Academic journal article AEI Paper & Studies

Economic Substance Requirements and Multinational Firm Behavior

Academic journal article AEI Paper & Studies

Economic Substance Requirements and Multinational Firm Behavior

Article excerpt

Abstract

The OECD's Base Erosion and Profit Shifting project has focused on income attributed to intangibles with an objective of curtailing perceived artificial profit shifting by multinational firms. A key part of this effort is a renewed emphasis on the concept of "economic substance." Economic substance standards require companies to locate employees and other people functions in jurisdictions where the companies report profits related to intangibles. Our analysis suggests that an emphasis on economic substance tied to people functions can have a significant impact on the scale as well as the location of economic activity (i.e. employees dedicated to the creation and use of intangibles). Furthermore, the likely implications on economic activity can be highly unfavorable for high-tax jurisdictions. Viewed from a U.S. perspective, this new international environment provides one more impetus to strive for a reform of the corporate tax code to make it more competitive. In the absence of such changes, the United States--which taxes corporate income at a rate higher than most developed economies--will risk losing economic activity to other countries.

Keywords: BEPS, economic substance, intangibles, international tax, transfer pricing

I. Introduction

In an attempt to reduce perceived tax avoidance through profit shifting, the Organisation for Economic Co-operation and Development (OECD) has reinforced the concept of "economic substance" in its Base Erosion and Profit Shifting (BEPS) project reports dealing with transfer pricing. This is aimed at securing one of the key objectives of the project: that multinational enterprises (MNEs) report taxable income in the jurisdictions that host the income-generating economic activity. The allocation of income associated with intangibles features prominently in these reports. The OECD has identified intangibles--a mobile form of capital that can be moved across jurisdictions without significant (non-tax) costs--as a key area where enhanced guidance can have a significant impact in limiting the ability of an MNE to "artificially" shift profits from high tax to low tax jurisdictions. The OECD's new guidelines, presented in the report on BEPS Actions 8 through 10 (OECD, 2015), emphasize that when reporting profits related to intangibles in a certain jurisdiction, the MNE also should be able to demonstrate the location of employees necessary for the development, management, and exploitation of the relevant intangibles within that same jurisdiction. (1) This is intended to minimize (if not entirely eliminate) "artificial profit shifting" where the location of income attributed to a company's intangibles is disassociated from the location of important people functions.

This paper explores the potential consequences of this evolving international tax regime, comprising newly defined standards on economic substance as well as their expected enforcement in an environment shaped by the BEPS project. In particular, we develop a theoretical model to analyze the impact of economic substance requirements on firms' behavioral responses with regard to both the scale and the location of intangible capital. The model also analyzes the corresponding scale and location of people functions necessary for the development, management, and exploitation of the firms' intangible capital under varying standards of economic substance. Such "complementary labor" is used as the measure of economic substance with regard to intangibles in this paper. This is the labor necessary for the creation and productive deployment of intangible capital.

Our analysis suggests that higher economic substance requirements can have a significant impact on the scale as well as the location of economic activity - i.e., employees dedicated to the creation and use of intangibles. Furthermore, this impact on economic activity can be highly unfavorable for high-tax jurisdictions. Viewed from a U. …

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