How can the multinationals pay so little tax?

This week I am plunging right into the subject of taxes paid by multinationals. I am sure you have seen in the media all these large corporations accused of not paying their fair share of taxes. It is very easy to see in tabloids but also on more respectable sites this kind of tables:article-2287216-18663FC8000005DC-684_634x766Some tax shy companies

However, we need to distinguish many concepts here to avoid being lost in the complexity of corporate taxation. Here are a few you should consider.

  • Tax avoidance is the legal usage of the tax regime to one’s own advantage to reduce the amount of tax that is payable by means that are within the law. This is legal albeit frown upon.
  • Tax sheltering is very similar, although unlike tax avoidance tax sheltering is not necessarily legal. Money is then placed into Tax Havens, which are jurisdictions which facilitate reduced taxes. Think of Virgin Islands, Monaco, etc.
  • Tax evasion, on the other hand, is the general term for efforts by individuals, corporations, trusts and other entities to evade taxes by illegal means.

While there is bad press for all these concepts, it is important to remember that these large corporations are accused of aggressive tax avoidance. However, as the former CEO of Google Eric Schmidt famously answered UK members of Parliament: “I think the most important thing to say about our taxes is that we fully comply with the law and we’ll obviously, should the law change, we’ll comply with that as well.”


Hello Motto*

But how do they do it?
There are many ways but they all follow the same pattern.
A multinational which we will call Megacorp has operations in many jurisdictions. Its headquarters are in the US, where the corporate tax rate is 35%.
Examples of markets where it operates are the US, the UK (corporate tax rate of 20%), France (33.33%) and curiously they also have a small office in the Bahamas (0%).
Megacorp sells a range of consumer electronics with few equivalents on the market, to consumers and professional clients.
The equipment Megacorp sells is the fruit of many years of research while its large audience is the consequence of a strong brand image, developed over the years. Megacorp products are also protected by patents.

Tax regulations stipulates that Megacorp should be taxed in each country on the profits it generates locally.
So how can Megacorp reduce its tax payments?

The solution is to split itself in a myriad of companies and lodge different types of assets depending on the tax rate of a country.
In the US, Megacorp created Megacorp Inc, a subsidiary manufacturing the key products of the firm.
In the Bahamas, Megacorp created a subsidiary, Megacorp Limited, which owns the patents and brands of the mother company.
In the UK and France, Megacorp created  distribution networks.

view from office

View from the Bahamas office

Megacorp Limited can now charge Megacorp Inc a fee for using its patent in its manufacturing process. The fee is calculated so that Megacorp Inc does not generate any profits from manufacturing.
Megacorp Limited also charges a fee to the UK and French subsidiary for the right to use its brand when selling products. Without surprise, the fee is so high that the UK and French businesses are barely profitable.

Eventually, Megacorp Limited is generating very high profits, which are taxed at a 0% corporate rate.
However, if it wants to bring these profits back into the US, Megacorp will have to pay some tax on these earnings abroad. This cash abroad is “trapped” or “stranded” until corporations like Megacorp manage to lobby the US government to create a tax amnesty to repatriate these dollars to the US, at a lower than 35% rate.

stranded dollarsShipwrecked – new season

There are many ways to actually go about this process. Here is a document which explains them pretty well from the bottom of page 2.

What is important to remember is that corporations can lower their corporate tax rates because they are allowed to do so. Many countries have created a race to create exemptions to attract the empty shells like Megacorp Limited. Multinational corporations set up new subsidiaries looking at where they can minimise taxation but at the same time repatriate as much cash as possible to pay shareholders dividends.

What can we do about it?
I can see three potential solutions.
First, one could do nothing about it. If this is legal, there is no need to react. After all, we could congratulate corporations for trying to maximise profits, as this is the essence of capitalism.

Second, you could start boycotting the firm’s products. Stop using Google as a search engine, stop posting on Facebook, do not smoke BAT’s cigarettes (do not anyway), stop having coffee at Starbucks… The worry is that you would need to exclude a lot of products and services from your list given the widespread phenomenon. The OECD, a group of rich nations, computes a value of €250bn as legally avoided every year.

Last but not least, write to your local politician. Large corporations employ battalions of lobbyists to sway laws in their favours. But your local politician is often worried about reelection. Write to him/her. If politicians thought their local election would be partly based on them acting against tax avoidance, this problem would be solved quickly.

hollande brushNow brush up the tax code please

Actually, pressure groups are already succeeding.
The OECD has managed last week to get 80 major countries to sign an agreement called Base Erosion and Profit Shifting – BEPS. It opens the gate to a revision of international tax treaties in such a way that the mechanisms I described a bit earlier are reduced or sometimes eliminated. A downside of the agreement is that it is not binding. However, OECD has managed to convince many countries that actively benefited from tax avoidance to ratify it and the organisation itself has a strong track record of delivering and monitoring new changes.There is hope that tax avoidance by multinational corporations can be reduced.
Ironically, this major impulse is coming from an organisation whose workers are exempt from tax on their wages!

*Say it with the voice of the Motorola advert

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