Data from South African corporate tax returns for 2010 to 2014 has revealed that 10% of large multinationals doing business in the country reduced their taxable profit by 98%.
This much-needed research into the link between the size of a multinational enterprise and profit shifting was done by National Treasury director Hayley Reynolds and Ludvig Wier of the Department of Economics at the University of Copenhagen.
Their collaborative effort was done within the cumbersomely abbreviated UNU-WIDER SA-TIED project (the ‘United Nations University World Institute for Development Economics Research’ and the ‘Southern Africa – Towards Inclusive Economic Development’ programme).
The research has resulted in a paper called Big and ‘Unprofitable’: How 10% of multinational firms do 98% of profit shifting.
As with all studies, the field had to be limited to the data that was available, that is, to companies directly owned by a parent based in a tax haven. Reynolds and Wier found that the biggest 10% of foreign-owned firms account for 98% of the total estimated tax loss.
The study did not include foreign-owned companies where the parent is not based in a tax haven. However, these enterprises can also use artificial methods to reduce taxable profits, such as moving intangible property to a tax haven, for which a royalty must be paid. Hence, the total tax loss caused by profit shifting is most probably underestimated in the study.
Although the most well-known profit shifting mechanism is transfer pricing, there are many other ways in which a company can artificially move profits to a tax haven where they are not taxed or are taxed at a much lower rate. For example, leveraged interest deductions, hybrid instruments (interest payments deducted for tax purposes but where the receipt in the other jurisdiction is treated as a non-taxable dividend), and an inflated charge for logistical services. Certain tax havens allow a notional interest deduction to be made against profits.
As treasury will no doubt be undertaking further such in-depth studies based on data obtained by the South African Revenue Service (Sars), it will have to ensure that Sars starts collecting the relevant data from tax returns.
The study found that tax havens not only enable tax avoidance for large multinationals, they also create competitive distortions between larger and smaller firms.
The Base Erosion and Profit Shifting (BEPS) process, a joint Organisation for Economic Co-operation and Development (OECD) and G20 initiative, resulted in a number of reports that gave best practice recommendations for neutralising profit shifting mechanisms, including hybrid mismatch arrangements and leveraged interest deductions. These reports were published in 2015. As interesting as this particular study is, treasury has much work to do to come to grips with those two reports that were published in 2015.
Unfortunately the best deterrent to profit shifting, whether through transfer pricing or another complex tax avoidance mechanism, is for Sars to have highly skilled teams of specialists supported by skilled auditors, who will not only timeously identify tax avoidance risks, but will be able to carry out an effective audit and obtain the relevant evidence to raise an assessment.
The problem with loopholes
Unfortunately, many complex tax avoidance mechanisms rely on a loophole in the law, or in differences between international laws. These are very difficult to identify, and even though they may be terribly aggressive, they are technically legal. As much as tax activists may argue that arbitraging a tax loophole is not within the spirit of the law, this argument is unlikely to be effective in a court case. Loopholes have to be timeously identified by skilled specialists within Sars, who can then recommend how legislation can be changed to neutralise them or render them obsolete.
Tax avoidance mechanisms that can be challenged with existing legislation must be identified, generally by scrutinising tax returns or collected data. The problem with a risk engine is that it can only identify what is known before the tax return for that particular year is finalised. At best it can be two years out of date.
If only Sars had enough audit staff to use the results of this study. To investigate, say, the largest 50 foreign-owned companies across various industries would require between 200 and 500 skilled Sars auditors, plus a solid base of legal support. A complex tax avoidance audit can take five years, and that is before the assessments are issued. Which is most probably why treasury is keen to find legislative solutions. But without a detailed understanding of what it is that they are trying to prevent, the solutions are unlikely to be effective.
We can expect our legislation to become more complex but less effective, the large multinationals to not give an iota, and for individuals to take the brunt of any tax shortfall in raised taxes.