Menu
Tax Notes logo

Resetting Expectations for a Digital Deal Under the Biden Administration

Posted on Feb. 1, 2021

With a new administration, hope is building that a U.S. government that’s more open to multilateralism will take the lead to reach a global agreement on taxing the digital economy. That optimism is supported by Treasury Secretary Janet Yellen’s Senate testimony indicating strong support for U.S. multilateral economic engagement and an OECD-led deal.

But that’s not to say it’s a done deal. At the January 27 meeting of the OECD inclusive framework, Harvard economics professor Jason Furman, who served as a senior official in the Obama administration, tried to temper expectations, saying other countries shouldn’t expect “a 180-degree shift” in the U.S. stance on digital negotiations from the Biden administration. (Related coverage: Tax Notes Int’l, Feb. 1, 2021, p. 646.)

Further, the notion that all that’s needed to reach a deal is — as French Finance Minister Bruno Le Maire has said — for President Biden and Yellen to “give their agreement to the taxation of the digital giants” reflects a misunderstanding of the mechanics of the U.S. government.

The same hurdles that faced both the Obama and Trump administrations (and led the first to take a tough stance in digital negotiations) remain: the unlikelihood — regardless of approval from the executive branch — that Congress will enact the measures or that the Senate will ratify the treaties needed to effectuate any deal. A lack of unified corporate support also makes it harder to get legislative approval (even though Congress has displayed rare bipartisanship in its opposition to attempts to tax U.S. digital companies). Add to that a looming challenge that seems largely unrecognized — whether any multilateral agreement would bind China or provide it with more opportunities to use multilateralism to its own advantage — and you have a much more complex picture than the post-inauguration anticipation paints.

The project’s objective is also unclear. Is it to ensure that the United States agrees to a deal for the sake of reaching an agreement — even one that has little chance of being implemented by Congress — perhaps to allow other countries to declare political victory or ensure the validity of the OECD’s continued role in global economics? Or is the goal a real modification of international tax rules to reflect 21st-century ways of doing business? This discussion assumes the second.

Congress: The Linchpin for a Deal

Unlike in a parliamentary system, the U.S. government operates on the principle of separation of powers, meaning that regardless of what the executive branch negotiates, Congress must pass any measures necessary to implement a multilateral tax agreement by either a majority or two-thirds vote.

As drafted, the OECD’s proposals for taxing the digital economy would require congressional action on several fronts. (Prior analysis: Tax Notes Federal, Dec. 2, 2019, p. 1407.) They face major roadblocks by infringing on two fiercely guarded congressional powers: the House’s taxwriting power and the Senate’s treaty ratification power. Further, Congress’s makeup, with a slim Democratic majority in the House and a 50-50 split in the Senate, will make any legislation — especially tax legislation — difficult to enact.

Pillar 1

Even if the Biden administration agreed to a deal on pillar 1 that expands market-based taxing rights, Congress would have to approve U.S. adoption (changes to rules regarding U.S. source, taxing effectively connected income, and determining a U.S. trade or business would all be required). If Congress failed to act, other countries could still tax U.S. resident taxpayers’ profits. But because the proposal involves a coordinated mechanism for allocating residual profits, including multiple country panels and information exchange, it would be difficult to implement without U.S. participation.

The pillar 1 proposal also would require changes to treaty definitions of permanent establishment and business profits, which would require two-thirds approval by the Senate. It’s hard to overstate the challenges involved in getting a level of approval on an agreement that would also seem to require Congress to cede some of its powers. Further, attempting to assert new taxing rights based on an OECD agreement when the Senate hasn’t agreed to modify existing treaties could mean countries have committed treaty violations. Much of the profits being reallocated under pillar 1 are probably from countries other than the United States. However, that situation could prompt U.S. companies to repatriate intellectual property to ensure themselves of U.S. treaty protection — a costly proposition for the U.S. fisc, because those transactions would generate (creditable) foreign taxes.

Pillar 2

Unless pillar 2 classifies the global intangible low-taxed income regime as compliant, Congress would have to modify sections 951A, 960, and 250 accordingly. The difficulty in making those changes is illustrated by the lack of movement on technical corrections to the Tax Cuts and Jobs Act proposed over two years ago and the wide split between Democrats and Republicans on what changes to GILTI might be needed. While progressive Democrats and the Biden campaign have advocated expanding U.S. taxing rights on U.S. multinationals’ foreign earnings, Republican lawmakers have flatly rejected changes to the TCJA.

Congressional Analysis

Speaking at a January 12 event hosted by the National Foreign Trade Council, Elizabeth Bell, House Ways and Means Committee senior staff, described Congress’s likely analysis for considering whether to support the type of multilateral agreement proposed by the OECD. She said the first question is the revenue impact: In a pandemic environment in which funds are key, congressional approval of a revenue-losing measure would be a tough sell.

A second consideration is what the United States stands to gain. Lawmakers are unlikely to support a measure unless it’s viewed as helping the country. That doesn’t necessarily mean a revenue raiser, but it does mean that any agreement must demonstrate positive benefits for, if not the fisc, then businesses, citizens, or trade. A proposal targeted at extracting more taxes primarily from U.S. companies probably wouldn’t be characterized that way.

Finally, members are likely to ask if the pain of the agreement is worth the gain.

Framing the questions like that helps shift the focus from the idea that all that’s needed to reach a deal is to extract concessions from the Biden administration to what type of agreement has a chance of being implemented.

Revenue Impact

When the OECD released the latest versions of its digital blueprints in October 2020, it also released an economic impact assessment (unfortunately based on data that predated the TCJA and many countries’ implementing recommendations of the base erosion and profit-shifting project).

The assessment concludes that the two pillars could increase countries’ corporate annual income tax revenues by $50 billion to $80 billion total, although most of those gains would come primarily from pillar 2. It says that under pillar 1, approximately $100 billion of profit could be reallocated to market jurisdictions, which would benefit low-, middle-, and high-income economies and harm investment hubs. Pillar 2 would mostly affect multinationals with low-taxed profits, which the OECD has said would reduce differences in effective tax rates across jurisdictions.

The OECD impact assessment includes no per-country results. Given the relatively small amounts to be reallocated, the proposal might not significantly harm the U.S. fisc. But there’s also no immediate U.S. revenue gain being highlighted at this point. And if, as predicted, pillar 2 prompts other countries to raise their tax rates, that would reduce U.S. revenue in the form of increased foreign tax credits offsets.

Does It Benefit the United States?

The countries that most strongly support the project see as a clear objective their increased taxing rights over the profits of U.S. digital companies. If that increases the foreign taxes of U.S. companies, and those taxes are creditable in the United States, the project probably doesn’t benefit the United States.

The best argument for how the deal can benefit the United States is that without it, the costs for U.S. companies to invest in and do business overseas will rise. That’s a difficult argument to rest a congressional case on, given that it’s based on a hypothetical that assumes that countries with digital services taxes would withdraw them in the event of a deal and that more countries would adopt them in the face of strong U.S. opposition and increased costs to their consumers.

Another potential disadvantage is the increased cost of investment. The impact assessment notes that the proposals would lead to a relatively small increase in multinationals’ average investment costs, with an ensuing very small negative effect on global investment expected to fall predominantly on highly profitable multinationals in digitalized and intangible-intensive sectors and those engaging in profit shifting. In a pandemic environment, an international agreement that results in increasing, albeit possibly small, investment costs for U.S. companies is likely to face fierce opposition in Congress.

In response to questions from the Senate Finance Committee, Yellen emphasized as a project benefit the prevention of a race to the bottom in corporate tax rates. But the OECD proposal doesn’t bind other countries to adopt the rules, and an expansion of U.S. taxation on foreign earnings (as proposed by Biden and other Democratic lawmakers) while other countries reject that approach would leave the United States alone and on top. That’s not in the United States’ best interests.

Is the Pain Worth the Gain?

The impact assessment argues that the proposals are needed because absent a consensus-based solution, unilateral tax measures will proliferate, and tax and trade disputes will increase. The OECD says that will undermine tax certainty and investment and result in additional compliance and administrative costs, which could lead to a reduction in global GDP of more than 1 percent.

But in determining whether the good outweighs the bad, Congress will need to consider that the proposals don’t provide any binding commitment or timeline for the withdrawal of active DSTs or any clear measures to guarantee an increase in tax certainty.

Other Considerations

While they’ve received little attention, several additional factors are likely to be on Congress’s radar or played as part of the Biden administration’s negotiating hand.

China

The biggest economic and foreign policy concern uniting Congress is the threat China poses to U.S. economic dominance and national security. In her Senate hearing, Yellen called China the country’s “most strategic competitor” and noted the need to take on its “abusive, unfair, and illegal practices.” Nobody disagreed.

Others, including former U.S. Trade Representative Robert Lighthizer, have said that China’s admission to the WTO allowed it to take advantage of the opening of the global trading system without fully adopting global rules, to the disadvantage of the United States and other developed countries. Mark Wu of Harvard Law School, a member of Biden’s trade transition team, has argued that reforms are needed for the WTO to adapt to meet what he calls the “China, Inc.” challenge (“China’s Rise and the Growing Doubts Over Trade Multilateralism,” in Trade War: The Clash of Economic Systems Endangering Global Prosperity (2019)).

China has made no secret of its opposition to the proposals. The China International Tax Center/International Fiscal Association China branch said the OECD “aims too high” — especially pillar 2. It called the minimum tax proposal more like “a hypocrisy,” arguing for “serious carve-outs.”

Remarkably, despite the growing recognition that China continues to benefit from a multilateral system that’s not enforced against its state-run economy the way it is against market-based economies, countries still seem determined to enter into another multilateral agreement that China has no intention of adhering to and would be unenforceable against it.

Business Concerns

Tax legislation is hard enough to enact even with unified business support; without it, it’s next to impossible. Consider two recent examples: the TCJA and the 2016 House Republican proposal for a destination-based cash flow tax. The first, which included a large reduction in the corporate tax rate and other major tax benefits for passthrough businesses, faced such serious obstacles to passage that it had to be pushed through without providing even Treasury officials a chance to review it until just weeks before enactment. The second, despite having wide support from public policy economists and many businesses, was eviscerated by just a few companies.

Rather than being unified in their support for the current OECD proposals, U.S. businesses are fiercely divided, as seen in the widely varying levels of support in their comment letters.

Proposed FTC Regs

Unilateral DSTs aren’t the only concern for U.S. companies. Proposed rules (REG-101657-20) that would severely curtail U.S. multinationals’ ability to credit foreign taxes paid target the broadened nexus rules that are part of DSTs but are much wider in scope. If the regs are finalized as is, taxes imposed under pillar 1 wouldn’t be creditable in the United States.

A cynic may ask whether the Biden Treasury’s approach might be to agree to a deal so adverse to U.S. companies that, when combined with more restrictive FTC rules, it would force them to band together to ask Congress to support an OECD agreement and enact a U.S. version of the rules. However, that kind of approach could backfire spectacularly, as seen when the Clinton administration tried to respond to the tax planning opportunities in the new check-the-box regs via Notice 98-5, 1998-1 C.B. 334, and Notice 98-11, 1998-1 C.B. 433. It ended up being forced to withdraw those notices amid strong business opposition, which led to Congress threatening a legislative response.

Democracy

In positing itself as rulemaker — and in some cases, judge — for the reallocation of multinationals’ global profits, the OECD appears to strip some democratic processes from local legislatures in a way that would likely be unpalatable to U.S. lawmakers. Belgian legal and economic advisers Tiberghien commented that the proposals “may have a disproportionate impact on the democratic decision-making process and the OECD risks putting itself in the place of legislators.” The group also mentioned the need to avoid creating a “second and competing (arbitrary) international tax system.” (Prior analysis: Tax Notes Federal, Dec. 7, 2020, p. 1557.)

Realistic Principles for a Digital Deal

So then, what would a deal that might be passed by Congress (including any necessary treaty ratification) entail? It would involve considerable revisions to the current proposals and need to be based on the following principles:

  • clear gains for the United States in the form of increased U.S.-source-based taxation on the residual profits of foreign-headquartered multinationals;

  • simpler, lasting principles — that is, based on something other than arbitrary descriptions of business models or revenue thresholds;

  • flexibility for governments to modify rules as needed, rather than inserting the OECD as global rulemaker;

  • specific timelines for repealing DSTs and clear penalties for failure to comply;

  • strong measures to prevent arbitrary and extraterritorial audit assessment and a way to enforce them (such as mandatory binding dispute resolution); and

  • binding commitments on China, coupled with clear measures to address a lack of compliance.

Successful U.S. leadership in multilateral engagement also requires ensuring that negotiations aren’t taking place in two international organizations simultaneously, with countries agreeing to one position in one forum while advocating for a contrary position elsewhere. An OECD-based multilateral solution for taxing the digital economy won’t effectively prevent the spread of DSTs if, for example, a majority of the 25-member U.N. Tax Committee (in which the United States has no role) agrees to add to the U.N. model treaty a provision blessing them.

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.

Copy RID