By Professor Sara L. McGaughey, Griffith Business School & Professor Pascalis Raimondos, QUT Business School
The current international company taxation system goes all the way back to 1923 and a ‘Report on Double Taxation’ solicited by the League of Nations. It was a time when the word “wireless” described radio communication and air travel was still not a regular means of transport. Most firms were national, and value chains were concentrated in one place.
The two core principles outlined in the report granted each country the right to tax profits accrued within its own borders, and to enforce arm’s length rules that restrain profit shifting. Nowadays — with more complex ownership structures for multinational enterprises (MNEs), finely-sliced global value chains and production networks, and global firms selling goods from the ‘cloud’ — the effectiveness of these two principles is in doubt.
Nevertheless, they remain the basis of our world-wide corporate income tax system (Separate Accounting). The stakes are high for both business and government. MNEs invest millions of dollars to minimise their tax, sometimes jeopardizing their reputation in the process (see LuxLeaks and the EU case against Apple). Nonetheless, this investment seems to be paying off. Governments are finding it increasingly difficult to collect revenues from corporate income taxes (see OECD data), partly due to MNEs shifting profits to lower tax regimes. Governments around the world are exploring ways to defend their tax base against such erosion.
U.S. defence against profit-shifting
The U.S. has one of the world’s highest corporate income tax rates (35%) and strictest Internal Revenue Services (ask any American living abroad). To protect its tax base, U.S. has to date tried to modify — but essentially remain within — the existing system. U.S. corporate tax law stipulates that a U.S. multinational shall pay taxes on its world profits rather than its U.S. profits. Recognising the possibility of double taxation, the U.S. law offers a tax credit. Taxes paid in, say, Ireland will be credited towards the U.S. profit before a tax is imposed.
Guess what: this defence against profit shifting does not work either. U.S. multinationals find several ways to avoid repatriating their profits into the U.S. One way is for a MNE to not earn profits abroad, and instead reinvest offshore earnings to expand even more its overseas activities.
Faced with this ill-functioning international tax system, the OECD’s 2015 Base Erosion Profit Shifting (BEPS) initiative is timely. It proposes 15 action points to close loopholes that extremely mobile and intangible activities create (e.g. where a ‘cloud’ belongs for tax purposes). While such initiatives are welcome, they do not change the fundamental problem that global firms are taxed according to nationally defined profits. Profits are based on accounting information, which is easily manipulated. More fundamental reform of the corporate income taxing system is needed.
What is the Trump administration’s proposal?
Corporate tax in the U.S. will be reduced from 35% to 20%, with tax paid on a firm’s ‘destination-based cash flow’. Cash-flows are defined as revenues from sales in the U.S. minus labour costs. Both are relatively easy to define as they are based on activities (sales and employment numbers) that are not so easy to manipulate. No capital or intangible (R&D, blueprints, goodwill) assets are involved in cash-flows. Material costs — i.e. costs of buying inputs from other firms — are not part of the cash flow either. The logic for this is that ‘material costs’ are revenues for the firms that sell these inputs, and thus a cash-flow tax has already been imposed on the domestic suppliers. In the case where these materials are imported, a border adjustment tax will be imposed on these materials — hence the ‘destination-based’ wording used above. If sales are exported to other countries they will not be taxed — only sales within US will face this destination-based tax.
There are some very positive aspects of this proposal. The problematic word ‘profits’ is out; the word ‘cash-flow’ is in. Taxation is based on activities that are difficult to manipulate, rather than on accounting profits. The intangible and extremely mobile factors are no longer part of the equation. Overall, the proposed reform resembles the highly successful value added consumption tax (VAT), where it is the activity (consumption) of the consumer that is taxed rather than her income. The ‘destination-based cash-flow’ tax is indeed a VAT tax (taxing domestic sales) put together with a payroll subsidy (deducting labour costs).
There are, however, some problems. For example, the proposal may fall foul of WTO rules as it both imposes an additional tax upon the importation of a good and indirectly subsidises exports. While WTO has approved the use of destination-based VAT for indirect taxation, it has not approved them for direct taxation. By allowing deduction of labour costs the proposal looks very much like a direct tax, thereby making it uncertain whether WTO will approve it. Moreover, even if it is approved, destination based VAT instruments have been around some time now and are not without problems. The VAT fraud in the EU is the most well-known example, and no solution is possible without more cooperation among countries. Finally, experience shows that VAT taxation takes 2-3 years to be implemented. That may be a conservative estimate when such a company tax reform will be the first of its kind in the world, creating uncertainty for some time.
Is Trump’s ‘destination-based cash-flow’ tax a viable proposal?
The scholarly literature suggests it is, if all countries impose it at the same time. With only one country imposing it, there will many issues that have not been thought through. The lesson from past experiences is that cooperation among countries is the only viable way forward for designing corporate taxes for firms that operate around the world. An example of this is seen right now within the European Union, where there is a movement towards implementing a Formula Apportionment method for taxing corporate profits. Under this method countries first agree what is the common consolidated tax base (i.e. firms’ total profit). Thereafter, this profit will be apportioned among the countries according to the activity that the firm has in each country. Taxing firm’s profits according to location-based activity is the system that the U.S. has used internally among its states for the last 40 years. This is similar for Canada among provinces, Switzerland among cantons and Germany among landers — all federal countries with a strong will to cooperate.
Of course, with President Trump’s eye on quick gains for America and not on long-run multilateral agreements, such a cooperative reform seems unlikely. The destination-based cash flow tax contains a lot of positive things that, if legal under WTO, might be the way forward for unilateral reforms of the corporate tax system. That said, the hasty introduction of a non-cooperative international corporate tax regime heightens administration and compliance costs for MNEs. It creates more uncertainty in the international business environment that may deter investments at a time when growth is needed. Overall, the Trump administration’s proposal may ultimately harm the very tax base it seeks to protect.