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Selling a Digital Brooklyn Bridge

Posted on Nov. 23, 2020

Soon after the Brooklyn Bridge opened to pedestrian and vehicle traffic in 1883, one of the world’s greatest con artists, George C. Parker, saw the opportunity to make thousands of dollars off immigrants and tourists eager to acquire a piece of the bridge, giving birth to the phrase “And if you believe that, then I have a bridge to sell you!”

The parallel between con men trying to pull a fast one over unsuspecting (and mostly poorer) investors and organizations developing solutions for taxing the digital economy is unnervingly apt. And at least with the Brooklyn Bridge, there was a real asset — it just didn’t belong to the person claiming the ability to sell it. In the search for a digital pot of gold, countries are being sold on the existence of an ephemeral revenue stream.

U.N. Developments

The most recent introduction into the con of simple fixes for developing economies comes via a new proposed article 12B to the U.N. model treaty. A subcommittee of the U.N. Tax Committee, led by individuals from India and Argentina, acting (as do all members of the tax committee) in their individual capacities, developed article 12B. The new article is closely modeled on article 12A, a provision for a withholding tax on fees for technical services introduced in the 2017 model treaty (that provision, or variations of it, has been included in approximately 65 bilateral tax treaties, mostly between developing countries). As drafted, article 12B closely resembles India’s equalization levy, first passed in 2016 and vastly expanded earlier this year. (Prior analysis: Tax Notes Int’l, July 13, 2020, p. 285.)

The U.N. subcommittee had been tasked with developing proposals for taxing the digitalized economy, giving special attention to the interests of developing countries, administrability, fairness, and certainty, while taking into account different economies and market forces. Its proposed solution is a 3 to 4 percent withholding tax on “automated digital services,” a new term defined as any payment for a service provided on the internet or an electronic network requiring minimal human involvement from the service provider. The proposed commentary lists the types of services meeting that definition, including online advertising services, sale or other alienation of user data, online search engines, and digital content and cloud computing services.

As an alternative to the gross basis withholding tax, paragraph 3 of the proposed article would allow taxpayers to elect to have their qualified profits from automated digital services subject to the domestic rate. Qualified profits are defined as 30 percent of the amount resulting from applying the group’s overall profitability ratio for that business segment to the gross annual revenue from automated digital services derived from the source jurisdiction.

Ripple Effects

Unfortunately, the United States — the headquarters jurisdiction of the largest tech companies whose profits article 12B seeks to tax, isn’t a member of the U.N. Tax Committee, which is limited to 25 members (the committee turns over every four years and will reconstitute in 2021). Even if article 12B is included in the next version of the U.N. model treaty, which appears likely, it’s doubtful that any U.S. treaty will include the provision. But that doesn’t mean the U.N. committee’s decision to include it in the model treaty (accomplished by simple majority agreement) would be without import. At a minimum, the provision could hasten a process already underway: encouraging U.S. multinational enterprises to repatriate their intellectual property to the United States to avoid the withholding tax.

The adoption of article 12B by the tax committee has other implications. Providing for a withholding tax on digital services payments in the U.N. model allows advocates to argue that that kind of tax has been endorsed by a major international organization. That endorsement could in turn provide a springboard for expanding the provision’s scope, or form the basis for the plausible claim that the approach provides an alternative to the more complex proposals being negotiated at the OECD — which, unlike the United Nations, requires consensus agreement among 137 countries to proceed. It also grants a measure of legitimacy to similar types of unilateral rules that have already been enacted by some countries, such as India’s equalization levy, which the U.S. trade representative is investigating as a trade violation.

Who Benefits?

There’s one important distinction between the OECD and U.N. processes that’s especially relevant in the debates over withholding taxes on digital services: The lack of any impact analysis by the U.N. (or any of the countries advocating for the proposal) regarding the proposal’s possible economic effects. But some indication of how the tax costs are borne is provided in tech companies’ responses to the unilateral digital taxes that have been springing up around the world. The day the U.N. Tax Committee ended its 21st session, an article summarized how the cost of the digital taxes on digital service providers such as Apple, Amazon, Google, and Facebook is mainly being passed on to consumers (although others, such as Netflix, are holding off on passing them on). (Prior coverage: Tax Notes Int’l, Nov. 2, 2020, p. 700.)

In addition to extensive debates over digital services taxes, the 21st session of the U.N. Tax Committee also considered a proposal to limit publication of the lengthy summary of individual countries’ unique transfer pricing practices (an appendix to the U.N. transfer pricing manual) to an online format. The proposal was rejected after a compelling case was made about the lack of internet access and electricity in many developing countries.

The lack of basic digital infrastructure in so many developing countries — precisely the ones a withholding tax on digital services is supposed to help — makes the position being advocated at the United Nations particularly troubling. Given that doing business in developing countries is often much more expensive than elsewhere, imposing additional costs in the form of taxes is likely to discourage businesses from investing in those countries, thereby depriving them of the infrastructure needed to expand their economies. As the world navigates the third economic revolution, imposing more obstacles to developing countries’ ability to access information technology risks leaving them behind for good.

It’s especially ironic that the proposals are being pushed by two countries whose economic development of late has a poor track record: A report from McKinsey highlights India’s “decade of lost opportunity,” while others point to the decades of gaps between China and India’s economic growth. And a recent World Bank assessment of Argentina’s economy highlighted how “the historical volatility of economic growth and the accumulation of institutional obstacles have impeded the country’s development.”

Digital Withholding: The Latest Fad?

Included among the targets for meeting the U.N.’s ambitious sustainable development goals by 2030 is strengthening domestic resource mobilization, such as through international support to developing countries to improve domestic capacity for tax and other revenue collection. The push for mobilization has led to increased advocacy of new ways for developing countries to extract revenues from multinational corporations doing business there. But given that digital withholding taxes are likely passed on to consumers, imposing them is unlikely to meet revenue targets and could even prove harmful. As such, the taxes are just the latest in a long line of perhaps well-intentioned but often misguided policy proposals by international organizations for developing countries. (See Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (2011).)

A recent paper by Aqib Aslam and Alpa Shah of the IMF proposes an alternative approach for taxing the value users contribute to the digitalized economy: a royalty modeled on the extractive industries. The approach is built on the IMF’s expertise in consulting with developing countries on their tax systems, and so is inherently tied to the legacy of corporate exploitation of developing countries’ mineral resources. (A recent Financial Times article highlights just how closely the wealth of the West is tied to that exploitation, telling the story of Belgium’s Union Minière du Haut-Katanga; William Dalrymple’s The Anarchy (2019) tells a similar story about the East India Co.) But tech companies aren’t corporate mine raiders. And the assumption that multinationals doing business in a jurisdiction are there simply to extract disregards the potential they have to provide platforms for future growth and maximizes the chances that developing countries will be left even further behind in the next wave of development.

OECD Sales Pitch

The U.N.’s proposed panacea for taxing the digitalized economy may be the most fairy-tale-like because it promises so much, while providing so little, to those most in need. But the OECD’s proposals also deliver little and offer no clarity over what problems they are trying to address. The U.N. proposal at least has a clearly stated objective and a means of achieving a solution, which the OECD proposals lack.

Pillar 1

The stated purpose of pillar 1 is to “adapt the international income tax system to new business models through changes to the profit allocation and nexus rules applicable to business profits.” To achieve that, pillar 1 would expand a market jurisdiction’s taxing rights when a business has active and sustained participation there through activities in, or that are remotely directed at, that jurisdiction. Pillar 1 also attempts to improve tax certainty via innovative dispute prevention and resolution mechanisms. But if that’s truly the case, there’s a big disconnect between the goal and the mechanisms for achieving it. While pillar 1 contains proposals for expanding the taxing right of market jurisdictions, it does so only for limited segments of the economy — automated digital services and consumer-facing businesses — with no real justification for that scope other than that it was needed to “bridge the gap between those members seeking to focus Pillar One on a narrower group of ‘digital’ business models and those insisting that a solution should cover a wider scope of activities.”

Further, the quantitative work to assess the proposal’s impact highlights just how little revenue pillar 1 is expected to produce for the countries that have the most at stake. The OECD’s impact analysis concludes that pillar 1 “would involve a significant change to the way taxing rights are allocated among jurisdictions, as taxing rights on about USD 100 billion of profit could be reallocated to market jurisdictions,” and would lead to a “modest increase in global tax revenues,” or $5 billion to $12 billion of global revenue gains. According to the impact assessment, on average, low-, middle-, and high-income economies would all benefit, while investment hubs would lose tax revenue.

The assessment uses favorable assumptions to show at least some reallocation of revenue under pillar 1. Speaking during a November 2 webcast held by the European Tax Policy Forum and the Tax Foundation, İrem Güçeri of the OECD Centre for Tax Policy and Administration acknowledged that the most recent official impact assessment is subject to considerable uncertainty. Some observers have questioned its conclusions or suggested that the projected results fail to take into account likely behavioral responses. (See Güçeri, “The State of Uncertainty: Reflections on BEPS and the OECD’s Two-Pillar Approach,” Tax Foundation presentation, Nov. 2, 2020. Prior analysis: Tax Notes Int’l, Feb. 3, 2020, p. 549.)

The OECD’s big selling point, despite the proposal’s complexity and lack of significant additional revenue, is that without a new approach, the world will likely descend into a chaos of unilateral digital tax measures generating more costs for cross-border investment and retaliation. Embedded in that projection is the assumption that the remedy isn’t worse than the cure — that behavioral responses to pillar 1 won’t harm cross-border investment as much as unilateral taxes.

If, as articulated in the preface to the pillar 1 blueprint, what’s really sought is simply a greater taxing right for market jurisdictions through new nexus rules and increased profit allocation, that could probably be better achieved by building on existing rules. The challenge, of course, is that the most powerful voices aren’t really interested in accomplishing that, unless it’s another jurisdiction’s income that’s being reallocated.

Pillar 2

The OECD’s impact assessment projects bigger fiscal benefits from the pillar 2 proposal — $42 billion to $70 billion of additional estimated global tax revenue, which combines both direct revenues ($23 billion to $42 billion) and additional gains from reduced profit shifting ($19 billion to $28 billion). The assessment boosts its projections by taking credit for $9 billion to $21 billion of revenue from the 2017 U.S. tax law changes (section 951A inclusions of global intangible low-taxed income).

But the policy goals of pillar 2 — to address remaining base erosion and profit-shifting challenges — are even vaguer than those of pillar 1. The OECD says pillar 2 rules are designed to ensure that large multinationals pay a minimum level of tax regardless of where they operate or are headquartered. The blueprint says pillar 2 does that via interlocking rules to accommodate different tax system designs and business models, ensure transparency and a level playing field, minimize administrative and compliance costs, and ensure minimum taxation while avoiding double taxation or taxation when there’s no economic profit.

But there are many questions about the need for new measures to address remaining BEPS challenges that the blueprint doesn’t begin to answer. For instance, should those measures be adopted before there’s been any meaningful study of the impact of the original BEPS provisions or of countries’ experiences in implementing them? If you’d just finished the Brooklyn Bridge, you wouldn’t necessarily want to start building another bridge connecting Brooklyn to Manhattan until you knew existing traffic warranted it. (That’s what happened several years after the Brooklyn Bridge opened. When the need for “speedier communication” became apparent, New York’s governor approved the formation of the East River Bridge Commission in 1895.) But with the Brooklyn Bridge, you’d at least have some visual confirmation of just how much traffic was crossing the bridge each day. There’s almost no transparency into how BEPS has affected profit shifting to date.

The OECD’s impact assessment acknowledges that “curtailing the ability of governments to offer very low tax rates” could “reduce their ability to use tax incentives to pursue specific policy objectives, such as promoting innovative activities or economic development.”

The OECD has said both pillars would lead to a “relatively small increase in MNE investment costs,” with harm to global investment of less than 0.1 percent of GDP, and would mostly affect highly profitable MNEs whose investment is less sensitive to taxes.

But the rosy predictions about the revenue gains mostly ignore the strong arguments countries have to be able to continue to offer their own tax incentives, as well as that the proposals will result in changes in taxpayer behavior to avoid additional taxes. Countries should be wary of buying a share of pillar 2. They might end up not only with no share in a digital Brooklyn Bridge, but they might find they’ve bought something with high costs for investment and domestic policy choices without producing much additional revenue.

“If you believe that, do I have a bridge to sell you” increasingly looks like a phrase that can be applied not only to gullible tourists, but also to supposedly sophisticated finance ministers looking for an easy way to address their domestic fiscal challenges.

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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