Talking with the taxman about fairness

Companies feel that the ground is being shifted beneath their feet. They feel that changing demands are being made of them in many ways, only one of which is tax. We pay what the law requires us to pay, they say. The problem is that society clearly no longer believes that simply adhering to the law is enough. Society demands that companies play a proper role in funding the state and infrastructure in the countries in which they are active. Society is right: the law is not enough, we need the lens of fairness.

Society includes investors, and investors increasingly share this societal view. A reminder of the statistics from a plenary question on aggressive corporate tax planning from the PLSA conference earlier this year: 

Less than 10% believed that any tax minimisation within the law is in shareholders’ interests; nearly half worried about potential reputational risks to the company; around a third expressed concern that aggressive tax planning actually harms a company directly by undermining investment in local infrastructure and society.

This is a marked shift in mindset. A few years ago the majority of what is naturally a conservative group would have been clear that tax minimisation is in shareholders’ interests. A reminder: the PLSA conference attendees are those shareholders, as pension fund representatives they are long-term asset owners. By definition, they believe in capitalism because they are responsible for capital.

Society’s (and investors’) thinking has shifted because corporate tax planning is seen to have brought merely adhering to the law into disrepute.

Let’s consider the words one large company uses in its tax disclosures. “Traditionally, taxes generally fall due where profits are generated,” it states. This is true: corporation tax is generally levied on profits generated within national borders, or at least that is the simple starting point for what becomes more complex thereafter. The problem is that many multinationals have organised themselves in ways that mean that the second half of this company’s sentence isn’t necessarily true. It goes on: “which should be aligned with where the economic activity takes place”. But profits can be shifted so that they no longer reflect where the economic activity takes place — and very often they are.*

There are three key ways in which profits are shifted by multinationals:

• intellectual property licensing drawing fees for the use of trademarks, patents or other IP from one country to another
• debt structures drawing interest payments from one country to another
• transfer pricing raising the cost of some goods or services and so lowering profits in one country and raising them elsewhere (or vice versa). There is always a transfer price to be set between companies within a multinational, but the term transfer pricing has come to be understood as manipulation of profits through the prices set (tax authorities intervene where it is clearly abusive)

In each case the structure tends to mean that these moves shift profits from relatively high tax jurisdictions to lower tax ones. Certainly this is what campaigners allege — and it is notable that multinationals tend to place intellectual property in lower tax jurisdictions and to lend money from such jurisdictions too. Both lower their overall tax burden. These steps can be taken by many companies even without particularly aggressive structures that exploit differential tax treatments by different authorities. But even without particularly aggressive planning, profits are no longer always aligned with where economic activity takes place. These structures risk unfairness — and by divorcing tax payments from economic activity, they risk the legitimacy of business.

It’s not surprising that the OECD, the club for rich countries, calls its main efforts to address aggressive tax planning BEPS, Base Erosion and Profit Shifting. Making profits more fairly reflect economic activity is the clear ambition.

One important element of the BEPS approach is to seek to address the issue of excessive debt and profit shifting through interest payments. If adopted generally, in effect this would limit interest payments to no more than 30% of EBITDA. This would help address the odd situation whereby our tax approach incentivises companies to take on more debt and so be less robust and less stable, by introducing what is sometimes called a thin capitalisation constraint. Companies would no longer be permitted to have such a thin sliver of equity capital that their debt interest payments suck out the bulk of their otherwise taxable profits. Such a change would render companies markedly more stable. Reflecting such a thin capitalisation approach within borders as well as on the international level which BEPS is considering would make more of our companies more robust and more resilient.

The potential benefits of rebalancing the current tax disadvantage of equity against debt financing is shown in a recent European Central Bank study of banks. ECB economist Glenn Schepens compared the capital ratios of a group of Belgian banks with a control group of peers. In 2006 Belgium had reduced the tax advantage of debt financing by also allowing equity financing to be tax deductible. The impact on capital ratios was marked:

All these capital ratios seem low in our modern post-financial crisis era, but the shift in the capital structure of Belgian banks as a result of this limited change is notable. Applying a similar policy shift to the rest of the business world could lead to a remarkable shift in the long-term resilience of business. (I am grateful to my friend Peter Elwin for drawing this study to my attention).

The FT’s Martin Wolf recently proposed radical reform for corporate taxation, a form called destination-based cashflow taxation. I am simplifying, but the underlying concept is that taxes would be levied depending on sales in a country rather than production. The structure also seeks to favour local investment and local employment. The argument is that the venue of sales is more transparent and less susceptible to shifting and manipulation than production and profits. Wolf says: “The present origin-based corporate tax system, especially with deductibility of interest and insufficient deduction for spending on investment, is creating huge problems. Instead of tinkering endlessly with it, we need more radical reform.

The letter in response to this proposal written by a group of tax reform campaigners notes that this looks rather like a form of VAT and so embeds many of the regressive elements of that tax (noting that in this case it is regressive cross-border as well as within countries). Instead they propose a form of international formulary apportionment. Formulary apportionment, sometimes known as unitary taxation, has typically only been applied within national borders, such as within the US, as a way to allocate taxation between its states. In essence, the level of a company’s economic activity in a state is determined according to a formula (using some combination of the proportion of overall sales, payroll and property in the state as compared with the nation overall). Over time, the formula has shifted from generally equal-weighting these three elements to a greater favouring of sales. A sales-dominated formula is perhaps not far removed in effect from what Wolf was proposing.

Introducing an international form of formulary apportionment would be a major endeavour — reaching global agreement as to the formula and as to what is treated as a taxable unit whose profits must be apportioned would be difficult. In particular, the defined taxable unit might introduce new opportunities for tax structuring and strategies that minimise tax. I vividly remember the horror generated in the corporate world in the 1980s and early 1990s by the thought that US states might start extending unitary taxation internationally. UK companies mounted a stout defence and ensured that their government threatened the US with tax retaliation should this ever have been delivered. The stated concern was that one state, or one country, might unilaterally impose global change; the silent concern was that it might undermine the multiple existing tax strategies the multinationals then had in place. The campaign was such that the plans were set aside in spite of being deemed constitutional. But maybe they will be revived in a new and broader form.

It is hard not to agree with Martin Wolf that radical reform is needed. Something needs to give. So the ground will shift further, and companies will again complain that they do not have the certainty they desire. The answer may be for them to plant themselves in the firmer ground of fairness — such that profits genuinely are made where their economic activity takes place, or at least taxes are paid where their economic activity takes place. Until that happens, campaigners will continue to highlight the discrepancies between the level of taxes paid by companies such as Starbucks, Amazon and Apple and the level of their economic activity.

I know that I will return to fairness in taxation in future blogs. It is one of the key areas where thoughts of fairness need to be applied, and where much fresh thinking is coming — in personal and property taxation as well as corporate. I’m looking forward to the Fair Tax Conference in London next week, the launch of Fair Tax Week.

* I’m not naming this company because I do not want to be seen in any way to be singling it out for criticism. It has had its share of tax disputes but it is more than usually transparent on tax matters.

Does the tax advantage of debt impact financial stability?, Glenn Schepens, ECB Research Bulletin No. 27, September 2016