A QUESTION
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OF DEVELOPMENT SYNTHESES OF AFD STUDIES AND RESEARCH
Full study downloadable at: https://www.afd.fr/en/assisting-developingcountries-taxation-after-oecds-beps-reportssuggested-approach-international-donor-community
THE TAX DILEMMA OF LOWER-INCOME COUNTRIES Base erosion and profit shifting, or “BEPS,” refers to a common form of tax planning by multinational corporations that depends upon corporate subsidiaries located in tax havens. BEPS poses an especially difficult policy challenge for developing countries, especially those of lower income. The world’s poorer developing countries require increased government revenues in order to meet their populations’ urgent needs in health, education, and employment. Lower-income countries, however, are more limited in their abilities to raise government revenues than are the world’s wealthier countries. In wealthier countries, the bulk of government revenues come from broadly applied forms of personal taxation, including the personal income tax and consumption taxes like the VAT. In poorer countries, however, low per capita earnings in themselves limit the amount of revenue potentially available from personal income and consumption taxes. Moreover, in the poorer countries, a large proportion of economic activity tends to be “informal,” in the sense that many business transactions are conducted in untraceable cash, and many employment arrangements are not documented.
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Low-income countries face substantial tax policy challenges arising from tax avoidance techniques that for many years have been used routinely by multinational companies. This policy brief explores how the international donor community might most productively offer technical assistance to developing countries in the area of taxation, in light of the OECD’s recently completed study of “base erosion and profit shifting (BEPS).” It observes that the most productive technical assistance efforts might extend beyond the boundaries of the particular international tax issues addressed in the BEPS reports.
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How can the international donor community assist developing countries in taxation?
The combination of low per capita income and economic informality substantially limits the ability of many developing countries to raise revenue from “workhorse” taxes like the personal income tax and the VAT. As a result, total tax revenues, measured as a percentage of gross domestic product, tend to be much lower in the world’s poorer developing countries than in wealthier countries.
Another form of taxation, the corporate income tax, exists in virtually every country in the world. Over time, the corporate income tax has fallen into political disfavor in many of the world’s wealthy countries, largely based on a belief (which is common among economists but not universally shared) that taxes on corporate income unduly discourage business investment and therefore economic growth. Many countries accordingly have reduced their reliance on corporate income taxation in recent decades.
TOTAL TAX REVENUES AND CORPORATE INCOME TAX REVENUES IN VARIOUS INCOME GROUP COUNTRIES
25 20 ■ Low income 15
■ Lower-Middle income ■ Upper-Middle income
10
■ High income
5 0 Tax revenues (as % of GDP)
Corporate income tax revenues (as % of total tax revenues)
Developing countries, however, generally have not been able to reduce the relative importance of the corporate income tax in their fiscal systems. Income generated by corporations, particularly the local subsidiaries of foreignowned multinational groups, tends to represent a large share of the total income generated each year in the poorer countries, and corporate business generally is documented by modern records-keeping systems. As a result, the relative share of total government revenues represented by the corporate income tax has generally remained higher in lower-income than wealthier countries.
Many countries offer investing corporations explicit and formal exemptions from taxation. These take such forms as “tax holidays” exempting companies from taxation for periods of ten or fifteen years for example, or exemptions from taxation for companies willing to invest in designated “economic development zones.” Over the years, though, BEPS planning techniques have in effect enabled companies to also enjoy substantial implicit exemptions from taxation in countries where they invest and conduct business.
Despite their relative dependence on corporate tax revenues, however, developing countries perceive strong pressures to minimize the tax burden on corporations in order to avoid discouraging inbound investment. The pressure of tax competition often is said to create a “race to the bottom,” under which countries compete to exempt investing companies from taxation.
BEPS TAX PLANNING TECHNIQUES
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Approximately seventy years ago, international tax practitioners developed informal techniques of tax avoidance using corporations established in tax havens (what we now call “BEPS” transaction structures), which over the years have resulted in the extension of significant de facto tax exemptions to multinational companies. These arrangements conform to four patterns, which today are familiar to all international tax practitioners:
MICHAEL C. DURST RESEARCHER AT THE INTERNATIONAL CENTRE FOR TAX AND DEVELOPMENT.
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SOURCES: Total tax revenues/GDP (2015): Data from UNU-WIDER/ICTD Government Revenue Dataset; Corporate/total tax revenues (2012): Data from IMF (2014).
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Loan-based income-shifting transactions: A multinational group establishes a “finance company” in, say, the Haven Islands, which imposes no corporate income tax, effectively contributing to the finance company a large amount of cash. The finance company then extends a loan to a group member that performs manufacturing operations in a developing country. The operating company deducts interest paid on the loan, thereby reducing taxable income in the developing country, but no tax is imposed on receipt of the interest by the finance company in the Haven Islands.
THE RECENTLY COMPLETED BEPS ANALYSIS The 2008 global financial crisis led to public sentiment, in many countries of the world, that governments and the international community should end BEPS-style tax planning arrangements. In 2012, the Organisation for Economic Cooperation and Development (OECD) began its study of the perceived problem. Although the OECD is comprised of relatively wealthy countries, the organization recognized the special corporate-tax difficulties faced by developing countries and consulted with their governments.
Intangibles-based income-shifting transactions: A group contributes valuable intellectual property, like the trademark to a popular brand of beer, to an “intangibles holding company” established in the Haven Islands. A member of the group that distributes its beer in a developing country pays royalties to the Haven Islands company for the use of the trademark. The royalty payments are deductible in the developing country, thereby reducing the distribution company’s tax liability in that country, but no tax is imposed when the royalties are received in the Haven Islands.
The completed OECD studies are voluminous and cover a number of technical topics in corporate tax law. Two of the BEPS recommendations (which appear both in the primary BEPS reports and in special studies of the needs of developing countries) appear especially to offer a realistic possibility of revenue benefits to developing countries, even in the short to medium term. These include recommendations that (i) countries adopt more stringent limitations on interest deductions, and (ii) that countries seek to simplify the operation of “transfer pricing laws,” which are complex rules intended to ensure that subsidiaries of multinational groups earn reasonable, “arm’slength” levels of income in countries where they operate.
Income-shifting transactions involving related-party transactions in services and tangible property: A multinational group engaged in mining, for example, might establish a “hub” company in the Haven Islands. The hub company might “purchase” valuable mining supplies and equipment from one group member and “resell” the supplies and equipment, with a profit markup, to a mining subsidiary based in a developing country. Alternatively, the hub company might contract for the performance of technical services by employees of the parent company and “resell” the services at a profit to the subsidiary. Under both scenarios, inflated payments from the subsidiary reduce the group’s tax liabilities in the developing country and shift profits to the Haven Islands.
TECHNICAL ASSISTANCE The Platform for Collaboration on Tax (PCT), a consortium of organizations including the OECD, the IMF, the World Bank and the United Nations, has committed itself to maintaining an active program of technical assistance in taxation to developing countries. In addition, a number of national governments are likely to continue offering technical assistance in tax to developing countries, as they have in the past.
Income-shifting transactions involving outbound sales of products: These kinds of income-shifting transactions are common in the natural-resources and agricultural sectors. As an example, a multinational group might be involved globally in the tire business. The group might have a purchasing subsidiary in a developing country, which buys raw rubber from farmers and ships it to the group’s tire-making plants located around the world. The group also might establish a “marketing subsidiary” in the Haven Islands. The purchasing subsidiary might then enter into contracts to sell the rubber to the marketing company at 10 percent below the world market price; the marketing company might then contract with the group’s tire-making subsidiaries around the world, to resell the rubber to them at 5 percent above the market price. In this manner, substantial taxable profit can be shifted away from the developing country where the rubber is produced.
The challenges facing technical assistance efforts have always been, and will remain, substantial. A recent PCT report confirms that these challenges can be of a political as well as a technical nature. Pressures of tax competition, of the kind mentioned earlier in this policy brief, are likely to cause political ambivalence in many countries concerning the desirability of tax measures that would result in effective tax increases for investing companies. Sometimes, this ambivalence can involve active disagreement between officials in different governmental departments. For example, finance and tax officials might favor measures to increase tax collections from multinationals, whereas other officials charged with encouraging investment might strongly oppose the measures. In light of this kind of political ambivalence, the PCT report warns: “An indispensable prerequisite to improving tax capacity is enthusiastic country commitment.”
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An essential part of successful technical assistance, therefore, consists in obtaining committed support for the assistance efforts from senior levels of government, as well as the personnel within the tax administration who will need to implement any recommended improvements in tax administration. The situation of each country is likely to be unique, with countries varying significantly in the extent of their perceptions of being exposed to tax competition, and also in the current level of training and technological capacity of their tax administrations. It is also important that governments receiving technical assistance in taxation be committed to attaining, as necessary, and maintaining a high quality of governance generally, to ensure that tax revenues raised are devoted properly to public goods and services. In entering into engagements to provide tax technical assistance, donors should avoid prematurely formulating specific proposals for legal changes or other reforms in the host countries in which it will be working. Instead, a donor should be careful to initiate a process in which host-government and donor personnel first jointly conduct research on the various elements of the country’s revenue and tax administration system and then together identify particular projects that appear to offer the best prospect of being productive. Therefore, a donor’s first task should be to establish ongoing consulting relationships with the tax administrations and finance ministries of countries that have requested assistance, and to establish ongoing dialogues with officials concerning the kinds of technical assistance that are likely to be most beneficial to the particular country.
BIBLIOGRAPHIC REFERENCES DURST, M. C. (2017), “Assisting Developing Countries in Taxation after the OECD’s BEPS Reports: A Suggested Approach for the International Donor Community”, AFD Research Paper Series, No. 2017-49, July. INTERNATIONAL MONETARY FUND (IMF) (2014), “Spillovers in International Corporate Taxation”, IMF Policy Paper. OECD (2015), “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments: Action 4 Final Report”, OECD/G20 Base Erosion and Profit Shifting Project. OECD (2015), “Aligning Transfer Pricing Outcomes with Value Creation: Actions 8-10 Final Report”, OECD/G20 Base Erosion and Profit Shifting Project. PLATFORM FOR COLLABORATION ON TAX (2017), “A Toolkit for Addressing Difficulties in Accessing Comparables Data for Transfer Pricing Analyses”.
Donors should remain open, depending on how their collaborations with host countries proceed, to offering assistance in the areas of personal as well as corporate taxation. There may well be opportunities to engage productively in technical assistance relating to the kinds of corporate tax issues addressed in the BEPS studies, particularly with respect to interest limitations and the improvement of transfer pricing methods. In addition, countries might be interested in broader corporate tax initiatives, like expanding the use of “alternative minimum taxes,” perhaps based on a company’s turnover rather than net income, as a backup to the regular corporate income tax. Given the political and economic pressures of corporate tax competition, however, it may be more realistic in some situations to focus additionally on opportunities for improving domestic tax administration, for example in the areas of individual income taxation, consumption taxation like the VAT, and property taxation. It is also important that technical assistance efforts include careful evaluative follow-up. A great deal remains to be learned about the effectiveness of different types of tax improvements, in both the corporate and noncorporate areas, and technical assistance provides an important opportunity for empirical evaluation.
CONCLUSION The OECD’s BEPS studies, and related analyses by international organizations, have provided valuable insights into the nature of corporate tax base erosion in all countries, including developing countries which tend to depend especially heavily on corporate taxation. Donors, including national governments as well as international organizations, have opportunities to assist developing countries in improving their tax systems, including by implementing some of the BEPS reforms. Donors should, however, be aware of the political as well as technical challenges to tax-system improvement, and should remain open to a wide range of potentially helpful measures. Most importantly, donors should work closely with host governments to ensure that technical assistance efforts respond realistically to a country’s perceived political and economic constraints.
A QUESTION OF DEVELOPMENT is an AFD Research Department publication which presents syntheses of studies and research initiated or supported by the AFD. This series aims to summarize the questioning, the approach, the lessons and the prospects of the study presented. Thus, it intends to open new avenues for action and thinking. The analyses and conclusions of this document are formulated under the responsibility of its author(s). They do not necessarily reflect the point of view of the AFD or its partner institutions • Publication director: Rémy RIOUX • Editorial director: Gaël GIRAUD • Agence Française de Développement: 5, rue Roland Barthes - 75598 Paris Cedex 12 • Copyright: June 2018• ISSN: 2271-7404 • Conception and Layout: Ferrari / Coquelicot • English editing: Eric ALSRUHE •