The Tax Policy Outlook for Developing Countries: Reflections on International Formulary Apportionment

transfer pricing; formulary apportionment; base erosion and profit shifting (BEPS); OECD; IMF.The author offers a retrospective analysis of his recently-completed extensive research on the technical feasibility of international formulary apportionment of corporate taxable income, as a replacement for the body of ‘arm’s-length’ transfer pricing rules generally in use around the world. In this retrospective analysis the author considers recent analytical work on base erosion and profit shifting (BEPS) conducted by the Organisation for Economic Cooperation and Development (OECD) as well as the International Monetary Fund (IMF). The author focuses especially on the needs of developing countries, which, because of problems associated with informal economic activity, need to rely more heavily on corporate income taxation than wealthier countries. The author generally agrees with the approach taken by both the OECD and IMF, which (i) would rely on targeted measures to curtail BEPS and would not seek to fully replace arm’s-length rules with a formulary system, but (ii) would nevertheless incorporate elements of a formulary approach in order to remedy apparent defects in some important aspects of current arm’s-length rules.DfID, NORAD

Limitations of the BEPS Reforms: Looking Beyond Corporate Taxation for Revenue Gains

A version of this paper has previously been published by Bloomberg BNA, Inc., which reserves all rights. Reprinted by permission. developing country taxation; base erosion and profit shifting; transfer pricing.This paper argues that global corporate tax policies have long been dominated by a political consensus among governments of countries at all levels of economic development, to the effect that forces of tax competition render taxation of the cross-border income of multinational companies both infeasible and unwise. Current tax laws around the world, which permit widespread tax avoidance through shifting corporate profits to tax havens, reflect the implementation of this political consensus. The global political consensus against effective corporate tax rules seems likely to survive the current efforts of the OECD, in its studies of base erosion and profit shifting (BEPS), to devise legislation that would revitalise corporate income tax. Countries around the world, therefore, are unlikely to implement more than symbolic and minimally incremental BEPS reforms. This paper warns that the current high level of attention being paid to BEPS in the media and by international organisations might lead developing country governments to expect unrealistic returns from efforts to implement BEPS-related reforms. The paper therefore advises governments of developing countries to be selective in allocating resources to implementation of BEPS reforms, generally focusing only on those reforms that will clearly generate increased revenue in light of the very limited administrative resources typically available to developing country revenue agencies. In general, developing countries will be well advised to devote the bulk of their enforcement resources to the development of fiscal instruments that do not encounter the political obstacles facing taxation of cross-border corporate income. These include excise and general consumption taxation, income taxation of large and medium-sized domestic businesses, natural resource royalties (as opposed to income-based taxes on mineral producers), real property taxation and payroll taxation.DfID, NORAD

Improving the Performance of Natural Resource Taxation in Developing Countries

This paper explores the administrative challenges posed to developing countries as a result of the increasing emphasis in fiscal regimes for natural resource extraction since the Second World War on income-based taxes, including both corporate income and resource rent taxes, as opposed to royalties. The paper identifies both the political consequences and technical challenges (particularly in the area of enforcement of arm’s length pricing in the natural resource context). Politically, the paper argues that reduced reliance on royalties has clouded the imagery of natural resource taxation as a means of ensuring governments fair market compensation for the alienation of their non-renewable resource endowments, and instead has rendered natural resource taxation increasingly vulnerable to the political scepticism that has surrounded corporate income taxation in recent decades. The greater exposure of natural resource levies to this scepticism appears to have led to high levels of toleration of corporate tax avoidance by governments at all levels of economic development. From a technical perspective, the paper argues that income-based levies are intrinsically far more vulnerable to avoidance than royalties, posing substantial administrative challenges to those developing countries that wish to achieve high levels of tax compliance. Today, natural resource fiscal regimes around the world typically employ a mixture of royalties and income-based levies; this mixture is intended to afford a balance of protection against financial risks to governments as well as investors. Despite the shortcomings of income-based levies, this paper does not advocate that the practice of mixed fiscal regimes be abandoned. Nevertheless, the paper argues that in the interest of greater administrability, the mix of fiscal instruments might be adjusted to some extent in favour of royalties, especially to the extent royalties include rates that adjust with product prices, so that their incidence correlates to a substantial extent with investors’ net income. In addition, the paper suggests technical means by which developing countries might improve the performance of income-based natural resource levies. In particular, using the Norwegian reference pricing system for North Sea Oil as a model, the paper argues that developing country governments might obtain greater control over revenue losses by adopting ‘administrative pricing’ regimes. Under these the government, rather than the taxpayer, takes the initiative in establishing arm’s-length product prices based on both posted price benchmarks and research into local pricing conditions (including, for example, local variations in product quality, and prevailing industry practices with respect to sales contract duration). Although administrative pricing regimes are now most common with respect to oil and gas, the paper recommends that the use of these regimes be expanded to hard minerals taxation. The paper also explores the extent to which developing country governments might apply principles of administrative pricing not only to the determination of product prices, but also to the arm’s-length limitation of related-party expenses for services and supplies, as well as the control of excessive interest expense

Limitations on Interest Deductions: A Suggested Perspective for Developing Countries

interest deductions; related-party loans; OECD; base erosion and profit shifting; BEPS; transfer pricing.This paper evaluates the efforts of the Organisation for Economic Co-operation and Development (OECD), in its project on base erosion and profit shifting (BEPS), to control profit shifting by members of multinational groups through payments of interest on related-party loans. Currently, members of groups appear be shifting large amounts of income from countries around the world to affiliates in zero- or low-tax countries, through the relatively simple expedient of creating loans between identically-owned group members. The resulting revenue losses are especially serious for developing countries, which depend more heavily than other countries on revenue from corporate income taxation; in addition, it appears that groups investing in developing countries sometimes employ tax planning through related-party loans very aggressively. The paper evaluates the OECD’s proposal for a ‘group-wide’ limitation on interest deductions, under which only loans obtained by group members from unrelated parties would generate deductible interest payments, and the resulting deductions would be apportioned among group members based on measures of their relative levels of economic activity. The paper agrees with the OECD’s conclusion that the group-wide approach should be more difficult to avoid than existing kinds of interest-limitation regimes, including ‘thin capitalisation’ regimes based on debt-to-equity ratios, and limitations on deductions based on percentages of companies’ earnings before interest, tax, depreciation and amortisation (EBITDA). The paper nevertheless concludes that the suggested approach remains vulnerable to very difficult and perhaps intractable problems of identifying ‘interest’ in today’s highly complex international environment. Therefore it will be very difficult at best for revenue agencies to administer successfully, even if the OECD’s approach proves politically feasible. The paper recommends instead that countries devise means of incorporating the control of interest deductions into their generally applicable transfer pricing rules. Under this approach, excessive deductions of all kinds could simultaneously be limited to reasonable amounts. The paper suggests a format for a transfer pricing method that might fulfill this need, a Shared Net Margin Method (SNMM). The paper concludes that if a more comprehensive approach to transfer pricing rules proves politically infeasible, the OECD’s approach to interest deductions would represent a substantial improvement over current forms of interest limitations, and countries should adopt the OECD approach. For the longer term, however, effective control of interest deductions will probably require a thorough revision of transfer pricing rules, perhaps along the lines of SNMM.DfID, NORAD

Beyond BEPS: A Tax Policy Agenda for Developing Countries

base erosion; profit shifting; tax competition; transfer pricing; unitary taxation; formulary apportionment.As the Organisation for Economic Co-operation and Development (OECD) moves to the final stages of its work on base erosion and profit shifting (BEPS), this paper reflects on the most promising directions for legislative changes and other action which developing countries might take to protect their corporate tax bases. The paper observes that the barriers facing developing countries generally do not arise from technical difficulties in designing and implementing legislative measures. Indeed, effective controls on base erosion are well-known among policy-makers, particularly limitations on outbound deductions and withholding taxes to discourage excessive outbound payments to affiliates. Instead, the most important impediment to effective control of base erosion is the pressure of tax competition – namely, the fear that effectively imposing income taxes on inbound investors will deter employment and economic growth. The paper does not seek to assess the objective validity of this fear, but observes that it is in fact pervasive, and that effective policy-making must recognise the practical political barriers this fear imposes. With the seriousness of tax competition borne in mind, the paper enumerates and briefly comments on the following topics, all of which should be developed in future research efforts: (i) the possible utility of simplified measures to discourage base erosion, notably the greater use of withholding taxes (a measure which the OECD’s BEPS effort has not sought to address); (ii) the potential for both incremental changes to transfer pricing rules to facilitate enforcement and administration (for example, the use of Brazil-style standard margins and markups), as well as the longer-term possibility of unitary taxation; (iii) the importance of regional coordination of tax policies to mitigate tax competition; and (iv) the continuing role of international groups such as the International Monetary Fund (IMF) and non-government organisations in assisting developing countries to generate realistic assessments of the trade-off which may exist between effective corporate taxation and inbound investment.DfID, NORA

A Simplified Method for Taxing Multinationals for Developing Countries: Building on the 'Amount B' Proposal to Repair the Transactional Net Margin Method

This paper considers whether the ‘Amount B’ proposal currently being negotiated in the Inclusive Framework, for the attribution of fixed remuneration for the ‘routine’ distribution and marketing activities of MNE affiliates, may offer a useful template for the re-working of the widely used ‘transactional net margin’ transfer pricing method (TNMM). The TNMM has for years posed severe difficulties for tax administrations around the world, especially in developing countries. The paper focuses especially on two variants of the Amount B proposal which have been offered by Johnson & Johnson and Procter & Gamble, and suggests how a revised TNMM might be expanded to apply to MNE affiliates engaged in activities in addition to marketing and distribution. The paper acknowledges that a restructured TNMM would remain in some ways an imperfect tax administration instrument, and that its construction will involve some unavoidable technical challenges (as would be true of any meaningful reform of rules for the international division of profits for tax purposes). Nevertheless, a restructured TNMM could provide significant relief to hard-pressed developing-country tax administrations, and the paper argues that it should figure among the objectives of the OECD’s current efforts at international tax reform