Revenues from the corporate income tax are especially important to developing countries, which, largely because of their low per capita incomes, have greater difficulty than wealthier countries in collecting broad-based taxes like the personal income tax and the VAT. Much of the corporate tax revenue of developing countries comes from multinational companies which have invested in the countries, establishing local subsidiaries that are engaged in distributing the group’s products (including, for example, automobiles, pharmaceuticals, and branded grocery and household cleaning products), manufacturing products on behalf of the group, or providing services on behalf of the group. For tax-planning purposes (“base erosion and profit shifting,” or “BEPS” planning) MNE’s for many years have established their operating subsidiaries as “limited risk” entities. The limited risk entities enter into contracts with other group members under which (i) the other group members are supposed to insulate the entities from business risks, and (ii) in return, limited risk entities agree to transfer much of their profits, through the payment of royalties, management fees and interest on loans to group members (often called “hub companies”) that are located in countries with zero or low corporate tax rates. After making these payments, the limited-risk entity earns only a low, steady level of income which is taxed by the country where the subsidiary is located.
This kind of arrangement, of course, limits the tax revenues available to governments in the countries where the limited risk entities are established. But for many years, countries of all levels of economic development have tolerated the BEPS tax structure, probably motivated largely by a desire to encourage inbound corporate investment. After the 2008 financial crisis, sentiment arose around the world that BEPS structures were excessively reducing the taxable incomes of MNE subsidiaries around the world; From 2013 to 2015, the OECD conducted a project aimed at identifying changes to tax rules that would curtail BEPS. As a result some restrictions have been placed on BEPS around the world, but the BEPS structure, with its limited risk subsidiaries, remains an important component of international tax planning, including in developing countries. The apparent revenue losses caused by BEPS, especially in developing countries, remains under intensive discussion within the OECD and other international forums,
The revenue losses from BEPS-style tax planning are increased, especially for developing countries, by deficiencies in a particular transfer pricing method, the Transactional Net Margin Method (TNMM), which is prescribed in the OECD Transfer Pricing Guidelines for use around the world. The TNMM is the OECD transfer pricing method that is best suited to determining whether limited risk subsidiaries, like those used in BEPS structures, are earning sufficient levels of income under the arm’s-length standard.
Here is how the TNMM is supposed to work in theory: A revenue authority desires to test whether, say, the local distribution subsidiary of a global beverage MNE is earning enough income to satisfy the arm’s-length standard. To do so, the revenue authority attempts to locate “comparable uncontrolled” beverage distributors in the local country or a nearby jurisdiction – that is, beverage distributors that are financially independent, and not owned or controlled by an MNE. The tax administration might locate, say (remember, we’re seeing how the TNMM is supposed to work, not yet how it works in practice) 50 independent comparables (enough to support a valid statistical analysis) and conclude based on these comparables that an arm’s-length range of operating margins for the distribution subsidiary under examination is 2 to 4 percent. If the taxpayer has reported a margin of lower than 2 percent, the tax authority is entitled to propose an adjustment.
All of this seems sensible enough in theory, but in practice the “uncontrolled comparables” that are needed to apply TNMM in a statistically valid way almost never can be found in a given country. The reason is that uncontrolled entities generally do not exist in a market that is dominated by MNEs. For example, in any country in which controlled distributors of globally branded beverages exist, competing, uncontrolled distributors of globally branded beverages are unlikely to exist, because it is impossible for uncontrolled distributors to compete with the MNE subsidiaries in terms of scale of operations, access to marketing assistance from the parent company, and similar factors of competitiveness. Similar phenomena are found in many other industries: independent comparables, in adequate numbers to support TNN analysis, rarely can be found. Taxpayers then are, in effect, free to point to a very small group of alleged comparables (or even a single alleged comparable), which may not even be close in function to the taxpayer under examination, and claim that a very low level of income is sufficient under the arm’s-length standard.
The result is that many tax administrations, especially in developing countries with small economies and therefore especially small pools of even remotely satisfactory comparables, are seriously impaired in their ability to enforce reasonable levels of income from locally operating MNE subsidiaries. Indeed, a number of developing countries have not been willing to make the expenditures needed to subscribe to commercially available financial databases, and to train specialized personnel to perform analyses with the databases; these countries have essentially no means of controlling profit shifting by local MNE subsidiaries. Revisions to transfer pricing rules, including the TNMM, are among the measures now being considered in connection with the international effort to design international tax reforms for countries around the world, including developing countries, in order to achieve better control of BEPS.
For those who would like to learn more about this subject, which can be presented only in very abbreviated form in a blog entry, I am attaching two links. The first is to a book I completed in early 2019, which attempts to explain the history, politics, and a bit of the economics of base erosion and profit shifting; I hope the book makes the topic of corporate tax reform in developing countries accessible to specialists and non-specialists alike. The second link is to a paper I published very recently about efforts to reform the TNMM. I hope you find both these items helpful.
- Click here for "Taxing Multinational Business in Lower-Income Countries: Economics, Politics and Social Responsibility" by Michael C. Durst
- Click here for "A Simplified Method for Taxing Multinationals for Developing Countries: Building on the ‘Amount B’ Proposal to Repair the Transactional Net Margin Method" by Michael C. Durst
Michael Durst is a leading tax commentator and author in the United States and internationally. His insights are informed by a long career in tax law which has included private advisory and transactions practice with leading firms notably as a world recognized expert on transfer pricing, senior government service, practice as a law professor, and mission service for the International Monetary Fund. He is a Senior Fellow at the International Centre for Tax and Development. He is particularly interested in the effects of international taxation and tax planning by multinational enterprises on the development prospects for and tax administration of developing countries.