- Zachary Mazur
Poland's Message in Davos on Tax Fairness and Transfer Pricing
Last week Poland's Prime Minister, Mateusz Morawiecki, took a stand against his fellow EU members at the World Economic Forum in Davos, Switzerland. This time it wasn't about immigration or conflicts over the rule of law or liberal principles. During a panel discussion that importantly included the prime ministers of Ireland and the Netherlands, Morawiecki called out the continued existence of tax havens within Europe.
Here's what he said:
"There are tax havens in the world, but also in Europe, which use their power or abuse their taxation systems to the detriment of other countries. We should stop this. Because this is not helping the EU build trust towards each other. We have seen leadership on this issue from President Macron in the context of digital taxation. On top of this, I would be in favor of eliminating all the tax havens in Europe."
The full video is available here.
There is quite a bit to unpack in this statement. First of all, it may come as a surprise to some that there are tax havens within Europe. When we hear the term, we usually think of island destinations like Grand Cayman, the Bahamas, Bermuda or the Seychelles. But in fact some of the most popular and effective tax havens are in Europe, and they include two countries whose heads of state were sitting on the stage with Morawiecki, Ireland and the Netherlands.
Tax havens, for the most part, combine two main characteristics that make them attractive for avoiding tax: opacity and low income tax rates. Any jurisdiction, including certain states in the US (Delaware, Wyoming, etc.) can be attractive for shifting profits and avoiding liabilities. Tax havens are also places where governments make sweetheart deals for certain companies so that they can avoid paying taxes, even if nominal rates are within the normal range. Opacity is important because it allows companies to avoid being asked uncomfortable questions about the structure of their business.
Morawiecki's public concern for lost tax revenue coincided with the publication of a report from a government think-tank, the Polish Economic Insititute (PIE). The report focuses on lost tax revenues for the whole of the European Union, not just Poland. Clearly, the intention was to build consensus among other member states to stem the tide of tax avoidance. PIE calculates that EU member states lose around €170 billion per year to various forms of artificial income shifting and fraud from individuals and corporations. To put this in perspective, the International Monetary Fund estimated that tax havens account for between $500-600 billion in lost revenue across the world. That would mean that Europe accounts for almost one-third of total losses. Multinational enterprises' use of EU tax havens accounts for €60 billion per year, according to the report.
What we are to gather from PIE's convincing argument is that the EU is shooting itself in the foot by allowing tax havens to attract corporations to lower their tax bills within the single market. Companies operating across the Union can exploit one country and move profits out and never pay corporate income tax. The entire system creates market incentives for a race to the bottom. Governments adjust their tax regimes to attract corporations, and set up secret arrangements for certain companies, as was exposed in the Lux Leaks scandal in 2014.
Although many of us have heard of tax havens, the functional mechanics of tax avoidance are the reserve of specialists. To be clear, I am here referring only to "tax avoidance," that is legal means of lowering tax liability, as opposed to "tax evasion," which are illegal means of the same. Although the line can often be blurry, there are several tax avoidance methods that are accepted by finance ministries across the world. One of the most important of these is "transfer pricing."
Transfer pricing is the price of transactions between related business entities. That's quite a vague definition, so let us examine a concrete example. Around 20 years ago Microsoft hired KPMG to design a tax strategy. The solution they came up with was quite creative. Microsoft would produce CD-ROMs in Puerto Rico at a subsidiary factory and thus send all of its profits to Microsoft-Puerto Rico. Though Puerto Rico is a territory of the United States, it has its own tax regime. It also has a long history of corruption, and KPMG negotiated a sweetheart deal so that Microsoft would pay no income taxes.
But how does this work in practice? Transfer pricing allows subsidiaries of a single company to exchange property or goods among themselves in an effort to lower their taxable income in one jurisdiction. With tech companies this happens quite easily. Intellectual property, algorithms, technology or "know-how" can be sold between entities at "transfer prices." It is important to note that there was no economic or business justification for this factory in Puerto Rico. It did not serve any purpose and was not even the cheapest place to produce CDs. Its purpose was to avoid taxes by moving all software to Puerto Rico from where it was sold to other subsidiaries of Microsoft to wipe out any transactions that occured in other jurisdictions. In effect, the fictional sales happening at "transfer prices" erode taxable income in one place and move it to another.
Facebook has a similar arrangement, operating some of its customer service centers in Ireland for the purpose of transferring intellectual property and technology to the Emerald Isle where they can avoid tax.
The digital age has raised new challenges for tax authorities. Products, services, technologies, algorithms and applications flow freely across the world. Domestic and international law has not caught up to the realities of e-commerce and as a result it's too easy for companies to avoid taxes. Moreover, the advantage is on the side of enterprise. Large corporations have the resources to hire consultancy firms and high-powered law firms to come up with ever more complicated explanations and justifications for their tax solutions. Meanwhile, tax authorities have limited resources and, frankly, do not tend to attract the best lawyers in a given country because they cannot compete on compensation. In the above mentioned tax avoidance case with Microsoft and Puerto Rico, the IRS actually hired outside council to fight the case in 2013. However, despite the new manpower the two sides are still litigating tax bills. It is likely that KPMG and Microsoft's lawyers will be able to carry this on past the statute of limitations without a decision being rendered.
The consultancy and accounting industry refers to the avoidance of tax responsibilities in one country in favor of shifting profits over to low tax jurisdictions as "tax risk management." The phrasing here is telling. Managing risk is what business analysts and bankers are supposed to do. Everyone learns in their Finance 101 courses is how to hedge their bets, to invest on both sides of an issue so that matter what the outcome may be, they will always make money. And what the tax consultancy industry is telling their clients that paying taxes is just another risk. You can either be exposed to it, or you can find a way to not be exposed. This attitude contains the claim that paying taxes is somehow optional. But why is it optional for multinational corporations (MNCs), handling millions and billions of dollars in revenue, while individuals are not afforded the same "right" to avoid such risk?
This raises the question of what tax justice actually looks like. Or put another way, what are taxes actually for? The way that we answer this question has nothing to do with economics and everything to do with our moral and political philosophy. In our data driven world it's important to keep things in perspective and take stock of the fact that not everything is quantifiable. All the data and valuations formulas in the world cannot actually account for the fictitious transactions created by transfer pricing and other forms of tax avoidance. But we know to some degree what the effects are.
Relations among EU countries are presently as tense as they have ever been. Britain is leaving, there have been no solutions found to immigration issues, and Europe has remained a union of two or even three speeds. Tax justice has exposed the problem of inequality among member states even further. Until some collective action is taken, there will continue to be a gap between the countries that have decided to be tax havens and the rest (like Poland) that lose potential tax revenue to avoidance arrangements.