Just a thought...

Foreign direct investment (FDI) is changing significantly. As Professor Mihir Desai of Harvard’s Graduate School of Business explained: ‘FDI was just about, well, let’s invest in countries… [where] … we can produce for that country. Now it’s much more about a global production process, where cost factors, especially taxes, are central.’

 

In a world where so much of the production and management process is electronic, there is far greater flexibility as regards the physical or registered location of a company. So, even if a mineral resource is mined in a country in Africa, the mining company can have its headquarters thousands of kilometres away in a location selected for its favourable tax regime – among other factors. Professor Desai’s research shows that a 10% difference in the rate of corporate tax can equate to up to 8% less FDI in a country.

 

 

Considering the vast differences in tax rates among countries around the globe, it is clear that the corporate world would look to maximise the potential benefits of lower tax rates in particular countries. The goal of the company is to achieve what has been called ‘stateless income’ – where the business records its income in low-tax or no-tax jurisdictions in which they may have only minimal operations.

 

Although there may be ethical concerns arising from the fact that tax revenue is lost by the country in which the company started and in which its founder probably has citizenship – and possibly where most of its employees live and work – the practice of profit shifting makes good business sense.

 

But authorities the world over are concerned about the negative impact of the practice, which could amount to as much as $600bn in lost taxes to various countries, according to an International Monetary Fund estimate. The Organisation for Economic Co-operation and Development (OECD) is actively engaged in putting together policies and action plans to limit the impact of this approach by big business. Both the UK and the US are among the 100 states implementing the OECD’s measures, the most significant of which is the base erosion and profit shifting (BEPS) policy. As members of the G20, they are at the forefront of calls for global corporates to pay their fair share of tax to the country where their revenue is generated.

 

 

Despite the above, both countries are clearly looking to attract foreign investment through dramatically lowering their own corporate tax rates. As an example, the Trump administration has lowered the official US corporate tax rate from 35% to 21%. The many loopholes, however, will ensure that the effective rate will be much lower. And the fall in the rates of UK corporation tax over the years is quite startling: from 52% in 1982, rates have fallen to 19% now and will decrease further to just 17% in 2020.

 

This trend has been seen elsewhere, and not just in the ‘tax havens’ that are viewed with disdain. Ireland, for example, cut its corporate tax rate to 12.5% purely to attract more business to the country.

 

This seems somewhat hypocritical: on the one hand, governments are endorsing and participating in global measures to eradicate profit shifting; on the other, they are encouraging FDI in their own economies by lowering their domestic tax rates on corporate profits. The lowering of tax rates is bound to result in profit shifting, as described. The comment by New York Times columnist Floyd Norris highlights the issue from another perspective: ‘There is something ridiculous about a tax system that encourages an American company to invest abroad rather than in the United States.’

 

 

In an ideal world, countries would receive the tax revenue that logically should be theirs. The world of corporate tax is far from ideal, however, and as long as countries speak the language their peers want to hear – of the need for companies to pay taxes in the country where they do their business – but act differently in their own backyard, profit shifting will continue.