Big Mac and fries to go (offshore)

McDonalds have announced that they are moving their European headquarters from the UK to Switzerland.

The message from the Guardian is that this is being done “to benefit from Switzerland’s advantageous intellectual property tax laws.” Don’t believe a word of it. There are no defects in European intellectual property laws, and no particular reason to think that McDonald;s would be any better protected if its contracts were under Swiss law than any other country that bases its laws on OECD principles. In fact since most of McDonalds intellectual property contracts relate to branding rights which are (a) probably agreed according to local law and (b) typically not up for renewal and (c) could have been written under Swiss law principles at any time if anybody wanted to draw up a contract on that basis, this is the purest of pure hokum.

The real reason is tax, and I will explain the reason why.

McDonalds is a US corporation and the US company is taxed on its worldwide income and the passive income of its subsidiaries located in tax havens, ... OK low tax countries. A lot of McDonalds income derives from its franchises. I don’t know the ins and outs, but as well as selling buns and burgers to the franchisees, the corporation will charge each franchisee a hefty whack for the use of the brand, logos etc., which all count as royalties. It also charges its foreign subsidiaries for the same rights where it operates its own Restaurants. The local McDonalds companies would have paid these royalties away ot an offshore affiliate that held the rights to licence the brand, where the cash accumulated at a low rate of tax. Under US tax rules this income would have been treated as active business income and thus not taxed until remitted to the US.

The problem is the UK link in the corporate structure. Let us assume that all the European subsidiaries and the offshore IP repository were all below the UK in the group structure. Then UK tax rules regarding controlled foreign corporations would also apply. For many years the UK tax man would not have cared two hoots about the offshore IP, but that all changed when HMRC decided that royalties should be treated as passive income ad included in the assessable income of the UK parent.

Which is very inconvenient for a US group like Mcdonalds paying royalties from countries all over Europe to another group company and bringing the cash anywhere near the UK. Particularly when other EU or European countries would not try the same trick. But isn't this just aiding and abetting tax avoidance? Not really. The royalties paid out of high tax EU countries are arms length royalties that reflect the value of the brand and are approved by local tax authorities under their transfer pricing rules, and although it is not taxed immediaely, in order to pay shareholders a dividend the cash has to be brought back to the US where it will be subject to taxation at the Federal tax rate with credit given for foreign taxes paid on the income dividended to the US.

Well, if they get a credit for all foreign taxes, why do they care? Because the US foreign tax credit system is a complicated beast and it imposes some rules. Credits are given on income taxes actually paid on the income of the foreign company only up to the US tax rate on that income as determined under US rules, and subject the fur constraint that different baskets of income are treated separately. Foreign taxes in excess of any limitation in a basket (called excess foreign tax credits) may be carried forward 5 years or back 2, but are lost thereafter. There, I said it was complicated.

The problems for McDonalds would be twofold. First of all they would have a headache over whether for US purposes the new UK tax is a tax on the income of its UK subsidiary, because ostensibly it is a tax on the income of another company that is imposed on the UK company. Next there would be a problem because UK tax is imposed on royalty income which is in a different US tax credit basket to ordinary business income. The royalty income taxable in the UK is far higher than the amount of third party royalty income taken into account at the group level (because all intra-group transactions are netted out when the consolidated income is calculated), which means the limitation in the royalty basket is likely to be exceeded. So McDonalds' worldwide tax bill will be increased considerably.

And that is why McDonalds are moving to Swizerland, but it could have been Ireland, or Luxembourg or the Netherlands. Other companies who have recently done the same include WPP, Shire, United Business Media, Regus, Henderson, Brit Insurance, Hiscox, and Charter.

This will be one of the least successful tax grabs ever, from a headstrong government that won’t appreciate that businesses always have the option to go elsewhere and won’t sit around to be picked apart by the tax man. More importantly for the government, they should realise that in the past 25 years, Britains economic growth was a chieved by pursuing a strategy of low taxes, limited government interference and a business friendly attitude, which gave it advantages ver continental rivals with higher taxes and greater compliance costs. On the ther hand those other countries had better infrastructure and more productive workforces. By undermining the previous policies, the UK is placed in a strategic no man's land, and the private sector will continue to suffer.