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WORKSHOP #2: TAXING SUBSTANCE

- ECONOMIC VALUE CREATION

Introduction In this workshop we will bring together different stakeholders to discuss and formulate responsible tax principles related to aligning business profits with real economic substance and value creation.

Businesses benefit from and depend on infrastructure, educated and healthy workforce, customers and the rule of law that governments provide from tax revenue. In turn companies and businesses that operate in countries should abide to sound corporate governance principles, fair play and an approach to business that stakeholders can trust. This means applying a responsible tax policy that takes a distance from the examples of abusive tax practices we have seen evidence of in media and through NGO exposures. Finally, business activities should reflect the reality, that profits have a physical location, and the expectation, that if a business has an activity in a country it is expected to pay a “fair” share of tax, which have emerged from broader stakeholders, politicians and the media. However, this is not as simple as it sounds.

Discussion point 1: IBIS and Christian Aid proposed a principle in 2012: Companies’ tax payments should reflect the location of business activities: Taxes should be paid and reflect where the business activities take place.1

In workshop #1, it was raised that this actually is a ”new” principle emerging in the BEPS process (and from the EU) as a normative principle. International tax treaties for example are based in the residence / source principle and the idea of origin of wealth, and transfer pricing is about the correct value being allocated to the traded goods or services and not the location. But it is clear that the intent of the BEPS project is to align taxation with economic activities and value creation2 and that this is emerging as a new norm in international taxation that business need to relate to.

Workshop #2 of The Tax Dialogue on corporate responsibility will aim to clarify our understanding of the principle, discuss the merits and perils and refine the wording to reflect the new norms and the business reality of how this norm applies to current responsible tax practices.

Discussion point 2: Furthermore, better knowledge and revelations about existing abusive tax planning schemes, enables us to also discuss the meaning of this principle and how it has been challenged by examples of irresponsible practices. This allows a discussion on how to overcome these challenges by adhering to responsible tax principles and outline in more detail the best practice approaches to responsible tax for particular high risk transactions.

In relation to developing countries, which can have limited capacity to monitor and identify abusive tax planning schemes several international organisations3 have engaged with the topic and in particular identified three challenges to taxing economic activity that impact these countries’ tax base.

1 IBIS and Christian Aid 2012 2 OECD 2013 3 See literature from UNCTAD 2015 and IMF 2014

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High risk issues:

1. Subjective intra-group trade in intangibles and services (see figure 1), which can be hard to price and find objective comparable prices for. Often such comparables simply do not exist due to the small size of a market, or uniqueness of a product.

2. IMF’s work on spill overs in international corporate taxation with a focus on developing countries also highlight treaty shopping as a key issue for abusive tax practices that negatively impact developing countries’ tax base (see figure 2).

3. Finally, intra-firm financing can also play active part in abusive tax optimisation schemes that challenge the fair distribution of profits and distort the alignment between economic activity and taxes paid.

It is proposed that these three issues should be addressed in a responsible company’s tax policy. This can be done by including positions on the issues. If there is agreement on the relevance of the issues and the need to address these, it will be helpful to discuss merits and perils of making the following qualifying statements and to improve the exact wording of the statements. Finally, it can be useful to have inputs from participants on whether any other high risk issues related to aligning profit with economic substance have been left out?

The following proposed positions/statements are subjective and not prepared by tax lawyers, but aim to qualify for these particular high risk areas how responsible corporate practice looks.

a) Companies will aim to have profitable business (net income) in all subsidiaries with real economic activity in particular in developing countries that can be fiscally fragile.

b) Companies should clearly state that they accurately price intra-firm trade along-side with clear statement of principles especially with regards to intangible assets such as intellectual property and brands. Profits from intangibles assets such as brands or services should not be booked in low tax jurisdictions where there is no or little physical operations.

c) Companies will only engage in intra-firm financing from a legitimate business objective, which is clearly outlined in principle and explained by both the lender and the borrower in order not to be primarily driven by tax considerations.

d) Companies will aim to structure their businesses without engaging in treaty shopping practices. Company structures that make use of treaties will be from legitimate business perspective based on economic substance and activity in the countries in question rather than favourable tax treaty rates.

Please note that it is proposed that all of the above should be combined with transparency of accounts, and narrative statements in particular when deviations from these principles occur in relation to subsidiaries located in developing countries/fiscally fragile countries. This will be discussed in workshop #4 and not on this occasion.

Literature (hyperlinks):

IMF, 2014, Policy paper: spill-overs in international corporate taxation UNCTAD, 2015, working paper: FDI, Tax and Development IBIS and Christian Aid, 2012, Draft principles for responsible tax OECD, 2013, BEPS action plan

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Illustrative figures: Figure 1: Intra group trade portrayed by the OECD in the BEPS project here:

Figure 2: The IMF portrays an example of the mechanisms of treaty shopping