Though the scale may differ, India is also not immune to the challenges posed by profit-shifting
The last few years have seen an unprecedented increase in the number of tax matters that have captured the public imagination. Indeed, this is now a global phenomenon with the UK faced with Amazon and Starbucks; the US with Google, Microsoft and Apple among others; and even India with Vodafone and now Shell. The Apple case, in particular, has attracted a great deal of public interest, not only because of the high profile nature of the company and its hugely successful products, but also because of its factual and legal peculiarities, specifically the use of stateless corporations whose income is not taxed anywhere. The recent testimony of its CEO recently before a US Senate Sub-Committee has also intensified the debate, not only on the appropriateness of Apples tax policies but on the overall scheme of taxation of multinational corporations generally.
While it is easy to get sidetracked with the fascinating nuances of the Apple case, the central issue here is far more complicated and goes to the root of how economic and commercial changes in the business environment over the last few decades have affected tax matters.
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It has been recognised for a better part of the last century that the interaction of domestic tax systems could lead to persons being taxed in multiple jurisdictions. A simple and well known example is of an author whose royalty income will be taxed both in the country where he is a resident and also in the country from where he earns the royalty income. This problem has, to a large extent, been overcome at a bilateral level through tax treaties designed to eliminate such double taxation through appropriate credit/exemption provisions.
However, in addition to the possibility of double-taxation, the interaction of domestic tax rules in certain cases also presents some planning opportunities which could facilitate shifting of profits to low-tax countries and thereby achieving a significant reduction in tax costs. These gaps in the international tax regime are not addressed in the prevailing treaty regime, and hence provide opportunities for multinational groups to: (1) shift profits from high-taxed jurisdictions (typically the country where the global parent is based) to low-tax countries; and (2) retain or reinvest profits accumulated in such low-tax countries without repatriating them to the home jurisdiction.
For instance, in the case of a US-headquartered group, this may involve housing global intellectual property rights (and the consequent profits from its exploitation) in a jurisdiction such as Ireland and retain/reinvest the profits into global operations, without repatriating them into the US. This allows for a significant tax benefit by deferring US taxes till such time as the profits are repatriated to the US.
The global reaction
Policy makers, NGOs (and even consumers) across jurisdictions have taken umbrage at such practices and, consequently, there are increasing calls for strong action against companies adopting such techniques. Corporations, on the other hand, contend that their obligations to shareholders require them to only pay as much taxes as are legally required, and that they cannot be held liable to compensate for gaps in the international tax regime.
If the responsibility for the loss of revenue is placed squarely at the door of the corporations, without acknowledging the shortcomings in the legal regime, corporations would face increased uncertainties as they would be expected to operate within the four corners of a regime whose boundaries are not only extremely vague but also highly discretionary. On the other hand, with countries across the globe facing fiscal challenges and falling tax revenues, it is logical to expect that the current status quo cannot continue for long.
To some extent, legislative tools already exist to counter profit-shifting. For instance, transfer pricing rules require transactions between related parties to adhere to an arms length standard, which is what unrelated parties would charge each other for similar goods/services. In the context of profit-shifting, the appropriateness of the profits earned by an entity can be determined by the application of transfer pricing principles, i.e. on the basis of functions performed, assets owned and the risks undertaken by it. This would suggest that a proper application and enforcement of transfer pricing norms would go a long way in addressing this issue, i.e. by demonstrating that the profits earned by the overseas subsidiary in the low-tax jurisdiction are not commensurate with the functions performed, assets owned and risks undertaken by it.
However, on a practical level, the application of the transfer pricing principles poses significant challenges, considering the relative ease of shifting assets (especially intangibles) and risks, as well as in determining the substance of such shifts. The fact that such transactions seldom take place in a third-party context also poses problems in the application of the arms length principle. These challenges are recognised, including by the Organisation for Economic Co-operation and Development (OECD), which is moving ahead with updating its transfer pricing guidelines that will help bring more certainty to this issue. In addition to international efforts in this area, detailed domestic guidance will also go a long way in meeting the challenges posed by profit-shifting in a balanced and reasonable manner.
To some extent, the problem of profit-shifting can also be addressed through suitable anti-deferral regimes under domestic law. Such regimes are already in place in several countries and seek to tax profits earned by overseas subsidiaries, even though they may not have been distributed as dividends. Such regimes typically apply only to passive income such as royalties, interest, rents, etc, though there are increasing calls for expanding these to cover all income. Though attractive at first blush, such an expansion could prove to be a significant dampener to cross-border investment flows and could impose significant costs on legitimate business expansions.
The Indian context
India, too, is not immune to the challenges posed by profit-shifting, though the scale of the problem may not be comparable to that of the US. However, Indian administrators, too, have the necessary policy tools, which can be appropriately leveraged and ramped up to meet such challenges. For instance, transfer pricing in India is now well into its second decade, and despite the heavy volume of litigation, its principles are well understood across the tax landscape. With international efforts under way, particularly at the OECD level to provide greater guidance on applying transfer pricing tools to counter profit-shifting, India can also effectively leverage on these efforts to be part of a global solution in this regard.
While concerted national and international action is the need of the hour, countries must resist the pressure to come up with simplistic and populist solutions to what is undoubtedly a very complex issue. While there may be no silver bullet, any long-term solution should necessarily be balanced and designed so as to not impose unnecessary burdens on legitimate cross-border business activity.
The author is deputy CEO, KPMG in India