Tax haven: Corporations win big, but who loses?

A report by the EU Tax Observatory, an independent research lab hosted at the Paris School of Economics, shows that multinational corporations avoided paying $200 billion (€188 billion) in taxes worldwide in 2020, the last year for which data is available.

All this money was evaded through profit shifting, a strategy used by companies that have subsidiaries in many different countries. 

They register a disproportionate amount of their profits in territories with low or no taxation, known as tax havens. This happens even though the profits were made in other countries.

But how does profit shifting work, why does it matter, and who are the winners and losers?

How does profit shifting work?

Picture a multinational company that works in two different countries. Most of the work is done in a country with high taxation. However, intellectual properties such as patents and design blueprints are held by a subsidiary in a territory with lower taxes.

The company in the first country, where the profits are made, must pay the subsidiary to use the registered properties. As the multinational controls both entities, it can set up the price of the transaction. In the end, it makes the company in the high taxation territory pay lots of money to the subsidiary in the tax haven.

After the deal, the profit ledger in the first company falls, while the balance in the tax haven subsidiary increases. The multinational can now declare less profit in the place where taxes would be higher and more in the place where they are lower.

This is not merely an exercise of imagination: it happened recently with US footwear giant Nike. A document leak showed that while production and sales of sneakers happened in high-tax countries, the local units of the company had to pay royalties to a subsidiary in Bermuda, where taxes are virtually non-existent. Similar schemes were reported for multinationals such as Microsoft and Apple.

Why does it matter?

The global tax revenue lost to profit shifting was around $200 billion in 2020, a year when the COVID-19 pandemic massively hurt economic activity. In 2019, that figure was $250 billion.

To put the revenue loss in 2020 in context, it's around a fifth of the investments that developing countries need to mitigate the effects of climate change, according to estimates made by an expert group of economists that met at the COP27 in Sharm el-Sheikh, Egypt.

Idann Gidron, data coordinator at the EU Tax Observatory, said only large companies can afford to trade in international markets and open subsidiaries in offshore tax havens. This way, the biggest players end up with a smaller tax burden.

"This creates fiscal injustice because the smaller actors in the economy have to contribute more than the wealthiest," he said.

Who wins?

Of course, the biggest winners of profit shifting are the companies that save on taxes. A disproportionate amount of them come from the United States. Around 40% of all profits shifted globally originate from US multinationals.

While conglomerates save billions by shifting profits, it's the tax havens that also benefit. 

Gidron says for their research, countries with effective tax rates below 15% are considered tax havens. It considers the rates that are normally applied and not what is written on paper, as legal loopholes are often used to reduce taxation levels.

The report also takes into account countries where multinationals make profits that are excessively high in comparison to the total wages they pay locally — an indicator that the profits booked are being transferred from places where the real work got done.

Some tiny countries do not apply taxes at all but still benefit from an increased level of economic activity on the ground. Even if the local units are very small operations for the multinationals, they can still be significant for smaller economies.

Larger tax havens, on the other hand, can apply their lower taxation rates on the shifted profits. Even if the taxes are comparatively low, they line their pockets with revenues they wouldn't otherwise have access to.

Where are the tax havens? 

"People tend to think that profit shifting is related to countries in the Caribbean, but the tax havens that are attracting most of the profits are actually in Europe," says Gidron. 

Countries like the Netherlands, Ireland, Switzerland, Luxembourg and Belgium receive more shifted profits than tropical paradises like Panama or Bermuda. This results in budget surpluses in those countries. In Ireland, for example, shifted profits generate around 60% of all the corporate tax the country collected in 2020. 

Taken together, the main European tax havens got an extra $32 billion in tax due to profit shifting in 2020. This means that they are making, just in extra taxation money, an amount roughly equivalent to the GDP of countries like Senegal, Honduras or Bosnia. 

Overseas British territories and crown dependencies also drive a significant share of tax abuse. In 2020, $76 billion in profits were shifted in places like the British Virgin Islands, Bermuda, the Cayman Islands and Jersey. 

Who loses? 

At an international level, profit shifting is a negative sum game. The extra revenue tax havens get is deflected from countries with higher taxation rates. At the end of the day, this reduces the public money available to governments throughout the world.  

The biggest losers are other European Union members and other countries in the Organization for Economic Cooperation and Development (OECD). Germany, the most affected country proportionally, could have earned 26% more in corporate taxes in 2020.  

However, significant profits are also being booked away from emerging and developing countries: around $60 billion in 2020 — and that value fell due to COVID-19 from $75 billion in 2019.  

One example is Brazil, which lost a potential $7 billion in tax revenue in 2020. That amount would have been sufficient to include 4 million more families into Bolsa Familia, a basic income program that aims to eradicate poverty. 

Is it legal? 

According to Liz Nelson, director at the research and advocacy group Tax Justice Network, the legality of tax schemes such as profit shifting is often decided only in courts of justice, as they tend to operate in gray areas of legislation. 

It's not illegal for a multinational to open branches in different countries, and these branches are free to trade among themselves. However, there's a reason why profit shifting usually happens with the transfer of immaterial goods and services. 

While the same tax reduction goals could also be achieved by slyly pricing the sales of material goods, intangible properties are not usually traded in an open market. This is important because, according to international regulations, the prices paid between different units of a multinational should mirror what is usually seen in transactions by unrelated parties.  

When there's no clear indication of what a normal price is, it's harder for tax authorities to build a case against abusing multinationals. 

"Such schemes may not be criminal in a legal sense, but morally they're wrong," Nelson said. "Governments are complicit, and multinationals are complicit. They are creating hardship for people that might be their employees." 

What can be done to solve it?  

According to the EU Tax Observatory, the level of profit shifting has been stable globally since 2015, despite initiatives by the likes of the OECD. The researchers say that this does not necessarily mean that previous policies had no effect, as they could have prevented the amount from increasing. However, they acknowledge that more should be done. 

In 2021, around 140 countries signed an agreement to implement a global minimum corporate tax rate of 15%. However, the EU Tax Observatory researchers claim that the tax deal is insufficient due to loopholes that would allow some countries to keep on taxing companies at lower levels.  

Instead, they are proposing a higher taxation bracket of 20%, with the suppression of all loopholes. This, they say, could generate an extra $250 billion in tax revenue worldwide every year. 

Edited by: Gianna Grün, Andreas Becker, Ashutosh Pandey

Data and code behind this analysis are available in thisGitHub repository.

More data-driven stories by DW can be found here.