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IMF stance tears up the TP rulebook

In a sign of the shifting global tax consensus, the International Monetary Fund has come out in favour of dropping the arm’s-length principle (ALP) but there is little sign of a clear solution for enterprise.

The IMF report on corporate tax has stirred the debate on how best to reform the international system. Multinational companies (MNEs) stand to lose out if tax policymakers take up the wrong solutions.

“There have long been doubts about the future of the arm’s-length principle,” one TP executive at a major European bank said. “Anyone working in transfer pricing for a large MNE could see how easy it was to get around the rules 20 years ago.”

“The authorities started to make it harder by raising impediments to this kind of thing, but it remains relatively straightforward to trap profits offshore,” the executive told TP Week.

The OECD set out to develop a policy framework for tackling base erosion and profit shifting precisely because of the economic problems it poses for many countries. The IMF’s endorsement of IMF may be a sign of a global shift.

The arm’s-length principle has been a fundamental part of how businesses operate for decades. For a long time, the OECD and the IMF assumed the ALP was unquestionable and it just needed tweaking to make it work better. Those days are over.

“The ALP seems to work fine for some transactions, but certainly not all,” IMF tax chief Ruud de Mooij told TP Week in an interview. “The way in which arm’s-length prices are set for, for example, intangible assets or risk is incomprehensible for an economist like me.”

“Many transfer pricing experts I speak to acknowledge that the fiction of the ALP is to a very large degree arbitrary and easy to manipulate,” he added. “These issues have only grown in importance recently.”

Alex Cobham, chief executive of the Tax Justice Network, suggested the IMF’s conclusion was long overdue. He even implied the fund has gone further than the OECD.

“The OECD has asked the question of whether it is time to go for radical reform – and now even the IMF has joined the call we’ve been making for decades,” Cobham said.

The IMF has been careful not to endorse any of the OECD’s proposals. The organisation is not a standard-setting body and its experts are supposed to inform the public debate, rather than dictate policy. It is also possible that its experts are divided over the report’s findings.

So, the fund framed the possible solutions in terms of a choice: Either create a minimum tax rate within the existing system or redesign the entire architecture of international tax. This is where the debate gets controversial.

The destination principle

One option on the table is the destination-based cash flow tax (DBCFT) that would apply to goods and services produced overseas but purchased domestically. The proposal has been compared to a form of import tariff and VAT.

The Republican Party once vaunted the DBCFT as the best way to reform the US corporate tax system. The party dropped the proposal as it rushed to finalise its tax bill, though the Trump tax cuts came with a border adjustment tax built into its provisions. The plan was to drop the worldwide tax system.

“Since the idea was briefly raised to prominence in Trump’s US tax reform debate, it has been savaged for reasons of practicality as well as the likely impact in exacerbating inequalities both within and between countries,” Cobham said.

However, the US has not moved away from a worldwide system to a strict territorial model like the rest of the world. In the past, this has pushed American businesses to find ever-more-creative ways to shift income out of the country.

“Historically, if you had an Irish subsidiary and you sold goods and services in other EU countries the profits would be booked in Ireland,” one tax director at a US software company told TP Week. “That’s just because the contracting and licensing went through the Irish subsidiary.”

This is how tech companies like Microsoft have managed to pay a rate of tax below the US headline rate. Yet the problem of location is much older than the digital tax debate. The high-tech sector just magnified an old problem in international tax.

Michael Devereux, director of Oxford University’s Centre for Business Taxation, came up with the proposal in 2002 to resolve the problem of location.

“The existing system affects real business decisions about where to locate operations and financial decisions about assets,” Devereux said. “The DBCFT would be neutral to those decisions. It would treat debt differently to equity.”

“It would also be neutral on location because it would tax profits wherever the customer is and the customer is immobile,” the professor added. “Consumers are not going to move just to save Procter & Gamble taxes.”

There are some issues with the interpretation of the proposal. Customers and users are not always the same, for instance, nor are they necessarily in the same place. It’s quite straightforward in the case of Netflix, where users are customers and the location is the same. It gets more complicated when it comes to Google adverts.

The user may be UK-based and click on an advert for a company based in Malaysia, while the search engine is technically located in Ireland. Devereux argues that the UK should have taxing rights because that’s where the sale is ultimately made. This could solve a lot of problems in tax, including the question of how to treat intangibles.

“Under the existing system, you can put your intangible assets in a tax haven and pay higher royalties to your jurisdiction from the tax haven,” Devereux said. “That just would not work under the DBCFT.”

“The DBCFT would treat such inputs in the same way,” he continued, adding, “So when it comes to paying royalties, where you situate your intangibles wouldn’t matter anymore.”

Every proposal has its critics and the DBCFT is no exception. Many tax reform campaigners argue the proposal would be regressive and it would grant the developed world an unfair advantage over developing countries. The IMF has disputed this claim.

“Analysis by some of my IMF colleagues finds that low-income countries will likely gain from a DBCFT compared to the current system,” de Mooij said. “This is for two reasons: first, they no longer lose revenue from profit shifting; and second, they consume out of development aid so that the destination base is broader than the origin base of tax.”

“Negative effects may arise, however, for resource-rich developing countries, but this can be resolved by maintaining primary taxing rights on natural resources in the location country.”

Of course, the IMF is never short of critics. The Tax Justice Network would favour its own version of unitary taxation and apportion the profits on the basis of employment and tangible assets, as well as sales. Unfortunately, the DBCFT does not go far enough for this NGO.

“It is odd though that the IMF seems cautious about including employment in the formula for taxation,” Cobham said. “That they even contemplate a [DBCFT] – which is a different way of allocating tax base on the basis of sales – suggests that they have not considered the development implications seriously.”

“We suggest the IMF think again,” he stressed.

Fear of change

Much like the OECD, the IMF has looked at the possibility of a global minimum tax rate and a shift to some new kind of apportionment. This solution is very popular among tax justice campaigners and think tanks, but even they disagree on the details of what form it should take.

“Formulary apportionment has several merits, but also raises several new challenges,” de Mooij said. “Under [a residual profit split] system, the income of a multinational company would be split into a ‘routine’ return on investment and a ‘residual’ return on investment.”

“The weights in the formula could be based on the destination of sales, which would have the merit of limiting tax competition and be closer to income attribution to countries where the users and consumers of digital services reside,” he explained.

There are good reasons why businesses fear the demise of the arm’s-length principle. A shift towards formulary apportionment could lead to double, if not triple or quadruple taxation. This would take a serious toll on any company’s profit margins.

“You could take Apple, a trillion-dollar company, and look at the number of customers they have in Germany, for example,” the tax director at a software company said. “That’s how you’d approach settling what the company owes in taxes.”

“The same principle would apply to Facebook,” they continued, adding, “you look at its reach in a particular jurisdiction and take into account its global profits.”

Cobham claimed this solution could raise tax revenues in developing countries by more than 30%. The problem for advocates of formulary apportionment is that it would require an international consensus and there is little sign of such unanimity.

“In theory it’s simple to allocate profits on a local basis, but if you don’t have a consensus on the rules you run the risk of double taxation,” one head of tax compliance at a UK-based bank said. “That’s why it would become a nightmare from a risk management perspective.”

Where MNEs operate locally through subsidiaries or permanent establishments, developing countries might be able to wage a tax claim on the income of such multinationals. But such MNEs working with local businesses on a contractual basis are unlikely to see their profits re-allocated to that jurisdiction.

Country-by-country reporting would, in theory, support such a dramatic shift in the international system. Tax authorities could use the combination of new reporting and TP standards to challenge multinationals booking profits in a place like Ireland or the Netherlands.

The BEPS project may have set out to resolve the problems in the global tax system, but it was really just the start of a much wider policy debate. This means traditional transfer pricing might find itself on the chopping block.

The full interview with IMF tax chief Ruud de Mooij can be read in full here.

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