Rethinking International Tax Law, Lecture 1

I recently started the Rethinking International Tax Law MOOC on Coursera, offered by Universiteit Leiden. This post is the first of what should be a series containing my notes on the weekly content covered by the course.

Course Structure

Week 1: Building a base case from real tax structures

Week 2-5: Analysis of the base case’s building blocks.

• Week 2: Design of Corporate Tax Law systems
• Week 3: Principles of international taxation & tax treaties
• Week 4: Transfer pricing
• Week 5: European Union law and Fiscal State Aid

Week 6: Ethical issues of international tax planning.

Evaluation

Weekly quizzes.

Weeks 1, 3, and 5 have peer-reviewed assignments.

Week 6 will have a forum debate.

Module 1: Introduction

The debate in international tax law has largely focused on the tax-paying morality of multinationals. Are corporations contributing their fair share of taxes to the countries in which they are doing business? By not paying taxes, or paying little taxes, do multinationals damage countries’ economies? Is the problem worse if multinationals do not pay any or little taxes when doing business in third world countries?

OECD takes a prominent place in international tax law discussions because of its know-how on tax treaties, continuing the work on double taxation started by the League of Nations in order to replace the bilateral treaties that predominated up until then. The Organization’s Model Tax Convention, and its Commentary, has been used as a reference for tax treaties worldwide, even when at least one of the parties is not a member.

The European Union also plays a role in the discussion, harmonizing the tax treatment between its member states. However, it still has not achieved many significant results, apart from a few directives on intercompany payments of dividends, interest, and royalties and the tax treatment of mergers.

Tax planning is not, by itself, illegal; in fact, the potential for tax planning exists within the legal framework of multinational corporatoin taxes since the foundations of the modern corporate law system were established in the 1920s. Some countries since them have sought, with varied degrees of success, to reduce the opportunities for tax planning, acting either alone or within organizations such as the OECD or the European Union.

Base Case Structure

During the next weeks, the course will analyse real-world tax structures in order to identify common elements between the corporate approaches.

The structure presented above for Amazon’s European activities was obtained from the European Commission’s investigation of a tax partnership between Amazon and the government of Luxembourg, briefly discussed on the references of this post. A rectangular box represents a legal entity, and lines between two entities represent that the company above (the parent company) holds an interest in the company below (the subsidiary). Triangles indicate partnerships between legal entities, which are not themselves entities and therefore are always represented by one or more of the partners. An oval form, not present above, indicates business activities not conducted in the form of a company or partnership.

Here, the US companies are the parners of Lux SCS, a Luxembourg partnership that owns the Amazon group’s intellectual property rights to operate Amazon’s European websites. It also controls Amazon EU Sarl, a Luxembourg company to which Lux SCS licenses the IP, receiving royalties in return.

Since the partnership is regarded as a fiscally transparent entity, it is not subject to Luxembourg corporate taxes. The US partners can defer the payment of US taxes until their profits are repatriated. So, there’s a case of double non-taxation.

The US partners have also sought confirmation from the Luxembourg tax authorities that the US partners do not have any other taxable presence in Luxembourg.

The royalty paid by Amazon EU Sarl to Lux SCS is deductible at the company level, and the amount of tax deductible royalty is determined through transfer pricing analysis, which can lead to issues, as pointed by Ault. (2013) There is no withholding tax on royalty payment.

Amazon EU Sarl provides intra-group loans to other companies. The interest payments on those loans are usually tax-deductible for the company paying the interest, and taxable at the level of interest recipients. The company, however, has loaned from Lux SCS, which could lead to the taxable receipts being partially offset by the tax-deductible payments.

The structure described above shows the four elements identified by OECD as the base case structure for the international tax structures of multinationals:

1. Minimization of taxation in the source country
2. Low or no withholding tax at source
3. Low or no taxation at the level of the recipient
4. No current taxation of the low tax profits at the level of the ultimate parent.

As discussed in the Resources section, this structure finds parallels in other multinationals, such as Apple and Starbucks, some of them investigated by the European Commission.

Introduction to BEPS

Base Erosion and Profit Shifting reduce countries’ tax bases and have several consequences that worry the OECD:

1. Fairness

• Diminish the money available for public services
• Corporate avoidance may impact tax compliance of individuals.

2. Distortion of Competition

• Multinationals end up paying less taxes than their national competitors

3. Distortion of Investment Decisions

• Companies may base their investment decisions on tax issues instead of genuine business considerations.

The momentum created by the recent financial crisis has given traction to the OECD’s work on addressing aggressive tax planning, with support from the G-20 countries. On July 19, 2013, the OECD released an action plan, identifying 15 action points to address BEPS. Their action plan aims to involve stakeholders, including coutries from outside the OECD and other stakeholders, to introduce changes to the current international tax law system in order to create a coherent, transparent and mutually beneficial order.

The final BEPS report proposes 15 action points that should be implemented swiftly by countries worldwide. That proposal, however, is not free from criticism: Michel P. Devereux and John Vella argue that the 1920’s compromise that originated the current international tax law system is not an adequate fit for the modern economy, and that the BEPS roadmap merely patches up the existing issues instead of proposing an approach fully adequate to the demands of the 21st Century.

Resources

EY Global Tax Alert Library

Glossary of Tax Terms

M. S. Corwin. Sense and Sensibility: The Policy and Politics of BEPS.

Base Erosion and Profit Shifting are discussed through two streams:

• Policy debate on the adequacy of international tax rules for protecting national taxation
• Public debate, focused on the moral issues

The policy conversation has produced many interesting insights, but action on them has been significantly impacted by the polarization in public debate, especially after the 2008 crisis. Initial popular impressions might run counter to what has been learned through the academic investigation, but still garner enough political traction to be put into practice.

However, one cannot simply disregard the public perceptions, especially since it gets some of the facts and, in a democratic regime, will inevitably result in change. Instead, the policy debate should harness that perception and ensure that laws and coordinated action are directed in ways that actually solve the problem and address the concerns of the stakeholders.

Hugh J. Ault. Some Reflections on the OECD and the Sources of International Tax Principles.

Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2013-03, pp. 1095-1201.

The international tax systems have their roots on work done in the 1920s under the League of Nations.

From that seminal work grew the structure of the tax principles that we know today: residence taxation, permanent establishments, reduced source taxation, credit and exemption methods for relief of still existing double taxation, and the like.

As the original report points out, the end goal was to establish a scheme where all incomes would be taxed exactly once, resultin in tributary fairness. Ault claims that most work since them has focused on double taxation, and the issue of double non-taxation has not received enough attention.

Double non-taxation appears in three forms:

• Tax evasion
• Tax avoidance
• Tax subsidies and “substantive” tax competition

OECD measures on the subject need to deal not only with the differences between European finance ministers across the political spectrum, but also with other G-20 countries, such as the USA and China, that have different perspectives on the theme.

Key pressure points:

• Hybrid Mismatch Arrangements and Tax Arbitrage: e.g., creating instruments that generate deductible payments in one jurisdiction but are treated as nontaxable receipts in the other jurisdiction.
• Digital Goods and Services: how can taxation cope with the digital economy?
• Intragroup Financial Transactions: generating interest deductions in a high-tax jurisdiction with corresponding receipts by a related party in a low-tax jurisdiction.
• Transfer pricing: prices for goods and services sold between related legal entities within an enterprise can be used for shifting income to avoid taxing, by setting prices that don’t reflect market conditions and risks. IP is also a relevant question here.
• Antiavoidance Measures: how to evaluate their effectiveness?
• Preferential Regimes: countries have preferential regimes to attract investment in certain activities, opening opportunities for tax planning.

A truly global framework goes beyond the actual scope of OECD, but its work on international taxation is widely recognized, and that legitimacy has benefited both from the organ’s expansion and the inclusion of nonmember countries into the OECD-led discussion of international tax. Still, any reform will face significant inertia among member states.

European Comission. State aid SA.38373 – Ireland. Alleged aid to Apple.

This decision concerns Irish tax rulings that validated advance pricing arrangements (APAs), a method of transfer price arrangement.

APAs are arrangements that determine, in advance of intra-group transactions, an appropriate set of criteria (e.g. method, comparables and appropriate adjustments thereto, critical assumptions as to future events) for the determination of the transfer pricing for those transactions over a fixed period of time.

The allegation here is that Apple used such arrangements to establish prices that, instead of reflecting market demands, are calculated to leverage the different tax regimes on each country.

By validating such arrangements, Ireland had, in fact, conceded an undue benefit to Apple, since the Article 107(1) TFEU states that any aid granted by an EU Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the provision of certain goods shall be incompatible with the common market, in so far as it affects trade between Member States.

Since the advantages do not fall into any of the exceptions built into article 107(2) and 107(3) of the TFEU, meant to grant social aid, promote projects of important European interest, remedy internal distortions or facilitate (within certain limits) the development of certain activities or areas, the European Commission found the Irish aid incompatible with the internal market. A similar case is SA.38944, which discusses APAs practised by Amazon and validated by Luxembourg.

The internationally agreed standard for setting such commercial conditions between companies of the same corporate group or a branch thereof and its mother company and thereby for the allocation of profit is the “arm’s length principle” as set in Article 9 of the OECD Model Tax Convention, according to which commercial and financial relations between associated enterprises should not differ from relations which would be made between independent companies.

Ilan Benshalon. Who Should Decide Whether the Apple is Rotten? Tax Disclosure and Corporate Political Agency

Discussions about public finance are not merely a technical matter, but involve political and moral issues. Therefore, the discussion about tax planning and corporate tax disclosure necessarily involves the idea of corporate social responsibility.

The author sustains that corporate actions should reflect the political preferences of their shareholders when taking business decisions with political implications, such as tax planning. In this specific case, the corporate political agency is especially relevant, as the corporate tax questions are, ultimately, political issues.

Corporate disclosure is defended by Benshalon as a means to allow shareholders to see how a corporation acts and pressure it into reflecting their political positions on the relevant issues. Disclosure should go beyond financial data and include information on the social and environmental impact of corporate activities, correcting “some of the negative political externalities associated with investors’ rational indifference”.

Since corporate activity plays a key role in public policy, disclosure should become an important way of exerting civic influence. By informing investors, corporate disclosure contributes to creating the well-informed citizenry that is crucial for democracy.

Brock and Russell. Abusive Tax Avoidance and Institutional Corruption: The Responsibilities of Tax Professionals

The authors claim that some tax-reduction schemes are not morally acceptable, as they “severely inhibit the ability of taxation institutions to collect revenue efficiently and equitably.” Since their case aims to disavow tax avoidance schemes that go agains the spirit of tax laws, the moral case itself relies a lot on the idea that there’s a moral duty to obey the law.

Brock and Russell, however, raise a more interesting argument when they point out the elitist character of tax avoidance: “a very high level of technical expertise is required to establish and manage an effective tax avoidance strategy, and that expertise does not come cheap.” Given the advantages that such big corporations receive from governments – both from favorable legal frameworks and from direct incentives –, tax avoidance structures may result in a de facto wealth transfer from the general population to corporations. (including shell companies created for super-rich.)

Tax Justice Network. Ten Reasons to Defend the Corporation Tax.

This document aims to establish an internationally valid case for corporate income tax across the world, claiming that such taxes can address political and economic inequalities. Corporate income taxes usually range between 20 and 35 percent, leading many corporations to seek tax havens where they can pay significantly less. Besides the use of tax havens, companies also benefit from loopholes, incentives and other legal possibilities for tax avoidance, leading to claims of corporate free-riding on public services.

The network’s claim of corporate tax as a defence of political and economic equality fails, however, to take into account the role of selective government action, instead of a blanket reduction of such taxes, in the creation of plutocratic models. It also goes from “rich people own most stocks” (a factual claim) to “the burden of corporate taxes falls mostly on the rich”, as if there were no offsets other than dividend reduction.

The paper seems to be mostly based on an antiquated First World labor perspective, generalizing American realities as if they were equally valid worldwide and embracing a demonizing view of capital not directly related to job creation.