“The OECD is now using ‘substance’ as an excuse to return international tax to an outdated concept of physical presence.”
I have been critical of the OECD ever since its ‘Harmful Tax Competition’ programme at the beginning of the century.
The organisation and its predecessors did important work in the early days, helping to rebuild international trade after the World War II by reducing double taxation and discouraging the barriers to cross-border business caused by national tax systems.
Admirably, the OECD’s founding aims were focused on increasing wealth through trade:
“to achieve the highest sustainable economic growth and employment and a rising standard of living in Member countries”;
“to contribute to sound economic expansion”; and
“to contribute to the expansion of world trade.”
Sadly, like many bureaucratic organisations, it seems to have lost sight of its purpose and has ended up pursuing policies that are not just irrelevant to its supposed aims but are actually opposed to them.
The Wrong Organisation Pursuing the Wrong Ends
The OECD is an organisation of governments, the governments of 35 of the old industrialised countries, and it pursues the interests of its members. Rather than its original people-focused aims of increasing employment through international trade, it now focuses on the desires of its member governments.
Unfortunately, although those countries commonly built their wealth on international trade, those governments now see themselves as threatened by new competitors and many are becoming more protectionist.
Moreover, those governments are, almost all, in severe financial difficulties. Government programmes are out of control financially and tax revenues cannot keep up with the ever-increasing spending, leading to seemingly incurable annual deficits.
That fear seems to have permeated the OECD, and its focus has shifted from helping people to helping its member governments. Rather than the optimism of its founding charter, seeking to increase citizens’ living standards by encouraging world trade, the OECD declares that its BEPS project “provides governments with solutions” to help them increase their tax take from business.
The Wrong Objective
This government-focused, tax-driven approach conflicts with the OECD’s supposed objective of increasing ‘employment and a rising standard of living in Member countries’.
Unfortunately, increasing taxation on businesses is often seen as a painless way for governments to raise money. Those that pay are multinational corporations and their wealthy investors, enabling governments to provide services and benefits to their citizens without having to ask those citizens to pay for them.
But the evidence of many wide-ranging studies is increasingly clear – this view of taxation is wrong.
Business Taxation Damages Living Standards
One result that is clear from virtually all the economic analysis is that taxing business hurts employees.
The precise figures vary, but all agree that most of the cost of business taxation falls not on the investors but on the workforce.
As businesses have less money to invest, and the returns on that investment are reduced by taxation, they invest less and therefore fail to create well-paid sustainable jobs.
Perhaps the most obvious way in which this works is by discouraging saving. High taxes on businesses or investment returns tend to act as a disincentive to investment and so reduce the pool of available investment capital and therefore slow growth and lead to fewer jobs being created.
High taxes also reduce entrepreneurship. The difficulty of setting up a new business, the time and money spent in gaining skills, the effort and risk of creating and producing a product, the risks of seeking customers, are all set against the potential rewards. If taxes are increased, the rewards are reduced and so business creation becomes less attractive.
High-Tax Countries are Ignoring the Evidence
This is not just a theoretical problem; it is a huge practical one.
Higher taxes result in more unemployment, and the evidence for that is painfully clear; with unemployment rates of over 20 per cent in Greece and Spain, and over 10 per cent in France, Italy and Portugal, the high-tax OECD member governments are failing their citizens.
And those figures mask an even bigger problem; rigid employment laws often protect those in work, leaving the full force of this economic failure to fall upon young people looking for their first jobs. The results of that are scandalous; 2016 saw over 50 per cent youth unemployment in Greece, 45 per cent in Spain, over 30 per cent in Italy, almost 25 per cent in France.
But this problem is not uniform across OECD members. The practical evidence fits with what we would expect from the theory – those countries with higher taxes have lower job creation.
The graph below compares EU member countries, but there is a strong overlap between that and the OECD, and the result of these high-tax policies is what we would expect - those countries on the left of the chart, with lower taxes, were far more successful at creating jobs. Those on the right, with higher taxes, were not.
So, the fundamental problem of the OECD BEPS project is that it has the wrong objective. Trying to help governments collect more taxes from business is the wrong approach, especially for an organisation supposedly dedicated to increasing employment opportunities and living standards for people. Far better to reduce the tax barriers to investment, increase growth, allow jobs to be created and grow tax revenues that way.
The Wrong Approach
But as well as its aims being wrong, the mechanism the OECD has for achieving those aims is based on an outdated view of business that is increasingly in conflict with the modern economy.
The OECD believes that ‘actual business activities are generally identified through elements such as sales, workforce, payroll, and fixed assets’, and that regarding anything else as a creator of profit is likely to be an artificial construct designed to reduce the corporation’s tax liability, creating ‘segregation between the location where actual business activities and investment take place and the location where profits are reported for tax purposes’.
An Outdated View of Business
In viewing customers, workforce and physical assets as the drivers of profits, the OECD has failed to understand the realities of modern business.
The most obvious area that the OECD has ignored is intellectual property. But that is generally regarded as being the most important aspect of modern business; not just registered patents but also the wider range of ideas, business concepts, branding and reputation.
The shift from metal-bashing to the knowledge economy is probably the biggest change in the business environment in a generation, yet the OECD is trying to pretend that it hasn’t happened and that profits are made, and can still be taxed, on the old basis of physical activity.
Another vital factor missing from the OECD’s list is financing. Anyone involved in business knows that the essentials for a new venture are the ideas and the financing to enable that concept to happen.
Yet those are not just missing from the OECD’s list of sources of profit; the whole approach of its BEPS project seeks to deny the role of intellectual property and finance in the business value chain.
An Attack on Innovation
This anti-innovation attitude runs right through the OECD BEPS project, in the concept and the practicalities.
Action 1 addresses the tax challenges of the digital economy – the OECD’s approach of helping its member governments rather than their citizens means that, rather than seeing innovation as a source of opportunity, a way to increased living standards, it regards it as a threat to established tax revenues.
Action 4 seeks to deny companies a tax deduction for interest payments, treating finance as a tool of tax avoidance rather than an essential ingredient of business success.
Action 5 requires ‘substance’ for profits to be attributed to a part of the business; primarily this is an attempt by the OECD to shift the allocation of profits away from intellectual property and the knowledge economy and back towards physical assets and employees.
Article 7 on permanent establishments has a similar approach. In deciding whether a business has a taxable presence in a particular country, the OECD is trying to shift the focus away from the business-related concepts that we have used in recent decades and back towards an earlier view of physical contact. Removing the warehousing exemption and widening the agency concept mean that, rather than concepts based on the role of the operation in the value chain, the OECD is using outdated tests of physical assets and customer sales.
‘Substance’ as a cover for physical assets
Actions 8 to 10 on transfer pricing again show the same refusal to accept the realities of modern business. For generations international tax has been based on the arm’s length price – allocating profits between different segments of a multinational business has been done on the basis of a fair price, what the different parts of the groups would charge each other If they were independent businesses.
That was a flexible concept that allowed the international tax system to respond to business developments – as particular aspects became more important to business, so those parts of the business became more profitable and the allocation of taxable profits followed the business reality.
But no longer; the OECD is now using ‘substance’ as an excuse to return international tax to an outdated concept of physical presence. If the holder of the group’s intellectual property cannot demonstrate ‘substance’ – a concept that seems to be based on the idea of a physical research laboratory and its staff – then the group cannot justify allocating profit to it.
Wrong Objectives, Wrong Approach
These errors in the OECD’s approach, of ignoring the realities of modern business and focusing too much on an out-of-date concept of physical activity, seem to come directly from it having the wrong objectives.
Because the OECD is trying to help its member governments collect more tax, rather than encouraging international trade to provide opportunities to their citizens, it sees innovation and intellectual property as a threat rather than an opportunity.
Technology and innovation have brought benefits that were undreamed of even just a generation ago – not just new business and job opportunities but also services that were almost unimaginable just a few decades ago.
But rather than celebrating this as an achievement of its mandate, increasing living standards for the people, the OECD merely sees the mobility of intellectual property as a threat to the tax revenues of its member governments.
The OECD’s attack on intellectual property and financing, disallowing the allocation of profit to parts of the global business that cannot demonstrate physical ‘substance’, is not really driven by any concept of how businesses operate but merely by its member governments’ fear that part of the profits of multinationals is being generated outside their tax nets.
The Ultimate Aim?
Perhaps the ultimate aim of the OECD BEPS project can be seen in the European Union’s tax objective. Many of the OECD member governments are also EU members, and so there can be overlaps between their policies.
The European Union’s goal is the Common Consolidated Corporate Tax Base, under which the taxable profits of a multinational group are calculated centrally, according to a centrally-determined method, and then those profits are allocated to the different countries based on a pre-determined formula based on the location of staff, customers and physical assets.
This is a complete abandonment of the arm’s length principle and a shift to a completely different way of looking at international tax.
The OECD’s BEPS proposals do not go that far. Rather than replace the arm’s length principle, they just abuse it, denying the legitimacy of profits based on intellectual property or group financing. But the effect is much the same – a shift away from allocating profit based on business principles and a fair arm’s length price, towards a system based on physical presence and physical activity.
Lack of Flexibility
One weakness of both the OECD and EU proposals is their lack of flexibility.
The EU’s Common Consolidated Corporate Tax Base (CCCTB) requires detailed systems of how taxable profits are calculated and how they are then allocated between countries. Any changes to that would have to be agreed between the various member governments, a cumbersome process that will not be quick enough to react to changes in the business environment.
Similarly, the OECD is moving away from the flexible arm’s length basis, under which profits were allocated on a fair commercial basis that could change with business practices, and is instead adopting a set of arbitrary rules that will become set in stone and slow to react because of the need to secure agreement between member governments.
Bureaucrats Increase Bureaucracy
After the insistence on physical ‘substance’, the other most striking feature of the OECD’s BEPS project is the bureaucracy.
Actions 11, 12 and 13 are all about data gathering, imposing detailed and stringent requirements on multinational businesses to provide automatic information to tax authorities, whether required or not.
In particular, the country-by-country reporting demanded under Action 13 requires businesses to provide information on where their profits arise and where their sales, employees and physical assets are located.
But as well as a huge administrative burden, it is no coincidence that this includes the information that would be required to calculate the formulary apportionment of profits under the EU’s Common Consolidated Corporate Tax Base, highlighting the concerns that, although the OECD’s method is different, the two organisations’ aims are similar.
One fear is that tax authorities will use this as a way to spot profit pools that they will then attack. Rather than the arm’s length principle of allocating profits to different parts of the group on a fair commercial basis, companies will increasingly face demands to justify any profits that are not allocated on the physical ‘substance’ basis of customers, employees and tangible assets.
The problems of the OECD’s BEPS project are not accidental; they are a direct result of the organisation having a fundamentally wrong approach.
Rather than its original aims of promoting employment and raising living standards for people, it has become focused on protecting its member governments and their tax revenues.
It is this that has resulted in its attack on intellectual property and group financing; their objection seems not to be a philosophical one but rather a fear that these aspects of business are more mobile and that therefore they could arise in countries outside the OECD members’ tax net.
But the danger of the OECD’s approach is that it will damage investment and destroy jobs. Rather than solve the problems of its member governments’ finances, this attempt to raise more taxes from businesses will reduce employment opportunities and lower living standards, preventing the economic recovery that too many OECD members need.
The OECD and its member governments are burying their heads in the sand, refusing to acknowledge either the reality of the importance of the knowledge economy for modern business or the overwhelming economic evidence on the harmful negative effect of increasing business taxation on investment and jobs growth.
Richard Teather is Senior Lecturer in Tax at Bournemouth University, a regular writer and conference speaker and has acted as a tax policy adviser to various governments and business organisations around the world.