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COVID-19 Upends the OECD's Digitalization Project

Posted on Apr. 6, 2020

The coronavirus pandemic has economies cratering. Healthcare systems are unable to ensure adequate support for caregivers and the ill; governments don’t know how to protect their citizens’ physical and economic welfare, with several heads of state under quarantine; and companies worldwide are under extreme strain. And yet the OECD has said that work on its project to address the tax challenges of digitalization will continue full steam ahead.

But COVID-19 is toppling many of the assumptions the project is based on in ways that make it untenable for the OECD to carry on the work in its current form.

The Postponement Ask

On March 23 the U.S. Council for International Business (USCIB) made several recommendations on how U.S. fiscal policy and tax administration could respond to the coronavirus, including a request that the OECD postpone its work on taxing the digital economy for at least six months. Although it acknowledged that an international solution on the topic remains critical, the USCIB said governments and taxpayers need to channel their resources to address the pandemic. It pointed out that it’s simply not prudent for more than 135 countries to attempt to reach consensus now, when governments must first respond to the crisis. The USCIB said the G-20 and OECD should reassess the workplan as information on the coronavirus’s health and economic effects develops and determine whether additional postponement is required. Other organizations, including the Federation of German Industries, have sent similar recommendations to their governments.

So far, the OECD hasn’t taken kindly to those suggestions. On March 17 it issued a formal statement that the project will proceed along the planned time frame with appropriate precautions. Pascal Saint-Amans, director of the OECD Centre for Tax Policy and Administration, has so far rejected any notion of extending the deadline, suggesting that many companies, both tech and nontech, seem to have different views on the matter. He reiterated that the OECD is progressing on the digitalization workplan to meet deadlines set by the G-20.

In a March 30 letter to the editor that implicitly supports the OECD’s approach, Reuven S. Avi-Yonah of the University of Michigan argued that the pandemic has increased the likelihood that the OECD’s pillar 1 proposals will be implemented. (Prior analysis: Tax Notes Federal, Mar. 30, 2020, p. 2087.) The massive increase in the profits of digital giants stemming from pandemic-related events should lead to a governmental and public desire to extract more revenue from those companies, according to Avi-Yonah.

Where Does Value Come From?

Underlying both the OECD’s current digitalization work and earlier base erosion and profit-shifting project is the assumption that highly profitable companies aren’t paying enough tax or are extracting more than their fair societal share. The theory is that corporate taxes should be higher because business as a whole extracts more from civilized society (profits and shareholder distributions) than it contributes (jobs, products, and services). The pandemic may force a rethink of those premises.

Over the last month, practically all in-person interaction has been replicated in virtual form. None of that would be possible without the major investment in networks, infrastructure, and risk-taking that’s been undertaken by tech companies over the last several decades. Perhaps it’s time to shift the debate on how to impose additional taxes on the massive profits tech and other companies make from increased use of their services; instead, we could ask whether they’re sufficiently compensated.

The Value of Risk

A 2017 event at the Urban-Brookings Tax Policy Center focused on whether entrepreneurs are overtaxed. The event was part of a larger debate over whether tax systems adequately compensate entrepreneurs and innovators for the risk-taking activities society needs to maintain economic growth and improve productivity. In that context, instead of focusing on the massive profits generated by a few large companies, we could remember that most start-up companies fail. In many cases, founders lose capital and labor without being able to reap the benefits of the associated losses.

In a paper written in conjunction with the Tax Policy Center event, Eric Toder demonstrated why the appropriate tax rate on profitable start-up companies should adequately reflect the losses associated with, and incurred by, most start-ups. He showed how the tax system provides incomplete loss offsets for those entrepreneurs: When failure comes before success, investors probably don’t have gains to deduct any losses against. Even if losses can be carried forward and used to offset future gains, the effective deduction rate is reduced by the delay in claiming a loss.

Similarly, Susan Morse of the University of Texas highlighted how poorly the tax system compensates the type of losses incurred by resource-constrained, loss-making start-up companies by providing support only ex post, in the future, and if the start-up becomes profitable (“Entrepreneurship Incentives for Resource-Constrained Firms” (Apr. 28, 2017)).

Comparing the U.S. and Swedish tax systems’ incentives (and disincentives) for entrepreneurs and innovation, Julie Berry Cullen and Roger Gordon noted that companies with losses don’t receive corporate tax rebates and that any tax savings resulting from tax-loss carryforwards are reduced in present value because they’re deferred (“How Do Taxes Affect Entrepreneurial Activity?: A Comparison of U.S. and Swedish Law” (undated)). Restrictions on the deductibility of losses may harm owners when they’re most in need of help. Although focused on two countries, the authors’ points apply more universally.

It’s widely accepted that innovation and risk-taking are needed to maintain economic growth (see Zoltan J. Ács, Sameeksha Desai, and Jolanda Hessels, “Entrepreneurship, Economic Development and Institutions,” 31 Small Bus. Econ. 219 (2008)). And as Cullen and Gordon have pointed out, successful companies provide benefits not just by creating products — there are also spillover effects that may play an important role in generating economic growth (Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S. (2002)).

Pharma companies get a bad rap much of the time for generating excessive profits, overpricing needed medicines, and ensuring that profits from blockbuster drugs are attributable to low-tax jurisdictions. But it’s those same pharma companies that society turns to for preventing or treating the coronavirus. Concerns about unconscionable price hikes on a few possibly beneficial treatments have already started swirling, but like with tech companies, it may be that the system fails to adequately compensate the losses generated in the search for a cure for COVID-19.

In a March 26 news conference, National Institute of Allergy and Infectious Diseases Director Anthony Fauci said the National Institutes of Health is “working with a variety of companies to take [on the] risk” of producing a vaccine without being certain that it would be ultimately be approved. He said that when asking companies to take on those kinds of risks, “you’ve got to give some backup to them,” such as by directly funding them. A few days later, Johnson & Johnson demonstrated the benefits of risk-taking, announcing that it has identified a lead vaccine for the virus. It said that as part of a venture with a division of the U.S. Department of Health and Human Services, it will contribute up to $1 billion to co-fund vaccine research, development, and testing. The company added that as part of that commitment, it plans to expand its global production capability, quickly begin production at risk, and offer an affordable, public vaccine on a nonprofit basis.

Refitting biological pharmaceutical plants can be an expensive proposition, and it’s especially risky when the drug is unproven. Allowing companies that discover and produce successful treatments to reap high profits is another way of compensating them for taking risks.

The Value of Business

While government leadership is sorely needed in a crisis, businesses can use their production and research capabilities to help in ways governments can’t. Companies worldwide are repurposing factories and designs to make the products needed to fight the virus. French luxury goods maker LVMH has shifted its production from perfumes to hand sanitizer (Leila Abboud, “Inside the Factory: How LVMH Met France’s Call for Hand Sanitiser in 72 Hours,” Financial Times (Mar. 19, 2020)). The fashion industry (including Gap, Zara, and Nike) has begun working with vendors to shift to the production of protective medical gear, and engineers and manufacturers (including Dyson and GM) have been producing ventilators rather than other products.

It may be hard to stomach the extraordinary wealth accrued by a handful of business tycoons generated by a small number of companies. But when considering the contributions those companies make to help society manage global crises, perhaps they aren’t paying too little tax after all.

Global Supply Chains

The movement toward manufacturing through global value chains was a marked trend for most of the last two decades (see Anna Ignatenko, Faezeh Raei, and Borislava Mircheva, “Global Value Chains: What Are the Benefits and Why Do Countries Participate?” IMF WP 19/18 (Jan. 18, 2019)). But even before COVID-19 struck, there were indications that this trend might be starting to reverse. In January 2019 McKinsey and Co. reported that goods-producing value chains have become less trade-intensive, showing the decline between 2007 and 2017 of the percentage of exports of gross output in those chains (“Globalization in Transition: The Future of Trade and Value Chains”). That reversal is partly the result of a shift in labor-cost arbitrage, and partly because global value chains are becoming more knowledge-intensive and reliant on highly skilled labor. Goods-producing value chains are tending toward regional concentration, with companies increasingly establishing production closer to demand. McKinsey explained those shifts as attributable to three factors: the rise of emerging markets’ share of global consumption, emerging markets’ buildout of better domestic supply chains, and the reshaping of global value chains by cross-border data flows and new technologies.

The coronavirus pandemic is likely to accelerate those trends. In hindsight, it seems obvious that part of what led to the rapid spread of the virus was the globalized nature of business. But the virus and resulting travel restrictions have exposed the weaknesses in value chains, both from the perspective of the supply of goods and in interactions among individuals, and it will undoubtedly force companies to restructure them to be less dependent on networks that can prove unreliable in a crisis.

The travel restrictions have exposed another weakness of global supply chains. Many structures depend on individuals being in a location for less or more than a specific amount of time. Corporate-imposed locational requirements might be set up to ensure that an individual’s activity doesn’t create an unintended permanent establishment. Conversely, other structures rely on decision-makers and key individuals to perform their work in a given jurisdiction to establish that risk and profits reside there. Travel disruption means that tax conclusions that rely on location planning to establish or refute a tax presence might need to be rethought.

Nothing in the OECD’s digitalization project explicitly refers to the need to modify international tax rules to reflect the consequences of global supply chain structures. But implicit in the assumption that companies show higher global profits on their financial statements than are properly being booked where the sales occur is that centrally booked profits should be allocated globally. If business activities and the resulting profits become more diffuse because of concerns about supply chain disruptions and recognition that the travel network is fragile, the need for a push to reallocate global profits might be mitigated.

The Weaknesses of BEPS

The OECD’s BEPS project was premised on the idea of perpetual economic growth and ever-growing profits generated by always profitable companies. Any discussion of how losses might be relevant in offsetting the profits that all countries wanted to be able to tax was muted in the discussion of how to prevent profit shifting across jurisdictions.

Because the BEPS recommendations proceeded from the assumption that companies would always be profitable, they focused on limiting the ability to realize the economic benefit of deductions. Action 4 is a good example: It recommended limiting the deductibility of interest expense based on earnings, the assumption being that many companies were incurring an improper amount of debt to take advantage of the associated tax benefits. Absent was any meaningful conversation about the procyclical nature of the recommendations and the possible real-world consequences of limiting interest deductibility when a severe economic downturn could result in almost all companies facing losses rather than producing taxable income. In that environment, the economic harm from being unable to recoup the costs of interest expense is multiplied.

Fiscal Policy for Downturns

In response to many of the same concerns that drove the BEPS recommendations, the United States enacted limitations on interest expense deductibility and anti-hybrid rules as part of its 2017 tax reform. In the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), Congress temporarily reversed some of the restrictions on the deductibility of interest expense. In hindsight, it was perhaps inevitable that the revenue raisers and anti-base-erosion measures enacted almost 10 years into a cycle of economic growth would be repealed as soon as economic hardship hit.

On March 21 the OECD outlined a series of tax measures countries could be taking in response to the pandemic, many of which are in the CARES Act. The list includes waiving or delaying payroll-related taxes; deferring or adjusting business income tax advance payments; and making loss carryforward provisions more generous, such as by turning carryforwards into carrybacks. Not on the list is the U.S. reprieve from restrictions on interest deductibility.

The U.S. reversal of the limitation on losses, combined with the OECD’s omission of that suggestion, highlights a fundamental weakness in the OECD’s tax policy focus over the past decade. Because policy was made based on the assumption that companies exist in a world where there are only profits and never losses, it didn’t fully consider the imbalance between the taxation of profits and the recognition of losses. It’s in a downturn that those imbalances become most apparent, when the cash flow implications of the timing differences between taxing profits and recognizing losses become most acute. The lack of attention to cyclical policy in good times has forced legislative bodies to respond with temporary measures that are unlikely to be well thought out and that leave interpretive questions in their wake.

Today’s environment should be a wake-up call to all OECD participants that any rules being drafted must take into account not just how best to tax profits, but how best to write tax policy to reflect the reality of economic cycles as well. Unfortunately, it’s easier to get countries aligned on divvying up companies’ excess profits than on who should bear the losses. The effort becomes even harder when losses are recognized across all jurisdictions.

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

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