Revelations that South Africa is losing an estimated R7-billion a year because of tax avoidance by multinationals has highlighted calls to rethink how countries tax these entities.
International efforts to ensure that corporations are taxed where economic activities occur and reduce profit shifting to low-tax jurisdictions have been criticised as not doing enough to stop this, a practice that is particularly debilitating for developing countries.
But there are alternatives, according to a tax justice advocate, and if regional leader South Africa was to explore these, it would pave the way for others.
Widely publicised research released late last year by the SA-Tied (Southern Africa — Towards Inclusive Economic Development) project, suggests that 98% of the tax loss is linked to profit shifting by the biggest 10% of multinational corporations. It estimates that the country is losing about R7-billion in tax annually.
About half the profits moved out of South Africa end up in Switzerland, the research found. It also highlights the importance of factoring in firm size when considering the extent of profit shifting and says not accounting for this could lead to underestimating the extent of the practice.
Using information from the South African Revenue Service for the period 2010 to 2014, the research is the first to use data from a tax administration in a developing country.
Only Germany, Norway, Sweden and the United States have previously granted access to tax return information on multinational entities, according to the authors, Ludvig Wier of the University of Copenhagen and South African treasury official Hayley Reynolds.
Some forms of profit shifting are legal, the authors say in a press statement, but some, such as transfer mispricing, are not. Transfer mispricing occurs when a multinational imports goods or services from another branch in a lower-tax jurisdiction at inflated prices to increase its costs and reduce taxable profits in a higher-tax jurisdiction.
In a separate paper, which investigated transfer mispricing in South Africa, Wier estimates that revenue losses because of it equate to 2% of foreign-owned firms’ tax payments, or almost R1-billion each year.
In their joint research, Wier and Reynolds say, even though foreign-owned firms in South Africa make up only 2 000 of the 1.2-million companies in the country, they are typically much larger than domestic firms and account for more than 30% of total sales of all companies.
Their research sorts foreign-owned firms into 50 groups according to size based on their wage bill and identifies firms owned by a parent company domiciled in a tax haven and the firms that are not. It finds that, despite similar wage bills, fixed assets and turnover in both haven-owned and non-haven-owned firms, major discrepancies emerge in the figures for taxable profits.
They say, among the largest 2% of firms, the wage bills of haven-owned firms were 6% higher, as was turnover, and they had 22% more fixed assets, but their taxable profits were 72% lower.
The research also suggests that the bulk of this “profitability gap” is driven by resource extractive companies, even though they only account for 2% of foreign-owned firms. This is followed by the financial industry, which accounts for 19% of the profitability gap.
The effects can be particularly pernicious in developing countries. The researchers say, historically, in developing countries, a substantial amount of tax revenue has been collected from large corporations. This is true for South Africa, where corporate tax amounts to 19% of total tax receipts, or twice the developed-country average. And, like many developing nations, they say South Africa is fiscally constrained.
Global efforts to address these kinds of tax avoidance activities have centred on the Organisation of Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting initiative, in which South Africa has long participated.
But international tax justice advocates have argued that the OECD’s approach has serious flaws.
According to Alex Cobham, the chief executive of the Tax Justice Network, the OECD’s insistence on basing international tax rules on the arm’s length principle lies at the heart of these kinds of multinational tax abuses.
This approach, he says, treats multinational groups as if each corporate entity in the group is individually maximising its profits, requiring that any transactions between group entities take place at market prices, or “as if they were operating at arm’s- length from each other”.
But multinational groups “exist precisely when it is more profitable to internalise such transactions than it would be for independent entities to operate separately; and profit is maximised at the global, group level”, he argues.
“As such, the OECD approach creates clear incentives to manipulate the prices on intra-group transactions in order to shift profit away from the location of the underlying economic activity that gives rise to it, and instead to some low- or zero-tax jurisdiction.”
According to the Tax Justice Network’s own 2017 research, profit shifting results in an estimated revenue loss of $500-billion globally.
The systemic fix, says Cobham, is to eliminate arm’s-length pricing and to “tax multinationals at the level of the group, with their global profits apportioned between jurisdictions as tax base according to the share of real economic activity taking place in each”.
But, he says, lower-income countries may not have the political power to ignore the OECD, or to take on multinationals directly.
He says there is a solution, first proposed by the Tax Justice Network and now backed by the Independent Commission for the Reform of International Corporate Taxation (ICRICT), which would leave the OECD rules in place but would create a backstop to limit the degree of profit shifting.
In February last year, the ICRICT endorsed a way to improve the rules for taxing multinationals — a unitary taxation approach known as formulary apportionment. According to the United States-based Tax Policy Centre, this would assess a multinational firm’s income in different countries, using a formula that includes a combination of its sales, assets and payroll in each jurisdiction.
Although the OECD efforts are a step in the right direction, they do not address the core deficiencies of the existing system, according to the ICRICT. It says the OECD provides a “patch-up of existing failed approaches and [has] failed to address the more fundamental issue of profit shifting”.
Revisions to transfer pricing rules continue to “cling to the underlying fiction that a [multinational enterprise] consists of separate independent entities transacting with each other at arm’s length”, but the reality is that these companies are unified firms “organised to reap the benefits of integration across jurisdictions”, it says.
Formulary apportionment is the best method to ensure that the countries in which the multinational firms’ profits are made get their fair share of tax revenues, the ICRICT argues.
Formulary apportionment does have challenges, according to the Tax Policy Centre, starting with the need for major economies to agree to scrap the current arm’s-length approach and consensus on how to allocate corporate income among jurisdictions.
But, the ICRICT says, without a global agreement on this approach, an individual country or region could consider implementing it as part of an alternative minimum tax regime. A country could apply a multifactor formula to a multinational firm’s global income and compute the minimum tax payable on the apportioned income, for example at 80% of the regular corporation tax rate.
“The minimum tax would be payable if it exceeds the jurisdiction’s regular corporation tax payable computed on the [multinational enterprise’s] local income as determined under conventional arm’s-length transfer pricing methods,” the ICRIT says.
A country could do this without reneging on existing multilateral agreements or commitments to the arm’s-length principle and the OECD transfer pricing guidelines.
The European Union is contemplating legislation that would tax firms on a formulary apportionment basis but only in the EU. But, Cobham and other academics, who undertook work for a left-leaning coalition of European parliamentary members, identified risks with this approach, not least of which is that companies will simply shift profits to jurisdictions outside the EU.
The ICRICT stresses the need to adopt an approach that prevents this.
The treasury did not respond to requests for comment.