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Is the OECD’s Project Salvageable?

Posted on Dec. 9, 2019

The United States has been proactive in the negotiations over the OECD’s project to address countries’ concerns about the international tax system, but the era of U.S. multilateral engagement in the tax sphere may be coming to an end.

Under pressure from the U.S. business community, Treasury’s efforts to engage with other countries in updating the international regime may be heading in the same direction as much of the rest of U.S. foreign and trade policy: away from multilateralism in favor of an isolationist and protectionist bent. On December 3 Treasury Secretary Steven Mnuchin sent a letter to the OECD secretary-general expressing fears about potential mandatory departures from the arm’s-length and taxable nexus standards. He said the United States believes that the goals of pillar 1 could be achieved by making the proposal a safe harbor regime — an idea that’s unlikely to be warmly received by other members of the inclusive framework. His letter provoked an urgent response from the OECD requesting that Mnuchin visit Paris before the end of the year. (Related coverage: p. 1664.)

But having successfully pressured their government to back away from the OECD’s pillar 1 work, will U.S. companies end up shooting themselves in the foot? Does the U.S. decision reflect nothing more than shortsighted attempts to protect quarterly earnings-per-share numbers at the expense of larger long-term U.S. interests, the U.S. role in the global economy, and U.S. growth and stability? Or was rejecting the OECD approach the only rational response to a process that seems likely to harm the financial statements of many U.S. corporations, as well as the U.S. fisc?

Some indication of how unilateral actions might play out in the tax field was revealed with the Office of the U.S. Trade Representative’s recent publication of the results of its section 301 investigation into France’s digital services tax. However the United States chooses to respond to the French DST, the outcome won’t be good for U.S. consumers or businesses. The consequences of France’s actions highlight how a U.S. pullout from the OECD process might produce harm far beyond what anyone could foresee. But given how the process was playing out, it’s still unclear whether there was a better choice.

Reallocating Global Profits

The first pillar of the OECD’s unified approach raises more concerns for U.S. multinationals and the U.S. government than does pillar 2 because it’s intended to reallocate a portion of multinationals’ profits from residence and source countries (where value-generating activities take place) to market and destination countries. (Prior analysis: Tax Notes Federal, Dec. 2, 2019, p. 1399.) Under any scenario, it seems virtually certain that the United States would bear a large cost of reallocation. U.S. businesses are among the world’s largest and most profitable, and the most successful sell their goods and services globally. In short, any attempt to reallocate a portion of U.S.-headquartered taxable profits to market countries might place the United States on the losing end.

However, the United States is also the world’s largest market (U.S. residents are excellent consumers), so one would think its coffers could benefit from a plan to reallocate a share of multinationals’ profits to market countries. But which countries would be on the losing end should profits be reallocated to the United States as a market jurisdiction is harder to determine: China, Canada, Mexico, Japan, and Germany produce more than half of U.S. imports, supplying more than $1.2 trillion in 2018. (None of those countries has been an enthusiastic supporter of pillar 1.)

One can get a sense of what goods the United States is importing, and from which countries, based on the list of largest U.S. importers (see Table 1). It’s unclear whether the profits from those types of tangible goods would be reallocated under the OECD’s suggested formulas.

Table 1. Largest U.S. Importers

Rank

Company

Sector

1

Walmart Inc.

Retail

2

Target Corp.

Retail

3

Home Depot Inc.

Retail

4

Lowe’s

Retail

5

Dole Food

Produce

6

Samsung America

Conglomerate

7

Family Dollar/Dollar Tree

Retail

8

LG Group

Conglomerate

9

Philips Electronics NA

Electronics

10

IKEA International

Retail

Source: Nick Routley, “Top U.S. Companies by Import and Export Volume,” Visual Capitalist, Mar. 12, 2019.

The top 10 U.S. exporting companies are notable in that none is the kind of company with excess profits that other countries are so fixated on; instead, the export market is dominated by recyclables, natural resources, and chemicals (see Table 2).

Table 2. Largest U.S. Exporters

Rank

Company

Sector

1

America Chung Nam

Paper/Recyclables

2

International Paper Co.

Paper/Packaging

3

Ralison International

Paper/Recyclables

4

Koch Industries Inc.

Conglomerate

5

International Forest Products

Paper/Forest Products

6

DeLong

Animal Feed/Grain

7

WM Recycle America

Diversified/Recyclables

8

Shintech

Chemicals

9

Louis Dreyfus

Cotton/Diversified

10

WestRock

Paper/Packaging

Source: Nick Routley, “Top U.S. Companies by Import and Export Volume,” Visual Capitalist, Mar. 12, 2019.

So far, the conversation has been mostly about large tech companies, but as many of the comments to the OECD pointed out, more and more companies can be properly characterized as “digitalized” — and the number will only continue to grow. The United States has been consistently opposed to a project limited to rewriting rules for a narrow segment of the economy.

U.S. Business Concerns

A public consultation on pillar 1 was held November 21-22 in Paris, and the written comments submitted in connection with it showcased many of the concerns U.S. companies have about the time-pressured efforts to rewrite international tax rules to allocate a greater share of corporate profits to market jurisdictions. Among the most thoughtful and reasoned was a letter from the Alliance for Competitive Taxation, an organization made up of more than 40 U.S. multinationals in a range of industries. Members include Johnson & Johnson and Procter & Gamble, which presented at the consultation and have been most proactive in advancing solutions to the problems the OECD is working to address. (Prior coverage: Tax Notes Int’l, Dec. 2, 2019, p. 838.)

The organization said its members have made three key recommendations to Mnuchin in connection with the OECD project: the importance of retaining the arm’s-length standard, the need for mandatory binding arbitration, and the repeal of other countries’ unilateral measures. It also noted that the OECD consultation document doesn’t seem to adhere to the principles the alliance finds important — principles previously articulated by the OECD as project goals. Specifically, the coalition said the OECD approach lacks a mechanism to prevent double taxation and a description of the procedures to prevent and effectively resolve disputes. It added that “there is serious reason to doubt that the Project will result in more stable and consistent international tax rules that, on balance, will reduce uncertainty, tax disputes, and compliance and administrative burdens.” Also — and of no less significance — it criticized the project’s timeline, calling it insufficient to work through the issues raised and reach broad agreement on a common approach.

The Business Roundtable said the pillar 1 proposal deviates from the key principles of the 1998 Ottawa Tax Framework — avoiding double taxation, taxing net business profits (as opposed to gross revenue), allocating profits among a controlled group based on the arm’s-length standard, and creating globally consistent fundamental income tax rules and effective dispute resolution mechanisms. It warned that failure to adhere to those principles would make it hard for multinationals to expand their overseas operations.

The United States Council for International Business, while confirming its support of the OECD’s efforts to reach agreement on a unified approach to international taxation, argued that the approach seems to lack a unifying tax policy rationale, that policy decisions are getting ahead of impact assessment, and that there’s too little attention on eliminating unilateral measures by inclusive framework members.

Other U.S. business groups, writing with more obvious self-interest, outlined why their industries should be carved out of the pillar 1 proposals. The American Petroleum Institute said it supports excluding the extractive industries from calculating the formulaic amounts (amounts A, B, and C), adding that it’s important that the source country be entitled to tax any profits derived from the extraction of natural resources. The American Chemistry Council supported narrowing pillar 1 to industries for which there’s a perception that the arm’s-length principle isn’t working, such as business models that are able to exploit markets without having a physical presence and that are highly digitalized. It also suggested that the OECD consider carving out business-to-business sales of tangible personal property.

Weighing Against a Global Deal

It’s hard to dismiss as unfounded the concerns of U.S. business groups. Countries haven’t provided assurances that they will revoke or withdraw their unilateral measures if an agreement is reached. In fact, proposals for unilateral measures to tax U.S. tech companies are proliferating, suggesting that other countries aren’t fully committing to the OECD process. And some members of the inclusive framework haven’t hesitated to declare their continued opposition to mandatory binding arbitration, citing sovereignty concerns. Those actions suggest that the fears of U.S. business groups are reasonable, and that the principles crucial to achieving consensus on a multilateral agreement won’t be adhered to. Why not simply withdraw now, rather than engage in a time-wasting exercise?

Just as important, unilateral action against U.S. tech companies sets France up as a new world leader. And a world in which France starts the trend for unilateral actions that extract more taxes from U.S. multinationals might reflect the image that French Prime Minister Emmanuel Macron apparently wishes to create for himself (“Emmanuel Macron Has Issued a Wake-Up Call to Europe,” Financial Times, Nov. 10, 2019: “Mr. Macron is making an art out of disruptive diplomacy.”).

In considering the rationale behind U.S. companies’ opposition to the pillar 1 proposals, one must also factor in the strong distrust businesses have for the OECD. Fostered in no small part by being scapegoated in the base erosion and profit-shifting project, U.S. companies likely correctly believe they’re better able to sway domestic lawmakers, rather than bureaucrats who answer primarily to an international organization directly responsible to no one.

Another significant factor weighing against U.S. participation in a global deal on pillar 1 is the Trump administration’s rejection of multilateralism generally and international organizations particularly. Rejecting U.S. multilateral efforts in the tax field is consistent with the overall tenor of current U.S. foreign and international economic policy, including condemnation of long-standing military alliances, withdrawal from international trade deals, and willingness to use tariffs as an economic and foreign policy lever. Why should international tax be any different? Viewed in that light, the fact that engagement in the global tax arena has continued for the past three years could be considered an aberration.

Possible Outcomes

But before completely withdrawing from multilateral negotiations over a rewrite of global tax rules, it’s worthwhile to consider all possible outcomes.

Collapse of Pillar 1

U.S. withdrawal from pillar 1 negotiations — or suggesting a counterproposal that sets the bar too high for many countries — could result in the collapse of multilateral efforts to date because it in effect also withdraws the OECD’s G-20 mandate to reach global consensus on new international tax rules, stripping the OECD of its basis for proceeding with the project.

What happens then? The OECD’s rationale for pillar 1 has been the threat of unilateral action — although DSTs adopted or proposed by a few aggressive countries on a handful of companies are unlikely to bring about the collapse of the international tax system. But should those taxes prove successful, why wouldn’t other countries follow? If more countries jump on that bandwagon, and there’s no way to alleviate double tax on gross revenues, that will probably seriously impede both the profits and operations of the companies subject to the measures. Increasing reluctance of U.S. companies to enter foreign markets is not an unlikely outcome.

Even more troubling, unilateral digital taxes are not truly unilateral. Instead — as is evident from the U.S. trade report on the French DST — they’re likely to lead to retaliatory action. As history, including trade negotiations with China, informs us, retaliatory tariffs generally breed more retaliatory actions, with generally unfavorable and sometimes ominous results. Once the genie is loosed, it’s hard to bottle up again.

No Deal/Maintaining the Status Quo

But consider another option, even if the pillar 1 work collapses. What if, either because of a reluctance to get involved in a trade spat with the United States, or because they don’t see the revenue intake being worth the cost, countries decide not to enact unilateral DSTs? Does that mean all is copacetic for U.S. multinationals? Not likely.

In explaining their reasons for fully engaging in OECD efforts to revise the taxation of the digitalized economy (a reversal of their more aggressive stance in the BEPS project), Treasury officials have emphasized tales of U.S. companies being subject to aggressive taxes on audit from foreign jurisdictions. Even without a law change to allocate more profits to market jurisdictions, some countries took matters into their own hands on audit, using lawless threats and innovative transfer pricing approaches to assess additional taxes on U.S. multinationals. In that kind of world, the U.S. treasury stands to lose because of the generous U.S. foreign tax credit, while U.S. companies would lose as a result of uncertainty and the expenses associated with competent authority procedures.

In other words, the status quo isn’t pretty. And it’s unlikely to improve — in fact, it’s more likely to deteriorate further — should current global efforts collapse.

Concerns over the status quo help explain why the United States and its companies have focused on the risk of double taxation and the need for better dispute resolution, two aspects of pillar 1 they’ve said are important but aren’t being adequately addressed. Without a real commitment by other countries to follow through on those obligations should consensus on an agreement be reached, the United States sees little benefit in supporting the OECD process.

Deal Proceeds Without the United States

But what if U.S. rejection of multilateral efforts didn’t prevent the work from continuing? Perhaps the Paris environmental agreement, agreed to and rallied around by more than 190 countries even after U.S. withdrawal, may provide a template (Nathan Hultman and Paul Bodnar, “Trump Tried to Kill the Paris Agreement, but the Effect Has Been the Opposite,” Brookings Institution (June 1, 2018)).

One could envision a similar scenario playing out in the multilateral tax sphere. Perhaps U.S. rejection of the OECD’s work on pillar 1 doesn’t keep other countries from forging a multilateral consensus on how to tax highly lucrative multinationals whose profits accrue through remote sales or services. There wouldn’t appear to be any downside for those countries in pursuing that path, and it could be that the agreed-on formulas would be more beneficial for developing countries with large markets than it would be if the United States remained involved. Overall, continued engagement in multilateral efforts could still benefit other countries, even without U.S. participation.

So, what happens if a multilateral agreement that allows other countries to more aggressively tax a larger share of the profits of U.S. multinationals is reached but the United States had no part in negotiating it? Several outcomes are possible, each more troubling than the last. One is for other countries to simply assert more taxing rights over the subsidiaries of U.S. multinationals. Ironically, U.S. companies might respond by unwinding their global supply chain or principal company structures and moving their intellectual property back to the United States to ensure protection under U.S. tax treaties.

Alternate routes involve other countries taxing U.S. companies in violation of tax treaties or terminating those treaties, either of which could spawn myriad and spiraling negative consequences. With treaty termination, withholding rates on investment into the United States would increase to 30 percent, making it prohibitively expensive, and willful disregard of existing treaties could spark harsh U.S. responses.

No Conclusion in Sight

U.S. multinationals and the U.S. government continue to have good reasons to be concerned about OECD efforts to rewrite international tax rules via pillar 1. The project has such an overly aggressive time frame that it’s unlikely to result in coherent rules. It also lacks a principled basis and will strip elected officials of some of their authority over how U.S. companies’ profits are taxed.

The U.S. reset of the pillar 1 negotiations makes it unclear whether the project has a future, and the alternatives to U.S. participation in the process are hardly better. A world in which the tax rules are rewritten in a way that discourages foreign investment and global trade and encourages unilateral actions and retaliatory measures doesn’t create an environment conducive to lasting prosperity.

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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