Corporate taxation: Harmonized rules instead of uncoordinated national actions

SAFE Policy Lecture: A team of the International Monetary Fund discussed alternatives for reforms of the international corporate tax system

At a SAFE Policy Lecture on 10 May, Victoria Perry, Alexander Klemm, and Shafik Hebous from the Fiscal Affairs Department of the International Monetary Fund (IMF) presented reform ideas for the international corporate tax system in the House of Finance.

As they argued, the current system faces challenges such as profit shifting into low tax countries and tax competition between states. This is also not entirely resolved by the International Framework on Base Erosion and Profit Shifting (BEPS), an initiative of G20 and OECD countries, which Victoria Perry sees as a step into the right direction. “Quite a lot of progress has been made”, she said. According to her, the framework closed legal loopholes in multilateral corporate taxation. However, it could not fully resolve profit shifting practices. Further, unilateral actions like the US tax reform (GILTI) foster tax competition and may result in wasteful allocation.

According to the IMF experts, a global solution is much needed. However, they expect that such a global reform will be challenging to implement because of the various national interests and the complexity of the tax legislation. Furthermore, Alexander Klemm said that low-income countries are particularly affected by tax avoidance schemes. Finally, according to the IMF experts, digitization challenges the most fundamental norm of corporate taxation: physical presence. The principle “taxed where value is created” does not apply to business models of digital giants like Google or Facebook, and other highly digitalized businesses, as they do not rely on local presence. As a result, European governments have put forward the argument that the value of such businesses is to a large extent generated by users who share their private information. Existing digital taxes are complex and target a small group of prominent digital companies; this kind of ring-fencing certain digital activities is misplaced, Klemm argued, because digital services are heavily used in the traditional production economy, too. There is no consensus on how digital services should be treated under the existing regime; this is why the IMF experts advocate harmonized rules instead of uncoordinated national actions.

Alternative tax regimes

Perry, Klemm, and Hebous also talked about possible reforms of the international tax system. A topical discussed solution is minimum taxation, which guarantees that the profits of multinational enterprises are subject to some minimal level of taxation. On the one hand, a minimum tax on outbound investments would reduce profit shifting as multinationals would have a smaller incentive to retain profits in foreign subsidiaries, which pay no or low taxes abroad and the incentives to attract direct investments by tax undercutting by the source countries would be lower. On the other hand, minimum taxes on inbound investments address the tax base erosion. According to the IMF experts, especially low-income countries could benefit from such a tax. It would be compatible with the existing tax system and therefore is relatively easy to implement. However, minimum taxation could also increase distortions depending on implementation and would be suitable for unilateral actions though more powerful in case of multilateral implementation, said Klemm.

Shafik Hebous introduced three alternative approaches, which could, if implemented globally, address the problems of profit shifting and tax completion. The “destination-based cash-flow tax (DBCFT) can be regarded as a tax on economic rents and is robust to profit shifting. For example, a multinational enterprise exports at low transfer prices to foreign affiliates subject to low taxes. Under the current regime, these revenues are part of the tax base of the parent firm. This sort of mispricing does not longer reduce tax liabilities under DBCFT. The IMF estimates that the global level of tax revenues would remain roughly constant; however, the adoption would create winners and losers in the short term. While DBCFT would be beneficial for non-resource-rich low-income countries, export-oriented countries like Germany with a trade surplus are most likely to lose revenues under the new regime. However, Hebous emphasized that the regime is not consistent with rules of the World Trade Organization (WTO) and also violates double taxation agreements which would hinder the implementation.

A second alternative approach Hebous discussed is “Formula apportionment” (FA) that would eliminate profit shifting. The countries would first need to agree on a common tax base. Then, the taxable profit would be divided among countries according to a formula. Each taxing authority could apply its own tax rate to the allocated tax base. “It will be difficult to harmonize the tax bases across countries,” Hebous said. As the countries need to agree on the formula and tax base, it would also be a long process until implementation. Further, tax competition would not be removed as the countries have their own tax rates.

Finally, Hebous introduced a hybrid tax scheme of “Residual profit allocation” (RPA). It is based on the distinction between a “routine profit” reflecting an acceptable return on the economic activity and the “residual profit” which refers to the excess over what is considered a normal profit. While established conventions or corporate taxation are followed for routine profits, residual profit could be apportioned on a unitary basis. The implementation of this reform would be less difficult as it preserves elements of the current tax regime, Hebous said.