Making Sense of Profit Shifting: Victoria Perry

Victoria Perry is Assistant Director in the Fiscal Affairs Department and Division Chief of the 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. Policy Division at the International Monetary Fund.

At the IMF since 1993, Ms. Perry has provided technical assistance in tax policy and revenue administration to more than 40 countries in Africa, Europe, and Asia. From 2002 to 2008, she served as Division Chief for Revenue Administration in the IMF’s Fiscal Administration Department.

Previously, Ms. Perry was the Deputy Director of the Harvard University International Tax Program, where she taught comparative income taxation and value added taxation and provided technical assistance in revenue policy through the Harvard Institute for International Development. Prior to Harvard University, Ms. Perry was a Partner in the Boston law firm of Hale and Dorr (now WilmerHale), practicing tax law.

Ms. Perry is a member of the Board of the National Tax Association and previously served as President of the American Tax Policy Institute and Chair of the Value Added Tax Committee of the American Bar Association Section of Taxation. She is a co-author of the book, The Modern VAT, published by the IMF in 2001.

Ms. Perry received her J.D. from the Harvard Law School, and her B.A. in Economics and Philosophy from Yale University.

In this interview with the Tax Foundation, Ms. Perry shares her insights into how the 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. phenomenon is impacting developing countries. Ms. Perry, for example, discusses why profit shifting may disproportionately affect developing countries, how the IMF advises developing countries on issues related to tax competition, and the future of the corporate tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and further multilateral cooperation in international taxation. This interview is part of our 2015 Tax Foundation Forum series and has been edited for clarity and length.

Tax Foundation: What are the unique factors or drivers underlying the profit shifting phenomenon? And how is profit shifting affecting developing countries?

Victoria Perry: The driver is an attempt to minimize the overall tax burden that falls on firms doing business on an international basis. And some of the things that facilitate that are what the OECD/G20 Base Erosion and Profit Shifting (BEPS) project is all about. It’s important to note, though, that the BEPS project addresses these issues in part but not in full.

The IMF paper, “Spillovers in International Corporate Taxation,” highlighted that the whole international corporate tax architecture under which we now labor was developed almost a hundred years ago, in a time where the global economy was really very different than it is now. And some of the dynamics that underlie that architecture make it fairly easy to set up transactions that can be used to legally minimize the corporate tax burden. I add in this context that we’re not talking about evasion. That is, we’re not talking so much about clearly illegal activity, like hiding accounts offshore. As you see from reading the recent press, rather, we’re talking about entering into transactions that are fully legal, but designed to facilitate the minimization of tax.

The current system was designed for a world where advanced countries dealt with each other. Nobody gave too much thought to the developing countries. Countries tended to be both “residence” and “source”, as we say in the tax field. They both exported and imported—frequently in a quite balanced way.

One of the aspects that make this slightly problematic for the very low-income countries is that they tend to be source countries and not so much residence countries. Another way of putting that is that they tend to be the sites where production, mining, or other kinds of activity take place but not the location from which capital is exported elsewhere. In other words, they tend to import capital. And when that’s in the form of foreign direct investment, they become what we call source countries.

The current system evolved—though without central planning—in order not to necessarily favor one or the other. It was designed to basically shift the source taxation to the residence country–because sometimes companies are resident, sometimes they’re source—and it was intended to be a logical system free of confusion and double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. .

Because of the ways in which the world has changed, that desire to avoid double taxation in the system itself, and also through tax treaties, has allowed a situation to arise in which at least some of us are no longer so concerned about avoiding double taxation as we are about avoiding what some now call “double non-taxation” or base erosion.

The current system permits quite a lot of double non-taxation. Many of your readers will have heard of examples of large multinational corporations avoiding millions of dollars in taxes in the United States or United Kingdom. But for developing countries, it can be more of a problem than it is for the developed countries—the absolute numbers may not be as large but the relative amounts can be bigger.

And, developing countries typically rely more heavily than advanced countries on the 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. . So an erosion of their corporate income tax base has a greater adverse effect, as it’s a bigger part of their tax revenues. A significant hit to their corporate income tax revenues is really a problem in terms of their domestic revenue mobilization.

TF: What are some of the channels through which we see firms minimize their tax liability? And which of those channels are especially prevalent with respect to developing countries?

Perry: A lot of the channels have been highlighted by the OECD/G20 BEPS project, of which there are a number of different strands. Within that project, two of the channels that are of special concern for developing countries are the use and abuse of bilateral tax treaties and, very broadly speaking, certain transfer pricing issues. But there are other issues for developing countries that aren’t even addressed in the BEPS project itself. One of those, for example, is direct taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. competition between countries using tax incentives.

Suppose you’re an island with a lot of beaches, but there are four other islands right around you with a lot of similar beaches, and some hotel company says: “We’re going to build a new hotel and it’s going to employ 1,500 people. We can put it on your island or we can put it on another island.” Countries faced with that or an analogous situation have a tendency to enter into agreements that reduce the tax burden on the hotel.

That desire to attract foreign direct investment is very strong and totally understandable. One of our initiatives right now—and this is actually not part of the BEPS project, but like that project it’s at the request of the G20 leaders—is picking up on exactly this. We’ve been working with countries for many years, offering advice on the use of tax incentives and potentially destructive tax competition.

The IMF is now drafting a paper with other international organizations, including the World Bank, on fair and efficient ways of using tax incentives that might lead to less destructive tax competition and perhaps better outcomes—closer to serving the goals of the countries.

There’s also a somewhat obscure area that we’re looking at on what we call “indirect transfer of assets.” An example of this is the “Vodaphone case” from India. The concept relates to whether a country can impose a capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. on a transaction that is defined by transferring the value of something located within their country, but where the technical ownership transfer takes place offshore.

This is a particularly acute problem for developing countries, especially for such countries that have mineral wealth, because the legal rights to mine or extract those assets are frequently transferred offshore. And whether that gives rise to a taxable event is a very big issue for developing countries.

The IMF has been monitoring and writing about all of these areas for decades, and they are now coming to the fore and being brought together with this much-increased focus on international tax issues.

A key premise to multilateral cooperation in international taxation is that it’s possible to determine in which jurisdiction value added occurs or income should be booked. What are challenges in determining the source of income on a geographic basis?

This phrase “should be booked,” emphasis on “should,” is another way of saying the key phrase that has been kicked around during the whole BEPS discussion: “Taxation should apply where value arises.” But it’s very hard to say where that is. What does it even mean?

So, part of the problem in this whole area is to look for a normative or almost existential place where income is really derived. But the whole idea is basically a humanly agreed construct, so where it really is depends on what the goals are.

This is the question that underlies a lot of the debate about using “formulary apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. ,” instead of the current transaction-based approach, to splitting income across jurisdictions.

Again, it’s not clear what formulas you would think “should be used” in determining a profit split using that sort of methodology. It depends on whether you think the location of the people doing the work, the location of the people that are consuming the goods, the location of the capital, or the location of the firm is more important. “Should” is not necessarily an operative term here.

In some sense, there has to be some agreement about the type of process and outcome that is desired.

So your view is that determining specifically where value added occurs is difficult?

Well, if you want to think about it in a metaphysical way, it’s quite difficult. But if you want to think about this in more practical and operative terms—which I think is what all of us, not just the IMF, in this exercise are trying to do—there are certainly ways of doing so. You have the notion that there’s income and taxes should be paid on it. The crux of the problem now is the extent to which the system allows legal behavior to take place that minimizes that tax base, given a certain amount of activity, in a way that wasn’t originally intended to happen. What has happened is that the developed countries think there should be a certain amount of tax coming out of the corporate tax base and that tax appears to be less than the system would have anticipated. So I think that’s really the issue.

For developing countries, the argument is that it seems clear that profits are being booked elsewhere or “stripped out.” It’s probably the case that they’re being stripped from developing countries simply in order to be minimized, as an overall proposition, rather than being moved intentionally from, say, a sub-Saharan African country to, say, the United States. It’s more likely that the taxable profit base is artificially vanishing somewhere in the process. And for developing countries, that’s really a problem, because they really need the revenue.

Has profit shifting increased over time?

That’s one of the things that the OECD’s BEPS project is trying to assess. “Action 11” is an attempt to measure profit shifting and base erosion. I don’t think there are any particularly good answers to that coming out of that process yet, but it’s still ongoing. Our paper last summer, as well as a recent working paper—used panel data and macroeconomic, national income account flows between countries to try to look at potential minimization in tax payments and the effects on tax bases.

In the data, we do see that actions of one country can have quite an impact on the overall tax base of other countries through tax competition. I think it’s important to say that all of these things in a sense boil down to tax competition.

And as long as you have different jurisdictions competing for activity and tax revenues, then there will be different kinds of tax competition going on.

What advice does the IMF give developing countries in responding to tax competition?

Tax competition is certainly a very important focus. The IMF has always urged that developing countries assess very carefully what benefits they’re deriving versus the costs of giving these tax incentives.

We try to help countries learn or develop the capacity to measure the tax costs of the incentives. But the harder side and one of the things we’re looking at in the upcoming paper is to try to establish a better framework and better tools to measure what the benefits are.

Benefits are frequently measured in terms of static measures, for example, number of jobs created. But even that’s hard to do and not necessarily even fully dispositive. In most cases, we’ve emphasized the need for revenue in order to make investments in education and help build human capital infrastructure in countries.

So, for every dollar given up through a competitive tax incentive there really needs to be a careful assessment as to whether the benefits that are being derived are greater than the benefits that the government could develop by investing that money in its people.

When we give technical advice to countries, we look at a fairly detailed level at what sectors of the economy are paying tax and how much tax is coming from each sector, in order to understand the dynamics of the tax system.

In very low-capacity countries, our revenue administration colleagues do spend quite a lot of effort helping countries set up functions, such as targeted audits, so that they’ll be able to spend their time productively looking at areas where there might be things going on that could be combated if they were seen. That doesn’t necessarily mean illegal activity, by any means, but it may mean ambiguous activity.

The question is: Can the countries in which multinationals are investing do a better job of checking to make sure that transactions are being accurately and coherently categorized by the countries’ officials as well as by the company itself?

Does profit shifting disproportionately affect developing countries?

I think what’s safe to say is that for many developing countries the problem of loss of revenue from profit shifting is now a relatively much larger problem for them than it is for some developed countries, like the United States.

In terms of absolute numbers, of course, it’s not close because developing economies are mainly so much smaller. But relatively speaking and relative to the taxes they can raise, it’s a very big problem.

Which type of developing countries are most affected by profit shifting?

They are all affected, but developing countries in which there’s a lot of foreign direct investment particularly so. And one area of particular importance is therefore developing countries that have substantial natural resources. Those countries can also be subject to tax competition. The minerals are under the ground in that country so you would think that it wasn’t terribly competitive. But at the same time, a multinational company has only a certain amount of capital to invest, and it can invest it either there or in a mine somewhere else. So, there’s tax competition there as well.

What are some key implications of profit shifting for developing countries?

The key implication is that developing countries lose domestic revenue from a revenue source that, on a relative basis, is more important for them than for developed countries. Profit shifting disproportionately affects domestic revenue mobilization, which is rightly a huge focus of the financing for development work that’s going in the Sustainable Development Goals project of the United Nations, following up on the Millennium Development Goals. Financing for development is a crucial aspect of that. And domestic revenue mobilization is a crucial element of financing for development.

Different techniques may be used for shifting profits out of developing countries than are used in some of the highly complex economies and legal systems, like the G20, or the G7, certainly. Because developing countries tend to be source countries and have in some sense simpler economies and generally lower-capacity tax administrations, there are different ways of minimizing the tax base in those countries than may be prevalent in the more advanced economies. And so our advice with respect to those developing countries might be somewhat different from the advice one would need to give to the very highly developed economies.

Hybrid instruments, which are a big focus of the BEPS project, for example, may be less of an issue for developing countries, whereas bilateral tax treaty issues are very salient for developing countries.

Is there enough information right now to make informed policy prescriptions and recommendations? Or is anything missing that’s significant for our understanding of profit shifting?

More data is always good. The problem with some of these issues is that they can only be understood at an extremely micro-level in terms of the behavior that’s going on. So it’s sometimes hard to get that micro-level understanding, especially in developing countries.

We did get a start on some of this in the paper from last summer and in our recent working paper.

But I do think the world needs to work much harder on understanding exactly what is going on with these behaviors.

So would you say that access to better data could potentially change the IMF’s current recommendations?

As Keynes said, when criticized for inconsistency, “When I get new information, I change my mind. What do you do?”

So, of course, I would never say that if we got different data we wouldn’t change our minds. However, at the moment, I don’t see any specific area that I could say that about.

Using the incentives and tax competition area as an example, I don’t think the framework—what I noted earlier about assessing the cost and benefits of tax incentives—would be likely to change. But it would be much easier to assess those costs and benefits if we had better data—and better models.

We’re continuously working on this with countries, so–yes, understanding the cost and benefits of tax competition would be easier with more specific data.

What are possible solutions to address profit shifting?

Proposed solutions range from some of the fairly narrow approaches that the BEPS project is taking, and I don’t mean that as a criticism, to approaches that require an overhaul of the whole system. I think what the BEPS project is doing is actually quite remarkable. Nobody would have thought four or five years ago that the OECD countries would be able to take such a project as far as they have. So I don’t mean to undermine that in any way. But nonetheless, as the projects itself says, this is all within the existing framework, trying to fix bits of the existing framework. Nobody thought that was possible, and I think progress is really being made in that regard.

But proposed solutions go from that narrower end all the way up to: ”Let’s just throw out the whole transactional system and go to something like formula apportionment.” And at the end of our paper, we tried to outline alternatives for reform that have been highlighted in the discourse.

There are other potential solutions, such as shifting from a residence-based corporate tax to a destination-based corporate tax, and putting everybody on a territorial system. The United States, for example, is still trying to be on a worldwide system. And there certainly are also intermediate approaches to change the nature of profit shifting.

So there’s a whole broad range of proposed solutions, ranging from the quite narrow but nonetheless admirable and perhaps feasible, to very broad sweeping changes to the underlying system.

And—as I said earlier—one of the reasons that the underlying system should be changed is that the architecture was designed in and for a world that didn’t look anything like the current world. It was a world in which major countries traded much less than they do now, they traded with each other, and they traded in tangible property.

So there is a broad range of possible solutions, but what’s feasible as a matter of international agreement is different from what’s theoretically possible.

And which of those possible solutions do you see as the most important and viable to address profit shifting from the perspective of developing countries?

Each of them would have different effects, some of which we don’t even know. In our paper, we did try to take a first quick look, using data for U.S. multinationals only, at what the impact would be if certain kinds of formulary apportionment were applied to the tax base, instead of using the current transaction-based system.

It’s not necessarily clear, by any means, that such a solution would benefit developing countries more than the status quo in terms of measuring their piece of the pie. It would depend upon what the formula was.

If you were to start from scratch—but we are not, though, and that of course is the problem—how you would design a system that was specifically intended to benefit developing countries is an interesting question. But of course, you have to think about the world as a whole if you’re going to design a system from scratch.

In finding a solution that works for developing countries, too, is multilateral cooperation a key component?

Yes, in lots of ways. I think a global tax system obviously is better with multilateral cooperation. That’s especially true in the tax competition and tax incentive area. But it’s true in many of these other areas as well. Multilateral cooperation would, I’m sure, be ideal.

Since a higher degree of multilateral cooperation in international taxation is not in place currently—in the meantime, are unilateral actions from developing countries inevitable in order to protect their tax bases?

It depends on what you mean. There’s such a range of possible actions. That question could cover simply imposing a five percent withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. tax on service fees paid to headquarters, for example. That would be a unilateral action if it wasn’t already present in their law. And that would be a measure that would raise some money. But then there are much more radical unilateral actions that countries could take. Some would say that fairly major emerging countries have changed their approach to transfer pricing issues. That’s relatively unilateral.

Countries can unilaterally say they’re never going to give any tax incentives again and not compete with their neighbors. But if other countries continue to play the game, countries that are not engaged in offering tax incentives probably do lose out.

So, this is a very tricky area.

What do you want to see happening in the next 1-3 years in terms of addressing profit shifting for developing countries?

I think that one of the areas that developing countries should probably be quite careful about is entering into new bilateral tax treaties.

Countries need to assess rather carefully whether a treaty is actually about real trade. Is it really with a country that you sell things to or buy things from? Or is it going to be used as a way of shifting profits?

Countries already have an existing network of treaties. And in fact, enormous numbers of treaties have been signed by developing countries over the last 20 to 25 years.

And so that’s an area where one might advise caution going forward. That’s not to say that you can change the past, but treaties are still being negotiated and signed. So that’s an area where it’s key for a country to assess what the potential outcomes are from the actions that it takes. Whether that’s giving tax incentives or signing tax treaties, it’s just very important to analyze in advance what the potential outcomes may be.

And that’s one of the things we try to help countries do: Think about what this is going to mean for them two steps down the road.

We have a fairly large number of people working with countries on confidential technical assistance related to their fiscal regimes for natural resources, which is largely designed around trying to think about what’s going to happen five years from now if, for example, the price changes, or the oil field turns out to be better or worse than expected. The fiscal design that a country implements needs to consider these and related aspects.

What is the difference between multilateral cooperation in taxation and multilateral cooperation in trade? Why should taxation be more difficult?

I think there’s probably more underlying agreement in the world of economics on the benefits of trade. There are political and other problems, but there’s pretty much underlying agreement in the theory of the value of free trade or relatively free trade. There’s not really underlying economic agreement on what it means to say income should be taxed in country x or y.

So it’s harder to develop a multilateral consensus around the concept because the concept is much less well-defined in the world of international taxation than it is in trade.

With the global economy becoming increasingly integrated, the digital economy growing in importance, and determining where value added occurs on a geographic perhaps increasing in difficulty, what is the future of the corporate tax base?

That is the big question. The BEPS project and G20 focus on international corporate taxation stemmed from the realization that the corporate tax base was eroding, which raised the concern that there might not be a future for the corporate income tax.

I don’t think that necessarily has to be true. But there’s a reason why it’s sometimes easier to raise indirect taxes on consumption than it is to raise taxes on these very complicated international transactions.

Still I don’t think that the corporate income tax is on its way out. It’s probably too important for that.

It’s really people who earn income, so if you could tax all the income to the right people, you probably wouldn’t need a corporate income tax. But that’s just not the case. So it serves an extremely important function at capturing some of the return on capital, if you want to tax the return to capital.

Some people don’t want to tax the return to capital. But that’s a normative question about what you think about fairness versus efficiency. So I personally think there is a future for the corporate income tax.

The world very obviously has for the present decided that it doesn’t want the corporate income tax to just wither away. And that’s what’s causing all of this action right now.

In addition to “Spillovers in International Corporate Taxation,” what are some of your own favorite papers or resources related to profit shifting?

It isn’t really about profit shifting, per se, but readers could benefit, if they’re interested at all in formulary apportionment, from Michael Durst’s series of articles on Bloomberg BNA.

Dan Shaviro from NYU Law School has written some very clear explanations of aspects of international taxation that are at issue now.

And if you want to really delve into the technicalities, there was a very good, major, article on the Luxembourg Leaks in the Guardian.

The IMF, in May, also released a working paper aiming to assess the magnitude and revenue implications of base erosion and profit shifting with respect to developing countries.

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