Tackling corporate tax avoidance in a global economy: is a new approach needed? - Economic Affairs Committee Contents


CHAPTER 4: International reform

The OECD Base Erosion and Profit Shifting project

87.  The OECD is working towards reform of its existing framework, based firmly on existing principles. Its first report on "Base Erosion and Profit Shifting" (BEPS) was presented to a G20 meeting in February 2013. That report lists some of the ways multinational companies use to avoid tax, notably on more aggressive forms of avoidance that can lead to non-taxation.[92] It acknowledges that "the international common principles drawn from national experiences to share tax jurisdiction may not have kept pace with the changing business environment", that "there is no question that BEPS is a pressing and current issue for a number of jurisdictions"[93] and that "it is also important to revisit some of the fundamentals of the existing standards"[94] of international taxation. The OECD's plan of action for the next two years was published on 19 July 2013, after we completed our inquiry.

88.  Mr Pascal Saint-Amans, Director of the OECD's Centre for Tax Policy and Administration, told us "whatever the economic debate on the value of corporate income tax, there is no political maturity to move out of corporate income tax"[95], which we understand to mean a tax broadly in its existing form. He said:

"That is the fundamental approach: taking nothing for granted, just revisiting the basics. Those basics include: the way you eliminate double taxation in the tax treaties; key definitions such as permanent establishment definitions, beneficial ownership definitions, and some others; the transfer pricing rules; and the arm's-length principle—how does it work? Is it fine or not fine?"[96]

89.  Business witnesses broadly supported the OECD's approach. Mr Paul Morton, Head of Group Tax of Reed Elsevier, said:

"The OECD is supportive of refining and improving the current system based on the arm's-length standard and the current definition of 'taxable presence', rather than starting afresh. Within that context, the suggestion is that we look carefully at 'permanent establishment', the attribution of profits to individual countries, the deductibility of some kinds of expenditure and other design features of corporate tax systems. For our part, we entirely agree that these areas should be looked at, particularly the definition of 'permanent establishment' and the allocation of profits between countries. The processes at the OECD are conducive to doing so in a thoughtful way, engaging the tax authorities of all members and non-members, as well as the business community through business organisations."[97]

Ms Helen Jones, Head of Tax at GlaxoSmithKline, said: "We should continue to support the OECD in giving more clarity to the international allocation of profits."[98]

90.  Others were more cautious. Mr Bartlett of BP said:

"The fundamentals of the system are not broken. The arm's-length transfer pricing still secures us an answer in 99 cases out of 100. Yes, there are uncertainties but usually, through the efforts of HMRC with other overseas taxing authorities, we reach a sensible outcome. Yes, there are sometimes uncertainties as to whether we are creating a taxable presence in some countries but, again, we normally reach a conclusion on these matters. The fundamentals still work for us."[99]

Mr Roy-Chowdhury feared reform might reintroduce double taxation: "We probably need to incrementally change the way that we tax profits but …. there are going to be winners and losers. Which jurisdictions are going to be willing to be losers? We need to ensure that we do not end up with double taxation for those businesses."[100]

91.  Some witnesses did not agree that the OECD BEPS approach was the best way forward. Professor Bond said:

"There are some fundamental problems with [the OECD] approach … it is a very artificial activity to seek to allocate the profits of a global business to different territories. It is not typically the way that businesses manage their affairs. In extreme cases, there is no right answer: if the only way profits are generated is the result of multiple activities taking place in two or more locations, and without each of the activities there would be no profits, then there really is no logically correct answer as to how you divide up the profits between the different activities in the different locations."[101]

92.  G8 leaders agreed at Lough Erne on 18 June 2013 to "support the OECD's work to tackle base erosion and profit shifting. We will work to create a common template for multinationals to report to tax authorities where they make their profits and pay their taxes across the world".[102]

93.  We agree that fundamental reform of the international tax framework should be pursued in the OECD. As things stand, there are too many opportunities for multinational companies to manipulate their affairs to reduce their global tax payments. Corporate manipulation of the system so as to avoid taxation reduces governments' revenues, undermines public trust in the tax system. We recommend that the Government should continue to play its full part in encouraging the OECD's reform agenda to an early successful conclusion. At the same time the Government—and the Treasury review we propose—should explore the scope for more radical alternative approaches to corporate tax.

Options for radical change

94.  Even if the OECD BEPS project is eventually successful in reducing—or even eliminating—the most aggressive aspects of multinational tax avoidance, many problems surrounding the international taxation of companies will remain. By allocating taxing rights for different forms of income—retained earnings, dividends, interest and royalties—differently, and by having complex and arbitrary rules for the allocation of profit between countries, the system will always invite multinationals to take taxes into account in their decisions where to locate. Differential rates and tax bases between countries will affect the location of real economic activity and of taxable profit. This chapter considers two possible alternative options to the present international framework: a unitary tax, and a destination-based tax.

UNITARY TAXATION

95.  A unitary tax is perhaps the best known radical alternative to the existing system. Professor Sol Picciotto of Lancaster University said:

"What is needed is a new perspective, a new way of looking at multinational companies … When you think of a company like Google, it looks like a unitary entity. But from a legal point of view, they actually consist of hundreds of different individual companies. …. Instead of trying to treat them as if they were independent entities in different countries, the perspective should be to accept that they are unitary entities and build on that."[103]

96.  The European Commission's proposal for a Common Consolidated Corporate Tax Base (CCCTB) would be a form of unitary tax. Mr Philip Kermode of the European Commission said: "We take it as a single economic entity. The multinational is an entity and therefore the attribution of the profits is done in a formula way."[104]

97.  CCCTB would work on the basis of formula apportionment. Instead of complex rules to identify profit arising in each country, a multinational company's global profits would be divided between countries for taxation purposes according to an agreed formula. Professor Picciotto wrote: "It should be stressed that this approach [formula apportionment] does not seek to attribute profit, since it assumes that the profits of an integrated firm result from its overall synergies, and economies of scale and scope. It allocates profits according to the measurable physical presence of the firm in each country."[105]

98.  In the CCCTB proposal, EU member states would be free to charge tax at any rate of their choosing on their allocation of profit. The most commonly favoured formula is based on the location of tangible assets, employment and the destination of sales. Some have argued that intangibles, such as intellectual property, patents and brands, by their nature highly mobile, should be part of the formula. But including them in the allocation formula of a unitary tax would be to invite multinational companies to hold them in low-taxed jurisdictions. Mr Kermode said: "We examined the idea of putting intangibles in the formula, but if you do that, you create the opportunity to manipulate it."[106]

99.  Tax practitioners expressed reservations about unitary taxation with formula apportionment, for example that the nature of the corporate entity would be altered by its tax treatment. Mr Chris Sanger of Ernst and Young said: "Whether you insource or outsource the activity, that would change the allocation."[107] And formula apportionment is criticised as unlikely to reflect the "true" location of profit. Mr Steve Edge of Slaughter & May argued: "The thing you can say about apportionment is that it will produce a consistent answer but consistently the wrong answer."[108] That view assumes the existence of a "true" location of profit. A different view is that multinationals make higher profits because they operate internationally and the benefits cannot be allocated directly to any location. As Mr Kermode put it: "The group is more than the sum of its parts."[109]

100.  The Government is sceptical of the EU Commission's proposals for CCCTB. Mr Fergus Harradence, HM Treasury, said: "We have a number of concerns about it which we have expressed to the Commission and other member states. … The first problem … you in effect require countries to operate two tax systems with different rules… .also very unclear exactly what the formula would be … real scepticism about the benefits of this initiative."[110] Mr Edward Troup of HMRC said: "Formula apportionment… has not been a great success even in those countries which have sought to apply it … The challenges … are how you design the CCCTB formula apportionment basis and also how you get there from here, given how established the transfer pricing approach is in most of the countries of the world."[111]

101.  Whatever the benefits of moving to a unitary system, Professor Freedman identified three significant obstacles: "First, you have to agree the base, then you have to agree the allocation, then you have to agree who is going to administer this."[112] It seems clear that reaching agreement on all three would be formidably complex and difficult within the EU, let alone more widely, raising tricky issues ranging from accounting standards to the scope for manipulation of formula apportionment based on sales, as Professor Picciotto,[113] and Professor Auerbach noted.[114] Problems could also arise from a mismatch of skills and resources between national tax authorities administering a unitary system, even if the obstacles to setting one up could be overcome. Even then, if some countries stay outside the system, rules would be needed as to how profit would be allocated between the unitary area and other countries, probably based on the existing arm's length approach. As Mr Ashley Greenbank noted: "You would not escape having to transfer price into and out of the area."[115]

102.  A unitary tax system treating multinational companies as single entities in a global economy is attractive in theory. But there would be formidable difficulty in reaching global agreement, or even within the EU, on a common tax base, let alone on the appropriate allocation.

DESTINATION-BASED TAX ON CORPORATE CASH FLOWS

103.  Another radical reform would be to tax corporate profit where goods and services are sold to a third party. A tax levied on profit in the customers' country would mean that companies could not easily shift their tax base. As Professor de la Feria stated: "Customers are not easy to move and there is nothing that a company can do to move the customer: the customer base is where the customer base is."[116] This is generally known as a destination-based tax, as proposed in a submission to the IFS Mirrlees Review.[117]

104.  A destination based tax would be broadly similar in effect to VAT, in that VAT is levied in the country of the consumer (the destination country) rather than the country of the supplier (the source or origin country). As with VAT, exports would be zero-rated for the tax, but imports would be taxed. This introduces an asymmetry, common also to VAT: income would be taxed in the country of residence of the customer to whom the good or service is sold, while expenditure would be allowed against tax in the country in which it is incurred. Under such a tax, cross-border transactions within a multinational would not ultimately affect the company's tax base.[118]

105.  Proponents of a destination-based tax argue it should be enhanced by also switching the tax base from profit in company accounts to cash flows on real activities: that is the tax would be levied on all income from real transactions less all expenditure on real transactions. This would make the tax even more similar to VAT—the main distinction is that the cost of labour would be deductible from the tax base, whilst it is not deducted for VAT. The effect would to reduce the tax base to economic rent only—i.e. profit over and above the minimum required to undertake an investment. In economic terms, this is similar to the effect of giving an allowance for corporate equity, described in Appendix 5.

106.  In principle, such a tax would have several advantages. First, since no tax is levied on investment that just earns the minimum required rate of return, the level of investment should be unaffected by the tax. Second, the location of real activity would be unaffected by the tax, since although the extent of tax relief on real expenditure would differ between countries depending on the tax rate, prices would adjust to offset this effect.[119] Third, since there is no explicit relief for the cost of finance, there is no incentive to use debt, rather than equity, as a source of funds. Fourth, there would be considerably less scope for shifting profits between countries. Professor Auerbach gave two examples where profit shifting would no longer be possible:

"Example one: Suppose a UK company shifts reported profits abroad by understating the value of sales to a foreign subsidiary. Under the proposed tax system, such sales would be ignored and hence would have no impact on the UK tax base.

Example two: Consider a UK company that borrows from a related foreign party, overstating the interest rate on the loan to increase domestic interest deductions and increase interest receipts reported abroad. Because the interest paid abroad would not be deductible …
this transaction would have no impact on the UK tax base.

In both of these examples, the shift of a pound of income from the UK would have no UK tax consequences."[120]

107.  Since the tax would be based on the location of the consumer rather than the location of production or ownership, the pressure of tax competition between countries would be diminished or eliminated. Countries could therefore levy higher rates of tax without fear that economic activity would move elsewhere. However, if only some countries introduced such a tax, they would be more attractive as a location of real productive activity compared to countries with conventional taxes. For example, if the UK alone introduced such a tax, then as Professor Auerbach wrote: "With new investments facing a zero rate of corporate tax in the UK, they will be taxed less heavily than in countries that impose positive tax rates, even low ones, on corporate income [profit]."[121]

108.  Which countries would gain or lose from a destination-based cash flow tax? Mr Mike Lewis of Action Aid feared that a destination-based tax would lead the tax base to move from developing countries, where goods are produced, to developed countries, where the sales take place.[122] But this effect would only occur in some cases. The overall impact for each country would depend on its balance of payments position. Broadly under the current system, a country taxes the value of exports but does not tax the value of imports. This would be reversed under the first step—a switch to a destination-based tax. A country would therefore raise additional revenue if it had a trade deficit (as many developing countries do), and vice versa. But since a destination-based tax would reduce pressures for tax competition between countries, any country which lost out could raise its corporation tax rate to offset the lower tax base.

109.  As with VAT, implementation of a destination-based cash flow tax would require the "destination" of the good or service sold to be defined. And also like VAT, there are difficult issues such as how tax can be collected on digital products, and on the profits of banks.

110.  Broad international agreement would be helpful for introducing a destination-based cash flow tax—but not necessarily essential. Given that such a reform would give more favourable tax treatment for investing in a particular location, there would be some advantage for companies to locate in countries which had reformed their system. This in turn would give governments in unreformed countries an incentive to reform. These incentives suggest that if even a relatively small number of countries implemented such a reform, then others would also seek to do so.[123]

111.  A destination-based cash flow tax could dramatically reduce the scope for profit-shifting and tax rate competition between countries. It might also be much easier to implement than a unitary tax as agreement from many countries might not be needed to begin implementation. We recommend that a detailed study should be undertaken, alongside other options, by the Treasury review we propose to investigate reform of corporate taxes, including the scope for wide international adoption of a destination-based tax and whether the UK could bring in a destination-based tax unilaterally.


92   Examples from OECD, Addressing Base Erosion and Profit Shifting February 2013, pp 40-42. Back

93   Ibid. page 5. Back

94   Ibid, page 8. Back

95   Q105. Back

96   Q106. Back

97   Q30. Back

98   Q32. Back

99   Q18. Back

100   Q42. Back

101   Q8. Back

102   G8 2013 Lough Erne Leaders' communiqué, 18 June 2013, paragraph 3. Back

103   Q116. Back

104   Q105. Back

105   Professor Picciotto, paragraph 18. Back

106   Q112. Back

107   Q53. Back

108   Q83. Back

109   Q112. Back

110   Q141. Back

111   Q141. Back

112   Q122. Back

113   Professor Picciotto, paragraphs 15 & 17. Back

114   Professor Auerbach, paragraph 8.  Back

115   Q83. Back

116   Q123. Back

117   See Alan Auerbach, Michael Devereux and Helen Simpson, Taxing Corporate Income, Reforming the Tax System for the 21st Century: the Mirrlees Review-Dimensions of Tax Design, Oxford: OUP, 2009. Back

118   Auerbach, par 11. Back

119   See Alan Auerbach and Michael Devereux, Consumption and Cash-Flow Taxes in an International Setting, Oxford University Centre for Business Taxation 12/14, February 2010. Back

120   Professor Auerbach, Paragraphs 15, 16 and 17. Back

121   Professor Auerbach, par 28. Back

122   Q68. Back

123   Rita de la Feria and Michael Devereux, Designing and Implementing a Destination-Based Corporate Tax, paper presented at Oxford University Centre for Business Taxation symposium, June 2013, see http://www.sbs.ox.ac.uk/centres/tax/symposia/Pages/AnnualSymposium2013.aspx Back


 
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