Taxing Diverted Profits: The Empire Strikes Back

There’s big news from across the pond. The U.K. government’s Autumn Statement (formerly known as the pre-Budget report), released December 3, promises to change how multinational corporations will be taxed – and offers a cautionary tale for would-be U.S. tax reformers.

Britain will introduce a “diverted profits” tax, targeting corporations that use “artificial arrangements” to shift profits overseas. The rate of tax on diverted profits, 25 percent, will exceed the basic U.K. statutory rate, which falls to 20 percent in April 2015.

Chancellor of the Exchequer George Osborne estimates the new tax will raise £1 billion in revenue over the next five years. “We will make sure that big multinational businesses pay their fair share,” Osborne said.

Some pundits are calling this the “Google tax” because it’s expected to broadly apply to the tech sector, which is famously adept at shifting profits away from source countries, where real economic activity occurs, to low-tax jurisdictions that often share no connection to the underlying commerce. Here, we’ll avoid the term “Google tax” to ward off confusion with similarly named measures in other countries that target users of online search engines. Besides, the erosion of Britain’s corporate tax base is not limited to the tax planning efforts of tech firms. One could just as easily label this the “Starbucks tax.”

But whatever you call it, a diverted profits tax is in the works for two reasons. First, Britain’s territorial tax system is not equipped to deal with profit shifting. Second, 2015 is an election year in the U.K.and Prime Minister David Cameron wants to get reelected.

Cameron’s messaging is crystal clear: Keep British profits in Britain. Why? Because his administration needs to be perceived as tough on corporate tax avoidance. The optics will, no doubt, appeal to British voters. Never mind that the idea probably won’t work.

For better or worse, U.K. tax treaties determine how British firms can shift profits around the globe. Sophisticated taxpayers will soon find legal ways to sidestep whatever rules Osborne and Cameron come up with. There’s also a good chance the diverted profits tax will conflict with rulings handed down from the European Court of Justice. It’s doubtful these problems can be successfully addressed without a coordinated multilateral action like BEPS, the base-erosion and profit-shifting project being advanced by the OECD.

Why should Americans care about any of this?

A few years ago the U.K. witnessed a strange phenomenon. A slew of domestic firms began relocating to foreign jurisdictions that offered a more favorable tax environment. These were often places like Ireland, the Netherlands, and Luxembourg. Sound familiar? Here in America, we call these transactions corporate inversions. You may have heard of them this summer.

Rather than sit idly by and watch U.K. employers migrate overseas, Parliament decided to compete against these rival economies. Lawmakers replaced Britain’s worldwide regime (which taxed profits regardless of geographic source) with a territorial regime (which exempts foreign-source profits). They also began a series of statutory rate cuts, resulting in the 20 percent rate that takes effect next year. These corporate reforms were not revenue neutral. They came at a price, requiring a VAT increase to avoid blowing a hole in the country’s deficit.

This trio — territoriality, corporate rate reductions, and VAT hikes — represents a distinct international trend. Many nations have adopted these changes over the last two decades, including all of the United States’ major trade partners. In effect, the U.K. was going with the flow for the sake of global competitiveness. It seems to make sense: Compete or be trampled on.

But here’s the tricky thing about territoriality. People tend to conceptualize the “source of income” as fixed by nature and objectively discernible – like the time of day or the temperature outside. They are wrong. The geographic source of commercial profits (for tax purposes) is surprisingly malleable. Competent tax advisers can manipulate the source of income to suit their needs — economic reality has nothing to do with it.

If a country operates a territorial regime and businesses are able to recharacterize locally generated earnings as foreign, then you’ve essentially rendered those profits exempt from domestic taxation. That’s not the outcome most advocates of territoriality have in mind.

A few years after the U.K. adopted a territorial regime, stories began to appear in the British media about highly profitable firms that were paying zero corporate taxes. The public was treated to stories about a waitress or bartender who paid more income tax than Starbucks with its 700 retail shops across the country. It was pointed out that Starbucks was doing nothing unlawful. In fact, it was fully compliant with all relevant tax obligations.

Sure, firms like Starbucks were earning abundant profits on British soil. But through a series of paper transactions with related parties, the profits were sourced to foreign entities beyond the reach of the U.K. tax net. This was all perfectly legal.

Recently the new boss of Starbucks’s British operations, Mark Fox, admitted the company was unlikely to pay U.K. tax anytime soon. He was nonchalant about profit shifting: “Fundamentally, the piece that was aerating was around royalties – the fact a brand is paying a royalty to an entity outside the U.K. – and to me that’s very, very ordinary … It happens across the sector and therefore it doesn’t bother me at all.”

Not exactly a mea culpa. But Fox has a point. The British government brought this on itself when it adopted territoriality without proper safeguards. Companies will earn profits in Britain but pay the tax in Ireland. Deal with it … and enjoy your cappuccino!

Everyone agrees the U.S. tax code badly needs reform. Should we follow the international norm, like the Brits, and adopt a territorial corporate regime? If so, what safeguards will be required to protect against wanton base erosion and profit shifting? The tax reform draft proposed in February by Rep. Dave Camp offered a series of options, but they had a chilling effect on the whole tax reform movement.

The message is this: Once people realize what a functional territorial regime looks like, they suddenly become less enamored with the concept. One of several reasons why U.S. tax reform won’t be easy.