Museo del Prado
Madrid, Spain
2015 Edition
Group of 7
Taxing Multinational
Corporations
Two hundred and twenty-five years ago, Benjamin Franklin, one of the founding fathers of the United States, once
quipped, “In this world, nothing can be certain, except death and taxes.” As the largest international corporations,
ranging from General Electric to Deutsche Telekom, from Google to Royal Dutch Shell, and from Toyota to
Anheuser-Busch InBev, become more adept at gaming the international tax system, which academics and
policymakers alike have for years described as broken, the taxes that multinational corporations must pay to sovereign
states become ever smaller. Thus, however applicable Franklin’s saying may have been over two centuries ago, the
certainty of “death” and “taxes” for corporations is, for lack of a better way to phrase it, not so certain. At the
upcoming Group of 7 (G7) summit in Madrid in March 2015, when several of the most prominent heads of state,
finance ministers, and other senior government leaders meet, one of the top priorities on the agenda is addressing the
issue of taxing multinational corporations. Members of the summit will be faced with the daunting task of revamping a
system of international taxation that has not seen significant change since the beginning of the century.
Gabriel Rosen
[email protected]
Harvard Model Congress Europe 2015
www.hmceurope.org
“THAT FELLOW BEHIND THE TREE”
TAXING MULTINATIONAL
CORPORATIONS
By Jacob Steinberg-Otter
INTRODUCTION
Multinational
corporations comprise
some of the most wellknown companies of
contemporary society.
[http://www.2luxury2.com/bm
w-sony-and-disney-top-thisyears-list-of-the-worlds-mostreputable-companies/]
Two hundred and twenty-five years ago, Benjamin Franklin, one of the
founding fathers of the United States, once quipped, “In this world, nothing
can be certain, except death and taxes.”
The applicability of this witty aphorism, however, may not be as
universal as Franklin thought, especially in the economic world we live in
today, dominated by large, multinational corporations. As corporations are
legal persons distinct from any shareholder, member of the board of
directors, employee, or executive, its existence is indefinite and, unless
closed by its owners or because of economic woes, permanent. And as the
largest international corporations, ranging from General Electric to
Deutsche Telekom, from Google to Royal Dutch Shell, and from Toyota to
Anheuser-Busch InBev, become more adept at gaming the international tax
system, which academics and policymakers alike have for years described as
broken, the taxes that multinational corporations must pay to sovereign
states become ever smaller. Thus, however applicable Franklin’s saying may
have been over two centuries ago, the certainty of “death” and “taxes” for
corporations is, for lack of a better way to phrase it, not so certain.
At the upcoming Group of 7 (G7) summit in Madrid this March 2015,
when several of the most prominent heads of state, finance ministers, and
other senior government leaders meet, one of the top priorities on the
agenda is addressing the issue of taxing multinational corporations.
Members of the summit will be faced with the daunting task of revamping a
system of international taxation that has not seen significant change since the
beginning of the 20th century.
The task will be difficult. Not only are the details of the issue complex,
but also the political pressures are great. Multinational corporations have
some of the largest political leverage today, and no one enjoys paying taxes.
HARVARD MODEL CONGRESS
Members of the G20 may find themselves struggling with how to advance
meaningful change in an intense environment. Indeed, some policymakers
may find it easier to maintain the status quo and emerge from the summit
with no significant redress to the corporate tax avoidance phenomenon, as
captured by the statement of Senator Russell B. Long, one of the most
significant US tax policymakers of the 1900s: “Tax reform means ‘don’t tax
you, don’t tax me, tax that fellow behind the tree.’”
Yet despite the difficult task in front of you, the G20 remains the
greatest hope for meaningful change, and as political momentum continues
to build, attendees of the summit may find that the opportunity to act is
more promising than once perceived.
EXPLANATION OF THE PROBLEM
Historical Background
Corporation – a firm that
meets certain legal
requirements to be
recognized as distinct
from its owners
Limited liability – legal
protection of
shareholders (or owners)
from the corporation’s
debts and obligations
exceeding the value of
the share (or portion of
ownership)
Entity shielding – legal
protection of a
corporation from the
owner’s personal
creditors
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Ancient and Pre-Modern Roots
Corporations, or specific legal entities of persons and material resources
chartered by governments, have existed for thousands of years. As early as
800 BCE, business people in ancient India used a corporate form called the
sreni, or a legal entity similar to guilds, through which trade was channeled.
Sreni were registered with local authorities, had their own seals and insignia,
were organized with officers through a centralized management system,
could sue and be sued, could own property and assets separately of its
constituents, and conferred shared responsibility over its liability and assets.
Thus, sreni shared many of the characteristics that we normally associate
with corporations in the 21st century even though sreni first came into
existence before the Common Era.
The nature of modern day corporations and their historical origins,
however, are most often traced to the development of corporations in
Western legal traditions. Legal entities similar to modern corporations
existed as far back as ancient Rome, where there existed a limited set of
recognized legal personalities, including municipalities (municipia);
associations, guilds, and public bodies like universities (collegia); charitable
organizations (pieae causae); estates opened but not yet transferred to their
next possessor (hereditates iacentes); and entities holding government
leases, assisting in tax collection, public works, and management of estates
on behalf of the government (societates publicanorum). Although these
means of social organization bore some resemblance to modern
corporations in that they were non-natural forms of legal personhood, they
also differed sharply from present-day manifestations of corporations. None
of these legal entities simultaneously conferred limited liability to their
owners; protected the entities’ assets from the creditors of the entities’
owner(s) (entity shielding); allowed the delegation of responsibility to act in
the name of the organization to people other than the owner(s) (direct
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Direct agency – the
ability for a person to act
in the name of a
corporation (other than
the owner[s])
Continuity - the ability of
a corporation to live
beyond the life spans of
its owners, as ownership
can be transferred
through sale or gift
Shareholder – an entity
that holds a share, or unit
of ownership proportion
to the company’s capital,
in a corporation
agency); and could exist beyond the temporal lives of the entities’ owner(s)
(continuity), all of which are considered essential aspects of corporations
today.
In medieval and Renaissance Europe, the revival of long-distant trade,
particularly in Italian cities like, Pisa, Venice, Florence, and Sienna,
combined with strong commercial influence over the political process in
Italian cities, led to the creation of laws and legal concepts that would lay
further groundwork for the rise of modern corporations. Through the
structure of compagnia under medieval law, merchants were provided a
form of weak entity shielding for their private, commercial activity, whereby
personal creditors held a reduced claim to business assets. During the 10th
and 11th centuries, the earliest form of limited partnerships, called
commenda, arose. Commenda had two partners: a passive investor that
provided capital and a traveling trader who contributed labor and initiative,
and the relationship would only last as long as a single, round-trip naval
voyage. The passive partner usually enjoyed limited liability, protecting him
from any imprudent borrowing by the active partner, and the commenda
held strong entity shielding. A version of the commenda, called societá in
accomandita, was later developed for terrestrial use, lasting for short-term
arrangements between the investors of and managers of the accomandita.
Following the development of corporations in Italy, similar legal
structures evolved in other parts of Europe. For example, around 1250 in
France, citizens in the French town of Toulouse founded the Société des
Moulins du Bazacle (Bazacle Milling Company), one of the first joint-stock
companies in France and, indeed, the world, that initially sold 96 shares of
stock, with prices varying according to general economic conditions and mill
output. Shareholders appointed a board of directors at yearly meetings to
manage the company, the company maintained limited liability, and the
company was treated as a distinct legal entity as early as the 14th century. In
England, the monarchy chartered several companies as early as the 1407 to
engage in trade with other European countries and Russia, although these
companies did not become incorporated until later centuries. Stora
Kopparberg, the world’s first limited liability corporation as we know them
to exist under modern conceptions, was established in Finland as a mining
company in the year 1288.
Early Modern History
Multinational
corporation – an
enterprise operating in
multiple countries but
managed from one home
country
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The evolution of modern, multinational corporations has largely been a
function of the broader trend of globalization over the last several centuries.
As the world has become more interconnected and interdependent due to
technological and economic developments, the trend gained greater
momentum following Christopher Columbus’s voyages to the Western
Hemisphere in the late 15th century. The intercontinental naval journeys not
only led to permanent and significant connection between the two halves of
the world, but it also shifted the center of commercial attention and
advantage from the Mediterranean Sea to the Atlantic Ocean.
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Mercantilism – body of
economics popular
during the 1500s and
1600s that involved the
strict governmental
regulation of the national
economy, usually through
creating a favorable
balance of trade,
gathering of rare metals,
the development of
agriculture and
manufactures, and the
establishment of foreign
trade monopolies
After Columbus’s expeditions, Spain and other European countries
expanded their colonization of the Americas as well as other regions of the
globe, and as they colonized, they created corporations to promote trade
with and to further the territorial acquisitions of their home countries. The
two most prominent examples of this phenomenon include the British East
India Company (or simply the East India Company), founded in 1600 by a
royal charter from Queen Elizabeth, and the Dutch East India Company,
which was founded by the Dutch government in 1602. Other countries
subsequently established similar East India companies, including Denmark,
Portugal, France, Sweden, and Austria, and for the most part, investors were
protected from responsibility for the debts and other actions of the
companies, thereby exercising limited liability. These East India Companies
engaged in trade primarily in India but also in other parts of South and East
Asia, including China, as well as Africa and the Americas. To varying
degrees, they could wage war, try and convict people for crimes, negotiate
treaties, coin money, and establish colonies on foreign lands. Their business
activities mainly involved establishing trading posts in foreign lands,
maintaining plantations for the growth of products, and creating factories to
process some of the raw goods. Thus, since these companies were
incorporated in one country but established branches or subsidiaries in
foreign territory, they were paragons of some of the first and most
prominent multinational corporations in modern history. As unofficial and,
occasionally, official arms of European governments, corporations served to
further the colonizing, mercantilist interests of Western nations for several
hundreds of years. Multinational corporations accumulated great financial
and economic power through the public trading of their shares, and these
colonizing enterprises lasted through the 17th century to the 19th century.
Late Modern Period
Starting in the late 18th century and early 19th century, more corporations
became multinational, coincident with the Industrial Revolution. As the
birthplace of the Revolution, Britain attracted many continental enterprises
to settle down in London and in the textile regions of northern England.
British and European merchants traveled the world searching for new
export markets and settled in many foreign trading ports. London served as
an intermediary of the financial system, where individuals engaged largely in
portfolio investments, a form of foreign investment.
The last third of the 19th century saw the transportation and
communications revolutions. With the spread of railroads, steamships, and
telegraph cables, the delivery of goods and information became much
quicker and more feasible. These developments, coupled with the growing
wealth of Western countries, facilitated the development of firm activities
across national borders. European and US companies sought to secure
resources like rubber, coffee, metal ores, tobacco, and sugar in order to
further their imperialistic desires. Britain was by far the dominant corporate
force, commanding the largest empire the world has ever seen, undergoing
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industrialization earlier than any other country, and holding a capital,
London, that served as the financial center of the globe.
By the late 19th and early 20th centuries, the drive for obtaining colonies
where European nations presumed raw materials for economic and military
might were located further exacerbated the struggle for power in Europe,
and with the greater international expansion of socio-economic and political
dominance came the greater spread of corporations’ international activities.
Banking institutions began to internationalize, establishing branches and
subsidiaries in foreign land, which allowed them to invest and organize the
provision of capital. Manufacturing began to internationalize, too, as some
textile firms began global operations before World War I.
The 20th Century
Double taxation – the
paying of taxes twice on
the same source of
earned income, usually to
two different taxing
entities
Model convention – an
accord between members
of an international
organization that serves
as a guideline for
establishing tax
agreements
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As the first corporate income taxes began to appear in the early 1900s,
so did the issue of double taxation. The first attempts to remedy the issue
came with bilateral treaties. The agreements most often occurred between
neighboring European countries. In the 1920s, during the aftermath of
World War I, the issue of how to tax corporations with operations in
several countries became more prominent. Demand for natural resources
continued during the interwar period, providing an impetus for US and
European corporate ventures to expand. While the ventures of European
multinational corporations slightly declined following the First World War,
the presence of US corporations abroad expanded.
With the further internationalization of corporations came a growth in
the need to develop means to manage the taxation of the enterprises. The
League of Nations, an international organization created as a result of
World War I, appointed economists to devise potential solutions to present
to its members during several conventions, including in 1923 and 1927.
While the initial goal was to reach a multilateral agreement, member
nations consistently rejected this idea; nonetheless, members of the League
supported drafting a model convention that could serve as a template for
bilateral agreements between nations, insisting on keeping the model
convention non-binding to allow for the flexibility to generate nationally
differing tax systems congruent with one another. Accordingly, model
conventions occurred in 1928, 1935, 1943, and 1946.
After World War II, the United States emerged as the clear, principal
corporate force, with US corporations dominating foreign investment
activity for the next two decades. Simultaneously, European and Japanese
corporations began to play ever-greater roles in the global economy. In the
1950s, European, Japanese, and US banks invested large amounts of money
in industrial stocks, prompting corporate mergers and further capital
concentration. With the further globalization of corporations, efforts to
establish mechanisms to tax their expanding international activity increased.
Since the fall of the League of Nations, the Organization for Economic
Cooperation and Development (OECD) took the lead as the primary
multilateral policy forum for negotiations on international tax issues. The
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members of the OECD maintained the same mentality they had during
negotiations in the League of Nations: they resisted a multilateral treaty to
address the taxation of corporations operating across borders but advocated
for the further development and adaptation of the model convention. The
OECD published its first model convention and commentary in 1963 and
subsequently republished versions in 1977, 1991, 1992, 1994, 1995, 1997,
2000, and 2003.
The 20th century saw major technological advances in shipping,
transportation (especially via air), communications, and later,
computerization, accelerating multinational corporations’ increasingly
international investment and trade. Meanwhile, new advertising capabilities,
through radio, television, and other means, assisted corporations in the
expansion of their market shares. Indeed, multinationals’ expansion abroad
is reflected in the rapid rise in the number of bilateral treaties. In 1958, 263
treaties were in effect, increasing to 333 by 1963 and 600 by 1978.
Following the 1977 model convention, as global capital markets became
further liberalized and the tax ratios in industrialized nations rose, rendering
the issue of double taxation more significant, the number of treaties
skyrocketed to over 1500 by 1998. Nearly all of the more than 2000
agreements in force today.
In 1980, the United Nations published its first model convention, a
modest remaking of previous OECD versions, and it republished a
modified version in 2000. Overall, the UN model convention has had a
limited yet visible influence on bilateral agreements in the last 30-plus years.
Base erosion and profit
shifting – tax planning
strategies that exploit
mismatches in tax rules
to make profits
“disappear” for tax
purposes or to shift
profits to places where
there is little to no real
activity, but the taxes are
low, leading to little
corporate tax actually
being paid
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Issues with the Current International Corporate Tax System
In the midst of an increasingly interconnected world, countries have
struggled to keep their tax laws at pace with global corporations, fluid
capital, and the digitized economy. Corporations have used the legal gaps
that have evolved over time to avoid taxation in their home countries while
increasing their activities abroad to low- or no-tax jurisdictions. The core of
the problem involves base erosion and profit shifting (BEPS), which the
OECD and G-20 have announced as a top target for international
negotiations. BEPS is a complicated process by which corporations shift
profits across borders to take advantage of lower tax rates than the country
in which the profit was actually earned through the sale of products or
services. The three most popular mechanisms through which this occurs are
hybrid mismatch arrangements, special purpose entities (SPEs), and transfer
pricing.
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Hybrid Mismatch Arrangements
Hybrid mismatch
arrangements –
arrangements exploiting
differences in tax
treatment of entities,
instruments, or transfers
by two or more taxing
authorities
Hybrid mismatch arrangements constitute agreements exploiting the
differences between two or more countries’ treatment of entities, financial
instruments, and transfers of assets or liabilities among firms for the
purpose of taxation. The agreements often involve dual residence entities,
whereby a corporation is considered a resident of two countries, allowing
corporations to make use of foreign tax credits to avoid paying taxes in the
other residence. Another feature common to hybrid mismatch agreements
includes hybrid instruments, whereby corporations, for example, may file
activity in one country as debt and file activity in another country as equity.
Hybrid transfers, meanwhile, are arrangements in which the transfer of
assets among firms is treated as a transfer of ownership for one country’s tax
purposes, while the transfer is treated as merely a loan with collateral for
another country’s tax purposes.
Often, the result of hybrid mismatch agreements is double non-taxation,
whereby a corporation is not taxed anywhere for the profit it has earned, or
tax deferrals, which, if the delay is maintained for several years, may be the
functional equivalent of double non-taxation. These arrangements
significantly reduce overall tax revenue for governments. Anecdotal
evidence is just one way to illustrates the massive effect this has upon
government budgets: for example, New Zealand settled cases with 4 banks
in 2009 for a sum of NZD 2.2 billion; Italy recently settled a number of
cases with hybrids for approximately EUR 1.5 billion; and in the United
States, the amount of tax at stake in 11 foreign tax credit generator
transactions can be as much as USD 3.5 billion. Additionally, businesses
that have access to sophisticated tax advice, and thus are able to take
advantage of hybrid mismatch agreements, gain unintended competitive
advantages over small and medium-sized enterprises that cannot easily
make use of the arrangements. Furthermore, hybrid mismatches can raise
questions on the fairness of the system, where mismatch opportunities are
much greater for taxpayers with income from capital rather than labor. The
ability of one group of taxpayers to reduce their taxable income could be
perceived as unfair, thereby undermining the public confidence in the
fairness of the tax system.
Special Purpose Entities
Special purpose entity – a
legal entity created to
hold some of the assets
and liabilities of a parent
corporation in another
jurisdiction
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Special purpose entities (SPEs) are legal entities with little or no
employees, operations, or physical presence in the jurisdiction(s) where they
were created, while the parent firm is normally located in another country.
Almost all of the assets and liabilities of the SPE derive from investments in
or from other countries, and the main purpose of the SPE consists of group
financing or holding activities; in other words, channeling funds from nonresidents to other non-residents.
To varying degrees, SPEs allow the parent firm to keep the assets and
liabilities of the SPE off their balance sheets for accounting purposes. The
result is that corporations can alter the amount of taxes they have to pay in
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some countries. The cases of Luxembourg and the Netherlands can
illustrate the magnitude of SPEs and their prevalence as a tool of taxavoidance for corporations. Total inward stock investments into
Luxembourg in 2011 equaled USD 2.13 trillion, with USD 1.99 trillion
earned through SPEs, while outward stock exchanges from Luxembourg
equaled USD 2.14 trillion, with about USD 1.95 billion from SPEs. The
Netherlands performed even better, attracting USD 2.63 billion and USD
3.02 billion in inward and outward stock investments, respectively, through
SPEs. Therefore, the large sums of money upon which firms are able to
avoid paying taxes and the complex legal arrangements necessary to
establish SPEs in foreign countries lead SPEs to have comparable effects as
hybrid mismatch arrangements upon countries’ tax bases, competition with
other, smaller corporations, and perceived fairness of tax systems.
Transfer Pricing
Arm’s length principle –
a concept that holds that
transactions should be
valued as if two unrelated
parties carried them out
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Transfer prices are the prices that one firm pays to its parent firm, or
vice versa, for the receipt of goods or services. They are used not only to
calculate the amount of money that should be allocated to the different
branches of the larger, multinational corporate entity, but also to calculate
the tax the multinational corporation owes. In many situations where the
countries between which the transfer occurs have a bilateral agreement on
how to tax multinational corporations, the amount of tax owed is calculated
using the arm’s length principle, although some countries (notably Brazil)
occasionally use other principles to calculate taxable income. The arm’s
length principle requires that operations should be priced by comparing
them with similar operations carried out at market prices, as if both parties
were not affiliated; in other words, at arm’s length.
A significant problem with the arm’s length principle is there is no easy
method to calculate transfer prices. Particularly in developing countries, the
developing country subsidiary may be one of few, if not the only firm, in the
particular line of business. As a result, there are no other transactions to
which the firm and the taxing authority can compare the current transaction.
Furthermore, intangible assets, such as intellectual property, may be unique
and thus exceedingly difficult to designate with a transfer price. Therefore,
transfer prices are usually assigned following a negotiation between the
corporation and the tax authority. Ideally, the negotiation would be
conducted with an equal access to information and a shared objective in a
zero-sum game; however, in actuality, corporations and governments are put
at odds, with the former’s objective being to maximize profits while the
latter’s being to maximize revenue. In addition, a large international
business exists to help companies minimize the amount of money paid on
transfer prices, and corporations often have greater information, employees,
and resources at their disposal. Accordingly, transfer pricing often results in
profits being artificially shifted to low- or no-tax jurisdictions, where the
resources to combat transfer pricing abuse are smaller. Additionally, since
there is no mandatory, global system of information sharing on the activities
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and transactions of multinationals, which could possibly assist taxing
authorities in evaluating the appropriate transfer price, corporations are left
at a greater advantage for another reason.
To understand the magnitude of the effect of transfer pricing, Global
Financial Integrity in Washington, DC generated an estimate of the lost
potential revenue for governments, ranging in the hundred billions of
dollars. Christian Aid, a prominent, global non-governmental organization
based in the United Kingdom, estimated that from 2005 to 2007 alone, the
United States and the European Union lost a total of USD 1.1 trillion
because of mispricing.
Residence principle –
rule that holds an entity is
taxed by the jurisdiction
where it is resident on all
of its domestic and
foreign income
Source principle – rule
that holds a state may tax
the income of all sources
within its jurisdiction
FOCUS OF THE DEBATE
In order to represent your country well at the upcoming G7 summit in
Europe in March of 2015, you must understand the policy preferences of
your country in particular and present and advocate for them well. Below,
you can find a summary of the general preferences of developed and
developing countries on the issue of taxing multinational corporations.
However, the simple fact that your nation may fall into one of the two
categories below does not necessarily mean that your country’s views are
completely consistent with what is explained below, nor are the following
sections supposed to exhaustively explain the nuanced positions of every
G20 member. Your duty, therefore, is to research the policy preferences of
your administration and come prepared to support them, using the
subsequent sections merely as a guideline.
In order to understand the preferences that developed and developing
countries have on the issue of taxing multinational corporations, as well as
the systems they currently have in place to tax them, it is important to first
understand two principles of international taxation. The first is called the
residence principle, which holds that the state in which a corporation is a
resident taxes the corporation for both its domestic and international
commerce. The source principle, meanwhile, holds that the state taxes any
entity operating within its jurisdiction, but only on its domestically earned
income.
Developed Countries
The position that developed countries take towards taxing international
corporations is hard to place. In order to operate and pay for the services it
offers, the state must tax legal persons, including corporations. Thus,
developed nations would find it in their best revenue-building interests to
institute a worldwide system of taxation, which is further explained below.
Since the worldwide system is based primarily on the residence principle,
and since most multinational corporations are based in developed nations,
residency-based taxation may seem like a natural choice for developed
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Statutory tax rate – the
percentage tax rate
appearing in tax law,
before any deductibles or
rebates
nations to raise revenue. Indeed, for many years, residency-based taxation
was the principle of choice for developed countries.
However, several other factors have gone and continue to go into the
evolving policy preferences of developed countries. As residence-based
taxation naturally leads to greater taxation of corporations, in an effort to
ensure their own corporations are on an equal playing field with foreign
corporations, developed nations have progressively moved away from the
residence principle and warmed up to the source principle. The lower
amounts of revenue on which their home multinational corporations have
to pay taxes, the better they are able compete on a global level with their
corporate counterparts based in other nations. Such a transition also reflects
a desire of developed nations to prevent their corporations from moving
their residency to other, more tax-friendly countries. Reducing corporate
taxes, both through statutory rates (which have dropped starkly over the last
several decades) and through a shift towards source-based taxation, has
become the tendency of developed nations.
In general, since developed nations are more likely to host multinational
corporations, they are more likely to advocate for preventing other nations
from collecting the income of their corporations’ global activity, as it would
hurt their international competitiveness.
Developing Countries
Developing countries often find themselves in a dilemma on the issue of
taxing multinational corporations. For them, both the residence principle
and the source principle of taxation may cause economic conundrums. On
the one hand, favoring the residence principle may deprive a developing
country of significant revenue, since developing countries are, for the most
part, source countries. On the other hand, favoring the source principle
may lead to an effective cost increase for foreign investment: if the resident
country adheres to a residence principle-based form of taxation, that would
lead to an effective increase in the costs associated with investment into the
source country, thus discouraging investment and, consequently, further
development.
Accordingly, although the source principle of taxation may on its face
seem preferable, it may be so only if the residence country is willing to grant
a tax deductible for taxes already paid on the transfer of assets across
borders to the source country. Thus, it would be in the interest of
developing countries to negotiate tax treaties with provisions reflecting this
concept.
Developing countries, therefore, have to toe the line between
encouraging foreign investment while raising revenue, and developing
corporations often have a much more difficult time performing the latter
than developed nations. Developing countries are more likely to favor
taxing multinational corporations, though, because most multinationals are
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in developed nations, and thus they are not as concerned with equalizing
the international corporate playing field or advancing business interests.
POSSIBLE SOLUTIONS
Transition to a Fully Territorial Tax System
Territorial system – a tax
system that taxes
domestic, but not foreign,
income
Worldwide system – a
system by which
domestically-owned
corporations are taxed on
all global income
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A territorial system for the taxation of multinational corporations would
entail a country taxing only the income corporations earn within its borders.
All the income corporations earn outside of the country would be
exempted for tax purposes. The territorial approach has been widely
adopted by countries, including but not limited to Hong Kong, the United
Kingdom, Belgium, and the Netherlands.
The benefits of the system would include, first and foremost, simplicity:
the current international taxation system is incredibly complex, and a
territorial system would reduce taxing authorities’ concern to only domestic
income. Corporations would also benefit from the reduced complexity,
because it would allow them to minimize their administrative burden.
Furthermore, eliminating the taxation of a corporation’s profits earned
abroad would reduce disincentives for domestic corporations to bring their
overseas income “home,” encouraging, in theory, the corporation to invest
in its country. Additionally, the system equalizes tax costs between
international competitors operating within the same jurisdiction, allowing
them to compete on equal playing field with each other. Multinational
corporations would also be subjected to less taxation, thereby allowing
corporations to be competitive on a global level with their foreign
counterparts.
However, the system would also encourage corporations to shift their
profits to countries with low tax rates. This would benefit countries with very
low rates while reduce the tax revenue for countries with high rates, leading
the former to see a drop in tax revenue and the latter to see a rise. It would
also benefit some corporations more than others—particularly those in
industries that can easily move their investments and profits to other
countries, like pharmaceuticals and software. Additionally, the territorial
system would risk higher taxes on smaller businesses, solely domestic
businesses, and individuals in countries with higher corporate tax rates, for
as policymakers sought to offset the loss of corporate tax revenue, they
would likely have to expand the tax base elsewhere.
Transition to a Fully Worldwide Tax System
Under a worldwide tax system, all of the income that a resident of a
country earns would be subject to taxation, including both domestic and
foreign income.
Because a worldwide system would subject all of a corporation’s income
to taxation, it would allow for greater tax revenue for the country of
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residence. Additionally, a corporation would not face any incentive to invest
at home or abroad, for all assets would be subject to taxation regardless of
the location of investment. It also eliminates the incentive for corporations
to game the system for the same reason.
However, a worldwide system would complicate an already complex tax
system, creating an administrative ordeal. Furthermore, as the current
trajectory for countries’ tax frameworks is towards territorial systems,
adopting a worldwide system would put the corporations based in that
country at a competitive disadvantage with foreign countries and may
encourage them to move abroad and/or move their operations out of
countries with worldwide systems. Countries that have many multinational
corporations located within them may also find it politically difficult to
institute such a system, as corporations have already successfully shifted
much of their income overseas.
Establish a Global Incorporation Process
Instead of divvying corporate profits among residence and source
countries, the international community could establish a mechanism for the
establishment of a global corporation. A company would not be
incorporated and listed in any particular jurisdiction; rather, the
international community would institute an international organization where
companies would register as multinational corporations. Under such a
system, the organization would be given jurisdiction to register and tax
multinational corporations as well as generate laws to govern them. The tax
revenue remaining after paying for operational costs would be transferred to
the member states.
Such a system would remove incentives for multinational corporations
to artificially split their activities across several jurisdictions to avoid paying
higher taxes. However, it would require each country to pass legislation in
its jurisdiction bringing it to fruition, and countries may have to forgo any
right or jurisdiction over the multinational corporations, thus threatening
their sovereignty to act over legal entities within their borders.
Institute a System of Automatic Information Sharing
Proponents of an automatic system of information sharing claim that it
would have a much higher deterrence effect for tax evasion, which is illegal.
If businesses know that all information on their income, expenses, and
other essential accounting information will be shared with all countries, they
are less likely to attempt to break the law. It may also assist in reducing
transfer pricing abuse, since if countries have access to more comparable
transactions that have taken place, taxing authorities may find it easier to
designate an arm’s length price.
Opponents, however, sight excessive burdens on businesses and
financial institutions. As many jurisdictions provide that taxpayer
information is considered confidential, requiring automatic disclosure may
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jeopardize legal protections already in place in many countries.
Furthermore, using comparable transactions obtained through an
information sharing system in evaluating transfer pricing, opponents argue,
would be unfair, since the level of competition, value of goods and services,
and the presence of substitute or complementary goods and services may
differ across countries, thus generating a skewed or inaccurate transfer price.
Address Transfer Pricing Abuse Directly
Formulary
apportionment – a
system that allocates all of
a corporation’s global
income based upon the
amount and level of
operations it has in each
country in which it
operates
Intangibles – an asset that
is not physical in nature,
such as intellectual
property
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Another issue that policymakers can consider addressing at the
upcoming G20 summit is transfer mispricing. Among the proposed
solutions is exchanging the arm’s length principle, which has proven, in
some instances, to have issues in practicality and applicability, with a system
of formulary apportionment. This system would require that taxable profits
to be distributed among all relevant countries based upon the total property,
payroll, sales, or capital stock in each country. The system would reduce the
incentives for corporations to move operations from high-tax countries to
low-tax countries, it would treat subsidiary firms owned by the same parent
company yet operating in multiple jurisdictions the same regardless of their
location of operations, and it would eliminate some of the administrative
complexity currently present in some countries’ systems of taxation.
However, such a system may result in double taxation if all of the relevant
countries do not adopt similar schemes and do not adopt the same formula
for taxation, which would require a high level of coordination and political
maneuvering. Additionally, formulary apportionment would require
creating a common set of accounting standards that all countries party to the
system can agree (or at least reconciling the differences).
An alternative solution is to modify the current transfer pricing system,
with specific attention to intangibles, to which taxing authorities have a
particularly difficult time applying the arm’s length principle. One possible
way to address transfer pricing with intangibles would be the application of
the transactional profit split method, which first identifies the profits or
losses to be split for the relevant enterprises from a transaction, and then
splits the profits or losses among them, approximating the division of profits
or losses that would have been anticipated and reflected in an arm’s length
agreement. Such a method does not require a comparison to comparable
transactions, which is particularly useful in unique transactions (like
transactions involving intangibles). The method, however, may be hard to
apply, because tax administrations may have difficulty evaluating
information from foreign affiliates involved in the transactions, and when
applying the method to operating profit, it may be challenging to identify the
appropriate operating expenses associated with the particular transactions to
allocate costs for the determination of profits.
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QUESTIONS FOR POLICYMAKERS
Policymakers must consider a plethora of questions when determining
how they will vote and act on the issue of taxing multinational corporations.
There is a range of domestic and international considerations, including but
not limited to the following:
How many multinational corporations are based in my country,
and how much political clout do they hold?
How do multinational corporations affect the economic growth
and stability of the domestic economy?
How effective would be a potential solution be in addressing the
issue, and what would be its implications, positive and negative?
How does a potential solution affect the domestic and
international economies?
What is the ideology of my administration, and how does the
issue of taxing multinational corporations, as well taxation in
general, fit into that ideology?
What would my government or I need to do to implement a
potential solution, and how difficult would it be to implement,
both in terms of practicality and politics?
How does a potential solution affect the sovereignty of my
country, and how much do I (or should I) care about a possible
reduction of it?
When it comes to designing a resolution at the G20 summit,
policymakers should first consider what issue or issues in taxing
multinational corporations they wish to tackle – transfer pricing, hybrid
mismatches, and so on. Following that, they should then consider how they
want to address it – through information sharing, implementation of
another principle for the arm’s length principle, institute a global
incorporation process, etc. Finally, policymakers should come up with a
means to execute whatever solutions they choose – leaving implementation
on a voluntary basis for member states, establishing an agency to monitor
member states compliance, creating incentives and disincentives, economic
or otherwise, to ensure compliance, and so forth.
CONCLUSION
The issue of taxing multinational corporations will take considerable
research and debate before a remedy emerges. Taxation is a fundamental
feature of every state, the means through which governments are able to
generate the necessary resources for all the other functions it performs,
from social services to the national defense. As 18th century Irish statesman
Edmund Burke aptly stated, “The revenue of the state is the state.”
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Reforming tax laws can be exceedingly difficult, though. As nearly all
countries have gone through waves of attempts to reform their own
domestic systems, the prospects of reform can be summarized in the
phrase, “tax reform is dead, long live tax reform.” To be successful at the
G7 summit in Madrid in March 2015, policymakers must be sharp, driven,
convincing, prepared, and willing to negotiate. Time will tell if the
international tax system will see its first major revamping in the last century.
GUIDE TO FURTHER RESEARCH
Policymakers at the G20 should look for information on the current
problems with the international corporate tax system, the potential efficacy
of solutions, and the viewpoints of the administrations they are representing.
Thus, policymakers should first make use of the publications of
international economic institutions, such as the OECD, the UN, the IMF,
and World Bank. These publications can provide valuable information and
research on the current state of affairs and the implications of proposed
solutions. Policymakers should also make use of publications from
academic sources (such as leading universities), think tanks, and other nongovernmental organizations, which may provide valuable information as
well. Universities’ economics departments and public policy schools
regularly print information and research that may prove valuable, and
databases like LexisNexis, Westlaw, and HeinOnline offer a wealth of
academic literature on the subject.
In order to understand the perspective of the administration they
represent, policymakers should use news sources, such as the New York
Times, the Associated Press, the BBC, and the Economist, to read about
the actions of their heads of state on this issue and analysis of the policy
preferences of the administrations. Additionally, G20 policymakers should
research the official publications and statements of the countries they
represent, including but not limited the financial and foreign ministries’
webpages.
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