Multinational companies have emerged from international investment and trade as capital can be used more efficiently on a worldwide scale. However, for international investment to be more efficient than domestic the investor needs a double taxation treaty that ensures that income generated by the foreign investment is not double taxed by both the country of residence of the investor and the country the income is sourced from.

In order to prevent double taxation the international taxing rights are currently allocated as follows: Active or business income is taxable in the country where the activity takes place, that is, where the income is sourced from. Passive or capital income is taxable in the country where the owner of the capital is resident. Company residence is based upon the place of management or the place of incorporation of the enterprise.

Types of passive income:

Double taxation treaties reinforce the residence-source allocation of international taxing rights. However, the source country can also be allowed to tax passive income even if there is a treaty in force. The actual allocation of taxing rights depends on the power relations of the particular treaty partners. Capital-exporting developed countries prefer the OECD model treaty, which is more favorable to residence, while capital-importing developing countries prefer the UN model treaty, which is more favorable to source.


The multinational corporation can shift its profit by transferring equity capital and ownership of intellectual property to its subsidiary that is resident in a tax haven. As a result its passive income is shifted to the tax haven.

In addition, the multinational corporation can shift its profit by transferring business risks to its subsidiary that is resident in a tax haven.

The active income of a subsidiary that is resident in a non tax haven state can be shifted by transfer pricing, when the subsidiary sells products or services to another subsidiary that is resident in a tax haven below market price or purchases products or services from it over market price.

To sum up the above, the multinational corporation is able to allocate its income by transferring capital, intellectual properties and risks and in addition by transfer pricing the products and services that are produced by the group. This means that the value of the income allocated to a particular nation state is the sovereign decision of the multinational enterprise.


The non tax haven state can levy a withholding tax on the interest and royalty paid out by the local subsidiary to another subsidiary that is resident in a tax haven. If however the high tax jurisdiction has a double taxation treaty with the tax haven state then passive income is taxable at residence.

In the absence of a double taxation treaty or directive the multinational corporation can channel passive income through a so-called conduit company which is resident in a country which have a double taxation treaty with the high tax country. The income is directed via the conduit company to the so-called beneficial owner company which is resident in a tax haven free of withholding tax. This structure is known as treaty shopping, as the beneficial owner of the income uses the intermediary state only to benefit from its double taxation treaty.

One of the main attacks launched by multinational corporations against domestic income comprises interest charged by a subsidiary that is resident in a tax haven to another subsidiary resident in a high tax jurisdiction. The multinational group puts its equity capital into its subsidiary located in a tax haven, whereas it finances its other subsidiary located in a high tax country by debt borrowed from its low taxed subsidiary. In this way, the income of the thin-capitalized subsidiary is shifted to the thick-capitalized subsidiary resident in a tax haven.

Against thin-capitalization the high tax state can defend itself by applying the so-called thin-capitalization rule, when it does not allow interest to be deducted above a certain limit if the subsidiary located in its jurisdiction is financed excessively by debt.

Against transfer pricing developed OECD countries fight by applying the so-called arm’s length principle, when the high tax state compares the prices of intercompany sales and purchases to the prices that have evolved between independent companies, i.e. the market prices. After establishing the arms’ length or market price, the state adds the difference to the income of the resident company. However, the establishment of the arm’s length price is practically impossible due to the following main causes.

The first problem is that the bulk of world trade takes place among multinational corporations, so there is practically no arm’s length price which could be applied between related companies. The markets typically dominated by multinationals (e.g. banking-, pharmaceutical-, automotive-, telecommunication-, computer industry, etc.) do not have a large number of independent participants.

The second problem is that one of the main goals of market competition is the establishment of prices, so the correct arm’s length price cannot be established cost effectively by way of calculation. The result of calculation, therefore, will be a broad range of prices which is more than sufficient for the multinational corporation to locate its income where it is optimal.

The third problem is that if the market profit is attributed to all related companies, a residual profit will arise in consequence of the fact that the aggregated income of the multinational corporation exceeds that of a group of independent companies (cet. par.), which is mainly due to centralized management and economies of scale.

The multinational enterprise which has succeeded in shifting its profit to tax havens is at the same time faced with a problem. The multinational corporation is structured hierarchically, that is a listed parent company, which is usually located in a high tax jurisdiction, owns all the subsidiaries resident in various states. The multinational corporation needs to report profit on the stock exchange, but at the same time wants to declare loss to the tax authority. The profit, however, which is shifted to tax havens generates a loss for the parent company listed on the stock exchange.

The solution to this contradiction is called a consolidated financial statement following the accounting standards of US GAAP or IFRS (EU). In a consolidated financial statement the income of the non tax haven parent company and that of the tax haven subsidiaries are published together.

Nation states have responded to this attack by inventing the so-called controlled foreign corporation rule. In applying this legislation, the high tax jurisdiction adds the retained earning of the subsidiary resident in a tax haven to the income of the parent company. In this way the shifted profit becomes taxable by the non tax haven country.

However, the controlled foreign corporation rule can be avoided as well:

The proposed solution against profit shifting of multinational corporations is the application of the so-called formulary apportionment method or unitary taxation, where the aggregated income of the multinational corporation is distributed among the countries where it performs its activities using arbitrary weighting of different factors, such as payroll, assets, or sales [1]. However, this method does not differ substantially from the current system where multinationals allocate their own income arbitrarily, as we are faced with the same problem of how to allocate income truthfully among states.

The ideal method would allocate to every state the real value of the income locally generated, as the public services rendered have contributed to the generation of the income, and therefore the state is entitled to its fair share in order to be able to provide the services continuously. But the real value of the income is impossible to calculate in the absence of competition.

On the other hand, applying the formulary apportionment method does not in itself prevent the abuse. The value of income could also be manipulated in the formulary apportionment system, as multinationals could relocate those factors the formulary apportionment is based upon to where taxation is more favorable.


The true allocation of income among states is not cost effectively feasible. Even if the multinational enterprise does not want to abuse the system, it cannot calculate the real income attributable to its subsidiary operating in a particular state.

Furthermore, even in the case of an ideal international taxation system where all states applied the same tax rate and there were no tax havens, it would be advantageous for the multinational enterprise to set off loss generated in one state against profit generated in another state. However, the artificial reduction of profit generated in a particular state reduces the tax revenue levied on the income and so deprives that state of funds needed for rendering the public services that contribute to the generation of profit.

In the present international taxation system with different tax rates and tax havens, multinational corporations are even more motivated to shift profit to countries with more favorable tax regimes to optimize their tax burden.