Archive for Tax policy

There Must Be a Better Way. Right?

Some readers have asked me the following question: isn’t there a better way to figure out where a given multinational’s income should be taxed than by applying the arm’s length standard to intra-group transactions and performing complicated and subjective transfer pricing analyses? Couldn’t we in fact do away with transfer pricing altogether by simply taking the total income earned by a multinational and dividing it in a reasonable fashion across the various countries in which it does business? Wouldn’t life be simpler for both taxpayers and tax authorities if they didn’t have to worry about finding arm’s length prices to apply to all of the transactions that take place within a multinational group?

9921998_sThis proposed method of figuring out a multinational’s taxable income in any particular jurisdiction is known as formulary apportionment, and it’s a tempting alternative to transfer pricing for a variety of reasons. Identifying arm’s length transfer prices is a complex exercise, typically with no single objectively correct answer, and as a result there’s the fear that transfer prices may be manipulated by multinationals to yield favorable tax outcomes. Apportionment, by contrast, would apply a simple formula to a multinational’s worldwide profits to calculate the tax owed in each specific jurisdiction. Advocates argue that this would reduce the scope for multinationals to use financial trickery to reduce their taxes.

Unfortunately, an attempt to move toward formulary apportionment would probably create at least as many problems as it would solve. A good corporate tax system should avoid introducing distortions into the economic decision-making process, so that projects or transactions occur when they have economic merit and don’t occur when they don’t. But unless there is an international consensus on the use of apportionment – as well as on the details of the specific formula to be used – apportionment would be tremendously distortionary.

Imagine a situation where one country uses apportionment while its trading partner doesn’t. In that case companies doing business in both countries would inevitably encounter numerous situations where certain activities would result in non-taxation of profit, while other activities would result in double-taxation. Certain economically worthwhile activities would never happen, while other activities would take place purely for the tax benefit they provide. Even if the company’s overall tax bill is unchanged, society would lose out as a result of this misallocation of resources.

Could this problem be avoided if there was an international consensus on the use of formulary apportionment? Probably not. Even if every major country agreed to switch to apportionment, it is hard to imagine that all of them would agree on the specific formula to use to divide up multinationals’ income. Each country would, naturally, prefer to calculate its share of a multinational’s income using elements (e.g. overall sales, workforce, or assets) that work to their advantage. And then even if a common formula could be agreed on, that formula would encourage companies to manipulate the elements of the allocation formula, again distorting economic activity by incentivizing behaviors that have no real economic rationale.

To add to the list of problems, apportionment would be an accounting nightmare for multinationals, which would have to gather and present data on the group’s worldwide activities to each individual country in a manner consistent with that jurisdiction’s specific book and tax accounting rules. Furthermore, under apportionment exchange rate movements would alter how much tax a multinational owed in each country by affecting any elements of the allocation formula that are measured in units of currency, such as sales or assets. For example, if China’s currency were to continue to strengthen against the dollar over time, China would be able to claim a larger and larger share of the income of multinationals doing business there, even if those multinationals had no change in their sales or transactions. That would be a rather odd tax system indeed.

To be clear, I am not arguing that the current international system of corporate taxation never distorts economic activity. Specific tax incentives for certain industries or activities, as well as varying rules on deductibility from country to country, can and do have these effects. But to justify the enormously complex and expensive undertaking of trying to switch the world economy to formulary apportionment the new system would have to be an unambiguous improvement. It is not.

Attacking the Cash Box

A colleague of mine yesterday highlighted comments made recently by Robert Stack, deputy assistant secretary for international tax affairs at the US Treasury Department: “We are determined to put a big dent in the ‘cash box’ because countries cannot afford large piles of untaxed income.”

4871276_sBut what is a “cash box”, anyway?  The concept is pretty simple: it’s a company within a multinational group located in a low-tax jurisdiction that owns some sort of valuable asset. That company may not even have any employees, but since it owns the asset it is legally entitled to the profits that are generated by the asset, thereby ensuring that a portion of the multinational group’s income gets taxed at a very low tax rate.

But for tax authorities, restricting the use of such arrangements is trickier than it might seem. Let’s use an example to illustrate. Imagine there’s a company called SuperTech USA that develops a fantastic new product. SuperTech USA sets up a subsidiary on a lovely tropical island that happens to have a corporate tax rate of zero, and then has SuperTech Island Co purchase the designs and technology underlying that product. SuperTech Island Co hires a contract manufacturing company in China to make the product, and contracts other SuperTech affiliates around the world, possibly including SuperTech USA, to essentially act as local sales agents.  From that time onward, whenever SuperTech products are sold to consumers the local sales affiliates get some sort of arm’s length compensation for their services (maybe a sales commission), but SuperTech Island Co gets the rest of the revenue. If it’s really a good product with fat profit margins then it’s likely that the bulk of the group’s profits will actually belong to SuperTech Island Co and be subject to zero corporate income tax.

If you are interested in stopping this type of arrangement, how would you go about it? Perhaps you might consider blocking the initial purchase of the asset by SuperTech Island Co. But companies buy and sell assets all the time for perfectly reasonable business reasons, so any sort of simple rule prohibiting that won’t work. What about requiring all of SuperTech’s sales revenue to belong to the local sales affiliates rather than to SuperTech Island Co?  Allowing the owner of an asset to claim the income generated by that asset is a basic element of our notion of property rights, so we can’t easily tamper with that.

The OECD seems inclined to address the issue in a different way: require SuperTech Island Co to pay much more compensation to SuperTech’s local sales affiliates. That’s a transfer pricing issue, and would depend on making the argument that SuperTech Island Co is paying its sales affiliates less than what it would have to pay to unrelated sales agents. Given the abundance of sales people in this world eager to have a good product to sell, it seems likely that would be a difficult argument to make. Trying to tweak existing transfer pricing rules to address this particular situation would likely open an entirely new can of worms.

Instead, Stack indicated that the US government thinks a better approach would be for an international agreement to allow countries to tax income earned by companies domiciled outside their jurisdiction. In other words, Treasury would like to get other countries to agree to allow the US to tax the profits of SuperTech Island Co even though that company is not located in the US. Needless to say, however, reaching such an international agreement could be extremely difficult.

But the economist in me wonders if the root cause of this sort of arrangement is really something else: incorrect initial valuations of the asset.  If the price that SuperTech Island Co had to pay to acquire ownership of the asset fully reflected the future stream of income that could be expected from that asset, then it seems likely that there would not be much of an incentive to move the asset in the first place. With the transaction described above SuperTech USA would record a large amount of income in the year of the asset sale – on which it would pay US tax rates – in exchange for a stream of tax savings in future years.  It strikes me that a correct initial valuation of the asset should take this into account. And if it did, then perhaps the cash box problem would not be so much of a problem after all.

German Wishes for Irish Taxes

Ireland has long been a favorite country for multinationals to set up shop in, thanks in part to its 12.5% corporate tax rate – one of the lowest in the world. A typical situation would be for a multinational based in the US or Asia to set up an Irish subsidiary as the principal entity from which to run its European business, thereby allowing it to legally record a significant portion of its European income in Ireland.

But this low tax rate has not been so popular among other European countries, as it is seen as making it difficult to compete with Ireland in their ongoing quiet contest for tax revenues from multinationals. So with the visit of German finance minister Wolfgang Schäuble to Dublin this week to deliver some low-interest loans, The Irish Times posed an interesting question: why hasn’t Berlin demanded that Ireland raise its corporate tax rate in exchange for its assistance?

German officials mystified by inaction on Irish corporate tax rate

German finance minister Wolfgang Schäuble is in Dublin tomorrow to help Ireland’s Halloween party with a €150 million loan from Germany’s KfW state development bank. Matched by the European Investment Bank (EIB), this is the starting capital for Ireland’s Strategic Banking Corporation of Ireland…

As on previous occasions where Ireland was looking for something from Berlin – the prom note reconfiguration, or the bailout itself – Berlin demanded something in return, having already given Dublin what it wanted first…

Given the regular German swipes at Ireland’s 12.5 per cent tax rate, it’s interesting that Berlin never followed the Cyprus strategy. Last year, Nicosia was “encouraged” to make a sovereign decision to raise corporate tax rates as a precondition for the required assistance.

It’s a good question, though I’d like to rephrase it slightly: why does Germany treat Ireland so differently from Cyprus when it comes to providing financial assistance? One possible explanation is that the corporate tax rate in Cyprus, which had been set at 10%, was seen by Germany as being more egregious than Ireland’s rate. But it may also be a subtle symptom of the north-south divide in Europe that has emerged so strongly in recent years. The distrust and hostility between northern European nations and southern Europe has been displayed in many ways since the Eurozone crisis began in 2009-10. Perhaps this is another one.

Fighting Over Tax Revenue in Europe

There’s been a burst of news recently about how multinational companies (“MNCs”) use corporate structures (and of course the transfer pricing that goes with it) to reduce their tax bills. Starbucks, Apple, and most recently Amazon have all been getting lots of unwelcome press about their European tax planning strategies.

This is nothing new, of course. But there does seem to be a slightly different flavor to the criticism this time around. In the current round of attention it seems that national tax administrations are coming under as much scrutiny as the companies involved, with certain countries being accused of essentially colluding with MNCs to facilitate their tax minimization. Last week we learned that the EU has commenced an anti-competition investigation against Luxembourg related to the tax treatment that the country applies to MNCs.  And this week it was announced that Ireland will, under pressure, revise its tax regulations to eliminate one type of corporate structure that MNCs can use to reduce their tax liabilities.  The Economist reports:

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BONO may front one of the world’s most popular rock bands, but the U2 singer did not earn many new fans when he recently defended Ireland’s controversial tax policies, which are widely seen as helping multinationals to avoid paying their fair share. Even Ireland’s government seems to be having doubts. On October 14th it announced plans to close the country’s biggest loophole, the “Double Irish”.

The Double Irish allows companies to shift their profits from high-tax countries to havens… Users can thereby cut their effective tax rate—perfectly legally—far below Ireland’s already low 12.5% rate, in some cases down to less than 2%…

From January all new companies domiciled in Ireland will also have to be tax-residents there, making the Double Irish impossible. Ireland is acting under pressure from America, the European Commission and the OECD, which are working on multilateral reform of international tax rules to curb avoidance.

On one level focusing attention on the countries involved, rather than MNCs, makes perfect sense.  After all, MNCs are simply doing the best that they can for their owners, given each country’s tax rules as they are written. (The degree of involvement that MNCs have in the writing of those tax rules is an interesting but separate question that we’ll have to leave for another time.) So if you think that MNCs should pay higher taxes, you really should be directing your criticism at the creators and administrators of tax regulations, not the taxpayers.

But why now?  And why does the attention seem to be falling not on those stereotypical sunny, shorts-wearing, palm tree-fringed, tropical island tax havens, but instead on respectable (if rather more gloomy, weather-wise) northern European nations like the Netherlands, Luxembourg, and Ireland?

I think a couple of factors are contributing to this.  First of all, I don’t think it’s a coincidence that the countries in question are EU members. In case you hadn’t noticed, the EU has been going through a bit of an economic rough patch over the past few years. The eurozone financial crisis that began in earnest in 2010 has highlighted and contributed to dramatic differences in economic performance and budget policy between EU member nations. Suspicion and resentment between European countries over economic and financial issues has probably never been greater since before the second world war.

But more specifically, I think that the troubled economic landscape in Europe over the past several years has brought to the forefront something that usually lies unseen in the background, but which transfer pricing practitioners are constantly reminded of: the world’s major countries are engaged in a constant, usually quiet battle with each other for tax revenue from MNCs.  It’s not quite true that MNC tax payments are a zero sum game, but as a first approximation that idea captures how tax administrations view the problem.  Each MNC has a pie of global tax payments. And each tax administration wants to capture as large a slice of that pie as they can.

So as many European countries feel the accumulated burden of years of economic and financial struggle, it’s not surprising that they have become more aggressive with each other in their battles over the share of the tax revenue they can claim from the world’s largest MNCs. I think this phenomenon will help keep the pressure on the participants in the OECD BEPS project to make sure that the new rules that come out of those negotiations are quite strict. And I’m sure we haven’t heard the last of how Europe’s low-tax jurisdictions help the world’s MNCs to reduce their overall tax bills.