PhD Candidate, Institute of Economic Studies, Charles University
Disclosure statement
Miroslav Palanský has received funding from the EU's
Horizon 2020 research and innovation programme under grant agreement No.
727145. This article is based on research undertaken in the UNU-WIDER
research project: ‘The economics and politics of taxation and social
protection’.
Tax havens have become a defining feature of the global financial
system. Multinational companies can use various schemes to avoid paying
taxes in countries where they make vast revenues. In new research,
my colleague Petr Janský and I estimate that around US$420 billion in
corporate profits is shifted out of 79 countries every year.
This equates to about US$125 billion in lost tax revenue for these
countries. As a result, their state services are either underfunded or
must be funded by other, often lower-income taxpayers. It contributes to
rising inequality both within countries and across the world.
Given the nature of the issue, it is intrinsically difficult to
detect tax avoidance or evasion. To get round this, we use data on
foreign direct investment (FDI) collected by the International Monetary
Fund to examine whether companies owned from tax havens report lower
profits in high-tax countries compared to other companies.
We found that countries with a higher share of FDI from tax havens
report profits that are systematically and significantly lower,
suggesting these profits have been shifted to tax havens before being
reported in high-tax countries. The strength of this relationship
enables us to estimate how much more profit would be reported in each
country if companies owned from tax havens reported similar profits to
other companies.
We found that lower-income countries on average lose at least as much
as developed countries (relative to the size of their economies). At
the same time, they are less able to implement effective tools to reduce
the amount of profit shifted out of their countries.
Three channels of profit shifting
There are three main channels that multinationals can use to shift
profits out of high-tax countries: debt shifting, registering intangible
assets such as copyright or trademarks in tax havens, and a technique
known as “strategic transfer pricing”.
To see how these channels work, imagine that a multinational is
composed of two companies, one located in a high-tax jurisdiction like
Australia (company A) and one located in a low-tax jurisdiction like
Bermuda (company B). Company B is a holding company and fully owns
company A.
While both companies should pay tax on the profit they make in their
respective countries, one of the three channels is used to shift profits
from the high-tax country (Australia in our case, with a corporate
income tax rate of 30%) to the low-tax country (Bermuda, with a
corporate income tax rate of 0%). For every dollar shifted in this way,
the multinational avoids paying 30 cents of tax.
Debt-shifting is when company A borrows money (although it does not
need to) from company B and pays interest on this loan to company B. The
interest payments are a cost to company A and are tax-deductible in
Australia. So they effectively reduce the profit that company A reports
in Australia, while increasing the profit reported in Bermuda.
In the second channel, the multinational transfers its intangible
assets (such as trademarks or copyright) to company B, and company A
then pays royalties to company B to use these assets. Royalties are a
cost to company A and artificially lower its profit, increasing the
less-taxed profit of company B.
Strategic transfer pricing, the third channel, can be used when
company A trades with company B. To set prices for their trade, most
countries currently use what’s called the “arm’s length principle”. This
means that prices should be set the same as they would be if two
non-associated entities traded with each other.
But, in practice, it is often difficult to determine the arm’s length
price and there is considerable space for multinationals to set the
price in a way that minimises their overall tax liabilities. Imagine
company A manufactures jeans and sells them to company B, which then
sells them in shops. If the cost of manufacturing a pair of jeans is
US$80 and company A would be willing to sell them to unrelated company C
for US$100, they would make US$20 in profit and pay US$6 in tax (at
30%) in Australia.
But if company A sells the jeans to its subsidiary company B for just
US$81, it only makes US$1 in profit and so pays US$0.3 in tax in
Australia. Company B then sells the jeans to unrelated company C for
US$100, making US$19 in profit, but not paying any tax, since there is
no corporate income tax in Bermuda. Using this scheme, the multinational
evades paying US$5.7 in tax in Australia for every pair of jeans sold.
How to stop it
The root of the problem is the way international corporate income is
taxed. The current system is based on an approach devised almost a
century ago, when large multinationals as we know them today did not
exist. Today, individual entities that make up a multinational run
separate accounts as if they were independent companies. But the
multinational optimises its tax liabilities as a whole.
Instead, we should switch to what’s called a unitary model of taxation.
The idea is to tax the profit where the economic activity which
generates it actually takes place – not where profits are reported. The
multinational would report on its overall global profit and also on its
activity in each country in which it operates. The governments of these
countries would then be allowed to tax the multinational according to
the activity in their country.
In practice, defining what exactly constitutes “economic activity
which generates profit” is the tricky bit. For a multinational that
manufactures phones, for example, it is not clear what part of its
profit is generated by, say, the managers in California, designers in
Texas, programmers in Munich, an assembly factory in China, a
Singapore-based logistics company that ships the phone to Paris, the
retail store in Paris that sells the phone, or the French consumer.
Different proposals for unitary taxation schemes define this tax base
in various ways. The five factors most often taken into account are:
location of headquarters, sales, payroll, employee headcount and assets.
Different proposals give different weight to these factors.
Ultimately, introducing unitary taxation would require a global
consensus on the formula used to apportion profits. And, admittedly,
this would be difficult to do. As the OECD says:
“It present[s] enormous political and administrative complexity and
require[s] a level of international cooperation that is unrealistic to
expect in the field of international taxation.”
But, seeing as the current system costs governments around the world
around US$125 billion annually, is global cooperation really more
expensive than that?
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