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executive insight

Last week the EU fired its first shot at tax-avoiding multinationals: those engaged in a form of fiscal villainy that apparently costs the world between $100-billion (U.S.) and $240-billion in lost tax revenues. The alleged perpetrators, Starbucks and Fiat, are each accused of erecting a complex web of cross-border transactions with the connivance of the Luxembourg and Netherlands tax authorities. They have been ordered to pay back between €20-million ($29-million Canadian) to €30-million, a paltry sum given the scale of the investigation.

The European Commission (EC) brought out the big guns for this job, which came in the form of an investigation into illegal state aid by Netherlands and Luxembourg. In its effort to find the evidence of sophisticated tax avoidance, the commission used new powers of search and discovery to compel the companies involved to reveal the nuts and bolts of the transactions.

These included a Dutch coffee-roasting subsidiary of Starbucks buying coffee beans at a substantially inflated price from a Swiss Starbucks subsidiary, while paying an excessive royalty to a British Starbucks subsidiary for coffee-roasting know-how. These devices shifted profits away from the Netherlands where the roasting activity is located, thus saving money for the Seattle-based company.

Such complicated shenanigans, known in accounting jargon as transfer pricing, are worthwhile and multinationals do this all over the world, many times over. The trick involves shifting taxable profits from one jurisdiction to another, perhaps by charging too much interest for an intercompany loan, or an exorbitant fee for a bit of internal management consultancy, until the profits have been siphoned from an operating subsidiary in a high-tax jurisdiction (where there are assets, jobs and real activity), and arrive in a tax haven, a letter box and an e-mail address in the Caribbean.

Many U.S. companies do this and even if Starbucks is being told to repay a relatively small sum for tax it did not pay over the past five years or more, the point is that the commission is targeting these cases. They are sending a message to big companies everywhere that the game is over, that they will be pursued, not for cheating, lying or concealment – but for doing sweetheart deals with governments. The EC wants everyone to believe that government-sponsored deals that enable multinationals to trade investment in one country (factories, jobs) in return for the right to export profits tax-free to another jurisdiction where taxes are nil or de minimis are now proscribed.

How will this be achieved unless the world dances to the European tune? The answer is that the EU is working hand-in-glove with the OECD, which (in an unlikely coincidence) has just published its proposals for global reform of international tax rules to combat base erosion and profit shifting (BEPS). This huge two-year project has the aim of changing tax rules worldwide to ensure that profits are taxed where economic activity is carried out and value created. It has been a vast undertaking, involving not just consultation with OECD member states, but 1,400 submissions from industry, NGOs and academics and 12,000 pages of comments.

Inevitably, given the scale of the consultation, the resulting recommendations are probably less aggressive than the OECD's tax attack dogs would have liked: better transfer pricing rules that focus less on what contracts say and more on the economic reality of transactions. There will also be better co-operation, and in cross-border digital commerce VAT (value-added tax) will be payable in the country where the consumer is located, rather than in some convenient zero-rated tax haven.

The EU's next target is likely to be Apple's tax arrangements in Ireland: the consumer tech company is the very essence of a multinational company that dreams up and designs products in the U.S., makes stuff in China and sells it in multiple jurisdictions with numerous points in disparate locations at which work is done before it ends up in the pocket of a paying consumer. The question is where the value is created and who gets the right to tax the added value. When you begin to try to tease out the amount of value that ends up in a $400 (U.S.) cellphone or $1,000 laptop at each stage of the process of manufacture and distribution (not to mention marketing, advertising and promotion), you begin to understand why the OECD's research staff are wading through thousands of pages of learned comment.

You might also wonder how the U.S. government feels about this and the answer is: high anxiety. On the one hand, the Obama administration is very keen to support level playing fields and the suppression of tax havens. On the other hand, voices in Congress are complaining that U.S. companies are being targeted and there is concern that the release of the EU tax attack dogs will only result in more U.S. jobs moving offshore. The fear is that a crackdown on government-sponsored tax avoidance schemes will lead to real competition between states. In other words, if we can't do sweetheart deals to get the factory and the jobs, then let's just cut our tax rates altogether.

By global standards, America is a high corporate-tax jurisdiction (but low personal-tax jurisdiction) and U.S. corporations solve this problem by keeping billions of dollars earned offshore in bank accounts offshore. This could get worse for Uncle Sam.

What is the solution? If we assume that the objective is desirable, then we need to think more profoundly about what should be taxed. There is little chance of widespread agreement around the world on what should make up the tax base on which a tithe should be levied: profit is an opinion, not a fact. The only truth lies in the cash flow that a company receives in the form of turnover and pays out in the form of wages, rents and other costs. What is left is either invested or paid out in dividends to business owners.

If we agree that governments have a right to tax economic activity for the common good, then we must focus, not on some ephemeral notion of profit, but on cash transactions and payments. A turnover tax is a brutal but simple way of ensuring that the state is able to benefit from a share, even a very small percentage, of real economic activity. At the other end of the scale, a tax on dividends paid ensures that the owners of capital are paying their fair share of the burden of running the state, from which their enterprise benefits hugely. A dividend taxed at source ensures that investors, no matter where they live, will pay their share of tax on the cash flow they derive from a profitable enterprise.

Fairness has become the fashionable political idea of the moment, If we focus on how to make business taxation fair, we need to junk our obsession with the definition of profit and focus instead on cash: who earns the cash, who gets paid. What share is deserved by the investor for his capital and risk-taking and what is deserved by the state for providing the infrastructure that makes business possible. It would concentrate minds and might simplify the solution.

Carl Mortished is a Canadian financial journalist based in London