The patent box illustrates the challenges governments around the world face as they compete for foreign investment with their tax policies, while simultaneously playing the role of responsible global citizen.
In a broad sense, governments are transitioning to tax rate competition rather than tax base competition, and businesses are getting caught in the change.
The European Commission, for example, continues to try and breathe life into the notion of a Common Consolidated Corporate Tax Base that would apply a common definition to what is in and out of the tax base.
Governments are already competing on corporate tax rates: India, Italy, Luxembourg and the UK (among others) are all planning rate reductions this year, and the US may join them.
Of 52 countries surveyed recently by EY, only Peru is planning a corporate tax rate increase in 2017.
Much of the work of both the OECD and the European Commission aims not only to bring about consistency among tax systems but also to remove elements of competition that the consensus views as harmful.
“Countries have tried to forensically target the unfair methods of tax competition that lead to a shrinking tax base,” says Matthew Mealey, EY EMEIA International Tax Services Leader
“They are trying to distinguish between harmful tax competition and fair tax competition without impinging on national sovereignty to set tax policy.”
History of reform
The short history of this huge reform process starts with the global financial crisis.
Governments have tried to reduce tax “leakage,” tightening their tax laws and increasing their audit and enforcement scrutiny as revenue dwindled.
But instead of an orderly transition, businesses and governments trying to operate in this new environment are now experiencing uncertainty.
Most countries want to stop the various forms of tax base competition they often describe as harmful and unfair.
But sticking to their new path sometimes proves challenging, leaving their tax laws in conflict and taxpayers struggling to figure out how to comply.
Keeping up with the pace of reform is a major challenge for companies today, says Vaibhav Sanghvi, Tax Director for Asia-Pacific and Japan for the US software maker Symantec, who is based in Singapore. “You won’t find a single tax director who says they have all the resources they need.”
Sanghvi says changes to IT systems are often necessary to comply with the new regulations and reporting requirements, which is a complex process.
The long-term trend of digitalizing the tax collection process has helped governments collect revenue because their tax authorities now can maintain databases of information on taxpayers and their transactions, building profiles of them over time rather than relying on information disclosed in individual tax returns.
There’s also increased interest in tax from the media, nongovernmental organizations and the general public, and an expectation that the authorities will do something with the reams of data they are collecting.
Searching for a solution
The G20 first turned to the OECD for a solution in 2012.
The BEPS plan can be grouped into three categories:
- Tax laws of countries should be internationally coherent and should not leave any income inappropriately untaxed or double-taxed.
- Tax authorities should obtain insight into the global operations of taxpayers and be able to share relevant tax information with each other.
- Profit should be taxed where value is created.
Three of the actions relate to the area of transfer pricing and seek to make it harder to shift profits to low-tax jurisdictions, the type of activity that leads to base erosion.
The base erosion issue prompted the UK and other countries to change their patent boxes to make certain companies receive the tax incentive only when the research is done inside the country itself.
Beyond patent boxes, the OECD recommends that tax inspectors challenge the tax effectiveness of the transfer pricing arrangements that businesses declare in their returns, forcing them to justify why profits are booked in specific locations.
“The new guidance bases the transfer pricing analysis on the real deal, not the paper deal,” says Rotterdam-based Marlies de Ruiter, EY Global ITS Tax Policy Leader and former Head of the OECD’s Tax Treaty, Transfer Pricing and Financial Transactions Division.
Push and pull: challenges
Challenges to a smooth transition from a mix of base and rate competition to more focused rate competition are coming not just from countries but from different levels of government as well.
Taxpayers are familiar with the push and pull over tax laws when policymakers and tax administrators have different ideas of how a new tax rule should be implemented.
Highly negotiated incentives — sometimes characterized by very low tax rates for certain types of transactions — are one type of measure that will be under pressure going forward, says Chris Sanger, EY Global Head of Tax Policy, based in London.
The new tax environment is also increasing tension between governments and the international bodies that recommend global or regional standards.
The European Commission, for example, has contributed to this uncertainty, raising a new question in the process: should the new BEPS recommendations be used to tax old transactions?
Since 2013, the European Commission’s Directorate-General for Competition has reviewed more than 1,000 tax authority rulings for what they argue may be unfair tax benefits.
These State aid cases have yielded four final decisions and another three open formal investigations.
But the heavy financial impact — not to mention the reputation risk — outweighs that small volume.
“The European Commission is the epicenter of European Union pressure for tax reform,” says EY’s Mealey.
Opponents say the European Commission doesn’t have jurisdiction because the problem of base competition is a flaw in the globally accepted system of accounting rules and norms.
Oddly, the State aid cases have reinforced the basic message of the BEPS plan and compelled Member States to comply.
Rebalancing the scales
Uncertainty isn’t limited to the countries in the EU.
Developing countries have been fighting for years to secure more tax from multinational businesses.
Indeed, developing nations are more prone to tax losses than developed ones as a result of profit shifting, according to a 2014 International Monetary Fund (IMF) study titled Spillovers in International Corporate Taxation.
It found that overall losses for all countries are about 5% of corporate income tax revenue, but the figure jumps to 13% in non-OECD countries.
The IMF report advises countries to take a cautious approach when entering a bilateral tax treaty and pay close attention to potential risks because “a treaty with one country can become a treaty with the rest of the world.”
“In the modern world of tax planning, companies will route their investments through the country that has the treaty most favorable to them,” says Victoria Perry, the assistant director of the IMF’s Fiscal Affairs Department.
Developing countries are starting to demand revised treaties — or are canceling them altogether.
In 2011, Mongolia canceled its treaty with the Netherlands as it sought to collect tax from a mining company.
In Kenya, Tax Justice Network Africa has sued to nullify the country’s treaty with Mauritius, arguing it clashes with the constitution. (The treaty is based on the OECD model treaty.)
Another indicator of developing countries’ concerns is messaging by nongovernmental organizations and the G77, a coalition of developing countries, that there is a need for a stronger alternative to the OECD dialogue on tax.
Those forces advocate an upgrade of and additional resources for the tax work of the United Nations.
Perry says that rather than handing out tax incentives, governments should work on improving their tax administration and providing businesses with a smooth experience, featuring minimal bureaucratic hassles, rather than lowering the tax rate.
“Survey after survey of businesses show that all of that is more important than the tax rate,” Perry says.
And they should require companies to file tax returns even if tax holiday incentives are offered to obtain information regarding the business in their country, says Perry.
As countries seek more from their taxpayers, they could end up in conflict with each other over where a multinational organization’s profits arise and taxes should be paid.
Statistics show that the inventory of unsettled cross-border tax disputes — most commonly on the issue of transfer pricing — was already rising before the BEPS changes.
The backlog in OECD countries jumped 163% between 2006 and 2015, according to OECD data. (So-called mutual agreement procedure [MAP] cases involving two OECD members are double-counted.)
The BEPS plan was cognizant of this demand and aims to improve dispute resolution mechanisms.
One of the BEPS reforms is focused on making the MAP — the key process for companies to ask two countries to collaboratively discuss who levies what tax — more timely and efficient.
“Sometimes companies send letters to governments to invoke a MAP and don’t even get an answer,” says de Ruiter.
Other dispute resolution tools are becoming more popular, including advanced pricing agreements, in which businesses and governments negotiate what prices should be used for cross-border, intragroup transactions before tax returns are filed rather than argue about them after.
The reform process requires that all countries publish a basic profile of their relevant tax authorities, processes and contact details, which will be posted on the OECD website and assessed for effectiveness.
The organization of the information, including instruction on how to access MAP in a country-specific manner, will prove very useful, according to Douglas O’Donnell, Commissioner of the US Internal Revenue Service’s Large Business and International Division.
By 2019, controversy statistics will include inventory totals between specific countries, as long as there are at least five cases, according to O’Donnell.