High income economies have tended to follow irresponsible fiscal policies over an extended period of time. While we might quibble over whether the better approach to deficits is to spend less or tax more, or indeed some combination of the two, governments have been trying to access new sources of revenue.
At the November 2014 G20 meeting the Australian Treasurer Joe Hockey had plenty to say about taxation:
“At the beginning of the year we set out to restore integrity and resilience to our tax bases, and give our citizens the confidence that everyone is paying their fair share of tax. Now I can say that we will bring international tax rules into the 21st century and ensure the rules keep pace with changing business models.
We have reached consensus on all of the 2014 OECD’s Base Erosion and Profit Shifting Action Plan deliverables, and this keeps the action plan on track for completion in 2015.
Our effort has continued right up to this Summit, and I welcome the recent proposal to amend certain intellectual property regimes or ‘patent boxes’ to ensure that they are not inappropriately used for tax avoidance. This proposal continues our work on harmful tax practices and I commend it to other G20 and OECD members for their consideration.”
Let’s ignore, for argument sake, the failure to distinguish between tax avoidance and tax evasion. Rather I want to focus on the notion of so-called “harmful tax practices”’.
The OECD has been campaigning on “harmful tax practices” since the late 1990s. The OECD had been commissioned by member states to “develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases”. The report itself was a somewhat wordy affair that actually failed to define what ‘harmful tax practices’ constitute. Instead there was a vague reference to spillovers: “If the spillover effects of particular tax practices are so substantial that they are concluded to be poaching other countries tax bases, such practices would be doubtlessly labelled ‘harmful tax competition’.”
The harm of such practices is defined by its consequences – apparently tax competition affects business location decisions, erodes tax bases, undermines tax neutrality, and social acceptance of taxation. Most damning of all, however, is that the OECD was unable to produce any actual evidence of these dire consequences, arguing instead: “A regime can be harmful even where it is difficult to quantify the adverse economic impact it poses”.
The dog had eaten their homework. As I have written elsewhere in the case of the UK and US and in the case of Australia, there is no evidence to support the notion that those nations’ tax bases are being eroded.
Let us rewrite the OECD complaint as follows: If the spillover effects of particular business practices are so substantial that they are concluded to be poaching other businesses customer bases, such practices would be doubtlessly labelled harmful business competition. It now becomes apparent what the game is. Few economists would be concerned at all by that complaint. We all understand that the effects of competition can be harsh on weaker competitors. It turns out that governments and politicians, like business, don’t always appreciate having to work at improving themselves and offering a more attractive mix of services and taxation in order to attract business.
The international tax regime has evolved over time to minimise double taxation so as to enhance the scope for international trade. In essence that has meant the establishment of an international tax cartel where governments have divided up the tax base and apportioned “market share” to each other. It is perfectly understandable why governments would want to establish a tax cartel. Every government has to make a choice as to the public services-tax mix that it is going to offer and a tax cartel with reduced competition makes that choice easier.
Of course, we know that cartels are unstable and members have incentive to cheat. At some point members realise that by lowering their prices – in this case taxes – they can gain market share. So too with the international tax cartel – some countries have chosen to lower their taxes and work harder to attract economic activity to their shores. Other countries, rather than respond to such competition by competing themselves, have chosen instead to engage in fiscal imperialism – bullying and cajoling sovereign nations to change their domestic policies. Or worse – threatening and intimidating companies that take advantage of the tax incentives governments establish to attract their business. Another private sector analogy suggests itself – we all know and understand the distinction between profit-seeking and rent-seeking.
It is important to point out that the famed double Irish-Dutch sandwich, for example, does not rely on bank secrecy, but rather is a function of national laws specifically designed to promote economic activity. There is nothing stopping any of the countries that regularly complain about that strategy from adopting similar policies. Contrary to what politicians would like us to believe there is an important distinction between tax avoidance and tax evasion. It can never be “unfair”, or immoral for that matter, for any person of company to be fully compliant with their legal obligations under tax legislation.
The OECD’s work on harmful tax practices/competition and base erosion and the like has given intellectual respectability to an otherwise grubby political squabble over tax shares. To be sure, the OECD itself is a political organisation that has to respond to member concerns. Yet it should not expect to avoid criticism in what is ultimately a political dispute within a tax cartel.
Sinclair Davidson discusses tax reform
Multinational corporations, stateless income and tax havens by Sinclair Davidson, published by the ACCA (Association of Chartered Certified Accountants) the global body for professional accountants.
Last weekend, the OECD presented its first BEPS recommendations to the G20 for an international approach to put an end to so-called “stateless income”. Seven “Actions” are being proposed, as part of a 15-point plan.
Ensure the coherence of corporate income taxation at the international level, through new model tax and treaty provisions to neutralise hybrid mismatch arrangements (Action 2).
The basic idea behind hybrids is to have the same entity or transaction treated differently by different countries to avoid paying tax. A typical hybrid instrument would allow a company to treat something as debt in one country and equity in another. Hybrid transfers are arrangements that are treated as transfer of ownership of an asset in one country but as a loan with collateral in another. By playing off one country’s tax system against another, like children sometimes do with their parents when they try to get what they want, the most successful hybrids achieve double non-taxation – the company doesn’t pay tax anywhere.
Realign taxation and relevant substance to restore the intended benefits of international standards and to prevent the abuse of tax treaties (Action 6).
“Treaty shopping” is the most common form of treaty abuse. It generally refers to arrangements through which a person who is not a resident of one of the two States that concluded a tax treaty attempts to obtain benefits that the treaty grants to residents of these States. How? By setting up a shell company in one of the treaty States and routing investments through it. OECD and G20 countries have all agreed to reject treaty-shopping practices. Proposed drafts of a specific anti-abuse rule based on a “limitation-on-benefits” provision and a more general anti-abuse rule based on a “principal purpose test” have been unveiled to ensure that only “true” residents get the benefits of the treaty.
Assure that transfer pricing outcomes are in line with value creation, through actions to address transfer pricing issues in the key area of intangibles (Action 8).
Most world trade actually takes place within multinational enterprises, for example the headquarters in Germany paying a subsidiary in India to carry out research or manufacture components. This payment has to be at arm’s length to ensure that profits (or losses) are allocated among the different parts of the group in a fair and sound manner. How to apply the arm’s length principle in practice is detailed in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Easy in many cases, it may get extremely difficult, and subject to manipulation, when we are talking about intangibles, like famous brands, patents, algorithms or the like. Estimates of annual investment in intangibles in the United States alone are between $800 billion and $1 trillion, with a stock of intangibles of up to $5 trillion. Now, new guidance has been developed to align the transfer pricing rules with modern business.
Improve transparency for tax administrations and increase certainty and predictability for taxpayers through improved transfer pricing documentation and a template for country-by-country reporting (Action 13).
Countries have agreed that companies should report on a country-by-country basis certain key information, such as assets, sales and number of employees. This will provided tax administrations with a broad picture of the group structure and where profits are made and allocated for tax purposes. The focus can then be on those that engage in aggressive tax planning that separates the location where profits are made from where they are reported for tax purposes.
Address the challenges of the digital economy (Action 1).
The digital economy does not generate unique BEPS issues, but some of its features can exacerbate BEPS risks, such as the importance of intangibles, the mobility of users, network effects and multi-sided business models. (If you thought certain things, like an e-mail address, an app, a videogame, an Internet search, were “free”, look at how much money Internet advertising generates). It’s hard to say where certain activities or assets “are” for tax (and other) purposes. Depending on how you look at it, it could be on the computer of the user watching an ad, the firm paying for that ad, the server streaming it, the head office of the owner itself… Or take an off-line delivery service (pick your favourite): despite its considerable sales in a country like France, in theory, its French operation is only a delivery company processing orders for a firm based in (pick your favourite again). This ability to centralise infrastructure at a distance from the market and sell into that market from a remote location, generates potential opportunities to achieve BEPS. It does so by fragmenting physical operations to avoid taxation, especially when combined with the increasing ability to conduct substantial activity with very few personnel. One year from now, an agreement will be reached so that this will not be possible anymore.
Facilitate swift implementation of the BEPS actions through a report on the feasibility of developing a multilateral instrument to amend bilateral tax treaties (Action 15).
Even in the old economy, governments took steps to ensure that international taxation didn’t harm firms operating across borders. 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. The OECD has been working for years to help tax administrations and policy makers cooperate across borders. The OECD Model Tax Convention serves as the basis for the negotiation, application, and interpretation of over 3000 bilateral tax treaties in force around the world. Its Commentaries have been cited by courts in virtually every OECD member country, as well as in many non-OECD countries. Now change is coming in several key areas. But without a mechanism for swift implementation, changes to model tax conventions will only widen the gap between these models and the content of actual tax treaties. Such an implementation mechanism does exist, and it is a multilateral instrument. Difficult? Yes, but it is feasible, and developing it is necessary not only to tackle BEPS, but also to ensure the sustainability of the consensual framework to eliminate double taxation. So not only feasible, also desirable (at least by those like us who think change is needed).
Counter harmful tax practices (Action 5).
The OECD published a report on Harmful Tax Competition: An Emerging Global Issue in 1998, but 15 years later, concerns about the “race to the bottom” on the mobile tax base are as relevant as ever. The focus has shifted though. In 1998 a major concern was regimes partially or fully isolated from the domestic economy (“ring-fencing”). For example, this could take the form of giving firms resident status to avoid paying taxes in another country, but not allowing them access to local markets where they would compete with national firms. Today, across the board corporate tax rate reductions on particular types of income are of growing concern. To counter harmful tax practices more effectively, Action 5 commits the Forum on Harmful Tax Practices (FHTP) to revamp the work on harmful tax practices. Priority has been given to improving transparency, with the obligation to exchange information on rulings related to preferential regimes. The focus is now on requiring substantial activity for any preferential regime with a special focus on the “patent boxes” which are mushrooming these days. – regimes that subject certain IP income to a preferential rate of tax. Going further, the work will engage with non-OECD members on the basis of the existing framework and consider revisions or additions to the existing framework.
You can contact the BEPS team at CTP.BEPS at oecd.org (replace ” at ” by @)
Pascal Saint Amans on fighting tax avoidance by multinationals
The next time somebody asks you take part in a consumer survey or opinion poll, ask them how much they’re prepared to pay for your time and opinion. They’ll probably stop pestering you in case you talk to them for hours about the aliens who stole your chocolate cake. Working for nothing is such an accepted part of the modern economy that it’s the person who calls it into question who is labelled crazy. Millions of us toil away humbly for well-known companies without getting paid. Some airlines won’t even let you board unless you make your own ticket, or else they’ll charge you a fortune for printing it at check-in.
It’s obvious that by doing what a travel agent or airline employee used to, you’re saving the company money and helping to boost its profits. Some of your other contributions to corporate well-being aren’t so easy to define and measure though. If you upload a video, does the site add the same value if 10 people watch it or 1 million? And if the site uses your video to attract advertisers, is the ad money made in your country, the countries where the video is seen, the country where the computer storing it is kept, or none of these?
Increasingly, the last answer is the one favoured by multinationals, and that poses problems for taxation. Some businesses that are worth billions may pay practically no tax in the places where they operate and make profits. Not because they’re defrauding the system, but because tax systems simply haven’t kept up with how firms in the digital economy in particular add value and make profits, on intangible assets such as design and licensing for example, or even by exploiting your personal data.
Other firms also avoid paying what most citizens would consider “fair” taxes through “(tax) base erosion and profit shifting” or BEPS as the OECD calls it. As we discussed in this article, BEPS schemes themselves can be extremely complicated, but the basic idea is simple: shift profits across borders to take advantage of tax rates that are lower than in the country where the profit is made. Three popular mechanisms for doing this are hybrid mismatches, special purpose entities (SPE), and transfer pricing.
Hybrids try to have the same money or transaction treated differently (as debt or equity for instance) by different countries to avoid paying tax, and often feature dual residence – companies that are residents of two countries for tax purposes. An SPE is an entity 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.
Transfer prices are the prices various parts of a company pay each other for goods or services. They 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 and the lack of good “comparables” (similar operations carried out at market prices by unrelated entities) often results in profits being artificially shifted to no- or low-tax jurisdictions.
International tax rules are generally efficient in ensuring that companies are not subject to double taxation, but BEPS takes advantage of gaps in the rules to avoid paying tax completely, so-called “double non taxation” or to pay a sum across two or more countries that is less than what they would pay in a single country.
Opportunities for MNEs to pay less tax harm everybody. Governments lose revenue and may have to cut public services and increase taxes on everybody else. But businesses suffer too. Small businesses, businesses working mainly in one national market and new firms can’t compete with MNEs who shift profits across borders to avoid or reduce tax. And an MNE that doesn’t shift profits is at a disadvantage compared to its BEPSing rivals.
What can be done? Today, the OECD launched a 15-point Action Plan that will give governments the domestic and international arms they need to combat BEPS. The Plan recognises that greater transparency and improved data are needed to evaluate and stop the growing disconnect between where money and investments are made and where MNEs report profits for tax purposes.
The Action Plan will for example stop the abuse of transfer pricing by ensuring that taxable profits can’t be artificially shifted through the transfer of patents, copyright or other intangibles away from countries where the value is created, and it will oblige taxpayers to report their aggressive tax planning arrangements.
When we wrote about BEPS in February, we mentioned the sense of urgency surrounding the OECD work, with the proposal that a workable plan be agreed on within six months. The next steps will take a bit longer of course, but not that much longer. The actions outlined in the Plan will be delivered over the next 18 to 24 months by the joint OECD/G20 BEPS Project, regrouping all OECD members and G20 countries on an equal footing. To ensure that the actions can be implemented quickly, a multilateral instrument will also be developed for countries that want to amend their existing networks of bilateral tax treaties.
Some may protest and try to get the plan neutralised, but would they really prefer the alternative if the no action is taken to address the weaknesses that put the present consensus-based multilateral framework at risk and countries apply: “… unilateral measures, which could lead to global tax chaos marked by massive re-emergence of double taxation”?
The simplest way to pay less tax is to earn less, but if you’re a multinational enterprise, there are other options, including double deductions – pay your tax in one country then deduct that sum in two or more other ones. You can also make your income disappear for tax purposes by getting a deduction in one country that isn’t included in the calculation anywhere else. If you’re really smart you can even generate foreign tax credits for taxes you didn’t actually pay at all. The exception proves the rule, and while most OECD documents contain some warning about there being “no magic/silver bullets”, that doesn’t apply to international taxation.
The bullets are “hybrid mismatch arrangements”, hybrids for short, and although they cost the rest of us billions of dollars a year, they’re perfectly legal, for the time being anyway. The OECD’s Centre for Tax Policy and Administration and the Canada Revenue Agency have just organised a meeting with senior tax officials from OECD countries to discuss the issues raised, following the publication of an OECD study Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues.
Hybrids exploit the fact that although the economy is increasingly globalised and integrated, corporate tax systems are still running on principles established around a hundred years ago for firms operating mainly in one country, with little need to consider how different systems affected each other. International tax expert Professor Reuven S. Avi-Yonah put it like this when testifying to the US Congress Ways and Means Committee: “corporate residence is not a particularly meaningful concept, it makes little sense to base the entire US international tax regime on it.” Multinationals certainly don’t base their tax strategies on it and take advantage of mismatches between national legislations via aggressive tax planning.
The basic idea behind hybrids is to have the same money or transaction treated differently by different countries to avoid paying tax. One common feature of hybrids is dual residence, companies that are residents of two countries for tax purposes. Speaking during the debate on the UK budget earlier this year, Conservative MP Charlie Elphicke denounced the “magic roundabout” that allowed companies like Google to avoid tax, pointing out that the company “took about £2.15 billion in revenue from the UK in 2010, making an estimated £700 million profit, yet it did not pay any tax. In fact, it declared a loss of £22 million”.
Amazon is another case in point. If you look at their accounts, you’ll find that they may not actually trade in a country they do business in, since they only have a delivery company there. 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.
Apart from dual residence, the other most common elements that hybrids exploit are entities, instruments and transfers. The details are complex and vary from place to place, but one firm offering to help companies avoid tax through hybrid entities, in this case limited liability companies, sums up the approach in the clearest of terms: “The [entity] allows for a real presence [in the host country], with all the normal benefits of [that country’s] legal structure and bank accounts… but reap the profits – tax free!”
A typical hybrid instrument would allow a company to treat something as debt in one country and equity in another, while hybrid transfers are arrangements that are treated as transfer of ownership or an asset in one country but only as a loan with collateral in another.
By playing off one country’s tax system against another, the most successful hybrids achieve double non-taxation – the company doesn’t pay tax anywhere, an unintended consequence if ever there was one of the tax laws of the countries concerned. It’s worth repeating that none of this is illegal. Replying to criticisms of its low tax bill, a spokesperson for Google said: “We have an obligation to our shareholders to set up a tax efficient structure, and our present structure is compliant with the tax rules in all the countries where we operate.”
That may be true, but it raises a number of issues. Obviously companies act like this to reduce the revenue tax authorities receive. The total sum isn’t known and a few jurisdictions may benefit at the expense of the rest, but some figures are available. In 2009 New Zealand settled cases involving four banks for a combined sum exceeding NZ$2.2 billion (€1.3 billion); Italy has settled a dozen cases involving hybrids for around €1.5 billion; while in the US the amount of tax at stake in 11 foreign tax credit generator transactions has been estimated at $3.5 billion.
Then there’s the issue of fairness and trust in the tax system. A new OECD study, Taxing Wages shows that the tax burden on earnings is continuing to rise in OECD countries. Governments trying to convince workers that they have to pay for austerity measures would have a better chance of convincing them if capital income was seen to be taxed fairly. Local businesses that don’t have the multinationals’ means to use hybrids and other means of paying less tax may feel they’re being treated unfairly too, and they are at a competitive disadvantage.
What can be done? A number of countries have introduced rules which specifically deny benefits arising from hybrids by linking the domestic tax treatment of an entity, instrument or transfer involving a foreign country with the tax treatment in that foreign country. The OECD recommends such initiatives, along with two others: sharing intelligence and experience on tackling hybrid; and consider introducing or revising disclosure initiatives targeted at certain hybrids.
Tax Inspectors Without Borders/Inspecteurs des impôts sans frontières The OECD’s Task Force on Tax and Development has launched an initiative to help developing countries bolster their domestic revenues by making their tax systems fairer and more effective. The OECD will establish an independent foundation, to be up and running by the end of 2013, that will provide international auditing expertise and advice to help developing countries better address tax base erosion, including tax evasion and avoidance.