Income Shifting

Income shifting - it is a phenomenon where associated or affiliated entities or personal or capital related entities develop tax planning techniques that enable them to transfer revenue between high-tax countries to low-tax countries. In addition, they are very often used to reduce the taxable amount of revenue by generating artificial costs, in particular through intra-group debt financing costs (loans, leases, interest on loans) and intra-group low value added services (accounting, marketing or administration services). Typically, income shifting is used for transferring from parent company (high tax bracket) to child company (low tax bracket).

Income shifting in tax manners

This phenomenon is very often used in the payouts of high-level managers and directors of international companies. Aware of the fact that their salaries are subject to high taxation, they try to reduce their tax liability by moving into self-employment or transferring their assets to countries with harmful tax policies. Three types of tax schemes are most often used, such as:

• the personal income scheme;
• the capital returns scheme;
• the firm tax scheme.

The first is based on the use of the self-employment mechanism by deducting tax deductible costs, which economically constitute a private benefit rather than a business advantage. The next one assumes that a person who has income in a given company capitalizes it into shares, which are then paid out in the form of a dividend, which is generally taxed with a smaller tax scale and can be easily transferred between countries. The third one assumes that, by using links between companies, non-market prices are set in order to reduce the tax base of a company that is subject to a higher tax rate.

Transfer pricing as a counteract to a income shifting

The transfer pricing rules developed at the beginning were designed to counteract the phenomenon of income shifting. Starting from the general public, the transfer price is the price that was determined in a transaction between related parties. It should be consistent with the arm's length principle that the price agreed between related parties should be comparable to the price that would be agreed between unrelated parties.

Empirical research indicates that the introduction of transfer pricing solutions into the legislation of member states (including OECD) has had a significant impact on the reduction of international income shifting transactions. Compared to countries where no pricing-transfer rules have been introduced, in comparison to those where they have been introduced, the observable reduction in income shifting is on average 50 percent.

Cons of income shifting

In particular, the phenomenon of income shifting has a negative impact on the countries in which such groups operate. This is manifested, among other things, by a reduction in the real revenue to the state budget from income taxes or other taxes on wealth. As a result, a company can save money by abusing tax laws. On the other hand, the States are not in a position to implement the envisaged investments as the real receipts are much lower than those foreseen.

Footnotes

Income Shifting — recommended articles

Thin capitalization — Net gain — Cash earnings — Trade exchange — Ownership interest — Preservation Of Capital — Total capitalization — Shareholder loan — Earned Premium

References

• Dharmapala D. (2012), What Do We Know About Base Erosion and Profit Shifting? A Review of the Empirical Literature, CESifo Working Paper, nr 4612, s. 30-36
• Le Maire D., Schjerning B. (2012), Tax Bunching, Income Shifting and Self-employment, EPRU Working Paper Series, nr 2012-04, s. 7-10
• Lohse T., Riedel N. (2014), Do transfer pricing laws limit international Income Shifting? Evidence from European multinationals, CESifo Working Paper, nr 4404, s. 3-6

Author: Klaudia Urbańska