Profit shifting is a problem. Its newest regulation as well?

There are two main channels to shift profits. When looking at numbers, the most relevant one is tax-motivated transfer pricing: multinationals price intra-firm trade in such a way that there are deductible expenses in high-tax countries. The taxable profits are then booked in low-tax countries. An example is the situation in which companies charge extremely high license payments for the use of a patent or trademark that is allegedly owned by a related affiliate in a tax haven.  

The second main strategy is debt shifting: instead of investing non-deductible equity directly in high-tax affiliates, multinationals put the equity in an internal bank in a tax haven. The internal bank passes on the capital as loans to related affiliates. Such a structure creates tax deductions in high-tax countries and causes little tax payments on received interest income in the tax haven. Differently from transfer pricing, and more importantly, debt shifting directly reduces capital costs and fosters investment. 

Earlier regulation: The BEPS Action Plan 

There is no doubt that profit shifting is problematic. Empirical evidence suggests a direct loss in corporate tax revenue of about 10-15%, which translates into a loss of about 0.3-0.7% of GDP. These numbers are not extremely high, but they are substantial and justify concern. In response, the G20 tasked the OECD with developing the Base Erosion and Profit Shifting (BEPS) Action Plan, which was launched in 2015 and included fifteen actions to curb BEPS. These actions particularly addressed interest deductibility, controlled foreign corporation (CFC) rules, transparency, and country-by-country reporting. The Dutch Ministry of Finance and various academic evaluations have reported positive effects from these measures. 

However, there remains debate on whether the BEPS Action Plan has effectively reduced profit shifting. While the BEPS Action Plan has had some success, it is seen as weak in addressing issues in the digital economy and so-called homeless profits. To tackle these remaining challenges, the OECD launched BEPS 2.0. 

‘Profit shifting is a problem, but OECD Pillar I and II might lead to even bigger problems.’

BEPS 2.0: OECD Pillar I and II to target remaining issues 

With BEPS 2.0, the OECD is aiming to address two remaining issues in international taxation: the pricing of royalties on intangible assets that are hard to value and homeless profits generated by digital firms with no physical presence in certain countries. To tackle these, OECD Pillar I proposes a partial formula-apportionment system, reallocating a quarter of residual profits (those exceeding a 10% return on turnover) to market jurisdictions, where sales occur. This aims to reduce the importance of transfer pricing and target homeless profits. 

Pillar II introduces a global minimum tax rate of 15% for large multinationals, ensuring that countries participating in the Inclusive Framework (IF) impose this minimum. This aims to prevent profit shifting to tax havens and curb international tax competition. More than 140 countries, including all G20 nations, are part of the IF, and in 2021, they approved both Pillar I and II. While the Global Minimum Tax (GMT) is set to be implemented by 2024 in the European Union and other countries, the United States and China have not adopted it.  

Criticism of Pillar I and II 

Pillar I of the OECD's tax reform faces criticism for its complexity, potential for double taxation, and administrative challenges. It may also encourage firms to shift sales to low-tax countries, harming high-tax jurisdictions. Pillar II with the GMT apparently holds promise but could limit developing countries' ability to attract foreign investment due to their reliance on tax incentives. The GMT also introduces legal uncertainties, compliance costs, and could fail to resolve tax competition issues. 

Evidence from Norway suggests that tightening transfer pricing rules yields small tax gains but incurs significant compliance costs, particularly when it applies to small firms. Similarly, although targeting large multinationals only already, the OECD's recent reforms could also lead to excessive regulation and new challenges. 

Alternatives 

Taking in consideration the criticism on both Pillar I and II, an alternative could be to define virtual affiliates. For example, the Dutch website of Amazon would constitute a Dutch affiliate and trigger corporate tax liability in the Netherlands, meaning countries could apply their existing toolset, including the BEPS actions and royalty taxes. Such a setting might be easier to handle and could reduce a very complex problem.  

Furthermore, the approach allows for beneficially differentiating between less harmful debt shifting and detrimental transfer pricing. And doing so is possible even in a unilateral fashion and under full tax competition: implement proper CFC rules and royalty taxation, but be more lenient on earnings stripping rules and debt shifting. The former two instruments are known for being largely robust to standard tax-competition incentives.