False Profits

AuthorMichael Keen

False Profits Finance & Development, September 2017, Vol. 54, No. 3

Michael Keen

 Avoidance by multinationals and competition between governments are forcing a rethink of the international tax system

The League of Nations did not have a Facebook page. Its staff didn’t Google or order online from Amazon. A century ago foreign direct investment involved tangible things like railways and oil wells. Royalties meant charges on coal and the like, not payment for the use of brand names or patents. Multinational enterprises did not dominate world trade.

Things have changed. The international economy has seen the rise of multinationals and the growth of trade in services and global capital flows. Intangible assets such as patents and telecom licenses have become central to modern business, and digital technology offers opportunities to do business in a country with little if any physical presence there. These changes raise tax issues unimaginable in the 1920s. Yet the framework established by the League of Nations still dominates how we tax multinationals.

The stresses placed on that framework have increased over the last decades, bringing it close to the breaking point—perhaps beyond.

Two problems—distinct but related—are at the heart of those stresses. One is tax avoidance by multinationals: the use of legal ways to shift profits from where they will be taxed at a high rate to where they will be taxed at a low one. The other is “tax competition” between governments: the use of low rates or other favorable tax provisions to make themselves more attractive for real investment and less vulnerable to avoidance activities that shift paper profits abroad (making other countries correspondingly less attractive and more vulnerable).

A quick guide International taxation is horrendously complicated (a serious problem in itself). Here is a quick account of how the system for taxing multinationals works.

At the heart of how countries determine the taxable profits of companies within a multinational group is the principle of “arm’s length pricing.” This means calculating the profits earned by each such company by valuing any transaction it has with other companies in that multinational group by using prices at which unrelated parties would have undertaken that transaction. Each country then taxes the profits allocated in this way to any member of the group that is either legally established or has a clear and reasonably sustained physical presence there (in the jargon, a “permanent establishment”). This establishes the tax base in what is often called the “source” country.

At a second step, under “worldwide” taxation, the country in which the parent company is resident for tax purposes also taxes income earned by its affiliates abroad, though it will often give a credit for taxes...

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