TAXING INCOME WHERE VALUE IS CREATED.

Author:Christians, Allison
 
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INTRODUCTION I. THE KEY ROLE OF VALUE IN INCOME TAXATION A. Measurement of Income B. Error Detection and Correction C. Arm's Length Transfer Pricing II. LABOR EXPLOITATION AS MARKET DISTORTION A. Rights Violations as Revealers of Compulsion B. Calculating a Counterfactual: Unexploited Labor C. Living Wage Methodology III. ADJUSTING PRICES FOR EXPLOITATION A. Case Study: Unilever B. Application C. Implications CONCLUSION INTRODUCTION

Highly profitable companies like Apple, Google, and Amazon pay very low rates of taxation around the world because their profits are allocated strategically to take advantage of favorable tax conditions. Governments have participated in creating this environment through tax competition, but they simultaneously seek to protect their own taxing rights. They do so by devising tax base protecting rules to counter the status quo, most recently on an internationally cooperative basis through the "Base Erosion and Profit Shifting" (BEPS) initiative spearheaded by the G20 and Organisation for Economic Co-operation and Development (OECD). (1)

However, whether intentionally or not, the foundational allocation rules embraced and enforced by BEPS ensure that highly productive, higher income countries are systematically assigned a larger share of revenue than less productive, lower-income countries. Lower-income countries are thus systemically deprived of the revenues necessary to improve their productivity and therefore unable to claim an appropriate share of global profits despite making key value contributions to the global economy.

This Article argues that this status quo is objectionable and inconsistent with stated goals. Taking as a given the core principle that income should be taxed in accordance with value creation, (2) the Article proposes an approach to more appropriately allocate profits to value-adding jurisdictions, while maintaining consistency with established legal principles. The approach requires a rigorous application of the principle of fair market value to the profit allocation rules applicable to multinational groups.

To demonstrate with a concrete example, the Article examines wages paid to workers in low-income countries and shows that in specified sectors and geographic locations, there is a gap between market price and fair market value that distorts the allocation of tax revenues, assigning too little to the country of production. This gap is the result of labor exploitation that has been well documented in multiple forms across multiple disciplines, even leading to anti-dumping measures. (3) The analysis illustrates how assigning income based on value creation is an inherently imperfect exercise that overtly rejects market distortions in some cases while ignoring them in others. It demonstrates how allocating income to take more distortions into account would be possible using established methods.

By engaging with the underlying idea that income should be taxed where value is created, the proposal would fundamentally align with the international tax system while also moving toward other international goals, including development goals. Were countries to adopt the proposal, the revised allocation outcome ought to be accepted by countries where the world's multinationals are headquartered. (4)

Part I outlines the core role valuation plays in income taxation and explains why fair market value is viewed as key to allocating profit to the proper taxpayer and, by extension, the proper government. Part II analyzes the labor price-value gap and proposes that in order to more accurately assign income where value is created, governments would be justified in reallocating profits of multinationals to low-wage countries, even when labor continues to be underpaid. Part III demonstrates how to implement the proposal, using a test case to lay out the circumstances under which profits could be reallocated for tax purposes to adjust for the effect of labor exploitation on the fair market value of goods produced by multinationals. The Article concludes that while the proposal may be perceived as provocative by some, it is consistent with the universally embraced goal of taxing where value is created, should that remain a core international tax goal.

  1. THE KEY ROLE OF VALUE IN INCOME TAXATION

    One of the main problems in designing an income tax regime is that taxpayers will inevitably--whether intentionally or otherwise--incorrectly identify or undervalue their sources of income. (5) They may use legal structures and entities where available to shift income sources to jurisdictions that tax them less, and away from jurisdictions that would tax them more. Which country ought to tax a given income stream is therefore a continuous question for lawmakers. The foundational principle that guides their response is that income ought to be taxed in the country or countries where value is created.

    The recently adopted U.S. tax reforms prioritize this principle by proclaiming that the income of U.S.-based multinationals can no longer be diverted out of the U.S. taxing net by artificially shifting profits overseas. (6) Similarly, the OECD put this aim center stage in its BEPS initiative. (7) The European Union followed suit in its Anti-Tax Avoidance Directive (8) and in the development of its Common Consolidated Corporate Tax Base proposal. (9) The G-20 agrees this is the appropriate guiding principle for taxation. (10) Non-governmental organizations and activist groups such as Oxfam and the Tax Justice Network embrace the goal as essential for fair taxation. (11) Finally, representatives of multinational companies also make the same claim. (12) The idea may be simply stated and intuitively appealing, but experience demonstrates that it is complicated to achieve in practice.

    In pursuing the ideal, tax policy leaders of the past century, namely the member countries of the OECD, have worked resolutely to settle their own most pressing concerns while less attentive to those of lower-income countries that are not in global leadership positions. (13) An unsurprising result of this imbalance of policy attention is that the income tax allocation standards embodied in OECD models and guidance systematically under-assign profits to low-income countries. These countries contribute vast stores of value to the global economy, including core natural resources that are integrally necessary to produce virtually everything delivered through global supply chains. The struggle to raise revenues from these contributions to the global economy has led countless tax law and policy observers to wonder why low-income countries appear locked in a perpetual state of "inability to tax." (14)

    Focusing on the tax policy problems that the global tax system has addressed, even if not yet fully resolved, reveals a structural explanation. We may observe from a century of experience with international taxation across the globe that taxing income where value is created, especially in the context of integrated enterprises operating across borders, is associated with adjusting stated prices to account for various sources of distortion. To date, distortion has been readily recognized in the case of related parties: when members of a group are related through legal ownership and control, the tax system routinely investigates the prices they set in transfers among themselves. (15) Because this distortion is so pervasive and has such an impact on global tax outcomes, OECD member countries developed consensus on the concept of arm's length transfer pricing over several decades and recently reaffirmed their commitment to the paradigm. (16)

    Yet related parties are not the only subjects that require scrutiny in the tax system: neglect or mistake that assigns income to the wrong taxpayer may originate in any number of phenomena. One example of these, which serves as a point of focus for this Article, involves valuation errors that result from cases of labor exploitation in which workers are compelled to trade their labor for less than a living wage. Where it is possible to measure the fair market value of labor exchanged under such circumstances by reference to reliable external data, a correct tax assessment would adjust prices according to standard globally recognized principles.

    To set the stage for a proposal to make these kinds of corrections, this Part explains why the concept of market value is centrally important to the concept of income and how tax systems normally detect and respond to common sources of valuation errors, with arguably the most emphasis on the mechanism of transfer pricing.

    1. Measurement of Income

      The term "market," "fair," "true," "clear," or "actual," when applied to value, reflects an idea fundamental to the measurement of income that when unrelated parties willingly transact, neither being compelled to trade and both having reasonable knowledge of the material facts, the price thereby agreed reflects the accurate and appropriate value of the transaction between them. (17) Thus, being unrelated, being uncompelled, and having adequate information are key to establishing market value.

      Often cited by courts and scholars for this general legal proposition, Black's Law Dictionary adds that a price obtained from a sale "forced by the necessities of the owner" is not a market price, that is to say, does not reflect its fair value. (18) Black's further notes that a market price is one that "would be fixed by negotiation and mutual agreement, after ample time to find a purchaser, as between a vendor who is willing (but not compelled) to sell and a purchaser who desires to buy but is not compelled to take the particular article or piece of property." (19)

      Thus characterized, the price determined by parties in such a market is appropriately adjudged a "market price" and therefore accorded deference for tax purposes with consequences for both parties. It is on the basis of the idea of market value or fair...

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