Transnational corporations (TNCs) and their accountants and other enablers are becoming ever more aggressive in finding ways to escape tax, often via devious pathways through the international tax system. Pretty much every TNC in the world today has multiple affiliates in offshore tax havens. They hold trillions of dollars of untaxed or hardly taxed profits offshore – and The sums are growing fast.
Countries are engaging in a global race – harmful tax wars – to cut taxes to attract money and investment. Effective rates can fall below zero, as politicians shower them with subsidies for fear they will flee.
Worse still, powerful forces are now campaigning to abolish the corporation income tax entirely.
Why is corporation tax so important?
Corporation tax is an especially precious part of any tax system, particularly for developing countries where alternative revenue sources are thin. Corporation taxes are very progressive, and they raise significant sums of money for public services.
See our full report entitled Ten Reasons to Defend the Corporation Tax.
See John Christensen discuss transfer pricing, one of the most important issues in international tax (3.20 minutes).
Also see how Google dodges tax.
Fact: just three big U.S. corporations held some $135 billion offshore in 2013.
Perhaps more importantly, corporate income taxes are a crucial backstop for the personal income tax. The more corporation taxes are cut, the more wealthy folk shift their income out of the personal tax category and into corporate forms, so as to pay the lower corporate tax rate. The more they do this, the more governments feel they must cut personal taxes on wealthy people to stop it. The entire tax system gets compressed, led downwards by the corporation tax.
Worldwide, corporations are currently sitting on trillions of dollars’ worth of idle, uninvested cash piles. Cutting taxes on them is like pushing on a string: it won’t increase investment or growth. Some also argue that taxing corporations is an essential democratic brake on excessive corporate power. (For plenty more reasons why we need corporation taxes, see here or here.)
This page provides a brief overview of some of the main issues involved in taxing TNCs, and pointers to two solutions that could transform the way we tax them.
Tax evasion and avoidance: what is the difference?
By definition, tax evasion involves breaking the law, while tax avoidance supposedly doesn’t – though it does involve getting round the spirit of the law. Yet there is a big grey area or overlap between the two. A lot of what gets called ‘avoidance’ is in fact rather more like evasion.
Rather than get bogged down in the complexities what is avoidance and what is evasion, it’s usually better to use other terms, namely tax cheating, tax dodging, or tax abuse. These move away from the legal niceties and focus on what matters: whether the practices are abusive from an economic and political perspective.
Who oversees the global tax system?
When an investor parks money or invests in a foreign country, the question then arises as to which country gets to tax which bit of the resulting income. Each may want to maximise its share of the tax ‘pie,’ and this tension can cause conflict. Over the last century a loosely co-ordinated international tax system has emerged to deal with these conflicts, and to make sure that people and corporations don’t get taxed twice on the same income.
The OECD, a club of rich countries, oversees the system, and devises the broad framework of rules and tax treaties that countries sign up to. Unsurprisingly, the system tends to try and resolve the tax conflicts by favouring rich countries over poor ones. A potentially more legitimate alternative overseer – the United Nations Tax Committee – has been largely ‘captured’ by the OECD: severely weakened and pressured to adopt its positions.
Even on these unequal terms, the OECD system is utterly broken. Its most foundational principles, designed for the international trading system of a century ago – are unfit for the modern age.
These principles treat a TNC not as a unified body but as a fictional collection of loosely connected separate entities which trade with each other: no more than the sum of their individual parts. The prices of these internal trades are supposed to happen at “arm’s length” – in other words, as if they were fully independent entities trading in free and fair markets.
In the real world, of course, a TNC is much more than the sum of its parts: otherwise, what would be the point of being a TNC? And those internal market prices can be easily bent to suit the TNC and its tax accountants, as the next section on transfer pricing explains. Often there simply isn’t any way to determine what the true market price should be: the price ends up being the price that the TNC’s accountants say it is.
In the final section, we describe a practical alternative based on economic reality – unitary tax (see below) – which bypasses the OECD’s unworldly assumptions.
Let’s say it costs a TNC $1 to produce a bunch of bananas in Ecuador. It can sell it for $10 in Germany. Here’s how the TNC cuts its tax bill.The Ecuador affiliate sells the bunch to an affiliate of the TNC in a tax haven for $1. The tax haven affiliate sells it to the TNC’s German affiliate for $10. The German affiliate sells it to a German supermarket shop for $10, the true market price in Germany.
So what happened here?
The Ecuador subsidiary had costs of $1 and sold at $1, so its profits – and therefore its tax bill – are zero. The German subsidiary bought at $10 and sold at $10, again for zero profits and zero taxes. But the tax haven subsidiary bought it $1 and sold at $10, for $9 profit. But the tax haven doesn’t tax profits, so the tax bill is zero there too! There are many different ways to achieve the same effect.
See this interactive graphic for a visual illustration.
Transfer pricing, profit-stripping, and more
More than half of global trade is reckoned to take place between affiliates inside TNCs: that is, across borders but within the same corporate group. TNCs and their accountants can manipulate the internal ‘transfer prices’ of these trades to shift profits artificially around the world, in ways that bear no relation to underlying economic realities.
TNCs usually manipulate transfer prices to shift profits from high-tax jurisdictions to low-tax jurisdictions, and to shift costs into high-tax jurisdictions, where they can be offset against tax. Corporate tax bills are reduced, helping corporations free-ride off the tax-funded benefits provided by governments. There is nothing economically productive about this.
In a related method, TNCs create subsidiaries in tax havens either to carry out “activities” (such as financial transactions, logistics, consulting) or to act as “holding companies” to own assets such as intellectual property rights, bonds, or shares. Profits are then simply attributed to those tax haven entities, even though they are shams and often exist only on paper.
TNCs also escape tax is through using tax treaties between victim countries and treaty ‘havens’ such as Mauritius, Ireland, the Netherlands or Luxembourg. Read more about tax treaties here.
Countries put in places defences to tackle such abuses, but these are often leaky, and tax advisers find pathways around them. Leading to new defences – and so on. As a result, the international tax system grows ever more complex.
See more on our detailed Transfer Pricing page, here.
We offer two big solutions to the problem: unitary tax, and country by country reporting.
Unitary taxation is a way of taxing TNCs according to the genuine economic substance of what they do and where they do it – rather than the current system where they are taxed according to the artificial legal forms that their accountants contort them into. This system is economically just and far more efficient – and already working successfully in several places.
See also this large research project on unitary tax and developing countries, here.
But under a unitary tax system, you take a TNC’s total global profits then allocate them to the countries where it does business, using a formula based on genuine economic factors like sales, payroll or physical assets. This treats TNCs like unitary wholes, rather than as loose collections of separate entities trading with each other – and it completely ignores the internal transfer prices with which they trade with each other.
Imagine a company with 10,000 employees in Sweden, 10,000 employees in Tanzania, and two tanned accountants throwing paper aeroplanes in an office in Bermuda. Under current rules, the profits are all shifted to Bermuda, which doesn’t tax them. But under unitary tax, you take the company’s global profits then allocate nearly 50 percent to Sweden, nearly 50 percent to Tanzania, and almost none of those profits to Bermuda. Each country can tax its portion of the global profits at whatever rate it likes.
Under this system the Bermuda operations would make almost no difference to its tax bill – so TNCs would not bother setting up many offices in tax havens.
With a unitary tax system we would see the tax havens’ most loyal supporters melt away – and the havens would be far easier to tackle on a host of other issues such as secrecy and international crime.
Country by country reporting is, essentially, a transparency requirement. Currently, companies publish economic data (such as profits, taxes or sales) on a global or regional basis, but it is impossible to unpick this to see what is happening in each place where it does business. Country by country reporting would require them to break this information down by country, to help citizens, investors and tax authorities find out what TNCs are doing and where they are doing it. A powerful campaign is now underway to support the initative – and it has already had its first successes. Read more here.
Country by country reporting could also, if properly implemented, become a first step in a unitary taxation system, by providing a breakdown of the underlying economic data upon which profits could be apportioned to the different jurisdictions for tax purposes.
Dec 2012 – Towards Unitary Taxation of transnational corporations: Prof. Sol Picciotto. Our seminal report making the case for reform
Feb 2012 – The corporation tax is under attack: it must be defended
March 2011 – Stateless Income, by Prof. Ed Kleinbard. About all those profits stashed overseas.
See also our previous Transfer Pricing site. Updated until Jan 2014. Contains more detailed descriptions of transfer pricing, and a wealth of links and further analysis.
See also The Guardian’s Tax Avoidance page. A UK-focused site.