What could a new system for taxing multinationals look like?

FOR YEARS governments have grumbled, simmered and raged as multinational companies have shifted profits out of tax collectors’ grasp and into low-tax havens. The OECD, a club of mostly rich countries, estimated in 2015 that avoidance robs public coffers of $100bn-240bn, or 4-10% of global corporation-tax revenues a year. Now the fiscal fallout from covid-19 is adding urgency to governments’ efforts to claw some money back—most notably in America, where President Joe Biden plans to raise taxes on corporate profits, including foreign income.

Mr Biden’s proposals will grind their way through Congress. Finance ministers from the G7 group of countries are likely to discuss global tax reform when they meet in London on June 4th-5th. And later in the summer 139 countries will discuss changing the system for taxing multinational companies. The confluence of a political shift in America and a global push to raise more tax revenue to pay for the pandemic means a degree of optimism is in the air. The proposals under discussion may initially raise only a modest amount of revenue, but they still represent a big break with the past.

The foundations of the global corporate-tax system were laid a century ago. It recognises that overlapping taxes on the same slice of profits can curb trade and growth. As a result, taxing rights are allocated first to wherever profits are produced (the “source”) and then to wherever the parent company is headquartered (or “resident”). A multinational based in America but with an affiliate in Ireland, for example, typically pays taxes in both places. Where the company makes its sales is irrelevant. Payments between an individual firm’s various legal affiliates are recorded using the “arm’s-length” principle, supposedly on terms equivalent to those found on the open market.

These principles, now baked into thousands of bilateral tax treaties, have had two unintended consequences. First, they have encouraged governments to compete for investment and revenue by offering tantalisingly low tax rates (see chart 1). In 1985 the global average statutory corporation-tax rate was 49%; in 2018 it was 24%. Ireland boasts a statutory rate of just 12.5%; Bermuda, 0%. Second, tax competition has encouraged companies to shuffle their reported profits to low-tax places. In 2016 around $1trn of global profits were booked in so-called “investment hubs”. These include the Cayman Islands, Ireland and Singapore, which apply an average effective tax rate of 5% on the profits of non-resident companies.

There is a huge mismatch between where tax is paid and where real activity takes place. Analysis by the OECD suggests that multinationals report 25% of their profits in investment hubs, although only 11% of their tangible assets and less than 5% of their workers are based there. Parents can allocate paper profits to affiliates in tax havens by having them hold intellectual property that is then licensed to other affiliates in high-tax places. The problem seems to have worsened over time, perhaps because more firms make money from intangible services, from software to streaming videos. The share of American multinationals’ foreign profits booked in tax havens has risen from 30% two decades ago to about 60% today. Most investors and bosses view firms’ tax bills as a black box that only a few lawyers and tax experts truly understand.

One way of capturing the scale of manipulation is to examine what would happen if there were a single common tax rate. A recent study by Thomas Torslov of Kraka, a Danish think-tank, and Ludvig Wier and Gabriel Zucman of the University of California, Berkeley, tried to quantify this. A staggering $670bn in paper profits, which are unconnected to things like factories, would have moved in 2016—almost 40% of multinationals’ foreign earnings. Big Western countries are losers from the current system: profits in America and France, for instance, are depressed by around a fifth (see chart 2). By comparison, havens collect more revenue, as a share of GDP, despite their rock-bottom effective rates. Hong Kong collects a third of its corporate-tax receipts by attracting profits from high-tax countries; Ireland, over half.

The rise of Silicon Valley has added fuel to the fire. Some governments gripe at giant firms serving customers without any physical presence in their country and while paying no tax. The problems posed by the tech firms are not in fact new: pharmaceutical companies have long held mobile and hard-to-value intellectual property; exporters do not incur tax liabilities where they sell. Still, digital services have become a target. More than 40 governments, from France to India, are either levying or planning to levy digital-services taxes on the revenue of firms such as Amazon, Google and Facebook.

The growing sense of anarchy over how to tax Silicon Valley, the global desire to raise more tax revenues and a more conciliatory White House all mean the scene is set for a global deal. The OECD’s forthcoming summit is not the first time it has tried to orchestrate reforms—it helped pass changes to the transfer-pricing regime in 2015. But this time two more ambitious proposals are under discussion.

The first would reallocate taxing rights so that a slice of profits could be levied according to, say, the location of a company’s sales. That right could be incurred even if the company had no physical presence in the country. Mr Biden’s negotiators have proposed a reallocation that would apply to the 100 biggest and most profitable companies worldwide; in return, the Biden administration wants all the digital-services taxes to be dropped. The second element would apply a minimum rate of corporation tax, putting a floor on the race to the bottom. The Biden administration is gunning for a global minimum tax rate on foreign earnings of 21%, applied to profits within each jurisdiction separately.

You say you want a revolution

Could these ideas form the basis for an eventual deal? The proposal for profit reallocation has been broadly welcomed by other big rich economies. Yet there is still plenty of scope for disagreement on the details. Assessing the location of sales made by one business to another, if it then goes on to make sales in a different country, is tricky. Some governments also still want to turn the screws on Amazon, Apple, Facebook, Google and the like: the European Union seems to be preparing to go ahead with a digital levy regardless of the outcome at the OECD. That in turn could cause some American lawmakers to eschew global co-operation. Meanwhile, many tax havens may resist higher minimum tax rates that eliminate the advantage for companies of booking profits there.

As a result any deal will involve compromises. The amount of profit that is reallocated in order to resemble economic reality more closely could be capped. For example, the OECD’s blueprint does take the radical step of considering companies as a whole, rather than separated into affiliates. Still, most profits would remain taxed as they are. The right to tax, say, 20% of profits above a routine rate of 10% of revenues would be reallocated according to a formula that could be based on sales. Meanwhile America’s preferred minimum rate of 21% is unlikely to be agreed on more widely, as countries sniff about tax sovereignty. A rate of 10-15% is much more realistic.

How much difference would changes of this magnitude make? The reallocation plan, as it stands, aims to raise a puny $5bn-12bn in annual revenues. The OECD reckons that a minimum rate of 12.5% would raise $23bn-42bn directly through the higher rate, and another $19bn-28bn by reducing profit-shifting. These figures are not particularly impressive, although they might let governments crank up domestic tax rates without worrying as much about the danger of capital flight.

Still, an agreement on new principles could leave the door open to bolder changes later. Carlos Protto, one of Argentina’s representatives in theOECD talks, says that focusing only on the biggest multinationals helps build consensus now, but also notes that many countries expect the scope of any reforms to be broadened eventually.

What if countries cannot agree? America will forge ahead with reforms to its domestic taxes, including provisions that could unilaterally increase the tax load of American subsidiaries of foreign companies that pay skimpy tax bills globally. Meanwhile digital-services taxes could spread like wildfire—potentially incurring American tariffs in retaliation. On May 10th the United States Trade Representative held a fourth day of hearings on retaliating against foreign digital-services taxes. Overhaul or not, tax bills will rise. ■

A version of this article was published online on May 10th, 2021