Taxing Multinationals - A Primer

I figure before I get into the latest OECD pronouncement, it may be a good idea to give some of my readers a little primer on how multinational corporations are taxed, so you can understanding the tricks companies engage in and what the OECD is proposing to fix them.

Almost all countries follow the same pattern of taxation of corporations.  First, there are "resident" corporations and "nonresident" corporations - terminology differs but the concepts are the same (in the U.S. we use the terms "domestic" and "foreign").  Resident corporations are generally taxed on all of their income.  Nonresident corporations are generally taxed only on the income they earn within the country.   So, for example, the federal income tax is imposed on JP Morgan Chase, which is a domestic corporation, on all of its income wherever earned, and its imposed on HSBC, which is a foreign corporation, only on the income it earns in the US.

The first thing you should know is that most countries respect the "fact" that corporations organized elsewhere are separate entities.  If JP Morgan Chase has a subsidiary in Ireland that is wholly owned by Chase U.S., then the income earned by Chase Ireland isn't taxed by the U.S. when Chase Ireland earns it.  It is only taxed when Chase Ireland pays a dividend to Chase U.S., which, of course, is something that Chase U.S. has total control over.

So what makes a corporation resident or nonresident?  Well, that varies from country to country, and this is one of the disconnects that companies can exploit.  Under U.S. rules, residency is determined by looking at the country where the corporations is organized.  So if a corporation was formed in Delaware for example, it is considered a domestic (resident) corporation under U.S. tax rules.  If it is formed in the Cayman Islands, it is considered a foreign corporation.  Most other countries determine "residence" by reference to the place the corporation is "managed and controlled."  This might sound like an ephemeral concept.  Certainly if a British bank forms a subsidiary in the Cayman Islands it is still managed and controlled in the UK, right?  Well, no, generally management and control is located where the major business decisions are made, and believe it or not that means where the board of directors meeting is held.  So that British bank can assure that the Cayman Island subsidiary is not resident in the UK simply by flying its executives to the Caymans one or two times a year for board of directors meeting, and viola, they are nonresident.  Pretty cool, eh?  Under U.S. rules its even easier - all you have to do is form the corporation there and have an address (some law firms in the Caymans are the headquarters for thousands of companies) and poof, your a foreign corporation.

Obviously, residency is something that can be easily manipulated.

The third thing that you should know is that multinational corporations generally have total control over how much income is earned by each of their subsidiaries in the various countries.  They do this through a mechanism known as intercompany pricing.  Consider Apple - the component parts of an iPhone are manufactured in various countries in Southeast Asia, shipped to China for assembly into a final product, then shipped to the U.S. for sale.  How much of Apple's profit is taxed in each country?  That is determined by the prices charged when the goods move from one company to another.  And it also depends on how you set up the arrangement.  For example, when the iPhone is assembled in China, who owns it?  Does the Chinese company actually buy the component parts, assemble them and then re-sell them to Apple US?  Or does Apple US own the components and the Chinese company is just a "service provider" putting them together on Apple's behalf?  More likely, Apple has some other subsidiary organized in a tax haven like Mauritius that owns the components, pays the manufacturers of the components and the Chinese assembler, then sells the finished product to Apple US at a mark-up, taking some of the profit for itself.

But the real value of the product is not in the physical components - it's the technology and the name.  Where is that located?  Well, you would think that's an easy question to answer, but it's not.  Technology is not a physical thing, it's an idea, and when you have a large multinational with subsidiaries organized all over the world, it's kind of easy to manipulate which of those subsidiaries "owns" the idea.  Once you decide that, then the other subsidiaries can use the idea under licenses from the owner, and the licensees then pay royalties to the owner for the use of the idea.  Royalties are generally deductible expenses, so if the licensees are in high tax countries and the "owners" are in low tax countries or tax havens, the effect is to shift income to the havens and lower the overall taxes paid by the multinational.

Now, one could argue that, to the owner, the royalties are income earned in the country where the royalties are paid from.  And in fact most countries treat them that way.  Under US tax law, when a U.S. person pays a royalty to a foreign person, tax is supposed to be withheld on the royalty and paid over to the U.S. government at a rate of 30%.  BUT, of course, there is a catch.  The US has income bilateral income tax treaties with 58 countries that reduce that tax, in a majority of cases to 10%, but in many cases to zero.  Most other countries have the same.  And if Apple India pays a royalty to Apple Mauritius, its the tax treaty between those to countries that determines the rate of tax paid on the royalties.

One other thing companies can manipulate is the manner in which they invest in their companies.  They can form a corporation in France, for example, and invest by buying its stock, with the French company then using the money for its operations in France.  But they can also loan money to its French company as well.  When the French company pays back the loan, it's not considered dividends (even though, logically, it is paid back out of the earnings of the company).  Even better, interest on the loan can be deducted in computing the income subject to tax in France.  So let's say that Apple has a pile of cash in Apple Ireland which loans it to Apple France.  Apple saves taxes merely by paying interest on the loan.  Actually, the interest doesn't have to be paid - since most countries allow you to account for interest when it accrues rather than when it is paid, Apple France gets a deduction even if it doesn't pay the interest.  The holy grail, of course, is the so-called "hybrid" investment.  This is when the "investment" qualifies as a loan under French tax law, but is treated as stock under Irish tax law.  Dividends are never "accrued" - they only count as income if they are paid.  So with a hybrid investment and no actual payments being made, you get the deduction in France and no income in Ireland at all.  Viola!

I could go on and on about this, but you get the idea (I hope).  A multinational is basically a large group of companies operating all over the world, and much of what goes on is that they are buying and selling physical goods, services and technology and loaning funds among themselves up until the time that the final product is sold to the consumer.  And the amount of income that is taxed in each country is determined by the prices charged on these transactions - something that the corporation has total control over.  There are rules that exist to are designed to combat the shifting of income by manipulative pricing, but these rules are proving to be totally inadequate to combat the problem.

And that, my dear readers, is what the OECD report - entitled "Base Erosion and Profit Shifting" is all about.