Many companies keep some of their profits in low tax jurisdictions that are not their main place of business. Governments in high tax jurisdictions often object to such practices and have sought to make it more difficult.
Last year, the UK announced it would introduce a “General Anti-Abuse Rule” that would give domestic tax authorities wide powers to impose taxes on companies that have, otherwise legally, kept profits in lower-tax jurisdictions. Other jurisdictions – most notably the US – attempt to tax companies on their worldwide profits, including those made by “controlled foreign corporations”. Both approaches have perverse and economically harmful consequences.
A far better solution is to permit territorial taxation, with clear, non-arbitrary rules.
In a report published on 28 November last year, the British government’s Public Accounts Committee (PAC) claimed that it is “immoral” for a foreign corporation to minimise its tax obligations – and that such action is also economically harmful because it disadvantages British businesses. The PAC singled out Starbucks, Google and Amazon for such practices, leading to a flurry of media attention to these allegedly immoral companies.
Starbucks quickly caved in to what its executives presumably thought was a burgeoning PR problem and on 2 December offered to pay an additional $32 million on top of the $14 million it has already paid to the British government in corporation taxes.
Google refused to pay more taxes than it legally owes – and for good reason. According to a report in The Independent on 13 December, the company’s Chairman Eric Schmidt said that “… to go back to shareholders and say, ‘We looked at 200 countries but felt sorry for those British people so we want to [pay them more]’, there is probably some law against doing that.”
Even if it is not strictly illegal for companies to pay more tax than legally required in any jurisdiction, it is at the very least an abuse of shareholders’ trust. In other words, the PAC had it precisely backwards: it is immoral for companies not to shift their profits to low tax jurisdictions if it increases their profitability.
But what of the other claim: that such practices harm the British economy? Again this is based on faulty logic. Currently, any British citizen may legally establish a company in another country, remit payments there and thereby avoid British corporation tax.
This is a bit of a simplification: it actually takes careful planning because the UK has developed rules to attempt to ensure individuals and companies don’t escape tax just through accounting tricks, but if you follow those rules you can shift income outside either country perfectly legally. So, the PAC’s assertion that the tax rules disadvantage “British” businesses is true only in the tautological sense that it means businesses that are domiciled for tax purposes in Britain end up paying more tax than businesses tax-domiciled elsewhere.
Moreover, the rules do not disadvantage British entrepreneurs. Quite the opposite: they enable such entrepreneurs legally to avoid paying high corporation tax rates. As a result, those entrepreneurs, and the companies they own, are better able to reinvest in their business – to the benefit of customers, employees and the wider public.
Reinvestment often results in innovations that raise productivity and/or create products or services, with associated benefits to consumers and/or other producers. Over time, this process of innovation leads to economic growth. Thousands of entrepreneurs already do this, from small businesses all the way to Richard Branson’s Virgin Group. And the internet has significantly reduced the cost and difficulty of establishing a company in a foreign jurisdiction.
By enabling British entrepreneurs to build businesses that are tax-domiciled in another jurisdiction, the current rules also discourage excessive taxation of businesses that are tax-domiciled in Britain. The government knows that entrepreneurs have a choice, so it is forced to keep British taxes somewhat competitive, with a top corporate rate of 28 per cent. It also imposes some restraint on individual taxation, since lower individual taxes encourage entrepreneurs with foreign tax-domiciled businesses to locate in Britain. That is why Britain offers individuals who are resident but not domiciled in the UK the option of paying a flat tax of £30,000 per year, rising to £50,000 for individuals who have lived in the UK for 12 years or more.
By contrast, companies tax-domiciled in the US are required to report profits on their worldwide income, including those generated by “controlled foreign corporations” (CFCs) – companies in which the US corporation is a significant shareholder.
However, companies may defer the declaration of profits until they bring the money into the US. Since the profits accruing to CFCs can only be distributed to shareholders after they are repatriated to the US, multinational companies face a quandary: do they continue to reinvest in their CFCs or do they bring home the bacon? It turns out that to a considerable degree, they choose reinvestment. The non-partisan Tax Foundation puts the total assets held overseas by US corporations at approximately $1.7 trillion.
A recent report for the Wall Street Journal found that last year alone sixty of the US’s largest publicly listed companies parked a total of $166 billion in assets offshore. Several of these companies reported little or no profit in the US, while reporting billions of dollars in “deferred” profits in their CFCs.
At some point, however, shareholders are going to want to see a return on their investment. One option is simply to reincorporate overseas and grant existing US investors stock in the new company equal in value to their US stock. Risk management company Aon moved its incorporation to the UK in 2012, reducing its tax bill by about 5 per cent according to a report in the Wall Street Journal. The same report noted that 10 publicly listed US companies had reincorporated or planned to reincorporate since 2009.
But reincorporation is time consuming and expensive – often requiring changes in accounting practices, personnel relocation and other adjustments. Perhaps that explains the recent formation of Let’s Invest for Tomorrow (LIFT America), a coalition of US businesses seeking to shift the US to a system of territorial taxation.
Under such a system, companies would only be taxed on the profits made in the US; profits made overseas would be taxed, if at all, in the jurisdiction in which they were made. A territorial tax system would likely encourage US businesses to repatriate a much higher proportion of their overseas profits. As a result, rates of investment in the US – both by those businesses with CFCs and by their shareholders – would rise, which would likely result in more rapid economic growth.
The US could go further: if it were to eliminate most or all of the existing corporate deductions, which range from R&D tax credits and accelerated depreciation to investments in municipal bonds, it could reduce rates of corporation tax without impacting government revenue.
This would result in fewer distortions to the allocation of investments, which – all else being equal – would result in more investments that generate improvements in products and production processes. Over time, this would generate higher rates of economic growth, which in turn would lead to more revenue to the government. Indeed, a scenario can be imagined in which the US government sequentially lowers rates of corporate taxation, while maintaining revenue from a combination of corporation tax and income tax.
To see how this would work, consider that the British government currently nets approximately 9 per cent of its total revenue from business taxes. By comparison, the United States, where the top rate of corporation tax is 7 per cent higher than the UK at 35 per cent, nets only 8 per cent of its income from business taxes. The Tax Foundation recently estimated that the dynamic revenue-maximizing rate of corporate taxation would be 14 per cent. But in the same study, the Tax Foundation notes that the optimal corporate tax rate is zero:
- The model estimates that while cutting the corporate rate from the revenue-maximising rate of 14 per cent to zero would cost $9 billion of federal revenue, GDP would rise by roughly $300 billion, a payoff of about 33 to 1. The numbers suggest that the best corporate tax rate would be zero, unless every dollar flowing to the federal government is orders of magnitude more valuable than dollars retained by households and businesses.
- But Britain seems to be headed in the opposite direction. In his “Autumn Statement”, Mr Osborne laid out his plans for going after “abusive tax avoiders” by introducing a “General Anti-Abuse Rule”, what is known in other jurisdictions as a general anti-avoidance rule, or GAAR. While details have not yet been released, GAARs have generally been used as a means of making certain kinds of avoidance illegal. Since tax avoidance is by definition legal, this is a rather odd idea – and is contrary to the rule of law, as legal scholar John Prebble has noted:
- “In its essentials, the archetypal GAAR simply says that tax avoidance arrangements are void for tax purposes. On analysis, the circularity of this form of rule differs little in structure from that of the notorious Article 386 of the Criminal Code of the Qing dynasty of China, which made it an offence to “[Do] that which ought not to be done”.”
- As if to emphasise the degree to which a GAAR is contrary the rule of law, Obama sneaked one into the Healthcare and Education Reconciliation Act of 2010.
Meanwhile, for those companies that can’t be caught by the GAAR, Osborne pledged to work with the G8 to establish international rules that would make it more difficult for companies to locate in low-tax jurisdictions.
No specifics were given but presumably the intention would be to coordinate tax rules so that companies tax-domiciled in lower tax jurisdictions would be forced to pay punitive taxes on their operations in G8 countries. The potential for mischief to result from such an agreement seems huge; one can imagine all kinds of protectionist trade and investment restrictions emerging that would harm everyone except a few vested interests.
In announcing his clampdown on “abusive tax avoidance” and his commitment to the establishment of a global tax oligopoly run by the G8, Osborne was perhaps responding to pressure created by the Public Accounts Committee. If so, that would be a pity as his response is likely to undermine tax competition, resulting in higher tax rates. Those higher tax rates would in turn reduce investment and economic growth in Britain and around the world.
Over time, lower rates of economic growth mean reduced tax revenue. Given that Britain, like the US, is currently facing a prolonged fiscal crisis, with government debt forecast to remain close to 100 per cent of GDP for many years, that is a miserable prospect.
Osborne knows that high taxes are bad for businesses and bad for the economy. In his Autumn Statement he observed, “Punitive tax rates do nothing to raise money, and simply discourage enterprise and investment into Britain. … HMRC data reveals that in the first year of the 50 per cent tax rate, tax revenues from the rich fell by £7 billion and the number of people declaring incomes over one million pounds fell by a half. A tax raid on the rich that raises almost no money is a con.”
In the most recent March Budget, Osborne announced that he would cut the top rate of corporation tax to 20 per cent from 2015.
Osborne’s commitment to corporation cutting tax is a much more constructive solution to the problem of tax avoidance. Obama should do the same – and should also introduce territorial taxation. And governments everywhere should eliminate deductions.
That way people and companies would have both fewer options to avoid paying tax and less reason to do so: taxes would be lower and fairer. Moreover, since tax deductions distort investment, their removal would mean more resources would flow into investments that yield innovation and growth. Over time, competition in the setting of corporate tax rates, would lead to lower, flatter rates with fewer deductions. Ultimately, governments might scrap corporate taxes altogether. The benefits of that would be enormous.
This column originally appeared in the Cayman Financial Review.