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Disparate tax rates ensure tax competition despite OECD BEPS action plan

Lawrence Hsieh  Senior Legal Editor, Thomson Reuters Practical Law

Lawrence Hsieh  Senior Legal Editor, Thomson Reuters Practical Law

Multinationals are still concerned with government attempts to recuperate tax revenue lost to Base Erosion and Profit Shifting

Multinationals are keeping a close eye on government efforts to recover tax revenue lost to Base Erosion and Profit Shifting (BEPS). This refers to wholly legal tactics employed by multinationals to reduce taxes by shifting profits from high-tax to low-tax jurisdictions. This behaviour shrinks the pool of income (“tax base”) that can be taxed in high-tax jurisdictions, to generate the tax revenue necessary to fund various government programs.

BEPS occurs daily in the supply chain. When unrelated companies buy and sell goods and services or license intellectual property, they typically negotiate “arms-length” pricing – the buyer wants the lowest, and the seller wants the highest price possible. However, related companies in a multinational group have the tax incentive to manipulate the pricing of their intercompany transactions (transfer pricing) to shift profits to low-tax jurisdictions. Many countries have transfer pricing rules to prevent inappropriate profit-shifting but multinationals are adept at manipulating the rules to “misprice” their intercompany transactions in order to lower their overall tax liability.

The Organization for Economic Cooperation and Development (OECD) plans to tackle transfer mispricing and other perceived abuses by implementing the multilateral BEPS Action Plan. The Plan presents governments with solutions for closing the gaps in current international rules. Some countries, however, have decided to take unilateral action to protect their tax bases. The UK recently instituted the Diverted Profits Tax (DPT), which targets multinationals that have significant economic activity in the UK but that shift income to low-tax jurisdictions by not having a fixed UK place of business (permanent establishment).

Critics contend that the DPT is nothing more than a pre-emptive tax revenue grab. One can debate whether the DPT (or the Plan) is a good policy but one thing is certain – regulatory competition among jurisdictions is still one of the best tools to prod governments to offer incentives that actually work to stimulate economic growth. Regulatory competition is also inevitable as few genuinely dispute the fact that sovereigns can impose whatever tax rates they desire to wrest business away from other jurisdictions.

Pressure on Ireland from high-tax jurisdictions resulted in banning the much-maligned “Double Irish”. This practice was used by multinationals to shift IP-derived profits from low-tax Ireland to even lower tax jurisdictions like Bermuda. However, by holding steadfast to its 12.5% corporate tax rate, which is one of the lowest in the developed world, Ireland appears confident that it can protect its tax revenue without increasing taxes.

If the Plan to re-shift profits back to high-tax countries works- such countries purportedly experience real economic activity- multinationals will (all other factors being equal) simply move more of their high-value operations to developed low-tax jurisdictions like Ireland. These countries are better positioned than tax havens to offer the workforce and technology that multinationals crave to grow their businesses.

Commentators say BEPS distorts corporate board investment decisions towards activities that have higher after-tax rates of return. Shareholders, however, may not care about the “distortion”, as long as they believe that the tax advantage is sustainable. Like “death and taxes”, disparate tax rates are enduring, if nothing else. This is why tax arbitrage will continue to be a part of corporate strategy even if the Plan takes hold.

View the story as it originally appeared on The Economist Intelligence Unit.

Learn more

Base erosion and profit shifting (BEPS)
BEPS Global Currents – See beyond the surface

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