International Tax Planning

The OECD’s Conquest of Domestic Tax Codes: Understanding the Costs and Consequences of the BEPS Project


By By Jason J Fichtner and Adam N Michel, Mercatus Center at George Mason University (01/02/2017)

Recent global events from the release of the Panama Papers to a series of high-profile inversions have given international tax regulators both rhetorical ammunition and public support to execute a global crackdown on multinational tax planning. The goal is to increase total taxes paid by global businesses, regardless of their location, legal structure, or industry.

It just so happens that international tax regulators are already working to boost global corporate tax revenue by increasing tax transparency and coordinating international tax reporting. These are the goals of the Base Erosion and Profit Shifting (BEPS) Project of the Organisation for Economic Co-operation and Development (OECD). The results of a two-year long project should give pause to policymakers and activists alike – increasing global tax transparency and cracking down on perceived tax dodgers may have unintended consequences and come at a high cost. 

The goals of global transparency are fundamentally at odds with the international corporate income tax systems’ most valuable features—diversity and competition. Effective transparency and full taxation of corporate profits will require transferring control of corporate tax rules from individual nations to international regulators who can consolidate and unify tax rules across the world.

The most comprehensive proposal to increase international information sharing and rule harmonization is the package of BEPS Project reforms put forward by the OECD. Close examination of the proposed rules shows that the centralisation of tax authority sacrifices compliance efficiency, taxpayer rights, and nations’ ability to set the tax policies best suited to their populations. Furthermore, the proposed regulations would likely fail to increase corporate tax revenues.

 

The OECD takes on Base Erosion and Profit Shifting

Driving the OECD’s effort to increase global transparency and tax collection are 15 proposed packages of rules – called ‘action items’ – outlined by the BEPS Project last year. The action items illustrate the difficulty of truly increasing transparency and rule congruency.

Many of the new rules are either poorly understood or lack sufficient international consensus and have created unnecessary uncertainty for businesses around the world. For example, Carol Doran Klein of the US Council for International Business, characterised the OECD report on controlled foreign corporations as a set of rules that can be safely ignored due to lack of consensus on fundamental issues.  

The result of this uncertainty has been governments around the world haphazardly implementing portions of the new OECD standards, leaving behind rules which are locally inconvenient. A 2015 Deloitte survey found that a majority of firms think the centralization plan will have a bigger impact than they anticipated and could result in harmful double taxation of their profits due to incongruent implementation of the OECD’s suggested rules. 

Global efforts to crackdown on corporate tax planning rely heavily on changes to the valuation of intangible assets and tax information sharing. These two topics are covered in OECD action items 8 and 13. By understanding some of the flaws in these two reforms, the reader can begin to understand the complexity of the full task the OECD has undertaken. 

 

Action 8: Globalisation and Intangible Property

The OECD has identified intangible assets such as patents, trademarks, and other intellectual property as key components in international base erosion and profit shifting. Action 8 aims to align value creation with the accounting protocols that govern the valuation of intangible assets moving across national borders. The OECD report covers the minutia necessary for tax administrators to comply with the goal of sourcing income to measurable economic activity.

However, the OECD’s project continually bumps up against the fundamental issues intrinsic to the task of taxing global profits. Intangibles are by their very nature fungible, transcending the artificial boundaries of the nation-state. These knowledge-based assets can be difficult to price and difficult to attribute to a location because there are no comparable products and development often occurs through a diffuse global production chain. How should a firm go about valuing the Apple or Coca-Cola trademark? Where exactly is the economic activity that makes a cola product with the Coca-Cola trademark more valuable than an identical product without the label?

Under current tax law, corporations can move an intangible asset to a low tax country without disrupting their physical operations. Under new rules proposed by the OECD, which artificially try to tie value to a physical location, economic pressures will instead encourage firms to transfer real economic activity to low-tax jurisdictions. New OECD rules may end up distorting the location of tangible assets and jobs – rather than the current non-distortionary relocation of intangibles. The OECD cannot stop tax planning – it can only change which type of assets are transferred when the planning takes place (the physical Coca-Cola plant or the ownership of the name).

 

Action 13: Costly Transparency and the Dark Side of Disclosure

Action 13 requires large multinational enterprises to provide new detailed annual reports of their business activities in each jurisdiction where they do business, known as ‘country-by-country reporting’. The goal of this new regime is to make multinational firms more transparent in their reporting and to help tax administrators root out profit shifting from high- to low-tax jurisdictions.

Collecting and reporting this new information will be incredibly costly for companies as it represents a substantial change in how businesses currently report tax information. There is also concern that the new country-by-country reports will be used to justify frivolous audits, which will increase real profit shifting in the form of jobs and investments. During a discussion about the implementation of country-by-country regulations in the US, Douglas O'Donnell, Commissioner, IRS Large Business and International Division said that it “isn't yet known how the information will be used”.  This uncertainty bolsters the widely held fear that tax administrators, in attempts to expand their tax base, will use this new tax information to pressure companies to artificially align taxes with sales, employment, or asset locations.

Data security is also an issue. Assembling a new, centralised database of highly sensitive corporate financial information increases the vulnerability of proprietary business data. It would take just one breach of the system in any one of the party jurisdictions for all the information to be exposed. Evidence from a World Bank working paper finds that this type of reporting transparency exposes firms to “a significantly higher level of corruption” in less developed nations.  Even well-developed countries with the most robust institutions struggle to uphold the rights of taxpayers and secure sensitive data.

 

Global Competition is Good

Corporate tax codes are highly complex and are designed to accomplish a herculean task—fairly and efficiently collecting taxes from business networks across hundreds of countries. This task has become increasingly difficult as multinational corporations expand their global supply and distribution networks across countless boarders.

International tax competition aims to attract economic activity by reducing the rate at which profits are taxed in a given country. If a firm moves from a high-tax country to a low-tax country, the high-tax country’s corporate tax base will shrink—it will face ‘base erosion’. In other circumstances, a business might shift profits rather than physical property to lower its tax burden, a process known as ‘profit shifting’.

Any tax system is able to fully tax all corporate profits if tax rules are centralised at an international level. However, the sovereignty of individual counties to set their own domestic rules is a fundamental feature of the global economy. Countries compete on innumerable margins for capital investments. The United States and Europe offer highly educated workforces and modern infrastructure. Developing countries compete by having less expensive labour and less intrusive regulations. The figure below shows the diversity of tax rates just within the OECD – each country is able to choose the tax policy best suited to its populations and industries. It seems peculiar that governments would not be allowed to compete through their tax codes, given the wide diversity of other laws and regulations.

 

Recognising the benefits of tax competition does not deny the costs associated with the current system of complex treaties necessary to facilitate communication between international tax authorities and reconciling differences among tax codes. However, it is important to remember that the type of tax competition the OECD is attempting to stop through the BEPS Project is a fundamental characteristic of jurisdictional diversity. The benefits of having a diverse global economy, with policies designed to suit their populations, accrue on many margins outside the tax code.

 

Is the System Worth Saving?

The documents released in the Panama Papers and recent high profile inversions have highlighted the fact that businesses are adept at using legal means to exploit tax rules to their advantage – as their shareholders expect any profit maximising firm to do. Substantiating this claim, recent academic evidence on international information exchange initiatives shows that dramatic increases in information exchanges have thus far not resulted in reduced tax evasion.

The corporate income tax often sparks controversy, as economists generally find it to be a distortionary and inefficient mechanism for raising revenue, while the public generally views it as a desirable tax on rich businesses and owners of capital. In reality the corporate tax burden falls on people, and by many accounts, much of the tax actually falls on workers, not shareholders. By most accounts, the corporate tax is inefficient as it double taxes income, penalises business activity, and requires a bevy of accountants and lawyers to comply with the complex regulations.

There is near-universal agreement that the corporate income tax is severely flawed, and the BEPS Project highlights the need for a new approach. Unfortunately, there is no silver bullet solution to taxing corporate income in an open and diverse global economy. The policy options are (1) repeal the corporate income tax and replace it with a more transparent tax on consumption, (2) continue to operate the current imperfect system with marginal reforms, or (3) further centralise global tax rules under the direction of an international body like the OECD.

First, any one country could benefit greatly by moving away from the corporate income tax and toward a more simple and efficient system for raising revenue. There is not room to discuss the case for repealing the corporate income tax in these pages, but it is a reform worth considering.

Second, a country like the US (which has the highest corporate income tax in the developed world) could benefit from ending worldwide taxation and moving toward a territorial tax system like most European countries, allowing full expensing, and lowering the corporate income tax to an internationally competitive rate – between 15 to 20 per cent. 

The third option, to further centralise global tax rules, should be resisted. The problems of base erosion and profit shifting identified by the OECD are problems intrinsic to taxing corporate profits, not to the way the tax information sharing is designed. The international community should be cautious of OECD attempts to eliminate tax competition by consolidating international tax rules. The identified problem likely has no solution, and the unseen costs to the OECD’s proposed solutions will certainly outweigh the uncertain benefits. The current BEPS Project unduly favours transparency and uniformity over the costs of complexity, compliance, and the loss of economic growth permitted under competition between sovereign tax regimes.

 

 

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