G7: The Big Step Forward on Global Taxation of Multinational Corporations

A “big step forward... towards an unprecedented global agreement on tax reform.” This is how the European Commission for Economy Paolo Gentiloni greeted the agreement reached in London during the last meeting of the finance ministers of the G7, the group of seven large countries formed by Canada, France, Germany, Japan, Italy, the United Kingdom, and the United States, in which Gentiloni represented the European Union. The aim of the agreement is to work together to fight a certain type of tax avoidance at the international level, that according to some estimates, subtracts 240 billion dollars from state coffers each year, affecting public spending for consumption and investments that is so important now, for example, for the stimulus policies of various countries to face the pandemic.

The London agreement has two pillars. The first attempts to remedy the growing disconnect between the geographic areas in which multinational corporations generate profits and those in which they report those profits – and thus pay taxes. In the case of the United States, for example, from the start of the century, the share of profits reported by American multinationals in tax havens has doubled, exceeding 60 percent in 2018, while those same multinationals have only 5 percent of their workforce in those tax havens. With reference to a company with a minimum profit margin of 10 percent on global revenues, the agreement states that one-fifth of the profits above that level and the right to tax them could be distributed among the countries in which the multinationals operate based on the revenues generated locally.

The second pillar of the agreement aims to reduce the incentive that countries have to competitively lower their tax rates on profits in order to attract multinationals and the jobs they offer. Due to this downward competition, over the years many countries have gradually reduced the tax burden on corporations. In recent decades, in particular, the average global corporate tax rate has fallen from 49 percent in 1985 to 24 percent in 2018. According to KPMG, in the European Union today the average rate is approximately 20 percent, with a certain degree of variability: in Italy we are at 25 percent, while Ireland is at 12.5 percent. The London agreement states that countries cannot go belong a minimum common rate of 15 percent, an important commitment especially for countries with low rates such as Ireland.

A simple example can help understand the problems that the London agreement seeks to solve. Take the case of a multinational corporation with its headquarters in Ireland and a branch in Italy. The parent company produces motors in Ireland, that are then exported and sold by its branch in the Italian market. The cost of production of a motor for the parent company is 500 euros, while the distribution cost for the branch is 100 euros, against a revenue from the final sale of 800 euros. The profit from this operation is 200 euros (i.e. revenue of 800 euros minus 500 euros of production cost and 100 euros of distribution cost). If this profit remains with the branch, it is reported in Italy and entails the payment of 50 euros in tax (i.e. 200 euros times the Italian rate of 25 percent). If it is allocated to the Irish parent company, the payment is cut in half, to 25 euros (200 euros times the Irish rate of 12.5 percent).

What determines the country in which the profit is reported? It depends on how much the parent company charges the branch for the motor, i.e. the choice of what is called “transfer pricing.” If the parent company transfers the ownership of the motor to the branch at a price equivalent to the production cost of 500 euros, the branch records the entire profit of 200 euros in its accounts. If the transfer price is set at 700 euros, the branch has nothing left after having paid the distribution cost: the entire profit goes to the parent company. In the first scenario, the profit generated in Italy is taxed in Italy: the multinational contributes 50 euros to the Italian state. In the second scenario, the profit generated in Italy is taxed in Ireland: the multinational contributes 25 euros of taxes to the Irish state. In the first scenario, the Italian state is obviously happier; in the second, both the multinational and the Irish state are happier.

To summarize, by deciding strategically on the transfer price, the multinational is able to shift the profit (“profit shifting”) from the country with the higher tax rate to the one with the lower tax rate. This way it is able to pay fewer taxes, with the side effect of increasing the tax revenues of the second country to the detriment of the first. Yet this provides an incentive for the country with the higher rate to lower it, triggering a potential vicious circle of downward competition on the rates between the two countries, given that low tax revenues are still better than no tax revenues. The goal of the second pillar of the London agreement is to set a lower limit to this race to the bottom. The goal of the first pillar is to make the practice of profit shifting harder upstream.

Although the logic of the London agreement is clear, we could ask what the first pillar is needed for given that laws already exist on transfer pricing. Such laws already require the transfer price between parent companies and branches to be appropriate, i.e. in line with the market price that the parent company would apply to a company not affiliated with it for the same transaction. The response to that question is that the dematerialization of the economy poses challenges that traditional transfer pricing regulations have difficulty addressing. The reason is that, for the transfer of intangible goods, such as a usage license or a brand, an algorithm or the composition of a drug, the determination of the appropriate price is more complicated than for a tangible good, such as a motor. For this reason, in a dematerialized economy, requiring multinationals to pay taxes where their revenues are generated, instead of doing so where they report their profits, could be much more effective than investigating the alchemy of their transfer prices for the transfer of intangible goods.

Apart from profit shifting and downward tax competition, for many there is at least another reason for reforming global taxation in terms of taxes on business profits. This is a reason of equity. Since it is principally multinational corporations that are able to reduce their tax burden through profit shifting, the result is that those enterprises succeed in obtaining an artificial competitive advantage with respect to their national competitors. The advantage is artificial because is does not come from the fact that those corporations are more efficient in offering goods and services, but from the fact that they can afford the legal advice necessary to navigate the complexities of international taxation. Moreover, since it is the shareholders of multinationals that benefit from the strategic reduction of their taxes, profit sharing benefits only those who have sufficient financial resources to participate (directly or indirectly) in the share capital of those enterprises.

The words of Paolo Gentiloni cannot but recall those of Neil Armstrong in taking the first step on the moon: “That’s one small step for a man, one giant leap for mankind.” Starting with the G20 in Venice in July, time will tell if the London agreement is a giant leap as well.

Gianmarco Ottaviano is a Professor of Political Economy at the Bocconi University, where he holds the Achille and Giulia Boroli Chair in European Studies. He writes for il Sole 24 ore and lavoce.info. For Economia&Management he expands on the comments and analyses published in those locations.