While individual persons have to live somewhere, and therefore in almost all cases have to be taxed somewhere (they are dealt with below), the same is not so true of corporations. A corporation with distributed ownership, with its holding company in a suitable jurisdiction (eg Denmark), and with a carefully formed international structure, can reduce its tax bill to single figures, or even to zero. Press reports abound of such – usually privately-controlled – companies which have miraculously, so it seems, managed to escape taxation.
Of course national tax authorities have fought back against aggressive corporate tax planning, by banning or penalizing the use of out-and-out tax havens, and by the use of transfer pricing rules (regulation which prevents a company from making its profits in a low-tax jurisdiction when the commercial activity took place in a high-tax jurisdiction).
In planning international corporate structures, there are two major sets of legislative measures which need to be taken into account in addition to transfer pricing rules as such: Double Tax Avoidance Agreements and Controlled Foreign Company (or Corporation) laws. DTAAs and CFC laws have come about for almost opposite reasons – DTAAs are the result of bi-lateral national attempts to create an investment-friendly tax canvas, while CFCs are aimed at preventing tax avoidance by international corporations – but both impact heavily on transnational taxation. In addition, both are intricately involved with 'offshore'.
DTAAs could be said to be the children of withholding taxes – once high-taxing countries realized that it was open to foreign owners of local income flows to expatriate them under various pretexts, they quickly began to impose taxes on outgoing income of various types, including interest, royalties, dividends, rents and fees, regardless of the destination of the income flows. But this practice penalized foreign investors, who often had no way of reclaiming the tax paid (usually in the 20-30% range) even though they were going to be taxed again on the income flow in their home countries. So the practice grew up of bi-lateral agreements (DTAAs) between countries which wanted to encourage trading and investment links, aimed at mitigating the effects of withholding taxes. Typically, a DTAA creates mechanisms for the reclaim, or at least the setting-off, of tax paid in one country by a resident (individual or corporate) of the other country, and the creation of preferential withholding tax rates, sometimes even zero, for certain types of income.
DTAAs have become the norm between high-taxing countries, but there are also a number of offshore (say, low-tax) jurisdictions, which have established a network of DTAAs, making them extremely useful as bases for holding companies. Cyprus is a prominent example: while it is no longer an 'offshore' jurisdiction as such, it has low taxes, and has very good DTAAs, particularly with the countries of the old USSR, making it an ideal base for investment into that region.
Some high-tax countries have tried to prevent over-use of low-tax intermediate holding company locations by re-negotiating DTAAs (eg India and Mauritius); but the more normal route is via CFC legislation.
At its simplest, a country's CFC law tries to impose tax on the profits of foreign subsidiaries of its domestic companies if those profits are being 'artificially' held away from the jurisdiction. Clearly, a UK company (for example) subject to 30% local taxation, which earns untaxed profits in, say, Labuan, where it has a holding company for its Korean manufacturing subsidiary, is not likely to repatriate those profits to the UK if it can avoid it. The UK's CFC law taxes those profits if they fall outside a number of permitted categories, which include 'reinvestment' broadly defined. Foreign profits which have been taxed at an 'acceptable' rate are seldom caught by CFC laws.
Currently, CFC rules apply in 14 OECD countries: Australia (since 1990), Canada (1976), Denmark (1995), Finland (1995), France (1980), Germany (1972), Italy (2002), New Zealand (1988), Norway (1992), Portugal (1995), Spain (1995), Sweden (1990), the UK (1984), and the US (1962).
In addition, Hungary has a very limited type of CFC, and legislation is proposed in Austria.
Corporate Taxation: A Brief Guide To Transfer Pricing
Once upon a time, it was easy: as (say) a Dutch widget manufacturer you set up a holding company in the Netherlands Antilles and a manufacturing subsidiary in Brazil. The widget factory in Brazil made its widgets at 1 Cruzeiro each and sold them to the holding company at 1.01 Cruzeiros. The holding company sold the widgets on to the Dutch parent at 9.5 Florins each, and the parent supplied its customers in Holland at 11 Florins each, with local sales costs of 1.4 Florins.
Result: profit per widget of 0.1 Florin in Holland, 8.4 Florins in the Netherlands Antilles (let's pretend that 1 Cruzeiro = 1 Florin for this game), and 0.01 Cruzeiros in Brazil. Tax bill, zero or close to it, because at that time there was no taxation in the Netherlands Antillles for offshore corporate profits. Even today there is very little, and the Netherlands Antilles company is pretty much free to pass on its retained earnings however it chooses. But today, the authorities in all but the most undeveloped countries are highly aware of the habits of international businesses, and apply transfer pricing rules of various types to invoicing for both incoming and outgoing goods and services.
In our example, neither Brazil nor the Netherlands would nowadays accept the pricing basis described, although the Netherlands Antilles, like most 'offshore' jurisdictions, would neither know nor care about the transactions involved if they did not touch the lives of local inhabitants.
So far, so simple; but when we try to answer the question, what basis of transfer pricing would be accepted? it becomes anything but simple.
For OECD countries, there are OECD Guidelines on Transfer Pricing, although the US (an OECD member) has its separate but broadly similar Section 482 rules (of the Tax Code). Underlying both sets of rules is the 'arm's length' principle, which says, obviously enough, that inter-company pricing should be based on the idea that the two parties involved are not connected.
Outside the OECD, there is a jungle of different sets of rules, although over time there is a gradual tendency to accept the OECD's Guidelines as a basis.
However, the Guidelines themselves are work in progress, having been amended many times since their original issuance in 1979, and the OECD, which has to work by consensus, does not find it easy to keep up with business trends. That is especially true of the Internet, which has recently begun to have a profound impact on the conduct of international commercial affairs.
The arm's length principle can be traced to Article 9 of the OECD Model Tax Convention, which provides: [When] conditions are made or imposed between ... two [controlled] enterprises ... which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
US Treasury Regulations Section 1.482-1(b)(1) define
the arm's length standard for tax purposes: In determining the true taxable
income of a controlled taxpayer, the standard to be applied in every case [i.e.,
there is no exception] is that of a taxpayer dealing at arm's length with an
uncontrolled taxpayer. A controlled transaction meets the arm's length standard
if the results of the transaction are consistent with the results that would
have been realized if uncontrolled taxpayers had engaged in [comparable transactions
under comparable circumstances].
While transfer pricing is relatively straightforward in the case of the manufacture of widgets, and there are likely to be comparable business situations out there in the market place, such inter-company transactions as intellectual property licensing (royalties), participation in capital markets structures (interest or capital profits), profit-sharing, multiple ownership and leasing create serious difficulties of definition and plenty of scope for dissension between taxpayers and the taxing agencies.
An important development during the 1980s and 1990s was the emergence of Advance Pricing Agreements (APAs) in a number of countries. Under an APA, the tax authority agrees in advance to a pricing policy, giving certainty of tax treatment to the tax-payer concerned. However, APAs can run into trouble when multiple jurisdictions are involved, and there are obvious difficulties in predicting a trading environment some years ahead of time.
One of the particular difficulties the OECD has faced in recent years is to deal with the emergence of the concept of the permanent establishment as a key feature in the taxation of trans-national businesses, and especially so because of the impact of the Internet. These difficulties are not really capable of being resolved within the overall framework of disparate country taxation structures, which are very unsuited to international business operations. To a certain extent, transfer pricing rules can by-pass this difficulty, but only as long as arm's length pricing is applicable – and as noted above, there are considerable limitations on its usefulness. And when a permanent establishment is created in a country where there is no legal organism, classical transfer pricing techniques have no relevance.
Corporate Taxation: The Future
As will be seen from the last two sections, corporate taxation is a truly international subject, and any company doing business in more than one country will inevitably find itself enmeshed in a more or less complex web of international treaties, rules and agreements, particularly if it wishes to minimize its tax bill.
The Internet has introduced a permanent shift in the balance of power between the taxman and his tax-paying corporate targets: countries are anchored in the physical reality of their territory, while companies will increasingly be free to locate large parts of their economic activity in low-tax areas. On the corporation tax level E-commerce and e-business, especially the offshore variety, offer multiple possibilities for companies to structure themselves so that a larger and larger proportion of their profits ends up in a low-tax area.
Corporate activity, much of it Internet-related, will therefore thrive in most of the important offshore jurisdictions, which will continue to offer strong tax competition in the corporate sector to the world's largest economies.
The transfer of profitability from high-tax to low-tax areas will however take a very long time, and many of the ways in which it will come about are really just embryonic at this time. As an example, business exchanges, which are one of the most innovative concepts to have arisen so far through the Internet, are natural offshore residents: yet only a few of them are being located offshore, where they would achieve maximum tax efficiency. This will change as international tax planners and their corporate clients begin to understand the possibilities offered by offshore e-commerce.
When a new business is being established or an existing organisation is modifying part of its mode of operation, the starting point for such remodelling is, and has to be, the preferred and most effective business structure. However, once that is identified, the question as to where to locate different parts of the structure inevitably takes into account the various tax issues. The idea is to create a tax-optimised supply chain.
One obvious area is the centralising of procurement for the whole organisation where economies of scale can be useful in finding cost savings. Most organisations can benefit from a centralised approach for other specific functions e.g. manufacturing, distribution and sales.
Where this leads to improved profitability
(as it should) countries with a low corporation tax regime are more appropriate
for the realisation of profits. For example
It's obvious that international corporate tax planning needs to take full account of the DTAA and CFC landscape; and this becomes even more important if transfer pricing techniques are being used to optimize profitability patterns. There is little point in contriving to make a super-profit in Labuan if it is immediately taxed by a home country authority half a world away.
Personal tax planning using 'offshore' has come to be seen as somehow reprehensible, or at least attackable, but corporate tax planning remained respectable until 2010, when the OECD launched a new anti-business offensive on behalf of its high-taxing member states, under its BEPS (Base Erosion and Profit Shifting) initiative, which will attempt to impose far stricter rules on transnational business taxation.
While the OECD's efforts to corral international business income flows can easily be seen just as a desperate attempt by its highly-indebted members to squeeze more money out of multinationals, and indeed that is just what it is, its game has reached a tipping point at which companies will likely no longer accept goverments as occasionally awkward partners, but will come to treat them as enemies.
Businesses will continue to try to convince governments and tax authorities that their business models and transfer pricing structures have been set up for genuine commercial reasons, rather than tax planning alone; but they will increasingly adopt tactics intended to stymie the tax collectors outright. When no trust is left in the business/government relationship, which is now close to being the case, businesses will go their own way, and the result for country tax collectors will be the opposite of what they intend.
While corporations are busy redesigning themselves to function tax-effectively on a global basis in these and other ways, there has as yet been no comparable internationalization of the actual charging and collection of corporation tax, which is carried out in each country according to that country's rules and rates of taxation. That said, the last twenty years have seen a gradual competitive process in which countries have tended to lower their corporation tax rates in order to attract international investment. This process can only continue and even intensify, as international business find it ever easier to move their headquarters, manufacturing sites and distribution networks around the globe, using outsourcing, virtual distribution and supply networks, and business exchanges.
One of two things will happen: either corporation tax will disappear altogether; or a global harmonized rate will be agreed. In either case the massive paraphernalia of DTAAs, CFCs, transfer pricing, and the gigantic corporate tax optimization industry will shrivel up. Perhaps the first result is more likely. Two steps on the road to the simplification of corporation tax are the harmonization of accounting standards, which is far advanced, as described below, and harmonized calculation of the corporate tax base, which is an explicit goal of the European Union, currently being resisted by the UK and Ireland, but which will surely come into force within the next ten years over much of the globe. It is not yet clear which international organization will have the supervision of a globalized tax base - perhaps a glorified OECD, given its work on permanent establishments and Internet taxation.