Multinational corporations employ complex product supply chains and intra-industry trade of differentiated outputs and inputs across many countries. Also, statutory corporate income tax rates vary widely across the different countries. The combination of complex supply chains and variable tax rates provides opportunities for multinationals to reduce global tax paid by shifting profits from high tax rate countries to low tax rate countries. Strategies used by multinationals to reduce global company tax paid include: shifting global corporate debt expenses to the high tax rate country; and shifting overhead expenses for management and marketing, and for the development of intellectual property and other intangible investments, as higher input costs to the higher tax rate countries.
The operation of, and some of the pros and cons of, proposed reforms to reduce profit shifting are described and assessed. Options include: individual country administrative changes and global cooperation as proposed by the Organisation for Economic Co-operation and Development (OECD); a common corporate tax rate across countries; tax a measure of multinational global income, and then allocate shares to individual countries; and, replace the current source and income company tax base with a destination base cash flow tax.
Problems with Profit Shifting
In addition to the loss of potential tax revenue, and especially for countries with high corporate tax rates, profit shifting by multinationals results in efficiency and equity costs. Further, observed government responses over time work to aggravate these adverse effects in supporting a global race to the bottom.
An important tax distortion and efficiency cost of profit shifting by multinationals is that the unwarranted tax concession available to multinationals is not available to primarily domestic base and emerging companies. The artificial and non-justified tax concession advantage for multinationals becomes a barrier to entry for the domestic base and emerging companies. Efficiency costs include the loss of the benefits of competition, and lower incentives to, and rewards for, new entrants to innovate with new products and production processes.
Lower effective rates of income taxation on multinationals involved in profit shifting has adverse effects on the vertical and horizontal distribution of taxation. Capital income, including from dividends and capital gains received by shareholders, forms a higher share of incomes of the better off. Lower effective corporate tax rates provide a tax avoidance strategy for those on high incomes and marginal tax rates on other investment options, including unincorporated businesses, to shift their savings from these other higher taxed options to shares in multinationals.
In a dynamic or multi-period context, profit shifting by multinationals is one of the reasons for governments with relatively high corporate tax rates to reduce their rates over time. For example, for OECD countries, the average corporate tax rate has fallen from 32.5% in 2000 to 25.7% in 2008 and to 23.9% in 2018. Key reasons include: to improve the attraction of globally mobile savings funds to domestic investment; and, to reduce the reward for profit shifting. Unintended and undesirable side-effects of this race to the bottom in lower and lower corporate tax rates include further losses of revenue, adverse redistribution and equity effects, and larger efficiency costs.
Regulations to Reduce Profit Shifting
Many countries individually and in cooperation have adopted more rigorous measures of taxable corporate income to reduce profit shifting. For developed countries, much of the reform has been supported by the OECD Base Erosion and Profit Shifting (BEPS) project. BEPS has proposed limits on negative gearing, measures of and limits to transfer pricing, protocols for information collection and sharing, and facilitating dispute resolutions. An attraction of the regulation strategy is that it retains individual country autonomy over their corporate income tax system, including the corporate tax rate and of the interface of corporate tax with personal and other taxes on debt interest, dividends and capital gains taxes.
Undoubtedly, more effective and more tightly administered regulations reduce extreme forms of profit shifting by multinationals, but they face significant limitations. For example, limits on negative gearing, such as limits on debt to equity or debt interest to profit ratios, are somewhat arbitrary with the individual multinational company optimum ratio dependent on many factors, including industry and product mix and stage of product life cycle. The application of transfer pricing rules includes challenges in the allocation of overhead and joint product costs of development of intellectual property, management and marketing across the many differentiated products sold by multinationals in different countries and along different steps of the supply chain. Taxation, including profit shifting, is just one of the variables considered in the allocation of these joint product costs.
The added complexity of the regulation option comes with higher costs of both tax compliance and tax administration. Also, the development, application and administration of the rules invite expensive costs to society and multinationals of lobbying and rent seeking.
A Standard Global Corporate Tax Rate
If all or most countries adopted a common corporate tax rate, most but not all the incentives and rewards for profit shifting would be removed; an agreed global measure of taxable corporate income would be a desirable complement.
For many countries, the loss of autonomy over the taxation of all companies may be regarded as a significant downside, and more so the larger the difference between the agreed standard rate and the current government rate. Company tax is only one component of the tax wedge between the pre-tax return received by the company investor and the after-tax income received by the saver, with taxation of saver debt interest, dividends and capital gains included. Then, many countries could largely offset the first-round effects of a shift to a standard global corporate tax rate with compensating changes to the personal income taxation of dividends and capital gains for residents and of withholding taxes for non-residents.
Global Income Tax Base and Apportionment
An alternative global-focussed reform to reduce profit shifting by multinationals is to adopt a measure of each company’s global profit, and then apportion the global taxable sum to individual countries who then impose their chosen tax rate, perhaps the current rate. This option allows individual countries to choose a tax rate to reflect individual country different preferences for tax and expenditure as a share of GDP, and of company tax in the aggregate tax take.
A key and controversial challenge with the global company income tax option is the choice of criteria for allocating the global taxable sum across different countries. Suggested criteria include shares of company; sales quantity or value; employment or labour costs; and, a combination. While the chosen criteria will have minimal implications for decisions by multinationals on investment, production and profit allocation, the choice will change the distribution shares of revenue by country relative to the current outcome. For example, different countries are bound to have different shares of multinational global sales and employment.
Destination Base Cash Flow Tax
Two features of a destination base cash flow tax (DBCFT) replacement for the current source base corporate income tax base largely remove the opportunities for multinationals to shift profits around countries to reduce global tax paid. A destination or consumption base includes imports, including intermediate inputs for multinationals, in the tax base and stops transfer pricing. While debt interest is a tax deduction under the current income tax, it is not a deduction with the DBCFT.
Individual countries are free to choose different DBCFT rates. It is likely that a higher rate than the current rate will be required to collect the same revenue.
There are significant challenges to the introduction of a DBCFT, and to date no country has made the change. Neutrality of tax treatment of multinationals, other companies, and unincorporated business organisations would require extending the DBCFT to all business organisations. Further, the interaction of the cash flow and destination base for business investment income with the current income base tax system on capital income, including interest, dividends and capital gains, paid by savers who provide the investment funds would require resolution.
Conclusions
Profit shifting by multinationals is an important problem in terms of foregone tax revenue, and for efficiency and equity of the tax system. With the importance of overhead and joint product costs in company profits and the growing share of multinationals in company activities, the profit shifting problem is not about to disappear.
Different proposals to reduce profit shifting have different implications for practical and political feasibility, for individual country autonomy, and for effectiveness in reducing profit shifting. Each of the reform options considered has some advantages and disadvantages, and none is a silver bullet or an obvious choice.
Further reading
Freebairn, J 2019, ‘Multinational corporations and profit shifting: Problems and policy options’, Australian Tax Forum, vol. 34, no. 2, pp. 341-356.
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