In that article I favoured reform based on a simple apportionment of total profit reflecting the scale of operation in different countries. But many correspondents rushed to the defence of the status quo in international corporate taxation, under which the principal basis of deciding where profits are earned is the “arm’s length principle”. The principle is described in a 371-page document published by the OECD.
The arm’s length principle came into being when global business was far less extensive than today. The normal pattern of multinational business was vertical integration of the supply chain. If a weaver in England owned a wool producer in Australia, then the profits could be fairly and simply divided by reference to the profitability of independent English weavers and Australian wool producers.
So today we ask the hypothetical question: “Suppose the different geographical operations of a global corporation were independent businesses, what would then be the profitability of each of the independent businesses?” It is only necessary to ask this question of Starbucks to see why the arm’s length principle can never work.
The entire rationale of Starbucks is that its different operations are not independent businesses. Starbucks is a global brand and those who enter its coffee shops know that they can expect a similar experience whether the outlet is in Birmingham, Beijing or Buenos Aires. Starbucks sources globally and shares experience worldwide on everything from shop layout to preparation of the coffee.
And that is why Starbucks is profitable. It is easy to set up a coffee shop, and both economic theory and the experience of people who run coffee shops confirm the profitability of an undifferentiated commodity in a competitive market with free entry is low. The hypothetical world which the arm’s length principle envisages is one which could not generate the profits which the principle attempts to tax.
So where do the profits that Starbucks earns through its global reach arise? From everywhere it operates, and from nowhere in particular. That is the lacuna which this company, like many others, has utilised to claim that a material share of its returns accrues to a Netherlands corporation that provides licences and receives royalties. But whatever the answer to the question “in what jurisdiction did the profits from the company’s scale and scope arise?” may be, that answer is not “in the Netherlands”.
Can you really visualise an independent business that has never bought a bean of coffee, talked to a customer or pulled an espresso, but has established a global brand and expertise in the operation of coffee shops which it sells to independent operators around the world? Not only could the hypothetical world of the arm’s length principle not produce much in the way of taxable profit; it could never exist.
Perhaps Starbucks is just a hard case, an exception to a rule that generally works well. But Starbucks, not the vertically integrated wool weaver, is typical of modern multinational business. The problems that arise in attributing its profits to jurisdictions are essentially the same as the problems encountered in attributing to particular jurisdictions the profits of Google or Vodafone, of banks and pharmaceuticals groups, and of most other companies whose low tax payments are controversial.
If there were few economies of scale and scope in operating business multinationally, there would be few multinational businesses. But there are many. These businesses find it hard to match the operating costs of the best local providers – no Starbucks barista will work as hard as a dedicated owner-proprietor of a coffee shop. Without the economies of scale and scope they derive from global operations, there would be little profit for governments to tax.
The OECD asserts that the practical difficulties of the arm’s length principle are outweighed by its theoretical soundness. The reality is that these practical difficulties arise from its theoretical weakness.