Taxation and development
The tax landscape has been shaking over the past few months, as an OECD-led historic reform of our international corporate tax rules is moving at the speed of light. Often referred to as BEPS 2.0, it sounds like a dull technical matter. Nothing could be less true. Unlike BEPS 1.0, the proposals entail fundamental changes, including a fixed minimum effective tax rate on corporate profits. Despite the big interests at stake, few countries have so far taken a clear position. The economic impact assessment that the OECD has promised to deliver by October will most likely be a changemaker. All countries want to know: how is this going to affect me? In this blog I will show that there might be unexpected outcomes. As the rules are proposed now, Jersey and Barbados could end up being big winners.
Ahead of the impact assessments, the OECD is organizing a workshop to get input from experts. I will participate as well and I did some thinking about the first step of such an analysis. Here’s the key thing: before considering issues like data sources or aggregation levels, it should be explored how firms and governments will respond to the new tax standards. Analysing this for the proposed minimum tax rules, I found something unexpected and rather alarming. None of the options currently on the table provides strong protection against profit shifting!
How is this possible? Well, let’s do the analysis. First we need to make assumptions about the response of tax-aggressive firms and low-tax countries. For the firms, this is straightforward. They want to keep their tax bill as low as possible, and if they need to change their structure to limit the effects of new rules, they will do so. Mind you, this is not about the average firm. Fortunately, an increasing number of multinationals takes a more responsible approach to tax. The minimum tax rules are needed for the rest – especially for firms with directors who still think that capitalism means their only duty is to maximize net financial profits for shareholders.
For low-tax countries, the key question is whether they will raise their tax rates to the agreed minimum. The answer may differ among countries.
On the one hand, there are jurisdictions like Bermuda that have never had a corporate tax. They might well keep it like that, because the new rules won’t force them to introduce one. It would be a huge administrative challenge to do so from scratch. Moreover, the tax would also apply to domestic companies that may not have a clue what base erosion is. As long as these jurisdictions can attract some presence or fees from foreign firms, they are unlikely to respond.
On the other hand, there are jurisdictions like Jersey that do have a corporate tax system. Most of them used to tax domestic companies at normal rates while giving foreign investors a special treatment. When such preferential regimes came under pressure, some switched to a single low-tax regime for foreign as well as domestic firms. In the case of Jersey, this came at a high price; it had to introduce a sales tax to make up for the lost revenues. Thus, if foreign firms will pay a minimum tax on their profits anyway, these jurisdictions are more likely to pocket that money themselves. By raising their rates to the minimum, they will also increase revenues from domestic companies that they never wanted to exempt in the first place. Other low-tax countries, such as Barbados, have stuck to special regimes but opened them up to domestic companies too; these are even more likely to adopt the minimum rate.
Various options for minimum tax rules are on the table. First there is the possibility of carve-outs, that is, exemptions for low-tax regimes that meet the BEPS 1.0 standard or the new global standard on real economic activity. This is a no-brainer: by exempting all low-tax regimes that are currently allowed, the new rules won’t offer additional protection. Most countries have already closed, amended or replaced their regimes that were non-compliant. Thus, low-tax countries have already responded. For tax-aggressive firms, then, the choice is easy. They can add some substance to their existing profit shifting structures or they can switch to other structures. Either way, they get away without contributing more to public coffers.
For other design options, things are more complex. It helps to evaluate the responses in reverse, a trick from game theory. Let’s look at a scenario without carve-outs, with the Tax on Base Eroding Payments taking priority over the Income Inclusion Rule and involving a proportionate withholding tax or non-deduction. For those not familiar with the jargon, this means that a source country – where a multinational has operations – ensures that profits from those operations are taxed at least at the minimum rate. To that end, the country checks for payments of interest, royalties and technical fees to foreign recipients at what rate they are taxed abroad. If they are taxed below the minimum, the source country ‘tops up’ the foreign tax by charging the difference. Sounds like a good defence mechanism, right?
It does until you look at the responses. First, assume a low-tax country does not raise (or introduce) corporate tax. How will a firm shifting profits to that low-tax country respond? If the firm does not change its structure, it will pay the minimum rate on the shifted profits, because the source country tops up the tax paid abroad. However, if the firms stops shifting profits, it will pay the full domestic rate in the source country, which is probably higher. Thus, the profit shifting continues.
Next, assume the low-tax country does increase its tax rate to the minimum. How will the firm respond now? Basically, the pay-off is the same: the firm minimizes its tax charge by continuing to shift profits to the low-tax country and paying the minimum rate there.
This is where the reverse analysis trick comes in. Given the responses of tax-aggressive firms, a low-tax country will be better off adopting the minimum rate, because it will capture more revenues and the profit shifting will continue anyway. However, this only goes for low-tax countries that already have a corporate tax, as explained above. Therefore the expected responses are that firms continue profit shifting and that some low-tax countries adopt the minimum rate, but others do not. This leads to an alarming insight.
With these design elements, a source country that is suffering from tax avoidance will only recover part of the revenue losses from profit shifting towards some low-tax countries (those that do not adopt the minimum rate).
What about imposing a full withholding tax or non-deduction, instead of a proportionate one? Wouldn’t this provide stronger protection against profit shifting? The result is somewhat counter-intuitive: it makes matters only worse. This is because of the expected behaviour of tax-aggressive firms. They can minimize their tax charge by using a low-tax country that charges exactly the minimum rate. In this scenario, source countries gain nothing at all, because base-eroding transactions will be diverted to destinations that just escape the Tax on Base Eroding Payments. Paradoxically, the big winners would be low-tax countries like Jersey and Barbados. By raising their own tax rates to the minimum, they can gain revenues and attract business away from profit shifting destinations without a corporate tax.
I evaluated various other design options as well, but they all fail to provide better protection to source countries against profit shifting. For more details, click here for an Excel sheet with the analysis.
Fortunately, with a little tweak in the design of the Tax on Base Eroding Payments, the outcome for source countries can be much improved. More about this in my next blog tomorrow!
For now, I just want to make the point that the first step in the economic analysis is absolutely key – one should consider carefully how firms and governments will respond before starting to put figures to the proposals.