How U.S. Firms like Google and Amazon Minimize Their European Taxes

Some tax 'loopholes' are legal, but could nonetheless hurt firms’ image with consumers.

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A picture dated October 16, 2008 shows a poster with an image of Britain's Queen Elizabeth II incorporated into the Google's logo at the company U.K. headquarters, in London.

Britain is a huge market for Amazon, the U.S. online retailing giant, accounting for as much as 25% of its total sales outside the U.S. — more than $5 billion annually. The company also employs about 15,000 staffers in the U.K. But it paid less than $3 million in tax to the British Inland Revenue last year.

How so? Because Amazon’s main European operations are incorporated in the Grand Duchy of Luxembourg, a speck on the European map that, like Britain, is a member of the European Union but that for years has done a roaring business by offering foreign companies extremely low tax rates. By being based there, Amazon reports only about $330 million in revenue in the U.K. — compared with almost $12 billion in Luxembourg, where its taxes came to just $10.7 million. That’s a rate of just 0.009%. Amazon can do this because its U.K. arm is registered as a service company for the Luxembourg holding company Amazon EU SARL.

(MORE: U.K. Slams ‘Immoral’ Tax Practices of Multinational Companies)

That type of complex corporate structure — used by many multinationals operating in Europe, including Google and Starbucks — is legal. It simply takes advantage of sharp differences in corporate tax rates and incentives in Europe to optimize tax payments and in the process boost profits. The European Union is a single market, which means that companies can incorporate anywhere and sell their goods and services across the continent, but because there is no harmonized taxation system, it’s a playground for smart accountants and tax specialists who know how to exploit the differences.

Google bases its European operations in low-tax Ireland and remits some of its profits to a company in Bermuda as payments for intellectual property. Starbucks is based in the Netherlands and pays a Swiss company for its coffee.

(MORE: The $7 Cup of Starbucks: A Logical Extension of the Coffee Chain’s Long-Term Strategy)

Now comes the political backlash. The Public Accounts Committee of the British Parliament on Monday released a report that called this type of business practice “immoral” and asked companies, including the three U.S. firms, to pay more. “We consider that paying an appropriate amount of tax in the country in which profits are made is not only a matter of basic economics. It is also a matter of morality,” Margaret Hodge, who chaired the committee, said in a statement. “The U.K. should be taking the lead in making this point.”

Some Britons are hoping that the public fuss about the low tax payments will shame the firms into changing their arrangements. Referring to Starbucks, which has posted a financial loss in Britain for 14 of the past 15 years despite having a 31% market share, U.K. Business Secretary Vince Cable told the Guardian that he “can fully understand why people would vote with their feet as a result of their tax dodging.”

It’s not just Britain that is starting to make a fuss. France has taken legal action against both Amazon and Google, and a report in the French business daily Les Echos says the socialist government is looking to beef up its arsenal tax measures. Legislators in Germany and Italy are also angry. After all, at a time when governments are looking to cut spending and raise taxes, it’s galling to discover that some of the richest companies in the world seem to be thumbing their noses at you, tax-wise.

(MORE: Tax the Rich? French and British Leaders Spar over Plans to Make Wealthy Pay Up)

However, other than sending in tax inspectors to ensure that nothing fraudulent is being done, there’s not a great deal that governments can do to root out the practice. The key here is what’s known as transfer pricing, which is accountant-speak for determining which revenues and profits should be recognized in which parts of a multinational company with affiliates in numerous countries. For example, Google has a very strong case to make that its intellectual property (in other words, the sophisticated algorithms that make its search engine so useful) is something for which its subsidiaries worldwide should be paying for — thereby transferring a portion of their revenue back to Google elsewhere.

Over the past decade, international rules that govern transfer pricing and tax loopholes have been tightened under the auspices of the Organisation of Economic Co-operation and Development (OECD), which in particular has put growing pressure on tax havens. The OECD is now trying to take its work a step further with an initiative called base erosion and profit shifting. This came out of the G-20 meeting in Mexico last summer; the OECD is supposed to issue a report on the subject in early 2013. But as it acknowledges, “domestic rules for international taxation and internationally agreed standards are still grounded in an economic environment characterized by a lower degree of economic integration across borders, rather than today’s environment of global taxpayers, characterized by the increasing importance of intellectual property as a value-driver and by constant developments of information and communication technologies.”

In other words, you can howl as much as you want, but as long as there are free markets, different tax rates in different countries and armies of clever accountants, public shaming may well be the most effective strategy to deal with the problem.

MORE: Europe’s Fiscal-Crisis Measures Are Working … Sort Of