How to make multinationals pay taxes honestly
A major concern the governments the world over has been to make the multinational enterprises (MNEs) pay legitimate taxes due to their respective countries. Wilful avoidance of taxes or tax abuse by MNEs by transferring their profits to affiliates located in tax havens is a widely practiced phenomenon. This matter is particularly concerning to the developed countries as they are robbed of the much needed resources for spending on physical infrastructure and human development and anti-poverty interventions. The low capacity of tax administrations in developing countries and asymmetric power and resources between the MNEs and tax authorities makes it an unequal game.
In India, the studies show that the effective tax rates on MNEs is lower than those of domestic companies. A Christian Aid study[i] in 2013 based on sample data of multinationals in India shows that they (i) report 1.5% less profits, (ii) pay 17.4 per cent less in taxes per unit of asset, pay 30.3 per cent less taxes per unit of profit and have 11.4 per cent higher debt ratios than the companies with no connection to tax havens. Surely, better tax collection from them would enhance the ability of the governments to enhance allocations to education and healthcare relative to GDP from the prevailing low allocation of 3.4 per cent and just about one percent respectively. With 40 per cent of the 1.3 billion people in the age group 0-14, the future of this population depends crucially on enhancing allocations to these sectors.
The MNEs resort to tax abuse by creating a web of complex subsidiaries, locating them in tax havens and allocating the profits to these jurisdictions. In the prevailing framework of taxing each entity separately, transactions within the affiliates are done to minimise tax payments. Although the “arm’s length pricing rules” has been recommended, many of the MNEs are command prices as oligopolies and most developing countries do not have sufficient number of potential comparable transactions to determine the prices objectively. With intangibles like trade names, goodwill, and brand recognition and intellectual property rights (patents, copyrights, brands and trademarks) are used for manipulation and applying the arm’s length principle in valuing the transactions between related parties is meaningless. Furthermore, MNEs act as intermediaries in product distribution and sales, advance loans and charge interest payments to one another and charge fees for activities such as management services, treasury services and investment services to reduce the tax liability.
Concerned about the pernicious practice, G-20 countries entrusted the OECD with the task of setting the action plan to minimise base erosion and profit shifting (BEPS).. The OECD has put forward 15 action plans for the countries to follow in its various reports. However, these proposals do not go far enough. In fact, there is considerable unease among the developing countries about the OECD proposals due to (i) the discussion in OECD is dominated by developed countries and the representatives of MNEs and. (ii) Interests of developed and developing counties do not always converge.
The Independent Commission for the Reform of International Corporate Taxation (ICRICT), a group of leaders from government, academia and civil society created to promote reforms in international corporate taxation is vexed with the phenomenon. Its review states that the OECD action plans are in the nature of patch-work of existing approaches. The MNEs are essentially unified firms organised to maximise profits across jurisdictions and treating them as independent entities and applying the arm’s length principle for transfer pricing is meaningless. Large MNEs are oligopolies and there are no comparable local firms that can serve as benchmarks. In addition, the OECD proposals fail to deal with the problem of shifting profits through the exploitation of intangible assets mentioned above.
The ICRICT declaration has called for a paradigm shift. It states that a serious attempt to stop BEPS requires that the fiction that a MNE is made of separate independent entities must be abandoned. ICRICT recommends that a MNE and its subsidiaries should be considered as a single firm and allocate its worldwide profits to individual countries according to an agreed formula to include factors such as employment, sales, and resources used and fixed costs. These MNEs are listed in the stock market and would not understate their worldwide profits. Of course, formulary allocation can result in tax competition by individual countries to attract investments to their jurisdictions. To avoid such race to the bottom it recommends forging a consensus on a minimum tax rate.
However, the challenges arriving at consensus formula at the international level are formidable as the interest of the countries are not single peaked. When there are differences, the MNEs will play one country against other. Therefore, even as taking the unitary approach and formular apportionment remains the goal, the ICRICT recommends interim approaches with single entity as the central piece of reform. Under the “profit-split” method, the combined profits of MNEs are allocated according to the “allocation keys” which reflect each entity’s contribution to the generation of profit at a transaction-level rather than at an entity-level. However, at present “allocation keys” are ad hoc chosen by MNEs and hence subject to manipulation. The second suggestion is to adopt the “net margin” method according to which the net profit rate is ascribed to MNE’s local affiliates as an appropriate fraction of the global net profit rate of the corporate group. As the profit rate would be applied to earnings before interest, the tax base would not be eroded by means of intragroup loans. Currently, Brazil applies a modified version of this method by prescribing different sets of rules for local affiliates to determine the maximum amounts of deductible expenses and the minimum amounts of taxable income, based on fixed gross margins according to the types of businesses or transactions. These rules minimize the need for subjective judgment and discretion, so they have proved easy to administer, and have resulted in a limited number of conflicts and court cases between MNEs and the Brazilian tax authority. In European Union (EU), there is a proposal to adopt the “Common Corporate Tax Base” approach according to which the EU corporate group apportions the profits to member states. This proposal has been approved by the European Parliament but yet to be applied for want of consensus.
The important point is forcing the multinationals to pay legitimate taxes particularly to developing countries is a formidable task. While this is a work in progress, the way forward is to treat the affiliates of MNEs not as different entities but consolidate their profits and allocate them based on a formula. This would also require a change in the global system of tax governance to ensure universal membership and open and democratic structure. There is much to be argued for bringing international taxation matters under the UN aegis as this institution alone can provide the sanctity for rules based on the principle of sovereignty of all countries.
(The author is Emeritus Professor, NIPFP. He is also a Commissioner of ICRICT).