Vol.3 No.11, 01 April 2003
Taxation Issues with Respect to International Corporations
by Mark Hennesy
Most Developing Countries, including South Africa, are vying among themselves to attract investment by multi-national corporations. The author of this contribution to SANE Views, list member Mark Hennesy, points out here that this is by no means an automatically favourable arrangement for our national economy
For many years Mark Hennesy was a senior manager of a South African subsidiary of an American multi-national corporation. He is therefore intimately acquainted with the cost accounting. tax and profit structure of such corporations. The purpose of this submission by him to SANE Views is to draw attention to the potential loss of tax revenues by South Africa, and similarly by other developing nations, in favour of developed countries that are the homes of International Corporations'. In this contribution he points out some of the reasons why this is so.
- International corporations are measured by the results that they declare in the country in which they are registered. The Executives that run those companies are measured and compensated in accordance with those results. Therefore there will be every incentive for them to maximise the profit that they can declare in the country in which they are registered - the 'Home Country' - regardless of the comparative tax regime in that country relative to that of the foreign subsidiaries of the corporation. There will, therefore, be a compelling incentive to transfer as much profit out of the subsidiaries and to the Corporate Head Office as they possibly can. As companies are taxed on the profit they declare, this means that the tax paid in the country where the subsidiary operates will be reduced and the tax paid in the 'Home Country' will be increased.
- Besides the generally accepted factors for which corporations are entitled to bill a subsidiary - a cost to the subsidiary but revenue to the corporation - such as patent, copyright and trademark royalties, there are many other methods by which profit can be transferred out of the subsidiary to the corporation.
- When goods are supplied by the corporation to the subsidiary for direct onward sale in the subsidiary's market, or for use in products which are manufactured or assembled by the subsidiary for sale in its market, the corporation is virtually free within the bounds of the obvious 'retail' price of such goods in the home country, to set that 'transfer price' at any level it likes. The more that is charged, the lower is the profit in the subsidiary and the higher the profit in the Corporation Home Country. Therefore the tax paid in the subsidiary's country is reduced and the tax paid in the 'Home Country' is increased.
- Conversely, when finished goods, components or many natural resources are exported by the subsidiary to the Corporation, the corporation is largely free to set the price it pays for those goods. Once again there is every incentive to keep those prices low thus reducing profit and tax paid in the subsidiary's country and increasing the profit and tax paid in the 'Home Country'.
- International Corporations unilaterally impose a host of 'corporate charges' on their subsidiaries. These come in as many forms as accounting creativity can think of. Some of the most obvious are 'management fees' for supposed costs to the corporation of managing the subsidiary, 'knowledge transfer fees' in the form of charges for courses or educational material that the subsidiary has to accept, advertising material charges, inflated charges for product support, charges for personnel that are sent to 'support' the subsidiary, the cost of marketing programs and international conferences, literature, manuals, etc etc.
- In the subsidiary of an International Corporation there is no one looking after the interests of the taxation authorities in the subsidiary's home country, especially if it is a wholly owned subsidiary. Theoretically local directors should do that, but seeing as they are in their positions largely at the behest of the corporation's executives, they are unlikely to exert any influence in these matters. Even in a partially owned subsidiary, unless there is a powerful counter-balancing share holder whose income from the investment is determined by the profit made by the subsidiary, the interests of the corporation will take precedence over those of the subsidiary. Consequently the taxation interests of the 'Home Country' take, by default, precedence over those of the subsidiary's home country.
- While the tax authorities could audit transfer pricing and corporate charges for 'reasonableness' the chances of their having both the capacity and the 'internal' corporate know-how to be effective in this are very slight.
The outcome of this is that there is a very high likelihood of taxation subsidy flowing from the subsidiary country to the 'Home Country' wherever a subsidiary of an International Corporation operates. Taken in global terms this means that there is a taxation flow from developing and emergent countries to the developed world.
International Corporations do bring advantages, such as the introduction of new technology and expertise. It is therefore not suggested that one should be against such corporations operating or investing in our country. However we should be very aware of the disadvantages that arise from their operations and the way they are measured. Corporations and their executives will ultimately behave according to how they are measured. If that results in tax revenues flowing to the 'Home Country' rather than to South Africa, then that is what is going to happen.
South Africa should therefore in the first place be a little more careful before allowing South African assets to be taken over by international corporations, and then also be aware that in doing so, to a significant degree, our tax authorities are losing control of the future taxation flow from such assets. Similarly we should recognise that when we allow large owners of South African assets to move their 'Home Country' off-shore, something similar will take place.
In the second place South African tax authorities should apply innovative thinking to how to combat the distortions in tax flows. A movement of emphasis in the tax structure from profit to revenue would certainly help as far as imported goods are concerned, but this would tend to provide an incentive to exporters of finished goods, e.g. motor cars, to lower their transfer price to the corporation which would not help. Nevertheless the first step in addressing any problem is to recognise its existence, and that first step is the purpose of this memo.
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