Money on a table

The International Corporate Tax Problem – Base erosion and profit shifting (BEPS)

Corporate tax revenue in the Treasury Department’s 2020/2021 fiscal year budget accounts for 16% of total revenue collection in South Africa. Given that this figure is higher than many other countries the ability of corporations to find and use innovative solutions to avoiding tax contributions is of interest to governmental authorities in South Africa and internationally too.

One means by which corporations use inventive solutions is called “Base erosion and profit shifting” (BEPS).

This is where multi-national companies are artificially shifting their profits cross border to low tax jurisdictions in order to pay less taxation or by exploiting mismatches in legislation of different jurisdictions which may lead to double non-taxation. The result is that taxation is not being paid in the country where the main economic activity of the company takes place. In most cases this is legal and done within the parameters of the tax laws.

Domestic tax base erosion and profit shifting (BEPS) due to multi-national enterprises exploiting gaps and mismatches between different countries’ tax systems affects all countries. Developing countries’ higher reliance on corporate income tax means they suffer from BEPS disproportionately and South Africa is one such case.

This undermines the fairness and integrity of tax systems as businesses that operate across borders can use BEPS to gain a competitive advantage over enterprises that operate at a domestic level. When taxpayers notice that multi-national corporations legally avoiding income tax, it undermines voluntary compliance by all taxpayers.

To prevent and reduce such incidences the OECD/G20 committees published a framework to assist over 135 countries and jurisdictions to collaborate on the implementation of the BEPS Package.

The BEPS Package provides 15 Actions that equip governments with the domestic and international instruments needed to tackle tax avoidance. Countries now have the tools to ensure that profits are taxed where economic activities generating the profits are performed and where value is created. These tools also give businesses greater certainty by reducing disputes over the application of international tax rules and standardising compliance requirements.

OECD and G20 countries along with developing countries that are participating in the implementation of the BEPS Package and the ongoing development of anti-BEPS international standards are establishing a modern international tax framework to ensure profits are taxed where economic activity and value creation occur. Work is being carried out to support all countries interested in implementing and applying the rules in a consistent and coherent manner, particularly those for which capacity building is an important issue.

In South Africa a tax review committee, the Davis Tax Committee (DTC), was appointed on 17 July 2013 to inquire into the role of South Africa’s tax system in the promotion of inclusive economic growth, employment creation, development and fiscal sustainability. On the international front, the committee was required to address concerns about “base erosion and profit shifting” (BEPS), especially in the context of corporate income tax, as identified by the OECD and G20.

The OECD Report on Base Erosion and Profit Shifting notes the following:

  1. That although globalisation has boosted trade, increased foreign direct investments and has encouraged the free movement of capital and labour, it has also resulted in the shift of manufacturing bases from high-cost to low-cost locations.
  2. These developments encouraged multi-national enterprises (MNEs) to exploit the legal opportunities due to irregularities in the tax laws of different countries so as to minimise their global tax burdens. The aggressive tax positions taken by these multi-national entities (MNEs) heavily impact on countries’ corporate income tax regimes since MNEs represent a large proportion of global economics.
  3. Even though there are many ways in which domestic tax bases can be eroded, a significant source of base erosions is due to profit shifting which focuses on moving profits to where they are taxed at lower rates and expenses to where they are relieved at higher rates.
  4. MNEs may argue that they have a responsibility towards their shareholders to legally reduce the taxes their companies pay. They blame governments for coming up with incoherent tax policies and designing tax systems that provide incentives for BEPS.

For all member countries within the OECD region, corporate income tax raises on average around 3% of GDP or about 10% of total tax revenues. However in developing countries corporate taxes amount to over 25% of total revenues.

Corporate income taxes are important for developing countries for the following reasons:

  1. Collecting tax on profits at the corporate level is less cumbersome than taxing individual income tax.
  2. Government would have to rely entirely on the regressive VAT principle. If people choose to save their earnings rather than spend, VAT collections would be significantly reduced too.
  3. Corporate taxes are an important “backstop” to the personal income tax, in the absence of the corporate tax wealthy individuals would be able to hold their money in corporations and defer taxes indefinitely.
  4. Corporate tax is be needed to avoid excessive income shifting between labour income and capital income.
  5. Corporate tax also acts as a withholding tax on equity income earned by non-resident shareholders, which might otherwise escape taxation in the source country.

Shareholders value is determined by way of earnings per share. A key element of earnings per share is tax. For example in South Africa, if you have an effective tax rate of 28% your earnings per share are decreased by 28%. Although tax doesn’t affect all financial indicators it does affect ratios such as Return on Equity (ROE)or the Weighted Average Cost of Capital (WACC). There is therefore added pressure from a shareholders point of view to lower taxes and increase earnings per share.

Rather than circumvent taxation and fall foul of tax laws, consult a professional tax practitioner to provide you with up-to-date tax legislation should you be involved in multi-national entities operations.

Author Craig Tonkin