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News Analysis: Competition or Coordination: Responses to the Tax Cuts and Jobs Act

Posted on Jan. 15, 2018

The enactment of the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97), introduces a new chapter in the global debate over the benefits of tax coordination versus tax competition.

For the past five years, the OECD has touted the advantages and successes of tax collaboration efforts in advocating its base erosion and profit-shifting project. Other supporters of multilateral cooperation on tax matters say it can eliminate the race to the bottom that countries would otherwise engage in. They argue that it can prevent multinationals from playing countries off one another as they seek the most tax beneficial regimes, which could permit them to minimize their taxes and harm local economies.

Some observers question that narrative. In her new book, International Tax Policy: Between Competition and Cooperation (2017), Tsilly Dagan of Bar-Ilan University debunks the notion that coordination always benefits all participants. Dagan argues instead that multilateral tax cooperation efforts often fail to acknowledge related costs, including efficiency, distributive justice, and political participation costs. She contends that international tax competition plays an important role in negating the inequities of power associated with most coordination efforts. The focus of Dagan’s book — which went to press before U.S. tax reform was considered a realistic possibility — takes on added relevance in a post-reform world.

The weeks-old U.S. tax reform has already sparked intense debate in other countries over the best way to respond. In many respects, the reform can be understood as the ultimate competitive act: Congress acted unilaterally, and made no pretense of trying to harmonize or coordinate many of the new provisions with those of other countries or the BEPS project. At the same time, however, concerns about and responses to the BEPS project are evident in many of the TCJA’s international provisions.

Should U.S. tax reform be considered an example of the results of coordinated action, or an extreme unilateral response to those efforts? And will other countries respond with unilateral actions of their own, or through more efforts at cooperation? Those aren’t academic questions: Multinational companies will have to anticipate future law changes in other countries in deciding how to respond to the U.S. changes when restructuring both domestic and global operations.

OECD BEPS: Benefits of Cooperation

The OECD’s website describes the organization as having led the way on tax matters and promoting transparency and cooperation for the past 50 years. It depicts the BEPS inclusive framework as key in advancing multilateral cooperation. According to the BEPS action plan, coordinated work on tax matters is necessary because there are “gaps and frictions among different countries’ tax systems that were not taken into account in designing the existing standards and which are not dealt with by bilateral tax treaties.” It also states that “the global economy requires countries to collaborate on tax matters in order to be able to protect their tax sovereignty.”

The BEPS project focused on addressing double nontaxation, which results from gaps in the interaction of different tax systems. Those gaps are said to create policy concerns because income from cross-border activities might go untaxed or undertaxed. The BEPS action plan states that coordinated and collaborative action is needed because inaction would result in some governments losing corporate tax revenue. It also highlights concerns about the emergence of competing international standards and unilateral replacement of the current consensus-based framework. The action plan says unilateral measures taken without collaboration could lead to “global tax chaos.”

The G-20 supports the OECD’s coordinated approach to international tax policy reform. In its 2012 authorization for the OECD to undertake the BEPS work, the G-20 emphasized the need for an expanded effort led by the OECD to prevent base erosion and profit shifting that would include countries other than OECD members.

In sum, the G-20 and its agent, the OECD, have focused on coordination among a large group of countries — OECD members; the large BRICS economies of Brazil, Russia, India, China, and South Africa; and developing countries — as the sole way to deliver international tax reform to eliminate double nontaxation, while preempting concerns over the possibility of double taxation. The premise of the BEPS project, and the impetus that drove it, is that cooperative engagement among countries is necessary to address multinational entities’ tax avoidance and ensure that countries can collect sufficient tax revenue from multinationals, thereby promoting efficiency and equity in their domestic economies.

U.S. Tax Reform: Unilateral Action

In the United States, the legislative body fiercely protects its taxwriting prerogative, and the current Republican-led Congress didn’t feel compelled to strongly adhere to commitments made by the Obama Treasury. But while the U.S. Congress seems to have paid little attention to the Obama administration’s commitments to international tax coordination efforts, it’s inaccurate to describe the TCJA as a reversal of that administration’s stance toward international tax rules. Once the Obama administration realized that much of the BEPS rhetoric couched other participants’ intent to tax a share of the profits of U.S. multinationals, it became an unwilling participant in, and resisted many initiatives of, the BEPS project. (Prior coverage: Tax Notes Int’l , June 22, 2015, p. 1067.) Obama’s Treasury Department was able to scale back many parts of the BEPS initiative, including the scope of country-by-country reporting (action 13); transfer pricing (actions 8-10); and tax treaty revision, including permanent establishment changes (action 7).

But the fact that the United States declined to fully participate in the coordinated BEPS efforts doesn’t mean Congress ignored those efforts in enacting the TCJA. Arguably, other countries’ coordinated efforts expressed through the BEPS project influenced the international aspects of U.S. tax reform. The rewrite of the U.S. international tax rules is in no small part a reaction to competitive actions taken by other countries under the guise of the BEPS project.

The impetus for many of the international tax changes included in the TCJA is evident in the tax reform hearings conducted by Congressional taxwriting committees over the past four years. The hearings highlighted lawmakers’ concerns about other countries’ tax changes as part of BEPS, and the pressure they felt to respond by revising U.S. tax rules. In a 2015 hearing, Senate Finance Committee Chair Orrin G. Hatch, R-Utah, said that while international efforts to align tax systems are worth exploring, the United States shouldn’t negotiate agreements that undermine its interests “for the sake of some supposedly higher or nobler cause.” According to Hatch, Congress should focus solely on the U.S. economy, workers, and job creators in enacting tax reform. And in a hearing last year, senators welcomed reform proposals to protect those interests that included both an excise tax on base erosion payments and an inbound minimum tax. (Prior coverage: Tax Notes Int’l , Oct. 16, 2017, p. 203.)

Sentiment in the House was similar. According to the 2016 Republican blueprint for tax reform, change was needed to focus on investment in and for the United States. It included a proposal for rules that would “allow the United States to adopt, for the first time in history, the same destination-based approach to taxation that has long been used by our trading partners.” That proposal wasn’t in the TCJA, but some of the act’s provisions — while less radical than the destination-based cash flow tax — are clearly intended to achieve the same goals of encouraging U.S. investment and ensuring parity between U.S. and other systems. Those changes include the favorable rate on income from exports related to U.S.-owned intangibles, the penalty on outbound payments, the enactment of a territorial system, and lowering the corporate tax rate to 21 percent.

A New Round of Competition?

U.S. tax reform is already prompting countries to consider their own unilateral actions. China has temporarily exempted foreign companies from paying provisional income tax on Chinese profits if reinvested in China, specifically in sectors encouraged by China’s government; the tax holiday is retroactive to the beginning of 2017 (see Sui Lee-Wee, “China Offers Tax Incentives to Persuade U.S. Companies to Stay,” The New York Times, Dec. 28, 2017). The reporting has suggested a connection between the tax holiday and U.S. tax reform, quoting statements made by Chinese Vice Finance Minister Zhu Guangyao, who has promised to “take proactive measures” in response to U.S. tax reform.

Other countries are considering what reforms they need to respond to the United States. Australia — with a 30 percent corporate tax rate, now even more of an outlier following the reduction in the U.S. rate — is using U.S. reform to push for lowering its corporate rate. (Prior coverage: Tax Notes Int’l , Jan. 1, 2018, p. 33.) In November the Australian Treasury predicted that U.S. corporate tax cuts, which could lead to a boom in U.S. investment, would “draw funds and goods from the rest of the world.” It said a reduction in the U.S. corporate rate would result in a decline in capital stock in the rest of the world, and that other countries could see a permanent reduction in their levels of GDP and real wages unless they took steps to maintain their competitiveness. 

A group of German academics recently wrote that U.S. tax reform “would significantly affect corporate financing and location decisions of both U.S. and European multinational groups,” potentially resulting in “an erosion of European tax bases and an associated loss in tax revenue” (ZEW, “Analysis of U.S. Corporate Tax Reform Proposals and Their Effects for Europe and Germany” (Dec. 11, 2017)). According to the group, neither the OECD’s BEPS recommendations nor the EU’s anti-tax-avoidance directive is sufficient to prevent “the potential revenue loss associated with a reduction of the U.S. corporate income tax rate without putting the attractiveness of the EU as an investment location at a risk.” The group concluded that EU member states will face an increased comparative tax disadvantage. Their simulation of expected changes to U.S. inbound foreign direct investment predicts that the United States can expect additional net inbound foreign direct investment from EU countries of approximately €250 billion, suggesting that an increase in U.S. attractiveness as an investment location would come at the expense of European countries.

The group highlighted the need for EU countries (and Germany in particular) to develop responses to U.S. reform to ensure their competitiveness. They said European countries should focus on establishing and maintaining an attractive environment for multinational investments, such as through the introduction or advancement of tax incentives for research and development rather than by merely reducing the corporate tax rate. They discounted the value of BEPS initiatives and the anti-tax-avoidance directive as potential responses to U.S. tax reform, saying EU members should instead try to increase the international competitiveness of their tax systems.

Israel recently approved a reduction in its corporate tax rate from 24 percent to 23 percent, but Finance Minister Moshe Kahlon said in December that even more reductions in response to U.S. changes might be necessary. “There are many implications,” he said. “We will have to make adjustments.”

U.S. Tax Reform: Idiosyncratic BEPS

While in one sense U.S. tax reform represents an extreme case of unilateral action, it can also be seen as part of a legislative effort that pays tribute to the BEPS project. That’s evident in the way the changes adopted several BEPS recommendations, including the interest expense limitation and anti-hybrid rules.

In another important sense, Congress has acted collaboratively, even while acting alone. The minimum tax on U.S. companies’ foreign earnings (mislabeled as a tax on intangible income) is likely to significantly affect other countries’ incentives to compete on corporate tax rates. Far from producing a race to the bottom, the new U.S. rate of 10.5 percent (half the statutory corporate rate in 2018) imposed on the foreign earnings of U.S. multinationals’ controlled foreign corporations could reverse incentives other countries might have to reduce their own corporate rates much below that. At the same time, some countries might still see a competitive advantage in being able to attract profits from jurisdictions with higher rates, given that the U.S. minimum tax is imposed on an aggregate basis.

In other words, with the TCJA, Congress has to some extent adopted the goals of collaborative and coordinated action and incorporated them into a unilateral action. In so doing, it’s following a time-honored tradition in U.S. international tax policy. The U.S. foreign tax credit, adopted in 1918, represented the unilateral grant of relief from double taxation, in which the United States essentially agreed to subsidize other countries’ taxes imposed on U.S. taxpayers (see Michael Graetz and Michael O’Hear, “The ‘Original Intent’ of U.S. International Taxation,” 46 Duke L. J. 1021 (1997)). Congress’s adoption of a foreign minimum tax in the TCJA follows a similar approach to propping up other countries’ corporate tax regimes. Dagan’s book also supports the notion that competitive unilateral action by a single country — the United States — could benefit other countries.

The Downside of Collaboration

In her book, Dagan attempts to recast the international tax policy debate over competition and coordination to emphasize drawbacks of cooperation that are rarely considered, while highlighting ancillary benefits of competition. She argues that while international tax cooperation initiatives are generally portrayed as benefiting all actors, they’re often nothing more than instruments that serve the interest of strong and rich countries at the expense of developing ones. Dagan contends that despite its positive reputation, international tax cooperation doesn’t necessarily serve the best interests of all parties. It’s not just less powerful countries that could be hurt by cooperation — Dagan says it can lead to inefficiencies and regressive outcomes both among and within cooperating states.

According to Dagan, stronger and more well-connected countries enjoy a comparative advantage in tax coordination efforts, leading to possible disadvantages for poorer countries. For example, a higher tax rate might be imposed in countries for which lower taxes (and more investment) would be more beneficial. Dagan also points out that coordinated tax efforts could benefit the poor in rich countries at the expense of labor in poor countries, saying tax revenue might be regressively distributed among participating countries, resulting in “inequitable allocation of transfer payments among the poor in developing countries.”

Dagan demonstrates how her conclusions regarding potential downsides for international coordination efforts for poor countries are borne out by most current multilateral cooperation initiatives, which favor the interests of strong OECD countries over those of developing ones. Instead of focusing on coordination efforts for the ostensible goal of the greater good, countries should pursue their national interests and set their international tax policies to reflect their comparative advantages, allowing them to attract and retain mobile residents and factors of production, Dagan says. She argues that tax competition can promote important efficiency goals, such as the matching of public goods with individual preferences, decreased governmental waste, and the removal of political constraints that drive states to provide benefits only to select groups.

According to Dagan, it’s unrealistic to ignore the fact that to be competitive, countries must offer incentives that maximize residents’ benefits from foreign and local investments and adopt tax policies to attract desirable new residents. Tax policy goals must reflect those realities to enable states to maximize benefits for their own citizens.

Getting to a New World Order

In response to U.S. tax reform efforts, some countries may double down on coordination efforts. That might work best for EU members, which have strength in numbers. Other large, powerful, market economies might respond by enacting their own competitive reforms. And some countries will struggle to adapt to a new world in which U.S. multinationals can no longer obtain the same relative benefits by investing in or through their countries, as under the prior regime.

The bottom line is that only one thing seems certain: In the international tax policy landscape, the next five years should be as unsettling as the last five.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu

Follow Mindy Herzfeld (@InternationlTax) on Twitter.

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