Taxing big tech is starting to change

And you can see why.  Finance ministers see spectacularly profitable international behemoths making billions from their citizens while paying taxes more akin to a smallish domestic company. 

The EU estimates that digital businesses pay on average 9.5 per cent corporation tax, compared to an average of 23 per cent for traditional businesses. 

Of course the politicians have themselves to blame. Finance ministries around the world have allowed their tax codes to become overlong, bafflingly complex and nationalistic. 

Big tech is so vast, so fast growing, profitable and visible with all those consumer brands, that governments are sure to start ringing the changes

Tax convergence across the finance departments of different states is rarer than a budget surplus.

This opens the door to some top class, but broadly legal, tax manipulation in the shape of pricing of products or services across territories.

We have always had a fair amount of this from major industrial and energy businesses. 

But big tech is so vast, so fast growing, profitable and visible with all those consumer brands, that governments are sure to start ringing the changes.

So how is this tax manipulation done and what can governments do to counter it?

Transfer pricing

Transfer pricing is the main culprit. 

It allows a company’s finance director to maintain low levels of taxation regardless of how much profit is being made.

Since (for now) revenues are not taxed but profits are, the price of inputs is arranged so that most of the profit is booked in the lowest tax area in which that company operates. 

You order a book on Amazon.co.uk.  It is sourced in the UK, is despatched from Amazon’s UK warehouse and delivered to you in the UK.  But the invoice is from Amazon in the Netherlands. Easy. 

Big tech operates across most of the developed world so that leaves plenty of flexibility, especially as most of the value of these companies is in their intellectual property, not factories, offices and other hard assets. 

The ownership of this intellectual property can be shifted to a subsidiary in a low-tax country, which then invoices operations in higher-tax ones for the use of that know-how, transferring profits from higher-tax to lower-tax regimes.

This is only possible because tax authorities fail to enforce the requirement for companies to adequately justify the transfer pricing they are using: how can intellectual property actually reside in Ireland when there is no material headcount there either creating or maintaining it? 

If Google employs thousands of highly-paid engineers in California and none in Ireland, then it should be impossible to argue that its intellectual property, its most vital asset, exists in Ireland and not in the US. 

The US (and other governments) are failing to use their power to look through clearly fictitious transfer-pricing and tax the underlying reality of the business.

The alternative would be to get the companies to correct their transfer-pricing voluntarily, and the French may be showing us half the solution: tax revenue instead, as it is much harder to move. 

If a French advert is shown to a French consumer in France, it is hard to argue that the resulting revenue was generated in Ireland, simply so that a very low Irish tax rate can be applied to that transaction.

The EU has been arguing about what to do for months. 

France has lost patience and is proposing a 3 per cent revenue tax on digital companies providing a service in France. 

The UK plans to introduce something similar next April. Neither will be easy. 

The US sees this as an unfair burden on the largely US digital sector and has said it will retaliate so expect cheese, wine and Airbus planes to be more expensive when you next visit the US. 

The ideal would have been for the Organisation for Economic Co-operation (OECD) and the G20 to implement an international agreement for digital tax policies that combat the issue of tax avoidance. 

But the fact that two of Europe’s biggest economies have decided to take matters into their own hands shows the scale of political frustration with the status quo.

However, this is only half of the solution: the revenue tax model could be made more sophisticated. 

How to tax

Revenue tax should only apply if the proportion of a company's global taxable profits asserted to be earned in France is wildly different to the proportion of global revenue generated there. 

So if France accounts for 5 per cent of Google's global revenue but less than 1 per cent of taxable profits, the sales tax applies.

If 2 per cent of profit was deemed to come from France, that might be seen as acceptable and no revenue tax would apply. 

I suspect this would see a rapid correction in transfer pricing, as otherwise companies are going to find themselves taxed twice.

Some argue that France (or the UK) cannot afford to lose the internet giants. 

That is wrong. These are not truly global companies: they are US companies that have succeeded in Europe, have failed in China and are trying to develop a business in India. 

Everything else is too small to be relevant. They will not withdraw from such lucrative markets as France, Germany or the UK, as they would see sudden absolute declines in revenue and global profits - their shares would collapse. 

The bald fact is that these companies feel obliged to play the game of tax avoidance because some of their shareholders demand it. 

The tax authorities have been inert in standing up for those rules. 

If the rules are now tightened up, Google, Facebook, Amazon et al will abide by them. 

They may even be relieved to do so - international tax planning is time-consuming, expensive and distorts business decisions. 

No one enjoys it.  Straighten out the tax incentives and let everyone get on with managing their businesses.

By the way, this would increase tax take for the US as well - that is where the intellectual property truly resides, so that is where the benefits would end up being taxed. Someone tell Mr Trump.

William de Gale is portfolio manager at BlueBox Global Technology Fund