In this article about corporate taxation, we consider the issue of ethics in relation to the way companies currently approach the arrangement of their tax affairs. How do they respond to the tax inducements and the tax demands of the governments under whose regimes they carry out their businesses? How should the boards of multinational corporations and other international companies approach the making of policy in regard to paying taxes, and where do ethics come into it?
How important is corporation tax?
The short answer is that it is a significant generator of revenue for governments as a contribution to their expenditure programmes. But this then raises questions as to whether this is an effective and efficient way to do this. For very many years in the UK, companies were treated in the same way as individuals, paying income tax with an additional tax on their profits. This was changed in 1965 when a new corporation tax was introduced, replacing the income and profits tax regime. Companies were then taxed on their profits and shareholders were charged income tax on their dividends. This changed several times over the years and an initially simple tax regime became more and more complicated as governments introduced incentives and multiple tax bands and tried to close loopholes.
In the USA, the federal corporate income tax regime levies tax on net profits but appears to have echoes of the discarded UK income and profits tax system and is possibly even more complicated than the UK system with its different tax brackets and rafts of permissible deductions. A useful guide is Rob Norton’s article. His view is that taxing corporations is a very bad idea and popular mainly because no-one really knows who ultimately pays the tax and that very confusion makes it popular with politicians. The lack of effectiveness of the tax in raising revenue is illustrated by the fact that in the early 1950s corporate income tax represented a third of federal revenues, reducing to just over 6% by 1983 and despite subsequent rate hikes and a clamp down on allowances, it was still only just over 7% in 2003.
In the UK, most recently, from 2007 to 2016, the revenue raised from Corporation Tax has dropped from 10.5% of government revenues to 8.3% compared with VAT which has increased from 17.9% to 21.6%, while the take from income tax has remained roughly steady. Meanwhile the complexity has continued to increase. Those interested can see the detailed figures at the government’s website (PDF will open in a new window).
So it appears that the importance of the tax, at least in regard to the contribution it makes to government revenues in these two countries, has reduced dramatically over the years while the complexity has increased. The implication is that the cost of collection must have risen, reducing its efficiency.
What are the rules for a successful tax system?
An early view about taxes was that of the Finance Minister to French King Louis XIV, Jean-Baptiste Colbert, who famously remarked that the art of taxation consists of so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing.
A hundred years later, Adam Smith, in Wealth of Nations, written in 1776, spelled out four maxims of a good taxation system:
- firstly that taxes should be levied in proportion to the revenue enjoyed under the protection of the state, in other words, tax in proportion to income
- secondly that taxes should be stable and transparent, in other words certain and not arbitrary
- thirdly that taxes should be levied when convenient, in other words levied at a time when the payer’s income pattern means they have the resources to pay
- fourthly that taxes should be levied with the lowest possible weight, in other words at the lowest possible cost and certainly not at all if the cost exceeds the revenue gained.
A scholarly, if world-weary, assessment of Adam Smith’s four maxims in relation to the US tax system was written recently by Scott Drenkard. His conclusion is that the US tax system “notably deviates from these principles”.
We can perhaps abbreviate Adam Smith’s four maxims to just three principles when applied to corporate taxation. Taxes should be:
- simple, easily understood and accepted to be fair
- stable, certain and not subject to arbitrary or retrospective changes
- economical to collect in relation to the revenue raised from them.
An assessment of the corporation tax system in a country should be judged in relation to these principles.
What approaches do governments take and why?
Governments are seemingly torn between the wish to attract foreign firms to their shores to bring business and employment and the need to maximise the revenue drawn from companies resident in their jurisdiction. Hence on the one hand there is a steady race to the bottom in rates of tax and attempts to create the most attractive fiscal climate compared with their peers, and on the other hand a never ending struggle to clamp down on so-called loopholes.
According to a recent policy paper by the Oxford University Centre for Business Taxation (PDF), over the past twenty years the average corporate statutory tax rate in the G20 group of advanced nations has reduced from 41.5% to 27.1%
As an example, in 2010, UK Chancellor George Osborne promised to create the most competitive tax regime in the G20, and in 2015 the UK ranked number one with the lowest statutory rate and number five on effective average tax rate.
Other players in this field are countries which hope for revenue not from attracting businesses to set up local industries but as tax havens to generate fees and a modicum of tax revenue as the nominal home of foreign companies. Tax havens are generally thought to comprise small islands or states such as British Virgin Islands, Cayman Islands or Luxembourg, but they also include several states in the USA, such as Delaware. These all play a part in determining where corporation tax is paid and how much and to whom.
The counterpoint to efforts to attract foreign corporations by low tax rates and other concessions is resentment when companies take up these incentives by foreign governments and arrange their affairs to locate their businesses and pay their taxes in the overseas territories. Thus President Obama was eventually moved to raise the stakes in the game of corporate tax inversion by US companies by the strong threat of future action, thereby largely closing off this tactic. Similarly, the leak of the so-called Panama Papers has led to calls for action both against Panama and against companies seen to have used Panama for its tax haven facilities.
What approaches have companies taken and what have been the consequences?
Not surprisingly, companies, particularly multinational corporations (MNCs), have taken steps to arrange their affairs to take advantage of favourable tax regimes to the maximum extent legally possible. This has led to a burgeoning of the tax avoidance industry and the creation of some very complex schemes.
One of the biggest impacts, simply in the size of the numbers, is that of the USA, as a result of its perceived unfavourable corporate tax regime – it ranked 19th in 2015 in terms of its headline tax rate and 19th in its effective tax rate. Hardly surprisingly, major US-based international companies have arranged their organisations in such a way as to generate profits in tax friendly jurisdictions. However, the consequence has been to strand vast sums outside the USA for fear of the tax that would await their repatriation. Indeed, it has been estimated that at the end of 2015 $1.2 trillion was held overseas by US multinationals to avoid paying tax in the USA.
This, of course, has led to the tax inversion scheme whereby a US company would effectively reverse into (usually) a smaller company in a more favourable tax jurisdiction, using the stranded overseas profits, to enable the merged company to continue operating at a lower tax rate.
A recent IMF report (PDF) looked at the impact of all this on international corporate taxation. It looked at the impact of what it called “base spillovers”, by which one country’s actions directly affect others’ corporate tax bases, and “strategic spillovers”, by which they induce changes in others’ tax policies. It considered the tools of international tax planning, ranging from abusive transfer pricing to locating assets in low tax jurisdictions to avoid capital gains tax. It concluded, not perhaps surprisingly, that there was strong evidence of profit shifting. But putting together co-ordinated action to deal with the adverse consequences was not straightforward. For instance, countries’ interests diverged widely and the notion of harmful tax practices was ill-defined. Moreover, partial co-ordination could make matters worse.
Meanwhile, governments and supra-national bodies like the EU take their own, largely unco-ordinated retaliatory action. Hence India’s relatively new government promised to put an end to its predecessor’s practice of levying retrospective taxes on large foreign corporates, but earlier this year Vodaphone was being threatened with seizure of assets against a disputed 2007 bill for over $2bn. And the so-called Luxleaks affair caused Brussels to consider tax investigations into a number of multinationals on the basis that, as a state within the EU, Luxembourg had done tax deals with these companies which were against the rules of the EU. It has applied similar consideration to Ireland and the Netherlands in regard to their tax-friendly policies towards multinational companies.
What are the practical issues here and where do ethics come into it?
The main practical issues can be summarised as follows:
- governments set the rules within which companies conduct their businesses; for practical reasons these rules can only set out the main principles of behaviour, and the ethical dimension can only be broadly referred to within the context of the culture of a particular state. Moreover, there is room for debate whether governments are always more ethical than MNCs. This makes it not straightforward to co-ordinate a global set of guidelines for corporate behaviour
- to be effective, taxation must comply with the three principles summarised above: simple, certain and economical; sadly, there is probably not one government in the world whose tax policies comply with these principles
- governments themselves continue to create competitive tax regimes as a matter of explicit policy, while at the same time complaining when other governments’ policies prove more attractive than their own.
In 2012, the G20 leaders asked the OECD to research ways to capture the estimated 4 – 10% of tax that was being lost internationally to tax avoidance and to prevent base erosion and profit shifting The resulting project, christened BEPS, reported in October 2015 with recommendations that
- tax laws should be internationally coherent, avoiding double taxation as well as missing tax altogether
- taxpayers should be more open with tax authorities and tax authorities should share information globally
- profit should be taxed where it is generated.
The BEPS project recognises that current international agreements on taxation have their origins in agreements developed after the First World War and don’t work satisfactorily in the modern world. The main purpose of BEPS is to try to ensure that value is taxed where it is genuinely created. However, setting up a new set of international standards requires governments to agree on them and the standards themselves to be realistic and to be capable of practical implementation by MNCs and smaller international companies. They must not impose an intolerable burden on businesses or cause them to have to reorganise their value chains in ways which distort their optimum business models.
The ethical dimension was addressed by a joint study by Christian Aid, Oxfam and Action Aid, published in a recent report (PDF). While acknowledging difficulties, it tried to set out a practical set of rules for companies to follow in taking an ethical approach to paying their taxes. Hence it set out guidelines for MNCs.
First was a set of Key Principles by which a tax responsible company:
- is transparent about its business structure and tax affairs,
- assesses the fiscal, social and economic impact of its tax policies
- takes steps to progressively and measurably improve the impact of its tax behaviour
Secondly, there were eight principles defining tax-responsible behaviour
- Tax planning practices: aligning economic activities and tax liabilities
- Public transparency and reporting: being open about its calculations of income and profit
- Non-public disclosure: going beyond statutory disclosures, particularly with poorer countries
- Relationships with tax authorities: being open with tax authorities and facilitating tax generation in poorer countries
- Tax function management and governance: focusing on tax responsibility rather than tax minimisation
- Impact evaluation of tax policy and practice: on governments, employees and other stakeholders
- Tax lobbying/advocacy: looking for a level playing field, regardless of position or power
- Tax incentives: avoid anything other than incentives available to all.
The report recognises that, practically, the study has to limit itself to indicating the direction of travel for MNCs and to giving examples of what looks good practice. It also addresses governments, urging them to stop the race to the bottom and urging them to review tax treaties which disadvantage others and to try to ensure that profits are taxed where they are genuinely earned.
Five Golden Rules of Good Corporate Governance and corporate taxation
How do we approach this topic, via our Five Golden Rules of Good Corporate Governance? Well, our first two rules are most obviously applicable: Ethics and a Common Goal for the key stakeholders.
Firstly Ethics. The approach of Christian Aid and its associates is confident and clear. However, the obvious problem is that companies are governed by their constitutions which require them to give major consideration to their owners. Given the competing efforts by governments to attract the companies into their own tax jurisdiction, there would appear to be a very strong duty on the boards to look after the interests of the owners and the employees when considering how to organise the company’s structure and operations. Moreover, although the ethical position set out by Christian Aid is fairly generic, the interpretation in different countries of what constituted an ethical approach in that particular country wouldn’t necessarily prove consistent across the globe, particularly when considered in relation to its competitors.
Secondly Common Goal. This is, in some ways, easier to answer. We at ACG argue that good corporate governance requires a company to reflect the balanced aims of its key stakeholders. Now, perhaps, we have a route through the maze.
A multinational corporation has stakeholders which include the governments of the countries in which it operates. So here we have a calculation, albeit not necessarily an easy one, regarding where the constituent elements of a business actually lie. Where does the revenue get generated, where do the employees reside, where was the IPR of the business created? Now, perhaps, we can create a “fair” model which reflects the true underlying business model. This is not, of course, a model which maximises shareholder value, at least in the eyes of Milton Friedman, who wrote in his article in the New York Times in 1970 that “the social responsibility of business is to increase its profits”. He did, however, qualify this by saying that the manager’s duty to stockholders is to “make as much money as possible while conforming to the basic rules of the society, both those embedded in law and those embedded in ethical custom”. (I’m indebted to Prof Deidre McCloskey of the University of Illinois for these insights).
Our Third Golden Rule is about a Strategic approach to running the business, and it is, of course, generally accepted that major corporate decisions should be made with tax in mind, but not for tax reasons. This is something we have addressed several time recently in our articles about takeovers in the pharmaceutical industry, in which we have made clear that relocating a global business in a tax-friendly country of residence for the primary purpose of saving tax is often to the detriment of the underlying businesses, not to say damaging the integrity of the brand.
Our Fourth Golden Rule speaks to the Organisational appropriateness of the corporation in relation to its Goal. Here we can consider the gyrations MNCs have to go through to place intellectual property rights in obscure locations and have sales generated out of places remote from the previous core of the business. One could go on…..
Finally, our Fifth Golden Rule: Accountability and Transparency. This speaks for itself. One of the key recommendations of both the OECD and Christian Aid, and indeed all practitioners of integrity in the field, is the need to bring about a global understanding between countries that fosters greater transparency. Companies aspiring to give their brand the mark of good corporate governance have to do their best to move in this direction.
So we echo the aspirations of the BEPS project and the hopes of the Christian Aid report in believing that it is, indeed, possible for corporations to pick a way through the ethical maze of world taxation. But it isn’t simple, and it isn’t about maximising shareholder value. And following the principles of our Five Golden Rules will help corporate boards formulate policies on corporate taxation which, when assessed by their key stakeholders, can be judged to comply with good corporate governance.
- Corporate Taxation by Rob Norton
- HMRC (UK) Tax & NIC Receipts, monthly and annual historical record* (21st June 2016)
- What Can Adam Smith Teach Us About Tax Policy? by Scott Drenkard
- G20 Corporation Tax Ranking 2016, Oxford University Centre for Business Taxation
- IMF Policy Paper: Spillovers in International Corporate Taxation*
- Base erosion and profit shifting (BEPS), OECD
- Getting to Good: Towards Responsible Corporate Tax Behaviour*, Christian Aid/Oxfam
* PDF files