Taxing the digital economy: the struggle for real cash in a virtual world

By on 13/12/2018 | Updated on 07/08/2019
With the growth of digital businesses and complex global corporate structures, tax authorities are finding it ever harder to turn economic activity into public revenues.

Government tax bases are shrinking as digital services and global businesses expand, but there’s little global consensus on how to protect public revenues. Gavin O’Toole explains the problem – and finds solutions emerging in Brazil and the EU

“The line between what is legal and illegal is often very grey,” says Sol Picciotto, emeritus professor at Lancaster University Law School and a senior adviser to the Tax Justice Network. And this is particularly true of the ways in which big businesses handle their tax affairs, taking advantage of the gaps and uncertainties within a complex, outdated global tax settlement. “In this area we have got enormous grey areas, so they push the limits of legality,” says Picciotto. “They organise themselves in a way that minimises the tax they think they have to declare, and it is then up to the revenue authorities to try and challenge that.”

This is not a new phenomenon. But it is one that has become increasingly pressing, as economic changes have eaten away at governments’ tax bases: these days there are more and larger multinational corporations (MNCs),and many are tech businesses – making it hard to identify where their profits are generated.

In 2017, for example, Amazon’s UK operation reported turnover of $11.3bn and pre-tax profits of £72m –but paid just £4.5m in corporation tax. Tax authorities struggle to check and ascertain the tax liabilities of global businesses operating worldwide supply lines and complex organisational structures. But MNCs dominate growing slices of national economies. Amazon is taking business from the UK’s traditional retail sector, for example, which is easier to tax – occupying high street premises that pay business rates.

The transfer pricing system

For tax purposes, most MNCs’ local operations are set up as individual companies, which then ‘pay’ overseas arms of the business for goods,services and intellectual property. The prices they pay are set under a system named ‘transfer pricing’; but this gives MNCs an incentive to tweak those prices so that parts of the business based in the lowest-tax jurisdictions appear to make the greatest profits, reducing their overall liability. So, for example, the German arm of an MNC might pay an inflated ‘price’ for services provided through a division based in a tax haven, driving down the German subsidiary’s tax liabilities and protecting the money transferred from German tax rates.

The transfer pricing system provides plenty of room for MNCs to minimise their tax liabilities – but it does land many with big bills for accountancy and tax advice, as they must create convoluted organisational structures and demonstrate compliance with highly-complex rules. Picciotto suggests that many might back a simpler, more straightforward system: “The current system is so dysfunctional that I think it would benefit everyone if there was a more rational approach,” he says. “It’s pretty bad for the companies themselves – and at some point the multinationals might say: ‘Let’s look at this, we need a more rational system’.”

Assistant professor Maximilian Todtenhaupt of the Norwegian School of Economics, co-author of a report by the European Network for Economic and Fiscal Policy Research on tax avoidance in the EU, says that many tax practitioners currently operate in a fog of confusion. “It’s very worrying that we might have reached a point where the whole rule system is so complex that, on the one hand, it’s not very effective, and on the other, it’s not very efficient at stopping tax avoidance,” he comments.

Even those sympathetic to the system argue for reform. Professor Pasquale Pistone, the academic chairman of the International Bureau for Fiscal Documentation and a global authority on transfer pricing, notes that “transfer pricing is complex and no one can say otherwise.But we have been using transfer pricing for a considerable time and the issue is perhaps not necessarily whether it is adequate, but what can we do in order to make it adequate.”

The devil in the detail

At root, the problem with transfer pricing is that in recent years the nature of business and value-generation has changed substantially,making it much harder to pin down where value is created and to put a price on it. And MNCs now represent a much larger slice of economic activity, with 60-70% of all international trade occurring between MNC affiliates.

The ground rules for pricing these trades for tax purposes were set down by the Organisation for Economic Cooperation and Development(OECD) in 1995, in its transfer pricing guidelines. Since then, many tax authorities have established exhaustive regulations (TPRs) based on the principle of ‘arm’s length’trading, which holds that the price charged should be comparable to that paid in an equivalent deal between two independent entities.

This worked fine when MNCs were shipping goods with a clear market value, or providing fairly standard, well-understood cross-border services. But prices are much harder to ascertain when one arm of an MNC is, for example, allowing another to use bespoke digital technologies which are not traded in the wider market and have no easily-definable cash value. Today, for example, corporations generate huge profits from ‘intangible’assets such as patents or trademarks, which are hard to price.

As a result, there is great scope for MNCs to manipulate prices – ‘transfer mispricing’and thus shift profits between countries in order to reduce their global tax burden. The consequence is ‘base erosion’: a reduction in a country’s tax base.

Max Todtenhaupt of the Norwegian School of Economics says the system is so complex it’s not very efficient at stopping tax avoidance

Pressure for change

Tax-motivated profit shifting of this kind has risen up the multilateral agenda since the 2007-08 global financial crisis, with organisations such as the IMF pointing to “ample empirical evidence” that it is taking place. In the UK, for example,research has pointed to “substantial profit shifting” through transfer mispricing in intangible goods byMNCs.

Estimates of the global scale of annual public revenues lost to profit shifting vary. One recent estimate put global losses from corporate tax avoidance at about $500bn(£380bn or €435bn)annually, with developing countries hardest hit. As a result, this issue has become a focus for campaigning organisations such as Christian Aid, ActionAid, and Greenpeace.

In 2012, the G20 asked the OECD to investigate Base Erosion and Profit Shifting (BEPS), and a multilateral instrument (MLI) outlining measures for incorporation into tax treaties came into force this year. A BEPS initiative brings together 115 countries to collaborate on implementing the MLI. However, this project does not foresee an alternative to transfer pricing, and the MLI has not been signed by the US.

Challenges for the developing world

Critics of the current settlement point out that the transfer pricing system is difficult for developing world countries to implement. While the UN has created a subcommittee that explores ways of helping developing countries to deal with the complexities of transfer pricing – and, since 2012, has published its own guidelines – global rules continue to be set by the OECD.

“The BEPS/OECD process really is a Western, first-world, developed-country model which is complicated to implement in those countries themselves – and much worse for developing countries, which really struggle,” says Kathy Nicolaou-Manias, an expert on illicit financial flows who is working with the Collaborative Africa Budget Reform Initiative (CABRI) to develop a country risk profile tool for finance ministries.

“They don’t have sophisticated tax units; they don’t have a country-by-country reporting unit that’s going to look at transactions; they don’t have a common reporting standard; and even if they are producing all the data, they don’t know what to do with it because they don’t have the analytical capacity or people to analyse it,” she argues.

Professor Pasquale Pistone notes that “transfer pricing is complex and no one can say otherwise”

Alternative approaches

While the arm’s length principle for ascertaining transfer prices remains the bedrock of the multilateral consensus, alternative approaches to MNC taxation have been debated.

One option would be to treat a multinational group as one unit, then apportion its overall, global profits to the different jurisdictions in which it operates according to a formula – so called ‘formulary apportionment’. Each country would then apply its own corporate tax rate to the portion allocated it.

Such ‘unitary taxation’ is in theory simpler for governments and MNCs to apply – but huge challenges lurk in the complexities of designing a formula by which to apportion income.

A second alternative discussed recently in the US is called the destination-based cash flow tax, which has the effect of basing corporate taxation on the location of consumers rather than profits, production or corporate residence. Yet while this proposal has some support within the Republican party, it was not included in President Donald Trump’s 2017 tax reform after corporations expressed opposition.

The European Union

The European Union has been debating the introduction of a step towards a unitary tax for many years, with the broader ambition of ensuring fair competition in the field of corporate taxation within its single market.

Support for plans for a process leading to the eventual creation of a Common Consolidated Corporate Tax Base (CCCTB) has waxed and waned, but proposals relaunched in 2016 aim to begin harmonising the 28 corporate tax codes into an EU-wide corporate tax system.

This foresees, first, the establishment of common rules among member states for computing the tax base of large corporations in the EU; and, later,the creation a fully consolidated corporate tax base across the bloc. The proposals aim to overcome the problem that even where countries have the same nominal tax rate, different definitions of the tax base can result in very different effective tax rates.

However, the move faces resistance among member states – such as Ireland, the Netherlands, Luxembourg and Malta – which rely upon competitive corporate tax rates to attract investment.

Max Todtenhaupt points to problems with the EU proposal, noting that some forms of apportionment mechanism will give MNCs a continued incentive to reallocate profits. “If we define it according to sales, it is probably less problematic than if we define it by, say,production or output,” he says. “However, I cannot see a system where it is only apportioned according to sales because that would disadvantage some member states and not others.

“So it will always be a mixture – and if it is a mixture of factors, that’s problematic because it eventually provides an incentive to allocate resources to low-tax locations.”

Brazil – a way forward?

Brazil does not follow the internationally accepted arm’s length principle, and aligning its own rules with the OECD has become a key theme of discussions over the country’s accession to the organisation. Earlier this year they launched a joint project to map out a way forward.

The key way in which Brazil’s system diverges is in setting fixed ‘margins’ for a range of different sectors. Based on average market transactions, these avoid the need for each transfer to be priced individually by identifying comparable trades.

Marcos Pereira Valadão, a professor at Brazil’s Universidade Católica de Brasília School of Law, says the simpler Brazilian approach offers a clear alternative to ditching transfer pricing in favour an entirely new methodology,such as formulary apportionment.

“I believe it works satisfactorily, although it must still make some adjustments to cope with complex situations,” he says. “In terms of an economy the size of the Brazil’s and given the potential problems we have with this very complex issue, it is very simple in comparison to what countries like India and South Africa do.”

Pereira Valadão points to other home-grown innovations emerging from developing countries – such as Argentina’s “6th”commodity pricing method – that also seek to simplify a system that has been fashioned in the interests of the developed world. “The rules were developed by the rich countries and never took into consideration the deficiencies of the poor countries,” he says.

Professor Pistone believes that the simplified Brazilian system, or a version of it, could help to provide “safe harbours” – simpler tax arrangements that give corporations confidence that they are complying with the rules – to reduce the pressure on developing countries.

“Transfer pricing rules or standards were established long before developing countries could play a role in international taxation, but now we need to understand that perhaps it is time to reconsider that,” he says.“My hope is that the accession of Brazil to the OECD could allow the Brazilians to show the merits of transfer pricing margins, in order to make and operate safe harbours – enabling the world outside the OECD to follow this simplified version, rather than it imposing very complex rules on everyone else.”

Something’s going to move

Achieving a global concensus on tax reform is enormously difficult, with many countries benefiting from the current arrangements – most obviously the tax havens, plus the countries where MNCs are headquartered. However,the problem has become so acute that, alongside its wider tax reform efforts,the European Commission has been working on a dedicated tax regime for tech giants.

Early this year Dmitri Jegorov, deputy secretary general for tax and customs in Estonia’s Ministry of Finance, toldthe Global Government Finance Summit that the EC has set out both short-and long-term plans to stem digital tech’s erosion of the tax base. The first involves taxing digital businesses’ local revenues, such as advertising, data sales and fees charged to service users, rather than applying taxes to stated profits. And the second envisages a “corporate income tax on significant digital presence”, with liabilities “based, in most cases, on user participation.”

The European Commission hopes that wider, global tax reforms will avoid it having to go down this path; there are strong political and economic arguments against it unilaterally imposing a new tax on big digital businesses. Given the very disparate interests of national governments and the difficulty of coming to consensus, however, any global change will be slow incoming. And governments across the world are losing increasing portions of their tax revenue as the economy becomes ever more digitised and globalised. The obstacles to tax reform might be great; but the costs of inaction are likely, in the end, to outweigh them.

About Gavin O’Toole

Gavin O’Toole is a freelance writer and editor in London. He has written for leading newspapers, magazines, wire services and business schools about financial markets, business and regulation around the world. He has a particular interest in international relations, and a specialism in Latin American affairs. He has conducted research on this region’s political economy and has also published a number of books about its politics and natural environment. His latest title, Environmental Security in Latin America, will be published by Routledge in September 2017.

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