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 EUROPE 2015 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 TAXING MULTINATIONAL CORPORATIONS 2 HARVARD MODEL CONGRESS 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 EUROPE 2015 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. TAXING MULTINATIONAL CORPORATIONS 3 HARVARD MODEL CONGRESS 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 EUROPE 2015 TAXING MULTINATIONAL CORPORATIONS 4 HARVARD MODEL CONGRESS 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 EUROPE 2015 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 TAXING MULTINATIONAL CORPORATIONS 5 HARVARD MODEL CONGRESS 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 EUROPE 2015 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. TAXING MULTINATIONAL CORPORATIONS 6 HARVARD MODEL CONGRESS 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 EUROPE 2015 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 TAXING MULTINATIONAL CORPORATIONS 7 HARVARD MODEL CONGRESS 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 EUROPE 2015 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 TAXING MULTINATIONAL CORPORATIONS 8 HARVARD MODEL CONGRESS 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 EUROPE 2015 TAXING MULTINATIONAL CORPORATIONS 9 HARVARD MODEL CONGRESS 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 EUROPE 2015 TAXING MULTINATIONAL CORPORATIONS 10 HARVARD MODEL CONGRESS 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 EUROPE 2015 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 TAXING MULTINATIONAL CORPORATIONS 11 HARVARD MODEL CONGRESS 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 EUROPE 2015 TAXING MULTINATIONAL CORPORATIONS 12 HARVARD MODEL CONGRESS 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 EUROPE 2015 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. TAXING MULTINATIONAL CORPORATIONS 13 HARVARD MODEL CONGRESS 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.” EUROPE 2015 TAXING MULTINATIONAL CORPORATIONS 14 HARVARD MODEL CONGRESS 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. BIBLIOGRAPHY "A Brief History and Perspective on Multinational Corporations." Mr. Smiley's Classroom on the Web. Halifax Regional School Board, n.d. Web. 10 July 2014. <http://hrsbstaff.ednet.ns.ca/smileymi/Global%20History%2012/a_brief _history_and_perspective_.htm>. "Arm's Length Principle." OECD Glossary of Statistical Terms. OECD, 23 July 2007. Web. 11 July 2014. <http://stats.oecd.org/glossary/detail.asp?ID=7245>. 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