World leaders meeting at the G20 in Brisbane on 15-16 November 2014 are expected to approve initial steps toward reform of the global tax system. A tranche of proposals put forward by the Organisation for Economic Cooperation and Development (OECD) aims to ensure that multinational companies should no longer be able to reduce their tax bills by shifting profits to low-tax jurisdictions. A major step in this direction is a template for multinationals to report their economic activities and profits on a country-by-country basis. Mandatory disclosure will also include information to tax authorities about internal financial activities, including details of transfers within corporate groups - also known as transfer pricing.
The current world tax framework consists of about 3,000 treaties that have evolved over decades, based on a model drawn up in 1928. Multinationals are able to exploit this legal patchwork by identifying loopholes (or mismatches) between any two countries, enabling them to game the system. Transferring profits to a subsidiary in a low-tax or no-tax location has become a key technique, giving multinationals competitive advantages over national firms.
At the same time, economic activity in the digital economy is becoming increasingly intangible, as technology replaces the distribution of physical products with online services. This trend further extends firms’ abilities to make profits in countries without themselves having a significant physical presence, and to restructure corporate groups in ways that allow for profit shifting to jurisdictions where they will be lightly taxed. The OECD will continue to address this big agenda, and plans to submit further reports to the G20 in 2015 on tax-treaty reform and special issues relating to the digital economy.
Meanwhile, in the aftermath of the global financial crisis, governments are competing hard for inward investment and new jobs. Many countries are trying to entice investors with special tax advantages, or by offering low-tax deals to stave off relocation threats. These harmful tax practices cost significant sums in lost revenue, while simultaneously creating a global race to the bottom in corporate taxation. The UK’s "patent box" - a tax incentive for companies such as large pharmaceuticals to relocate ownership of their patents to Britain, by giving them a low tax rate on income attributable to a patent - costs taxpayers an estimated £1.1 billion a year. A dozen European states now have such provisions, and Ireland and Switzerland have said they will follow. Yet opposition from Luxembourg, the Netherlands, Spain and the UK has blocked a proposal which would limit such tax breaks.
The OECD’s reforms, taken together, represent a historic and welcome step in the right direction. But they amount to running repairs at a time when the system requires a fundamental overhaul. Current proposals are further weakened by the domination of rich countries, at the expense of the world’s poor. Developing countries need a much greater say, and country-by-country reporting must eventually be made public.
Over the long term, true progress towards fair taxation depends on scrapping the treatment of national entities within each corporate group as if they were independent of each other, whereas in reality they operate as an integrated whole under central direction. The G20 asked for reforms that would ensure that multinationals would be taxed “where economic activities take place and value is created”. This requires a new principle that recognises multinationals as unitary firms, and apportions their tax base according to their presence in each country.
The G20’s decision to reform international tax rules was essentially a political move, following public outrage at the scale of multinational tax avoidance. Yet this has now become a highly technical process that makes it hard for the public to follow. Will these measures represent the first step in a longer journey towards a more coherent international tax system, or a patch-up job that will allow the world’s richest countries to proclaim support for reform, while they continue to pursue harmful tax practices like patent boxes? In any event, the fundamental challenges will remain after Brisbane: aligning taxation with economic activity and value creation, and restoring public confidence in fair taxation.