Two pioneering studies which expose in new detail how multinational corporations avoid paying tax in a developing nation are likely to intensify pressure on the largest firms operating in Africa to pay their fair share of taxes to the countries in which they earn their profits.
The studies use actual corporate tax returns in a developing country for the first time to analyse how multinationals take profits earned in one country and shift them to a “tax haven” – a country with a lower tax rate – thus denying tax revenue to the government of the country where the profits are made.
Based on figures from South Africa’s tax authority, the principal study estimates that firms operating in South Africa but owned by a parent in a tax haven avoid taxation “on as much as 80% of their true income.”
Moreover, the study finds that a small number of the biggest multinationals – pre-eminently in the mining and financial industries – is responsible for the vast bulk of “profit-shifting”. It also gives a breakdown of the most frequently used tax havens.
While the research is limited to South Africa, it points to shocking levels of tax avoidance across the rest of Africa. One of the authors, Dr. Ludvig Wier of the University of Copenhagen in Denmark, told AllAfrica: “South Africa has, in comparison to the African region, a very strong tax authority and has already implemented a series anti-profit shifting policies. That is why we expect this phenomenon to be only worse in the rest of the region, where tax authorities are often severely constrained in their resources.”
The research has wide-ranging implications for development across the continent.
Typically, government revenues in developing countries depend more heavily on corporate taxes than those in economically developed countries. Pressure has been building in the international community in recent years to ensure, in the words of a study by the Organisation for Economic Co-operation and Development (OECD), “that profits are taxed where economic activities take place and value is created.”
The G20 group of countries endorsed an action plan five years ago to address the issue, and strengthening government capacity to collect taxes is one of the Sustainable Development Goals – seen as crucial if African nations are to grow their economies and reduce dependence on development aid.
The OECD has said that “aggressive tax planning” by multinationals is one of the factors contributing to losses of somewhere between four and 10% of global corporate income tax revenue, amounting to between U.S. $100 to $240 billion a year.
The head of an African Union panel on the subject, former South African president Thabo Mbeki, said recently that Africa’s annual loss through illicit financial flows has increased from $50 billion in 2015 to more than $80 billion a year. He has previously fingered international corporations as “the main culprits”.
“There is money that leaves the continent as a result of theft by Africans, whether by government or private sector people,” he told AllAfrica. “But the bulk of the funds that flow out of the continent is taken by big corporations. This poses a particular challenge, because they have got capacities which African countries don’t have – capacities to employ the best lawyers in the world, the best accountants in the world.”
The two ground-breaking studies, published in recent months, were carried out as part of a joint project including South Africa’s National Treasury and the United Nations University World Institute for Development Economics Research.
Both studies focus on how companies with affiliates in “tax havens” manipulate the flow of money between affiliates in different countries to minimise their tax obligations.
In the study on profit shifting, Wier and Hayley Reynolds of the South African National Treasury used corporate tax returns for 2010 to 2014 to estimate the loss of tax revenue by transferring income to affiliates in countries with lower tax rates. (South Africa’s corporate tax rate is 28 percent, four percentage points higher than the international average and 13 points higher than that in the nearest tax haven, Mauritius.)
Wier and Reynolds found what they characterised as “stark differences” between firms owned by parent companies in tax havens and other companies.
They report: “Among the largest two percent of firms, the haven-owned firms had six percent higher wage bills, six percent higher turnover, and 22% more fixed assets – but 72% lower taxable profits.” This suggested that a haven-owned firm in this category was reporting earnings of U.S. $70 million dollars a year less than one not owned by a company based in a tax haven.
The study also documents in detail for the first time how a small a number of the largest companies is responsible for most profit-shifting: “The combination of high profits and more aggressive profit shifting implies that the largest 10% of foreign-owned firms account for 98% of all profits shifted to tax havens,” it says.
Apart from the loss to government revenues that this leads to in financially-constrained developing countries, the study notes that the tax benefits accruing to the largest companies gives them an unfair competitive advantage.
The researchers emphasized that their work probably understated losses to tax revenue, since the data allowed them only to analyse profit-shifting to firms with parent companies in tax havens, and not to sister companies in tax havens, nor from parent companies in South Africa to subsidiaries in havens.
They said the financial industry was responsible for 19% of profit-shifting and mining for 28%, despite mining companies making up only two percent of foreign-owned firms. “This is alarming,” they said, “given the large share of total economic activity resource extraction constitutes in developing countries.”
Identifying tax havens to which profits are shifted, the study lists Bermuda, the British Crown Dependencies, Liechtenstein, the Cayman Islands, Mauritius, Singapore and – especially – Switzerland, where parent firms are responsible for half of the “profit gap” between haven-owned companies and others.
The detail provided by the study enabled the researchers to open what they called the “black box” of earlier international studies on profit-shifting across the wider world. Applying their findings to the earlier studies, they suggested that internationally “80% of the income of haven-owned subsidiaries is lost to tax havens.”
In a second study, Wier examined one of the ways in which profit-shifting is achieved – “transfer mispricing”, or inflating prices in a country where corporate tax is high when doing business with affiliates in those where taxes are lower.
He describes the phenomenon in this way: “[F]irms can reduce their tax bill by applying a high price on items flowing from affiliates in low-tax countries to affiliates in high-tax countries, and vice versa.
“This erodes the profits in the high-tax affiliate, which is paying the high price, but equally increases the profits in the low-tax affiliate, which is receiving the high price.”
Tax reform measures discourage mispricing by requiring companies to charge affiliates the same price they would charge when doing business with another, unrelated company – a practice called “arms-length pricing.”
But when Wier examined South African customs data from 2011 to 2015, he found that imports to South Africa from affiliates in low-tax countries were over-priced by at least eight percent.
The study provides “the first direct systematic evidence of profit shifting through transfer mispricing in a developing country,” he concludes. And although the lost tax as a share of total corporate tax revenue was no more than half a percent, he found that a relatively inexpensive automated system to flag suspected mispricing could realise a potential tax gain of tens of millions of dollars.