What are the options for reform available to the OECD?
In February, the OECD published its progress report on addressing base erosion and profit shifting. The OECD suggests that segregation between the locations where business activities take place and where profits are reported for tax purposes undermines the international corporate tax system. It will publish a further paper in June outlining its suggested solutions, which will require international agreement. Unilateral action would lead to double or multiple taxation. What tools (apart from recommending changes to sales taxes, such as VAT) are available to the OECD and what are the pros and cons for international trade?
Redefining where trading profits arise: Trading profits are treated as arising in the UK if they arise from operations carried on here. However, in common with all countries using the OECD model treaty, the UK relinquishes taxing rights unless there is a permanent establishment (a requirement hugely beneficial to e-commerce and digital technology businesses). The OECD could reverse this rule. However, this would require exporters of goods and services to register for tax in every country in which their sales depended on local operations. The regulatory burden would have an adverse effect on international trade.
Denying deductions for payments to tax havens: The deductibility of payments (in particular, interest and royalties) to affiliates in tax havens depends largely on the arm’s length principle. The OECD could suggest a rule (based on an anti-arbitrage or CFC approach) that deductions for such payments be denied if they are not taxed at a minimum rate in the affiliate’s hands (perhaps 10% to spare the UK government’s blushes in relation to patent royalties!). For economists who regard tax havens as malign, such a rule would not affect international trade. For economists who regard them as promoting healthy tax competition, it would.
Taxing interest and royalties at source: Instead of denying deductions for payments to tax havens, the OECD could recommend that the profit from the payments be taxed in the source state. Taking the Starbucks brand royalty as an example, the UK would tax the royalty by requiring a full withholding at source. The Starbucks brand owner could register for tax in the UK if it wished to prove that its profit from the royalty was less than 100%. However, the regulatory burden would likely have an adverse effect on international trade.
Global formulary apportionment: This is somewhat beguiling. On the face of it ‘GFA’ appears simple and practical. A deeper look reveals it to be dysfunctional economically and to pose major practical problems to implement.
GFA rewards value differently between countries than the arm’s length principle. This is particularly true of transactions in Intangibles and for intra-group financing. As such it puts associated and independent enterprises on an unequal footing for tax purposes. This distortion would constrain growth in international trade and investment. By contrast, the arm’s length principle gives a close approximation to the workings of the open market. Most economists, whether classical or Keynesian by persuasion, would agree that parity of treatment between members of an international group and independent enterprises is a good thing for everyone.
For GFA to work, the essential components (the unit to be taxed, how to define global profits and how to allocate them) must be agreed between all countries. But there will be winners and losers, especially in selecting arbitrary allocation keys. It is unlikely that countries will concede on points that disadvantage their expected revenue base. Furthermore, the switch to global formulary apportionment would need to happen in all countries at the same time. Otherwise there would be more than one regime for taxpayers to comply with. The compliance work would more than double as interfaces between the GFA and arm’s length regimes would themselves need to be priced at arm’s length. So, what at first sight might appear to be a simple alternative will create a compliance nightmare. Additionally, GFA comes with its own opportunities to avoid tax. One example would be artificially shifting factors used in the allocation formula to low tax countries. Further anti-avoidance measures would be needed.
Better enforcement of the arm’s length principle: This would clarify how to apply the arm’s length principle in practice. In many cases suitable comparables cannot be found. International guidelines need to be more specific on what to do in such instances. This occurs commonly in the transfer pricing of Intangibles and in transactions that do not normally take place between independent parties. The OECD is currently working on updating its guidance on Intangibles. It would be helpful if pressure at G20 level produced agreement between countries to arrive at consistent guidance on these implementation issues. These issues need to be resolved through international consensus incorporating the concerns of the developing economies.
Policymakers need to ensure any fix promotes long-term goals for international trade and investment, especially in sharing technology. Short-term fixes by governments, just to be seen to be doing something, may squander opportunities to raise living standards across all countries.
Martin Zetter is head of transfer pricing and senior economist at Macfarlanes LLP
