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Alternative Tax and Trade Routes for the Biden Administration

Posted on Dec. 21, 2020

President-elect Joe Biden’s ambitious tax campaign proposals may be all but dead given the makeup of the incoming Congress (regardless of Georgia’s results). But progressives remain hopeful that the administration will take regulatory action to advance their agenda, even if the legislative route is barred. At the same time, waiting on Biden’s doorstep are decisions that will need to be made about how to advance — or hold back on — international tax negotiations taking place under the OECD’s auspices, and how to address Trump administration tariffs and investigations into trade violations prompted by other countries’ unilateral moves on digital services taxes.

There are but few scenarios for how the administration will address the negotiations and progressive agitation for rolling back the Tax Cuts and Jobs Act amid a fiercely partisan Congress.

OECD Negotiations

In 2018 the OECD kick-started negotiations over new international rules to respond to challenges associated with taxing the digitalized economy in response to the EU’s announcement (COM(2018) 147 final) that it would pursue its own digital taxes in the absence of a multilateral agreement. The OECD’s response — drafted with input from Trump Treasury officials, who adopted the Obama administration’s position that the United States wouldn’t sign on to an OECD solution targeted at digital companies — was a two-pillar approach that broadened the discussion to include consumer-facing businesses. While pillar 1 of the OECD’s proposals would allocate more global profits of digital and consumer-facing businesses to market countries and potentially simplify transfer pricing for routine activities, pillar 2 builds on the OECD’s base erosion and profit-shifting work by proposing a global minimum tax.

The OECD released lengthy pillar blueprints in October; comments were due December 14 and a public consultation will be held in January. Meanwhile, political negotiations are essentially stalled, the result of an ambiguous letter Treasury Secretary Steven Mnuchin sent last December saying it was unlikely Congress would enact the proposals unless they included a safe harbor. But political negotiations are also stymied by lack of agreement over the project’s scope, including carveouts for each pillar. Some of the debates border on the absurd, such as whether various kinds of stones should be considered jewels (and so in scope as part of a consumer-facing business) or extractives (and thus specifically carved out).

Champions of the OECD negotiations — mostly European officials — have expressed hope that a new U.S. administration could provide a better opportunity for progress, with French Finance Minister Bruno Le Maire insinuating that the current stalemate is primarily because of the Trump administration’s intransigence. That’s not a difficult narrative to spin, given the administration’s oft-repeated rhetoric against multilateralism and multilateral institutions.

But the reality is murkier, and it’s unclear how much more leeway Biden will have — or will want to adopt — in the negotiations. The proposals’ outcome could hurt the U.S. fisc and U.S. businesses (many of which provide the types of jobs Biden has said he wants to grow), and there are fewer routes to positive outcomes for the United States. But the Biden administration is staring down some harsh alternatives if the negotiations don’t progress, including more countries imposing unilateral digital taxes (targeting a handful of primarily U.S. tech companies) and investigations begun by the Trump administration into those taxes as potential trade violations. There’s also the one investigation that’s already been concluded, finding France’s DST to be a trade violation and imposing tariffs accordingly, suspended pending France’s refraining from collecting the tax, which it has begun to do.

There are a few ways the situation could unfold.

Negotiate Based on Current Terms

Biden could continue the blueprint negotiations, which would probably require backpedaling from Mnuchin’s self-imposed safe harbor mandate while still leaving the United States (and other countries) wrestling with how to define consumer-facing businesses.

Alternatively, the administration could give up on the consumer-facing business concept, thereby allowing the project to proceed as originally envisioned — that is, restricted to digital services. But that approach would essentially require the United States to agree to relinquish a portion of its rights to tax the profits of its headquartered tech companies while receiving nothing in exchange.

Some might view that as a more conciliatory approach to multilateralism, but it could also look like giving in to financial terrorism. And, aside from the political question of whether it’s appropriate for the United States to hand over a portion of its tax base, there are the more technical questions about whether it makes sense to draft complex rules that rely on setting in stone the definitions of business models that are changing at light speed. Alternatively, a more formulaic definition could avoid the headache of writing rules that define types of businesses while still limiting the scope to the most profitable companies.

Even if the Biden administration decides to forsake the country’s fiscal interests in exchange for being able to portray itself as a multilateral player, it would bump up against the same types of challenges that led to Mnuchin’s letter. Pillar 1 as currently envisioned would require some type of change in U.S. tax laws, as well as IRS participation, to be implemented, so it couldn’t be adopted without congressional approval.

Whether the proposal retains its broader scope or adopts a narrower one restricted to digital, it’s highly doubtful that a majority of Congress — more bipartisan in its makeup and more directly responsible and responsive to constituents than the unelected Treasury officials negotiating the project — would adopt the necessary tax law changes. And if the changes require treaty amendments or — as the OECD recommends in the blueprint — a multilateral instrument, getting the measure through Congress gets tougher still because treaty matters require two-thirds Senate approval.

The political calculus that needs to be made on pillar 2 isn’t much simpler. U.S. companies might continue to believe that they would not be affected by pillar 2 because there’s a tacit understanding that the global intangible low-taxed income regime would be an approved global minimum tax regime and thus exempt. But that doesn’t necessarily save companies from the undertaxed payment rule that’s embedded in the pillar’s four-pronged approach. It’s also unclear how pillar 2 — which is based on separate jurisdictional accounting — would mesh with GILTI, which is based on U.S. tax concepts, as a technical matter.

For the Biden administration to sign off on pillar 2 as now envisioned, it must jump two hurdles. First, some countries have already started to object to a carveout for the U.S. regime. Speaking at the virtual Congress of the International Fiscal Association last month, Michael Williams of the U.K. Treasury suggested that an exemption for GILTI is the equivalent of a unilateral measure, which he said shouldn’t be any more appropriate for pillar 2 than for pillar 1. Second, Biden campaigned on promises of expanding GILTI to an even greater portion of U.S. multinationals’ global profits — without the exemption for a fixed return on tangible assets, and at a higher rate.

Negotiating a global plan that enshrines the TCJA’s version of GILTI could end up satisfying neither other countries nor Biden supporters (see, for example, blog posts by Brad Setser of the Council on Foreign Relations, a member of the Biden transition team, arguing that the TCJA’s failure to tax 100 percent of the offshore profits of U.S. multinationals at the full 21 percent corporate statutory rate facilitates tax avoidance). And there’s little chance other countries would buy into Biden’s vision of an expanded GILTI — no one else has expressed any desire to tax 100 percent of the overseas profits of their headquartered companies.

In any case, anything other than a complete exemption for GILTI would also require a split or Republican-controlled Senate to pass additional corporate taxes.

Revise the Term Sheet

A more sensible approach for the Biden administration might be to suggest a refresh of the negotiations. That could allow all parties to build on efforts made to date while allowing work to progress based on a preferably simpler angle. Rather than trying to create an entirely new and highly complex regime primarily to address some countries’ concerns over tech companies’ profits (or large sales in their jurisdictions without significant presence), a refresh presents the chance to revisit the physical presence requirement of the permanent establishment standard. Revisions to that standard are needed to reflect today’s economy, but rethinking the rules for allocating business profits (and losses) to PEs in a sensible and principled manner won’t happen overnight. (In the meantime, new EU efforts to police and potentially break up large tech companies could address more immediate concerns over high profits.) Similar substantive changes — such as revisions to the sourcing rules for advertising and sale of consumer data — could also lead to important changes in the way profits are allocated, but on a principled basis.

The other principal driver for the pillar 1 work is many countries’ desire to shift to a more market-oriented income tax base. That runs into the competing reluctance of large exporters to keep the tax base as is, so it’s not an easy negotiation. But it’s a necessary conversation, and one better accomplished on a principled basis, not restricted to an arbitrary definition of scope by industry based on business models that may be extinct before the new rules are even adopted.

A refresh on pillar 1 could also provide an opportunity to revisit pillar 2, and that could raise questions about whether it’s needed and what its scope should be. The United States could benefit if other large headquarter jurisdictions, including China, adopted tighter controlled foreign corporation rules, so a proposal recommending that could make sense. There’s also much agitation for developing countries to have a way to assert greater taxing rights on outbound payments. That could also provide a rationale for some variation on the pillar 2 proposal, which in its current form doesn’t seem to confer much benefit to smaller developing countries.

Moreover, a rethink of pillar 2 could provide more time to assess the benefits and detriments of changes made by the TCJA and BEPS reforms, and whether there’s a realistic chance of getting changes to the TCJA through Congress. Reform proposals are being made without any tax return data that could allow for analysis of corporate tax planning behavior after 2017.

If the Biden administration wants to push for a refresh of OECD negotiations, it might need to accept that other countries will proceed with unilateral digital taxes. But it’s possible those proposals would advance regardless; there’s nothing in the blueprints that mandates a timeline for withdrawal. In that case, Biden would then need to decide what, if any, response to make to DSTs.

DSTs and Tariffs

Whether the Biden administration pushes for a longer time frame for the OECD negotiations or tries to proceed with negotiations based on the current blueprints, it still will need to decide how to address unilateral digital taxes, which primarily target U.S. companies and which Trump has responded to by launching section 301 investigations. On both the tax and trade fronts, much post-election conversation has been focused on how fast and to what extent Biden will be able to roll back Trump’s actions.

On the tax front, the Biden administration could try to reverse Trump measures by attempting to put the brakes on the trade investigations into DSTs; allowing the investigations to proceed but failing to act in response; or pursuing potential responses other than tariffs, such as WTO proceedings. The third approach might be optimal: It doesn’t require complete passivity but is less inflammatory and immediately harmful than tariffs. Of course, a WTO investigation would take years to complete — and years represent eons in the tech industry.

Even if the Biden administration could adopt an approach that is less dependent on tariffs, it would still need to decide how to proceed with the French DST, in response to which tariffs kick in at the beginning of 2021. And leading Senate Democrats have already applied pressure to ensure the administration doesn’t give a free pass to other countries enacting DSTs.

The China Question

One of the biggest challenges Biden will face is China, the world’s second biggest market and home to some of the largest companies, including some tech companies (in 2020, three of Fortune’s top five companies in the world by revenue, and five of Investopedia’s top 10 by profits, are Chinese). How China intends to implement any OECD proposals should be just as important to the negotiations as U.S. plans, but remarkably little attention has been paid to that to date. Although China has CFC rules, they are weak and not regularly enforced.

The China question is also relevant to international tax negotiations because of the increasing sensitivity to how it successfully used its WTO admission to benefit its economy in a way not envisioned by the original members, something U.S. Trade Representative Robert Lighthizer has noted several times. Those concerns are part of the reason for U.S. frustration with the WTO’s composition, process, and decisions.

The WTO problems highlighted by the China situation should make the Biden Treasury reluctant to sign on to a multilateral deal that China can twist to its own benefit or that doesn’t require it to play in accordance with agreed-on global rules. Although Biden might differ from Trump in his public approach to multilateralism, it’s unclear that he could — or should — take a more conciliatory approach to China.

The Regs, the Rate, and the Foreign Tax Credit

Although Biden’s campaign tax proposals included ambitious promises to roll back the TCJA to impose additional tax burdens on U.S. multinationals, Congress’s makeup probably takes those legislative goals off the table. The question then becomes what Biden could accomplish via regulation — an approach liberally adopted by the Obama administration when it found itself blocked by Congress.

In a December 8 Urban-Brookings Tax Policy Center webcast, Chye-Ching Huang of the Center on Budget and Policy Priorities, who’s also on the Biden transition team, was enthusiastic about revisiting policy choices made by the Trump Treasury. Specifically, the regulations that expanded the statutory high-tax exception that applies to subpart F income to include tested income (taxable as GILTI) have received much attention.

Repealing the exception could allow the Biden administration to declare victory in erasing Trump-era corporate benefits, while in actuality imposing little additional cost on most corporate taxpayers. But that doesn’t mean it would be easy. If Biden decides to repeal those regs, he would have to do so through a whole new regulatory project. He would also have to address the statutory high-tax exception to subpart F. Part of the rationale for adopting the expanded high-tax exception was the recognition that taxpayers were planning into it anyway by generating subpart F income. If the Biden Treasury wants to drop the GILTI high-tax exception, it would still need to figure out how to address the planning opportunities presented by the statutory exception — which aren’t easily eliminated through regulation or executive order.

Biden will also have to decide what to do with the proposed foreign tax credit regulations
(REG-101657-20) issued in July. Those regs potentially amount to a stealth tax increase on U.S. multinationals — much larger than the tax benefit provided by the high-tax regulations — because they could severely limit the types of foreign taxes that could be eligible for an FTC. Addressing them will require the Biden administration to think about what its international tax goals really are. To date, the most obvious one is rolling back the TCJA. However, if the goal is less to score political points and more to make sure companies pay more taxes, finalizing the proposed FTC regs could be one way to go. Of course, doing so would not only make headline news, it would also probably curtail U.S. corporate investment overseas and cut into the profits of all kinds of companies — not just tech — which would trigger a whole other set of ripple effects. In reducing the profitability of U.S. companies and leaving them with less cash to invest, finalizing the regs could backfire spectacularly by putting additional pressure on domestic economic growth when it’s most needed — and without the upside of scoring political points.

However much the Biden administration and progressive Democrats might wish it, the past four years can’t be erased from tax history. Biden will have to consider how to make constructive changes based on the platform he inherited, rather than simply eviscerating it. That’s a tall order, both domestically and internationally.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker, and a contributor to Tax Notes International.

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