Responding to the recent political demands that companies pay the “right” amount of tax in the countries in which they operate, the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) initiative aims to create a framework to reduce the ability of companies to shift income to reduce their tax burden. Their proposals could impact substantially on financial services firms. Time is short, and the industry needs to respond now.
One of the significant consequences of the financial crisis has been the development of acute concern over whether corporations are paying the “right” amount of tax. These concerns have been fed by a number of key factors. First has been the need of governments in the developed world to sustain and maximize their tax take in the face of continued commitment to government expenditure at a time of economic retrenchment. Second, there has been increasing political and public outrage—stimulated in part by the mass media—at some multinational corporations that have been revealed to pay relatively low levels of tax.
At the same time, globalization has steadily increased the opportunity for corporations to arrange their affairs so that taxable profits are reported in low tax rather than high-tax jurisdictions. Globalization has made it much easier for businesses to locate productive activities in different geographic locations.
The resultant erosion of domestic tax bases (“base erosion”) and the associated transfer of reported profits to low-tax jurisdictions (“profit shifting”) has generated an increasing focus on “unfair” tax avoidance. It is argued that this damages the tax revenues of individual states; distorts economic performance; and brings taxation systems generally into greater disrepute. In some cases financial institutions (mostly, but not exclusively banks) have been criticized for facilitating such strategies, as well as undertaking them on their own account.
Prompted by policy developments at the G-20, the OECD has taken an increasing interest in this issue of BEPS. The OECD has argued, that BEPS has a number of critical consequences:
- Governments are harmed. Many governments have to cope with less revenue and a higher cost to ensure compliance. BEPS undermines the integrity of the tax system, as the public, the media and some taxpayers deem reported low corporate taxes to be unfair. In developing countries, the lack of tax revenue leads to critical underfunding of public investment that could help promote economic growth. Overall resource allocation, affected by tax-motivated behavior, is not optimal.
- Individual taxpayers are harmed. When tax rules permit businesses to reduce their tax burden by shifting their income away from jurisdictions where income-producing activities are conducted, other taxpayers in that jurisdiction bear a greater share of the burden.
- Businesses are harmed. Multinational enterprises may face significant reputational risk if their effective tax rate is viewed as being too low. At the same time, different businesses may assess such risk differently, and failing to take advantage of legal opportunities to reduce an enterprise’s tax burden can put them at a competitive disadvantage.
According to the OECD: “IT is an issue of fairness: when taxpayers (including ordinary individuals) see multinational corporations legally avoiding income tax, it undermines voluntary compliance by all taxpayers… . Business cannot be faulted for using the rules that governments have put in place. It is, therefore, the governments’ responsibility to revise the rules or introduce new rules. “The OECD is, therefore, the developing as a matter of urgency a program to tackle BEPS through new regulatory frameworks as part of its overall program of modernizing tax regimes.
So in July 2013 the OECD published its Action Plan to tackle BEPS. The Action Plan sets out 15 actions, many directly focused on corporate structure and performance, to address BEPS issues in a coordinated and comprehensive manner (see Table). Work to refine and implement the deliverables on BEPS is now being undertaken at a rapid pace. Much has been written in the specialist press and elsewhere about the potential implications. But the key point is that companies in the financial services sector need to consider— as a matter of urgency—how to respond.
Major challenges
The current political focus on fairness in corporate tax matters raises two fundamental challenges for financial services firms. First is the risk of changes to the law that will result in greater tax burdens and greater compliance burdens. Already some countries, including Mexico, France, Germany, Australia and Austria, have begun to introduce domestic measures targeted at BEPS. Norbert Walter-Borjans, finance minister of North Rhine-Westphalia, has argued forcefully that Germany should act unilaterally to tackle BEPS if the OECD project has not made sufficient progress by the autumn of 2014. Conversely in the UK, despite the government claiming it expects companies to “pay the tax they owe”, the chancellor of the Exchequer has announced his intention to “create the most competitive tax environment in the G-20.”
Second, the question of fairness raises issues of politics, morality and corporate reputation, beyond technical matters of finance, tax and compliance. It presents major challenges to senior executives, who are now having to balance their primary responsibility of maximizing returns to shareholders —and hence of minimizing avoidable costs—with that of being seen to behave in a responsible way in a broader context.
Defining fairness presents particularly acute problems, and translating it into a reliable basis for tax policy is even more difficult. The challenge has been faced on previous occasions. In Europe the long-standing Code of Conduct for business taxation was first set out in the conclusions of the Council of Economics and Finance Ministers of December 1, 1997, which gave guidance on how to identify potentially harmful tax practices. Key criteria included:
- An effective level of taxation which is significantly lower than the general level of taxation in the country concerned;
- Tax benefits reserved for non-residents;
- Tax incentives for activities which are isolated from the domestic economy and therefore have no impact on the national tax base;
- Granting of tax advantages even in the absence of any real economic activity;
- The basis of profit determination for companies in a multinational group departs from internationally accepted rules, in particular those approved by the OECD; and Lack of transparency.