Can tax laws keep up with globally operating businesses and constant technological change? This is a fundamental challenge confronting governments.
It is also the reason tax is getting a lot of attention in the Australian media, particularly coverage of the Senate inquiry into corporate tax avoidance. In response, the Treasurer Joe Hockey has signaled that the Australian Government will follow the UK and impose a 'Google Tax' (based on the UK's diverted profit tax) aimed at companies who shift profits overseas. The Government has also said it will impose GST on books, TV shows, movies, and music downloaded over the internet from foreign suppliers.
But are these initiatives partial 'fixes' when more fundamental reforms are required?
This is not a new issue. The world has not suddenly discovered that international tax laws are out of date with global firms and the digital economy. These issues have been on the OECD's work plan, along with those of national tax authorities, for many years. They only became a hot topic when the apparently low taxes paid by firms such as Google, Starbucks and Apple made headlines. As a result, governments came under political pressure to do something. This led to the launch of the high-profile base erosion and profit shifting (BEPS) program by the OECD and G20.
The UK's diverted profit tax, which commenced on 1 April 2015, has been criticised as a unilateral measure that preempts internationally coordinated action through BEPS. But the move is a response to political pressure in advance of the forthcoming UK general election. All governments are coming under increasing pressure to make sure companies pay their 'fair' share of tax. [fold]
The UK tax is complex, challenges some basic international tax principles, and introduces new concepts as to what constitutes profit shifting for tax purposes. It has to, because if 'diverted profits' could be identified under existing law there would not be a problem. The diverted profit tax applies in two cases: (1) where a foreign company structures its affairs to avoid establishing a UK taxable presence (a 'permanent establishment'); or (2) where a company which is taxable in the UK creates a tax advantage by involving entities or transactions with a 'lack of economic substance'.
In applying the law, a range of new tests and principles are introduced to determine when tax 'advantage' is the main motivation behind a transaction. In doing so, the UK law challenges the long-standing international tax principle that a foreign entity has to have a taxable presence in a country – a physical presence or dependent agent – before it is taxed. The concept of having a permanent establishment (such as a branch, property, employees) as a pre-condition before a firm is taxed is increasingly out-of-date in a world where goods and services can be delivered over the internet without the need for a physical presence. How to update the 'permanent establishment' rules is a controversial aspect on the BEPS work program. But the UK has unilaterally imposed a solution which is inconsistent with existing principles used by other countries.
The UK is also overriding the double tax treaties it has with other countries. As such, other countries may see the UK move as the application of extra-territorial laws that impact their tax base. How will they respond? The danger is that if they adopt their own unilateral measures, the result may be an even more fragmented and unpredictable international tax system.
Plugging digital holes in the tax net is hard and governments continually play catch-up with technological developments (GST may be applied to TV shows sold to Australian consumers, but the response may be an increase in illegal downloads, since it's easy to establish a virtual US email address), so the UK move is right in challenging the appropriateness of some long-standing international tax principles. But this needs to be done in a coordinated international manner. The UK approach is piecemeal and does not ensure taxing rights are apportioned equitably across countries.
BEPS is an effort for a coordinated international response, but the challenge will be getting agreed measures implemented by a wide group of countries. Another concern is that BEPS may not go far enough in challenging international tax norms such as the allocation of taxing rights between 'source' and 'resident' countries, and the relevance of the 'arms-length' principle to reconstruct transactions between integrated firms.
BEPS needs to move beyond trying to tweak existing international tax principles and consider such non-traditional ideas as formulary apportionment (allocating a multinational's profit across countries on the basis of economic activity) or some form of minimum tax.
Modernising international tax law is a hard slog; it needs to be done in an internationally coordinated way and will require some 'out-of-the-box' thinking. Yet the Australian Government will continue to be under political pressure to do something. In this regard, the image of representatives of major corporations struggling to explain to a Senate committee that they do not structure their affairs to avoid tax is a reminder of the power of transparency – requiring companies to publicly explain their tax arrangements.
Perhaps this should be the focus of the Government's response.
Photo courtesy of Flickr user Glenn Halog.