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
Types of passive income:
Interest: income from capital loaned
Royalty: income from intellectual property (patent, design, know-how, franchise,
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
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 European Court of Justice has declared in a court ruling that within the European
Union the subsidiary resident in a low tax jurisdiction cannot be taxed by the state
of residence of the parent company if the subsidiary performs a genuine economic
The residence of the listed parent company can be relocated to a state where there
is no controlled foreign corporation rule.
In the USA, the so-called check-the-box rule is used to circumvent the controlled
foreign corporation rule.
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 . 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
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.