From the Tax Justice Network blog, a response to the OECD’s Action Plan on corporate tax avoidance. Now updated, with full commentary below.
The OECD has now published its long-awaited Action Plan on how to deal with corporate tax avoidance. Our response is below. It is broadly in line with a briefing yesterday as a curtain-raiser to this report.
Taxing multinational corporations: OECD chooses a path strewn with obstacles, headed in the wrong direction.
TJN’s Response to the OECD’s Action Plan on “Base Erosion and Profit Shifting”
July 19th, 2013
The OECD this morning published its long-awaited Action Plan to tackle corporate tax avoidance, which has seen the likes of Starbucks, Google, General Electric, Vodafone, Apple, Amazon and many others avoid billions in taxes.
Having carefully examined the Plan, which the OECD sent us under embargo on Wednesday, we have not changed our overall assessment we published on July 17th.
- The Action Plan proposes the design of a series of piecemeal patches. These patches are generally to be welcomed, as immediate remedies to the gaping holes in the broken international tax system.
- After a year’s work, the OECD has only identified the issues on which work is needed; developing actual proposals will be a far more arduous task, and the timetables of up to two years are likely to prove optimistic.
- This approach is fraught with political obstacles. Although many of the envisaged measures are welcome, the overall approach would ultimately entrench the current broken system.
- The OECD’s recommendations are not binding, and would require many governments to reverse their policies, in the face of determined opposition from business, and from the influential armies of accountants and lawyers who greatly benefit from designing tax avoidance schemes.
- If governments did adopt the recommendations, this would intensify tax conflicts as each nation seeks to ‘grab’ as much cross-border income as possible for tax purposes. An already highly complex system will also become still more convoluted. Coordination will be extremely difficult, and the OECD’s ambitious idea for a multilateral convention is more likely to take twenty years than two.
- The OECD should open the door to an approach that many tax experts agree is superior: unitary taxation, where multinationals are taxed not according to the tax haven-friendly, inefficient and distorted economic forms that their accountants and lawyers contort them into – but instead according to the genuine economic substance of what they do and where they do it.
- The OECD experts have for years stubbornly clung to the outdated principles of a system devised 80 years ago, and have sought to close down any debate on this alternative, which would effectively cut tax havens out of the international tax system and restore countries’ abilities to tax multinational corporations. They claim that unitary taxation is not politically feasible.
- We demonstrate below why unitary taxation is more politically feasible than the OECD’s approach, if governments are serious about taxing multinational corporations. It can be introduced gradually, starting with a transparency requirement, then expanded, building on years of accepted practice.
Professor Sol Picciotto, a Senior Adviser to the Tax Justice Network, said:
“The Action Plan contains some ambitious measures, which would produce some benefits if implemented. But its approach is like trying to plug holes in a sieve. The OECD has chosen a road that is strewn with obstacles, and leads in the wrong direction.
The OECD has missed this big opportunity to crack open the door to the big reform that the world’s citizens need. It is still open to countries to adopt their own versions of worldwide taxation of multinationals, and for other organizations such as the United Nations to take a lead in developing an effective worldwide system.”
Part 2: detailed commentary
The section below explores the OECD report in more detail. The OECD Action Plan: the positives.
The Tax Justice Network supports the OECD’s efforts to strengthen international tax rules. The Action Plan is uneven, but in many respects ambitious. Some of its proposals would mean ending tax breaks that we have fought hard against, or introducing measures that we have supported. For example:
- Strengthening so-called Controlled Foreign Corporation (CFC) rules. These have been eviscerated notably by the U.S.’ so-called “check-the-box” and pass-through rules, and by the UK’s move to a ‘territorial’ system in 2012, as a result of lobbying by multinational corporations and their advisers;
- Limiting corporations’ ability to deduct interest and other payments made from affiliates in high-tax jurisdictions to related affiliates in low-tax or no-tax jurisdictions;
- Ending arrangements that facilitate so-called treaty-shopping, such as the ‘Dutch Sandwich’, and other abuses of provisions in tax treaties;
- Reforming the concept of “Permanent Establishment” and of attribution of profits, which are easily avoided by separating related functions.
A path strewn with obstacles, and leading ultimately in the wrong direction
Despite these positive recommendations, which if implemented would provide some relief for citizens who bear the economic brunt of corporate tax avoidance, the OECD report is build on a fatally flawed approach.
The OECD experts could have taken this unique political opportunity – on the back of widespread citizen protests and pressures from cash-strapped governments to tackle corporate tax avoidance – to set the world on the road towards a new and far better system. It does not do this, but instead aims to strengthen existing rules.
The fundamental flaw in the current system is that it tries to tax transnational corporations (TNCs) as if they were loose collections of separate entities operating independently in each country. This is a system built on a fiction: the OECD knows as well as anyone that these firms are not bunches of separate entities – but unified firms under central direction.
A tax system fit for the 21st Century would recognise this economic reality, and seek to tax them using a unitary approach. Most tax experts, even some at the OECD, recognise the clear superiority of the unitary approach.
Their main objection has been that such an approach would require a degree of political cooperation which would not be politically feasible. However, a gradual transition towards such a system is both possible and necessary, as we explained in our previous Briefing, and in a more detailed earlier report.
In our view, on the contrary, the OECD’s piecemeal approach is itself fraught with political obstacles, and is far less politically feasible as an approach, if we are serious about taxing TNCs effectively.
Recommendations are not binding; lobbyists will fight hard
Many of the measures that the OECD proposes to formulate would require states to reverse their international tax strategies, in the face of determined opposition not just from business, but also from the powerful firms of accountants and lawyers who find the current porous and complex system allows them to design highly lucrative tax avoidance schemes.
There will be many who will hope that while the OECD tries to flesh out these ideas into detailed provisions, the economic and political climate might change, fiscal pressures will abate, and press and public will lose interest in tax justice. We think this is unlikely.
More plausibly, cash-strapped governments will want to try to plug some of the holes in the leaky sieve of international taxation. Each will prioritise the measures that they think would least upset their own business lobbies. It will prove hard to persuade governments to repeal tax provisions that they believe attract business, even if these provisions harm other nations’ economies.
A recipe for conflict
To the extent that the OECD does succeed in persuading governments to follow its new recommendations, it faces an enormous task of coordination. If each state prioritises measures that give it a bigger slice of the tax pie, that is a recipe for international tax conflicts between nations. Some issues raised by countries have been ruled to fall outside BEPs project. These would add to the numerous conflicts that already bedevil the system. For example, India and other developing countries remain concerned about the limits current tax rules place on source taxation of foreign-based service providers.
Internet-based services: a growing headache
Many governments would like a quick solution to the problem to taxing internet-based companies. Google, for instance, has avoided large amounts of tax by selling its advertising through its affiliate in the tax haven of Ireland. The OECD is unlikely to deliver a good solution to this. One of the fifteen points in the Action Plan concerns the Digital Economy: it expects to deliver only an analysis in a year’s time, and even this deadline is unlikely to be met.
There are good reasons for this: the digital economy is not a distinct sector, but an important element in all business today, to a greater or lesser extent. Specific ways may be devised to tax some particular activities such as internet sales, but such partial and unilateral methods would produce imbalances and conflicts. In fact, the issues identified by the examples of Google, Apple and Amazon point to the more fundamental systemic flaws of the “separate entity” approach described above, which as we have pointed out the OECD does not propose to tackle head-on.
The OECD’s powers of persuasion
In its very tough task of coordination, the OECD’s only weapons are technical expertise and peer-pressure persuasion.
It proposes to use three methods.
First, at the most voluntaristic level, it will `revamp’ its Forum on `harmful tax practices’. This essentially entails using peer-pressure to persuade countries to remove tax breaks and preferential regimes.
Second, it will draw up revisions mainly of the Commentary to the Model Tax Treaty, and if necessary also to the actual model treaty articles. The treaty articles are legally binding, and the Commentary has significant legal effect in interpreting those provisions. But this effect only works if and when states actually renegotiate their existing bilateral tax treaties. With the best will in the world, this would take years.
Third, the Plan also proposes to formulate a multilateral treaty, which it hopes would override existing treaties. This poses complex legal problems, and a special group of international legal experts will be recruited for this delicate task. But such a multilateral treaty also would only come into force once ratified by individual states, and only among the states which do ratify it. We recall that in 1988 the OECD drew up, in conjunction with the Council of Europe, a multilateral convention on tax co-operation. This took over twenty years to gain more than a handful of ratifications.
Transfer pricing: a deeper and deeper hole
In our view, the OECD has chosen a road that is not only strewn with obstacles, but leads in the wrong direction. This can be seen most clearly, perhaps, with respect to the transfer pricing problem. Here, the OECD has dug itself progressively into a deeper and deeper hole by doggedly pursuing the fiction of “separate entity” and the “arm’s length method’, described above.
The Action Plan suggests that there is the beginning of a realisation of the need for a new approach, in mentioning that `special measures, either within or beyond the arm’s length principle, may be required’. This could potentially be construed as a possible tiny opening. However, it falls well short of the fundamental reorientation of approach that is required.
The OECD experts can be said to have done what could realistically be expected of them, given the political constraints. We had hoped for more, at least as regards transparency.
A road map to true reform
As we have pointed out, moving towards unitary taxation would not entail the sudden shock of a ‘big bang.’ It can be introduced gradually, building on existing practice. It involves three components, each of which can build on elements already existing in the current system.
A first, immediate step towards a unitary approach would be a transparency requirement, to require TNCs to submit to each relevant tax authority a Combined and Country-by-Country Report. This would outline the genuine economic substance of what the TNCs do and where they do it, and build on and enhance the already fast-emerging standard of Country by Country reporting.
This report should include global consolidated accounts, for which the OECD could and should develop a template. Action 13 of the Plan does seem to open up this possibility, and for this we must be grateful.
Second, tax authorities could use this information to apportion the global profits multinationals using appropriate allocation factors reflecting the economic substance of their activities around the world.
This can build on existing practice, in particular the so-called “profit-split” method already accepted by the OECD Transfer Pricing Guidelines, which aggregates the profits of related entities then apportions them according to so-called “allocation keys.” This is a narrower, transaction-level version of apportioning profits by formula.
This approach, as currently used, aggregates profits only at the level of bilateral transacting entities – whereas in reality TNCs use more complex cross-linkages among multiple affiliates. It would not be such a great stretch to extend this practice from the level of transacting entities to the combined whole. Indeed, there is already considerable experience in some sectors in applying formulaic profit apportionment, especially in the finance sector, e.g. where a trading book is transferred between offices in different time-zones over 24 hours. Formula apportionment of such profits has been done for 20 years through Advance Price Agreement (APAs) with banks. If firms such as Apple, Amazon, Google and Starbucks really do want to pay a fair level of taxes wherever they do business, they too could enter into APAs and agree an appropriate apportionment.
The experience of using profit split and APAs could be combined with proper research to determine appropriate apportionment formulae. Some degree of divergence of formulae is likely, but this is acceptable.
Some argue that states would simply aim to weight the factor which produces the biggest ‘tax grab’ for themselves – and that therefore it will be impossible for there ever to be full global agreement on a formula: and so, they argue, the whole approach is politically impossible.
But this is quite wrong, for several reasons.
First, full convergence is not necessary. Differing formulae could certainly lead to some overlaps between different countries’ tax systems – but as explained above this already happens under the current system, and the problem is likely to be less under unitary taxation.
Second, states won’t just go for the biggest possible tax grab – because they need also to consider the effects that this would have on inward investment. This is likely to lead to a more balanced approach towards designing a formula, and to encourage convergence. A balance between production and consumption factors seems best. In the US, the trend among states using unitary taxation has been for convergence (towards emphasising the sales factor.)
Some also argue that firms could still reorganise themselves to minimise their taxes.
This is true but it would happen to a dramatically lesser degree, and in a very different way. It is far harder for a firm to relocate physical assets, workers and sales to other countries than it is for them to shift artificial profits under the current system. And if they chose to divest some operations to truly independent third parties, they would lose the profits of synergy and scale. It is hard to imagine a company like Apple being willing to transfer to a truly independent wholesaler in a low-tax country a significant slice of its profits. Relocation of real activities may well occur, but this is very different from the artificial shifting of profits to largely paper affiliates that happens under current rules.
States would remain free to choose their own marginal tax rates. So countries could compete to attract genuine investment rather than formation of paper entities aimed at subverting the taxes of other countries.
Unitary Tax would therefore eliminate harmful tax competition, while allowing countries to make genuine choices between attracting investment in production and generating revenues from corporate taxation. Such a system would of course not be perfect, but aligning tax rules more closely to the economic reality of integrated firms operating in liberalized world markets would make it simpler and more effective.
The third important element of reform would involve a procedure for resolving disagreements and conflicts between states. Such a system already exists in the OECD’s Mutual Agreement Procedure (MAP) but it could be improved, as explained above, and extended to include negotiation of APAs.
Currently, the MAP is very secretive, and decisions often involving hundreds of millions or even billions of dollars are not published. The secrecy of both MAP processes and APAs greatly increases the power of frequent actors in these processes, i.e. the international tax and accounting firms – to the great detriment of the system as a whole.
Publication of both would be a great step towards a system which could both provide and more importantly be seen to deliver a fair international allocation of tax.
Not just the OECD.
A new approach to international tax in any case should not come from the OECD alone.
Although they propose to include at least seven of the eight non-OECD members of the G20, this still excludes the vast majority especially of developing countries. A more inclusive forum is needed. The United Nations Tax Committee should be the appropriate body – but it is hampered by lack of resources and bureaucratic problems. Nevertheless, if sympathetic governments could supply it with special funding, it could initiate a special project, following up its rewrite of the Transfer Pricing Manual which was published this year.
The IMF’s Tax Policy Department could also play a role, given its expertise. Indeed, the IMF last month recognised that there is considerable interest in a unitary taxation approach:
“such schemes—including their impact on developing countries—deserve a more thorough and realistic assessment.”
We hope that the OECD would also contribute to such a broader initiative to study and develop a new approach, even while it pursues its task of repairing the leaky sieve. The Tax Justice Network will continue its own work, and would be be happy to contribute to any initiatives aimed at restoring the integrity and efficacy of the international tax system.
Please contact Professor Sol Picciotto: