typically based in countries where their income is taxed lightly or not at all…Companies that have benefited from the current rules include Ensco Plc, Rowan Companies Plc and Transocean Ltd, which collectively accounted for over 60 percent of the UK market in 2012…"Currently, some companies making significant operating profits in the UK are able to move up to 90 percent of these profits overseas and out of the UK tax net," a spokeswoman for the UK Treasury said."In 2012, more than 1.75 billion pounds ($2.95 billion) was paid by oil and gas operators in the UK to contractors who lease drilling rigs and accommodation vessels. Almost no corporation tax was received on this," the finance ministry added. GENEROUS DEDUCTIONS Osborne's change, which will limit the amount companies can deduct from profit for such lease payments to 7.5 percent of the historical cost of the rig, will replace generous deductions calculated on the market value of rigs, which has been soaring.

While Osborne was right that a lease to value ratio near 15% is overly generous, his 7.5% might be a tad skinny. Let’s imagine an Irish affiliate that “owned” $30 billion in planes (see the financials for AerCap) that incurred operating and depreciation costs equal to 5% of assets ($150 million). I would argue for a 10% lease to value ration so the intercompany payment is $3 billion and profits of $150 million. This 15% lease to value ratio doubles those profits and leave the operating entities (the ones in high tax jurisdictions) with very little profit. So which approach is right? The OECD’s Action Plan 9 notes in its paragraph 63:

Risks should be analyzed with specificity, and it is not the case that risks and opportunities associated with the exploitation of an asset, for example, derive from asset ownership alone. Ownership brings specific investment risk that the value of the asset can increase or may be impaired, and there exists risk that the asset could be damaged, destroyed or lost (and such consequences can be insured against). However, the risk associated with the commercial opportunities potentially generated through the asset is not exploited by mere ownership.

The 15% lease to value ratio inappropriately assigns the expected return for bearing commercial risk to the Irish owner of the assets whereas the approach suggested here is to grant it only the return for bearing ownership risk or obsolescence risk as Miller and Upton noted. Their model would suggest that the appropriate profits for the Irish affiliate represent only a 5% return to assets with the remaining system profits accruing the operating entity. What the OECD has noted here is simply good finance and yet we often see the representatives of multinationals arguing for the overly generous 15% lease to value ratio. This is how transfer pricing abuse is done – these representatives basically lie to tax authorities under the assumption that the tax authorities are too stupid to realize they are being lied to.