Globalization and Tax Design

in Developing CountriesPresented to World Bank

April 30, 2003

William F. FoxThe University of Tennessee

Michael J. McIntyreWayne State University

Globalization has Many Dimensions

Trade is 25 percent of output in the average country

Trade grew 5.5 percent annually in real terms for the past 23 years

FDI reached $1.3 trillion in 2001

FIGURE 1: Tax Revenue as a Percentage of GDP by Continent

18.82

14.67

23.98

17.5019.44

16.28

18.78

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Perc

ent

Africa Asia Europe N.America

Oceania S.America

Total

FIGURE 2: Tax Revenue as a Percentage of GDP by GDP Per Capita Category

15.78

19.97

23.17

18.78

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Perc

ent

Low Mid High Total

Misc.5%

Extraction6%

Consumption38%

Direct33%Int. Trade

18%

FIGURE 3: Tax Components as a Percentage of Tax Revenue

FIGURE 4: Tax Components by GDP Per Capita Category

0.0

10.0

20.0

30.0

40.0

50.0

60.0

Direct Consumption Int. Trade Misc. Extraction

Low

Mid

High

FIGURE 5: Change in Tax as a Percentage of GDP by GDP Per Capita Category

0.0

5.0

10.0

15.0

20.0

25.0

Low Mid High Total

First YearLast Year

Implications of Globalization for Taxation

Tax Competition Problems of Attributing Revenues Tax Erosion/Avoidance

The Growing Importance of Tax Competition

Globalization increases tendency for competition

Competition limits the tax structures that countries can use Lower Corporation and Individual tax rates Less progressive tax structures Fewer taxes on luxury goods Tax concessions are one evidence of growing

competition Countries can try to cooperate but very difficult

to do because some don’t want to participate

Is Tax Competition Good?Can be Efficiency Enhancing

Forces tax rates down to benefit charges

Limits the “Leviathan effects” of government

Could encourage countries to design tax structures better and to administer them more evenly

Can lead to lower taxes on the most mobile capital

Tax Competition Can Be Harmful Can cause government to be too small

because taxes on capital are too low Race to the bottom Bottom line – Whether helpful or

harmful depends on the type of competition.

Tendency for government to be too small in some developing countries, at least in terms of essential services.

Forms of Tax Competition Competition for Economic Activity

Countries often set rates in line with other countries

Then give various concessions for some activities

Competition for corporate residences or tax base – The Tax Haven Very low statutory rates Incorporation fee

Do Taxes Affect Location of FDI?

Research says lower tax rates have a modest effect on attracting FDI.

Effects should depend on whether the residence is in a tax exemption or tax credit country

Tax Concessions Tax Concessions

Holidays are poorly targeted Incentives focused on capital investment can

be cost effective Business must believe policy will not be

changed once they locate Taxes less important than many other factors

Must be used sparingly to limit abuse Keep simple Keep records Evaluate the results

Consumption Taxes or Trade Taxes? Trade taxes collect 25% of revenues in

low income countries Consumption taxes are preferred

VAT or sales tax can always collect as much revenue

Domestic producers will produce greater value of goods

Lesser distortions in consumer behavior Can be transition effects of moving to

free trade after years of protectionism

VAT - Allocating Revenues with Cross Border Transactions

Implemented on destination basis Imports – collected at border by

Customs Can result in tariff like effects if not

administered like the Tax Department

Exports – zero rated Must make refunds for zero rating to

be effective

VAT - Allocation with E-Commerce

Many of the issues are the same as with traditional cross border commerce, but represents an extreme example of the problems

Frequently cannot require vendors to collect, nor can it be collected at border

With digitized goods or services do not know where consumers are located and country does not know what they buy. Effects of e-commerce: Fairness Lost revenue Economic Distortions

VAT - Allocation of Revenue

Discussion of using origin basis for services and e-commerce

Could move to origin based VAT for services and digitized transactions Exaggerates tax competition Fails to tax on consumption basis

Corporate Income Tax – Attribution of Revenue

Multinational enterprises potentially create significant problems for tax collection

Examples Transfer Pricing Other forms of Income Stripping

What is a Transfer Price Prices Charged to Related Persons

A Transfer Price is a price set by the taxpayer when selling to, buying from, or sharing resources with a related person.A person (legal entity, generally) is a related person with respect to another person if:

It controls that personIt is controlled by that personThey both are controlled by some other person.

Special Rules for Transfer Prices Needed to Prevent Tax Avoidance

Multinational enterprises (MNEs) use transfer prices for the sale or goods and services within a corporate group.

A transfer price may be contrasted with a market price C a price set by supply and demand in a competitive market.

Unless prevented from doing so, MNEs can use inappropriate transfer prices to strip profits out of a country.

Example of Tax AvoidanceStripping Earnings through Inappropriate Prices

ACo manufactures goods in Country A and sells them to a foreign affiliate, BCo, organized in Country B. The cost of manufacturing is $50 per unit, and the sales price to customers in Country B is $200.

If ACo sells to goods to BCo for $199, almost no profits will be taxable by Country B

If ACo sells the goods to BCo for $51, almost no profits will be taxable by Country A.

Approved Pricing MethodsInternational Agreement on How to Set Prices

In 1968, the U.S. Treasury published regulations that established the initial “arm’s length” pricing methods.

In 1994, the U.S. Treasury Department added some new pricing methods that divided up the combined profits of a common enterprise.

In 1995, the OECD approved of the U.S. new methods, to be used as a last resort. In practice, they are often the first resort.

Arm=s Length StandardComparison to Dealings with Unrelated Persons

Under the arm’s length standard, transfer prices are set at the level that would have occurred on a sale between unrelated persons dealing at arm’s length.

The problem is that this “arm’s length” approach works well only when comparable market prices are available.

The method suggests that each related-person transaction is looked at separately.

Types of Transfer PricesSituations When Transfer Prices Must Be Set

Sales of tangible property (generic) between related persons.

Sales of intangible property or sales of tangible property that embody proprietary intangible property.

Sharing of resources within a MNE intercompany loans; use of assets owned by another member of

the MNE group; sharing of legal department.

CUP MethodSales of Tangible Property

The paradigm arm’s-length method, looking at actual sales of the same or similar products with unrelated persons.

Example. ACo sells widgets to BCo, a related person. It also sells widgets to CCo, an unrelated person, for $100. Under CUP, ACo would charge BCo $100 (with possible adjustments for differences in shipping costs, etc.).

Resale Price MethodRelated Person Treated as Distributor

The taxpayer is viewed as a distributor earning the customary percentage of the final sales price.

Example. ACo sells widgets to BCo and BCo sells them to unrelated retail customers for $200 each. Distributers in a similar line of business usually earn 20 percent of the sales price. Under the retail sales method, the price on the sale from ACo to BCo would be $160

Cost-Plus MethodTaxpayer Treated as Contract Manufacturer

The taxpayer is given the gross profit percentage typically earned by unrelated persons in a similar line of business under a cost-plus contract.

Example. ACo manufactures widgets at a cost of $50, sells them to BCo, a related person, and BCo sells them to unrelated retail customers for $200. Contract manufacturers in similar lines of business typically earn a gross profit of 30 percent. Under the cost-plus method, the price on the sale from ACo to BCo is $65 ($50 + 30% of $50).

Summary of ExamplesComparison of CUP, Resale Price, and Cost-Plus

CUP Method

Resale Price Method

Cost-Plus Method

ACo's cost of goods sold $50 $50 $50BCo's sales to unrelated customers $200 $200 $200ACo's sales price to BCo $100 $160 $65Profit to ACo $50 $110 $15Profit to BCo $100 $40 $135

Total profits to ACo and BCo $150 $150 $150Earner of entrepreneurial profit shared ACo BCo

Double Taxation IssuesA Problem of Inconsistent Transfer Prices

If countries do not apply the same transfer pricing methods or apply the same methods in an inconsistent manner to a MNE, the MNE may suffer from double taxation.A solution is for countries to coordinate their methods and to allow “correlative adjustments” when one country adjusts a transfer price.Most tax treaties require correlative adjustments. The countries also agree to consult to avoid double taxation.

Correlative AdjustmentSales between Related Persons

Example. ACo and BCo are part of an MNE group. ACo sells widgets to BCo. Country A, in computing the income of ACo, properly increases the price of widgets from $65 to $75. Country B, in computing the income of BCo, should make a correlative adjustment and treat BCo as purchasing the widgets for $75. The result is that more income is taxable in Country A and less income is taxable in Country B.Double taxation may occur if Country B determines that the adjustment made by Country A is improper.

Tax Avoidance ProblemsShifting Income to Low-Tax Jurisdictions

Under CUP method, the MNE may use inappropriate comparables.MNEs typically use the resale price method to minimize taxes in the country of sale.MNEs typically use the cost-plus method to minimize taxes in country of manufacture.Treaty partners may use the exchange of information provision of their tax treaties to require consistent treatment in both countries.

Tax Avoidance ExampleDeflecting Income to a Tax Haven

Basic Facts. ACo, part of a MNE, manufactures widgets in Country A at a cost of $50. The widgets are sold in Country B to retail customers at a price of $200. The MNE has profits of $150.Tax Facts. ACo establishes HCo, a wholly-owned affiliate in County H, a tax haven. It sells the widgets to HCo for $65, using the cost-plus method. HCo sells the widgets to BCo, also a wholly-owned affiliate, for $160, using the resale price method. HCo ends up with profits of $95, ACo has profits of $15, and BCo has profits of $40.

Other Pricing Methods New Methods Approved in 1995 by OECD

The OECD approved (as methods of last resort) two new methods in 1995.

The Profit-Split Method, andThe Transactional Net Margin Method (TNMM).

TNMM is called the Comparable Profit Method (CPM) in the U.S. Treasury Regulations.Both new methods apply to sales of tangible and intangible property. Both are widely used.

Profit-Split Method(s) Several Variations of Profit-Split Method

The basic idea is that the income from some set of activities conducted by two or more related persons is aggregated and split up based on their contribution to the common enterprise.The method is treated as an “arm’s length” method because the split is supposed to be based on the splits typical of unrelated persons engaging jointly in a similar enterprise.

Example of Profit-Split MethodSimplified Example to Indicate General Rules

ACo and BCo are related persons engaged in the production and sale of pharmaceuticals. ACo engages in lots of R&D to produce its pills. BCo sells the pills after affixing its valuable trade name to the packaging. They earn profits of $8 million from the common enterprise.Based on comparisons with unrelated persons, the tax department of Country A determines that ACo contributions to the common enterprise accounts for about 75 percent of the profits. Its taxable profits would be $6 million (75% of $8 million).