Wanted: A new global tax architecture

If a Spaniard invests in English console and interest paid over to a Bank which remits the proceeds to Paris where they are deposited in his account, is his income received in England, in France or in Spain?”

Seligman’s {Double Taxation and International Fiscal Co-operation}.

Transnational corporations operate world-wide. Should a profit be taxed in their country of residence or the country where they carry on business or the source of income is located, i.e. in the home country or the host or source country?

The question was always complicated. But globalisation has added a new angle. Joseph E Stiglitz, Nobel Laureate, in his magnum opus Globalization and Discontents Revisited has roundly accused Apple as the poster child for ‘corporate tax avoidance’, with its legal claim that a few hundred people working in Ireland were the real source of its profits and then striking a deal with the Irish government resulting in paying a tax amounting to 0.0005 per cent of its profit. This is also true of Google, Starbucks and a host of other multinationals.

Stiglitz made the biting comment: “If everyone avoided and evaded taxes like these companies, society could not function, much less make the public investment that’s led to the Internet, on which Apple and Google depend.”

There have been calls for the overhaul of the principles governing taxation of MNCs. The rise of highly profitable technology-driven, digital-heavy business models provide the impetus for such overhaul. Christine Lagarde, Managing Director of IMF, has called upon the developing countries to impose heavier taxation on MNCs.

Writing in the Financial Times , she refers to the public perception that large MNCs pay little tax and avoid normal tax with ease. The fairness of the international tax system is now under question. The current situation is harmful to low income countries.

Developing countries are vulnerable to the phenomenon of Base Erosion and Profit-Shifting. Non OECD countries collectively lose about $200 billion per year in revenue, this is about 1.3 per cent of their GDP.

The idea that income and profits are obviously linked to physical presence or that transactions inside a complex corporate group can be valued based on an objective market benchmark represented two outdated assumptions about the international tax system. The problem of tax competition remains unaddressed. Principles governing the transfer pricing law and its concomitant arms-length guidance allowed profitable firms to pay little tax. There is a need for an alternative international tax architecture. Digital business models rely on intangible assets that are hard to value, like patents or software. They have less need for a physical presence to do business.

Lagarde suggests several alternative methods:

* Create minimum tax schemes and reduce the scope for shifting profits to low tax locations.

* Apply principles governing inbound investment allowing low income countries to retain more revenue by imposing minimum withholding taxes on cross-border payments like fees for services charged by the parent companies to local subsidiaries.

* Create a system that fully taxes routine profits on basic activities in the country in which they take place, while splitting any remaining profits among all the relevant nations. This is the ‘residual profit allocations’ approach. This will call for multilateral agreement.

* Multinationals may lose profits nominally in India but they extract large sums through royalties and other fees which are all tax deductible. They accumulate losses in India in order to ward off competition in the future.

The IMF points out that Double Tax Agreements impose revenue risks for developing countries by limiting the source taxing rights in order to attract FDI. Countries are increasingly seeking to adopt treaty anti-abuse provisions to counter treaty shopping. Developing countries have to put in place thin capitalisation rules.

Transfer pricing rules

Transfer pricing law relies on the well accepted principle that taxes should reflect where an economic activity occurs. Stiglitz poses the question, “How is it determined?” In a globalised economy, products move repeatedly across borders in an unfinished state: a shirt without buttons, a car without a transmission, or a wafer without a chip.

The flaw with the transfer pricing system is the assumption that we can establish arms length values for each stage of productions. Stiglitz says: “We can’t”.

The matter is made worse by the growing role of IPRs and intangibles. Ownership can easily be moved around the world. That is why the US abandoned the TP system long ago within that country, in favour of a formula that attributes profits to each state in proportion to the share of sales, employment and capital there. Says, Stiglitz, “We need to move towards such a system at a global level”.

The idea of minimum tax levy on all transnational corporations on their revenue should be explored.

It has been highlighted that the latest brand of MNCs like Amazon, Netflix, and Walmart show enormous losses and pay no tax. Procter and Gamble, HUL, Colgate etc., pay profits before tax of about 24 per cent on sale. Probably we should explore a minimum levy on all multinationals operating in India. When the transfer pricing law was introduced, there was self gratification that our laws had become modern. The views of international experts indicate that we should probably move over to a new system of levying Minimum Alternate Tax on TNCs.

Ramanujam is a former Chief Commissioner of Income-Tax, and Sangeetha is a Chennai-based advocate

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