Taxing multinational banks

The nature of international banking means that tax authorities have particular problems when trying to tax banks. Banks provide a range of intangible services and products to their international clients. Client lists are shared across their organisations and banks move in response to client demands. Banks operate an integrated trading model which allows responsibility for the "book" to move from a branch in one jurisdiction to the next as markets close and open in different time zones. The opportunities for profits shifting are endless, and its therefore not surprising that banks are the biggest users of tax havens.

The May 2011 edition of the Journal of International Taxation (sadly not available online) carries an important article on taxing multinational banks by Kerrie Sadiq of the Taxation Law and Policy Research Institute at Monash University, Australia. Sadiq argues that the exclusive characteristics of multinational banks create a situation whereby the prevailing system of taxing business, based on using transfer pricing rules to assign income to the source country where the income producing activities were based in practice, fails to take account of the way in which banks operate in practice:

"The current source and transfer price regime attempts to assign a geographical source to income by looking at the location of the income producing activities. Because of the legal principles that have developed, however, the geographical source to which the income is allocated may not be the location of the income producing activities. For example, parts of the multinational bank will often be allocated along functional lines, such as certain jurisdictions having the responsibility for trading when the market is open."

This reflects the reality of globalised financial markets. And rather than trying to tweak the unworkable transfer pricing regime which attempts to allocate income on the basis of wholly artificial legal forms, which unsurprisingly involve complex structures spanning multiplicities of subsidiaries located in tax havens, Sadiq proposes a shift to unitary taxation which divides the profits of the entire global entity and apportions them according to an economically justifiable formula.

Despite significant implementation and enforcement hurdles, Sadiq argues, formulary apportionment would allow a more equitable distribution of taxing rights between the relevant jurisdictions while also allowing the banks to shape their commercial operations in ways that are tax neutral (i.e. commercial decisions are driven by genuine economic factors rather than possibilities for tax arbitrage).

Unitary taxation offers a number of distinct advantages over the current system. It would go a long way towards overcoming the impossibility of applying the hopeless Arm's Length Principle to transfer pricing within banks (as Sadiq notes: "Placing a value on the use of (a) client list for transfer pricing purposes is difficult given that it is firm specific and, therefore, has no arm's length value"). It would also eliminate the possibility of double taxation of income, since the tax base to be divvied up between jurisdictions cannot exceed 100 percent of taxable profits. Above all, Sadiq argues, the unitary taxation model "provides greater alignment with the unique features of (multinational) banks."

This is a hugely important topic; absolutely central to TJN's goal of achieving inter-nation equity of taxation. The current article in the Journal of International Taxation is a two-parter. The second part will follow in a later edition and will pick up on the practical implications of adopting a unitary tax based on formulary apportionment as the best available system for taxing multinational banks. We will return to the subject once that article has been published, but meantime recommend you lay your hands on part one (published in the May 2011 edition).