Multinational companies evaded paying USD 200 billion (€188 billion) in taxes globally in 2020, according to a report by the EU Tax Observatory, an independent research lab housed at the Paris School of Economics.
Profit shifting, a tactic employed by businesses with subsidiaries across numerous nations, was used to evade paying all of this money. They record an excessive portion of their profits in tax havens, which are areas with little to no taxes, reported DW.com.
Despite the fact that the profits were earned abroad, this still occurs. But how does profit shifting operate, and what are the winners and losers, and why does it matter?
How does profit shifting work?
Imagine a global corporation with operations in two nations. The majority of the work is completed in a nation with high taxes. However, patents and design blueprints are examples of intellectual property that is owned by a subsidiary in a tax-haven jurisdiction.
For the subsidiary to use the registered properties, payment must be made by the company in the first country where profits are earned. Given its control over both entities, the multinational has the ability to determine the transaction price. Ultimately, it forces the high-tax jurisdictional company to make large payments to the tax-haven subsidiary.
Following the transaction, the tax haven subsidiary’s balance rises while the first company’s profit ledger declines. The multinational corporation can now declare a lower level of profit where taxes are higher and a higher level of profit where taxes are lower.
US footwear giant Nike experienced the above situation recently. According to a leaked document, the company’s local units were required to pay royalties to a subsidiary in Bermuda, where taxes are essentially non-existent, even though the production and sales of sneakers took place in high-tax countries. Multinational giants like Apple and Microsoft were the subject of similar schemes.
Why does it matter?
In 2020, when the COVID-19 pandemic hampered economic activity, the global tax revenue lost to profit shifting was estimated to be USD 200 billion. The year 2019 saw USD 250 billion as that amount.
According to estimates from a group of expert economists who convened at the COP27 in Egypt, the revenue loss in 2020 represents approximately one-fifth of the investments that developing nations require to mitigate the effects of climate change.
The EU Tax Observatory’s data coordinator, Idann Gidron, stated that only big businesses can afford to establish subsidiaries in offshore tax havens and engage in cross-border commerce. In this manner, the largest stakeholders experience a reduced tax burden.
“This creates fiscal injustice because the smaller actors in the economy have to contribute more than the wealthiest,” he said, as reported by the DW News.
Who wins?
Of course, companies that save money on taxes are the main beneficiaries of profit shifting. Their number from the United States is disproportionate.
Multinational corporations based in the US account for about 40% of all global profits.
Tax havens gain from this, but conglomerates also save billions of dollars by shifting profits.
Countries having effective tax rates of less than 15% are deemed tax havens, according to Gidron’s research. Due to the frequent use of legal loopholes to lower taxation levels, it takes into account the rates that are actually applied rather than what is stated on paper.
The research also includes nations where the profits made by multinational corporations are disproportionately large when compared to the total amount of wages paid locally; this suggests that the profits being booked are being transferred from locations where the actual work was completed.
Even in some small nations that have no taxation policies, there is more local economic activity, which is advantageous. Smaller economies may find value in local units, even if they represent very small operations for multinational corporations.
Conversely, larger tax havens can apply their reduced tax rates to the profits that have been shifted. They put money in their pockets that they wouldn’t otherwise have access to, even though the taxes are relatively small.
Where are the tax havens?
“People tend to think that profit shifting is related to countries in the Caribbean, but the tax havens that are attracting most of the profits are actually in Europe,” Gidron said.
Tropical paradises like Panama or Bermuda receive less shifted profits than nations like the Netherlands, Ireland, Switzerland, Luxembourg, and Belgium. In those nations, this leads to budget surpluses. For instance, in 2020, shifted profits accounted for nearly 60% of Ireland’s corporate tax revenue.
Profit shifting resulted in an additional USD 32 billion in taxes for the major tax havens in Europe when combined in 2020. This indicates that they are earning an amount that is roughly equal to the GDP of nations like Senegal, Honduras, or Bosnia, simply from additional taxes.
Another major contributor to tax abuse is crown dependencies and overseas British territories. Profits totalling USD 76 billion were moved to the British Virgin Islands, Bermuda, the Cayman Islands, and Jersey in 2020.
Who loses?
Countries with higher tax rates lose out on the additional revenue tax havens receive. Ultimately, this means that governments around the world have less access to public funds.
Other members of the European Union and other nations in the Organisation for Economic Cooperation and Development (OECD) are the biggest losers. The nation most impacted, Germany, might have received 26% more in corporation taxes in 2020.
But emerging and developing nations are also losing out on sizable profits: in 2020, they will lose about USD 60 billion, down from USD 75 billion in 2019 as a result of COVID-19.
Brazil serves as one example, having lost out on USD 7 billion in possible tax revenue in 2020. With that sum, 4 million more families could have been enrolled in Bolsa Familia, a basic income initiative designed to end poverty.
Is it legal?
Since profit shifting and other tax schemes operate in legal grey areas, Liz Nelson, director of the research and advocacy group Tax Justice Network, claims that the legality of these schemes is frequently determined only in courts of justice.
Multinational corporations are allowed to establish branches abroad and engage in internal trade with one another. However, profit shifting typically occurs in conjunction with the transfer of immaterial goods and services for a reason.
Although it is possible to achieve the same tax reduction goals by deceitfully pricing material goods sales, intangible assets are typically not exchanged on an open market. This is significant because prices paid between a multinational corporation’s units should reflect what is typically seen in transactions by unaffiliated parties, per international regulations.
When there’s no clear indication of what a normal price is, it’s harder for tax authorities to build a case against abusing multinationals.
“Such schemes may not be criminal in a legal sense, but morally they’re wrong. Governments are complicit, and multinationals are complicit. They are creating hardship for people that might be their employees,” Nelson said.
What can be done to solve it?
Notwithstanding initiatives from organisations like the OECD, the amount of profit shifting has remained steady worldwide since 2015, according to the EU Tax Observatory. Although prior policies might have stopped the amount from rising, the researchers point out that this does not imply that they had no impact at all. They do concede, though, that more needs to be done.
About 140 nations came to an agreement in 2021 to impose a 15% global minimum corporation tax rate. However, the researchers from the EU Tax Observatory assert that because of loopholes that would let some nations continue to tax businesses at lower rates, the tax agreement is insufficient.
Rather, they are suggesting eliminating all tax breaks and raising the tax bracket to 20%. There could be an additional USD 250 billion in tax revenue collected globally annually as a result, they claim.