Taxing at the source is fair in law, so why not in practice?

The general consensus in Australia today is that multinational companies are not paying their fair share of tax. We often hear that while it may be legal, it’s still wrong. And it’s wrong because it’s not fair.

International income tax is complicated. This complexity is being used as a smoke screen for people from both sides of the debate to gain mileage.

How can people be so convinced that something is unfair when really, it often is not?

It all starts with a simple concept that underlies the world’s international tax rules and makes them fair. This concept is “source”. This concept basically says that a country can tax the income of a foreign person or company when that income is sourced in the country. It is a fair concept. How can you tax a foreigner when the income has nothing to do with your country?

While most people would agree with the above, the train goes off the rails when we start talking about what causes something to be sourced in our country. The strong statements about things being unfair are all based on thinking that Company X makes $$$ from our country but only pays some small percent of that amount in tax. Local companies on the other hand pay 30%. This seems unfair and seems to deal with source.

The source matters

The problem is that most people just assume that if you make money from Australia (in other words, have Australian customers), then your income is sourced in Australia. This is incorrect at law and, in my view the law is fair. It needs to be understood that you don’t make your money where your customers are. You make money where you carry out your business or work.

Imagine this: A person lives in Hong Kong and is employed by another Hong Kong person. Their employer pays their salary into their Hong Kong bank account. Now imagine the worker comes to Australia for a month as part of their work. Our law will say that the salary is sourced in and taxable in Australia for that month. You will note that none of the person’s income came from Australia. But the principle is that they did their work in Australia and that is where the source is.

Now consider a person who makes shoes in their Hong Kong factory. They are doing the work in Hong Kong, any income from this work has a Hong Kong source. It is exactly the same principle as the worker who came to Australia. Now the final point: If they sell those shoes to Australian customers, the income is still from a Hong Kong source as they still made the shoes in Hong Kong. The location of the customer doesn’t change this.

Of course if they carry out sales operations in Australia, you can say some of the profit is sourced in Australia from the sales operation. But this will never be anywhere near the full profit. The majority of the profit is where the majority of the business activity is carried out. This is the manufacturing in this case. So, it is absolutely no surprise that this person will only pay a very small percentage of their profit to Australia, they only have a small Australian source. This is correct and it is not unfair.

Competing on tax rates

Let’s look at the next issue that comes from this. That is that our shoe manufacturer may pay less tax in Hong Kong on the Hong Kong source profit than they would pay to Australia if they were manufacturing in Australia. This happens because Hong Kong has decided to have lower tax rates than Australia just like

Australia may decide to have lower tax rates than another country. Is this unfair? I cannot see how anyone can say that it is. How can Hong Kong’s decision to have lower tax rates than Australia be called unfair? If a person is doing business in Hong Kong and thereby gets these lower tax rates, how can that be unfair?

Countries have different economic needs and different competitive advantages. Some will opt for low income tax rates within this context and that is their choice. It is not for others to say that it unfair if they succeed in attracting business with their lower tax rates. Australia has a lower GST rate than the UK equivalent VAT, can this be said to be unfair?

This brings me to the final point. If a place such as Hong Kong can attract productive businesses from elsewhere because of its low tax rates, is this unfair? The answer to this must be no. The world has long committed to open competition and business goes where it gets the best return. This is one notable reason why the tax take is flowing away from certain countries to others, it cannot be said to be unfair. Not when we are all taking various industries, capital and people form one another through open competition.

So where is the moral issue? There is nothing unfair that productive business may be based in a lower tax jurisdiction. Once a business is based in and doing its work in the lower tax jurisdiction, we cannot claw back the tax by ignoring the well-established source rules. If all a country contributes is the location of the customers, they can only claim a share of the source that might be justified on this basis. Some may indeed be justified but not all or even the majority. There is nothing unfair about many multinationals paying a tiny percentage of tax in the country where their customers are.

The final point is that if the multinational is not really doing business in the low tax jurisdiction but artificially pretending to be doing business there, then there is a problem and this is where the world needs to pay more attention. However, the simple paying of low tax where your customer is does not amount to this happening.

Nolan Sharkey has received funding from the Australian Research Council (ARC) to research international tax. As a barrister he advises on international tax issues.