Double Entry, With Knobs On

It is not the Left alone which complains about MNCs. So do governments, not just in India but in the developed countries as well. Reason: MNCs often get up to a lot of hanky-panky to reduce their tax payments whether in the foreign country or their own countries.

A few years ago, for example, there was a famous case in California involving a British bank and local tax authorities which went right up the US Supreme Court about the definition of global income. And, a few months ago, the EU and the US almost came to blows when the EU decided to clamp down on US firms avoiding paying tax in Europe through what the EU regards as tax subterfuge.

 

In a recent paper on the behaviour of MNCs*, Chander Kant, an economist at Seton Hall University in New Jersey, analyses the effects of local ownership requirements on the inter-country profit-sharing behaviour of MNCs.

He finds, perhaps not surprisingly, that while a great deal depends on the tax rates in the foreign country and their own country, the precise tax behaviour of an MNC is determined by which rate is higher, the foreign country rate or the own country rate.

This suggests that there is no automatic reason to assume that MNC cheat only their foreign hosts. Instead, they simply optimise their payments depending who is demanding how much. In that sense, they are pretty even handed.

Defining any payment that an MNC is obliged to make in return for which it gets no benefit as tax, Kant says that with local ownership requirements there is usually a tendency amongst MNCs to do what they can to reduce volume of payments to local owners.

In effect, says Kant, many MNCs keep two sets of accounts. Each set uses a different set of costs of intermediate products. One set is for internal purposes, the other is for showing to the government. This, as any Indian tax official will tell you, is what most Indian firms also do. It is, if you will, the double entry system with knobs on.

An increase in the reported costs shifts pure profits from the foreign country, while a decrease shifts them from their own country. By how much, of course, depends on the tax rates and the local ownership requirements which compel a MNC to disburse a share of the profits to local shareholders. This, as far the MNC is concerned, is a tax.

There are strong policy implications of this analysis. While foreign countries can justifiably insist on local ownership, when they do so they have to be prepared to live with the consequences to tax revenues. These may and do actually decline as a result of these requirements.

Nor is it possible to come up with an optimal mix of tax rates and local ownership requirements. This is because the real costs are never public knowledge and this allows the MNC to decide how much tax it will pay.

Capital and technology deficient countries, however, would probably benefit more if they equated their tax rates to the own country rate and did not insist on local ownership requirements. The benefits would accrue from investment and job creation.

*Local Ownership Requirements and Total Tax Collections by Chander Kant, Delhi School of Economics and Seton Hall University, New Jersey.

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