The OECD’s final package of proposals for reforming the international system for taxing companies brings to an end the two-year BEPS project led by the OECD and other G20 countries which also included participation by representatives of developing countries, business, academia and NGOs.
Developing the BEPS, or Base Erosion and Profit Shifting reform package has been a remarkable endeavour involving thousands of hours of work and meetings – and thousands of pages of background work, interim proposals and commentary. All this has been in response to the undoubted need to reform a dysfunctional and ailing system.
It seems likely that, irrespective of the actual outcome, politicians will hail the BEPS project a success. Despite not having yet seen the final proposals we are prepared to disagree. The BEPS project may lead to some improvement but it will not lead to an international tax system fit for the 21st century. It might appear churlish to reach this conclusion before the final proposals have been published, so let us explain why.
In the February 2013 report that kicked off the project, the OECD made it clear that its aim was to close loopholes and tighten and extend existing rules to shore up the current system. It was equally clear that the fundamental framework underpinning the system was to remain in place. Subsequent BEPS documentation confirmed this.
However, the major problems afflicting the international tax system ultimately stem from flaws in the framework underpinning it. If that same framework remains in place, those problems cannot ultimately be resolved.
There are two major flaws. First, the current framework relies at its heart on concepts and distinctions that are not suited to the realities of a contemporary multinational enterprise operating in a global business environment.
Essentially, the international tax system addresses the possible double taxation of income arising from cross-border activity by allocating primary taxing rights between “residence” and “source” countries. In a “1920s compromise” in the League of Nations, source countries were allocated primary taxing rights to the “active” income of the business and residence countries the primary taxing rights to “passive” income, such as dividends, royalties and interest.
This might have been a sensible system in the 1920s but it is ill-suited to dealing with modern multinationals operating in a truly global business environment. Modern multinationals have shareholders scattered across the world, a parent company resident in one country, a potentially large number of affiliates undertaking an array of activities, such as research and development, production, marketing and finance that are located in many different countries, and consumers that could also be scattered across the world.
In such a scenario, there is no clear conceptual basis for identifying where profit is earned; all those locations may be considered to have some claim to taxing part of the company’s profit.
Conceptually, the residence/source and active/passive distinctions do not offer much help. In practice, applying these distinctions in the context of intra-group transactions, where affiliated entities in different jurisdictions are assigned the status of “source” or “residence”, gives rise to extensive and significant problems, not least those relating to pricing transfers within the multinational group. Overall, they lead to a system which is easily manipulated, distortive, often incoherent and unprincipled.
Second, the system invites governments to destabilise it by competing with each other for economic activity, tax revenue and possibly to try to advantage their own domestic companies. For at least 30 years this has led to gradual reductions in effective rates of taxation of profit. Governments around the world compete in this way while also demanding that companies should pay their “fair share” of tax, whatever that may be. This tension is particularly evident in the UK, where the goal of having the most competitive corporation tax regime in the G20 is held concomitantly with an active role in pushing forward the BEPS project.
Competition is not only on rates, but also on many aspects of the tax base. Over the years countries have introduced rules that enhance their competitive position or seek to give an advantage to domestic companies, but in practice facilitate the erosion of the tax base of both domestic and foreign jurisdictions and thus further destabilise an already fragile system. For example, as well as reducing tax rates, countries have introduced patent boxes with lower rates of tax on royalty income, and relaxed anti-avoidance measures intended to prevent international profit shifting.
These two flaws will continue to afflict the international tax system even if the proposals resulting from the BEPS project were to be implemented adequately by all states. For this reason, we do not believe it will lead to an international corporate tax system fit for the 21st century.