Can the G20 make multinationals pay tax? Finance ministers adopted an ambitious action plan to partially rewrite current international rules to prevent mostly American multinational corporations from avoiding tax in countries where they do business. Is this a serious effort or an attempt to paper over problems? It’s a little of both.
Back in February, the OECD Centre for Tax Policy and Administration essentially admitted that its policies and treaty network enabled corporate tax avoidance. The OECD put out a report describing common avoidance methods.
That was an admission against interest for this mostly European organization, whose stated purpose is to facilitate commerce. Yes, paying no taxes does indeed facilitate commerce, as 17th-century British pirates understood.
The international consensus lasted for a long time, with every OECD member country protecting its own national champions, punctuated by occasional cross-border arguments like the GlaxoSmithKline settlement with the IRS. The result was-beggar-thy neighbor tax policies (Ireland and the Netherlands) and no one really caring that the rules were unenforceable (the US, Germany, UK, France).
The 2008 financial meltdown changed all that. European countries are sending their tax collectors out to collect more, often preceded by the guardia di finanza. The United States is the only country that isn’t calling for more tax enforcement. As the world’s reserve currency, the dollar confers the privilege of monetizing debts. And Americans are philosophically opposed to vigorous enforcement.
At the behest of European governments, the OECD has issued, and the G20 have endorsed, an action plan to salvage the current international tax system. The action plan contains a number of creative and forward-thinking ideas.
Unfortunately, the action plan is grounded in the current, unenforceable system of separate company accounting and transfer pricing, which is doomed in the long run. Transfer pricing is such a joke that the phrase has become a newspaper pejorative connoting tax avoidance through intercompany transactions. But fixing the system has to be tried and allowed to fail before we can move on to something better, like formulary apportionment.
Will the action plan stop multinationals from shifting income tax havens? Maybe. The OECD was bullied into respecting tax havens when the United States killed the 1998 harmful tax practices project some years ago. But the rules do not have to respect transfers of the rights to unique and valuable patents, trademarks and copyrights (intangibles) to havens, so that income earned in countries with real customers can be booked there. This strategy is central to Google’s planning and that of many pharmaceutical companies.
Unfortunately, the OECD doesn’t have any practical, easily administered ideas about how to stop the transfer of intangibles. The OECD’s own guidance recognizes self-serving intercompany contracts as valid, and flimsy shell companies formed in tax havens as independent economic actors. Financial accounting does not recognize these arrangements, which are ignored in formulary apportionment.
Why is tax jurisdiction important? The treaty network over which the OECD presides reverses the normal right to tax, which lies with the country where the income is earned (the source country). The OECD model treaty gives primary tax jurisdiction the country where the multinational is headquartered (the residence country). The treaty was intended to make it comfortable for multinationals to do business around the world, while being responsible only to their home governments.
Europeans are angry when an American household name multinational does business there and pays little or no tax–and then turns around and pays little or no tax to the United States, either. This happens because of shifting income to tax havens, overly generous US tax rules, or US concessions. Google had an important transfer pricing concession called an advance pricing agreement. So the Europeans and others like India want to reclaim tax jurisdiction when the income goes untaxed.
Will Google and its corporate brethren be required to pay taxes?The United States successfully deflected questions about byte taxes and tax jurisdiction over companies that can do business in a country without putting boots on the ground. But the agreement to study these issues will not prevent European countries from auditing Google and other digital economy players. None of these mostly American companies pays serious taxes in any customer country.
An important aspect of the action plan is its stated willingness to reopen the treaty concept of permanent establishment—an ancient physical presence test for tax jurisdiction that is being widely abused by multinationals. Permitting a rethinking of permanent establishment was an important concession by the United States.
What about developing countries? NGOs object that the action plan would do nothing to benefit Africa. Multinationals are doing business and extracting resources from poor countries without paying for the costs of their activities or otherwise contributing to the cost of government. Insufficient corporate tax payments are not the full extent of their depredations.
A couple decades ago, many developing countries signed OECD model treaties with developed countries that are home to multinationals. They didn’t realize the full ramifications of the concessions they were making. They were told that a tax treaty is good for inbound investment. The fact is that multinationals will do business in any country where there is money to be made, tax treaty or not. Ask Brazil, which has no tax treaty with the United States.
Developing countries should not sign OECD model tax treaties. They could ask for UN model tax treaties, but those treaties also concede a lot of source country tax jurisdiction. They would be better off signing only the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, so companies could complain about their tax bills, and bilateral investment treaties, which protect investors’ property rights.
More transparency is necessary. The G20 has called for automatic information exchange. Multinationals are almost as excitable on the subject of information sharing as individual tax evaders, because their tax planning depends on telling different stories to different governments. NGOs succeeded in getting country-by-country reporting, while the United States succeeded in getting it hidden from the public.
How will the OECD make any of this agreement stick? Substantive reforms require really boring procedural fixes. The action plan proposes an ambulatory multilateral agreement, along the lines of the ISDA Master Agreement, among OECD member countries so that new treaty clauses and rules of interpretation can have immediate effect. Otherwise, current bilateral treaties would have to be renegotiated, which would take forever.
Europeans wanted multilateral solutions. They have already been told that a treaty switchover clause directing the source country to tax income not taxed by the residence country, is appropriate. The multilateral agreement could read a switchover clause into existing treaties.But many of the problems, like unwarranted interest deductions and disappearing entities using the US check-the-box rules, are better addressed through changes to domestic law. The OECD has been tasked to develop best practices.
Why won’t the OECD study formulary apportionment? The United States, where formulary apportionment has been used successfully by individual states for more than a century, won’t let them. The OECD would be declaring its own previous work pointless. Moreover, the rival European Commission, which makes rules for the European Union, is already working on formulary apportionment in the form of the common consolidated corporate tax base project.
The international system is gradually moving toward formulary apportionment as a practical matter. If income from intangibles is allocated to source countries based on sales, that’s formulary apportionment. And that allocation is coming, whether the United States likes it or not, because nothing else is enforceable.
But the United States is still stuck on the idea that Washington will get to tax the residual returns. That’s what the Apple hearing was about. The next phase is the fight over which countries get to tax the residual returns/excess profits.