THe Four “R”s of Taxation

The “Four Rs of Taxation” is a concept attributed to the Tax Justice Network that fairly well sums up why tax and human rights are so closely linked.

Essentially, tax brings in essential Revenue to fund rights-related goods and services; tax Redistributes money from those with more to those with less; tax Regulates behaviour by providing dis/incentives; and tax encourages Representation as people can expect accountability from their governments for the contributions they are making through various forms of taxes.

In turn, human rights law tells us how we can create a fair and progressive tax system that is designed through democratic and rights-consistent processes, that results in the realisation of the human rights of all peoples.

See e.g. Philip Alston and Nikki Reisch, “Introduction: Fiscal Policy as Human Rights Policy” and Matti Kohonen, Radhika Sarin, Troels Boerrild, and Ewan Livingston, “Creating a Human Rights Framework for Mapping and Addressing Corporate Tax Abuses” in Alston and Reisch (eds.) Tax, Inequality and Human Rights, pp 3, 385-6.

The Social contract

Tax and human rights are inextricably linked and make up important parts of the social contract. Both taxation and human rights law concern the relationship between the individual and the state. The state’s primary duty is to respect, protect, and fulfill human rights. In so realising the rights of the people, the state confirms it legitimacy and is able to raise taxes to perform its functions. Human rights law tells us how that tax revenue can be raised and how it should be spent. Regressive fiscal systems, tax lobbying, and tax avoidance and evasion all undermine the social contract and harm the relationship between people and the state.

See e.g. Alston and Reisch (eds.) Tax, Inequality and Human Rights, pp X, 18-19, 238.

Why Tax is Essential for Human Rights

We need the revenue raised from taxation to fund essential human rights-related goods and services, such as hospitals, public schooling, social housing, public transport and infrastructure, libraries and internet access, and social security.

See e.g. Olivier De Schutter, “Taxing for the Realization of Economic, Social , and Cultural Rights” in Alston and Reisch (eds.) Tax, Inequality and Human Rights, pp 59-60.

THE REGRESSIVE IMPACT OF CONSUMPTION TAXES – CONSUMPTION TAXES: PART 1

Indirect taxes like consumption taxes are generally regressive. What this means is poorer households pay disproportionately more of their income because the tax is set at a flat rate and not dependant upon how much income they have. Exemptions on basic necessities may alleviate some of the burden, but the evidence on the ultimate outcomes for equality is mixed.

Source: Inter-American Development Bank, Recaudar No Basta: Los impuestos como instrumento de desarrollo, 2013, p. 247 cited in Human Rights Council, Report of the Special Rapporteur on Extreme Poverty and Human Rights, Magdalena Sepulveda Carmona, on taxation and human rights (2014) A/HRC/26/28, para. 46. See discussion: Kathleen Lahey, “Taxing for Growth versus Taxing for Equality – Using Human Rights to Combat Gender Inequalities, Poverty, and Income inequalities in Fiscal Laws” and Sandra Fredman, “Taxation as a Human Rights Issue” in Alston and Reisch (eds.) Tax, Inequality and Human Rights.

Why women pay proportionately more consumption taxes – Consumption Taxes: Part 2

Because women are statistically more likely to be low income, the primary carers of children, and the ones who spend their income on basic necessities, they are the people who prop up the revenue system by paying disproportionately more of the money they have on consumption taxes.

See e.g. Kathleen Lahey, “Taxing for Growth versus Taxing for Equality – Using Human Rights to Combat Gender Inequalities, Poverty, and Income inequalities in Fiscal Laws” and Sandra Fredman, “Taxation as a Human Rights Issue” in Alston and Reisch (eds.) Tax, Inequality and Human Rights, pp 89-92, 433.

Tampon Tax

Astoundingly, not only do women have to buy a product that men do not; they get taxed on it! We are talking about menstrual hygiene products. This practice is highly discriminatory. There is no equivalent for men getting taxed on a natural bodily function – even in New York, hair regrowth treatment was exempt from sales tax before the same courtesy was extended to pads and tampons! Some countries are recognising how problematic this is and are removing taxes on menstrual hygiene products (e.g. Australia). More need to follow suit. It makes one wonder if it would have taken this long if it were men bleeding every month…

See e.g. Bridget Crawford and Carla Spivak, “Human Rights and the Taxation of Menstrual Hygiene Products in an Unequal World” in Alston and Reisch (eds.) Tax, Inequality and Human Rights.

The International Tax Regime

To the extent that there is “an” international tax regime, the law itself is made up of double tax treaties and domestic country legislation. This policy framework is heavily influenced by a number of key players, but the Organisation for Economic Cooperation and Development (OECD) - made up of most of the world’s high income countries - has an overwhelming influence. The United Nations (UN) also plays an important (though less influential) role, as do international financial institutions the World Bank and the International Monetary Fund. Several smaller regional players like the African Tax Administration Forum (ATAF) and the Inter-American Center of Tax Administrations (CIAT) have also developed model treaties and other policy documents to try to assist their member countries. The European Union has prescribed tax policy directives for its member states (ATAD) as well as developing tax haven blacklists (with potential trade sanctions) in an effort to prevent tax evasion, fraud and secrecy.

The key modern reform efforts stem from the OECD in their G20-mandated Based Erosion and Profit Shifting (BEPS) project, which was delivered in 2015, with 15 action items. The OECD’s work is ongoing as they currently seek to develop new policies to address ongoing BEPS issues and the tax risks from digitalization of the economy (often referred to as BEPS 2.0). Civil society continues to push policy makers to adopt the simpler formulary apportionment approach to transfer pricing and to improve tax transparency (for example through public disclosure of country by country reports and other tax information).

The Hot Topics in International Tax

In seeking to understand the international tax regime, it is useful to break it down into eight of the most pressing topics: transfer pricing, permanent establishments, hybrids, withholding taxes, tax incentives, digitalisation, dispute resolution, and tax transparency.

We begin with explaining the difference between residence countries and sources countries and the concept of double taxation, before looking at each of these topics.

Finally, we explain NGOs public effort to rejig the entire system with the “formulary apportionment” approach.

Residence Countries versus Source Countries

First, in the context of cross-border transactions or activities within a multinational corporation, it helps to understand the residence country / source country dichotomy. Tax treaties dictate whether taxing rights that would otherwise extend to both countries should be allocated to the residence country or source country. In doing so, they ensure taxing rights are allocated to only one country (either the residence or source country) and, therefore, there must be a winner and a loser.

In this context, residence countries are generally where multinational companies have their headquarters or where the capital and assets of the company are owned, and tend to be upper income countries and tax haven countries. Source countries, on the other hand, are generally where the activity of the corporation tends to occur, such as mining the raw material, manufacturing, sales and distribution activities, banking, or telecommunication. Often, source countries are low and middle income countries.

The Concept of Double Taxation

Second, the concept that underpins the entire system is that corporations and people should not be made to pay tax in two different countries on the same profits - this is called double taxation. The concept of double taxation applies even where one country’s law results in no or minimal tax on those profits (for example tax haven countries). In this situation, the tax haven country may be allocated the taxing rights but not collect any tax. At the same time, the other country is prevented from taxing the profits that would have otherwise been taxable under their domestic laws. This concept is almost universally accepted as the cornerstone of international tax. Should it be?

Permanent Establishments

Generally, companies only have to pay tax in the country in which they are tax resident. If the company’s operations extend to another country, but no formal subsidiary or entity is created, they will only be taxable in that country if those activities constitute a “permanent establishment.” Until now, the definition of permanent establishment has relied heavily on the concept of a physical presence. These rules have been easy for multinationals to artificially avoid and have resulted in companies with significant and sustained economic activity in a country avoiding triggering a permanent establishment. The definition of permanent establishment therefore represents one of the key battlegrounds between residence and source countries.

Withholding Taxes

Multinational corporations can be very crafty with how they structure transactions. In this scenario, where a beer company’s headquarters holds the intellectual property such as the brand and recipe, they can effectively say that all the profit made by the subsidiary in the source country must be paid in an exorbitant royalty payment back to the company HQ. This means the source country would have no or tiny profit left to tax. A withholding tax is something the source country can impose on the royalty payment, but this can be limited in the amount by tax treaties. This is just one of many reasons why low income countries should be very wary about signing double taxation treaties.

Interesting note: In this scenario, transfer pricing would look at whether the amount of the royalty payment is correct.

Transfer Pricing

Transfer pricing looks at the transactions within multinational groups to see if the prices being charged for the goods or services truly reflect the market value. As the price of intra-group transactions can be manipulated, multinational groups can use it as a means to shift profits from high tax to low tax jurisdictions. Ensuring the prices are market value is the current mechanism to curb such practices.

This illustration shows a typical scenario where the subsidiary in the source country does the actual mining of the commodity. The product is sold to the headquarters (HQ) at a depressed price, leaving a profit of only 1 for the subsidiary. The HQ sells to the third party for the market price, which allows them to keep a profit of 45, merely for performing the sales and marketing function. Typically the HQ is located in a low tax jurisdiction such as Switzerland, Dubai or Singapore. The contrived nature of the arrangement is demonstrated by the fact that the product is shipped directly from the subsidiary to the end third party customer.

The winners? The company first and foremost because they have paid less tax, and also the residence country who gets the tax they do pay. The losers? The low income source country.

Hybrids

Ohhh now hybrids are complicated… But basically the thing to know is that either through how they structure an entity or how they structure an instrument, hybrids take advantage of the mismatches between country rules so that there is a tax deduction in one country and no corresponding taxable income in the other country. The result is that multinational groups can enter into internal transactions or structures that have no impact on the group’s profits, but lower the tax bill in one country without increasing the tax bill in another country.

Digitalisation

Digitalisation is SO hot right now. It’s the platform on which new OECD-led reform efforts are being made and could represent the biggest change in the international tax regime in decades.

Under current rules, a taxable presence (permanent establishment) is linked to physical presence in a country. The digitalisation of the economy has presented new opportunities for multinationals to have a significant and sustained economic presence without triggering a taxable presence. Similarly, transfer pricing allocates profits to entities that own assets, assume risk and perform functions. The digitalisation of the economy has allowed multinationals to capitalise on huge user and subscriber bases in countries with minimal profits being allocated to the source country.

The current OECD work is considering whether the taxable presence rules should be changed and whether the transfer pricing rules should be changed to adequately compensate the country generating the revenue through users and subscribers.

Tax Incentives

Low and middle income countries have faced enormous pressure for years to provide favourable tax concessions to attract foreign investment. Often this has meant agreeing a tax deal with the investing multinational company. There are benefits to foreign investment (such as job creation), however in many instances these incentives are being offered without adequate consideration. The concession may be in the form of a tax holiday which allows companies not to pay any tax for their first years of operation (often 5-20 years). It may also be in the form of a tax incentive which gives the company a reduced rate of tax, either for a prescribed period or for the duration of its operation in the country.

Studies are now showing that the importance of tax incentives has been overplayed and factors other than tax play a much bigger role in determining investment decisions.

See e.g. Olivier De Schutter, “Taxing for the Realization of Economic, Social, and Cultural Rights” in Alston and Reisch (eds.) Tax, Inequality and Human Rights, p 61.

Tax Transparency

It is very hard to catch multinational corporations doing naughty things if you don’t know what they are doing. There has been a push for increased transparency around global taxation through two avenues: exchange of information, and country-by-country reporting.

Exchange of information occurs when two tax administrations exchange information obtained from taxpayers to assist the other tax administration (who does not have access to the same information). Country-by-country reporting, brought in during the BEPS project, requires multinationals to provide a global roadmap of the businesses’ financial and tax results. This helps tax administrations to assess the likelihood of tax avoidance and the need for an audit - for example, by highlighting that the multinational is earning the majority of its profits in tax havens. Currently, country-by-country reports are only accessible by some tax administrations, however civil society and other stakeholders want these reports to be made public.

See e.g. Arthur J. Cockfield, “How Countries Should Share Tax Information” and Miranda Stewart, “Transparency, Tax, and Human Rights” in Alston and Reisch (eds.) Tax, Inequality and Human Rights.

Dispute Resolution

The mechanisms to resolve disputes under international tax law aren’t particularly exciting, but things could get bad if an arbitration system similar to inter-state dispute settlement in the field of foreign direct investment is introduced. What we have now with the Mutual Agreement Procedure (MAP) is a system where if a company thinks its profit has been subjected to double taxation, it can use the bilateral tax treaty (if there is one between the countries) to force them to sit down together and try work out a solution. Of course, this then turns on how much information and power the respective residence and source countries have, and it is often not an equal footing.

An Advance Pricing Agreement (APA) is a way for companies to confirm with the tax administrations in advance that a particular transaction complies with the international tax rules. This is a proactive measure that many tax administrations encourage to foster a culture of cooperation and transparency and to avoid costly and time consuming legal disputes down the track.

The Formulary Apportionment Approach

Formulary apportionment is a revolutionary alternative to taxing multinational corporations that is being advanced by a variety of players, including many non-governmental organisations. Instead of treating companies within a multinational corporate group as separate entities for tax purposes, formulary apportionment would require the group as a whole to report total profits, which would then be divided up amongst countries based on a prescribed formula. This formula would be made up of components such as number of employees, revenue earned, and value of tangible assets in each company. It would do away with all the complexities of transfer pricing, permanent establishments, withholding taxes and the effect of hybrids. This simple, mechanical approach would provide certainty to all stakeholders, eliminate disputes and remove the prospect of double taxation. The catch? Getting countries to agree on the formula.