Taxing profit is arbitrary and complex: let’s reduce the complexity edit

June 28, 2006

All governments seek to tax profit earned by companies. But they face at least two problems in doing so. Conventional wisdom says that governments have to compete with each other to attract scarce investment by multinational companies, and that such competition must inevitably lead to lower (and eventually zero) corporate tax rates.

-->Evidence on whether this is really happening is mixed and corporation tax revenues have been buoyant in the last 10 years. So reports of the death of corporation tax are premature, to say the least.

Yet governments do face a rather different problem in taxing company profit: where is profit located? This might have seemed an easy enough question to answer before our economies became globalised - and it still may seem fairly easy for many companies. But it is far from obvious for the large multinational companies which pay most corporation tax.

As a hypothetical example, consider the following company, which I shall call ABC. Its parent company is formally resident in the UK. But it has shareholders from all over Europe, and indeed the world. It conducts research and development in Germany and Spain, raises finance Luxembourg, Switzerland and the USA, has production plants in France, Greece and China, sells insurance online from servers in Hong Kong, and has customers in 37 countries around the world. Last year it made €500 million in profit, worldwide. How much profit did it make in France?

The international tax system has developed increasingly complicated rules to try to answer questions like that. Those rules build on a structure which was set up early in the last century at a time when international activities were still comparatively rare. The basic principle - as far as there is one - is that profit is levied where value of a good or service is created. So, for example, ABC's factory in France would pay tax to the French government «profit» made in France.

But the fundamental question remains: what «profit» is made in France? The French factory purchases goods and services from non-French subsidiaries of the same company. The international rules require trade between subsidiaries of the multinational to take place for tax purposes at an «arms length price»: that is, in principle, the price that would be used if the trade had occurred between two unconnected companies. But the goods and services exchanged are private to ABC - there are no comparable «arms length prices».

But there is something more fundamental here: in principle, there may be no prices which can be justified. Suppose that the profit made by ABC could be traced to a vital contribution from one of its R&D laboratories. Then arguably that laboratory is where the «profit» is generated - and royalties could be paid which would transfer the profit back to that laboratory. But what if both R&D laboratories each created a vital element for production? Then there is simply no way in principle to split the profit between Germany and Spain.

This is just one example among many; there are others. For example, why is tax not based on where the good or service is sold? After all, the consumer is a vital element in creating profit: without her there would be no profit. Or why is the tax not based on where the ultimate shareholders live? After all, they are the owners of the company which has generated the profit.

My point here is simple: there is no conceptual basis, no point of principle, which tells us where profit is really created. What we have instead is a set of arcane, complex and arbitrary international rules which are based on historic compromises and agreements, but which cannot be defended on a matter of principle.

What makes matters worse is that these rules are so complicated that almost no-one understands them. The tax lawyers who do understand, and exploit, them can earn a fortune in fees.

So where should we go from here? The European Commission's answer is that within the EU, at least, there should be single measure of profit. It would not matter whether ABC «earned» its profit in Germany, France or Spain - it would all be lumped together as EU profit. The problems arise when that profit has to be divided between individual EU governments in order to allocate taxes. How that would be done has yet to be determined. The allocation would necessarily be based on an arbitrary formula..

This proposal does not address the issue of tax competition. Under the Commission's proposal, Member States would continue to have different tax rates, which they would apply to their share of total profit. So governments may still have an incentive to compete. Of course, many apparently believe that such competition in corporate tax rates is beneficial; though for that to be true, it has to be the case that unconstrained governments generally choose tax rates which are too high.

But in any case, how far governments compete will depend on the formula chosen. And the evidence suggests that the desire to continue to raise revenue from corporate profit has proved strong: so far, at least, tax rates remain a long way from zero. So while corporation taxes exist, reducing their complexity is a worthwhile aim.