Watch Out, Capital Dumpers

A case for a minimum alternative tax on revenues, not on profits

Few would believe that the International Monetary Fund’s (IMF) managing director, Christine Lagarde, would ever call for developing countries to increase taxation of multinational corporations. She has done exactly that in an op-ed in the Financial Times (‘An overhaul of the international tax system can wait no longer’, goo.gl/XanF8z).

“The public perception that large multinational companies pay little tax has led to political demands for urgent action… with good reason. The ease with which multinationals seem able to avoid tax, and the three-decade-long decline in corporate tax rates compromise faith in the fairness of the international system.

A New Paradigm

“The current situation is especially harmful to low-income countries, depriving them of much-needed revenue that would help them achieve higher economic growth, reduce poverty and meet the UN’s 2030 sustainable development goals… “…developing countries that are especially exposed to profit shifting and tax competition with limited alternatives for raising revenue. IMF analysis shows that non-OECD countries collectively lose about $200 bn in revenue a year, or about 1.3 per cent of gross domestic product, due to companies shifting profits to low-tax locations.”

That is a devastating verdict. Lagarde adds, “An immediate impetus for an overhaul has been the rise of highly profitable technology-driven, digital-heavy business models. These rely to a great extent on intangible assets that are hard to value, such as patents or software. They also have less need for a physical presence to do business… these models highlight two outdated assumptions about the international tax system. First, that income and profits are necessarily linked to physical presence. And second, that transactions inside a complex corporate group can be valued based on an objective market benchmark.”

Three factors are at play. One is transfer pricing to shift most profits to low-profit jurisdictions (Luxembourg, Cayman Islands, Ireland). Most countries, including India, already have measures to check transfer pricing.

A second, very new phenomenon, is ultra-low interest rates created by massive quantitative easing by western central banks. This makes western capital artificially very cheap. That makes it economic for private equity to provide billions for ventures — mostly digital/ electronic ventures — that lose money for years while building market share by cutting prices below cost. Indian businesses call this ‘capital dumping’, using subsidised capital to gain market share at the expense of Indian rivals. Indian business calls for protection are usually shamelessly self-serving, but here they have a point.

Third, multinationals that nominally lose money in India nevertheless extract large sums through royalties and other fees. These payments are tax-deductible, increasing nominal losses in India even while facilitating a net outgo of cash. Worse, the accumulated losses in India, used to kill competition, can be set off against future profits, which will be made when local competitors have been killed and foreign suppliers can raise prices after acquiring dominant market share.

Lagarde says one solution is some form of minimum tax. India’s existing minimum alternative tax (MAT) will not work in these cases since it applies only to profits, which are non-existent in cases of capital dumping and fee-extraction.

Change With the Times

The right alternative is to tax revenues, not profits. This, indeed, was once considered by the Donald Trump administration to check the diversion of profits to low-tax jurisdictions. A tax on revenue will apply even to loss-making companies, which in traditional economics would be unfair. But traditional economics has disappeared in the era of unicorns that are valued at billions of dollars even while losing enormous sums to build market share.

What would be a fair tax rate on revenue? MNCs like Hindustan Unilever, Procter & Gamble, Gillette and Colgate have profits before tax of 20-24% of sales. At a corporate tax rate of 25%, this translates into taxes equal to 5-6% of sales. A fair rate might be half that — 2.5-3% of revenue — for the new breed of MNCs like Amazon, Netflix and Walmart, which show enormous losses, and pay no tax.

Lagarde says, rightly, that countries must weigh the pros of collecting tax revenue against the cons of driving away foreign investment. India’s market size is so enormous that only small or niche players will be discouraged, and the big boys will invest even if India levies a modest 2.5% tax on revenues as a minimum alterative tax.

Can this be levied only on foreign companies and not Indian-owned ones? No. That would violate World Trade Organisation (WTO) rules mandating national treatment for foreign investors. Such a tax would badly hit small and medium enterprises that face structural impediments, because of which the government is trying to assist them. This dilemma can be overcome by setting a high threshold of, say, ₹100 crore of revenue for the application of this tax.

Paying such a tax will be illogical for large Indian companies with revenues of over ₹100 crore that are bust and have defaulted on loans. Perhaps companies referred to the National Company Law Tribunal (NCLT) for defaulting can be exempted from the tax on revenue. None of the ‘capital dumpers’ will default on loans. For them, losses are a strategy, not a problem.

The issue needs further debate to finalise the details. But it is surely an idea whose time has come.

What do you think?