How to tackle profit shifting through intellectual property?

2021-02-22

Multinational companies like Apple, Google or Microsoft are heavily criticized for using complex business models to avoid taxation. One way to shift profits is strategic (mis-)pricing of intellectual property.

Multinationals locate property rights in so-called tax havens, i.e., countries with very low or even zero effective tax rates, and the affiliate in the high-tax country then pays royalties for the use of the intellectual property. Since royalties are generally tax deductible, this strategy reduces the tax base in the high-tax country and increases the tax base in the tax haven leading to a total reduction of tax payments for the multinationals. The described problem becomes more and more important since meanwhile one third of global exports happens within multinational companies and an increasing share of economic activity is related to the digital economy that is heavily knowledge based and requires relatively few physical activities. The spread of intellectual property rights, moreover, renders existing regulations of transfer pricing (e.g., the arm’s length principle) ineffective since market comparables do not exist. Finally, the growing importance of multinational firms and the digital economy become a challenge for basically all countries around the globe, with the exception of tax havens.

Why do governments not tackle profit shifting? In a global world where investment is highly mobile, multinationals threat to relocate business activities to other countries which would come with a loss in tax revenue, employment, and technological spillover effects for the former host country. Thus, governments worldwide compete for multinationals by implementing low effective corporate tax rates on mobile capital. Most of the current tax systems allow multinationals to shift part of their profits, either by strategic (mis-)pricing of intellectual property or by debt shifting, i.e., the replacement of non-deductible equity by tax-deductible internal debt from related affiliates. Such tax strategy is optimal from the viewpoint of a single country but results in a situation with a standard tax-competition prisoners’ dilemma, i.e., globally inefficiently low tax rates and excessive profit shifting. Enlarged possibilities to shift profits with royalties foster the latter outcome.

Against this background, we aim to answer the following question in a recent study: How can a country unilaterally defend its tax base against the new profit-shifting challenges, but still maintain its position in the race for multinational investment? Relying on a tax-competition model, we find a surprising answer that questions the current tax policy in the European Economic Area (EEA). A strictly positive withholding tax on royalty payments (so-called royalty taxes) is both optimal under international coordination (which is usual difficult to achieve) and the optimal unilateral response.

Royalty taxes restrict the possibility to deduct royalty payments. We show that optimal royalty taxes are always positive and likely features a medium range as lower bound. Under reasonable circumstances the deduction of royalties should even be completely denied. Our results therefore do not only challenge the limitations for the use of royalty taxes, set by many double tax treaties and multinational agreements, but also the complete ban of royalty taxes within the EEA following from the EU Interest and Royalty Directive. The introduction of royalty taxes in Norway and the Netherlands in 2021 shows that the proposal has already reached the political agenda.

Juranek, S., Schindler, D. and A. Schneider (2020). Royalty Taxation under Profit Shifting and Competition for FDI, Discussion Papers, 2020/11, Norwegian School of Economics, https://hdl.handle.net/11250/2677117.

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