06 Oct 2015 19:15 IST

Is it time to rethink tax strategies?

Until major tax reform takes place, the best minds in corporates will be dedicated to exploit loopholes

Not paying the taxman his due, is a trick that is as old as taxation itself. The easiest illegal tax avoidance scheme is when a person or a small firm simply hides revenue (by dealing in cash, for example) or artificially bloats expenses.

But legal tax avoidance is actually a larger problem. This is when individuals and companies find arbitrage opportunities through loopholes — some simple, others sophisticated — to skirt paying taxes. In many cases, tax strategies may end up altering corporate behaviour or even direct overall corporate strategy.

Skirting taxes

My own buying habits are a case in point. When I was living in Philadelphia 25 years ago, I set out to buy a new PC for my home office. Computers were expensive then, costing nearly $2,000 for a decent machine. Rather than pay the state of Pennsylvania its 6.25 per cent sales tax, I drove 30 miles across the state line to buy a computer from a store in Delaware, which even today, doesn’t charge sales tax. I used the $125 I saved, to buy a nice dot-matrix printer, which served me ably for nearly a decade. But consciously, albeit legally, I denied the state where I lived and worked in, its share of sales taxes!

I am not alone in thinking this way. Toyota, whose North American headquarters were in California’s Bay Area, decided to move to sprawling Plano, in Texas, a state that has no income tax. Nissan moved to Tennessee, another no-income tax state. Such relocations are generally good for employees. If their compensations remain the same, these moves may result in a significant pay increase. California’s highest personal income tax rates top 9 per cent.

The latest case

A government looks to tax revenues from businesses to redistribute resources to pay for society’s needs. But there is never enough money for government spending because the more a government collects in taxes, the more it spends. The only way corporations can defend themselves against aggressive governments is to invest in eminent legal and tax counsel, sometimes to come up with tax avoidance schemes that seem downright devious; but still legal.

The latest kerfuffle in the US is how companies use a strategy called “Corporate Inversion” to lower or avoid paying taxes. Tax advisory firms have been promoting this idea because the US is infamous for two tax rules — it collects taxes on companies’ global revenues and it does so at a whopping 35 per cent, the second highest rate in the world.

Corporate inversion allows a US company to simply shift its headquarters to a tax haven, such as Bermuda or Ireland. It does so by buying a smaller company abroad and transferring its headquarters designation and intellectual property to it. Nothing else changes — the company’s US operations remain the same with employees going to work as usual. The company will continue to pay full taxes on its US revenues, but now that it is headquartered abroad, it is no longer required to pay US taxes on its worldwide sales. The US government estimates that an amount equal to nearly $2 trillion in US company profits is sitting outside the US because companies are hesitant to bring back the funds and subject them to the 35 per cent tax.

Is there a solution?

There are simple solutions to de-escalate the tussle between governments and companies, but unfortunately, these haven’t seen the light of much debate.

A few years ago, Lawrence Lindsey, who served in many US administrations (including at the Federal Reserve during the Clinton administration), proposed replacing the corporate income tax system with one based on cash-flow. He said, “Administratively, it would be far simpler to collect a single tax on business. It would also minimise avoidance based on the definition of income. As we learned in the financial crisis, “Cash is a fact, income is an opinion.”

Implementing Lindsey’s ideas in India can dramatically alter the tax landscape. When we humans pay taxes, we do so largely on our salaries earned — less a few permitted deductions (mortgage interest, personal exemption, protected investments and so on). The logic is that no matter what our other expenses are, we still consume government services and need to pay for them.

A corporation today is permitted to deduct all of its “expenses” and pay taxes on only its “profits”. But ask five accountants to calculate a company’s profits and each will arrive at a different figure, all starting from the same top line number — revenue — which is reported to government agencies like SEBI. And then, there’s moral principle: whether or not a company earned a profit, it still used the nation’s infrastructure of roads, bridges and ports; and was still served by various government departments and should therefore, pay for those services. In other words, corporate taxes ought to be a cost of doing business, just like rent, employee compensation or utility bill.

Idea worth considering

A flat tax on corporate revenue or cash-flow and not corporate income is an idea worthy of consideration. It would implement fairness and transparency; and eliminate the need for corporate tax departments, tax lawyers, tax practices of the big accounting firms, lobbyists and special interest agencies in one simple stroke.

Until major tax reform takes centre-stage world-wide, tax strategies will continue to dictate corporate behaviour, where the best minds are dedicated not to product development or logistics, but to exploit loopholes to pay the smallest tax. And this doesn’t help society a bit. It is time we changed the status quo, and the sooner, the better.

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