Heard of the big tech companies which sell billions of dollars of products but barely pay any taxes?

Here’s how they do it.

The big tech companies sell digital products. These are products based on intellectual property (IP) or intangibles. Intangibles includes things such as brands, patents, know-how, copyrights, trade marks, etc.

Usually a company will develop its intangibles in its home country where taxes can be quite high. But it can sell these products around the world, while using some clever structures to avoid tax.

The corporate structure

RCo Group is an online retailer that operates in multiple countries. The group structure is shown in figure 1. The company sells both digital and physical goods. The physical goods are delivered to customers by a courier, whereas digital goods are downloaded directly from the company’s website. The company collects data on customers and uses that data to make recommendations to them, as well as to perform targeted advertising.

RCo is resident in State R and developed all the intangibles which are used to run the company’s websites. RCo remotely coordinates the sales and purchasing activities of the Group. These coordination services are provided to group entities in exchange for a management fee.

RCo Regional Holding company (a subsidiary of RCo) owns the rights to intangibles used on the websites in its region (State T and State S). These rights were acquired from RCo through a buy-in arrangement, where RCo Regional Holding paid an amount equal to the value of the intangibles and shares the cost of future developments that RCo performs. The intangibles are ultimately owned by RCo.

Although RCo Regional Holding is a holding company for entities in the region, its involvement with subsidiaries is limited as RCo performs group wide coordination activities. RCo Regional Holding has one employee and its premises are at a shared office space.

Orders from customers in the region are taken by RCo Regional Opco (a subsidiary of RCo Regional Holding). This company is a hybrid entity that is treated as a company under the tax law of State T, but it is transparent under the tax law of State R. RCo Regional Opco handles sales and payment processing and owns the goods it sells. Its employees also update the website as needed, however, the sales process is automatically conducted by software.

SCo is a subsidiary of RCo Regional Opco and provides logistics and sales support to customers in State S. Orders for physical goods are placed via the website and are fulfilled from the warehouse in State S. Digital goods are downloaded from third party servers, which are rented by RCo Regional Opco.

Taxes in State S

• SCo earns minimal taxable income because it assumes minimal risk and performs routine services.

• Revenue from transactions in State S is income for RCo Regional Opco, which is the counterparty to all transactions. RCo Regional Opco does not have a presence in State S and does not interact with customers. State S cannot tax the income as RCo Regional Opco is not resident.

Taxes in State T

• State T taxes the profits earned by RCo Regional Holding. State T has a preferential intellectual property (IP) regime, therefore the company pays less than the normal corporate tax rate for the royalties included in taxable income.

• RCo Regional Opco earns income from online sales, but this income is mostly offset by royalty payments to RCo Regional Holding and management fees to RCo.

• Payments from RCo Regional Opco to RCo are not subject to withholding tax under the applicable double tax treaty.

Taxes in State R

• State R taxes the profits of RCo. This includes the buy-in payment for intangibles. However, the value of the intangibles was low, due to an insignificant business track record at the time of sale, so the capital gain is small.

• RCo receives fees from RCo Regional Holding per the cost sharing arrangement – this income is taxable but may be offset since RCo may be entitled to R&D tax credits for further developing the intangibles.

• Ordinarily, State R’s controlled foreign company (CFC) rules would treat royalties received by RCo Regional Holdings as passive income and therefore include it in RCo’s taxable income. However, because RCo Regional Opco is a transparent entity for tax in State R, it’s income is treated as being earned directly by RCo Regional Holding. From the point of view of State R, RCo Regional Holdings does not earn royalties, so its income will only be taxable when paid to RCo.

• Since RCo Regional Opco is transparent for tax in State R, the CFC rules of State R do not apply and RCo does not impute income earned in RCo Regional Opco. Basically RCo does not have to pay taxes on income earned by RCo Regional Opco.

Conclusion

IP is shifted to State T at a low cost and then used from that state for commercial purposes. Entities in State T avoid creating a permanent establishment in State S. In this way, they can earn income from State S without paying tax there. In effect, all the income is accumulated in State T. The income is taxed at a low rate and not paid to the ultimate parent company (RCo).

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