A Tax on Aggressive Tax Planning

Tax planning by multinational enterprises (MNEs) is estimated to generate a worldwide loss of corporate tax revenues of between $100 billion and $240 billion. U.S.-based MNEs alone are believed to retain a total of $2 trillion in earnings outside the U.S., largely for tax reasons. Over the last few years, the Organization for Economic Cooperation and Development (OECD) has been trying to come to grips with the tax reduction strategies of MNEs. Its results, presented in the 2015 final reports of BEPS (Base Erosion and Profit Shifting) have disappointed many. That is understandable: Most of the proposals depend on further elaboration and on closer cooperation between states to be effective, while, evidently, many nations can improve their tax competitiveness by lagging in implementation. Yet, change is in the air.

The European Union (EU) quickly implemented many of the OECD proposals – to be sure, with modifications, phasing in, etc. The main reason for skepticism as to the real output of the BEPS project is that the architecture of the international tax system has remained intact. That architecture may have been adequate for the level of worldwide economic integration in the 1920s, when it was created. But now it is problematic to tax a multinational enterprise as if it consisted of many independent national entities. Yet, that is what we do. And because states have widely different effective tax rates and tax incentives, MNEs are allowed considerable room to reduce their tax payments worldwide.

Taking as a given that this so-called “separate entity” approach in international taxation will not give way to some system of worldwide taxation in the foreseeable future, the next-best approach may be to directly reduce the benefits of aggressive tax planning within the MNE. The OECD BEPS proposals are rather more cautious – they mostly aim at evident cases of aggressive use of tax rules. But aggressiveness is in the eye of the beholder, and nobody should want tax administrations worldwide to increasingly rely on circular definitions of tax avoidance. It would be much more transparent, both for tax administrations and for taxpayers, to use a quantitative criterion: When do we consider a tax burden to be too low?

A conditional withholding tax on intra-company flows of interest and royalties is a simple version of such a quantitative criterion. It has the potential to considerably reduce tax-driven income flows within MNEs. At a rate of, e.g., 15 percent, it would only be applied by state 1 on firm A1’s payment of interest or royalties to (connected) firm A2 in state 2, when firm A2 enjoys a low or zero tax burden on that income in state 2. Therefore, it directly cuts into MNEs’ benefits of tax planning. An alternative form is to apply the tax only when the recipient is a resident of a blacklisted tax haven. This approach, however, ignores the existence of preferential tax regimes in non-tax haven countries.

A mild – and ineffective – form of conditional withholding taxation is part of the revised 2015 U.S. Model Tax Convention. Another mild – and again ineffective – model was considered (but not adopted) in EU anti-tax avoidance legislation. In both cases, it seems, the analysis was that conditional withholding taxation directly tackles important channels for MNE international tax planning – but that it may interfere with national tax sovereignty. Yet, even inadequate starting points may develop into something more effective, as a conditional withholding tax has the potential for being self-enforcing. Jurisdictions faced with the reality that their low-tax offer is taxed away by states applying a withholding tax may as well choose to increase their effective tax rates.

There is a strong geopolitical aspect to international attempts to curb aggressive tax planning. Much of the money involved (dollar figures run into the trillions) consists of the worldwide earnings of U.S.-based MNEs that are channelled to tax haven jurisdictions through specific EU member states. Alternatively or consecutively, the money is used for real investment in developing countries, again often through EU jurisdictions. Jointly, (conduit) corporations resident in the Netherlands and in Luxembourg account for 40 percent of foreign direct investment stocks in G20 economies, and the Netherlands and Ireland together account for 15 percent of worldwide royalty receipts and 34 percent of worldwide royalty payments. Summing up, an important driver of MNE tax planning is the comparatively high U.S. corporate income tax rate, combined with a system of worldwide taxation that leaves ample leeway for postponing U.S. taxes as long as profits are not repatriated. The main facilitators of MNE tax planning are a limited number of EU member states. And then there is the suspicion that developing countries are among the main victims in terms of tax revenue foregone – a suspicion that is not easily quantified.

As the prospects for a reduction of the U.S. corporate tax rate seem to improve, there could be common ground for the U.S. and the EU to develop an effective “conditional withholding tax” rule to create a more stable international tax environment.

This post comes to us from professors Jan Vleggeert and Henk Vording at Leiden University in the Netherlands. It is based on their recent paper, “A Tax on Aggressive Tax Planning,” available here.