CHAPTER 4: International reform |
The OECD Base Erosion and Profit
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.
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"
and that "it is also important to revisit some of the fundamentals
of the existing standards"
of international taxation. The OECD's plan of action for the next
two years was published on 19 July 2013, after we completed our
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",
which we understand to mean a tax broadly in its existing form.
"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 principlehow does it work? Is it fine
or not fine?"
89. Business witnesses broadly supported the
OECD's approach. Mr Paul Morton, Head of Group Tax of Reed
"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."
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."
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."
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."
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
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."
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".
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 Governmentand
the Treasury review we proposeshould 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 reducingor even eliminatingthe 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 incomeretained
earnings, dividends, interest and royaltiesdifferently,
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
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."
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."
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."
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."
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
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."
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."
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
Mr Edward Troup of HMRC said: "Formula apportionment
has not been a great success even in those countries which have
sought to apply it
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."
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
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,
and Professor Auerbach noted.
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
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
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."
This is generally known as a destination-based tax, as proposed
in a submission to the IFS Mirrlees Review.
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.
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 VATthe 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 onlyi.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
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."
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
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.
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 stepa 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 taxbut 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.
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
92 Examples from OECD, Addressing Base Erosion and
Profit Shifting February 2013, pp 40-42. Back
Ibid. page 5. Back
Ibid, page 8. Back
G8 2013 Lough Erne Leaders' communiqué, 18 June 2013, paragraph
Professor Picciotto, paragraph 18. Back
Professor Picciotto, paragraphs 15 & 17. Back
Professor Auerbach, paragraph 8. Back
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
Auerbach, par 11. Back
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
Professor Auerbach, Paragraphs 15, 16 and 17. Back
Professor Auerbach, par 28. Back
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