- In order to assess the extent of risk to Australia's corporate tax base — and the possible policy responses to mitigate these risks — it is important to understand the underlying sources of risk to Australia's tax base. In particular, many of the underlying drivers of risk reflect either deeply entrenched features of Australia's corporate tax system or economic and policy developments beyond Australia's borders and/or control.
- Australia's corporate tax system does not operate in a vacuum, but reflects the commercial, legal and international environment within which it operates. Key structural features of the corporate tax system can act as a practical constraint on the capacity of Australia's tax law to respond to emerging pressures and risks.
- In the context of the US system, Edward Kleinbard referred to 'four non-economic axioms' that lay at the core of the system of taxing capital: debt/equity; corporate/non-corporate enterprises; capital gain/ordinary income; and the realisation principle. These distinctions are also reflected within the Australian corporate tax system.6
- There are reasons for these distinctions and they can be entrenched in commercial practice. Further, in some cases clear distinctions can be drawn between the economic substance of arrangements in different categories. However, at the margin there can be little, if any, economic difference between them.
- Wherever the tax system provides significantly different treatment to instruments or transactions that are substantially the same, tax planning and arbitrage opportunities will arise. As the Ralph Review noted:
Economic transactions should be taxed on the basis of their economic substance — not their legal form.
(Review of Business Taxation, 1999, p. 78)
- The principal mechanism for the division of taxing rights between countries is bilateral tax treaties. Australia's 44 tax treaties are broadly in line with the OECD Model Tax Convention (OECD Model Treaty). The structure of the OECD Model Treaty is essentially the same as the structure developed in the 1920s.
- Tax treaties seek to encourage economic activity by providing for fair, certain and efficient tax treatment of cross-border trade and investment, by preventing double taxation and tax discrimination against foreign investment and allowing tax administrators to share tax information in order to prevent evasion.
- A defining feature of tax treaties is that they are agreements by which countries voluntarily restrict their sovereign right to impose tax. Australia's tax treaties, consistent with the OECD Model Treaty, limit Australia's right to tax business profits. For example, foreign residents are generally only taxable on business profits to the extent they are attributable to a permanent establishment located in Australia. Australia's tax treaties also typically include provision for the reciprocal reduction in withholding taxes on interest, dividends and royalties payments to residents of treaty partner countries.
- When restricting Australia's taxing rights Australia's tax treaties implicitly assume that tax treaty partner countries will effectively enforce their right to tax (and hence have a tax treatment broadly equivalent to what would apply in Australia). In these circumstances, there is much less incentive to engage in profit shifting activity. However, where a tax treaty partner is not fully exercising its right to tax this can be considered as equivalent to having a tax treaty with a tax haven. As such, gaps, mismatches and inconsistencies in tax rules of treaty partner countries can pose risks to the integrity of Australia's corporate tax system.
- Tax treaties typically include 'transfer pricing' rules to address the challenge of how to ensure that appropriate valuations apply to cross-border transactions, particularly where they involve related parties. In theory, much of the risk of profit shifting by multinational enterprises could be eliminated by fully effective transfer pricing rules. However, there are often considerable practical and conceptual difficulties in objectively arriving at a unique valuation for many transactions. Inevitably, there is a range of possible valuations, which provide opportunities for profit shifting and this is a significant source of disputes both between multinational enterprises and tax authorities, and between the tax authorities of different countries.
- By design, it is not easy to amend or update an international treaty. Australia's tax treaties are binding international agreements that are incorporated into domestic tax law. As such, and consistent with other international treaties entered into by Australia, tax treaties are subject to a national interest assessment by the Joint Standing Committee on Treaties before any action is taken to ratify them. Australia's tax treaties do not have a sunset clause, but remain in place indefinitely and only in rare cases require periodic review of their effectiveness.
- In practice, this means that if circumstances change so that a tax treaty delivers inappropriate outcomes, Australia is restricted in what it can do in response, short of the often lengthy process of renegotiating the tax treaty with the partner country. Further, if a partner country does not agree to update or amend a tax treaty then the choice is between retaining a treaty that delivers inappropriate outcomes or the extreme option of unilaterally cancelling or suspending the whole treaty, on the grounds that it is no longer in the national interest. This would usually require evidence that the tax treaty partner itself was in some way complicit in, or indifferent to, the exploitation of the treaty and may require the giving of notice of such intention to the treaty partner. Australia has never cancelled a tax treaty and it is very rare for an OECD country to cancel a tax treaty.
- Following significant trade liberalisation and widespread financial deregulation, along with dramatic improvements in information and communication technology, recent decades have seen a sharp increase in the level of integration between national economies and a greater number of businesses with cross-border operations. Increasingly multinational enterprises adopt a 'global value chain', with business functions located where they can be undertaken most efficiently for the firm. The growth of global value chains has increased the scale and complexity of international trade and foreign direct investment. In turn, these developments have been an important driver of economic growth in Australia and globally.
- Moreover, the rise of the digital economy has meant that many transactions and functions that previously relied on a physical proximity with the market can now be undertaken more or less anywhere. This has meant that an increasing proportion of economic activity has become tradable — that is, subject to international competition — resulting in challenges and opportunities for businesses as well as substantial benefits to consumers (Department of Broadband, 2011).
- These developments in the global economy over recent decades pose a number of risks to the ability of the international tax system to deliver appropriate outcomes for all countries, including Australia.
- In the industrial age the bulk of economic activity could be attributed to factors of p
roduction — such as labour, land, buildings and structures, and plant and equipment — that had an clear physical location (Productivity Commission, 2011). This is reflected in many of the concepts underpinning the international tax framework — both in Australia and internationally — such as source, permanent establishment and residency that assume that it is possible to objectively determine where economic activity occurs.
- This assumption is fundamentally challenged by the rise of the digital economy, with the increasing importance to production of intangible capital (such as intellectual property, goodwill or 'brand names'), which by its very nature has no physical location, rapid developments in information and communication technology; and the integration of production in global value chains.
- The potential for developments in the digital economy to have an adverse impact on Australia's corporate tax base was identified in the ATO's 1997 report Tax and the Internet (ATO, 1997). This report was prepared to stimulate discussion of the key issues, particularly at the Joint Committee of Public Accounts and Audits, whose inquiry into electronic commerce led to the publication of its findings in its 1998 Report 360: Internet commerce — to buy or not to buy? The nature and extent of those risks have shifted as the digital economy itself has evolved, and the international tax system has not adjusted sufficiently to reflect this.
- To date, attempts to adjust the international tax system to accommodate the changes in the global economy have sought to 'shoehorn' these developments to fit within the existing industrial age concepts. For example, taxing rights in relation to e-commerce have been assessed by providing updated guidance on the concept of permanent establishment to, in some cases, extend beyond requiring a physical presence in a country.
- However, there are serious questions over both the appropriateness of the results produced, and the longer term sustainability of this approach. In particular, the 'arm's length principle' that traditionally underpins transfer pricing rules is very difficult to apply to transactions that would never happen between unrelated parties or in an open, competitive market (such as dealings in unfinished products, proprietary knowledge and information). As the OECD has observed:
A key issue is whether tax concepts developed for the industrial age can be made to work in the era of the digital economy.
Current international tax standards may not have kept pace with changes in global business practices, in particular in the area of intangibles and the development of the digital economy.
(OECD, 2013, p. 7)
- The global reach of multinational enterprises, along with the developments in information and communication technology and close integration of global financial markets, provides them with a high degree of flexibility in how to structure their affairs. Increasingly multinational enterprises operate as a single economic entity, rather than a collection of related separate entities.
- This means that multinational enterprises can be well positioned to structure their intra-group dealings in particular ways where there is a tax advantage in doing so (OECD, 2013, pp. 5-6). For example, mismatches in the tax treatment of economically equivalent items within or between jurisdictions give rise to tax arbitrage opportunities. For example, where a financial instrument has features of both debt and equity it is possible that it would be treated as debt for tax purposes in one country and equity in another. Tax arbitrage arrangements can exploit these mismatches, in some cases resulting in a net tax loss where there is no net economic outgoing.
- Multinational enterprises typically have flexibility in how they arrange their capital structure and so can locate debt (and therefore their interest deductions) in profitable parts of the group, reducing the global tax on their business profits. Where a group finance company is located in a low-tax country the resultant interest income would be taxed favourably (or sometimes not at all), resulting in a reduction in the total tax paid by the group as a whole. The OECD has noted that the tax treatment of debt means that 'leveraging high-tax group companies with intra-group debt is a very simple and straightforward way to achieve tax savings at group level' (OECD, 2013, p. 43).
- The current international tax rules were put in place when OECD countries represented the majority of global economic activity. However, growing diversity and changes in the composition of the global economy has implications for the sustainability of these rules.
- The growing integration of the global economy has been an important contributor to the rapid economic growth of emerging market economies generally. In particular, the 'rise of Asia' will be a defining feature of the 21st Century and will have profound global implications, including as a result of the composition of world economic activity (Chart 4).
Chart 4: Share of Global Economic Output
Source: Au-Yeung W, Kouparitsas M, Luu N, Sharma D, (2013 forthcoming) Long-term international GDP projections, Treasury Working Paper.
Note: Groupings are based on the International Monetary Fund World Economic Outlook aggregations. Emerging and Developing Economies includes China and India.
- Emerging market economies have increased from representing around 30 per cent of world economic activity in the mid-twentieth century to about half today, with this share expected to continue to rise to around 60 per cent by the middle of the next decade. Among other things, this shift in relative economic weight between advanced economies and emerging market economies has important geopolitical implications, including for the sustainability of the current international tax rules and institutions.
- The changing nature of the global economy is also evident in the composition of Australia's trading partners. These significant geographic shifts in global economic output are similarly reflected in the composition of Australia's trading partners. Over the past decade, China's share of Australia's merchandise exports increased more than four-fold, from 5 per cent to over 20 per cent (Chart 5). The International Monetary Fund projects that by 2015, China will receive around one third of Australia's merchandise exports and India will receive more than one tenth of Australia's merchandise exports, up from just 2 per cent at the start of this century (Sun, 2010). Overall, since 1998, emerging and developing market economies have gone from receiving less than one-third of Australia's merchandise exports to over half by 2012.
Chart 5: Australia's merchandise export destinations
Source: ABS Cat. No. 5432.0.
- Australia's corporate tax base can also be affected by tax policy responses of other countries. Globalisation has increased tax competition between countries. This has several dimensions. Tax competition can be either beneficial or harmful. Countries that operate as 'secrecy jurisdictions' can facilitate tax evasion by companies by enabling them to obscure the level, character and ownership of income and assets from tax authorities. Globalisation has also resulted in increased trade and investment between countries that may have inconsistent approaches to the tax treatment of cross border transactions.
- The potential for tax competition between countries to erode corporate tax bases has long been recognised.7 The AFTS report concluded that:
In a world of increased capital mobility, company income tax and other taxes on investment have a major impact on decisions by businesses on where to invest, how much and what to invest in and where to record their profits.
(AFTS, 2009, p. 149)
- There are two related but distinct elements to this argument. The first is that countries can engage in competition on corporate tax in order to attract increasingly mobile capital. There is a longstanding, widely held view in public finance that the sustainability of the corporate tax bases of national governments was likely to erode over time, as national governments reduced tax rates in order to attract increasingly mobile investment.8 The Ralph Review argued that 'the continuing globalisation of the world economy means that international competition for resources, particularly capital, is intensifying' (Review of Business Taxation, 1999, p. 23).
- The second element is that the highly mobile nature of some sources of income (including returns on intangible assets and financing transactions) provides an incentive for individual countries to try to use a low rate of taxation to induce that income to be reported in their jurisdiction.
- There is a clear distinction between policies aimed at attracting economic activity and the reporting of that activity.
- One perspective is that the increased mobility of capital associated with globalisation suggests, on the grounds of economic efficiency, a relative switch in the tax mix of countries away from capital taxation and towards other, less mobile, factors of production may be warranted.9 This point is made in the AFTS report (AFTS, 2009, p. 149. Vol 1). Importantly, the efficiency of the tax mix is a different question to the overall level of taxation and thus the size of Government. Investment decisions rest not only on the imposition and incidence of tax, but also on the broader economic environment within the country which among other things will reflect the overall efficiency of the provision of government goods and services (Cashin, 1995), (Tax Justice Network, 2013).
- The other perspective is that the competitive pressure from globalisation restricts the ability of national governments to raise tax revenue. Those concerned with this outcome emphasise the impact this has on the ability of national governments to provide goods and services that would improve the welfare of their citizens (Devereux, et al., 2002). On the other hand, there is a strong view that by imposing a more immediate recognisable cost on government expenditure, tax competition from globalisation imposes a discipline on both the overall size of national governments, as well as placing the onus on them to provide those goods and services as efficiently as possible (Brennan & Buchanan, 1980).
- Conceptually, there is a difference between this type of 'beneficial tax competition' and 'harmful tax competition', where countries use favourable tax treatment to induce multinational enterprises to account for that income in their jurisdiction, without a commensurate shift in real economic activity. Of particular concern in this context are 'mobile rents' (Devereux & Sørensen, 2006),such as returns from intellectual property, where the country in which the income is reported for taxation purposes can be different from that in which the rent was created (Auerbach, 1982).10
- There are two key problems caused by harmful tax competition. First, national governments who efficiently provide goods and services that support the creation of such mobile rents would not receive a return through the income tax system, leading to an under provision of government goods and services. Second, national governments could benefit from the creation of these mobile rents without having to provide goods and services that support them, allowing them to offer much lower rates of taxation to this type of income.
- The potential for harmful tax competition, particularly between tax treaty countries, to erode the tax base of countries has long been recognised. However, in practice it can be very difficult to distinguish between beneficial and harmful tax regimes. That is, what one country may view as a legitimate policy setting to attract investment another country may view as harmfully diverting the reporting of income for tax purposes from real economic activity in its jurisdiction.
- Historically, the laws in some countries have imposed strict rules protecting the secrecy of investments within that jurisdiction. Since the introduction of income tax, well-resourced individuals and multinational enterprises have sought to exploit these rules to evade their obligations under the tax laws of national governments. In addition to simply hiding income, 'secrecy jurisdictions' can enable the nature of financial flows to be disguised or misrepresented, and the beneficial ownership of assets to be obscured.
- While tax authorities typically have wide-ranging powers to gather information for tax purposes (OECD, 2012), there are practical difficulties and legal limits on the ability of national tax authorities to obtain information outside their jurisdiction. Despite significant progress in recent years in fostering greater international co-operation to improve transparency and exchange of information for tax purposes, the potential for 'secrecy jurisdictions' to be used to evade tax properly paid in Australia remains. In addition the peer review process of the Global Forum for Transparency and Exchange of Information for Tax Purposes11 which began in 2009 is not expected to be completed until the second half of 2013.
- In many countries there is growing concern that the current consensus on international tax rules, usually implemented through a network of bilateral treaties, is not resulting in appropriate tax outcomes for national governments, in particular due to profit shifting practices of multinational enterprises. While ideally these concerns would be addressed through multilateral efforts to update international tax rules, there is a risk that countries may instead act unilaterally, outside of the current consensus, in order to achieve what they see as more appropriate tax outcomes.
- As the
OECD has indicated, such 'unilateral and uncoordinated actions by governments responding in isolation' would bring with it an increased risk of double taxation, damaging cross-border trade and investment. From an Australian perspective, the implementation of such measures by other jurisdictions would either increase the risk of double taxation or result in a reduction of Australia's corporate tax base.
6 Distinctions that could arguably be added to this list in an Australian context include portfolio/non-portfolio investments and active/passive income.
7 The Ralph Review noted that 'competition among countries for taxation revenue poses a significant threat to national revenue bases and effective tax rates'.
8 See, for example, Sørensen (2007).
9 See, for example, Gordon (1986).
10 Although it should be noted that the transfer of intellectual property developed in one jurisdiction to another could itself have tax consequences.
11 The Global Forum is the continuation of a forum which was created in the early 2000s in the context of the OECD's work to address the risks to tax compliance posed by tax havens.