In September 2013, the leaders of the G20 countries meeting in St. Petersburg endorsed the OECD’s Action Plan on Base Erosion and Profit Sharing (BEPS).
The 15-point plan includes the following:
- Reforming international tax rules to meet the challenges of a digital global economy in which multinational companies create foreign subsidiaries with minimal or no physical presence
- Arresting the erosion of national tax bases by limiting use of third party debt to achieve excessive interest deductions
- Strengthening international governance of transfer pricing to discourage multinationals from eluding taxation via internal pricing schemes
- Boosting international tax transparency and facilitating exchange of information between national tax authorities
- Requiring multinational companies to disclose their international tax planning arrangements (declaring “what tax they pay where”)
The G20’s endorsement of the OECD plan reflects mounting worldwide pressure to close tax loopholes that enable multinational corporations to reduce their tax liabilities. The U.S. Senate launched an investigation of international tax avoidance that featured highly publicised testimony by the Chief Executive Officer of Apple Inc, which utilised an offshore vehicle in Ireland to shield $44 billion in otherwise taxable revenue. In Apple’s case, the financial costs of repatriating those earnings to the U.S. (subjecting the company to the home country’s 40 percent corporate tax rate) outweighed whatever public opprobrium resulted from Apple’s international tax machinations.
Other prominent American companies (Abbott Laboratories, Adobe, Google) faced similar condemnations of their exploitation of Ireland’s forgiving tax environment, which offers one of the world’s lowest corporate tax rates and a legal structure that enables multinationals to consolidate their global earnings in Irish subsidiaries.
But international tax avoidance is hardly limited to Ireland. In the United Kingdom (not traditionally viewed as a tax haven), Starbucks U.K. used royalty payments to another foreign subsidiary to reduce its tax liability to near zero. Starbucks’ voluntary offer to pay $16 million to the British treasury did little to allay public consternation over the company’s tax avoidance schemes.
Drivers of International Corporate Tax Avoidance
A number of factors drive the growing use of international tax shelters:
Globalisation: The expanding global operations of multinationals creates opportunities for corporate tax planners to employ transfer pricing mechanisms to arbitrage differences in national tax jurisdictions. At the same time, rising global competition generates incentives for Western-based multinationals to utilise arcane international tax arrangements as competitive weapons.
Digitisation: The rise of Information Technology and other knowledge-intensive industries heightens the role of intangible assets that companies can readily deploy across their foreign subsidiaries. This development enables multinationals to vest intellectual property in foreign units located in low-tax jurisdictions while charging royalty payments (and thereby lowering the tax liabilities) of subsidiaries residing in high-tax countries.
Government Complicity: National governments are deeply implicated in the rising use of tax avoidance schemes by global companies. Amid slow GDP growth and rising competition for mobile foreign capital, many Western governments have resorted to corporate tax cuts and other inducements. Between 2006 and 2013, the average corporate tax rate in the OECD fell from 28 to 25 percent. A number of developed countries (including high-tax jurisdictions like the United States and France) have created tax loopholes to entice foreign investors. Emerging markets like China (whose cost advantages over the developed economies are dissipating) also feel the pull of international tax competition.
Corporate Tax Rates in Comparative Perspective
Leveraging these shifts in the global environment, multinational companies employ accountants, lawyers, and financial engineers to arbitrage differences in national corporate tax systems.
The exhibit below reports the current corporate tax rates of 20 OECD countries. The findings are illuminating:
It is widely known that the United States has the highest headline corporate tax rate (40.0 percent) among the advanced industrialised countries. The U.S. is further distinguished by its practice of taxing the global profits of American-based companies. But these features of the American tax system exaggerate the corporate tax burden in the United States. The effective rate of corporate taxation in the United States (25.7 percent) ranks in the middle of the OECD group. The gap between the headline and effective corporate tax rates in the U.S. illustrates the proliferation of loopholes in the federal tax code. Furthermore, strong competition for investment has spurred bidding wars between U.S. states that lower the aggregate tax liabilities of both domestic and foreign companies.
Ireland resides on the other end of the corporate tax spectrum with a headline rate of 12.5 percent. Irish authorities claim an effective corporate tax rate close to the headline rate. But critics maintain that foreign multinationals like Apple enjoy an effective tax rate of less than 2 percent on their Irish subsidiary earnings. Moreover, Ireland’s tax laws allow multinationals to incorporate two Irish subsidiaries (“Double Irish”), one of which pays royalties on intellectual properties (thus lowering tax liabilities) and the other of which collects royalties in offshore tax centers like Bermuda and the Cayman Islands.
Switzerland also boasts comparatively low headline and effective corporate tax rates (21.2 and 20.6 percent respectively). Switzerland is commonly viewed as a tax haven, a perception enhanced by that country’s studious avoidance of the financial disclosure rules of the European Union. But the OECD does not formally classify Switzerland as a “tax haven”, a designation reserved for such places as Antigua, Barbados, Belize, British Virgin Islands, Cook Islands, Liberia, and Netherlands Antilles. Those entities typically have low or no taxes, limited transparency, and no requirement for substantial local activity (“Permanent Establishment”). Switzerland (along with EU member states like Cyprus, Luxembourg and Malta) earn the more benign designation of “offshore/or international financial center”.
The Netherlands is a noteworthy case of a mid-sized economy with a high concentration of home-based multinationals (ING, Philips, Royal Dutch, et al) and a large number of foreign multinational subsidiaries. In addition to a low effective corporate tax rate (18.0 percent), Dutch law permits foreign companies to funnel taxable income out of EU countries that withhold taxes to offshore vehicles outside of Europe. These arrangements (“Dutch Sandwiches”) prompted the European Commission to launch an inquiry of international tax practices in the Netherlands. (A similar EC probe is also underway in Ireland and Luxembourg.) The Dutch government responded by offering to renegotiate bilateral tax treaties with 23 countries. That action elicited a negative reaction by the foreign business community in the Netherlands (including the American Chamber of Commerce), which warned that modifications of the country’s forgiving international tax structure might impel the departure of key multinational companies.
Pushback from the foreign business community is also apparent in the United Kingdom. The government of David Cameron (supported by the U.S. Obama Administration) has taken the lead in the G20’s efforts to curtail international tax avoidance. But these initiatives provoked resistance by the Confederation of Business Industry (Britain’s foremost corporate lobbying organisation), which argued that the OECD action plan threatened U.K. competitiveness. Misgivings about the reform campaign also arose in the City of London, whose close links with offshore financial centers (Guernsey, Jersey, Isle of Man) create a vested interest in preserving international tax havens.
Conclusion: Dilemmas of International Tax Reform
The unfavourable reaction of the European business community underscores the dilemmas of international tax reform.
On the one hand, the current regime gives multinational corporations an unnatural competitive advantage over small domestic companies, which lack the financial, legal and technical resources to exploit international tax loopholes. This state of affairs distorts investment, shifts the tax burden from large to small companies, and undermines public confidence in the fairness and integrity of the tax system.
On the other hand, the business community raises legitimate concerns over unilateral efforts by Netherlands, U.K., et al to crack down on corporate tax avoidance. Effective reform demands a multilateral approach, including harmonised rules and norms to govern international taxation. Such a multilateral tax reform would supplant scores of bilateral tax treaties negotiated over past decades. It would also entail a level of international tax cooperation that has thus far eluded the OECD countries.