It will end a lucrative business model of the MNCs that park most of their profits in tax havens, bringing curtains down on the golden era of the havens themselves
The June 4-5 agreement between the G7 Finance Ministers (FMs) from the USA, Britain, Germany, Canada, France, Italy and Japan to plug the cross-border tax loopholes used by the giant multinational companies (MNCs) to evade taxes has immense potential to reform and revolutionise the global tax system. The reform blueprint is based on two pillars: first, to distribute the profits equitably among countries where these are generated, enabling them to tax such profits, and second, adoption of a minimum corporate tax rate of at least 15 percent globally.
By forcing the MNCs irrespective of their nature of business to pay taxes where they operate, it can bring to an end the decades-long "race to the bottom" in which some countries compete with each to attract corporate giants with ultra-low tax rates and exemptions, depriving the governments of other countries where the MNCs reap most of their profits of billions of dollars in taxes - money badly needed by them now to prop up their pandemic-ravaged economies. It will also bring to an end a very lucrative business model of these MNCs that park most of their profits in tax havens, bring to an end the golden era of the havens themselves. The tech giants which operate remotely through digital medium like Google, Amazon, Facebook, Apple etc. would also start feeling the pinch.
Rich nations like G7 as well as emerging economies have equally struggled in vain for decades to make the MNCs operating within their jurisdictions to pay taxes to them. But using a tax avoidance strategy called Base Erosion and Profit Shifting (BEPS), MNCs have been artificially 'shifting' their profits year after year from higher-tax jurisdictions to tax-havens where they pay little or no tax, thus 'eroding' the 'tax-bases' of the former. Countries like Ireland, Luxembourg, Cyprus, Caribbean countries like British Virgin Islands, Bahamas or Cayman Islands, and Central American countries like Panama have used their tax rate arbitrage to attract the MNCs- about 40 percent of MNCs' overseas profits are estimated to be shifted to low-tax countries in this way.
The tax losses are stupendous - estimated to be $50 billion for the USA and over $10 billion for India. A global minimum tax rate of 15 per cent would preclude countries from undercutting each other, yielding an estimated $50 billion-$80 billion in extra tax annually from the MNCs. Governments would still have the sovereign power to set their own corporate tax rates but not below the floor rate and if the MNCs still continue to shift their profits to a country with a lower tax rate, their home governments can 'top-up' their taxes to the minimum rate to eliminate the benefits from shifting of profits.
The US tax rate was cut down to 21 per cent from 35 per cent by then President Donald Trump in 2017, which his successor Joe Biden now proposes to increase to 28 per cent. The average OECD corporate tax rate in 2020 was 21.5 per cent, with 18 out of 37 members charging higher rates. Only three countries charge rates lower than 15 per cent: Ireland (12.5 per cent), Hungary (eight per cent) and Switzerland (8.5 per cent).
The average tax rate for Asian countries is around 23 per cent; while China and South Korea charge 25 per cent, Singapore charges only 17 per cent rate. In 2019, India also sharply reduced its corporate tax rates to 22 per cent for domestic companies (15 per cent for new manufacturing companies) without any deductions, aligning its corporate tax rate to global standards.
However, there are several zero-tax territories, mostly small economies like Bermuda, British Virgin Islands or Cayman Islands, in which even the crumbs thrown by the MNCs by way investment on subsidiaries and opportunity for employment that they create howsoever limited could be a bonanza. Corporate and financial services account for more than 50 per cent of government revenue in many of these small economies. Over many past decades, the low-tax or tax-less countries have thus enticed investments with lax rules that favour the MNCs and serve as conduits for them to avoid tax in other countries.
The Economist reported an IMF study in 2019 which found that such "phantom" investments by MNCs had pushed Luxembourg's stock of foreign-direct investment to $4 trillion, "an improbable one-tenth of the global total". Many small countries like Ireland, Cyprus, Hong Kong and Singapore have also benefited in this manner.
To book profits in low tax regimes, MNCs have all the leverage and wherewithal to relocate their subsidiaries and headquarters in any country across the globe - they can relocate their production units anywhere by arm-twisting the smaller countries to agree to their terms. By choosing a suitable transfer pricing mechanism, they can always transfer profits to their subsidiaries located within such jurisdictions to avoid paying taxes in countries where they generate most of their revenues by selling their products while booking profits in the tax havens. It would be in the interest of these countries to have their taxing rights over these companies in their own jurisdictions.
As the communique from the G7 had stated, "We commit to reaching an equitable solution on the allocation of taxing rights, with market countries awarded taxing rights on at least 20 per cent of profit exceeding a 10 per cent margin for the largest and most profitable multinational enterprises." The principle is that MNCs must pay taxes equitably in every market where they generate their profits, thereby apportioning their global profits to countries where their customers and users are located.
The business model of MNCs that rely on the tax havens would collapse like a pack of cards, as would the economy of tax havens themselves - especially of those that lack other significant sources of revenue - once the G7 proposals are translated into an international treaty, contours of which may be finalised in the broader G-20 meeting at Venice in July, which, in addition to the G-7 countries includes emerging economies like China, India, Brazil, Russia, South Africa, Indonesia and others. An agreement would usher in nothing short of a tax-revolution that would nudge the other countries also to fall in line. MNCs and tax havens would be the losers - indeed it might signal the ultimate end of the tax havens' business model, while large economies that give the MNCs most of their profits which are now being siphoned off to the tax havens would stand to gain the most. Countries like Ireland whose economy has boomed with the influx of billions of dollars in investment from the MNCs would be deeply unhappy and unlikely to give in, as would be the tax havens themselves.
To tax the digital transactions of global digital giants like Apple, Google etc. that carry out their activities remotely from another country, India had imposed a six per cent Equalisation Levy in 2016 on incomes accruing to foreign e-commerce companies from India in certain business to business transactions above a threshold. Several other countries had followed suit. This, however, hardly compensated for the revenue loss. Once the new tax regime comes into force, it will bring to an end such digital taxes as they will become redundant. India which is one of the largest and fastest expanding global internet markets has much to gain from the new tax regime, but must follow up with further reforms of its tax system and reduction of factor costs to attract international investment and industries.
The author is a former Director General, Comptroller & Auditor General of India. The views expressed are personal.