How can a minimum tax benefit source countries?

To my own surprise, I found that the current BEPS 2.0 proposals for a minimum tax won’t stop profit shifting. Unless, of course, the minimum rate would be close to the international average corporate tax rate. If it is set lower, the new rules may not increase revenues in source countries at all. Here is a proposal to tweak the rules in such a way that they will.

It involves a fair amount of ‘flip-thinking’. For those familiar with the concept: it sounds cheesy, I know. Yet it captures the essence rather well. For those who are not: flip-thinking means looking at something in an unconventional way, turning a problem into an opportunity. The problem here is profit shifting. The unconventional way of looking at it is that we shouldn’t try to stop it.

Minimum tax rules should be designed in such a way that the minimum tax charges end up in source countries as much as possible – without seeking to end profit shifting.

The current proposals won’t do that. They outline a Tax on Base Eroding Payments as a key defence mechanism for source countries. Basically, this is a conditional withholding tax on international payments of interest, royalties and technical fees, which can be used to shift profits out of the source country. The source country would levy the tax, or deny a withholding tax reduction, on payments to a country where the corresponding profits are taxed below the minimum. If the foreign recipient is taxed at a higher level, the tax is not levied, or a reduced withholding tax rate applies. This ensures that profits derived from operations the source country will be taxed at least at the minimum rate.

However, many low-tax countries will respond by adopting the minimum rate themselves. Companies located there will then escape the Tax on Base Eroding Payments. This leaves the source country empty-handed. The trick is to design a rule that allows source countries to levy the minimum tax on all payments that generate a profit abroad, regardless of the response of low-tax countries.

A normal, unconditional withholding tax works like that. It is a rather blunt instrument, though. Investors detest it, and not without reason. In principle, if a payment of interest, royalties or technical fees is subject to withholding tax, the foreign recipient of that payment can subtract the withholding tax it has already paid in the source country from its own corporate tax charge. The withholding tax then causes a shift of taxing rights to the source country, without raising the multinational’s total tax burden. In practice, though, a company cannot always recover the withholding tax. For example, because the recipient has large costs, and the corporate tax on its profits – if any – is much smaller than the tax that has been withheld in by source country. This causes double taxation, and many a company director has been diagnosed with a severe allergy to it. At present, developing countries often depend to some extent on normal withholding taxes as a generic defence against profit shifting, because they are relatively easy to implement. Is there a better alternative?

Yes, there is, and it’s called rebuttable withholding taxes. For non-experts: sorry for this awkward-sounding jargon. Rebuttable simply means that a firm can challenge a tax and reclaim it if the firm proves that it meets certain conditions. For the purpose of establishing a minimum tax on corporate profits, the withholding tax would be levied at the agreed minimum rate. The company receiving the payments on which the tax was withheld, can reclaim the tax if it shows that it’s not enjoying profits that are taxed below the minimum.

This may sound very similar to the flawed Tax on Base Eroding Payments proposal. Conditional, rebuttable, what’s the difference? Well, it is in the situations where the corporate tax on the recipient’s profits is large enough to allow to credit the withholding tax. In those situations, a firm does not need to reclaim the rebuttable withholding tax in the source country. Indeed, it should not be allowed to do so. Otherwise, low-tax countries could simply adopt the minimum rate without providing credits for foreign withholding taxes, and profit shifting firms would still end up paying the minimum tax in a low-tax country instead of in a source country.

Thus, a rebuttable withholding tax could ensure that the minimum tax is levied in source countries. It would therefore yield larger increases in tax revenues than the design options currently on the table. This will happen despite firms continuing profit shifting and regardless of policy responses by low-tax countries. Moreover, the risk of double taxation will be much lower than with normal withholding taxes. After all, if a foreign recipient makes losses, or profits that are lower than the withholding tax and subject to at least the minimum rate, it can reclaim the withholding tax in the source country.

To summarize, a minimum tax is unlikely to stop profit shifting. Therefore, let’s design it in such a way that profit shifting becomes a way to generate revenues for source countries. Turning the problem into an opportunity.