Corporation Tax

Corporations, like Vodafone, are undoubtedly avoiding tax. Unlike tax evasion, tax avoidance lies within the law but it is, arguably, unfair. Our government could have taken this weeks publication of the 'corporate tax roadmap'  as an opportunity to address this problem. Despite raising the issues, the document reveals that the government intends to maintain a system ridden with loopholes that enable the richest corporations to scheme out of paying tax in this country. 

Why tax avoiding happens and is not illegal. Multinational corporations have many operations - HQ, sales, shareholders and activities (development, HR, marketing) - that can be located all over the world. This makes things complicated when a national government wants to impose a tax on the profits that corporations make in their country. First, it has to be decided at which level of operations a corporation's profit should be taxed. The current global practice is to tax the activities section of a corporation. The implication of this is that the HQ of a corporation like GlaxoSmithKline needn't face any tax by the UK government even though it is located here. What if profits are sent back to HQ from subsidiary operations? In a credit system, like the US uses, profits repatriated to the US will be taxed unless they have already been taxed in another country.

As you can imagine, corporation tax in a global world economy quickly becomes very complicated. Designing a national corporate tax system is challenging and countries have taken varying approaches. In line with most other countries (other than the U.S.), the UK uses an exemption system whereby only profit that is generated in the UK is taxed. In recent decades, too, governments have been reducing corporate tax rates in a competition to attract big business. The resulting differences enable corporations to manipulate their capital flows in order to avoid tax. It is not illegal because their behaviour is not always observable and generally not verifiable. 

How to avoid tax. In the case of Vodafone the relevant avoidance is simple profit shifting; it has allegedly been pouring profits made in the UK (and probably elsewhere) into a subsidiary firm in Luxembourg to dodge UK tax payments and benefit from the lower Luxembourg tax rate. In trying to recoup the lost tax revenue HMRC faced problems verifying that Vodafone was in fact tax dodging. In court, Vodafone claimed that the government was discriminating against outward investment to other EU countries, which is inconsistent with the EU treaty! (Of course, they just happened to invest in a tax haven!)

Another way corporations can avoid tax is through debt.  The government's roadmap discusses this at great length. Let me give one example of how it works [see diagram]. Imagine that a UK based corporation sets up a company in the Cayman Islands (known as a controlled foreign company (CFC)). The UK entity can exploit the lower tax rate in the Cayman Islands in order to reduce the amount of its profit that is taxed at the high UK rate. How? The UK entity borrows money from the CFC and pays back interest. This interest is tax free in the UK, and though it is seen as profit to the CFC, it faces a much lower tax rate in the Cayman Islands. As a result, this lending strips profit out of the UK in the form of interest and the corporation holds onto the majority of the profits in the CFC based in the Cayman Islands. 

Since the key problem, which the government highlights, is the tax relief on interest payments we would expect the government to restrict interest relief. 

No Change. The government rejects the option to change the interest relief rules because "they are considered by business as a competitive advantage". Ha! - They are acknowledging that the relief rules mean that tax can be avoided! The government claims that the aim of their corporate roadmap is to achieve  'the most competitive corporate tax in the G20'. If they really want that, then the most sensible and direct option would be to reduce corporation tax. The message from the corporate road map paper is that if you're clever enough you can dodge tax payments.