Cash-strapped governments eye up international businesses generating revenue in their own jurisdictions and want a slice of the action. Yet, as these companies grow, competition between governments is becoming fierce as each tries to entice these businesses to domicile themselves within their economies. Meanwhile, cross-border business is at a real risk of suffering double taxation as tax authorities take unilateral action. Companies are going to need to be nimble to respond to these changes and not assume that they will go away any time soon. How will they respond?
“Globalization has totally transformed the world that tax legislation was originally designed to regulate,” says Piergiorgio Valente of Crowe Valente (Italy). “The death of distance in the digital economy has spawned global businesses that have, to all intents and purposes, outgrown and in some cases, even out-earn national territories. This creates real problems for national governments increasingly under pressure to collect taxes from a declining tax base.”
The Base Erosion and Profit Shifting (“BEPS”) project initiated by the Organisation for Economic Co-operation and Development (“OECD”) began in 2013, in response to concerns that countries were having their tax base eroded, with profits shifting to low tax jurisdictions. Original estimates suggest that somewhere between $240 billion and $660 billion of profits were shifted from higher tax to lower tax jurisdictions in 2012. The BEPS project was designed to protect the tax base of nations in a coordinated way with a coherent approach.
Amazingly for an international tax initiative, matters moved forward relatively quickly and five years later some of the proposals are starting to be implemented. In the U.K. for example, limits on corporate interest deductions have been introduced, country-by-country reporting is being implemented in the likes of the Netherlands and Germany and corporate tax departments are having to deal with administering master and local files to get their transfer pricing in order.
So What Went Wrong?
The BEPS project only fixes part of the problem. Five years is a long time in the tax world and the BEPS initiative deals with issues perceived to be a problem during the financial crisis, not the problems of the 2020s. Five years in the digital economy, meanwhile, represents a generational shift.
“The link between where income is earned and where it is taxed has increasingly broken down,” continues Piergiorgio Valente.
“Territories have historically gone out of their way to attract taxable income and thus improve their tax base. A key problem is that some countries have been far too successful in doing it, especially in some ’business friendly’ territories. Some companies have proven to be remarkably adept at managing their businesses to maximize the benefits. Tax competition between states—the U.K. could have a 17 percent tax rate by 2020 and be outside the restraining influence of the EU for instance, while the U.S. has just slashed its tax rate—is not just the preserve of smaller economies. Combined with ‘intangibles' being easily housed in tax havens, this means the traditional model of taxing profits where the assets are held and created is breaking down. It simply doesn't raise enough revenue.
A legacy of the financial difficulties of 2008 is that governments soon realized how over-dependent they were on just a few companies for the tax needed to fund their spending. The Taxpayers' Alliance in the U.K. estimated that, in 2013–2014, 0.6 percent of U.K. companies paid around 58 percent of U.K. corporation tax. That's around 6,400 companies. A shifting economy and a decline in profitability has a real impact on tax revenues.
To balance this, the U.K. tax system has a long-term trend of reducing tax rates for companies, presumably in the hope of attracting international business. Jobs are created and the ’shortfall’ is covered by taxing the income of employees at effective rates of up to 45 percent or 60 to 70 percent, on some marginal income, when the complexities of the U.K. benefits system are factored in.
This has been a long-term trend. In 2017 it was projected that around 10 percent of U.K. tax revenue will be paid by companies through corporation tax and business rates. The majority (around 60 percent) will come from income tax, national insurance (a tax by any other name) and value added tax—all essentially taxes borne by individuals.
Those individuals are now starting to question whether companies pay their fair share of tax, not just in the U.K., but also around the world.
The publication of the Panama Papers, the breaking of the link between where income is earned and where it is taxed and the rise of the Silicon Valley giants has overtaken the BEPS project. People don't understand why Facebook, Starbucks and Google don't pay more tax. They see and interact with them every day. In a time of growing populism, ironically driven by the platforms of these technology giants, governments wanting to get re-elected can't afford to wait for international consensus. And they've stopped waiting.
In February 2018, the U.K. Treasury announced its intention to consider taxing digital companies where they earn their income, rather than taxing profits. This is a major shift in U.K. thinking.
Politico has reported that leaked documents from the EU suggest the EU would like to tax digital companies on their gross revenues, based on where users are located and the advertising revenues generated. Combined with the work of the European Competition Commissioner on challenging “sweetheart” deals with Ireland, the EU is trying to seize the initiative on digital business. This is no doubt aided by the fact that its member states have yet to create a global digital business that can be targeted for retaliation.
Italy has approved a three percent levy on certain digital transactions, designed to level the playing field. This is due to concerns that digital companies have avoided taxes because they do not have a “stable presence” in the country, even though they generate huge revenues there. Elsewhere, Israel, Saudi Arabia, Taiwan and Turkey have also introduced the concept of virtual permanent establishments.
Never one to take a back seat, President Trump has signed the Tax Cuts and Jobs Act (TCJA) 2017, which, among other things, encourages the repatriation of funds to the U.S. and puts transactions with non-U.S. related parties at a disadvantage.
Jim Dawson of Crowe Horwath LLP in Atlanta argues:
“While these policies are clearly designed to appeal to an American electorate, they are likely to have the effect of forcing U.S. companies with international operations to review their structures. They will look to return funds to the U.S. and reconsider whether housing intellectual property in lower tax jurisdictions such as Ireland remains a sensible strategy. Every Dollar of income returned to the U.S. is potentially a Dollar not taxed overseas. This is the heart of the problem for international companies. They could end up being taxed twice—once on the profit in the U.S. and once on the income in Europe. At the moment there is no mechanism to credit one liability against the other.”
Taking this recipe above and throwing in the threat of a good old fashioned trade war—steel and EU car makers being the current center of attention—means that the tax system, like many traditional business models, is being rapidly disrupted. Companies can no longer assume that their operating and financing structures will remain efficient. Therefore they should:
By Laurence Field, Tax Partner at national audit, tax and advisory firm, Crowe Clark Whitehill, the U.K. member firm of Crowe Horwath International, eighth largest global professional services network, with more than 200 member firms operating across the globe.
He may be contacted at: firstname.lastname@example.org
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