1. Globalization and Tax Design in Developing Countries Presented to World Bank April 30, 2003
William F. Fox
The University of Tennessee
Michael J. McIntyre
Wayne State University

2. Globalization has Many Dimensions
Trade is 25 percent of output in the average country
Trade grew 5.5 percent annually in real terms for the past 23 years
FDI reached $1.3 trillion in 2001

3. FIGURE 1: Tax Revenue as a Percentage of GDP by Continent

4. FIGURE 2: Tax Revenue as a Percentage of GDP by GDP Per Capita Category

5. FIGURE 3: Tax Components as a Percentage of Tax Revenue

6. FIGURE 4: Tax Components by GDP Per Capita Category

7. FIGURE 5: Change in Tax as a Percentage of GDP by GDP Per Capita Category

8. Implications of Globalization for Taxation
Tax Competition
Problems of Attributing Revenues
Tax Erosion/Avoidance

9. The Growing Importance of Tax Competition
Globalization increases tendency for competition
Competition limits the tax structures that countries can use
Lower Corporation and Individual tax rates
Less progressive tax structures
Fewer taxes on luxury goods
Tax concessions are one evidence of growing competition
Countries can try to cooperate but very difficult to do because some don’t want to participate

10. Is Tax Competition Good? Can be Efficiency Enhancing
Forces tax rates down to benefit charges
Limits the “Leviathan effects” of government
Could encourage countries to design tax structures better and to administer them more evenly
Can lead to lower taxes on the most mobile capital

11. Tax Competition Can Be Harmful
Can cause government to be too small because taxes on capital are too low
Race to the bottom
Bottom line – Whether helpful or harmful depends on the type of competition.
Tendency for government to be too small in some developing countries, at least in terms of essential services.

12. Forms of Tax Competition
Competition for Economic Activity
Countries often set rates in line with other countries
Then give various concessions for some activities
Competition for corporate residences or tax base – The Tax Haven
Very low statutory rates
Incorporation fee

13. Do Taxes Affect Location of FDI?
Research says lower tax rates have a modest effect on attracting FDI.
Effects should depend on whether the residence is in a tax exemption or tax credit country

14. Tax Concessions Tax Concessions Holidays are poorly targeted
Incentives focused on capital investment can be cost effective
Business must believe policy will not be changed once they locate
Taxes less important than many other factors
Must be used sparingly to limit abuse
Keep simple
Keep records
Evaluate the results

15. Consumption Taxes or Trade Taxes?
Trade taxes collect 25% of revenues in low income countries
Consumption taxes are preferred
VAT or sales tax can always collect as much revenue
Domestic producers will produce greater value of goods
Lesser distortions in consumer behavior
Can be transition effects of moving to free trade after years of protectionism

16. VAT - Allocating Revenues with Cross Border Transactions
Implemented on destination basis
Imports – collected at border by Customs
Can result in tariff like effects if not administered like the Tax Department
Exports – zero rated
Must make refunds for zero rating to be effective

17. VAT - Allocation with E-Commerce
Many of the issues are the same as with traditional cross border commerce, but represents an extreme example of the problems
Frequently cannot require vendors to collect, nor can it be collected at border
With digitized goods or services do not know where consumers are located and country does not know what they buy. Effects of e-commerce:
Fairness
Lost revenue
Economic Distortions

18. VAT - Allocation of Revenue
Discussion of using origin basis for services and e-commerce
Could move to origin based VAT for services and digitized transactions
Exaggerates tax competition
Fails to tax on consumption basis

19. Corporate Income Tax – Attribution of Revenue
Multinational enterprises potentially create significant problems for tax collection
Examples
Transfer Pricing
Other forms of Income Stripping

20. What is a Transfer Price Prices Charged to Related Persons
A Transfer Price is a price set by the taxpayer when selling to, buying from, or sharing resources with a related person.
A person (legal entity, generally) is a related person with respect to another person if:
It controls that person
It is controlled by that person
They both are controlled by some other person.

21. Special Rules for Transfer Prices Needed to Prevent Tax Avoidance
Multinational enterprises (MNEs) use transfer prices for the sale or goods and services within a corporate group.
A transfer price may be contrasted with a market price C a price set by supply and demand in a competitive market.
Unless prevented from doing so, MNEs can use inappropriate transfer prices to strip profits out of a country.

22. Example of Tax Avoidance Stripping Earnings through Inappropriate Prices
ACo manufactures goods in Country A and sells them to a foreign affiliate, BCo, organized in Country B. The cost of manufacturing is $50 per unit, and the sales price to customers in Country B is $200.
If ACo sells to goods to BCo for $199, almost no profits will be taxable by Country B
If ACo sells the goods to BCo for $51, almost no profits will be taxable by Country A.

23. Approved Pricing Methods International Agreement on How to Set Prices
In 1968, the U.S. Treasury published regulations that established the initial “arm’s length” pricing methods.
In 1994, the U.S. Treasury Department added some new pricing methods that divided up the combined profits of a common enterprise.
In 1995, the OECD approved of the U.S. new methods, to be used as a last resort. In practice, they are often the first resort.

24. Arm=s Length Standard Comparison to Dealings with Unrelated Persons
Under the arm’s length standard, transfer prices are set at the level that would have occurred on a sale between unrelated persons dealing at arm’s length.
The problem is that this “arm’s length” approach works well only when comparable market prices are available.
The method suggests that each related-person transaction is looked at separately.

25. Types of Transfer Prices Situations When Transfer Prices Must Be Set
Sales of tangible property (generic) between related persons.
Sales of intangible property or sales of tangible property that embody proprietary intangible property.
Sharing of resources within a MNE
intercompany loans;
use of assets owned by another member of the MNE group;
sharing of legal department.

26. CUP Method Sales of Tangible Property
The paradigm arm’s-length method, looking at actual sales of the same or similar products with unrelated persons.
Example. ACo sells widgets to BCo, a related person. It also sells widgets to CCo, an unrelated person, for $100. Under CUP, ACo would charge BCo $100 (with possible adjustments for differences in shipping costs, etc.).

27. Resale Price Method Related Person Treated as Distributor
The taxpayer is viewed as a distributor earning the customary percentage of the final sales price.
Example. ACo sells widgets to BCo and BCo sells them to unrelated retail customers for $200 each. Distributers in a similar line of business usually earn 20 percent of the sales price. Under the retail sales method, the price on the sale from ACo to BCo would be $160

28. Cost-Plus Method Taxpayer Treated as Contract Manufacturer
The taxpayer is given the gross profit percentage typically earned by unrelated persons in a similar line of business under a cost-plus contract.
Example. ACo manufactures widgets at a cost of $50, sells them to BCo, a related person, and BCo sells them to unrelated retail customers for $200. Contract manufacturers in similar lines of business typically earn a gross profit of 30 percent. Under the cost-plus method, the price on the sale from ACo to BCo is $65 ($ % of $50).

29. Summary of Examples Comparison of CUP, Resale Price, and Cost-Plus
Method
Method
Method
ACo's cost of goods sold
$50
$50
$50
BCo's sales to unrelated customers
$200
$200
$200
ACo's sales price to BCo
$100
$160
$65
Profit to ACo
$50
$110
$15
Profit to BCo
$100
$40
$135
Total profits to ACo and BCo
$150
$150
$150
Earner of entrepreneurial profit
shared
ACo
BCo

30. Double Taxation Issues A Problem of Inconsistent Transfer Prices
If countries do not apply the same transfer pricing methods or apply the same methods in an inconsistent manner to a MNE, the MNE may suffer from double taxation.
A solution is for countries to coordinate their methods and to allow “correlative adjustments” when one country adjusts a transfer price.
Most tax treaties require correlative adjustments. The countries also agree to consult to avoid double taxation.

31. Correlative Adjustment Sales between Related Persons
Example. ACo and BCo are part of an MNE group. ACo sells widgets to BCo. Country A, in computing the income of ACo, properly increases the price of widgets from $65 to $75. Country B, in computing the income of BCo, should make a correlative adjustment and treat BCo as purchasing the widgets for $75. The result is that more income is taxable in Country A and less income is taxable in Country B.
Double taxation may occur if Country B determines that the adjustment made by Country A is improper.

32. Tax Avoidance Problems Shifting Income to Low-Tax Jurisdictions
Under CUP method, the MNE may use inappropriate comparables.
MNEs typically use the resale price method to minimize taxes in the country of sale.
MNEs typically use the cost-plus method to minimize taxes in country of manufacture.
Treaty partners may use the exchange of information provision of their tax treaties to require consistent treatment in both countries.

33. Tax Avoidance Example Deflecting Income to a Tax Haven
Basic Facts. ACo, part of a MNE, manufactures widgets in Country A at a cost of $50. The widgets are sold in Country B to retail customers at a price of $200. The MNE has profits of $150.
Tax Facts. ACo establishes HCo, a wholly-owned affiliate in County H, a tax haven. It sells the widgets to HCo for $65, using the cost-plus method. HCo sells the widgets to BCo, also a wholly-owned affiliate, for $160, using the resale price method. HCo ends up with profits of $95, ACo has profits of $15, and BCo has profits of $40.

34. Other Pricing Methods New Methods Approved in 1995 by OECD
The OECD approved (as methods of last resort) two new methods in 1995.
The Profit-Split Method, and
The Transactional Net Margin Method (TNMM).
TNMM is called the Comparable Profit Method (CPM) in the U.S. Treasury Regulations.
Both new methods apply to sales of tangible and intangible property. Both are widely used.

35. Profit-Split Method(s) Several Variations of Profit-Split Method
The basic idea is that the income from some set of activities conducted by two or more related persons is aggregated and split up based on their contribution to the common enterprise.
The method is treated as an “arm’s length” method because the split is supposed to be based on the splits typical of unrelated persons engaging jointly in a similar enterprise.

36. Example of Profit-Split Method Simplified Example to Indicate General Rules
ACo and BCo are related persons engaged in the production and sale of pharmaceuticals. ACo engages in lots of R&D to produce its pills. BCo sells the pills after affixing its valuable trade name to the packaging. They earn profits of $8 million from the common enterprise.
Based on comparisons with unrelated persons, the tax department of Country A determines that ACo contributions to the common enterprise accounts for about 75 percent of the profits. Its taxable profits would be $6 million (75% of $8 million).