In the early months of 2019, tax and transfer pricing professionals were captivated by the debate on digital taxation – and rightly so. As the debate drags on, however, the initial excitement has receded. The OECD is working towards a long-term solution in 2020, and the coming months will be decisive in shaping a respective consensus. It seems prudent to assume that the consensus will not necessarily depend on specific attitudes and preferences towards the digital economy, but rather on taxation in general. This article discusses a recent OECD publication on tax morality, as well as the tax policy agendas for the election of the European Parliament. Both issues foreshadow what the potential consensus on (digital) taxation might look like – and, spoiler alert, it does not look too good from the perspective of those in favour of tax competition and the principle of subsidiarity.
The question of tax morality
The OECDs draft working paper on the question “what is driving tax morale” was uninspiring. Essentially, the working paper presents survey-based research on tax morale in individuals, as well as MNEs – focusing on developing countries. The tentative conclusions and policy recommendations are not breath-taking, with the OECD emphasising that available data is sparse and that tax morality has not received much attention thus far. Based on the vague nature of the working paper, stakeholders were essentially free to submit any answer they deemed appropriate.
The first notable aspect of the discussion is that only 14 stakeholders cared to respond. The second, much more relevant, aspect is that the BEPS Monitoring Group (BMG) was, arguably, the most vocal stakeholder. The BMG submits, almost identical, comments to all OECD discussions and seized this new opportunity to castigate multinational enterprises (MNEs), as well as tax advisors, for their rampant immorality. The rhetoric of the BMG is rather predictable. It starts out by claiming that there are “considerable similarities between the techniques used for international tax evasion and avoidance for HNWIs [high net-worth individuals] and MNEs”. This claim is not exactly trivial, as it clearly suggests that the morals underlying tax evasion (illegal behaviour) are not different than those underlying tax avoidance (legal behaviour). By deliberately failing to distinguish between tax evasion and tax avoidance, the BMG is striving to (a) blow the problems caused by tax avoidance out of proportion and (b) to promote drastic regulatory countermeasures. The manifestation of this pattern of argument on the political agenda is, unfortunately, one of the most persistent outcomes of the BEPS.
While the BMG always skirts around the question whether it actually agrees with the ultimate aim of BEPS, i.e., ensuring that MNEs declare income and pay taxes where their economic activities occur, it is very clear on declaring BEPS to be a failure. There is, however, no objective support for claiming that BEPS failed to meet its aim (it actually is quite a suitable reform package), the BMG merely seems to dislike the fact that BEPS sustained the arm’s length principle (and separate entity approach) as the paradigm of international taxation.
The funny thing of the BMG contribution to the tax morale debate is that it reflects an eerie ignorance of how the arm’s length principle is applied in practice, as well as a strange idea on what can be expected of tax authorities. Specifically, the BMG claims that:
“To apply ‘functional analysis’, tax authorities need staff with a range of skills, who not only are familiar with the legal and economic techniques needed to interpret and apply the TPGs, but also understand the taxpayer’s business model and industry segment well enough to analyse the documented transfer pricing model, choice of method and selection of comparables. This need to conduct a functional analysis creates a severe information asymmetry, since a company will always know more about its own business and its sector than any outsider, especially tax authorities who have little background in the industry of the MNE and no detailed knowledge of the taxpayer’s operations.”
For those readers not being familiar with the arm’s length principle or transfer pricing, it must be stressed that a functional analysis is a rather simple exercise; i.e., to master the basic skills requires about a six-hour workshop. If you devote one or two weeks to this fundamental instrument of applying the arm’s length principle, you will be quite proficient. It is not rocket science, and it enables you to quickly and reliable differentiate between individual entities of an MNE – specifically, to distinguishing a contract manufacturer rendering low value-added services from a principal entity making unique and valuable contributions.
To claim that conducting a functional analysis and gaining a basic understanding of the business of a taxpayer is too much to ask of tax authorities borders on being delusional. If you want to tax MNEs on the value they create, could you at least have the courtesy to make an effort to understand how the value is created? Also, in real life, tax authorities are well capable and willing to challenge a functional analysis. Especially post-BEPS tax authorities will always check whether the “economic substance” matches your functional analysis.
Claiming that a “letter-box” is performing high-value added functions and is thus entitled to a large share of the MNEs profits will not work, and the modernisation of arm’s length principle resulting from BEPS will prove quite effective at curbing aggressive transfer pricing structures.
The hallmark of the BMGs agenda is to combine their unfounded critique of the arm’s length standard with the demand to abolish it and to apply global formulary apportionment instead.
Formulary apportionment, however, is not morally superior to the arm’s length principle. It is based on the notion that government (s) will decide what a “fair” allocation of profits among jurisdictions should look like. Instead of looking at the economic reality (value creation) of business, international taxation would be based on political decisions. Basically, governments, as long as they can agree on how to share the spoils, could then levy any tax on business they deem “fair”. Obviously, such a system would appeal to stakeholders considering governments to be morally superior. To embrace formulary apportionment requires being unafraid of the (inevitably) increased level of centralisation.
Unfortunately, there were no stakeholders defending the arm’s length principle in their comments to the OECD. Only the comments made by Harshad Tekwani from India were somewhat refreshing. Mr. Tekwani put the focus on the governments’ share of responsibility for facilitating tax moral by emphasising that: “Most of the people feel that the tax laws are punitive in nature. They feel that the laws are designed from a point to harass them. They do not have any trust in the government. As a result, most people feel demotivated and feel reluctant in participating in compliance with tax laws.” Among the reasons for these attitudes enumerated by Mr. Tekwani were (i) high tax rates, (ii) no help from government in compliance, (iii) Harsh punitive provision in case of non-compliance and (iv) no accountability of public money.
I was happy to read those comments, because they provide a welcome counter-weight to the BMGs advocacy of formulary apportionment and the believe in a morally superior role of government. Sure one could debate the merits of the individual reasons in more details, but how desperate we need such a counter-weight is evident when looking at the tax policy agendas promoted by German parties for the election of the European Parliament.
European elections – further harmonisation of tax policy in Europe
Below, I summarise the tax policy agendas promoted by the major German parties. Naturally, one should not overestimate the practical impact of these agendas. But while they may not translate 1:1 to the ultimate policymaking, they do provide a good indication of the general sentiment of the politicians towards taxation.
The conservatives (CDU/CSU) present a rather concise agenda and taxation is only dealt with at the fringes. They summarise their agenda by the following slogan, “Our Europe also ensures fair taxation for MNEs“ – expressing their feeling that it is an untenable situation that MNEs, by resorting to “crafty” tax structures shirk their responsibility to pay taxes. While wishing to preserve a certain (unspecified) degree of national tax sovereignty, they clearly see the prerogative of tax issues at the EU level. They explicitly favour the adoption of a “virtual permanent establishment”, as well as a common corporate tax base. In respect to the latter, they do not address the all decisive consolidation aspect; i.e. they are in favour of the common corporate tax base (CCTB) and do not seem to have a position on the common consolidated corporate tax base (CCCTB), which is sort of telling in itself.
The liberal democrats (FDP) compiled a rather broad and detailed agenda and devote a sub-chapter to taxation. The FDP is emphasising that decisions in respect to tax policy shall remain subject to unanimity, rejecting the introduction of qualified majority voting, and are opposed to granting the EU the privilege to tax (i.e. no EU tax). While the express consent to the CCTB (also with no clear position on CCCTB), they reject the idea of a European minimum tax rate. What is a little dubious is that they seem intent to abolish “tax deals” (it is not clear whether this also applies to advance pricing arrangements (APAs)). In respect to the taxation of the digital economy they explicitly favour relying on consensus-building on the OECD-level instead of introducing new policies at the EU-level.
The social democrats (SPD) place taxation high on their agenda, and their sentiment is clear; “Together, we can ensure that all companies finally make a decent contribution to the financing of the common good. … If the small café on the corner pays many times more in taxes than a large Starbucks branch, then something is wrong with the system.” They enumerate the following targets; (a) introduce CCCTB, (b) introduce European minimum tax rate, (c) introduce a digital tax, (d) abolish the unanimity principle and (e) introduce public country-by-country reporting. To them, these targets will facilitate a more moral tax system and they are also rather clear in their goal to ensure that “tax morality” will receive more attention in the future; “The question of tax justice will be a focus of the German Council Presidency in the second half of 2020”.
The Green Party (Die Grünen) present a similar agenda as the SPD – including a largely similar rhetoric; “One country alone wants a fair tax system in which the big coffee-chain pays just as much tax as the baker on the corner? Up to now, companies have only laughed about it and shifted their profits from country to country until they no longer paid any taxes.” Their agenda features the following: (a) CCCTB, (b) minimum tax rates, (c) the EU should get its own tax (EU tax) to finance the EU budget. Their stance on moral in taxation can be easily inferred from the headline of their sub-chapter on taxation: “drying out tax swamps and prosecuting people tricking with taxes”.
The agenda of the socialists (Die Linke) is largely similar to those proposed by the Green Party and the SPD. They strongly emphasise the tax gap (not differentiating between avoidance or evasion) and they generally seem to be more willing explicitly demand additional and higher for MNEs and rich individuals. Otherwise, however, their rhetoric is weirdly identical to those of the Green Party and the SPD; “In relation to their profits, Apple, Google, Amazon and Co pay less tax than other companies – and also less than normal employees or the bakery next door.”
While there are differences between the individual agendas, the commonalities seem to far outweigh the differences. All parties are willing to press ahead with reforms targeting further harmonisation (the CCTB seems a given). Especially the SPD, the Green Party, as well as Die Linke, have based their agendas on a view of tax morality akin to that promoted by the BMG. Compared to the targets of these three parties, the positions of the conservatives and liberal democrats appear somewhat lukewarm. While they are opposed to some of the more “radical” agenda items, there seems to be ample room for compromise when entering the nitty-gritty process of hammering out the European tax policies of the future (in the long term maybe even CCCTB).
In summary, taxpayers do not have to hold their breath in view of the European elections. The tax agenda for the EU is largely unaltered – with the trajectory towards further harmonisation, higher tax rates and stricter regulation sadly remaining all but promising.