Among the vast array of regulations and policies that impact and shape the global economy, international tax ruleInternational tax rules apply to income companies earn from their overseas operations and sales. Tax treaties between countries determine which country collects tax revenue, and anti-avoidance rules are put in place to limit gaps companies use to minimize their global tax burden. s play a significant role. Countries around the world have a diverse set of rules for taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ing multinational corporations, and these policies create various incentives for business investment and supply chains across the world.
Over recent decades there has been a significant shift in how countries design their international tax rules. The new policy approaches have changed the incentives that businesses face when arranging their supply chains and subsidiaries across the globe.
Many recent changes reflect the 2015 recommendations from the OECD project on Base Erosion and Profit ShiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. (BEPS). In many ways, the 2015 recommendations were intended to address a concern that policy gaps created too many opportunities for multinationals to minimize or avoid taxation.
However, there is still an ongoing debate about whether current rules, even those adopted with the BEPS recommendations in mind, allow for the pertinent countries to tax the right amount of income from multinationals. This conflict has led to development of unilateral initiatives by various countries that are dissatisfied with results from the current system.
The OECD and other multilateral forums are exploring options to resolve the current debate with policies that would adjust which countries can tax what share of income from multinational corporations. Just as the policy changes from BEPS created different incentives for business investment by multinational corporations and the design of their supply chains, this new debate will also change those incentives.
Tax policy can have a direct impact on the cost of capital, the ability for businesses to invest across borders, and the flow of goods around the world. Careful analysis is required to avoid policies that create real barriers to growth, and recent evidence of the impact of BEPS policies can help to identify how further changes to international tax rules might change business patterns and incentives for investment.
Before moving forward with new proposals, it is important to review what the BEPS recommendations were, how they were implemented, and how they impacted business behavior.
Why Do International Tax Rules Matter?
Businesses generally follow what makes most sense from an economic perspective when designing their supply chains and investing across borders. However, the economic reason for a certain structure may contradict with what makes most sense from a tax perspective.
For example, a business headquartered in the United States may want to sell its products in Europe. The company could set up a factory in Germany and a distribution center in France. The location of the factory and distribution center may make sense for various economic reasons, but high corporate taxes in both France and Germany could create tax challenges.
Without abandoning the economics of the arrangement, the company could minimize the tax impact by having the French distribution center borrow significantly from another entity in Ireland and deduct the interest payments against French corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. . Additionally, the German factory could be required to make royalty payments to a related entity in the Cayman Islands where the multinational has located the intellectual property. The royalty payments reduce the income that can be taxed in Germany.
With this result, the U.S. corporation can reach a new market in Europe relying on what both Germany and France have to offer from an economic point of view while minimizing its tax burden through various arrangements using subsidiaries in low-tax Ireland and in the Cayman Islands, where there is no corporate income tax.
This example is very much one of the past, however. France has rules that limit the deductibility of interest payments to related entities, and Germany denies the deductibility of royalty payments that result in an effective tax rate lower than 25 percent. Additionally, the United States has a tax policy that effectively sets a minimum tax on foreign income. Each of these approaches increases the taxes paid by the multinational group as a whole.
Taken together, these tax policies reduce the attractiveness of the German factory and French distribution center and change the landscape for future real investments abroad.
Similar policies designed to address tax planning that result in greater amounts of tax paid by multinationals come with trade-offs. In some ways the most direct trade-off is a choice between a company paying higher levels of corporate tax in a country versus having the real investment in the first place.
Why Did the Rules Change?
The approaches taken by the U.S., France, and Germany are all motivated by concerns that many countries around the world have regarding the ability of multinational companies to minimize their tax burdens. The BEPS project officially began in 2013 with the publication of the OECD’s Action Plan on Base Erosion and Profit Shifting. The plan laid out a multilateral process for the OECD to review policies that allow businesses to pay very low or no tax on income from international transactions and to address gaps and conflicts from the policies of various countries.
The underlying issue has been driven by differences in international tax regimes of countries, which impacts the tax revenues that countries collect as well as how businesses are structured.
On the first question, one survey reviewed estimates that ranged from 2-30 percent of corporate tax income being shifted out of high-tax countries. One estimate of the revenue impact of profit shifting in 2013 identified a revenue loss of 1.3 percent of GDP for non-OECD countries and 1 percent of GDP for OECD countries.
The size of these estimates has motivated the adoption of several types of policies, including:
- rules that apply domestic taxes to foreign subsidiaries (controlled foreign corporation [CFC] rules),
- restrictions on the use of special tax preferences for intellectual property (patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. nexus rules),
- limits on interest deductibility (thin capitalization rules),
- stricter rules on how companies price their cross-border transactions (transfer pricing regulations), and
- reporting requirements for businesses on where and how much taxes they pay in the countries where they have operations (country by country reporting).
Many countries have adopted these policies only recently, and their impact is becoming clear as more evidence is evaluated.
In the coming weeks, we will be reviewing the evidence that has been gathered on the impact of policies targeted at profit shifting. The impact of these policies should be taken into consideration by policymakers when determining whether additional measures should be adopted to further minimize policy gaps and opportunities for tax planning. Taxes matter for decisions to be made by businesses, individuals, and families, and it is important for policymakers to understand that rules can be designed to be neutral rather than distortionary.
Note: This is part of our Base Erosion and Profit Shifting (BEPS) blog series.
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