Are We Heading Towards a Corporate Tax System Fit for the 21st Century? by SSRN
Centre for Business Taxation, Oxford University; CESifo (Center for Economic Studies and Ifo Institute); Institute for Fiscal Studies (IFS); Centre for Economic Policy Research (CEPR); University of Oxford – Said Business School; University of Oxford – Said Business School
Oxford University Centre for Business Taxation; University of Oxford – Faculty of Law
November 20, 2014
The most significant problems with the existing system for taxing the profit of multinational companies stem from two related sources. First, the underlying “1920s compromise” for allocating the rights to tax profit between countries is both inappropriate and increasingly hard to implement in a modern economic setting. Second, because the system is based on taxing mobile activities, it invites countries to compete with each other to attract economic activity and to favour “domestic” companies. The OECD Base Erosion and Profit Shifting (BEPS) initiative essentially seeks to close loopholes rather than to re-examine these fundamental problems. As a consequence, it is unlikely to generate a stable long-run tax system. We critically examine the principle guiding the OECD’s reform proposals in its BEPS initiative and outline some more fundamental alternative reforms.
Are We Heading Towards A Corporate Tax System Fit For The 21st Century? – Introduction
The international system for taxing the profit of multinational companies is beset by criticism. The immediate problem is the perception of governments, commentators, the media and the general public that multinational companies are able to arrange their affairs to take advantage of deficiencies in the tax system to reduce their aggregate tax liabilities. This is on top of long-standing criticisms, which cut in the opposite direction, that the tax is particularly distorting to economic activity, affecting investment, financial and location decisions, and economic growth.
This paper spells out some of the most significant problems with the existing system. These stem from two related sources. First, the underlying framework of the system is based on an inadequate compromise in allocating the rights to tax profit between countries; and the system has become more complex and less suited to collecting an appropriate amount of tax as steps have been taking to shore up the compromise. Second, the system is subject to being undermined since the interests of national governments conflict with the basic tenets of the system.
When commercial activity moves beyond a purely domestic setting, many countries can potentially claim jurisdiction to tax the income. In principle this could lead to multiple taxation of income. The first problem stems from how the international tax system seeks to address this potential multiple taxation, which it does by essentially agreeing to allocate primary taxing rights between “residence” and “source” countries. Very broadly, the residence country is where a person who has the right to receive the profits of the activity resides while the source country is where the economic activity takes place; we discuss these terms in more detail below. And broadly again, in a “1920s compromise” in the League of Nations, source countries were allocated primary taxing rights over the active income of the business, and residence countries the primary taxing rights over passive income, such as dividends, royalties and interest.
Today this compromise is reflected in the OECD Model Treaty on which the great majority of bilateral double tax treaties are based. Article 7 of the Model Treaty allocates the right to tax business profits to the country of source if the “permanent establishment” threshold is met; whilst articles 10, 11 and 12 allocate the right to tax dividends, interest and royalties to the recipient’s country of residence, subject to the source country’s circumscribed right to impose a withholding tax on dividends and interest.
Theoretical and practical arguments have been articulated in favour of this allocation of taxing rights. For example, it has been argued that the ability to pay principle justifies taxation in the country of residence and the benefits principle justifies taxation in the country of source. However, these arguments do not stand up to much scrutiny. The ability to pay principle might reasonably apply to individuals resident in a country who should make an appropriate contribution to the public purse. But to apply such a principle to a tax on corporate profit it is necessary to look through the corporate form to see which individuals ultimately bear the tax. Since a tax on corporate profit may at least partially fall on the company’s shareholders, then in an open economy with international portfolio investment, the individuals who ultimately bear a tax on a resident company may be non-residents. So a tax on the profit of a company resident in country R will not necessarily fall on individuals resident in R, and hence cannot be justified by applying the ability to pay principle to those individuals in R. It might also be argued that businesses that benefit from public goods and services in the place in which they operate should make a contribution; but it is less clear why that contribution should be based on their profit.8 In fact, the allocation of taxing rights at the heart of the international tax system is best viewed as an arbitrary compromise, albeit one which has come to be accepted by large parts of the international community.
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