It is rare that the global transferpricing strategies of multinationalenterprises (MNEs) become front page stories. This has, however,been the case recently in a barrageof criticism that is still growingand suggests that such strategiesare responsible for global economic problems. Not surprisingly, the tax authorities of the world, collectively represented by the Organisation for Economic Co-operation and Development (OECD) and the UnitedNations, have announced their intention to address them.
The G-20 has asked the OECD to review applicable rules to reduce the ability of MNEs to shift profits to low taxation countries (i.e., tax base erosion). In the United States, Treasury Department officials sing a similar tune, advising that any broad tax reform must be focused on the tax base erosion fight.
At the same time, there has been controversybetween MNEs and non-OECD member countries concerning their own domestic tax base defence. This has occurred in the form of domestic tax policies of the BRICS countries (Brazil, Russia, India, China and South Africa), amongst others.
As the criticism of MNE effective tax rate (MNE-ETR) planning strategies builds, a neutral observer might wonder whether or not existing model treaties provide protection for the tax base of the respective countries and guidance to MNEs for framing their ETR strategies (the Foundation Questions). It helps to understand in this regard that prevailing MNE-ETR strategies were not developed as one event. They instead evolved over a long period of time, as have the substantive tax and transfer pricing policies of the countries seeking to defend their respective tax bases.
Origin of the OECD and UN Model Treaties
The OECD and UN model income tax treaties were designed to minimise income that would be allocated to "source" countries, with the residue allocated to "residence" countries. The terms originate in the use of trade between England and India as a tax model. The countries were described, respectively, as Imperial and Colony countries, which became the more polite "residence" and "source". Transfer pricing principles were ultimately developed to implement this same model.
The origins of these treaty models can be traced to the work of the International Chamber of Commerce (ICC) immediately following the end of World War I in 1918. All countries had crushing debt burdens and sought to impose tax wherever possible. Political power at the time was largely vested in the victors, particularly the few capital exporting countries.
The concept developed by the ICC from 1920 to 1923 reflected a balance of residence and source criteria for the allocation of combined income of MNE affiliates pertinent to specific transactional flows. The model developed by the ICC could be fairly characterised as prescribing residual profit split or model apportionment transferpricing results.
The League of Nations was organised at around the same time as the ICC, effectively as a global political organisation. It addressed tax issues in 1923 and abandoned the balanced approach of the ICC in favour of a predominant residence concept that became the base for the surviving OECD/UN model treaties.
In 1928, a final report was issued that became the benchmark for treaty negotiations in Europe and the United States, and eventually became the OECD and subsequently the UN model treaties. Once this treaty framework was in place, the balance of power between source and residence countries was changed significantly through a continuing redefinition of the scope of activities that would fall within the purview of a permanent establishment (PE) and minimisation of source-based withholding taxes on cross-border payments.
The net result of the League of Nations work was the following essential treaty principles:
- Source country (in this case India) should tax local operations, including property or other pertinent matters.
- Residual income should be earned by the country of residence (in this case England) that provided the knowledge and capital for the business.
- An interim holding company should be treated as being in a residence country.
- Subsidiaries should not be treated as a PE.
- Transfer pricing principles should be developed on a consistent basis.
Foundation Elements of the OECD/UN International Taxation Framework
Going back to the Foundation Questions, in relation to the OECD/UN tax framework the answer to both is clearly affirmative.
Tax base protection: The existing OECD/UN model treaties may have provided protection to the tax base of the residence countries designing the model at the time the policies were adopted in the mid-1920s.
MNE-ETR strategies: The paradigm that was anticipated in the League of Nations debates (the Intended Paradigm) was as follows. The source (India) country would earn, using current terminology, routine returns, while the residence (England) country would earn the residual income or profits. These results have been achieved by the common MNE-ETR strategies evolved to achieve exactly these results, in compliance with treaty and attendant transfer pricing requirements.
In current debates, this history is largely forgotten or ignored.
Posture of the Non-OECD Source Countries
In the interim, the world has changed dramatically. The source countries have become developed or residence countries. Not surprisingly, they have over time adopted their own versions of the imperialist mindset of the original colonial powers. Accordingly, BRICS and other source countries have aggressively defended their source country tax bases. Contrary to predictions made at the time of the 1920s tax treaty debates that source-based taxation would be of diminishing importance, the exact opposite is happening. The minority views expressed by the former colony countries in those historic debates have become their posture as they become economic powerhouses almost a century later.
In short, the posture of BRICS and other source countries is largely a rejection of the treaty policies developed in the post-World War I era.
Need for Reform
It seems reasonable to assume that all stakeholders should, at least grudgingly, agree that treaty policies are in serious need of reformulation to reflect the world of the 2010s, not the 1920s. Assuming there could be agreement on the need for reform, the question turns to who will lead the process.
The crescendo of criticism directed at MNE-ETR strategies has had the desirable result of highlighting the role of treaty policy in global economic matters. It is inevitable that this criticism will continue until a policy is formulated that reflects a reasonable balance of interests of the pertinent parties.
The first step in this process is to examine the Foundation Questions and understand how and why our current treaty policies evolved. The second step should be to acknowledge the need for all parties to come together to chart a common path forward. The third step will be to select a forum for such discussions. Finally, the parties will need to develop a harmony for their common futures, which should include the development of models by MNEs to evolve their ETR strategies.
The results of the process followed by the ICC and the League of Nations in the 1920s should no longer dictate our taxation policies, but the process itself should still provide interesting guideposts.
Co-authored by Bret Wells, Professor at the University of Houston Law Center