OECD work on base erosion and profit shifting
In late November the OECD said it was doing work on the problem of base erosion and profit shifting. This initiative has been backed by Germany, Britain, France, Australia and now New Zealand. The United States is also concerned.
The OECD work is looking to evaluate some key international tax rules, many of which originated in principles developed by the League of Nations in the 1920s.
These rules (which have served us well for nearly 100 years) are based on the assumption that foreign companies will pay tax in their home jurisdiction.
To prevent double taxation the main objective of double-tax treaties is to reduce source taxation by allocating taxing rights to the country of residence or reducing source-based withholding tax.
New Zealand enters into such agreements to encourage investment in NZ but also to allow, on a reciprocal basis, New Zealanders to invest in other countries on more favourable terms. More favourable because it means Kiwis face less risk of double taxation.
These principles were designed to minimise double taxation, trade distortions and impediments to economic growth. The OECD is concerned that corporations exploit differences in domestic tax rules and international treaties to provide opportunities to eliminate or significantly reduce taxation.
Some other countries do not impose tax on their own resident multinationals where they locate subsidiaries outside the jurisdiction and do not repatriate profits.
The result is that some multinationals appear not be paying tax on their business income where they are headquartered, owned, or where the activities relating to their business actually take place.
This has led the OECD to conclude that many international tax concepts "were built on the assumption that one country would forego taxation because another country would be imposing tax. In the modern global economy, this assumption is not always correct, as planning opportunities may result in profits ending up untaxed anywhere".
Developments in New Zealand
Revenue Minister Peter Dunne, to his credit, has the issue clearly on his radar screen, commissioning a joint Treasury and Inland Revenue Officials' report which was released just before Christmas.
The New Zealand response is two-pronged. First, it hopes to participate in the work of the OECD in the base erosion and profit-shifting project referred to above. As a part of this international examination of the problem a continued close association with Australian Treasury and Revenue officials is contemplated leading to a report to the minister in March.
The second part of the response is to give priority to projects that protect source-based taxation (New Zealand taxation imposed on foreigners in respect of New Zealand-sourced income). An issues paper on reform to the New Zealand thin capitalisation regime, for example, is expected shortly. Thin capitalisation is a regime that limits the amount of interest expense that may be claimed as a deduction against New Zealand-sourced profits when the borrower is controlled by non-residents.
What reforms are necessary and possible?
The OECD may consider basic reforms relating to where profits are sourced. It may need to redefine the source of profits with the growth of electronic commerce.
This cannot be done in isolation by New Zealand alone as it would make New Zealand (a small market anyway) undesirable as a business destination through tax protectionism. We have to wait and see what OECD proposals are considered possible.
The NZ officials' report - correctly, in my view - highlights three key areas where progress or reform must be made to address the multinational tax problem.
*Ineffective controlled foreign company (CFC) rules
Controlled foreign companies are foreign firms controlled by residents of a state. These residents can be subject to tax on the earnings of the CFCs through the attribution of the CFCs' income to them.
This problem area is arguably broader than just CFC taxation and extends to be residency base of taxation. It is no accident that three companies referred to in the second column were American multinationals operating in Britain.
One of the features of US tax is that profits can remain untaxed in the hands of the American company's foreign subsidiaries until they are repatriated to the US parent. Multinationals become particularly aggressive with reducing source-based taxation when there is no residency taxation (or such taxation is deferred until repatriation which may not occur). The reason for this is obvious.
Double non-taxation (neither source nor residence) creates significant profitability and it has been this which has caused significant public outrage.
Most CFC rules round the world exempt active income and tax only passive income (income from interest, dividends, and royalties). It may be necessary in the future for countries to consider CFC rules which tax not only passive income but also ensure foreign-sourced active income is taxed at a reasonable rate (for example 75 per cent of the home countries' corporate tax rate). New Zealand could look for reform in this area but it is really other countries that are causing the problem.
*Eliminating tax arbitrage
Tax arbitrage occurs when two domestic tax systems look at different entities or financial instruments and classify them differently. New Zealand is already closely looking at this area, particularly regarding Australian/NZ hybrid instruments.
*Related party transactions
Multinationals have entered into certain types of transactions involving business restructuring and transfer pricing. They have become expert in shifting profits between their firms based in different countries. We saw examples of this in the second column. Intellectual property companies (based in the Netherlands and in Bermuda) derived significant profits from royalties paid from British firms.
Specialisation of functions (such as a coffee trading company) allowed trading profits to move from Britain (with coffee beans becoming more expensive because of the margin charged by the Swiss firm) to Switzerland. Other examples of related party restructuring include changing either primary business functions (such as manufacturing or distribution) or business support functions (such as management or accounting) so full profit manufacturers or distributors are converted into entities which undertake significantly less profitable business functions. A limited risk distributor, for example, performs only the sale functions, meaning products are supplied directly by the manufacturer (a related company) to the end customer.
The limited risk distributor may have no credit or inventory risk and few assets. It will therefore have much lower profits.
These techniques are discussed in an excellent paper "Multinational Business Restructuring and Transfer Pricing: Are Tax Authorities Trying to Hold Back the Tide" by my colleagues Julie Harrison, Christina Stringer, and Jasneet Singh, based here at the Business School.
They note the OECD has concluded it is difficult to attack related-party deals. This is provided the economic substance of the arrangements is consistent with its form, and the pricing of the restructure and any other arrangements after the restructure is on an arm's length basis.
New Zealand needs to carefully focus on these related-party transactions and consider tax reform in this area. Currently where the taxpayer has used an approved method to calculate an arm's length amount for a transaction the onus of proof in respect of disproving it is placed upon the Commissioner. The Commissioner has a similar evidential burden only in criminal proceedings.
Germany has adopted new rules which impose an "exit tax"on business restructures. These rules tax lost business opportunity and profit potential when functions are transferred to another jurisdiction. New Zealand, on the other hand, does not even impose capital gains tax on the sale of income-producing assets when these are transferred overseas. But that is another story.
A combination of work performed by international organisations such as the OECD, the International Fiscal Association, and close co-operation by revenue authorities will be necessary to prevent New Zealand's tax base being eroded. It will not be an easy task.
Craig Elliffe is professor of taxation law and policy at the University of Auckland Business School.
The series
Part one: How multinationals operate in NZ
Part two: Tax tactics by corporates
Today: How Governments can tackle tax minimisation
