How to make multinationals pay taxes honestly

In India, studies show that the effective tax rate for MNEs is lower than that for domestic companies.

A major concern of governments world over has been to make multinational enterprises (MNEs) pay legitimate taxes due to their respective countries. Willful avoidance of taxes or tax abuse by MNEs by transferring their profits to affiliates located in tax havens is a widely practised phenomenon. This matter is particularly worrying to developing countries as they are robbed of much-needed resources to spend on physical infrastructure and human development and anti-poverty interventions. The low capacity of tax administrations in developing countries and asymmetric power and resources between the MNEs and tax authorities makes it an unequal game.

In India, studies show that the effective tax rate for MNEs is lower than that for domestic companies. A Christian Aid study in 2013 based on sample data of multinationals in India shows that they (i) report 1.5% less profits, (ii) pay 17.4% less in taxes per unit of asset, 30.3% less taxes per unit of profit, and (iii) have 11.4% higher debt ratio than companies with no connection to tax havens. Surely, better tax collection from them would enhance the ability of government to enhance allocations to education and healthcare from the prevailing 3.4% and 1% of GDP, respectively. With 40% of 1.3 billion people in the age group 0-14, the future of this population depends crucially on enhancing allocations to these sectors.

The MNEs resort to tax abuse by creating a web of complex subsidiaries, locating them in tax havens and allocating the profits to these jurisdictions. In the prevailing framework of taxing each entity separately, transactions within the affiliates are done to minimise tax payments. Although “arm’s length pricing rules” has been recommended, many MNEs command prices as oligopolies and most developing countries do not have sufficient number of potential comparable transactions to determine the prices objectively. Intangibles like trade names, goodwill, brand recognition and intellectual property rights (patents, copyrights, brands and trademarks) are used for manipulation and applying the arm’s length principle in valuing the transactions between related parties is meaningless. Furthermore, MNEs act as intermediaries in product distribution and sales, advance loans and charge interest payments to one another and charge fees for activities such as management services, treasury services and investment services to reduce the tax liability.

Concerned about the pernicious practice, G-20 countries entrusted the Organisation for Economic Cooperation and Development (OECD) with the task of setting up the action plan to minimise base erosion and profit shifting (BEPS). The OECD has put forward 15 action points for countries to follow. However, these proposals do not go far enough. In fact, there is considerable unease among developing countries about the OECD proposals because (i) the discussion in OECD is dominated by developed countries and the representatives of MNEs and (ii) Interests of developed and developing counties do not always converge. The Independent Commission for the Reform of International Corporate Taxation (ICRICT), a group of leaders from government, academia and civil society created to promote reforms in international corporate taxation, is vexed with the phenomenon. Its review states that the OECD action plans are in the nature of a patch-work of existing approaches.

The ICRICT declaration has called for a paradigm shift. It states that a serious attempt to stop BEPS requires that the fiction that an MNE is made up of separate independent entities must be abandoned. ICRICT recommends that an MNE and its subsidiaries should be considered as a single firm and allocate its worldwide profits to individual countries according to an agreed formula to include factors such as employment, sales, and resources used and fixed costs. These MNEs are listed in the stock market and would not understate their worldwide profits. Of course, formulary allocation can result in tax competition by individual countries to attract investments to their jurisdictions. To avoid such a race to the bottom, it recommends forging a consensus on a minimum tax rate.

However, the challenges in arriving at a consensus formula at the international level are formidable. Given the differences amongst countries, the MNEs play one country against another. Therefore, even as taking the unitary approach and formulaic apportionment remains the goal, the ICRICT recommends interim approaches with single entity as the central piece of reform. Under the ‘profit-split’ method, the combined profits of MNEs are allocated according to ‘allocation keys’ that reflect each entity’s contribution to the generation of profit at a transaction-level rather than at an entity-level. However, at present ‘allocation keys’ are ad hoc chosen by MNEs and hence subject to manipulation.

The second suggestion is to adopt the ‘net margin’ method, according to which the net profit rate is ascribed to an MNE’s local affiliates as an appropriate fraction of the global net profit rate of the corporate group. As the profit rate would be applied to earnings before interest, the tax base would not be eroded by means of intragroup loans. Currently, Brazil applies a modified version of this method by prescribing different sets of rules for local affiliates to determine the maximum amounts of deductible expenses and the minimum amounts of taxable income, based on fixed gross margins according to the types of businesses or transactions.

These rules minimise the need for subjective judgement and discretion, so they have proved easy to administer and have resulted in few conflicts and court cases between MNEs and the Brazilian tax authority. In the European Union (EU), there is a proposal to adopt the ‘Common Corporate Tax Base’ approach, according to which the EU corporate group apportions the profits to member states. This proposal has been approved by European Parliament but is yet to be applied, for want of consensus.

The important point is, forcing multinationals to pay legitimate taxes, particularly to developing countries, is a formidable task. While this is work in progress, the way forward is to treat the affiliates of MNEs not as different entities but consolidate their profits and allocate them based on a formula. This will also require a change in the global system of tax governance to ensure universal membership and an open and democratic structure. There is much to be argued for bringing international taxation matters under the UN aegis as this institution alone can provide the sanctity for rules based on the principle of sovereignty of all countries.

(The writer is Emeritus Professor, NIPFP, and Commissioner of ICRICT)

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