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Posted on Friday, 22 July 2016 15:30

Tax avoidance: how it works and how to stop it

By George Turner, Director, Finance Uncovered, United Kingdom

Illustration © Christophe ChauvinThe Panama Papers have put the spotlight on tax avoidance once again. This is, of course, not a new issue. Before that, we had Swiss Leaks and BVI Leaks. You may be asking: how does tax avoidance work and why have policymakers struggled to rein it in?

Firstly, it is important to understand that tax avoidance by multinational companies is different from tax avoidance by individuals. If an individual opens up a secret bank account or places his or her money under the control of an anonymous company, it is most likely to hide money. If this is tax-related, it is more likely to be 'evasion,' than 'avoidance' (the first is illegal, the second not).

Services being paid for are often illusory, concocted to move money to tax havens

But there are other reasons for hiding money too. It could be that the person is a politician and wants to keep the source of his or her money secret. The person could be looking to hide his money from his wife or mistress or a creditor.

None of these reasons are normally legitimate, but people don't normally hide money for legitimate reasons. These were the kinds of issues at the heart of the Panama Papers leak, and the solution to secrecy is simple: transparency.

Shortly after the publication of the Panama Papers, we saw a new attempt by world leaders to put pressure on secrecy jurisdictions to open up – something that came to a head at Britain's Anti-Corruption Summit on 12 May.

But tax avoidance by multinationals is different. Multinational companies are not single corporate entities. A multinational can be comprised of hundreds of companies scattered around the world. These companies trade with each other, moving money around different parts of the company.

There is, of course, no problem with this in itself. However, at some point, accountants realised that they could take advantage of company trading to move money from subsidiaries in high-tax jurisdictions to low-tax jurisdictions.

Instead of companies trading with one another on the basis of supply and demand, transactions are created in order to gain a tax advantage. It is indeed one of the paradoxes of the tax-avoidance debate that whilst so many defenders of tax havens see themselves as upholding the principles of a free market, tax avoidance at its heart is a market abuse.

A good example of how this works was discovered by Finance Uncovered's investigation into MTN, Africa's largest cellphone service provider. In that 2015 investigation, Finance Uncovered discovered that a number of profitable operating companies within the MTN group in Uganda, Nigeria and Ghana were paying an annual 'management fee' to an MTN company in Mauritius.

MTN did not employ any staff at its Mauritius subsidiary, and so it was difficult to understand what management the companies were receiving in return. MTN claimed that these transactions were not tax-driven, but the Ugandan authorities disagreed.

Right at the centre of many tax-avoidance cases is an economic fiction. Services being paid for are often illusory, concocted simply to move money to tax havens. In order to combat this, tax authorities have adopted what is called the arm's length principle.

Transactions are supposed to be discounted if they are not market transactions – in other words if they are not transactions that two independent companies would enter into. If such an artificial transaction is found, the government authorities add the money back into the taxable profits of the local subsidiary.

This sounds good in principle but is extremely complicated in practice. Finance and intangible assets are the most difficult to deal with. If one subsidiary loans money to another subsidiary, what is the interest rate that should to be applied? If it is too high, it can lead to profits being shifted artificially.

To detect that kind of tax avoidance, a detailed understanding of the firm and all of its transactions is required. The problems this causes for poorly resourced revenue authorities should be obvious.

The solution is to adopt a completely different way of taxing companies. An alternative to the arm's length principle is the unitary approach. Instead of treating a multinational as a hundred different companies – and attempt the impossible of unpicking all of its transactions – the unitary approach looks at a multinational as one corporation.

The approach then apportions the company's profit to each country based on the amount of economic activity that takes place there. Unitary taxation is already law in some states of the United States. It does have its problems – for example, working out the right formula can be controversial – but it has the benefit of being a much simpler system that cuts out all the shell companies used to move money around the world. That is perhaps bad news for accountants but good news for all of us. ●



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