Tax Transparency: Curbing Income Shifting

In late 2023, the IRS took a big step in what some sources are calling the “largest audit in its history,” involving potential back taxes owed by Microsoft. If found guilty, Microsoft could end up owing nearly $29 billion in back taxes, plus up to $10 billion in interest and penalties.

According to information released by Microsoft, “the main disagreement is the way the corporation allocated profits among countries and jurisdictions. This is commonly referred to as transfer pricing, and the IRS has established regulations that allow companies to use a specific arrangement for this practice, also known as cost-sharing.” The transfer pricing used by Microsoft meant that more income was reported by subsidiaries in jurisdictions with lower income taxes than the United States, with a corresponding decrease in income that was reported in the U.S. In Microsoft’s view, this income shifting complies with IRS regulations—of course, the IRS disagrees.

EU ACTION

Many companies, including those outside the U.S., use various legal tax arrangements to shift income. However, a recent directive in the European Union (EU) aims to combat and prevent these practices. Directive 2011/16/EU on administrative cooperation, commonly known as DAC6, was approved in 2018 and requires third-party reporting on cross-border tax arrangements that meet certain conditions. “Third-party reporting” means that entities other than the taxpayer must report information directly to tax authorities. Of course, this isn’t new: Income tax reporting in the U.S. includes Forms W2 and 1099, where employers, banks, and others report information directly to the IRS, and the Foreign Account Tax Compliance Act also requires foreign financial institutions to give information to the IRS. However, the scope of DAC6 appears to be much broader.

Under DAC6, third-party reporters include external tax advisors, lawyers, banks, accountants, and anyone who “designs, markets, organizes or makes available for implementation or manages the implementation of a reportable cross-border arrangement.” DAC6 also calls for automatic sharing of reported information between EU member states.

Importantly, the intent of DAC6 is to curb the use of aggressive tax strategies that shift income to low-tax-rate jurisdictions. New research from Anh Persson and Michelle Hutchens, accounting faculty at the University of Illinois Urbana-Champaign, and their colleague Alexander Edwards at the University of Toronto, examined whether DAC6 has had this intended effect.

In their recent publication, “Third-Party Reporting and Cross-Border Tax Planning,” they compare affiliates of large multinational enterprises (MNEs) that have at least one subsidiary in an EU member state to affiliates of similar MNEs that don’t have a presence in any EU member state. “In broad terms, we’re looking at how tax transparency affects the tax avoidance behavior of multinational companies. Transparency has been brought up as one of the tools to mitigate aggressive income shifting, and third-party reporting is one type of tax transparency,” Persson says.

Their publication notes that “unlike prior corporate transparency initiatives, which put the reporting responsibility primarily on the taxpayers, this directive puts the initial reporting responsibility on the third-party intermediaries who are involved in the reportable arrangement at any stage during the planning and execution process.” In a recent interview, Hutchens adds: “Under this regime, reporting occurs at the first stage of implementation, before these transactions are even fully implemented. So, tax accountants and tax lawyers have to report on plans for transactions that might not even have happened yet.”

DOES THIRD-PARTY REPORTING CURB ABUSE?

To answer whether third-party reporting curbs income shifting, the researchers compared pre-tax income and other accounting measures for companies affected by DAC6 to similar companies that weren’t impacted by DAC6 (the control group), while controlling for other factors known to impact results (e.g., company size and local gross domestic product). As Persson explains: “If you have one country with a really high tax rate and another country with a really low tax rate, with income shifting you see abnormally higher pre-tax profits reported by companies in the low-tax-rate country. You can assess the correlation between these things over time and across countries to get a sense of the income shifting. We also look at the effective tax rates, which is a rough way to capture tax burden.”

In the first part of their analysis, the researchers found a significant decrease in income shifting among companies impacted by DAC6, translating to a 2.2% to 3.4% higher reported pre-tax book income. Affected companies also have higher effective tax rates (ETRs) after DAC6—anywhere from 0.9% to 2.6% higher, depending on whether you look at book or cash ETRs, or one- or three-year ETRs. Compared to other research on income shifting, the researchers refer to this as a “significant but more modest” response.

Therefore, it appears that the increased transparency from DAC6 has reduced income shifting. However, while all member states in the EU have agreed to DAC6, not all of them have implemented it in the same way, as EU member states have flexibility in how DAC6 is encoded in their local laws. Although DAC6 says that penalties for third parties who fail to report should be “effective, proportionate, and dissuasive,” specific penalties vary from country to country. For example, in Germany, the maximum penalty is 25,000 euros, while in the Netherlands it’s nearly 35 times higher at 870,000 euros. One other large difference across countries is the legal protections extended to third-party reporters. For example, similar to the typical lawyer-client privilege, some, but not all, EU countries have extended legal privilege to tax advisors other than tax lawyers when implementing DAC6.

In addition to their main conclusion that the third-party reporting required by DAC6 decreased income shifting, the researchers also examined how the differences in country-level implementation of DAC6 impacted this conclusion. “You do see differences,” Hutchens says. “After DAC6, income shifting decreases, and it decreases more where we expect it to, in instances where the penalties are higher and where there aren’t generous legal privileges for the third parties.”

A WARNING TO AMERICAN CPAS

For certified public accountants (CPAs) and other accounting professionals in the U.S., these findings could influence how cross-border transactions are structured and reported. The research suggests a shift toward greater transparency in cross-border tax planning, leading to potential changes in how tax accountants advise on international tax strategies and structure transactions to comply with an increasingly stringent global regulatory environment.

Hutchens stresses that although DAC6 is a big deal in Europe, it’s also important for accountants in the U.S. to take note. For example, the Big Four firms have already highlighted and discussed the directive with their boards. Additionally, other countries are looking to see whether DAC6 succeeds, and if so, will likely adopt similar legislation.

According to Persson, transparency in tax reporting is only going to expand with time: “For CPAs, the scope of work is going to increase with respect to reporting and transparency. And this information is being shared across tax authorities and across countries, so CPAs will also have to consider the risks that they’re willing to tolerate under these new reporting regimes.”

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