The UN model favoured taxing income at the ‘source country’, which was a good model for the developing countries. This lethal combination of transfer pricing and tax havens makes it impossible to curb illicit capital flows, even as more and more economies confront rising public debt.

According to the latest report on illicit financial flows (IFFs), released last month by Global Financial Integrity (GFI), a Washington-based research and advocacy firm, $510 billion of black money flowed out of India from 2004 to 2013. That means an average annual outflow of $51 billion, or Rs. 3.3 lakh crore.

This is a conservative estimate. The GFI study of 2015, “Illicit Financial Flows from Developing Countries: 2004-2013”, did not include or cover misinvoicing of trade in services, cash transactions, and hawala transactions. If we took into account all those, the total outflow would be much higher.

Unfortunately, the mainstream discourse on tax evasion (which is illegal) and tax avoidance (which is legal but could be equally abusive) in India has consistently misrepresented the problem. The emotive, and largely symbolic, promise of retrieving black money stashed abroad by the corrupt has served to distract attention away from the entities that actually account for the lion’s share of illicit capital flight: multinational enterprises (MNEs). The key discursive move of separating the economic misdeed of tax-dodging from the social one of corruption has been largely bypassed, with the former conveniently lost in the sound and fury generated by the latter.

To be sure, from time to time, the odd court battle over tax evasion featuring a Vodafone or a Nokia does make it to the headlines. But even when it does, the discourse is mostly framed in terms of marauding taxmen persecuting blameless corporates.

The reality, if we go by the numbers, is often the opposite. According to the GFI report, trade misinvoicing (of goods) accounted for 83.4 per cent of the $510 billion of IFFs from India. The Organisation for Economic Cooperation and Development (OECD) estimates that more than 60 per cent of global trade occurs within MNEs — that is, between the subsidiaries of an MNE. Taken together, what these numbers indicate is a massive shifting of profits from jurisdictions with higher tax rates to those with zero or very low tax rates.

As the accounting expert, Prem Sikka, notes in a column, an MNE today is an integrated entity that coordinates the businesses of hundreds of subsidiaries spread across jurisdictions. But for tax purposes, these businesses are assumed to be separate economic activities. “So a single group of companies with 500 subsidiaries is assumed to consist of 500 independent taxable entities in diverse locations,” notes Mr. Sikka. “This leaves plenty of scope for profit shifting and tax games” (“OECD’s new tax proposals won’t stop companies shifting profits to tax havens”, Oct. 6, 2015, The Conversation).

Thanks to this evasion-friendly tax regime, MNEs with profits in billions of dollars enjoy an effective tax rate in the low single-digits.

The most popular mechanism for shifting profits is transfer pricing. For IT giants such as Google or Microsoft which are engaged in services, transfer pricing takes the form of a licensing fee or a royalty payment or interest paid by a subsidiary to a parent company located offshore. These payments are then treated as a cost in the jurisdiction where revenues are being generated, thereby slashing profits.

Transfer pricing channels a subsidiary’s profits through a cascade of companies incorporated in different jurisdictions, to eventual safety in a tax haven. Google has used Bermuda. Amazon uses Luxembourg. Microsoft uses Bermuda. Pepsi uses Mauritius. Pfizer uses Cayman Islands. The list could be expanded to include nearly every Fortune 500 company. But here’s the thing: it’s all legal.

This lethal combination of transfer pricing and tax havens makes it impossible to curb illicit capital flows, even as more and more economies confront rising public debt. While the European Union is estimated to be losing €1.1 trillion of income to tax-dodging every year, the bigger losers are the developing countries in Africa, Asia and Latin America.

According to the Tax Justice Network (TJN), a research and advocacy group, as of 2010, $21-32 trillion were held in 80 ‘secrecy’ jurisdictions. Its study of financial flows from 139 low- and middle-income countries from 1970 to 2010 found that “offshore earnings swamp foreign investment”. As of 2010, the elites of these 139 countries had accumulated unrecorded offshore wealth of $7.3-$9.3 trillion. This dwarfed the collective external debt of these nations, which stood at $4.08 trillion. In other words, if they could find a way to retrieve their assets stashed illegally abroad, they would be net creditors, not debtors.

India is a typical case. As per the Finance Ministry’s data, India received $392.2 billion in FDI in the 15 years from 2000 to 2015. But we lost much more in illicit outflows: $512 billion in just the 10 years from 2004 to 2013. As the TJN report sums up, “The problem is that the assets of these countries are held by a small number of wealthy individuals while the debts are shouldered by the ordinary people of these countries through their governments.”

And the best way to make ordinary people shoulder the state’s debt burden is to tax consumption more heavily than wealth. Hence, the growing importance of the Goods and Services Tax — a hard-to-evade indirect tax that would squeeze the salaried classes and local small and medium enterprises — to make up for the billions of dollars of direct tax revenue that the state is either unable or unwilling to collect from treaty-shopping MNEs.

The warped tax regime within nation states is paralleled in the international arena where the dice is loaded in favour of capital-exporting nations. With global trade being dominated by MNEs, it was found necessary to put in place a tax regime that ensured revenue for every country while avoiding double taxation. Two model tax treaties were developed, one by the United Nations, and another by the OECD.

The UN model favoured taxing income at the ‘source country’ — that is, wherever the income-generating economic activity took place, regardless of the residence of the enterprise’s owners. This was good for developing countries which, for years, had allowed their natural resources to be extracted by foreign capital, only to see the profits flow to offshore entities without doing much to enrich the local population.

In the OECD model, residents of a country would be taxed on their worldwide income, while non-residents would be taxed only on their domestic income.

Not surprisingly, it is residence taxation that has become predominant in tax treaties, for it suits the MNEs very well. The MNEs end up paying little tax in their own residence jurisdiction, since the bulk of their revenue is generated overseas. As for the countries where they actually make their money, there too they avoid paying income tax as they are non-residents and so are not eligible to be taxed anyway. It is this discrepancy of double tax avoidance that’s been at the heart of most disputes between Indian taxmen and foreign MNEs.

India, in its Double Taxation Avoidance Agreements, has opted for a predominantly OECD model, which means that the FDI we are manically seeking will pay very little or no tax in India on the income it generates from India. Not that this isn’t already the case, but presumably, it is important reassure investors that nasty surprises like the ones thrown at Nokia or Vodafone won’t happen again. Hence, the Finance Bill 2015’s much talked about Place of Effective Management, which is essentially a residence taxation concept.

A saner approach would have been to simply link taxation to sales and assets in India rather than the (putative) residence of ‘effective’ management. But one suspects this would not have pleased India’s democratically unelected foreign investors.

If there is one simple lesson we can draw from all this, it is that curbing illicit capital flight ought to be a higher priority than courting foreign capital. After all, isn’t it more sensible to try and get your hands on money that’s already rightfully yours than trying to get others to part with theirs for your development? But then, where finance capital is concerned, rare is the state independent enough to choose the sensible option over the imprudent one.

sampath.g@thehindu.co.in