Universiteit van Amsterdam Principles of economics and business 2 Economics of Taxation Multinational corporations avoid paying billions in taxes, can governments stop this? 1 Introduction A tax is efficient if it distorts market processes as little as possible, since economic agents attempt to limit, avoid and evade tax liability as much as possible (Nhekairo, 2014). A relatively recent study (Richardson and Taylor, 2015, pp. 458-485) provided results which lead financial experts to believe that U.S. multinationals are incentivized to utilize tax havens to minimize tax payments. Financial statements of companies, from Fortune 500 list, reveal that in 2015, over 2,5$ Trillion has been accumulated in overseas tax havens (Matthews, 2016). This forms a problem for both governments and citizens, as the national budgets used to build and maintain infrastructure, fund educational, healthcare and other institutions, etc., are reduced. Furthermore, to make up for the loss, governments often refill the treasuries with the money of the nation’s population instead. In recent years, many initiatives have been established on an international level, with the goal of preventing internal profit-shifting. An example would be the initiative by former UK First Secretary of The State, George Osborne, which led to the forming of so called ‘’Google tax’’, that prevents multinationals to minimize tax payments on royalties. In this research paper, the focus is mainly on multinational corporations and their management’s tax avoiding practices. Also, assuming that most of the companies included in this research have established operations in European countries and North America, the corresponding governments will be titled as ‘’Western governments’’. Therefore, the topic of this essays is: How can Western governments rule out corporate tax avoidance conducted by multinational corporations? The reasons for tax avoidance, involving elusive schemes and possible prevention measures, are the key concepts which are discussed. A clear focus will be on possible tax improvements through new tax proposals. The primary motivation for this study arises from the assumption that, when minimizing tax payments by stashing money in tax havens, multinational corporations take a considerable amount of money from the citizens and put it in their own treasures. In this paper, a literature review will be used to provide the answers to above mentioned central question. The literature consists of academic articles on financial, economic and social theories on tax avoidance and tax proposals, and how they impact corporate tax behavior. Considerable amount of literature and discussion will also be dedicated to the generally accepted main principles of taxation and corporate taxation income, and how they may influence tax proposals. After the analysis it should be clear how governments can shape legal frameworks to suppress profit shifting to low tax foreign jurisdictions. As part of the structure of the paper, this essay will further include theoretical background on the topic, followed by analysis, while the purpose of the final part is to answer the central question and set up a question for further research on this matter. 2 Theoretical background The primary tax discussed in this research is income tax. It can be defined as a financial charge imposed by a legal entity to taxpayers. In general, the amount of such levies depends on the tax rate which is defined by appropriate governing bodies. Governments impose such taxes to be able to raise revenues for their projects, to correct the prices of goods and services (e.g., alcohol, oil, and betting games), pay wages to the employees of government institutions and perform other duties. Because of the dynamic nature of economies, regimes can adjust the tax policies through new tax proposals. It is widely accepted that tax policies form a core guideline for implementation and adaptation of taxes (Kabinga, M., 2015, p. 5). Every country can tailor the tax framework according to the beliefs and plans of the government, thus possibly changing different aspects of corporate tax income. According to Organization for Economic Co-operation and Development (OECD), there are five main principles for forming a good tax system. First one is neutrality, meaning that tax systems should be neutral to all spheres of trade and should not have impact on business decisions. Also, all relevant taxpayers should be taxed in same manner. Efficiency is the second principal, implying that administrative and compliance costs should be minimized. Certainty and simplicity implies that meaning, impact and fulfilment methods of taxes should be understandable. Fourth principle, effectiveness and fairness, entails that taxes should encompass for all time periods, minimizing tax avoidance and evasion. The fifth principle is flexibility, and ensures that tax frameworks remain dynamic and flexible, so that taxes accommodate for continuous technological developments. Companies pursuing their opportunities may decide to sell their products and services in foreign markets. They can also expand their businesses or create new ones in other territories. This can lead to a scenario where a source of income is taxable in more than one country. If that income is taxed multiple times, we speak of double taxation. This can be seen as unfair, as it possibly generates negative impact on companies net revenues (as more tax is levied). It can also bring a firm in a disadvantageous competitive position if it’s forced to increase the prices of the goods and services in response to facing additional tax burden. To solve the issue, countries engage in bilateral negotiations. As a results, Double Tax Treatments, also known as tax treaties are often signed between the negotiating parties. The treaties define several aspects of multinational trade, like the percentage of taxes that a government may impose on a source of income and how that same income should be treated by negotiating participants. The agreements can also define in which jurisdictions different goods and services are taxable. On the other hand, countries can be negatively affected by corporate decisions of multinationals. Such scenario appears when a corporation decides to use methods to minimize the amount of payable taxes. According to tax avoidance, often indicated as tax elusion, is considered a legal act, unless proclaimed differently by the tax authorities, or by the courts as a cause of exploitation of tax regimes to one’s own advantage to reduce a tax burden (Ioannides et al., 2016, p. 9). This term should not be confused with tax evasion, which includes avoiding tax payments by illegal means. Profit shifting is a common avoidance method. It includes transferring profits from high tax jurisdiction to the low tax ones. When the tax is recognized in the latter jurisdiction, companies have made tax reduction, caused by the difference in the tax rates. To reduce the income tax owed, multinationals often shift profits to regions or countries known as tax havens, which are low-tax jurisdictions that grant tax avoidance opportunities to the investors (Desai, Foley and Hines Jr., 2006, p. 514). According to the researchers, many exotic island maintain low tax policies to make them attractive to foreign investment, which is crucial to their economies, since their own resources and production capabilities are often limited. Corporate secrecy, another trait related to tax havens, ensures that corporations aren’t forced to publish their financial data, making it difficult for jurisdictions to determine whether there is a practice of tax avoidance. 3 Analysis 3.1 Why are companies able to avoid tax? In general, despite the constant change in tax laws and tax avoidance opportunities, at least one of the three main principles of tax avoidance are made use of in tax avoiding methods (Joseph E. Stiglitz, 1989, p. 329). Postponement of taxes is the first one mentioned by Stiglitz and works because the postponed tax’s present discounted value is lower compared to a currently paid tax. The second principle explained by the author is tax arbitrage across individuals facing different tax brackets, or the same individual facing different marginal tax rates at different times, which can lead to tax induced transactions. The third mentioned principle is tax arbitrage across income streams facing different tax treatment. This principle is commonly noticeable in tax minimizing practices of multinationals with several operational entities spread across different countries with low corporate tax rates. In correspondence to the mentioned principles, several traits can be identified as contributing factors to tax avoidance. Low tax rates incentivize companies to transfer profits to other regions, which than increases retained earnings by allowing the firm to pay less tax. 3.2 How do corporations avoid tax? Companies have different options when it comes to tax minimization. Allocation of debt and earnings stripping is one of them. This method includes borrowing money in a region with high-tax policies and shifting it to regions with low-rate policies (Gravelle J., 2009 p. 732). More specifically, in this case debts are linked to the related firms in high-tax countries or when tax cannot be imposed in regard to unrelated debt, which leads to companies reducing the amount of taxes payable. Another method to avoid taxes is known as transfer pricing. In such scenario, through lowering the prices of goods and services of affiliates in high-tax regions and increasing the same in low-tax regions price shifting is made possible (Gravelle J., 2009 p. 733). This avoidance tactic is countered by at arm’s length principle. It includes that when transferred, asset has to be valued equally by all partaking parties. To help determine the value, participants can take other independent entities valuation into consideration. However, this counter measure is less effective when dealing with intangible assets, since they are more difficult to estimate. According to Gravelle (2009), transfer pricing technique is often used in U.S. because of the tax regulations on patents. Namely, when patent rights are transferred to a foreign low-tax subsidiary and the royalties paid are less than the true value of the intellectual property. Such methods can be combined into complex tax avoiding processes. Two well known are ‘The double Irish’’ and ‘Dutch sandwich’. These methods involve creating foreign subsidiaries in regions where tax rates and policies can be exploited for tax reduction, while secrecy policies ensure that the process is difficult to trace (Duhig and Kocieniewski, 2012, pp. 1-5). 3.3 How can we further tackle tax avoidance? Research studies indicate that corporate tax avoidance in the United States is significantly hampered due to lack of information and transparency (Gravelle J., 2009, p. 732). As already mentioned, many tax haven islands have a secrecy policy, where transactions and other information is not accessible to foreign institutions. Therefore, governments should oblige corporations to publish financial details in each country. This can be done by signing transparency treaties between nations. Regimes should also ensure that financial institution (such as banks) can’t provide financial means to unethical companies. When both combined, all financial information could be analyzed and corporation which exploit tax avoiding opportunities can be denied financial benefits. Also, transparency would force companies to transfer the fair share of their profits, which would increase the treasury of the home nation. However, convincing a party to agree can be a challenge. According to a recent study, islands with low populations are often dependent on big corporations investments, and thus maintain confidentiality to incentivize them to invest (Richardson & Taylor, 2015, pp. 465-470). But if economically powerful nations were to offer financial aid to the less developed islands, the chances of closing a deal could increase, since the latter party can sustain national welfare without having to rely mainly on foreign direct investments of corporations. Further insight in the tax avoidance methods and techniques used in this case study identify one common factor for the companies. Corporations can shift income and property, while also establish affiliates throughout regions without many noticeable restrictions. By doing so, companies can reduce taxable income through allocation of debt and transfer pricing between units with varying tax frameworks. Apple and Google were able to minimize tax payment by establishing subsidiaries (some without any employees and office spaces) and transferring patents and profits to units in territories which they saw fit for their schemes (Duhig and Kocieniewski, 2012, pp. 1-5). A possible solution to this issue is equalizing the tax rates between nations, while also forming strict regulations that define under which circumstances a unit can be treated as a subsidiary. In such situation, companies face costly barriers for establishing units abroad and shifting financial assets to minimize tax payments, and may even abandon mentioned activities. Having a standard tax rate between nations also reduces the impact of arbitrage opportunities, as it can lower price differences, because the fees for goods and services are less affected by tariffs. If above mentioned process proves ineffective, all Western governments should individually lower their tax rates. If the tax rates in United States where low (and similar to other regions), corporations would have to consider whether it is cost effective to open a subsidiary elsewhere to shift profits. Regimes do not have to fear effects of such measures, as a recent study indicates that lowering tax rates does not necessarily reduce tax revenues, because tax treaties bring more foreign investment (Hong, 2018, pp. 1286-1298). Yet a different approach to addressing the problem of corporate tax avoidance can be recognized. Western governments can publish list of all companies which behave unethically and avoid paying their fair share of taxes. This can create a negative public opinion of the same. People may boycott using goods and services of unethical companies, which would significantly reduce their profits. Even a step further can be taken, if the governments oblige rich, influential business individuals to publish their financial details. Unwilling activities can than be traced by jurisdictions, which than can indicate the ones responsible. Negative reputation may force the rich to abolish tax avoiding activities and start paying the fair amount. Western governments could also intensify their efforts in making people aware of the importance of corporate responsible behavior. By spreading the lists through social media, the reach of this information would be increased, thus increasing public awareness. This may incentivize businesses to behave more socially responsible. There are several limitations to be considered for this case. The author is a university student with limited knowledge on the topic. Therefore, several arguments and findings may lack additional explanations and interpretations, compared to similar studies. In this research case, more traditional and somewhat basic methods of tax avoidance have been included (profit shifting). This research lacks analysis and discussion on intangible assets, and tax reduction by shifting intellectual property. Therefore, a future study study can be conducted in attempt to find ways to stop tax avoidance by transferring intellectual properties. 4 Conclusion A significant number of multinational corporations are responsible for tax avoiding practices, which are worth several hundred billion dollars each year. This reduces national treasury budgets, as governments are denied of their revenue, while the burden is shifted to common people. This phenomena is globally present for several decades and it is a complex issue. Nations labeled as tax havens are forced to offer benefits to foreign investors to keep their economies running, by providing low tax rate regulations and secrecy policies. Businesses like Google and Apple conduct tax avoidance through complex and well-coordinated set of actions (The double Irish and the Dutch sandwich). Tax avoiding opportunities are found in jurisdictions with low tax rates, also known as tax havens. Secrecy policies also contribute to tax elusion, because companies aren’t obliged to publish financial details, making their activities untraceable for governments. Corporations have various methods at their disposal to reduce tax burdens. Price shifting is a common one, where businesses transfer money to low tax regions and thus cut tax payments. The double Irish and Dutch sandwich, are examples of complex tax avoiding methods used by various multinationals. Tax elusion can be tackled by combining different multinational regulations. Western governments should force transparency and completely abolish corporate secrecy. By doing so, suspicious business activities can be tracked. Regimes should also make sure that unethical businesses can’t receive financial means from institutions such as banks. The combination of previous 2 should discourage corporations to avoid tax. Financial aid should be given to tax haven countries to increase chances of signing anti secrecy tax treaties. Standardizing tax rates between nations is another way to prevent tax avoidance, because profit shifting can’t cut amounts of payable taxes in such scenario. If jurisdictions can’t come to terms, Western governments should all individually lower their tax rates, thus making tax avoidance through foreign subsidiaries less attractive. Another approach to stopping tax avoidance is publishing lists of companies which avoid taxes. This can create negative public opinion and affect business sales, thus forcing fair tax payment. Governments should also oblige rich individuals to publish their financial details, which can contribute to tracing elusive activities. Furthermore, by putting an emphasis on the importance of business ethics and social responsibility, regimes ensure that business ethics and social responsibility are valued by businesses. Literature Desai, M. A., Foley, C. F., & Hines Jr, J. R. (2006). The demand for tax haven operations. Journal of Public economics, 90(3), 513-531. Dowling, G. R. (2014). The curious case of corporate tax avoidance: Is it socially irresponsible?. Journal of Business Ethics, 124(1), 173-184. Duhigg, C., & Kocieniewski, D. (2012). How Apple sidesteps billions in taxes. The New York Times, 28, 1-5. Gravelle, J. (2010). Tax havens: International tax avoidance and evasion. National Tax Journal 69(4), 727-753. Hong, S. (2018). Tax treaties and foreign direct investment: A network approach. International Tax and Public Finance, 25(5), 1277-1320. Ioannides, I., Douma, W., Güven, O., Jancic, D., Pantaleo, L., Velde, S., . . . Vries, F. (2016). The inclusion of financial services in EU free trade and association agreements effects on money laundering, tax evasion and avoidance : Ex-post impact assessment. Brussels]: [European Parliament]. Kabinga, M. (2015). Principles of Taxation. Tax Justice and Poverty, 4(5). Matthews, C. (2016, October, 6.) How Fortune 500 Companies Avoided Paying Taxes on $2.5 Trillion. Retrieved from http://fortune.com/2016/10/06/fortune-500-tax-haven/ Nellen, A. (2012). Internet taxation and principles of good tax policy. Policy & Internet, 4(1), 1-21. Nhekairo, W. A. (2014). The Taxation System of Zambia. Lusaka: Jesuit Centre for Theological Reflection. Organization for Economic Co-operation and Development (OECD). (1998). Electronic Commerce: Taxation Framework Conditions. Retrieved from: https://www.oecd.org/ctp/consumption/1923256.pdf Richardson, G., & Taylor, G. (2015). Income shifting incentives and tax haven utilization: Evidence from multinational US firms. The International Journal of Accounting, 50(4), 458-485. Stiglitz, Joseph E. "The General Theory of Tax Avoidance." National Tax Journal, 38,(3), 325337.
