Source: Wikimedia Commons: author, Today Testing (https://todaytesting.com)In his Budget on 29 October, the UK Chancellor, Philip Hammond, announced a new type of tax. This is a ‘digital services tax’, which, after consultation, he is planning to introduce in April 2020. The target of the tax is the profits made by major companies providing social media platforms (e.g. Facebook and Twitter), internet marketplaces (e.g. Amazon and eBay) or search engines (such as Alphabet’s Google).
The proposed digital services tax is a 2% tax on the revenues earned by such companies in the UK. It would only apply to large companies, defined as those whose global revenue is at least £500m a year. It is expected to raise around £400m per year.
The EU is considering a similar tax at a rate of 3%. India, Pakistan, South Korea and several other countries are considering introducing digital taxes. Indeed, many countries are arguing for a worldwide agreement on such a tax. The OECD is studying the implications of the possible use of such a tax by its 36 members. If an international agreement on such a tax can be reached, a separate UK tax may not go ahead. As the Chancellor stated in his Budget speech:
In the meantime we will continue to work at the OECD and G20 to seek a globally agreed solution. And if one emerges, we will consider adopting it in place of the UK Digital Services Tax.
The proposed UK tax is a hybrid between direct and indirect taxes. Like corporation tax, a direct tax, its aim is to tax companies’ profits. But, unlike corporation tax, it would be harder for such companies to avoid. Like VAT, an indirect tax, it would be a tax on revenue, but, unlike VAT, it would be an ‘end-stage’ tax rather than a tax on value added at each stage of production. Also, it would not be a simple sales tax on companies as it would be confined to revenue (such as advertising revenue) earned from the use in the UK of search engines, social media platforms and online marketplaces. As the Chancellor said in his speech.
It is important that I emphasise that this is not an online-sales tax on goods ordered over the internet: such a tax would fall on consumers of those goods – and that is not our intention.
There is, however, a political problem for the UK in introducing such a tax. The main companies it would affect are American. It is likely that President Trump would see such taxes as a direct assault on the USA and could well threaten retaliation. As the Accountancy Age article states, ‘Dragging the UK into an acrimonious quarrel with one of its largest trading partners is perhaps not what the Chancellor intends.’ This will be especially so as the UK seeks to build new trading relationships with the USA after Brexit. As the BBC article states, ‘The chancellor will be hoping that an international agreement rides to his rescue before the UK tax has to be imposed.’
An investigation by the International Consortium of Investigative Journalists has revealed how more than 1000 businesses from 340 major companies from around the world have used Luxembourg as a base for avoiding huge amounts of tax. Many of the companies are household names, such as Ikea, FedEx, Apple, Pepsi, Coca Cola, Dyson, Amazon, Fiat, Google, Accenture, Burberry, Procter & Gamble, Heinz, JP Morgan, Caterpillar, Deutsche Bank and Starbucks. Through complicated systems of ‘advanced tax agreements’ (ATAs), negotiated with the Luxembourg authorities via accountants PricewaterhouseCoopers (PwC), companies have used various methods of avoiding tax.
Although such measures are legal, they have denied other countries vast amounts of tax revenues on sales generated in their own countries. Instead, the much reduced tax bills have been paid to Luxembourg. The result is that this tiny country, with a population of just 550,000, has, according to the IMF, the highest (nominal) GDP per head in the world (estimated to be $116,752 in 2014).
So what methods do Luxembourg and these multinational companies use to reduce the companies’ tax bills? There are three main methods. All involve having a subsidiary based in Luxembourg: often little more than a small office with one employee, a telephone and a bank account. All involve varieties of transfer pricing: setting prices that the company charges itself in transactions between a subsidiary in Luxembourg and divisions in other countrries.
The first method is the use of internal loans. Companies lend money to themselves, say in the UK, from Luxembourg at high interest rates. The loan interest can be offset against profit in the UK, reducing tax liability to the UK tax authorities. But the interest earned by the Luxembourg subsidiary incurs very low taxes. Profits are thus effectively transferred from the UK to Luxembourg and a much lower tax bill is incurred.
The second involves royalty payments for the use of the company’s brands. These are owned by the Luxembourg subsidiary and the overseas divisions pay the Luxembourg subsidiary large sums for using the logos, designs and brand names. Thus, again, profits are transferred to Luxembourg, where there is a generous tax exemption.
The third involves generous allowances in Luxembourg for losses in the value of investments, even without the company having first to sell the investments. These losses can be offset against future profits, again reducing tax liability. By transferring losses made elsewhere to Luxembourg, again usually by some form of transfer pricing, these can be used to reduce the already small tax bill in Luxembourg even further.
Tax loopholes offered by tax havens, such as Luxembourg, the Cayman Islands and the Channel Islands, are denying exchequers around the world vast sums. Not surprisingly, countries, especially those with large deficits, are concerned to address the issue of tax avoidance by multinationals. This is one item on the agenda of the G20 meeting in Brisbane from the 12 to 16 November 2014.
The problem, however, is that, with countries seeking to attract multinational investment and to gain tax revenues from them, there is an incentive to reduce corporate tax rates. Getting any binding agreement on tax harmonisation, and creating an essentially global single market, is likely, therefore, to prove virtually impossible.
The UK energy industry (electricity and gas) is an oligopoly. There are six large suppliers: the ‘Big Six’. These are British Gas (Centrica, UK), EDF Energy (EDF, France), E.ON UK (E.ON, Germany), npower (RWE, Germany), Scottish Power (Iberdrola, Spain) and SSE (SSE Group, UK). The Big Six supply around 73% of the total UK market and around 90% of the domestic market.
Energy suppliers buy wholesale gas and electricity and sell it to customers. The industry has a considerable degree of vertical integration, with the energy suppliers also being involved in both generation and local distribution (long-distance distribution through the familiar pylons is by National Grid). There is also considerable horizontal integration, with energy suppliers supplying both electricity and gas and offering ‘dual-fuel’ deals, whereby customers get a discount by buying both fuels from the same supplier.
Smaller suppliers have complained about substantial barriers to entry in the industry. In particular, they normally have to buy wholesale from one of the Big Six. Lack of transparency concerning their costs and internal transfer prices by the Big Six has led to suspicions that they are charging more to independent suppliers than to themselves.
Under new regulations announced by Ofgem, the industry regulator, the Big Six will have to post the prices at which they will trade wholesale power two years in advance and must trade fairly with independent suppliers or face financial penalties. In addition, ‘a range of measures will make the annual statements of the large companies more robust, useful and accessible.’ According to the Ofgem Press Release:
From 31 March new rules come into force meaning the six largest suppliers and the largest independent generators will have to trade fairly with independent suppliers in the wholesale market, or face financial penalties. The six largest suppliers will also have to publish the price at which they will trade wholesale power up to two years in advance. These prices must be published daily in two one-hour windows, giving independent suppliers and generators the opportunity and products they need to trade and compete effectively.
But will these measures be enough to break down the barriers to entry in the industry and make the market genuinely competitive? The following articles look at the issue.
As Elizabeth noted in Fuelling the Political Playing Field, there has been much debate recently about energy prices in the UK. Four of the ‘Big Six’ energy companies have now announced price rises. They average 9.1% – way above the rate of consumer price inflation and even further above the average rate of wage increases. What is more, they are considerably above the rate of increase in wholesale energy prices, which, according to Ofgem, have risen by just 1.7% in the past year.
The bosses of the energy companies have appeared before the House of Commons Energy and Climate Change Select Committee to answer for their large price increases. The energy companies claim that the increases are necessary to cover not only rising wholesale prices, but also green levies by the government and ‘network charges’ for investments in infrastructure. However, it is hard to see how, even taking into account all three of these possible sources of cost increases, the scale of price increases can be justified.
Another possible explanation for the price hikes is that they are partly the result of a system of transfer pricing (see). The energy industry is vertically integrated. Energy companies are not only retailers to customers, but also generators of electricity and wholesale shippers of gas. It is possible that, by the producing/shipping arms of these companies charging higher prices to their retailing arms, the retailers’ costs do indeed go up more than the wholesale market cost. The result, however, is higher profits for the producing arms of these businesses. In other words, a higher transfer price allows profits to be diverted from each company’s retailing arm to its producing arm.
This is an argument for making the wholesale market more competitive and for stopping the by-passing of this market by producing arms of companies selling directly to their retailing arms. What the companies are being accused of is an abuse of market power and possibly of colluding with each other, at least tacitly, to support the continuation of such a practice.
So is the answer a price freeze, as proposed by the Labour Party? Is it an investigation of the energy market by the Competition Commission? Or is it, at least as a first step, much more openness by the energy companies and transparency about their pricing practices? Or is it to encourage consumers to switch between energy companies, including the smaller ones, which at present account for less than 5% of energy supply? The videos, podcasts and articles consider these issues.
Why may the costs of energy paid by the energy retailers to energy producers/shippers have risen more than the wholesale price?
Explain what is meant by transfer pricing. How could transfer pricing be used to divert profits between the different divisions of a business?
How can transfer pricing be designed by multinational companies to help them minimise their tax bills?
Why is policing transfer pricing arrangements notoriously difficult?
What evidence is there to show that switching between retailers by customers can help to drive retail energy prices down?
How did the old electricity pool system differ from the current wholesale system?
Should electricity companies be forced to pool the electricity they generate and not sell it to themselves through bilateral deals?
Comment on the following: “The current electricity trading arrangements ‘create the very special incentive for the oligopolists. …The best of all possible worlds is where nobody invests. As supply and demand close up, the price spikes upwards, and supernormal profits result.'”
Original post Starbucks’ UK sales in 2011 were worth £398m. Costa’s UK sales were worth £377m. But while Costa paid £15m in corporation tax in 2011/12, Starbucks paid nothing! In fact since opening its first coffee shop in the UK in 1998 it has paid just £8.6m in taxes on UK sales of £3bn.
How is this possible? Let’s look at Starbuck’s 2011 UK sales. Even though these were worth £398 million, its costs were recorded as £426.2m, giving a loss of £28.2m. Costa, by contrast, reported a taxable profit of £49.7m.
So is Starbucks a commercial failure in the UK, recording year after year of losses? Not at all. Starbucks regards the UK as a highly profitable part of its business. As the Independent article below states:
…in its briefings to stock market investors and analysts during the past 12 years, Seattle-based Starbucks has consistently stated that its UK unit is “profitable” and three years ago even promoted its UK head, Cliff Burrows, to run its vastly larger US operation.
So how can reported UK losses be reconciled with a profitable UK operation? The answer lies in transfer pricing.
Transfer pricing refers to the prices a company charges itself when goods or services are transferred within the company but from one country to another. By varying the transfer prices, a company can choose where to make its profits. Thus if Starbucks’ US operation charges high prices to its UK operation for various services, such as royalties for the use of branding or for management services, or lends money to its UK operation at high interest rates, Starbucks’ profits will rise in the USA and fall in the UK.
Companies employ tax advisers (see for example) and ‘transfer pricing managers’ to help them move their profits from high tax countries to low tax countries. In Starbuck’s case, by charging its UK operation high prices for such things as ‘use of its logo’ it has chosen to move all its profits out of the UK and thus avoid UK corporation tax.
Apart from denying the UK government tax revenues, the practice by Starbucks distorts competition as competing UK companies, such as Costa, AMT, Caffè Ritazza and the many small independents, do not have the same opportunity for transfer pricing and do pay UK corporation tax. As the Guardian article by Richard Murphy below states:
We do have homegrown coffee shops in the UK. A lot of them. And they have to pay their taxes in full here in the UK. They can’t make payments to offshore entities for the use of their logos or advice on how to add hot water to coffee just to avoid tax: they have to pay in full on what they earn in this country. What Starbucks is doing may be legal, but what it also shows is that business does not operate on a level playing field in the UK.
And, as some of the articles below demonstrate, it’s not just Starbucks. Amazon, Facebook and Google have also been accused of avoiding taxes in the UK by engaging in forms of transfer pricing.
Update On 12 November senior executives from Starbucks, Google and Amazon appeared before the House of Commons Public Accounts Committee to give evidence on their non-payment of corporation tax and their apparent lack of profits in the UK. As you will see from the videos, the MPs were unimpressed by the answers they received.
At the G20 finance ministers meeting in Mexico the previous week, George Osborne, the UK Chancellor, and Wolfgang Schäuble, the German Finance Minister, called for “concerted international co-operation to strengthen international tax standards that at the minute may mean international companies can pay less tax than they would otherwise owe”.
There seems to be mounting international pressure on multinationals to cease using transfer pricing as a means of avoiding paying taxes. Whether it will be successful remains to be seen.
Further Update (June 2013) In June 2013, After continuing criticism of its tax avoidance policies, Starbucks agreed to pay £10m in corporation tax tin 2013/14 and a further £10m in 2014/15.
Explain how a multinational company can use transfer pricing as a means of reducing its overall tax liability.
Why may transfer pricing lead to an inefficient allocation of resources?
What policies can governments adopt to clamp down on the use of transfer pricing to limit their tax liability in their country?
What insights are shed by game theory in explaining why it may be very difficult to reach international agreement to clamp down on tax avoidance?
Is it immoral for companies to seek to minimise their tax liability? What are the limits of economics as a discipline in establishing an answer to this question?
The proposed digital services tax is a 2% tax on the revenues earned by such companies in the UK. It would only apply to large companies, defined as those whose global revenue is at least £500m a year. It is expected to raise around £400m per year.
