11 February 2016

Do Multinationals Pay Enough Tax?

The Shaw Sheet’s litmus test.

by John Watson

If you read bed-time stories to young children you will have discovered that they like to hear the same tale over and over again.  It doesn’t matter that they know the ending.  Their minds are locked onto a particular character doing or saying particular things and heaven help you if you try to skip a page.  Older readers demonstrate the same trait in a slightly different form.  Once we have enjoyed a book we like to read other books by the same author and not just any other books but other books using the same characters.  Did you enjoy a Hercule Poirot?  Agatha Christie wrote many more of them so you can enjoy stagey denouement after stagey denouement.  Do you like Brunetti?  Again, Donna Leon has provided a library of them, each replete with its description of an Italian meal.  Oddly, it doesn’t seem to matter that the later books are not as good as their predecessors.  The subject matter is familiar and that very fact commends them to the fan.

I don’t know how this translates for readers of magazines.  They have their favourite writers, of course, and the particular subjects that interest them.  After all, people read magazines entirely devoted to railways week in and week out.  Not all of it can be stunningly original.  Perhaps readers like to see the same topics explored and re-explored.  I hope so because, having talked about taxation last week, I’m going to talk about it all over again.

Last week’s article was about the Google settlement and why it was not necessarily wrong that the UK had extracted less money than the French and Italians.  That is interesting in itself, but a more fundamental question lies behind it.  What tax should we expect foreign multinationals to pay on the profits they make from selling to the British public?  It is only when one is clear about this that one can make judgements as to how well those expectation are fulfilled.

There are two quite different theories and, generally speaking, they are espoused by different people.  The populist press and the politicians look at multinationals selling into the British public and say “we should be getting some tax on the profits they make out of that”.  On that basis, tax on profits would be raised where sales were to UK customers even though the work which earned those profits had been carried out completely overseas.  Governments and tax authorities do not generally go so far.  They tax profits where the work which generates those profits is carried out, although this may be extended (as in the case of the UK’s new Diverted Profits Tax) to cover the place where the profits would have arisen but for tax-driven manipulation.

Let us suppose that sitting on the Cayman Islands there is an enormously clever man.  Pay him a large fee and he will email you investment recommendations which will make you rich.  “Expensive but worth it,” that is his motto, and because it always turns out to be true he has built quite a team as investment experts of different nationalities have gone out to the Cayman’s to hone their skills at the feet of the guru.  The profits of his company are enormous, and £100 million a year of them come from fees paid by UK clients.  Should that company be paying corporation tax on those fees?

Before we go on I need to clarify a couple of points.  The question here is about Corporation tax on profits.  It has nothing to do with the VAT which is suffered on turnover and generally borne by the customer.  The second is that our guru is an American.  Perhaps he chose the Cayman Islands because he liked the sunshine or perhaps because the tax rate would be lower than in the US.  Either way he did not go there in order to avoid UK tax.

As his company’s profits are generated by his activities in the Cayman Islands, lying back in the hot tub and contemplating  global economic trends as he twiddles the taps with his feet, the conventional answer is: that is the only place in which they are taxable.  How do you react to that?  Do you say “fair enough” or do you say that because he is selling into the UK marketplace he should be paying UK taxes and that it is outrageous that he is only paying tax haven rates?  If you are a populist newspaper or a political demagogue the word “outrageous” comes easily.  “Change the law at once,” you shout.  Okay, perhaps that is a good idea so let’s run with it and see if we can make it work.

Let’s begin then by making the Cayman company pay corporation tax at the UK’s 20% rate.  You’ll hear the mechanism for that described in many ways, “deemed permanent establishment”, “principles of attraction”, etc.  For our purposes, however, it all comes down to one thing: a tax charge by reference to the user of the services rather than where the services were or should have been performed.  Right then, assuming that the Cayman Islands charge no tax we have an overall rate of 20%.  Seems fair, you might think.

But if we are going to apply tax by reference to sales to the UK for this company, we have to have the same rule for other foreign companies too.  What happens then if the team doing the work is in the US?  Would they pay US tax on the basis that the work which generated the profits was done there or UK tax on the basis that the sales were to UK people?  They can’t sensibly be taxed twice so credit would have to be given for the US tax on profits against the tax due on sales.

That all works fine provided that all the relevant profits are made by the company which sells to the UK customers, but what about the profits of all the companies earlier in the economic chain?  Suppose the supplies to UK consumers are of gadgets, not advice, and that although company A sells them by mail order to UK customers, most of the price it receives is paid to component manufacturers who make the real profit, possibly in the Cayman Islands?  Well, if the goods are destined for the UK market, the UK should have its share of that as well, and also, going back, tax on the profits of the companies who sold things to the component manufacturers.

This might just work if all the companies were in the same ownership, because then they would be able to share information.  It becomes difficult, however, when you go beyond that because the component manufacturers will not want company A to know how much profit they make.  That means that you are restricted to taxing the profits of companies in the same ownership as company A and trying to back that up with some rule to counter manipulation of ownership.

Perhaps it could be done for a bit but it would not be long before economic pressures meant that companies in the chain were separately owned.  Any attempt to counter that would mean a heap of complicated and probably ineffective anti-avoidance rules, and the golden rule of tax collection is to keep things simple.  You only have to try doing your own UK tax return to see the need for that.

That is why those who run tax systems are keen to keep the focus of profit taxation on the place where the work is done or should have been done and eschew the taxation of profits by reference to where the customer is.  They all are almost certainly right in that judgement and by now you probably share it too.  If you do, however, remember it when you next read a press article about how multinationals trading in the UK are not paying much tax here.  Where was the work which created the value done?  That is the question, and if you keep it firmly in mind you will be able to judge for yourself whether, broadly speaking, they are paying the right amount of UK tax.

 

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