Territorial differences in taxation in an increasingly globalised business world have rendered the global tax system unworkable. The task of tallying the intricacies of local tax regimes and their myriad of bilateral treaties and regulations with multinational corporation tax structures has prompted calls from many quarters for a review of the international tax system.

Taxation has become an area of tension between mature and younger economies as Western multinationals increasingly look towards emerging markets for growth opportunities.

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Generally speaking there is an east-west divide when it comes to taxation systems, says PricewaterhouseCoopers partner Peter Maybrey. Less mature economies tend towards a source system whereby a company is only taxed on earnings in its resident location, whereas most Western economies have a system of double taxation, requiring firms to pay tax on a worldwide basis wherever the company has operations.

 

“The different systems are driving tax law changes as emerging economies begin to want their global share of tax revenues,” says Mr Maybrey.

Multinational companies based in mature economies frequently find themselves liable for double taxation: by the tax regime of the country in which the firm is resident as well as the host country of its foreign subsidiary. Double tax relief is a very difficult and technically challenging area requiring an enormous amount of data, says Peter Cussons, a tax expert at consultancy PricewaterhouseCoopers. “I had one client case where I had to get Swiss accounts dating back to the 1970s because of profits earned in the past; we were lucky they even existed,” he adds.

Co-ordinating moving parts

With so many moving parts to a company’s business structure alongside tax laws, which are constantly changing around the world, complexity has to be kept to a minimum to remain a tax-friendly jurisdiction. “If you think of the world as a 204 by 204 matrix with a flow from any host country to any of the other 203, there is a multitude of possible tax outcomes depending on host country taxation and ownership, where you are headquartered and double tax treaty consequences of that ownership,” says Mr Cussons.

There is empirical evidence to demonstrate that lowering the tax burden for companies leads to increased inward investment. A study by think tank the National Bureau of Economic Research in the US found that a 10% variation in tax rates in European countries led to a 7.7% reduction in investment, while outside Europe a 10% difference led to a 2.3% reduction in FDI. The report’s author, Mihir Desai, believes the effect could be particularly pronounced in Europe, where European affiliates of American companies are more likely to be indirectly held and foreign investments seem to be much more sensitive to taxes than elsewhere.

“Investment levels are highly sensitive to corporate tax rates and both smaller economies, such as Ireland, and larger economies, such as China, have benefited from adjusting their tax regimes to attract foreign investment,” says Mr Desai. US multinationals Google and Yahoo! both relocated headquarters from the UK to the lower tax juristiction of Switzerland, while Amazon and Microsoft moved to Luxembourg.

However, headline corporate tax rate is not always the deciding factor when companies are looking to invest, because lower, smaller tax jurisdictions cannot always offer available skills, access to markets and infrastructure. Indirect taxation, for example, has increasingly become part of the decision-making mix when companies decide on investment locations.

Mr Desai says the increase in companies uprooting themselves and their headquarters for tax purposes has been driven by businesses generally operating in a more decentralised way, the advent of enhanced communication technologies and greater mobility of human capital, as well as greater pressure to create value for shareholders leading to more sophisticated strategies.

Although tax regime is an increasingly significant factor, Mr Desai points out that indirect taxes, such as value-added tax (VAT) and import and export duties, have grown rapidly over the past few decades and may have a comparable or greater impact on investment decision making than income taxes because many countries permit multinationals to claim foreign tax credits for corporate income taxes paid to foreign governments, but credits are not available for indirect tax payments.

Tax recovery

Generally speaking, governments have put more emphasis on indirect taxation during the past few years, realising it is relatively easier to recover than corporate and income taxes. KPMG’s 2008 global tax survey found that governments are using indirect taxation to compensate for reduced corporate tax yields.

While corporate tax rates have been falling worldwide, with the average tax rate dropping by 0.9% to 25.9% from last year’s 26.8%, according to KPMG, indirect tax rates have remained relatively stable, suggesting that if indirect tax yields are compensating for declining corporate tax yields, this is being achieved in other ways: namely a widening of the indirect tax base and a stricter application of the rules.

This could involve the introduction of new taxes such as environmental taxation, which many tax experts believe will become increasingly important going forward, although global implementation is needed to avoid corporations establishing operations in poorer economies without environmental levies. As indirect taxation becomes a larger burden in many countries, governments’ indirect tax policies can have a comparable effect on the location of investment to headline corporation tax.

KPMG tax expert Sue Bonney says although indirect tax rates have not changed significantly and corporate tax rates have been steadily declining, more and more governments are introducing indirect tax systems. “There are currently 135 countries with these systems in place and more in the pipeline. There is also a steady expansion of the transactions that these taxes are applied to, and a new focus from tax authorities on efficient collection of indirect taxes through corporate tax departments,” she says.

Decision making

Indirect taxation is not the only issue surrounding tax regime which affects multinational decision making. While the UK scores highly on indirect taxation with the third joint lowest VAT in the EU at 15%, tax complexity was described as one of the reasons why United Business Media (UBM) moved its tax domicile from the UK to Ireland. UBM is one of a host of international firms, including Henderson, one of Europe’s largest investment managers; the serviced offices group Regus; and engineering company Charter, which has moved its tax domicile from the UK to Ireland.

The UK’s high corporate tax rate, in common with most big industrialised economies, ranks as the 20th lowest tax rate in the EU after the government lowered the rate to 28% from 30% in April 2008. But it is still higher than the global average of 25.9% and the EU average of 23.2%. Tax complexity, rather than high tax rate, is the reason given by many multinationals for moving their tax domiciles out of the UK as the country’s system has become progressively more complex since 1987, when there were about 3500 pages of tax legislation compared to the current 10,000-plus.

Changing its tax domicile cost UBM $3m and was therefore not a decision taken lightly or in the short term. According to a UBM spokesman, the complexity of the UK tax regime was the issue behind the decision to move to Ireland. “It must have been on the agenda of every plc with the capability of moving out of the UK,” he says. The tax burden for the company will not change greatly because the issue of foreign profits was less important than the stability and visibility of the tax regime over the short term, according to UBM. “It is massively complex if you are operating within 30 or 40 countries to manage the tax liabilities in the UK if those remitted profitability is taxed at different rates, whereas Ireland has a much more stable tax regime in relation to the foreign earnings issues,” he adds.

Global approach

The Institute for Fiscal Studies, based in the UK, argued in a paper issued in June that globalisation requires a new approach to corporate tax. Unlike most EU governments, the UK tax dividends received by UK resident firms from their foreign subsidiaries as well as profits earned in the UK. The authors of the report suggest moving to a form of destination-based corporate tax, levied where the sale of goods or services is made to the final consumer to remove distortions to the location of investment and substantially reduce the opportunity for companies to shift profits between countries. This could be achieved by introducing border adjustments, similar to VAT, in which exports become tax exempt, whereas imports are taxed.

The UK government requires resident multinationals to pay tax on profits earned from foreign subsidiaries. But bowing to pressure from the business community, an exemption programme for corporations’ foreign profits is said to be on the UK government’s agenda. On July 21, the then financial secretary to the treasury, Jane Kennedy, said in an open letter issued to the CBI and the City’s ‘100 Group’ that the government is still pressing forward with the introduction of a dividend exception but the fiscal risk of introducing it in 2009 is too great because of the economic climate; the government estimated that exemptions on foreign earnings would cost them £900m ($1448m).

Advertising giant WPP is in the process of considering moving its tax domicile out of the UK. A spokesman confirmed that the decision is under review and that the corporate headline tax rate was not the issue of concern. “WPP is an international business and almost 90% of our profits are foreign earnings so the UK taxing foreign earnings is the reason we would consider a move,” he says.

One of the world’s largest pharmaceutical companies, Shire, moved its tax domicile from the UK to Ireland in April with no staff relocation or job losses. Shire’s shift in tax domicile is typical in that it is not part of a wider corporate restructuring as it would have been in the past.

The company reported significant tax savings in the summer, as a result of moving its headquarters. A spokeswoman for Shire says the driving force behind the company changing its tax domicile is the firm’s increasingly international business. “The fact that 70% of the firm’s revenues are generated outside the UK called for a strategic review of the company’s tax strategy,” she says.

The tax residency move to Ireland was influenced by the firm’s operations. “We already had a base in Ireland of about 40 people, it is easy to travel to and there was a whole range of factors which meant Ireland was the optimum location for us as we grow into a more global organisation – it is not about avoiding paying tax where it is due but it is just good housekeeping,” she says.

A common system

EU taxation law threatens to supercede UK tax law. The EU has proposed a Europe-wide common system of corporate taxation which the UK, Ireland and Estonia have opted out of. Proposals have been drafted but it is still under consultation and has been put on hold by the French presidency. If the proposals make it through to legislation, the consequences for smaller, low-tax destinations such as Luxembourg are huge. Implementation of the proposals will be optional, which many experts say is an unworkable situation.

One of the world’s biggest multinationals, GE, has chosen its headquarters carefully with international headquarters in Brussels, its healthcare business and consumer finance global headquarters in the UK, and GE Oil & Gas headquarters in Florence, Italy. The company’s headquarter locations reflect a shift of gravity outside the US into bigger growth markets. “We are moving headquarters slowly – probably more slowly than I would like – but deliberately outside the US,” says GE chief executive, Ferdinando Beccalli-Falco. The move means that two of GE’s six major industry groups will be headquartered outside the US.

While tax regime can be an important government mechanism for attracting foreign investment, it is by no means the only factor multinationals look at when choosing an investment destination. There are many valid reasons to invest in a country, says Mr Beccalli-Falco. “Before making investment decisions, we look at opportunities for growth, a skilled and well-educated labour force and the rule of law,” he says. “Tax regime is not necessarily a deciding factor; merely a part of the mix.”

IN FOCUS

TAX CLINIC

Tax is rarely the main determinant in foreign investment decisions but it is increasingly an important factor. PricewaterhouseCoopers’ tax partner Peter Maybrey provides a checklist of points to consider when making a new business investment:

  • The headline rate of corporation tax (or tax on profits), usually the published rate applicable to a business of that size or nature.
  • The range of activities on which tax is charged or in respect of which deductions are allowed, generally known as the tax base.
  • Tax reliefs and incentives to encourage economic behaviours, such as investment in equipment or R&D activities or good environmental behaviours.
  • The growing focus on the total tax contribution expected of a business taking into account other indirect business taxes it bears or which it collects on behalf of government, such as value-added tax or goods and services tax, excise duties, stamp duties, employment taxes, business rates and environmental taxes.
  • The level of withholding taxes applied by a local territory when payments are made back to headquarters or affiliates.
  • A network of double tax treaties may provide relief from withholding of tax in various circumstances and determine how taxation of the same amount in both territories may be avoided.
  • Whether a subsidiary, branch or other corporate entity is most effective, perhaps differing if focus is on manufacturing, R&D and intangibles or financial services.
  • Application of a residence or territorial basis, determining whether, for example, in respect of amounts received from foreign subsidiaries, dividends are exempt from tax or any credit for tax paid on the profits out of which they arise merely determines where tax is suffered rather than increasing the overall burden.
  • The complexity of tax compliance and administration involving the extent of legislation, filing requirements, advance rulings and the attitude and approach of the tax authorities.
  • Whether an investment location is inside or outside the EU has an increasing influence on tax.