Since the 2008 global financial crisis, governments have had renewed vigor to increase tax compliance as well as look for new taxation possibilities. The focus on expanding the tax base is nothing new, but tax officials since the crisis, in developed and then later developing countries, began to suspect that many registered taxpayers were paying little or no tax. The main suspects have been groups of companies (and related parties), both domestic and multinational. Since then, we’ve been looking piecemeal at how to shine light on this murky part of the tax base. Nine years on, I think the only solution, especially for low-income, low capacity countries, is a four-pronged approach: Attack transfer mispricing, profit shifting vehicles, the damage caused by bad tax treaties, and the under use of exchange of information between countries.
estimating the size of the problem
Very little hard data is available to pinpoint exactly the size of the problem of profit shifting and revenue loss, but the headline numbers are significant:
- The $600 billion annual tax loss estimated by International Monetary Fund researchers Crivelli et al. (2015; 2016), which divides roughly into $400 billion of OECD losses and $200 billion elsewhere.
- The $100 billion annual tax losses that United Nations Conference on Trade and Development’s World Investment Report 2015 estimated for developing countries due only to conduit foreign direct investment through “tax havens.”
- The $100 billion to $240 billion globally that OECD researchers estimate.
- The $130 billion globally that the Tax Justice Network have estimated as annual losses due to avoidance by U.S. multinationals only.
A second approach has been to measure the “missing revenue,” i.e., the income tax gap generated by aggressive tax planning and profit shifting.
Experts agree on the problem, magnitude. but what about the solution? And are we missing something?
We have worked on shedding light on the issue for 10 years in the context of supporting implementation of detection tools, algorithms to capture where the problem is, how to make tax adjustments, etc. But is this enough? Specifically, we have helped countries in four key areas: (1) to introduce transfer pricing frameworks, (2) risk tools to detect transfer mispricing, (3) base erosion and profit shifting (BEPS) action items such as limitations on interest deductions (the single most effective vehicle for profit shifting) and rules to get tax passive income (capital gains, dividends, and royalties) earned by a resident company’s foreign branch, and (4) helped countries to improve tax transparency and exchange of information globally for tax purposes. All of these activities have resulted in revenue gains.
These areas are all important, but given the estimated revenue losses, we might be missing something. First, we have only recently begun to work on the effects of double taxation treaties on a country’s tax policy and on its revenue generating power. The new interest on treaties has been sparked by the OECD’s Multilateral Treaty Instrument, which covers the part of treaties that deals mainly with exchange of information, dispute resolution, and the definition of who is taxable in your country (known as “permanent establishment definitions”), but not the assignment of taxing rights.
The problem for developing countries (all net capital importing countries or countries that are net recipients of foreign direct investment) is that when they negotiated treaties, most of these countries believed they could spur investment by giving up taxing rights to the treaty partner (for example, some or all the rights to profit tax), giving up withholding tax rights, and giving up rights of taxing passive income such as dividends. There is scant analytical evidence that there is a correlation between foreign direct investment and the existence of tax treaties. Secondly, it turns out that most countries have no coherent “treaty policy” (the goal of treaties not individually but as a whole). Then there is the problem that treaties in many cases either contradict domestic law and/or cannot be applied.
Toward a solution
The solution is likely that we must tackle all four international tax areas at the same time: transfer pricing, BEPS, exchange of information, and resolving the treaty problem by designing a treaty policy consistent with tax policy and economic policy in general. All of these areas are related: You can’t fully understand a transfer pricing problem without getting information from other countries (exchange of information), BEPS issues also require exchange of information and are vehicles in some cases to transfer pricing. And treaties might negate all of the above or constrain policymakers to not implement good tax policy and administration.