Modernising international tax rules: from arbitrage to convergence?
November 2018 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
November 2018 Issue
Financial leaders will have noticed that the taxation of international companies, particularly those in the digital sector, has hardly been out of the news in the last few years. This article explores how international tax rules have changed in reaction to some of the concerns covered in the media, and how they could develop further, with uncertain implications for the bottom line of large corporations.
For around a hundred years, the taxation of international trade has rested on two main principles. The first is that profits should be taxed where value is created, rather than at the location of sale, so a company creating a product in country A, and then selling it to a customer in country B is taxed on the profits from the sale in A, not B. The second is the arm’s length principle. When a company (X) creates or part-creates a product in country A, which is sold to an affiliated company (Y) in country B for distribution, or for finishing and sale, the price paid by Y to X for tax purposes should equate to the price that Y would have paid X had there been no affiliation – essentially, had they been acting at arm’s length.
In a world where most cross-border trade was in goods, the majority of companies operated in relatively few jurisdictions, had simple supply chains (manufacture in one place, with maybe several ‘overseas’ distributors), their markets were fragmented and their competitors were easy to identify, largely, these principles worked well. The value creation proposition seemed fairly obvious, and it was relatively easy to identify comparable transactions with or between third parties to set arm’s length transfer prices.
However, in the 21st century, these principles have come under increasing pressure from a number of factors.
First, there has been an increased globalisation of companies, which has led to more complex and specialised supply chains. This makes setting arm’s length prices more difficult as comparable prices are harder to identify.
Second, more international trade is being conducted in services rather than goods. This makes it less certain where value is created.
Third, more businesses are dependent on intangible rather than tangible assets. As a result, it is harder to attribute value to intangibles, and it is easier to separate legal ownership of an intangible asset from its place of creation. This creates tax planning opportunities, with intangibles moving into low tax jurisdictions.
Fourth, while companies have become globalised, many countries have maintained their separate tax systems, and have competed for business from multinationals, using differences in tax rates and tax bases. This gave rise to ‘arbitrage’ opportunities, in which some profits ceased to be taxed anywhere.
Fifth, the rise of global brands, particularly in the digital sector, has caused a number of companies to have significant market power in many countries, but with little in the way of physical presence (“scale without mass”), and paying little tax in such countries.
Following the financial crash of 2008, it became politically impossible for governments to justify a system where multinationals were able to make profits ‘disappear’ through arbitrage, divert profits attributable to intangible assets to tax havens, and pay little or no tax in countries where they appeared to have market dominance. Also, arguably, the reputations of many large companies benefiting from such practices were harmed.
The last five years or so have seen concerted international efforts, led by the Organisation for Economic Co-operation and Development (OECD), to tackle many of these problems. In autumn 2015, the OECD produced 15 reports covering a wide range of challenges to the international tax system; these included many recommendations for action states could take to counter base erosion and profit shifting (BEPS) as arbitrage and other planning techniques were referred to. Since that date, many states have enacted legislation to counter BEPS and increase transparency around the tax affairs of multinational companies.
It is impossible to cover these in detail here, but to take a couple of examples, arbitrage opportunities, such as being able to make a tax deductible interest payment in one jurisdiction, but treat it as a non-taxable dividend when received by an affiliate, have been targeted and transfer pricing rules, especially those related to intangibles, now place greater focus on where people are based, activities take place and risks are borne. Less weight is given to legal ownership.
Arguably, the US tax system has historically ‘enabled’ BEPS greater than any other. The US system was particularly conducive to offshoring intangible assets, and allowing profits to be recorded in low or zero tax jurisdictions. In theory, these profits would be taxed if ever brought back to the US, but in practice, they were kept, indefinitely, in ‘sunny climates’. However, the Tax Cuts and Job Act (TCJA) of December 2017 is a significant step toward reducing BEPS in the US. From 1 January 2018, where a US-based company has profits attributable to intangibles kept outside the US in a low tax jurisdiction, these are subject to US tax on a current year basis, whether repatriated or not. There are complexities, and, in general, tax will not be at the full US Federal rate of 21 percent, but this is a significant departure from the past.
It might be expected that effects of all these measures would be to increase the effective tax rates of multinational corporations. On their own, this would be the case. However, the ‘broadening of the tax base’ that these measures have created has been accompanied, in many places, by reductions in corporate tax rates. The UK has reduced its rate to 19 percent and plans to reduce it further to 17 percent in 2020. The Netherlands has recently announced a reduction from 25 percent to 22.25 percent by 2020 on profits made by larger corporate taxpayers, and, of course, the TCJA reduced the US federal rate from 35 percent to 21 percent. A recent OECD report noted over a dozen enacted or announced reductions in corporate tax rates. Multinational corporations will need to model both tax rule changes and tax rate changes to properly understand the impact on their bottom line.
When undertaking such assessments, particular care will need to be applied to the US reforms, while the headlines may have been taken by the cut in the Federal rate, the TCJA also brought in a number of complex features, including global intangible low tax income (GILTI), base erosion anti-abuse tax (BEAT) and foreign derived intangible income (FDII). The tax deductibility of interest expense is also subject to new restrictions. The rules around these measures are still developing, however it is clear that it is too simplistic to assume profits from existing US operations will now be taxed at 21 percent, or that this rate will simply apply to new acquisitions. It could be somewhat higher or lower.
It also appears that change is far from over. In the case of large digital companies, concerns continue to be expressed around the ‘scale without mass’ issue. Currently, attention is focusing on companies where users are fundamental to the business model, such as social media platforms and platforms for buying, selling and reviewing products. Users frequently do not transact in monetary terms with the platform, the platform’s revenues come from advertising or commissions on sales made over the platform. However, many states feel that ‘their users’ contribute significant value to the business, and they should be able to tax that value.
Work is continuing at an OECD level around how profits from such value could be identified and measured. The EU Commission has proposals for a directive on digital taxation, and national governments, including the UK, have expressed their own views. Presently, it appears that there is some way to go to achieve consensus, and countries are bringing in ‘unilateral’ measures aimed at taxing digital revenues arising in their jurisdiction. The EU Commission has proposed an EU-wide ‘interim measure’, taxing 3 percent of digital revenues where users are crucial to the business model. The technical challenges of identifying what revenues derive from user created value, and how these can be allocated, are significant. Furthermore, a 3 percent rate could be significant for companies with low margins, while arguably, potentially under-taxing those with very high margins. However, it appears inevitable that some additional tax measures, both interim and long term, will be imposed on the digital sector.
While arbitrage opportunities between tax systems may have been reduced, significant differences between corporate tax systems remain – for example how quickly capital expenditure can be written off, and in incentives for research and development. The EU Commission, and some Member States, notably France and Germany, believe there should be greater harmonisation of corporate taxation across the EU. They have proposed a common EU corporate tax base and that corporate tax should eventually be calculated at an EU level for multinationals, and then allocated across Member States. Many states remain highly concerned about such proposals, but one prominent sceptic of such proposals has been the UK, so Brexit may lead to new momentum behind such moves.
In conclusion, in recent years, international action has combated many arbitrage opportunities between tax systems, and there has also been a widespread reduction in corporate tax rates – to this extent, corporate tax systems have ‘coalesced’. However, the US has, to some extent, gone its own way with its reforms, and further changes can be expected in the taxation of the digital sector. We are some way from full convergence of corporate tax systems, but there are pressures, particularly from the EU, for further measures in that direction.
Accordingly, tax is an area to which finance professionals, whatever their specialism, will have to continue to pay close attention.
Glyn Fullelove is the deputy president at the Chartered Institute of Taxation. He can be contacted by email: email@example.com.
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Chartered Institute of Taxation