Why Facebook's recent decision to pay more tax shows how flawed the system of corporation tax really is

Alex Wild
Facebook Debuts As Public Company With Initial Public Offering On NASDAQ Exchange
Facebook's recent restructuring of its business suggests that taxing profits might be the wrong approach (Source: Getty)

How glad should we be that Facebook is now going to book sales through its UK subsidiary rather than its Irish one, increasing its tax liability?

Probably not very. The next time we find out how much UK corporation tax Facebook paid, the odds that “fair tax” campaigners will be satisfied are about as long as the OECD’s transfer pricing guidelines.

Despite the change in location where sales are booked, the increased corporation tax payments will probably be modest. Even with a UK permanent establishment, the fundamentals of the business remain the same. Crucially, that Facebook will continue to create much of its value in the US.

Corporation tax applies to profits generated by economic activity carried out in the UK, not profits from UK sales.

Such an approach will always be problematic because no conceptual basis for allocating profits across multiple jurisdictions exists. A multinational may have research and development, manufacturing, finance, logistic and marketing functions all carried out in different countries. These are all economic activities that create value, but quite how much of a company’s profit can be attributed to each of these functions is open to interpretation.

Read more: Is Facebook's tax overhaul a victory for the Google Tax?

The current “arm’s length principal”, where two companies that are part of the same group are treated as separate entities, has come under attack from many quarters who favour a either a destination or unitary approach.

Both approaches are flawed.

A destination based approach would allocate profits according to where companies make their sales. This sounds relatively simple, but breaks the link between value creation and tax. For instance, the profits from the sale of a Mercedes, designed and manufactured in Stuttgart, from a UK showroom would no longer be taxable in Germany. Whether or not one thinks this is fair, getting agreement for such a system from net exporters would be difficult.

The other popular alternative is “formulary apportionment” which allocates profit according to an internationally agreed formula based on assets, labour and sales. But the extent to which value added can be attributed to assets, labour or sales varies greatly between industries: Facebook creates value very differently to BP. Even within industries, the mix between capital and labour can vary greatly.

Read more: Facebook grows revenue by 51.7 per cent

Instead, we should stop taxing profits altogether as recommended by the 2020 Tax Commission.

After all, when we tax companies, we are merely taxing shareholders, workers and customers through a different channel. Instead, corporation tax should be replaced with a single tax on distributed income from capital.

Capital inflows such as loans, interest received, shares issued and dividends received should be deducted from capital outflows such as dividends, interest payments, share buybacks and loan repayments. What remains is the taxable outflow.

If capital inflows exceed capital outflows, credits should be generated to offset future liabilities. Such a system would clear out a great deal of complexity and have the added advantage of removing the debt bias.

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