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Taxation of digital media: Is the playing field level?

Friday, 17 October 2014   (0 Comments)
Posted by: Author: Rupert Worsdale
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Author: Rupert Worsdale (Maitland)

A discussion on the likelihood of applying the so-called "double-Irish Structure” in South Africa. 

In a recent newspaper report, a senior executive of one of South Africa’s digital media companies complained about the unfair advantage that a particular US digital media giant had over similar South African companies, as the US group was not subject to South African tax on an estimated R800m to R1bn of advertising revenue attributable to South African users and, in addition, was not subject to very much tax anywhere else. The purpose of this article is to examine how such a US digital media giant might have achieved its tax efficiencies, which tax authority, if any, would be losing out and whether or not the same opportunities are available for digital media companies based in South Africa in relation to their international business.

A typical structure would be a so-called "double-Irish structure”, involving an Irish intellectual property holding company ("IP Co”) holding an Irish trading company ("Trade Co”). The IP Co would hold the key intellectual property and the Trade Co would trade with consumers outside the US. The IP Co would be managed and controlled in Bermuda where there is no corporate tax (or for that matter in the US, where there is no tax liability based on management and control alone).  The IP Co would not be subject to Irish tax (although the Irish, just recently, have proposed closing this loophole). The Trade Co would be Irish resident for tax purposes taxed at 12.5%, but would pay a substantial portion of its revenues to the IP Co, which would not be subject to tax.

The structure is depicted below:

Of course, the intellectual property that underpins the US digital media giant’s whole business model was developed in the United States. So how would it get that into the Irish intellectual property holding company? The answer is that the US parent would licence the software concerned to IP Co for an arm’s length royalty agreed with the IRS under an advance pricing agreement (APA). As far as newly developed intellectual property was concerned, the US parent and the IP Co would enter into a cost sharing agreement according to which they would each contribute to the research and development costs of new intellectual property pro rata to their turnover, but would then be able to use that intellectual property without the one having to pay the other a royalty for the markets to which it had exclusivity i.e. in the case of the IP Co, the rest of the world excluding the US. 

What of the US controlled foreign company rules, known as the Sub-Part F Rules (because this is the chapter in which those rules are located in the Internal Revenue Code)? They are similar to, but much more complex than South Africa’s CFC rules.  These rules were introduced in 1962 and are essentially anti-deferral rules - the indefinite deferral of tax is the economic equivalent of non-payment.  Since the introduction of the Sub-Part F Rules in the United States, there has been an ongoing battle between those who think that the United States should tax foreign earnings more aggressively and those who see the exemptions from the Sub-Part F Rules as supporting US commerce abroad. The Sub-Part F Rulesare frightfully complicated but, all that one needs to understand is that active income earned from unrelated parties does not fall within the rules and accordingly only comes to be taxed when repatriated to the United States.  Except for a narrow exception, inter-group payments of passive income do not escape the Sub-Part F rules, unlike under the equivalent South African rules. On the face of it therefore, the royalties paid by the Trade Co to the IP Co would fall within the Sub-Part F Rules. However, the US has so-called "tick-the-box” rules which enable one to treat underlying companies as see-through. The effect therefore of treating Trade Co as see-through would be that on a consolidated basis, the royalties paid by the Trade Co to the IP Co would disappear and the consolidated profit and loss account would show that all income was active income earned from unrelated parties. Thus indefinite deferral would be achieved.

The ability of US based multi-nationals to achieve these tax efficient structures arises from the impasse between those in the US who would like to see much stronger anti-deferral rules and those who would like to revert to a territorial taxation system so as to promote US commerce abroad. As far as the former group is concerned, its view is that the United States is the country that is losing out on tax.

A recent US Senate report stated that current estimates indicated that US multi-nationals have more than $1.7 trillion in undistributed foreign earnings. President Obama has introduced a new proposal to preclude foreign base company intangible income from escaping the Sub-Part F rules, but it remains to be seen whether this proposal will see the light of day.  The reason why other countries are not taking unilateral action is because the OECD is in the middle of its base erosion and profit shifting project (BEPS), having published its position papers at the beginning of this year.

So what is the position in South Africa - can South African media companies also use a "double-Irish structure” to exploit international markets?  In relation to international markets, their position is the same as that of the US giants i.e. the treaty structures favour the taxing right of the country of residence and not source.  However what about South Africa’s CFC rules?  Are they as generous as the US rules on non-related party income?  The answer is a qualified "yes” - they only permit deferral on income attributable to new intellectual property developed and owned offshore and not by the SA parent.  Ironically, they are more generous than the US rules on related party income.

So is the playing field level?  No it is not, but for much more complicated reasons than people tend to think.  

This article first appeared on the September/October edition on Tax Talk.



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