Monday, 11 February 2013

Multinational tax avoidance and international responses (1 of 2)

Ahead of tomorrow’s release by the OECD of what promises to be an interesting report on their plans to address multinational tax avoidance, this post is a primer on the issue and on the role of the OECD. I’ll follow up tomorrow with some analysis of the report itself.

What’s the issue

Multinational Corporate Tax avoidance: the perfectly legal but shockingly complex process of arranging special purpose companies and capital flows in artificial ways so that the group as a whole pays as little tax as possible worldwide. It’s a huge problem – the IRS figure for profits offshored by US corporations is 1.7 trillion dollars - and that’s just American firms. The problem is that while taxes are imposed by individual countries, multinational firms roam the world in search of advantage, setting up a management firm here, a registered office there. Individual tax authorities find it difficult to see the whole picture. These days too, most of the value in large companies comes from intangible things like brand and intellectual property, which are far harder to trace than physical sales or factories.
Avoiding tax is a game as old as tax itself, but lately opposition to multinational tax avoidance has gathered momentum and political support.

Why is this a problem ?

That $1.7 trillion kept offshore by American firms is not just a loss to the US exchequer – profits it might reasonably have expected to tax. It also makes an uneven playing pitch for American companies. The bigger multinational ones can avoid tax more easily than smaller, domestically-centred firms. That gives them an immediate advantage that biases against entrepreneurship, growth, and all the things needed to kick-start the economy.

A wider problem is that it’s not just the US that is losing tax: as discussed here, the loss in relative terms to countries in the global south is even greater. A recent Action Aid report details the case of a Zambian sugar company routing interest and dividend payments through Ireland and the Netherlands in order to avoid tax in Zambia; this in a country where 45% of children are undernourished, and 90% of rural dwellers live in poverty. Lives are, quite literally, at stake here.

It’s hardly surprising in this context that US President Obama harks back again and again to the need for corporate tax reform. Indeed, politicians the world over are excited about this issue now. South African leaders have spoken out about this for years. It’s debated in the UK parliament, makes primetime news in France, home of the OECD. This media coverage drives more political debate, which in turn puts pressure on the big international bodies to do something about this.

So who are these international bodies?

In this part of the world, the three international bodies shaping international tax are the European Commission (EC), the UN and the OECD. The EC has been working for the last seven years on the Common Consolidated Corporate Tax Base (CCCTB), of which more here.  Basically, this is a way of allocating the taxing rights on profits earned in the EU across the member states, depending on where the company has located its assets, its employees or its sales. It’s an idea that bubbles steadily under the surface, but for now, and as long as unanimity is required for big tax changes like this, it is not an immediate prospect.

The UN is obviously the most representative of the three bodies. It’s also the most focused on the global south, and last October produced a detailed Practical Transfer Pricing Manual for Developing Countries.  Like the OECD, its focus is on the tax rules in place between countries – tax treaties and transfer pricing arrangements. The UN models tend to favour developing countries by allowing tax to be withheld on royalty and interest payments of the kind documented in the Action Aid report mentioend above. However, while the UN may have the mandate, and the EU the immediate proximity, the OECD has the resources, and now, spurred on by increased political pressure, is developing new strategies to tackle the issue.

What has the OECD been doing so far?

The OECD is the body behind the dominant model tax treaty, which forms the basis for most bilateral treaties negotiated worldwide. It has fairly standard clauses on who has taxing rights in cross-border transactions, and aims at eliminating double taxation. They started looking at tax havens, or harmful tax competition in the 1990s. They developed a three-part test whereby a country with low or zero tax rates ring-fenced to a subset of companies and with a general lack of transparency would be regarded as a tax haven. The penalty effectively was to lose the benefits of the tax treaty network. Around this time, Ireland’s switch from a 10% rate in Shannon and for manufacturing, to a 12.5% rate for all neatly sidestepped the new rules. We have a low tax rate, but we’re not a tax haven as defined because we have no ring-fencing of the low rate to a particular subgroup of companies.

As well as identifying countries with harmful practices, the OECD focuses on transfer pricing, of which more here. Simply out, a transfer price is the price at which goods are sold between sister companies. It can be abused as a way of shifting profit from high-tax to low-tax locations by manipulating the prices or more commonly the level of royalty or management charges paid. Such transactions should be at “arms length”, meaning that the same rates and conditions should apply within a group of companies under common ownership as between unrelated firms. This is straightforward enough to police if you are looking at the selling price of something tangible, like cars or computers. It’s virtually impossible in the case of royalties for which there is no benchmark price outside of the group.

As if this wasn’t challenging enough for taxing authorities, there has been a raft of new and very complex tax structures adopted and mimicked by multinational firms in recent years. The best known locally is The Double Irish.  As reported by Bloomberg , this is a now-infamous means used by large US firms to channel royalty payments through Ireland on to Bermuda, reducing their overall tax bill to negligible levels. Ireland is not the only country whose tax system is used in this way. Even without a detailed knowledge of the particular techniques used to shift profit, there are signs plainly to be read: the number of companies now headquartered in The Netherlands, for instance; the levels of investment flowing in and out of Luxembourg. The issue is enormous, complex and difficult to tackle. How do you establish an arms-length price for something which is only sold to one related company? How can you determine where a company has operations if its product or service is as nebulous as the very cloud in which it hosts its files?
The way in which business is done by multinational firms has changed dramatically, and tomorrow the OECD reports on how it will change its approach to multinational tax evasion in response. A blog post here will analyse their new approach, and some of its implications.
Sheila Killian

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