There’s been a lot of talk about BEPS being the biggest shakeup in international tax in a century. But one thing that’s so far managed to survive the shakeup is transfer pricing and the arm’s length principle. The question is, for how long.
BEPS is to blame
Where alternative ideas might have been dismissed as academic theorizing in the past, there are increasing signs that some of these are beginning to gain traction in the real world. Notwithstanding its continued support for the arm’s length principle, the BEPS initiative should get some credit for this by having put tax avoidance and aggressive tax planning so publicly on centre stage. People are now beginning to ask whether BEPS alone is sufficient to tackle those issues without a fundamental rethink of the basis for allocating profits between competing taxing jurisdictions. Ironically, these doubts have been fueled by the BEPS mantra that profits should be taxed where the activities generating them are performed precisely because this just raises the question how to determine where those activities do take place. This is the space these alternative ideas might just be hoping to fill.
Coming into BAT
The most trending of these new ideas is the border adjustment tax, or ‘BAT’, currently being mooted in the US. While this may owe a lot of its current popularity to the current hausse around President Trump’s tax reform proposals, the idea itself wasn’t his. It was however put forward last year as part of Republican inspired tax reform proposals and there are signs that the President might just be buying into it. That’s not surprising when you look at all the things its proponents say it should do, in particular generate revenue (since the failure of Trumpcare, even more badly needed for the President’s much vaunted tax cuts), reduce the trade deficit, incentivize businesses to move to or stay in the US, and, if that wasn’t enough, it should also put an end to a whole raft of international tax avoidance practices. Of course the question is whether these claims can be justified. While the economists are still wrangling over the pro's and con's, and the lobbyists are providing some kickback, the tax avoidance claim seems to have something going for it. And as a tax lawyer rather than an economist it’s that that interests me.
The end of tax havens
So how would a BAT reduce tax avoidance? The answer is quite simple: it takes cross-border transactions and the prices paid under those transactions out of the tax computation equation. Under the current rules, the price paid by a US importer will reduce its taxable profits and, conversely, the price received by a US exporter will increase its taxable profits. If a multinational is able to manipulate those prices it can manipulate the amount of profit that the US gets to tax. And with a rate as high as 35% (or maybe even with just the 20% under the Republican plans) some will think that it’s worth manipulating. A BAT basically ignores cross-border transactions so imports are non-deductible and exports are not taxed (the big picture is a bit more complicated but that’s sufficient for current purposes). While BEPS actions reduce the scope for a lot of tax avoidance practices, it can be argued that this is simply focusing on the symptoms rather than the cause. And the cause is the inability of transfer pricing in general, and the arm’s length principle in particular to adequately address the problem. By ignoring these international transactions it no longer matters how much is paid or received nor who receives or pays it or where they are located. End of tax havens!
.....or is it?
A BAT would also provide a solution to the tricky question of where profits are generated by, in effect, allocating the right to tax to the jurisdiction where the sales take place: typically where the customer is located. On the face of it an easy to apply rule. That is, so long as you know who the real customer is, and what you mean by located….More scope for (aggressive) tax planning?
So while it might not be appropriate to counter the proposal with a simple ‘if it ain’t broke don’t fix it’, prudence suggests that even if it is broke, ‘don’t fix it until a better solution comes along’. If a BAT turns out not to be such a solution at least it has opened up the debate. After all, BAT is not the only new kid on the tax block…