Opinion: Why we need to shift towards a destination-based corporate tax system for a fairer world

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Nir Yaacobi, Lecturer in economics, Israel Academic College

• More than 130 countries have agreed to set a minimum global corporate tax rate of 15% from 2023, under the OECD’s global tax deal.
• But these rules are just further complicating an already complex system, which will limited effect on issues such as tax avoidance.
• We need to move from an origin-based corporate tax rules to a destination-based ones for a more just and efficient global tax system.

In October 2021, more than 130 countries agreed to set a minimum global corporate tax rate of 15%, to enable taxing companies in the places where their customers or digital users are.

The Organisation for Economic Co-operation and Development’s (OECD) global tax deal, which will apply from 2023, aims to reduce incentives for avoidance by multinational companies while limiting tax competition – the so-called “race to the bottom” where every country lowers its tax rate to attract businesses to relocate to its jurisdiction.

This deal is viewed by many as a big breakthrough in tackling distributive injustice carried out through international tax planning by multinational corporations.

Global tax deal will not sufficiently tackle issues such as tax avoidance

Well, I am sorry for being a party pooper, but this would only provide more jobs for tax advisors, accountants, lawyers and tax officials to develop methods of taking advantage of these new rules for more tax avoidance, leaving the goodwill with limited results.

Such rules are tangling the tax code further and beyond what it is already very complicated for the economy.

A taste of the complexity of these new rules can be seen in the language of the following examples: “taxing sales of foreign companies with global revenues of more than €20 billion and profitability above 10%” and “25% of residual profit defined as profit in excess of 10% of revenue will be allocated to market jurisdictions with nexus using a revenue-based allocation key”.

Another states that “rules will operate to impose a top-up tax using an effective tax rate test that is calculated on a jurisdictional basis and that uses a common definition of covered taxes and a tax base determined by reference to financial accounting income (with agreed adjustments consistent with the tax policy objectives of Pillar Two and mechanisms to address timing differences)”.

More rules are set to determine when a company’s foreign income should be included in the parent company’s taxable income, while another enables a country to reject a deduction on cross-border payments to the parent company. A further regulation makes it possible for countries to tax inter-company payments.

Anyone who is familiar with the field of tax avoidance can realize how many loopholes are hidden in such rules. All this mess would increase the effective average tax rate by only 0.7% across all jurisdictions, according to Tax Foundation experts. Since such reforms can be carried out only once in many years, this deal keeps afar the only feasible solution to tackling international tax avoidance – destination-based corporate taxation.

Most loopholes in international taxation stem from the fact that corporate tax is origin-based, not destination-based. An origin-based tax, such as corporate tax, is a tax where exports are taxed, while imports are exempt. The opposite is the case with destination-based taxes, such as value added tax (VAT) or sales tax, where imports are taxed while exports are exempt.

New tax rules only further complicate an already complicated process

Therefore, rather than creating another patch of rules that only further complicate what is already complicated enough, the reform that should be implemented is substituting the origin-based corporate tax for destination-based tax corporate tax.

Following such a reform, the tax on the multinational corporations will be dependent on the customers’ location and not on the company’s location, which many times is set only to minimize tax liability.

Accordingly, all tax planning of using fictitious transfer prices between affiliates in different jurisdictions or registering/placing the company in tax havens will be pointless. The tax would result from the customers’ location and the price they pay, instead of the company’s location and its transfer prices.

The customer’s location is not in the control of the company and setting a lower price would reduce the company’s net income more than it would reduce its tax liability. That is why these tax avoidance schemes won’t work with destination-based corporate tax.

Reforms would mean there will be no more “race to the bottom”. With a destination base, tax rate on capital can be equal to the tax rate on labour, thereby providing a fairer tax system counter to today, where tax competition lowers the tax on capital which is more mobile than labour.

Destination-based corporate tax means firms would be taxed where sales are made

With a destination-based corporate tax, all companies would be taxed at their sales destination without all these complex regulations as outlined by the OECD’s global tax deal. It will also eliminate the economic distortions that arise from fictitious transfer prices, tax shelters, tax planning and the authorities’ costs tackling these plannings. Each enterprise will be located where it is most economically efficient, and not due to tax considerations.

Notice that economically speaking, it makes no difference whether exports or imports are being taxed. They are approximately the same size and so would the tax revenues be. After-tax profits would be the same with those two bases as the foreign exchange rate adjusts to offset the change.

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To comprehend this exchange rate adjustment, let’s consider the following example. Assuming that corporate tax is 20%, it can be showed that following the alternation of the tax base from exports to imports, the local currency would strengthen by 20%.

Thus, the exporters would lose 20%, but will not pay 20% tax as before. Their net income would remain unchanged, and the importers will gain 20% from the local currency appreciation which will be offset by the 20% tax they now can’t deduct – leaving their net expenditure just the same as before the reform.

The only change will be with the exchange rate, all real variables such as the size of imports, exports and tax revenue will remain unchanged.

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What’s the World Economic Forum doing about tax?

The World Economic Forum has published its Davos Manifesto 2020, calling on business leaders to sign up to a series of ethical principles, including:

“A company serves society at large through its activities, supports the communities in which it works, and pays its fair share of taxes.”

Additionally, the Forum’s Trade and Global Economic Interdependence Platform provides a vital link between trade and tax communities to enable coherent policymaking which responds to societal needs and reflects business realities.

Taking its lead from OECD-led reforms, the work brings technical issues to a high-level audience and enables honest dialogue among diverse stakeholders on polarizing topics. You can find relevant publications here.

Everyone who is international tax planning savvy knows that most of the tax planning is made via income tax, while VAT planning is neglectable and harder to carry out. That is mostly because income tax is an origin-based tax, while VAT is a destination-based tax.

Therefore, the conclusion must be that the only way to a just, simple, and efficient international tax system is adestination-based corporate tax.