Developing countries and corporate tax – ten ways forward

Our last main blog before Christmas concerns developing countries. We are proud to publish an article by Krishen Mehta, one of our Senior Advisers, entitled The OECD’s BEPS Process and Developing Countries – a way forward.  This blog summarises the article, which is about how developing countries can protect themselves from corporate tax abuses, even while they wait for the OECD, a club of rich countries, to try and design new tax rules that they hope might help protect them.

The OECD’s BEPS Process and Developing Countries – a Way Forward

By Krishen Mehta, December 20, 2014

The OECD’s flagship Base Erosion and Profit Shifting (BEPS) project launched last year to tackle multinational tax avoidance holds much promise. But implementing it comprehensively will take time, and BEPS is being resisted not only by some multinationals but also, subtly, by some OECD member states which are tax havens themselves. Its eventual outcome and impact is therefore uncertain.

Developing countries may have more to lose from multinational corporate tax avoidance than rich countries do. They tend to depend more heavily on corporate tax revenues since the alternatives – such as raising tax from large numbers of very poor citizens – are harder. Poorly resourced and inexperienced tax administrations struggle to challenge abusive and complex transfer pricing arrangements, which involve manipulating the price of cross-border transactions between different affiliates within the same multinational corporate structure.

The OECD has consulted developing countries on BEPS but it is still unclear how much they will benefit. The OECD represents rich countries, and its member states will face constant pressure from their large corporations to maintain the status quo, or concede only modest adjustments to how tax liabilities are shared out between “residence” countries (where multinationals are resident, usually rich countries) and “source” countries (where many multinational corporations’ profits are sourced, often developing countries). Developing countries want to participate in BEPS but are also acutely aware that this club of rich countries may seek to protect its own members’ interests first.

I would argue that without impeding or running counter to BEPS in any way, developing countries can do a lot to protect their interests right now. Here are ten useful avenues to consider.

First, they can enforce general anti-avoidance rules, to prevent transactions that do not have any commercial substance beyond the underlying tax benefits.

Second, they can audit service fees and royalty payments that multinationals make ?to related parties. Inflating such cross-border payments is a common ruse to strip taxable profits out of developing countries. China, for example, is carrying out selective audits for the years 2004-2013, paying particular attention to related parties in tax havens.

A third possible approach ensures that domestic law and tax treaties follow the “source rule” for royalties and other payments. For example, where a multinational charges royalties for intellectual property to a subsidiary in a developing country, thus shifting taxable profits out of that country, the developing country can treat these royalty payments as the multinational’s foreign-source income, and apply withholding taxes.

Fourth, countries can strengthen their resources on advance pricing agreements (APAs), and expedite and sign more of these agreements. APAs agree on an appropriate transfer pricing mechanism to be followed over a fixed period of time, giving more certainty to multinationals and to tax authorities on future tax payments. (India has just signed its first bilateral APA, with Japan.)

Safe harbours, which put caps on allowable tax deductions, can be a fifth defence. For example, many countries have introduced safe harbours in the IT sector, set at cost plus 25 percent. The tax authority gains when the profit margin is less than 25 percent; the company gains when it rises higher. Much nonsense is avoided.

A sixth approach involves the profit split method, which adds up the profit from a group of transactions for all related parties, then divides these profits among those related parties according to certain proxy measures of genuine economic activity such as sales and assets employed by each party.

Number seven is obvious: insist on sound transfer pricing documentation, thus putting further pressure on multinationals to curb tax avoidance behaviour. ?

Eighth, also obviously, invest in better training for tax administrators and share best practices with other developing countries. We can learn from each other, and we should.

A ninth, important approach involves evaluating the informal economy to ensure that domestic corporations are not evading tax through trade mispricing, fraudulent reinvoicing and ‘round-tripping’ domestic capital out to a tax haven, then back home disguised as tax-preferred foreign investment.

Tenth, start implementing policies consistent with the spirit and intent of BEPS through both legislative and enforcement activity, without waiting for the final recommendations to be agreed. Countries including France and Mexico are already doing this.

The tide is shifting demonstrably towards greater tax justice, and the Luxembourg leaks will provide important further political momentum. Developing countries can support BEPS, but they should simultaneously make back-up plans to strengthen their own tax base for development, even while following internationally accepted practices.

Let us be smart about our tax policies and not wait for others to frame them for us.

Read the full article here.

Krishen Mehta is a former partner with a Big Four accounting firm, and a Senior Adviser to the Tax Justice Network. The views expressed here are his own.