Tax evasion and tax avoidance feature highly on the agenda of this year’s meeting of leaders of the world’s richest countries starting today at Lough Erne. Recent reports on the low or no corporation tax paid by large companies, and on tax evasion by individuals, have made headlines. Evidence of the erosive effects of such practices on public revenues and their implications for development has led to mounting public demand for reform.
In the run-up to the G8 summit, discussions have focused on three ways to improve tax compliance, and we can expect to hear more about these in the coming days. These are:
· improving cross-border exchange of information
· regulating the type of information shared (for instance, making the ownership of companies accessible), and
· modifying the current tax rules that entities exploit to cut their tax bills.
Despite media reporting on practices of evasion and avoidance, and growing public awareness, much of the language used to talk tax and transparency remains opaque: as Kevin Watkins put it recently, it is a ‘vocabulary that comes with the dark arts of tax evasion’.
For anyone trying to penetrate the maze of arcane terminology, here is a short glossary of ten terms that might help along the journey.
Arm’s length principle: the conventional approach to regulating transfer pricing (see below), outlined by OECD guidelines. The principle requires multinational enterprises to price their internal or intra-group transactions, and calculate profits, as if the transactions had taken place between independent businesses negotiating in an open market. Acting on the principle requires information on prices of comparable products or services. In practice, limited information and capacity to access and manage information act as obstacles to implementing this approach.
Automatic exchange of information: involves the systematic and periodic transmission of taxpayer information across countries. It contrasts with current forms, which depend largely on requests and the spontaneous exchange of information. Components of automatic exchange that need to be agreed on include the scope of income or transaction to be covered, the taxpayer information to be captured, the timing and format of transmission, and confidentiality.
Beneficial ownership: shell companies, foundations and trusts may exploit opacity for tax evasion practices by disguising who their actual owners are. Revealing the beneficial ownership – i.e. who really owns and controls a company – to tax authorities could be an important step in opening up corporate secrecy. The beneficial owner is the person who has the right to enjoy the income or capital associated with an asset; this is contrasted with legal or nominee owners, who may act as ‘fronts’ that conceal the actual beneficial owner. Requiring companies to provide complete and regularly updated information on their beneficial owners, to be included in public registers, is one way to tackle this.
Corporate profit shifting: refers to tax planning strategies that exploit loopholes in tax rules to make profits disappear for tax purposes, or to shift profits to locations where there is little or no real activity but where they are lightly taxed, resulting in no or little tax being paid. Transfer pricing (see below) is one of the mechanisms available to companies seeking to minimise tax liabilities in higher tax jurisdictions.
Country-by-country reporting: an accounting standard requiring companies to publish their financial reports separately for each country in which they operate. Current rules that permit multinational companies to report these details as a single aggregate (global or regional) figure prevent monitoring of where their activities are taking place. Proponents argue that country-by-country reporting could help expose and deter tax avoidance and yield information required for the implementation of accurate transfer pricing, in accordance with the arm’s length principle.
Double taxation and non-taxation: double taxation is the levying of tax by two or more jurisdictions on the same declared income, asset or transaction. This can occur when entities have gains from countries other than the one of residence. As countries continue to have different tax rules, companies may be exposed to having to pay tax in both countries under different laws. In practice, tax treaties between countries aimed at mitigating this risk have sometimes had the effect of ‘double no-taxation’, where companies pay no tax in either country.
Tax havens: places (state, country or territory) that offer light regulation, low, or zero, tax on some types of income, and which offer secrecy. Restrictive definitions limit tax havens to those places that also require little or no economic activity for a company to obtain legal status. Countries listed on various tax-haven lists include the Bahamas and the Seychelles, as well as Liechtenstein and Monaco. Non-sovereign jurisdictions commonly listed include the U.S. state of Delaware and UK Overseas Territories and Crown Dependencies such as the British Virgin Islands and Jersey.
Tax regimes: as seen above, variations in tax regimes across countries generate opportunities for tax avoidance. Tax regimes can be territorial or worldwide (based on residence). Under a territorial system, which exempts foreign profits, companies have an incentive to maximise overall group profit by shifting some of their earnings into low-tax jurisdictions. Under a worldwide approach, all income of domestically-headquartered companies is subject to tax, including income earned abroad. To avoid double taxation of the same income base, worldwide systems would need to provide credits for taxes paid to foreign governments. Still, this could imply a higher tax burden for companies headquartered in countries that adopt the worldwide model.
Trade mispricing: is one of the strategies used by large corporations to cut their tax bills. Transfer pricing is the mechanism to determine the price of transactions between subsidiaries of the same corporation. Transfer mispricing occurs when two related companies trade with each other and artificially distort the price at which the trade is recorded in order to minimise taxes due: for example, by recording as much profit as possible in a tax haven with low or zero taxes. This issue has become especially prominent since intra-group transfers have become increasingly important as a share of total world trade. According to one estimate, transfer mispricing costs developing countries US$550bn annually, more than five times annual aid flows.
Unitary taxation: is an alternative system to the transfer-pricing approach for the taxation of multinationals, under which the incomes of all the related parts of the company are aggregated, and the profits are shared between the different countries where they were generated, using an agreed formula. Critics warn that its feasibility is limited, especially in the short term, as it would require different countries to agree the appropriate formula for apportioning the profits.