Nations are racing to reach agreement by mid-2020 on reforming international corporate tax rules to address the digital economy and states need to monitor the effort, according to Karl Frieden of the Council On State Taxation.
In its May 2019 framework, the OECD proposed new international profit allocation rules and new economic nexus and digital presence concepts. It also drew on the Tax Cuts and Jobs Act’s global intangible low-taxed income and base erosion antiabuse tax provisions.
“The reason we need to pay a lot of attention is, some of it is stealing our stuff — economic nexus, market sourcing — although they’re not going as far as we do,” Frieden said December 16 at the New York University School of Professional Studies Institute on State and Local Taxation.
While the international community isn’t abandoning transfer pricing and permanent establishment, it will be setting those approaches aside for certain kinds of income, particularly for nonroutine returns, Frieden said. “They’re going to replace certain permanent establishment rules with economic nexus,” he said, adding that the U.S. Supreme Court’s decision in South Dakota v. Wayfair Inc. “is one of the driving impulses for that.”
“The states won’t react right away, but there is a huge and a very fast feedback mechanism now with the TCJA and Wayfair that’s playing out across the world, which will then affect what the states do,” Frieden said.
The thought in the international community is that the OECD’s original 2016 base erosion and profit-shifting project didn’t go far enough in addressing how to tax cross-border income, foreign-source income, and the digital economy, Frieden said. Then Congress in 2017 passed the TCJA, which dealt with some of the same cross-border and digital economy issues. The U.S. government moved away from worldwide taxation “in a very particular way” by taxing current domestic income and by shrinking the amount of foreign-source income taxed at the federal level to very particular categories — the GILTI and BEAT provisions, for example.
“That’s giving free license to a lot of countries to do something different,” Frieden said.
On the one hand, the TCJA attempted to isolate intangibles in “a sort of very rough justice way” with GILTI, Frieden said. But federal lawmakers also were trying to make a distinction between routine and nonroutine profits. Frieden said this is important because the OECD is also proposing a formula to distinguish between typical and nontypical profits.
“These concepts never matter that much if you’re just taxing profits,” Frieden said. “But when you break profits into two boxes, as is happening rapidly across the world right now, it gets very interesting.”
Most recently, the OECD on October 9 invited public input on the secretariat’s proposal for a unified approach under pillar 1, which Frieden said looks a bit like concepts from the world of state taxation.
“Pillar 1, if you want to think about it in a simple sense, is mostly about inbounds: How do we tax more inbounds that don’t have physical presence, or, do we need to use more market sourcing to get at and change some of the transfer pricing rules?” Frieden said.
The OECD is proposing more market sourcing with prescribed percentages, he said. Though nations haven’t yet agreed to the prescribed percentages, they’re not favoring single-factor sourcing, as is the trend in the states, Frieden said.
“It’s really interesting — more like a three-factor approach,” Frieden said, adding that the OECD would retain certain production factors. He also wondered whether states should reconsider three-factor sourcing if the rest of the world adopts the approach. At the same time, Frieden said that while the global tax community is moving toward formalizing certain kinds of percentages for market sourcing, “they’re not at all going to worldwide combined reporting or formulary apportionment.”
Frieden said the OECD’s pillar 2 looks more like the TCJA’s GILTI and BEAT proposals, and that it is about how nations address their own companies that they want to tax more, whether that be through some minimum tax on foreign-source income or by disallowing some deductions.
Then there are unilateral proposals like France’s digital tax, which Frieden said is basically a 3 percent gross receipts tax on mostly Silicon Valley types of companies. The momentum for such taxes is growing, with more nations expected to enact similar proposals in the next few months, he said. “Does that encourage other states to go the way Oregon just did?” he asked.
Frieden predicted that by this time next year, the OECD’s international tax reform will likely be the focus of entire panel discussions at state and local tax forums.