Preventing tax evasion – why companies need to do more

Lord Bilimoria, host of our summer 2019 ethics debate, introduced the discussion by affirming the significant, but often overlooked, contribution that businesses make to society – providing jobs which generate taxes, which in turn allow our modern society to function for the greater good. He spoke from his own experience of the pressure corporates often feel to put profits before ethical practices. His business, Cobra beer, nearly failed several times; however, what got the business through each time was a team of good people who were committed to doing the right thing. He also reflected on the grey area between clever tax strategies and excessive tax avoidance, and the difficulty of knowing what compliance means, noting that it often comes down to perceptions of what is right and what is wrong.

Guest speaker Lisa Rosen, Chief Compliance Officer at the European Bank for Reconstruction and Development (EBRD) opened the debate by providing insight into how the EBRD evaluates what constitutes acceptable – and unacceptable – tax practices. Though the EBRD itself is exempt from paying tax, it looks into the tax affairs of its clients and the development projects that it funds as part of its credit and legal due diligence processes.

Increasingly, the EBRD considers tax as an important factor in the appraisal of the non-commercial aspects of the projects it finances, in the same way it has considered environmental impacts and integrity for some time. It is particularly interested in the use of third jurisdictions by clients. The projects the EBRD finances must be physically located in one of the EBRD’s 39 countries of operations, but its clients may use interposed entities in other countries. While there may be valid commercial reasons for doing so, those structures may also be set up for tax reasons, including to exploit tax loopholes. That creates a risk of unfair competition between investors, income loss for the EBRD’s countries of operations, and ultimately reputational risk for the EBRD.

To address these risks, the EBRD has very recently introduced a new “domiciliation” policy with a two-fold approach:

• The EBRD assesses the acceptability of the jurisdictions used by its clients, relying on (i) the ratings of the Global Forum regarding exchange of information, (ii) the list of non-cooperative jurisdictions of the G20, and (iii) membership in the OECD’s Inclusive Framework on Base Erosion & Profit Shifting (BEPS).
• Once jurisdictions are deemed acceptable, the EBRD conducts project-by-project due diligence to assess compliance of the individual operation with global tax standards in order to understand the commercial rationale for the use of the third jurisdictions, the economic substance of the interposed entities, as well as the tax benefits associated with the structure and exchange of information between relevant jurisdictions. The EBRD admits that project-by-project due diligence is a challenging exercise and Lisa noted that this level of activity requires delicate judgement calls, and in many cases, challenges established practices.

The key point is to identify risks and, if needed, mitigating measures.  Risk indicators include, for instance, the use of harmful preferential tax regimes or a lack of economic substance. Mitigating measures may include increased economic substance, relocation or additional disclosures.

Participants were then asked the following questions:

• Relative to the EBRD’s test, are you confident that your organisation’s tax structures would be deemed acceptable?
• Do you believe your company has more work to do?

Approximately two-thirds of participants indicated they believe their organisation would meet the criteria as set out by the EBRD. As the discussion progressed, however, several noted a more accurate response would be, “Yes, but…”

Below are some of the key points raised in the discussion:

• The grey area between tax avoidance and tax evasion is difficult to navigate. Furthermore, several participants noted that aggressive tax planning, such as the so-called “Dutch sandwich,” is no longer acceptable. It was generally agreed that the world has moved on, and companies are now expected to be ethical and not just compliant.
• Meeting the expectations of clients and business partners, including with regard to responsible tax practices, can provide a strong rationale for ensuring compliance and moving the dial away from aggressive avoidance. Even companies that don’t sell to the public sector are finding that they are under pressure to be more conservative about tax planning.
• Mergers & acquisitions often leave companies with complex legacy operations they must unwind. Similarly, in periods of fast growth, corporates often find they don’t have a full view of their companies. Several spoke about their reluctance to set up new companies, especially in difficult jurisdictions, while others are finding it challenging to shut down unnecessary operations in order to “clean up” the corporate tax structures. The process for dissolving a company is often long and complex.
• Corporate structures that might raise a red flag can in fact still be legitimate. Participants would be comfortable supporting such corporate structures but had differing views on how strong the test should be. Some felt that the economic rationale for the structure must be obvious, while others felt that it would be acceptable if it passed the ‘front page of the newspaper’ test or the ‘stand up in front of a room and justify what you are doing’ test.
• Compliance professionals can find themselves at odds with commercial colleagues. The extent to which these issues matter also relates to the sector of activity. The pressure remains to find ways to deliver profit and create shareholder value, even in sectors where margins are increasingly squeezed. Some participants questioned the degree to which their role is to find ways for the business to do what it wants to do, versus enforcing an overall ‘ethical stance’ for the company. Some in the room felt uncomfortable that their challenge could be seen as a block on the business.  It was also noted that a lack of visible enforcement of tax rules can encourage a higher appetite for tax risk.
• One company has situated compliance within the legal team to ensure there is a “stick” to enforce responsible behaviours, when needed. Another uses a scorecard system to check whether tax structures are consistent with its framework of tax principles.
• Many companies lack resources in the compliance department and would struggle to find the resources to tackle tax due diligence to the extent the EBRD describes. Many corporates simply don’t have a team of experts to manage more compliance obligations around tax. A high proportion of the companies participating in the debate are taking a cross-functional approach to dealing with tax issues, using a team comprised of members from compliance, tax, legal, finance and some human resources. However other companies noted that the compliance function does not get involved in tax affairs at all.
• Ethical behaviour in organisations is a matter of culture. There will always be pressure on the business to perform, but many employees today also want to see their organisations behave responsibly. A strong character at the top of an organisation is needed to instil the right culture throughout the organisation. Good culture was mentioned by a number of participants as a key factor in striking the right balance in tax planning.

The GoodCorporation view

There are two factors which are significantly changing the approach to good tax governance. The first is the push by the OECD and national governments to tackle aggressive avoidance and tax evasion. The second is the Panama Papers and the Paradise Papers which are also making corporates much more nervous about using offshore tax havens. These two factors are driving a marked change in the last few years in the attitude in large corporates. While the direction of travel is clearly towards more conservative tax planning, the key problem for corporates is where to draw the line. This is compounded by the fact that complex tax structures can take a long time to adjust and unwind. Corporates are therefore wise to take a cautious approach and to seek to align the economic rationale of their activities with tax payments and to avoid tax avoidance schemes which have no clear business logic.

The UK Criminal Finances Act has introduced the concept of “reasonable procedures to prevent tax evasion” and we believe that this will push ethics and compliance officers much more into the tax debate inside corporates.  We also believe that corporates will increasingly look to provide evidence that they have reasonable procedures and are paying their taxes fairly.