The post-demonetization discourse in the country has focused on how greater digitization and formalization of the economy can bring a wider range of economic activity under the tax net. Apart from the fact that people are increasingly reverting back to cash as the economy gets re-monetized, this narrative ignores the growing evidence on tax evasion even in the formal sector by firms using ingenious methods to evade taxes and raise profits.
According to a recent study published by the United Nations University World Institute for Development Economics Research (UNU-WIDER), multinational corporations (MNCs) across the world might be evading taxes to the tune of $500 billion annually. MNCs generally shift profits to low-tax jurisdictions or ‘tax havens’ to reduce their tax liability, using a variety of methods from transfer pricing to transferring royalty-generating patents to allocating more debt to high tax jurisdictions. Realization of taxes from such shifted profits can increase the aggregate revenues of governments across the world by around 4.5%.
The latest estimates show that tax evasion by MNCs most likely hurts poorer countries more severely, a viewpoint increasingly being endorsed by a number of studies. A 2010 piece in the Monthly Review journal noted how developing countries lose out on tax revenue due to ‘profit-shifting’ by MNCs. The study cited the example of an MNC operating in Zambia, selling copper from the country to its subsidiary in Mauritius at €2,000 per tonne; the subsidiary reselling it at €6,000 per tonne and thus depriving Zambia of the opportunity to tax the margin of €4,000 per tonne.
Another study by the International Centre for Tax and Development (ICTD) shows that US-headquartered multinational firms in general book too much of profits in tax havens and too little profits in emerging market economies such as India and China.
Such profit-shifting behaviour among MNCs is induced by the huge tax arbitrage between jurisdictions. While the average effective corporate tax rate in China, Brazil and India ranges from around 17 to 32%, it is much lower in the tax havens of the world. It is no surprise that countries with higher corporate income tax rates generally tend to lose out more due to profit-shifting by MNCs.
Besides developing countries, the issue of tax evasion by MNCs is also biting many developed countries, most notably the USA, which itself has a high corporate income tax rate of 35%. Offshore profits of US companies was an election issue last year and President Donald Trump has committed to bringing back around $2.5 of accumulated corporate profits currently being parked abroad. Corporate tax evasion has become a big issue even in Europe, with the European Union taking issue with Apple Inc. and Ireland in a case of illegal tax benefits allegedly amounting to €13 billion.
For many years, the practice of using low-tax jurisdictions or tax-havens to avoid taxes and jack up profit margins was tolerated by the rich countries of the world as a legitimate fallout of the pursuit of profit. But the post-crisis stress in public finances in these countries and rising discontent over growing inequality has forced a rising tide of intolerance against such practices.
To tackle corporate tax evasion, the rich countries’ club, the Organisation for Economic Co-operation and Development (OECD) launched the Base Erosion and Profit Shifting (BEPS) initiative in 2013 with the backing of the G8 and G20 groups of countries. The BEPS initiative aims to reduce the misalignment between the profits of MNCs, and the location of their real economic activity, by creating a framework for countries to share tax and activity related data with each other.
Around 100 jurisdictions, including India, have committed to the implementation of the BEPS, according to a recent update by Ernst and Young. India has adopted the “country-by-country” reporting norms, which means that large MNCs will be mandated to disclose information about the entire group’s operations across the world to check if the company is shifting its profits to a low-tax jurisdiction to evade taxes.
India has already taken steps in the recent past to fix the loopholes that allow companies and investors to use offshore tax havens to evade taxes. Notable are the new tax treaties with Mauritius and Singapore, set to come into effect from April 1, 2017, which will tax capital gains at source. It is possible that plugging of such leakages might lead to lesser tax evasion, as available evidence suggests that MNCs operating in India, which have links to tax havens, pay relatively lesser tax than those without any such links.
Not only have havens often served as a destination for profits earned in India, they have also been used as conduits in round-tripping of funds in the garb of foreign investment. Since 2000, around sixty percent of all FDI equity inflows have been routed through the four tax havens of Mauritius (accounting for 34% of total), Singapore (16%), the Netherlands (6%) and Cyprus (3%), according to data from the Department of Industrial Policy and Promotion.
Around 18% of all FDI equity inflows from tax havens is likely to represent round-tripping, suggests research by K.S. Chalapati Rao and Biswajit Dhar, professors of economics at Institute for Studies in Industrial Development and Jawaharlal Nehru University respectively. Their analysis of FDI data between 2004 and 2009 showed that around three-fourths of all FDI inflows came from different tax havens while 14% of all FDI inflows were cases of round-tripping.
Round-tripping as defined by the authors does not always relate to clandestine activities like money-laundering. They classified all inflows by subsidiaries of India-based companies as ‘round-tripping’, although many a times the subsidiary might have actually raised money abroad for legitimate reasons. To illustrate, the authors classify the FDI inflows from Singapore’s Biometrix Marketing Pvt Ltd, which was a subsidiary of Reliance Genemedix PLC, to Reliance companies in 2007-08 as technically ‘round-tripping’. Although the transaction raised some eyebrows, Reliance defended the FDI inflow on grounds that the foreign subsidiary (Biometrix) had raised money from a Singapore bank to invest in Reliance group of companies in India, thus in effect representing legitimate inflow of foreign funds. The Singapore bank in question was the Singapore branch of ICICI Bank.
Besides round-tripping, a substantial chunk of the FDI inflows from the tax havens simply represent routing of funds from other countries to avoid paying higher taxes. The real extent of the evasion is however not accurately known because of data limitations, and most studies rely on different kinds of estimation techniques to quantify the loss in tax revenues.
Policymakers need to address two main challenges to tackle this issue. First, they need to ensure greater coordination and sharing of information among taxmen across jurisdictions to deter such practices. The recent efforts by the OECD and G20 are steps in the right direction. Secondly, they need to stress on detailed disclosures by corporations across the world, and make such information publicly available.
As the latest UNU-WIDER paper notes, the real breakthrough in understanding corporate tax avoidance strategies is likely to come only when corporate country-by-country reporting data is made public.