The OECD has just produced a report on “Base Erosion and Profit Shifting” (BEPS) which sets forth a set of proposals for tightening taxation of companies which operate across national boundaries to curb the abuses of “tax planning”, in response to a request from the G20. It remains to be seen how successful these will be in terms of increasing the tax take, although one can certainly hope for much to be accomplished in this direction, but it is clear from the nature of the proposals that they will not succeed in the broader objective of abolishing tax planning.
That this is feasible, without also abolishing the taxation of profits, is clear. One would treat “companies as single entities, rather than clusters of supposedly independent parties, and then carv[e] up taxing rights over the firms’ global profits according to an internationally agreed formula based on sales, assets, and other measures” (The Economist, 10-16 October 2015, p. 64). This will be referred to as the “single-entity system”. A mechanism of this type is employed in determining the distribution by state of profits in a federal system, inter alia in the United States. It has been found satisfactory.
Instead, what the OECD is proposing is a set of measures designed to ensure that companies actually pay what is their moral obligation under the present system, which was designed to secure the absence of double taxation of profits (but has the incidental effect of enabling many corporations to almost completely avoid paying taxes). Perhaps the most important proposed change is the shift to country-by-country reporting. This is a change that has long been sought by NGOs such as the Tax Justice Network which have the interests of developing countries at heart, and should result in a greater share of profits being taxed in the countries where they are earned, which is certain to benefit most developing countries, among others. It will become that much more difficult for a multinational to impute most of its profit to a low-tax jurisdiction where it neither raises capital nor employs labour nor sells its product. But it will still pay profits tax on the sum that it is estimated to have made in a particular jurisdiction, after paying for inputs bought from other members of the group, and selling outputs to other associated companies, at transfer prices that leave substantial room for disagreement. However, while firms are to be obliged to provide details of their national production and sales to the taxman, this information is not to be made public, thus impeding independent entities checking on the extent to which profit-shifting is really ended.
Another change is that companies will be obliged to provide details of “comfort letters” that they have received from some national tax authorities to other national tax authorities. (A “comfort letter” is a letter from one tax authority stating that it is satisfied with a particular company’s tax arrangements.) This will increase transparency.
Already some of the conservative powers are indicating their support. For example, the UK’s George Osborne is reported to have welcomed the proposals in his speech to the Annual Meeting of the IMF and World Bank in Lima. Certainly OECD is fully behind them. Since the USA apparently worked hard to prevent the OECD playing with more radical proposals, it is reasonable to infer that US support will also be forthcoming. The path thus seems clear for this, the biggest revision of the rules governing the taxation of direct investment since the 1920s, to be approved by the G20 in November.
It is worthwhile examining the case for more radical change. The alternative is spelt out in the second paragraph above, where it was termed “the single-entity system”. The case in favour of this more radical change is that it would abolish tax planning and save the real resources tied up in attacking and defending transfer prices; and that it would permit an increase in the rate of profits tax without the fear that this would undermine national competitiveness. The case against is that it would erode national sovereignty; that it would require international agreement on the parameters of a tax plan; and (conversely to the second pro argument) that it would make it too easy to tax profits.
Corporations would still need transfer prices in a world with the single-entity system, for the purpose of calculating the profitability of their subsidiaries in various countries. These transfer prices would, however, have no bearing on the company’s overall financial results. They could therefore be safely left to an individual company to determine; a company which made realistic choices would have a competitive advantage in deciding which subsidiaries to expand, but no more. It is my impression that this would avoid most of the costs of transfer prices, though it would be good to have some quantitative estimates of the saving.
Whether one regards an easing of the difficulty of taxing profits as an advantage or disadvantage of the single-entity system depends on one’s attitude to raising money via a tax on capital. Those concerned about the recent tendency to concentrate taxation on immobile factors of production, notably unskilled labour, will welcome increased opportunities of taxing capital. But there are those who welcome the threat of corporations migrating in response to increased capital taxes as a potent safeguard against high capital taxes, and who would therefore regard the increased ability to raise taxes provided by the single-entity system as a negative factor.
The factors on which it would be necessary to secure international agreement in order to introduce the “single-entity system” would be the rate of profits tax and the formula specifying the variables that would be used to divide up countries’ entitlements to the profit tax and the weights to be attached to each variable. Consider first the rate of profits tax. One of the objections to the single-entity system is that it would mean losing national sovereignty to decide the rate of profit tax, instead of which one would be obliged to accept whatever the international decision might be. (Can one contemplate a system in which the international agreement extends only to agreement on the formula by which taxes are to be raised, and individual countries are free to impose whatever tax rate they choose? No; there is no disincentive in such a system to prevent a small country from imposing an indefinitely high tax rate.) Sovereignty fetishists will doubtless take this loss far more tragically than some of us; the fear of losing firms to other countries already serves to deprive countries of meaningful choice.
The other question on which international agreement would be required is the variables, and weights, with which one would calculate a country’s entitlement to a share of a firm’s taxable profits. There is no doubt that the location of a firm’s customers is highly relevant. But clearly one wants to include the location of production as well as consumption, and here there is a choice (as well as the choice of the weight to be given to consumption versus production). At one extreme, one could look only at a firm’s employment of labour. At the other extreme, one could take a measure of the assets employed, which would require a rule for dividing assets among the several countries where a given firm operates. This is likely to be particularly problematic in the case of patents and other intangible property that the firm employs, since its use in one location does not preclude its use elsewhere. A possible solution is to attribute all capital, including intangible capital, to a corporation’s home country, except to the extent that physical capital is located elsewhere or capital was raised elsewhere. In general, one would measure a company’s production in a given location by a weighted average of the labour that it employs there and the assets that it utilizes there. This would result in country A being entitled to a share of corporation B’s profit of
αSA/∑Si + ßLA/∑Li + (1 – α – ß)KA/∑Ki
where α = the share of sales in determining the allocation of profits to different countries (α < 1)
SA = sales of corporation B in country A
∑Si = total sales of corporation B (= sum of sales in each country i)
ß = the share of labour in determining the allocation of profits to different countries (α + ß < 1)
LA = the labour force employed by corporation B in country A
∑Li = total labour force employed by corporation B
KA = stock of B’s assets deployed to country A
∑Ki = stock of assets deployed in all countries by corporation B.
The international decision variables would be merely α and ß (in addition to the rate of profits tax). This determines, as a residual, the share of assets in determining the allocation of profits to different countries. However, it might be that imposing the same value of α and/or ß on all firms would be unfair to firms in industries with abnormal production processes, which would point to a need for an international mechanism for negotiating α and/or ß by industry (not by firm).
Unless we are to take it for granted that the G20’s endorsement of this proposal closes the argument for the next 90 years or so, it is worth asking what can be learned from existing experiences about some of the crucial issues, such as whether some firms would be gravely penalized by using the same values of α and ß, as well as the value attributed to those variables in existing federal systems. It would also be desirable to have more knowledge of how large the savings would be in getting rid of tax planning and the dependence of profits on transfer prices.