Source and residence: the UN and the OECD

Following Angel Gurría's mostly good article in the Guardian today, and in advance of the forthcoming Doha conference, we think it's important to point out a crucial aspect about global taxation. Who calls the shots in the global tax system: the UN or the OECD?

The first answer is neither: they are both badly undermined by the forces of secrecy and abusive taxation, who exert a powerful influence on any body that might be able to act on a multilateral basis.

But these two organisations are, still, very important, and they will become more so. The purpose of this blog is to highlight some crucial differences between them. This is important. But first, a bit of background.

Developing countries have been the big losers from current systems of international taxation in several ways. The recent Christian Aid report outlines some important factors. But here are some things we'd like to draw attention to.

Developing countries are the most vulnerable to the global infrastructure of secrecy (discussed amply by TJN elsewhere) because they have least capacity to use the already very limited global mechanisms available to track and recover stolen or lost public assets. Taxes that have been evaded and avoided, and the larger capital flight that often underlies them, are the largest form of stolen or lost public assets, by a long way. A broad approach to increasing transparency in international taxation is essential, for rich and poor countries alike.

Also, there is a big difference between two models of international tax agreements, with truly huge implications for developing countries. Essentially, there are two ways to levy taxes in cross-border transactions. One is to tax it at source – where the taxable income is generated. The other way is to tax it on a residence basis - where the person who receives the income is based. If you don't know about this, it is worth getting your head around the idea, because it is important. The basic principles aren't that difficult to understand.

Essentially, the countries, with all the capital (the rich ones) prefer the residence-based model of taxation. That is because when one of their companies (let's say an American company, for example) invests overseas, say in a developing country: let's say Tanzania, for example. The Tanzanian subsidiary of the American company makes profits, and then the question arises: who gets to tax the profits? The country that is the source of the profits -- Tanzania? Or the country that is where the company has residence --America? (See here for a TJN briefing paper with a fuller discussion of issues in source- and residence -based taxation.)

It would be unfair to apply both kinds of tax (or tax would be levied twice on the same income) so countries sign bilateral tax treaties with each other -- to reach agreement on how taxes are levied. These treaties are based on two models: the OECD model treaty, which emphasises residence taxation (preferred by capital-exporting rich countries); and the United Nations model treaty, which emphasises source-based taxation, which is more favourable to (capital-importing) developing countries. (the more technical-minded might like to look at this brief slide presentation for more details.)

The way these models are applied has major implications for the Finance for Development (FfD) process, of course. Although a balance has theoretically been reached internationally between the two models, in effect the OECD model favouring capital-exporting rich countries has predominated over the UN model favouring developing countries. So at the end of the day, the rich countries get the lion's share of the taxes generated in poor countries. Is this unfair? Many people think so. As one authoritative analysis put it:

“Developed, capital-exporting countries have stacked the accepted rules of the international tax system in their favor… the source country's superior right to tax the income is a platitude, recited before it is taken away.”

And, reporting on a conference on these issues, the same analysis reported that

“There was nervous laughter when one speaker implied that the United States uses the OECD to do its dirty work in preventing source taxation and other impediments to what other speakers called ’fiscal imperialism.’”

Another analysis told this story:

""Fiscal imperialism," some of the South American hosts hissed at their smug developed-country guests. The OECD model treaty, the chief instrument of this policy, grants superior taxing rights to capital exporting countries, redistributing homeward the tax base of the countries that host their investors."

They seem to have a point. However, a purely source-based model (or a purely residence-based one) would in practice be hard to protect against abuse, so the best option to preserve the revenue bases of both developed and developing countries is a compromise between the two, but one that gives primacy to source-based tax while keeping the option of residence-based tax.

What is really needed is a joint approach by both developing and developed countries, to tackle the problem of avoidance and evasion which affects them all. The UN Tax Committee is mandated to look at, among other things, the tax treaties between developed and developing countries. The main problem with the UN Tax Committee – which could play a very profound role in reducing poverty in developing countries – is a lack of political will to tackle the issues, and a lack of resources to work effectively. This is why it is so essential for international civil society to engage. The UN Tax Committee must now be strengthened, and urgently. Read more here.

There are several ways that these issues could be tackled. One would be to improve the way information is exchanged between tax authorities. Currently, under the prevailing OECD model, information is exchanged only on request. In other words, you must know what you are looking for before you request it. What is more, the models that are used are based on bilateral, not multilateral treaties. Bilateral treaties are certainly better than nothing; but they have been adopted only in a very piece-meal way. While there are thousands of bilateral tax treaties between the world’s rich countries, developing countries (largely because of a lack of capacity) have signed very few indeed, meaning that these mechanisms for protecting their domestic tax bases are not available to them. A multilateral approach that includes developing countries would be far better. The OECD is pushing the bilateral approach: a UN approach could, if designed and used properly, be much more far-reaching.

It is essential to move to a state of affairs where information is exchanged automatically, and on a multilateral basis.

An effective way to bring about co-operation would be to impose witholding taxes at source on payments to countries that do not co-operate. This would need to be done in a co-ordinated fashion (the UN might appropriately play an important role here) in order to avoid the problem where the funds are simply driven to another country, and if done globally it would address a suspicion that only the wealthiest countries would benefit. It would require, among other things, a change in political will on the part of some rich countries (such as Britain and the United States) which attract capital from developing countries to their countries through offering secrecy facilities.

Another promising approach is to tax global businesses such as transnational corportions (TNCs) on a unitary basis, under which their tax basis would be apportioned according to a formula that would fairly take into account how much their activities in each country make to their global profit, which is then taxed accordingly and the resulting tax income shared according to where this is generated. European countries are already working on this.
More generally, it is essential to re-define the goals of the international tax regime. The UN Tax Committee could play a useful role here.

And finally, for this blog, it is essential that the UN formulate a code of conduct on taxation. This has to come from the United Nations, and not from the OECD or any other body. While codes of conduct are "soft", non-coercive measures, they can be enormously influential. A UN code of conduct could become a really important benchark against which the secrecy jurisdictions and the facilitiators: the bankers, accounting firms, legal firms, and so on, can be judged. The UN has now asked Prof. Mike McIntyre to write a draft UN Code of Conduct. This is not something that is to be passed at the forthcoming Doha meeting, but it is coming. The people in the black hats will hate it. McIntyre wrote an article about this for our newsletter, Tax Justice Focus, here. Read it, and support it as strongly as you can as it rises up the agenda.