“Google, the third-largest U.S. technology company by market capitalisation, hasn’t been accused of breaking tax laws,” Bloomberg concedes. But the tax arrangement is being done at a time when “the U.S. government struggles to close a projected $1 trillion budget and the European Union countries face a collective deficit of 868 billion euros.”

 

Draw your own conclusion, folks.

 

It remains to be seen whether the revelation will have any negative effect on Google, if at all. It seems unlikely that Internet users will switch to another search engine or that advertisers will take their dollars elsewhere just because Google is being as tax efficient as it is legally allowed to be. It’s even more unlikely that shareholders would object, unless the arrangements are proved to contravene the law. Indeed, if the company were remiss in legally shaving US$3.1 billion off its tax bill, questions will be raised about management’s commitment to shareholder value.    

 

So the proper response of CFOs to this story should be: How can I follow Google’s lead?

 

First, your company’s tax department should determine whether the company’s country of residence (that is, the jurisdiction where your holding company’s headquarters are located) allows your company to move property and operations (and thus income) outside of that country’s tax jurisdiction.

 

Google’s country of residence is the United States. In general, the income of controlled foreign corporations (CFCs) is required to be included in the U.S. parent’s federal gross income, which is taxed at a top rate of 40%. However, a CFC’s income can be exempted from U.S. tax if it is generated from products that have been substantially transformed in the foreign jurisdiction.

 

For example, write U.S. lawyers Joseph B. Darby III and Kelsey Lemaster, a CFC that sells steel rods made in the U.S. will have its income reported in the U.S. But if those steel rods are transformed into screws and bolts in the foreign jurisdiction, the income is exempted from U.S. taxes.

 

In Google’s case, the product is intellectual property. Under U.S. law, a U.S. company that transfers intangible property to an offshore party is deemed to have sold such property at rates “commensurate with the income attributable to the intangible,” regardless of the actual consideration received, and taxable as ordinary income, note Darby and Lemaster.

 

However, the transaction can be structured as a cost-sharing arrangement to jointly develop the intangible property. According to Darby and Lemaster, “the non-U.S. rights in the intellectual property developed under the cost-sharing arrangement will be treated as created in the jurisdiction where the intellectual property is intended to be utilised by the foreign subsidiary and therefore will not be subject to Code Section 367 [of the U.S. tax law].”

 

After three years of negotiations with the U.S. Internal Revenue Service, reports Bloomberg, Google received approval in 2006 for an advanced pricing agreement in which the U.S. company “licensed the rights to its search and advertising technology and other intangible property for Europe, the Middle East and Africa to a unit called Google Ireland Holdings.”