Originally published: April 2024
MNEs are taxed on an entity-by-entity basis and they allocate their profits to different entities primarily on the basis of the arm’s length principle (ALP), which requires a complicated transfer pricing (TP) analysis on any transactions within the MNE group. Tax justice activists generally dislike ALP, as they see it as a neoliberal invention swindling developing countries out of tax base (https://lnkd.in/g6_6SHq8). That’s an interest take, because (1) ALP was primarily developed by governments as a tool to stop MNEs from shifting profits artificially, (2) most MNEs are TP system agnostic as long as it is relatively neutral and easy to comply with and (3) it suggests a non-neoliberal, non-capitalist way to allocate profits of MNEs (overwhelming capitalists) is possible. If you want to tie profits of MNEs to a location, it seems easier to use a system that closely aligns with how MNEs operate. In their defence, criticism of ALP as being technically complicated is fair, particularly in context with developing countries with lower administrative capacity.
A large portion of tax justice activists have a formulaic apportionment (FA) approach as their favourite game in town. But, as in the Cardigans song, they might end up losing their favourite game (https://lnkd.in/g2kp6iH3). Firstly, it depends on how the formula works. If FA is ever adopted, the formula is likely a political compromise, likely reflecting existing power structures.
But there are other reasons to doubt that FA’s appeal to developing countries. In an ALP system, an MNE would charge an identifiable price for different services (eg financing, licenses, management fees, technical support) provided to local subsidiaries. Many developing countries apply withholding tax (WHT) on such fees and they fight hard to allow such WHT under their double tax treaties (DTTs). Although such WHT goes against ALP (ie there is no local functions, assets, risk unless it’s part of a permanent establishment (PE), in which case WHT wouldn’t apply), this fits into the DTT system, that allows WHT on certain identifiable services with passive elements.
Under FA, all MNE profit would be allocated to countries through an allocation key, which applies regardless of the locally reported margins. Can countries keep WHT under FA? WHT applies on income flows that have been allocated FA. Allowing WHT means allowing the countries to tax the income twice. Also, as the intercompany charges lose significance to the local tax base in FA, MNEs could just set all intercompany flows to zero. So, WHT on intercompany fees – a key element of the tax system in many developing countries – doesn’t co-exist easily with FA. And if such WHT goes, that’s a big hit to developing countries.
So would tax justice end up losing their favourite game?
Obvious disclaimers: this is not advice. These views are my own and do not necessarily represent my employer.
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