Transnational tax: this time Darling shouldn't back down

Another tax, another retreat. That seems to be par for the course with the Government's fiscal policy. Last week Chancellor Alistair Darling signalled that the Treasury, faced with an exodus from Britain of multinational companies, would backdown on plans to tax earnings from foreign subsidiaries.

Business rebels leading the campaign to stop the proposed changes were companies such as pharmaceuticals giant Shire and publisher United Business Media, which have already said they plan to relocate to Ireland, citing its 12.5 per cent corporate tax rate and advantageous tax treatment of foreign earnings. Other companies, such as the advertising giant WPP and British American Tobacco (BAT), threatened to join them if the Government's proposals were implemented.

But Mr Darling, speaking at last week's CBI dinner, told business that the new policy would be revenue-neutral and would not pose any risk to British companies with big intellectual property rights held overseas. The Treasury is still going through its consultation stage and has put together a special business forum to discuss the final package of tax reforms which is now expected at the end of next month or in July.

But, as Richard Murphy, the tax expert who advises the Tax Justice Network, argues: "It has no representatives from the professions, only one from the TUC, none from small business all of whom have interests in corporate tax – how can it come up with the right answers." This latest corporate tax furore began with the publication in June 2007 of an HM Revenue and Customs discussion document on the taxation of the foreign profits of large British-based companies. The document has its origins in two factors. First, as the UK tried to comply with recent EU legislation on the repatriation of dividends earned by foreign multinational subsidiaries, the Revenue was seeking to avoid the charge of double taxation on the profits of subsidiaries genuinely trading abroad.

Second, the Revenue was looking to clamp down on tax avoidance by transnational groups that artificially offshore their assets (often intellectual property) to minimise their tax liability.

In short, the aim of the proposals was laudable: don't double tax genuine commercial activity abroad but stop companies sending profitable assets offshore that should be subject to domestic taxation.

Obviously there would be winners and losers under this proposed scheme. The winners would be those, such as banks or manufacturers, whose subsidiaries actively trade abroad. In other words, they really run banks that provide services in overseas markets, or actually produce goods abroad that are sold abroad. If the current plans were implemented, dividends from these activities would only be subject to the tax rates of the countries in which they operate.

The losers would be those firms that don't actively trade abroad – the international companies that own intellectual property like licences, patents or copyrights and whose business is franchising out these assets in a process often conducted through a tax haven. In this way, the corporation can sell this intellectual property (which may well have been developed in the UK) back to its domestic subsidiaries and generate both an untaxed offshore profit and a generous tax deduction back in Britain.

It's no surprise that the companies kicking up the biggest fuss about the proposals and the heavy tax burden are those that pay the least amount. As Murphy, has pointed out: "According to their accounts, neither WPP nor BAT paid any tax in the UK in 2007. United Business Media only paid £5m tax worldwide in 2006 according to its cash flow for that year. And Shire, from 2000 to 2004, declared just £1m of tax liability in the UK."

What this issue highlights is the increasing difficulty faced by governments in taxing trans-national companies. Not only are global corporate taxation rates falling (in the UK it was reduced from 30p to 28p last month with more cuts promised), but countries are bidding against each other to lower the liability of the companies whose presence they court. Ireland is seen by other EU nations as an aggressive low-tax predator, and the Netherlands and Switzerland have been accused of similar practices.

Most corporate avoidance utilises the structure of transnational subsidiaries and takes the form of either non-compliant internal-transfer pricing or false invoicing. The former consists of artificially inflating costs in high-tax zones by charging for intellectual property or the services of an offshore vehicle, while offshoring the profits of that activity across international borders in tax havens or low-tax jurisdictions. With false invoicing, subsidiary companies artificially raise or lower the prices of imports or exports to minimise the tax liability of the holding group.

If transnationals increasingly avoid tax, the fiscal burden falls on employees as well as small and mid-range businesses that have not yet developed the structure that would enable them to offshore their profits.

The debate on multinationals and tax was inflamed by the publication two weeks ago of a report by Christian Aid. Entitled Death and Taxes, it contained startling figures on the global costs of corporate evasion, and even more emotive though entirely sustainable claims on the human costs of such activity. Christian Aid calculates that the developing world loses $160bn (£80bn) a year as a result of evasion. It argues that the loss of this revenue to the health and social services of developing nations will be responsible for the deaths of some 5.6 million children between 2000 and 2015.

However, nations are beginning to realise the scale and cost of tax avoidance. On 14 May the EU agreed to consider a new clampdown on tax havens, while the US is conducting a similar purge of rich individuals who have not paid tax on income generated from overseas deposits.

The real task, though, is to develop a global agreement on the taxation of transnational companies. Just about the only effective suggestion for repatriating tax revenues from companies to the nations that generated them is consolidated taxation. This approach would calculate the amount of tax owed to each nation on the basis of real trading activity, A similar formula is already used in the US for companies operating across state lines.

Just about the only major nation not taking corporate tax avoidance seriously is Britain. Indeed, of 72 tax havens, the UK in effect licenses more than 30 of them in Commonwealth countries and crown dependencies. That the Government now looks like retreating on its attempt to curtail some of the more outrageous accounting practices only shows that the political will to tackle this issue is lacking.

As Prem Sikka, professor of accounting at University of Essex says: "Governments continue to use 19th century ideas to deal with 21st century problems. They need to tax companies on the basis of economic activity arising within their jurisdiction rather than on the basis of some mythical place of residence."

Nonetheless, there is a global momentum for another agenda – not least because the figure of funds held offshore and free of any tax liability is estimated to be $11 trillion. Meanwhile, with the UN needing just $40bn to $60bn to meet its millennium development goals, the human cost of tax avoidance will only rise.

Philip Blond is a senior lecturer in philosophy and theology at Cumbria University