Corporate Tax Loopholes & How We Should Close Them: Part One by Umar Saeed

Developed nations have a problem. GDP isn’t growing the way it used to. Job prospects have diminished for the young and middle class. That means government tax revenues aren’t growing either. But the public still maintains a high level of expectations for government programs and services. Nations are struggling to find additional sources of revenues to bridge this fiscal gap. They know that debt only defers the tax burden — it doesn’t eliminate it. How can governments raise more money when the overall economy is struggling?

This struggle to find tax revenues without taxing the public further has highlighted an old and often ignored problem: corporate tax loopholes. There is a great deal of political will to eliminate tax loopholes. The public is tired of hearing about corporations reporting profits yet somehow evading taxes. This isn’t about tax rates being too high or too low. This is about the profits that form the tax base, the very thing being taxed, somehow eroding when it comes time to pay Uncle Sam. But this won’t be easy. Corporations play this game too well to simply change one rule or another. If governments want to win, we have to change the game itself. 

What is tax arbitrage?

On 29 June 2009, despite most of its stores and revenues being in Canada, Tim Hortons had officially repatriated back to Canada for tax purposes. So at some point after former NHL player Miles G. Tim Horton started the first “Tim Hortons Doughnuts,” in Hamilton, the company grew so large that it made sense to situate itself in Delaware for tax purposes. Tim Hortons was American. That was, until 2009 when it was again advantageous to move back to Ontario. This specific strategy is simply called “inversion.” The name stems from the fact that a company’s corporate presence is inverted from its primary place of business.

At a basic level, we all know what these companies are doing. Once companies get big, expectations of profit go up. Even something as simple as a coffee shop, once it’s big enough, spends a lot of money hiring tax lawyers and accountants to find strategies to “create value.” ¹

The most basic tax arbitrage tenet is to recognize revenues in a country where the tax rates are low and then recognize expenses and losses in an area where tax rates are high. In other words, setup the books so the profits and gains show up in a low tax regime and losses get stuck in a high tax regime. Inversion is just one step. To go further, companies use something known as “transfer pricing.”

Large companies often structure themselves as parents with children. The parent might reside in a low-or-no tax jurisdiction. Its child will reside in a place that provides good market demand for the product being sold. There may even be siblings. In the end, all of these children are controlled by the parent. The parent can initiate transactions that will vacuum profits from its children to itself. For example, a parent might purchase supplies for its child’s coffee shop at $1 per roll. It would then sell these cups to its children for $5 per roll. By overcharging its children for paper cups, it is effectively shifting profits from a higher tax jurisdiction into its lower tax one.

Does there have to be a jurisdiction?

Apple, Google and others have created a more convoluted and aggressive corporate structure to evade tax. They have setup their parents in tax havens, a practice that is common among hedge funds and more sophisticated offshore investing. They channel their profits to countries where income tax is low or non-existent. The dad is American and holds an investment in a foreign mother. The mother is Irish, and holds rights to royalties and international profits from its children around the world, which may be taxed mildly in Ireland. Whatever profits make it to the father are treated as investment income, which is a most favourable tax treatment in America.

What is most disturbing of this strategy is that legally, the mother claims no jurisdiction for tax purposes. Irish law asks where a company is managed and controlled to determine its tax residence. U.S. law asks where the company was organized, that is, where the articles of incorporation were filed. If neither country regards a particular corporation as a resident, there is no treaty to force a jurisdiction on that company for tax purposes. This tax loophole resembles a black hole.

Closing the loops

An estimated 44 countries accounting for 90% of the world economy are on board with a plan to reform corporate tax laws and treaties. They have asked the OECD to tackle the basic issues above as well as treaty shopping (manipulating tax treaties), hybrid mismatches (double dipping on deductions in different jurisdictions) and patent boxes (favourable treatment of intellectual property income). As a big step forward, on September 20th the Group of 20 finance ministers agreed to proceed with free exchange of tax information across jurisdictions. This cross-jurisdictional transparency is imperative toward understanding the extent of tax evasion in the first place. This type of exercise may lead to, “oh, I thought you were collecting their taxes.”

But many remain skeptical about whether governments will actually go through with closing these loopholes. First, it brings up fundamental questions about a nation’s sovereignty. For example, shouldn’t a country and its elected leaders be in control of its most significant power — the ability to tax its own citizens? Second, politicians may not follow through on reforming loopholes because they are caught in a “prisoner’s dilemma” with each other. Exploring these two issues may actually lead us to a different path to solve the problem at hand.

Next time, we’ll address these two issues and whether the game can be changed — for good.

Continue reading with part two.

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Umar Saeed is an accomplished professional in finance and accounting. On his website (www.umarsaeed.ca), where this post originally appeared, he writes essays to explain the elaborate connections between people and money, without making your head hurt. You can follow him on Twitter @UmarSaeedCA. You can read the rest of his posts at The Little Red Umbrella here.

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Image via Consortium News.