BEPS: OECD proposes “special measures” to shore up the arm’s length principle

Ofsted can make a school subject to “special measures” if it considers that the school is failing to give pupils an acceptable standard of education. I was reminded of this when an OECD paper published on 19 December proposed “special measures” to shore up the “arm’s length” principle underpinning the current, outdated international tax system. More on that below.

The OECD now has nine open consultations on proposed reforms to tackle base erosion and profit shifting (BEPS), following publication of six discussion papers in the week before Christmas. Continue reading

Is PwC’s survey a turning point in the tax transparency debate?

Reuters reported yesterday that a survey conducted by PwC showed that “most chief executives globally would support the publication of country-by-country financial information to help stamp out corporate tax avoidance”. If this finding is a fair reflection of opinion among CEOs, it marks a turning point in the tax transparency debate. (I should add that it seems to have emerged in February, when it was picked up by Christian Aid and Richard Murphy.)

The finding seems to have taken PwC by surprise. Page 17 of the firm’s report reads:

“Similarly, and perhaps surprisingly to some, almost six out of ten CEOs (59%) agreed that multinationals should be required to publish revenue, profit and tax disclosures on a country-by-country basis, although 36% of US CEOs (compared with 19% globally) disagreed. That 59% of CEOs agreed is surprising given what are believed to be widely held concerns that mandatory ‘country by country’ disclosure requirements will focus on data that is costly for businesses to generate and is not easy for the reader to understand. Perhaps this reflects the acknowledgement by CEOs that the provision of some kind of meaningful information on tax is a key part of building greater understanding.”

As this conversation on Twitter suggests, the obvious question is “what were they asked?” I did wonder whether the question might have been interpreted by some respondents as relating to the OECD’s development of a template for country-by-country reporting to tax authorities.

This morning PwC press officer Laetitia Lynn has posted a link to the survey data. If you follow the link to “Purpose”, the final question relates to tax policy and administration, and you will see that 59% of CEOs responding agreed that:

“Multinationals should be required to publish the revenues, profits and taxes paid for each territory where they operate.”

“Publish” is the key word here. CEOs are not tax specialists but I think they know the difference between publishing data and sharing it with tax authorities.

As I noted on the old blog last September, the objection to public country-by-country reporting that we hear most is that disclosure would result in more confusion, not less. On the other hand, many businesses with nothing to hide would welcome greater transparency because it would help to restore trust in big business.

Tax and development: Some essential reading on taxation of multinationals

If you need a better understanding of the controversy surrounding taxation of multinationals – and why the OECD is working on what one tax professional has called “a lifetime opportunity for governments to change the international tax landscape” – here is some essential reading.

Martin Hearson is a doctoral researcher at the London School of Economics and Political Science, focusing on the political economy of international taxation in developing countries. Working with the Norway-based U4 Anti-corruption Resource Centre, he set out to provide an “even-handed summary” of views on how tax-motivated illicit financial flows (IFFs) undermine efforts to help developing countries reduce their reliance on foreign aid.

The outcome is a 50-page guide for development practitioners, but the paper is likely to be very useful for “non-specialists” who may find – to quote the abstract – that “the complex discussion on taxation and IFFs is further complicated by the lack of clear definitions of relevant concepts, and by the often polarized nature of policy debates”.

Some tax professionals argue that the “aggressive tax planning” that is being addressed by the OECD’s action plan on “base erosion and profit shifting” is not technically “tax avoidance”. Such planning exploits gaps in the international tax system, and the only lasting solution is to change the law.

But for the purposes of the paper Martin has adopted (see 1.1) a broad definition of IFFs to incorporate “practices such as lobbying for tax incentives, transfer mispricing, trade mispricing, and exploiting tax treaties for tax avoidance”.

Martin’s paper is a timely, measured and informative contribution to the tax debate and it deserves wide circulation.

Christian charity defends $160bn ‘tax dodging’ claim (Tax Journal)

A leading charity’s claim that ‘tax dodging’ by multinationals costs developing countries an estimated US$160bn a year falls short of the standards that campaigners expect from companies, according to a tax expert.

Heather Self, a partner at law firm Pinsent Masons, was responding to articles published on the Daily Mail and Christian Aid websites. She told Tax Journal that Christian Aid had a ‘valid aim’ of helping poor countries collect more tax and rely less on aid. But she warned that ‘[Christian Aid’s] continuing use of unreliable and out of date figures, which exaggerate the extent to which behaviour by multinationals contributes to the problem, harms their case: they require transparency and accuracy from companies and should meet that standard themselves’. She added: ‘If reliable estimates are simply not available, they should acknowledge this.’

… Joseph Stead, Christian Aid’s senior economic justice adviser, told Tax Journal: ‘Christian Aid has discussed the provenance of the $160bn figure many times, including with Parliament on several occasions. While we do not deny, and have never denied, that more research would be good, we don’t believe that things have changed so much to invalidate the findings since we published our report. We have seen the G20 agree that the global tax system isn’t working, and the OECD admit that the problems are such that the issue is a threat to democracy. We have seen the OECD secretary general state that tax havens result in developing countries losing up to three times what they receive in aid.’

Read more at Tax Journal.

Multinationals: Three useful contributions to ‘the great tax debate’

“Multinationals and ‘the great tax debate’” is the title of a 30-page paper that was tucked inside my copy of Tax Journal last week. It is a useful contribution to the debate on the taxation of multinationals – whether or not you agree with its conclusions. It was written by John Watson, who retired last year after 35 years as a tax lawyer in the City of London.

The paper was published by LexisNexis, a division of Reed Elsevier, and is available on the Tax Journal website.

Last week Maya Forstater flagged a discussion paper titled “Profit Shifting and ‘Aggressive’ Tax Planning by Multinational Firms: Issues and Options for Reform”, published by the Centre for European Economic Research (ZEW) based in Mannheim, Germany.

Both Watson and the ZEW provide background information that is accessible and useful for non-tax people who need to understand the problems that have given rise to the OECD’s project on base erosion and profit shifting, as well as the possible solutions. I mention just a few key points here.

(I would also recommend Andrew Jackson’s series of blog posts on unitary taxation. Yesterday he considered the use of sales as a factor in the proposed apportionment of global profit.)

Solutions

Watson concludes that “the existing transfer pricing system should be left as it is, with the current OECD guidelines being preferred to a general move to unitary tax”, although in a discussion on unitary taxation he does point out that basing the tax charge on a group’s consolidated accounts is “not quite as radical as it might sound”.

Tax authorities “should not hesitate to use a profit split [in arriving at a transfer pricing adjustment] where it is the most appropriate method”.

Watson also suggests that opportunities for tax avoidance could be reduced by unifying tax rates.

Last year the House of Lords economic affairs committee suggested that “a destination-based cash flow tax could dramatically reduce the scope for profit-shifting and tax rate competition between countries”.

Watson writes: “The reasons why a jurisdiction might wish to tax profits ultimately funded by sales to its residents, even where those profits are generated elsewhere, are not wholly quixotic.”

He suggests “practical reasons” for a destination based tax, including:

“The non-taxation of a company’s profits means that it needs a lower pre-tax return to justify its shareholders’ investment, giving a commercial edge over fully taxed competitors. Once one group selling to a jurisdiction sets up operations in tax havens, others may find it necessary to do the same in order to maintain a level playing field.”

He says it is “difficult to see how a destination based tax on profits can be substituted for source based taxation unless the new regime is universal”, but “the possibility of a destination based top up tax is well worth considering further”.

This top up tax proposal occupies six pages of the paper and looks very complex. Watson says compliance would be expensive, so the tax would be charged only where a group’s sales to consumers resident in a country exceeded a substantial threshold, eg. £100m.

The ZEW paper describes “arrangements for [intellectual property]-based profit shifting which are used by the companies currently accused of avoiding taxes” and suggests that “preventing this type of tax avoidance is, in principle, straightforward”.

The authors Clemens Fuest, Christoph Spengel et al argue that in the short term, policy makers should focus on extending withholding taxes. “Other measures which are currently being discussed, in particular unilateral measures, like limitations on interest and license deduction, fundamental reforms of the international tax system and country-by-country reporting, are either economically harmful or need to be elaborated much further before their introduction can be considered”.

For “the longer perspective” the authors recommend investigation of “more fundamental approaches” such as a destination-based cash flow tax or CCCTB (the common consolidated corporate tax base, a proposal for unitary taxation within the EU).

Taxing multinationals: The trouble with transfer pricing

MailOnline claims to be the world’s largest English-language newspaper website, with 168m monthly global unique visitors, so Christian Aid has reached a potentially very large audience with a comment piece by Joseph Stead on 6 January.

Stead is senior economic justice adviser at Christian Aid. His article focused on the need for greater tax transparency, particularly in the extractive (eg. oil and gas) industries. He acknowledged that there are several initiatives requiring country-by-country reporting by multinationals. He wrote:

“Christian Aid estimates that tax dodging by multinational companies currently robs poor countries of US$160bn a year – far more than rich countries give them in aid. Of course, extractive firms are not responsible for all of this but they account for a high proportion of poor countries’ exports, so they very likely bear a disproportionate share of blame.”

The $160bn estimate drew some criticism on Twitter, and Stead has accepted that “we could do with better estimates”. The figure has been cited several times over the last five years and has been challenged by a (very small) number of tax professionals.

However, it does not include the impact of much of what the OECD calls “base erosion and profit shifting” (BEPS). There will be some overlap. Broadly speaking, Christian Aid’s estimate deals with deliberate mispricing, while BEPS is about the impact of gaps in the international tax system.

In both cases, the current transfer pricing system is a key feature.

Christian Aid’s report “Death and taxes: The true toll of tax dodging”, published in 2008, said developing countries were losing corporate taxes of $160bn a year due to two forms of “corporate evasion”. It added:

“The first of these is known as ‘transfer mispricing’, where different parts of the companies [this is a reference to different companies forming part of a multinational group] sell goods or services to each other at manipulated prices. [The] potential scope of this practice can be seen from the staggering fact that some 60% of all world trade is now thought to take place between global corporations and their subsidiaries. The other, ‘false invoicing’, is where similar transactions take place between unrelated companies.”

Christian Aid said that “these two forms of evasion are estimated to account for about 7% of global trade transactions each year”, and it combined that figure with World Bank figures on the volume of trade, and corporate tax rates, to calculate the implied loss of tax revenues.

That 7% estimate (see table 1 on page 53) is “Ray Baker’s ‘conservative estimate’ that 7% of trade volumes is illicit capital movement, by false invoicing between unrelated parties and by abusive transfer pricing within multinational groups”.

Baker is president of Global Financial Integrity, a think tank based in Washington DC. Its latest study, published last month, found that “crime, corruption, and tax evasion drained $946.7bn from the developing world in 2011”.

Baker’s 7% estimate was published in 2005. It was based largely on 550 interviews with senior executives of trading companies in 11 countries – respondents were assured of anonymity – in order to examine “the amount of mispricing in international trade between unrelated parties”. He wrote in “Capitalism’s Achilles Heel”:

“Mispricing in order to generate kickbacks into foreign bank accounts was treated as a well-understood and normal part of transactions.” He concluded that “thousands of companies provide helpful mispricing services to tens of thousands of their overseas customers in hundreds of thousands of transactions moving billions of dollars into western accounts”.

Moving on to transfer pricing between affiliates (ie. companies in the same multinational group), Baker said he had not done a formal investigation:

“I have, however, observed enough transactions, seen enough exaggerated intracompany (sic) prices, asked enough questions in dozens of countries, and collected and reviewed more than enough trade data to have every reason to conclude that, on a global scale, abusive transfer pricing between affiliated entities greatly exceeds mispricing between unaffiliated entities.”

He took the percentage for abusive transfer pricing to be the same as that for mispricing between unrelated parties in order “to be conservative”.

There is a distinction between deliberate mispricing (ie. lying) and applying a price that is within the range of possible answers that the law provides. The latter is an essential part of the tax compliance process and it may be the subject of negotiation with the tax authorities. But the system is flawed.

The OECD’s action plan is designed to fix weaknesses in the current rules that “create opportunities” for BEPS, which “relates chiefly to instances where the interaction of different tax rules leads to double non-taxation or less than single taxation”. Four of the 15 “actions” deal with transfer pricing.

The first 10 actions address:

  • the tax challenges of the digital economy (and in particular, the allocation of taxing rights between countries);
  • the effects of hybrid mismatch arrangements;
  • controlled foreign company rules (“CFC rules of many countries do not always counter BEPS in a comprehensive manner”);
  • base erosion via interest deductions and other financial payments;
  • harmful tax practices (broadly, preferential tax regimes);
  • tax treaty abuse;
  • artificial avoidance of “permanent establishment” status; and
  • transfer pricing issues including BEPS by (a) movement of intangibles among members of a multinational group, (b) transferring risks among, or allocating excessive capital to, group members, and (c) engaging in transactions which would not, or would only very rarely, occur between third parties.

The OECD has not tried to estimate the cost of BEPS. Pascal Saint-Amans is director of the OECD Centre for Tax Policy and Administration and is leading the BEPS project. There is an issue, he said last summer, but it cannot be measured: “We are not naive and we don’t want to come up with figures.”

But critics of the current “separate entity” approach, which relies heavily on the arm’s length principle for transfer pricing, argue that the whole system is flawed. Some say that a form of unitary taxation – with global profits allocated to tax jurisdictions on the basis of a formula – would eliminate profit shifting.

Sol Picciotto, a senior adviser to the Tax Justice Network, argues that unitary taxation would provide “a more sound foundation for the international tax system, one that matches the economic reality of [transnational corporations] as integrated firms”.

This week Ajay Gupta, editor of Tax Notes International, was looking back to 2013 and declared that “in the light of … multiple demonstrations of dysfunction and decay, we have selected the persisting vegetative state of global transfer pricing enforcement as the international tax development of the year”.

Last October Lee Sheppard, a contributing editor at Tax Analysts, wrote of the “twilight of the international consensus”. This consensus was “intended to permit multinationals to do business in treaty countries while paying tax only on income earned locally through separate entities and permanent establishments”. Sheppard added:

“This limitation of tax jurisdiction is key to the OECD model treaty. Of course, multinationals are vertically integrated and don’t transact with their affiliates at market prices. So an economic philosophy – which appears nowhere in the OECD model treaty – that multinationals should transact with their affiliates at hypothetical arm’s-length market prices was grafted on later.

“It has been an open secret for some time that multinationals – led by the Americans and their huge tax departments – have abused these privileges. The affected countries are no longer limited to corrupt, badly governed, resource-exporting countries. They now include European states with sophisticated tax administrations and the home governments of multinationals. Every country is just another country to be exploited.”

The trouble with the transfer pricing system is that it is based on fiction, but the OECD has claimed that it would be impractical to replace it. The OECD itself said that multinationals “have been able to use and/or misapply [the current] rules to separate income from the economic activities that produce that income and to shift it into low-tax environments”.

Unitary taxation seems, at least, to be based on economic reality. There is a strong argument that the OECD project will not be enough, and that root and branch reform of the system is necessary. And that should involve a long, hard look at the arm’s length principle and whether a different approach – such as a gradual move to unitary taxation – would be better.