BEPS: why you’re taxed more than a multinational

BEPSThe new OECD report on Addressing base erosion and profit shifting (BEPS) doesn’t sound like the kind of thing anybody would read for fun, but I guarantee that if you do read it, you’ll want to tell your friends (and enemies) about what you discover in its 80 or so densely written pages. Especially if you pay taxes. For instance, according to the IMF, in 2010 Barbados, Bermuda and the British Virgin Islands received more foreign direct investment (FDI) than Germany (5.11% of global FDI for the islands versus 4.77% for Germany) or Japan (3.76%). During that same year, these three small “jurisdictions” also made more foreign investments (4.54% combined) than Germany (4.28%).

So what is BEPS? “Erosion” refers to the erosion of national tax bases. “Profit shifting” is one way this happens. Companies use a number of schemes to shift profits across borders to take advantage of tax rates that are lower than in the country where they made the profit. Some multinationals end up paying as little as 5% in corporate taxes when smaller businesses are paying up to 30%. It’s all perfectly legal, and exploits the fact that tax systems are still essentially nation-based and were designed for the “old” economy in which, for example, profits from intellectual property were relatively unimportant. But even in the old economy, firms took steps to ensure that international taxation didn’t harm them. Many domestic and international rules to address double taxation of individuals and companies originated from principles developed by the League of Nations in the 1920s.

One of the most common mechanisms for exploiting flaws in the international tax system is a hybrid mismatch arrangement. As we explained in this post, the basic idea behind hybrids is to have the same money or transaction treated differently by different countries to avoid paying tax. For example, declaring the same transaction as either debt or equity depending on the tax rules of the various countries involved. Hybrids often feature dual residence, companies that are residents of two countries for tax purposes. Take Amazon for instance. Officially, they may only have a delivery service in many of the countries where they sell things. In Europe, the main business is based in Luxembourg, and the billions of euros in sales income generated elsewhere is not taxed in those countries.

The passages in the report about Luxembourg are well worth quoting. The Grand Duchy (population half a million) features in a discussion on so-called Special Purpose Entities (SPEs): “entities with no or few employees, little or no physical presence in the host economy and whose assets and liabilities represent investments in or from other countries and whose core business consists of group financing or holding activities”. Total inward stock investments into Luxembourg for 2011 were equal to $2,129 billion, with $1,987 billion being made through SPEs. Outward stock investments from Luxembourg were equal to $2,140 billion with about $1,945 billion USD being made through SPEs.

When I read the report, I thought that was a typo and checked the original data in the OECD Investment Database. But no, plucky little Luxembourg really did attract over $2 trillion in 2011. Luxembourg’s Benelux partner the Netherlands did even better. Total inward stock investments for 2011 were $3,207 billion, with $2,625 billion channelled through SPE. Outward stock investments from the Netherlands were equal to $4,002 billion with about $3,023 through SPEs.

Along with hybrid mismatches and SPEs, another favourite is transfer pricing (explained in more detail here). Around 60% of world trade actually takes place within multinational enterprises, for example the headquarters in the US paying a subsidiary in India to carry out research or manufacture components. This payment is a transfer price. Transfer prices are used to calculate how profits should be allocated among the different parts of the company in different countries, and are used to decide how much tax the MNE pays and to which tax administration.

There is no simple method for calculating a transfer price, so the final value is the result of a negotiation between the company and the tax authority. Ideally, this would be based on equal access to information, a shared objective and a “zero sum game” where an exemption in one jurisdiction is offset by tax in another. It’s not. International business consultancies have more people working on transfer pricing than any national tax authority. Prem Sikka of Essex Business School, co-author of a paper on The Dark Side of Transfer Pricing, claims that “Ernst & Young alone employs over 900 professionals to sell transfer pricing schemes. The US tax authorities employ about 500 full-time inspectors to pursue transfer pricing issues and Kenya can only afford between three and five tax investigators for the whole country.”

BEPS raises a number of questions concerning fairness and equity, including the fact that “if other taxpayers (including ordinary individuals) think that multinational corporations can legally avoid paying income tax, it will undermine voluntary compliance by all taxpayers – upon which modern tax administration depends.” There are wider economic risks too, for example employment, innovation and productivity could suffer if post-tax profit becomes the main criterion for investment.

So what should be done about BEPS? From the above, you’ll have understood that national solutions aren’t going to work. The report was commissioned by the G20 and the OECD will draw up an Action Plan, developed in co-operation with governments and the business community, to quantify the corporate taxes lost and provide concrete timelines and methodologies for solutions to reinforce the integrity of the global tax system.

If you’ve any experience of how these international efforts work, your reaction may be that there will now be years of discussion followed by a vague declaration that something must be done. So here’s a nice surprise for you: “It is proposed that an initial comprehensive action plan be developed within the next six months so that the Committee on Fiscal Affairs can agree it at its next meeting in June 2013. Such an action plan should (i) identify actions needed to address BEPS; (ii) set deadlines to implement these actions; and (iii) identify the resources needed and the methodology to implement these actions.”

By the way, did you know that one of the Virgin Islands was the inspiration for Stevenson’s Treasure Island? You couldn’t make it up.

UPDATE July 19 2013 The Action Plan against BEPS

Useful links

OECD Centre for Tax Policy and Administration

OECD work on exchange of information for tax purposes

OECD work on aggressive tax planning

OECD work on transfer pricing