The Misalignment of CbC Reporting and Value in Modern Business

In response to a growing chorus of tax authorities and public interest groups calling for greater transparency among multinational enterprises, in 2015 the OECD released its final report on action 13 of the base erosion and profit-shifting project, which first recommended country-by-country reporting of MNE global income, taxes paid, and other measures of economic activity.¹ As part of BEPS action 13, the OECD also recommended two new forms of transfer pricing documentation — a master file and a local file. Collectively, those two documents and the CbC report are intended to be used by individual tax authorities to gain a better understanding of the MNE’s global footprint while helping to identify potential BEPS activity.

To date, over 90 jurisdictions have adopted CbC reporting requirements, reflecting global acceptance of the regime. Moreover, with the execution of almost 3,000 bilateral exchange agreements, jurisdictions now have broad access to MNE CbC reports irrespective of the domicile of the ultimate parent company or filing entity. The rapid progression from a set of OECD recommendations in 2015 to today’s widespread use and exchange of CbC reports has been remarkable. However, as with any new tax reporting regime, taxpayers and tax authorities alike experienced logistical growing pains in the process, including complications associated with creating consistent (and reliable) CbC reports resulting from definitional and procedural ambiguities in the rules and regulations, as well as increasing reports of misuse — or at least a misunderstanding of the data — by taxing authorities. While the OECD has attempted to address the first problem with guidance and handbooks, the potential misuse or misunderstanding of the underlying CbC data is of growing importance and concern.

The CbC report can be a useful and meaningful tool when used for its commonly understood purpose: to provide a universal set of data points to enable meaningful comparisons across jurisdictions, industries, and regions, when used or read in conjunction with the details of the master and local files. Moreover, there is no disputing that the three documents could offer unprecedented insight into an MNE’s global footprint, while shining a spotlight on tax haven jurisdictions and potential for BEPS activities. However, in an increasingly common fact pattern, tax authorities are mistakenly using the CbC data as prima facie evidence of BEPS, as opposed to one of several sources of taxpayer data that must be considered holistically to get a true sense of the MNE’s global tax structure and potential risks. While some of that may be chalked up to overzealous tax agents or egregious audit and review policies, in many cases it could simply be a result of a taxpayer’s failure to provide sufficiently detailed master and local files for contextual purposes. Consequently, tax agents often have little more than the data provided in the CbC report to chart their path.

Traditionally, both tax authorities and companies have relied on company data such as head counts and intercompany contracts to determine profit allocation or assign value. Armed with new information on key metrics including revenues, profits, taxes, assets, and head count organized on a jurisdictional basis — that is, CbC Table 1 data — as well as identification of key functions and activities occurring in each jurisdiction — that is, CbC Table 2 data — tax authorities are now able to draw conclusions based on company-provided data and metrics that were previously unavailable outside of an audit. Unfortunately, without context, the core metrics of a CbC report can be misleading, particularly in light of current business trends and how companies operate in the modern world. The inherent suggestion in CbC reporting is that profit should generally somehow follow the metrics provided. When there is divergence — such as large profits in a country with few personnel or assets — then there is a misalignment of profit and substance, which must be explored under audit. Today, those metrics, especially for high-performing companies, can range from being merely misguided to being diametrically opposed to reality.

This article highlights some of the potential misuse and misunderstandings associated with CbC reporting data from a theoretical perspective and offers some insight into CbC-related audit activity based on real-life examples. In describing the ways in which a CbC report can be misinterpreted, or at least offer an incomplete picture of the multinational group, this article suggests ways for taxpayers to address and potentially mitigate audit risk and BEPS-related tax exposure emanating from their CbC reporting positions.

The Inadequacy of CbC Reporting

The beauty of CbC reporting lies in its credibility. Among the key metrics reported in a CbC report are revenues, head counts, assets, and capital. Each is easily verifiable based on ordinary course business records. The problem in CbC reporting lies not with the credibility of its numbers, but rather in the implied assertion that those numbers mean something, which oftentimes they do not.

As noted, CbC reporting is a great vehicle for providing a list of data points. At the same time, it is often wholly unreliable and misaligned to the purpose for which many tax authorities and stakeholders use or intend to use it. Many of those stakeholders wrongly conflate CbC data points with a factor for proper profit allocation, while waging a war both openly and covertly to evolve the CbC report into an indicator of where profit should or should not be allocated. Those people see a simple world in which profit should be allocated based on things you can see and touch, such as head count (without regard to what functions or value that head count produces) and assets (without regard to their output or effectiveness). CbC reporting is seen as a tool to shorthand a proper allocation of profits within an enterprise, apparently without regard to value creation.

Transfer pricing, however, is a lot more complicated than simply identifying some objective data points and allocating profits based on a resulting formulary apportionment relying on such data points. Indeed, the Tao of transfer pricing is that it largely (although not perfectly) aligns to value and value creation. That is because concepts like the arm’s-length principle look to how transactions would be priced under similar circumstances between unrelated actors. Assuming rational actors and shared knowledge of information, third parties contract in ways that result in prices that put profits into the hands of actors largely based on the value delivered into the multiparty value chain of a transaction. Put another way, in unrelated transactions your return is tied to the value (inclusive of risk control) you bring to the table.

CbC reporting might provide meaningful insights into value and value creation in an organization — if it were 1986. However, value creation in the modern world simply does not align with the antiquated and simplistic data set presented on a CbC report. Thirty-five years ago, there was a strong correlation between personnel and tangible assets and value creation. With limited exception, the more of those one had, the more profit one would expect to earn.

However, it is not 1986. The world has changed. A lot. And the ways in which it has changed cause CbC reporting to be wholly misaligned with value creation. The way businesses have evolved has significantly eroded the correlation between indicators such as head count, assets, or capital and value creation.

Heads are no longer necessarily linked to value. A model predicated on equal contribution across heads (such as a head-count-driven formulary apportionment) demonstrates a lack of a fundamental understanding of how businesses are organized and how they create value in the modern world. Different functions deliver different value. And the distribution of functions is not uniform, often by intention. Today, companies centralize functions in hubs worldwide, ring-fencing groups on both ends of the value spectrum, which has the potential to render the utility of CbC reporting head count insights meaningless.

A call center or central back office might employ 100 of a company’s 1,000-person workforce yet drive only 1 or 2 percent of corporate value. On the other extreme, companies routinely concentrate functions with relatively small groups of people who deliver outsized profits relative to their numbers. For example, a generic drug distributor may employ hundreds of personnel in its global sourcing and procurement function (which is one of the most valuable functions in its organization), with the vast majority of the sourcing and procurement profit concentrated in a dozen people who manage the buy-side pricing analytics. If those people happen to sit in a single country, they would produce seemingly troublesome results in a CbC report when untethered to context and actual facts.

Perhaps even more pronounced is the CbC report’s deficiency in providing any meaningful perspective on value associated with head count and capital assets caused by digital transformation. As industry leaders continue down their digital journey, technology replaces head count but also typically enhances the value and productivity of the remaining personnel. Across functions such as procurement, finance, and customer service, companies have used various digital technologies to replace human functions, resulting in operational savings and reduction of errors and allowing for force reductions or reassignment of employees to higher-value activities. The same value formerly created by X number of employees is now created (or even enhanced) by fewer employees and for less cost (combined capital and operational expense). Smart factories deliver greater output and effectiveness for less investment and with fewer employees. Because there is a real digital divide between leaders and followers, the impact of digitalization is not spread evenly. In this ever-digitalizing world, the idea of relying on CbC reporting alone to provide meaningful insights into where value is created or profits should be earned on any principled basis is misguided. That kind of reliance by a government agency in the course of legitimate government duties borders on malfeasance.

CbC Tax Audit Insights

Unfortunately, the threat of CbC data misuse is not just theoretical. Beginning in 2017 multinational groups began filing CbC reports for periods that began in 2016. Although it took a while to ramp up from when they first started receiving data, tax authorities opened audits and proposed adjustments based on CbC reports despite the OECD’s admonition that they be used only for audit risk assessment, not actual tax assessment.

As the CbC paradigm was being introduced, MNEs and tax advisers were concerned that a tax authority might look at a single metric, such as head count, and make an adjustment by allocating profit based on it. Based on what has happened since, those concerns were well founded: In one instance, shortly after the CbC report was introduced, the Austrian tax authority attempted to do just that in an audit of a Swiss-based MNE group. The MNE had a subsidiary in Austria that included manufacturing, contract research and development, and some management functions. It compensated the various Austrian functions on a cost-plus basis, taking the position that its Swiss headquarters controlled the group generally and the Austrian subsidiary in particular. The Austrian tax authority, however, took the position that the Austrian subsidiary was an entrepreneur and that the appropriate transfer pricing method was a profit split. But how to split the profit? The Austrian tax authority believed it had just the right data source — the CbC report — and just the right metric — the Austrian head count rather than the global one. That simplistic analysis does not consider what the people are doing or the relative value of those functions. Nor does it respect the company’s business structure and where its relative risks actually lie. Ultimately, the Austrian tax authority abandoned its ill-conceived approach, but the story is an important lesson in how CbC data can be misused.

The Austrian example, unfortunately, is not uncommon. The Taiwanese tax authority took a different approach to its audit of CbC data. Table 2 of the report requires MNEs to characterize each of their entities into one or more business activities such as R&D; sales, marketing, or distribution; and holding or managing intellectual property. One of the shortcuts a tax authority might take in an audit is to compare the profits of two group entities that are reported to be similar on Table 2, which is what the Taiwanese tax authority did for a U.S.-based MNE. In this case, Table 2 for entities in Taiwan and Korea reported only one function each — sales, marketing, or distribution. However, when considering the Table 1 figures, the Korean entity reported earning five times the profit of the Taiwanese entity. As a result, the Taiwanese tax authority opened a full-blown audit.

It’s no surprise that the facts were much more complex than the simple Table 2 characterization. The Korean entity had senior-level management, its own IP, a significant marketing function, and a specific amount of R&D. The Taiwanese entity, in contrast, was a simple distributor with no senior management, limited marketing, no IP, and no R&D. The U.S. MNE was unable to sufficiently distinguish or highlight the differences between the Korean and Taiwanese businesses, given the highly simplified nature of the CbC report. After a lengthy audit, and considerable cost and time, the MNE was able to convince the Taiwanese tax authority that its transfer pricing was correct based on the actual functional profile of the Taiwanese entity. However, the story clearly points out the limits to the CbC functional profiling.

A third example of CbC “misuse” comes from the Netherlands. An MNE had two business segments, each operating separate entities in the Netherlands. The entity associated with the first business segment was an IP holding company in the start-up phase and was incurring losses. The second entity was a distributor in a separate, established business that was earning normal profits. Even though the business lines are separate, a CbC report aggregates all of an MNE’s business in a jurisdiction. As a result, the data associated with the Netherlands showed a net loss. The Dutch tax authority began an audit of the distribution business and examined the transfer pricing documentation. Because the MNE’s two lines of business were separate, the documentation did not address the losses in the start-up business. The Dutch tax authority compared that documentation with the CbC report and immediately suspected something nefarious. The audit began to focus entirely on the CbC data and how it was developed.

Practitioners who have prepared CbC reports are well aware of the difficulties of reconciling the globally oriented report — nearly always based on the ultimate parent company’s accounts — with an individual entity’s statutory accounts generally used for local tax reporting. Recognizing that difficulty, and consistent with the tax audit assessment of CbC data, the OECD steers tax authorities away from audits directed at the CbC report itself. Not only does it often point to false issues, but the report itself can have very limited value in assessing the results of any particular MNE subsidiary.

Does ‘Less Is More’ Lead to More Transparency?

Given that the threat of CbC-related (or perhaps “CbC-inspired”) audits is no longer theoretical, MNEs might enhance their controversy positions by reconsidering both their approach to and attitude toward CbC reporting. As a preliminary matter, assume the tax authorities will treat any data in the CbC report as gospel, especially when that is the only information they have, apart from any locally filed tax returns. The Country X tax authority will know how the data on the Country X row of the CbC report marries up to the Country X tax returns, but it won’t have a clue about the data on the other rows. Consider the example above, in which the Taiwanese tax authority tried to compare the profits earned by an MNE’s local entity with a related entity in Korea apparently performing similar functions. Without additional information, the Taiwanese tax authority could not understand how and why the local entity was less profitable than its Korean sister entity.

To that end, could the MNE with the Taiwanese and Korean operations have taken a different approach to the CbC report to stave off the audit in Taiwan? MNEs should carefully assess their risks — including false positives — before filing their CbC reports. That sounds obvious, but the authors of this article have heard the phrase “I know where our risks lie” too many times to count. That is undoubtedly a true statement, but keep in mind that tax inspectors won’t have anywhere near the same level of knowledge about the group. If all the tax inspector has to go on is the CbC report, she won’t be able to simply focus on what the MNE knows to be the key or real problem spots. Rather, the tax inspector is likely going to start her exam by analyzing the key ratios and tests highlighted in the OECD’s Handbook on Effective Tax Risk Assessment and go from there.

MNEs should do the same. Step back. Consider what the CbC report says about the group from the perspective of a tax inspector who has no additional information to rely on. At a minimum, run the key ratios and analytics and piece together a risk profile using those data alone. Perform internal benchmarking and compare the ratios of group entities. If there are outliers between jurisdictions that perform the same functions, understand the reasons why and, at the very least, document them internally. For the MNE with the Taiwan operations, the company might have been able to check additional boxes for its Korea operations, particularly “holding or managing intellectual property” and perhaps “purchasing or procurement.” Identifying those additional functions would have appropriately distinguished the Korean entity from the Taiwanese entity and perhaps avoided a difficult audit.

Taken alone, the functions and activities listed in Table 2 provide very little information. As illustrated above, there were perfectly good reasons why the sales and marketing entity in Taiwan might not be as profitable as the sales and marketing entity in Korea. With only the CbC report in hand, however, those reasons were not readily apparent to the Taiwanese tax authority. It had no way of knowing that the Korean entity had substantially more substance relative to the Taiwanese entity.

Consider other factors that might contribute to differences between perceived like entities. For example, when taken into account, do local tax adjustments that don’t show up on a CbC report prepared using U.S. generally accepted accounting principles financials bring Country Y’s profitability in line with Country X’s? What about market or labor conditions that contribute to the difference, as well as one-off restructurings or new capital investments? The potential list of reasons for differences between Country X and Y results is endless. The key is to identify the most important drivers of those differences and, at a minimum, document them internally so that inquiries can be addressed effectively.

Of course, it would be ideal to persuade a tax inspector to move on from an MNE’s CbC report without first asking clarifying questions (or worse). That is where the master file comes in, as well as other related documentation. Since BEPS action 13 has been in effect, it’s fair to say that most taxpayers have also taken a “less is more” approach to preparing the master file. Most multinational groups are wary of saying too much or the wrong thing, fearing that the master file might get leaked to the public at some point. To that end, a large number of taxpayers start with language taken directly from their Forms 10-K and add only the information necessary to satisfy a literal reading of the rules.

While there is something to be said for the less-is-more approach, based on what we are already seeing on the audit front, MNEs might want to reconsider that strategy. As a practical matter, start with the internal CbC risk assessment (again, coming from the perspective of a tax inspector with little prior knowledge about the group). Does the master file help address any of the problems spotted as part of an internal risk assessment process? If not, consider whether more context or detail might help close the gap. Can and should any of the internal support be brought to the forefront and included in the external documentation? Consider, for example, the Swiss-based MNE facing an Austrian tax audit. What information — even very basic information — might have helped explain why a profit split was not appropriate in that case? Again, while the tax authorities will have a view of what is occurring locally, the CbC data alone won’t necessarily explain how those activities fit into the larger context. That is especially true when there is overlap in the types of activities performed in multiple locations (including the local country), but the substance of those activities in terms of value to the overall supply chain varies by a significant amount. What additional information might be provided to a tax inspector to minimize the chances that he will misinterpret your data?

No matter the approach — less-is-more versus writing the phone book — in almost no circumstance should an MNE view the master file documentation process as merely rolling the report over from one year to the next. At a minimum, take a fresh look at the file every year. How has the end-to-end value chain changed? Given the current environment, this is a particularly good time to have a look at your workforce. Has a formerly Country Y employee decided to move back to Country X, where the rest of his family is living? Is it a permanent move? Did key functions move with the employee, and if so, might that affect where value is being produced? Were technology or business processes created to facilitate remote work and distributed workforces? If so, where is the value creation related to those tools? In the same vein, as companies have been forced to shut down factories and lay off workers, consider how that has affected the supply chain — have functions and duties moved from one country to another? Thinking about those things may come naturally during a global pandemic, but they are lessons to be remembered even in a post-pandemic world.

While fear of a “CbC-inspired” tax audit — or multiple tax audits — is likely the number-one CbC-related concern for most taxpayers, the looming prospect of mandatory public CbC reporting coming to fruition is a close second. In fact, many taxpayers probably regard public CbC reporting — and the resulting public “audit” — as the greater threat, a fear dampened only somewhat by the so-far limited success in adopting tax transparency measures outside a few targeted industries (for example, extractives and banking). As taxpayers start rethinking how they explain their data when it comes to private tax audits, they should take that one step further and consider how the data might be explained if made public.

Several jurisdictions have debated enacting public CbC legislation over the last several years, but no single measure has garnered as much attention as the European Commission’s 2016 draft proposal on public CbC reporting. That proposal has gained — and lost — steam numerous times over the last five or six years but has yet to receive the support of enough member states to be enacted. Change may be on the horizon, however: At a February 25 meeting, European economy ministers voiced broad (although not unanimous) support for the draft proposal. Enactment is far from a done deal, but that was the first time the draft proposal has publicly received support from a majority of the member states.

From a political standpoint, a lot must still happen before multinationals with an EU presence are required to publicly file their CbC reports. Even if the EU draft proposal goes dormant once again, however, given the global momentum and sentiment building toward public disclosure (at least by taxing jurisdictions), future procedural delays may only be postponing the inevitable. Similar measures are gaining traction in the United Kingdom and United States, and on some level, it may only be a matter of time before mandatory public CbC reporting comes to fruition.

Even if mandatory public CbC reporting never gains the support it needs from a political standpoint, public CbC reporting may still become the wave of the future. Investor and public interest in environmental, social, and governance (ESG) policies and initiatives are driving many companies not only to address new areas and issues, but more importantly, to take affirmative actions that only a few years ago would have been unheard of. Given the business community’s overwhelming opposition to the various government proposals, it is somewhat ironic that voluntary public CbC reporting is becoming an important component in this regard. In 2019 the Global Reporting Initiative, a nongovernmental organization that helps multinationals voluntarily disclose and report on ESG metrics, adopted a new tax standard (GRI 207-4) that would require public CbC reporting. Several large MNEs have already begun reporting tax information in accordance with the new standard.

Publicly disclosing data when not mandated by law will not be the right decision for every multinational. That, however, should not diminish or minimize the need for and benefits of taking proactive steps now to become more prepared. When putting together a “private” CbC report — or even master or local file — for satisfying BEPS action 13 reporting requirements, consider what other data can be pulled at the same time that might help the overall picture. As discussed above, is there additional information that can be provided in a master file, local file, or even on Table 3 of the CbC report itself, that might help explain inconsistencies or otherwise reconcile the data to the facts? If taxpayers are hesitant to disclose additional data in a master file, consider keeping contemporaneous support in the internal workpaper files, where it can be quickly accessed if needed.

CbC reporting (and indeed, BEPS action 13 in general) is concerned with income taxes, but what about other types of taxes, including indirect taxes, tariffs, and social contribution taxes? In the same vein, the CbC report also asks for a breakdown of full-time-equivalent employees by tax jurisdiction, but what about part-time employees or independent contractors? Even if they are reported along with full-time-equivalent employees, that information is misleading in the absence of segmentation by employment classification, leaving the reader or auditor with an incomplete picture. Taxpayers might consider whether publicly providing those data and bringing the full facts to light make sense.

Again, publicly disclosing the group’s total “economic contribution” on a CbC basis is not going to make sense for every MNE, but just pulling the data for internal consumption and analysis might prove helpful. And it has the added benefit of giving taxpayers the option to publish the data on short notice. No matter how well data are protected, leaks can and do occur. Having the ability to respond in short order with concrete data and analysis can make all the difference in the world.

Conclusion

The global business community has now been living with BEPS action 13 for five years. Most MNEs have adopted a less-is-more approach for their CbC reports — and to some extent their master and local files — uncertain of how and the extent to which the information might ultimately be used and analyzed by tax authorities. The problem with that approach — at least as far as the CbC is concerned — is that the CbC report still provides an abundance of information. If misused or misinterpreted, those data may not adequately define or capture the company’s true value chain, especially in today’s world. Reflecting the tax authorities’ growing interest in and confidence with CbC data, we are starting to see a wave of new audits; as a result, companies may wish to consider creating stronger master and local files to support their CbC reporting positions. Indeed, with the growing popularity of ESG reporting and the threat of public CbC looming, companies may want to be even more proactive with their annual CbC reports, and in some cases go beyond current CbC requirements, to provide a comprehensive view of their business.²