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Economic Analysis: Will GILTI Save U.S. Multinationals From GLOBE?

Posted on Dec. 23, 2019

When it comes to the OECD’s global anti-base-erosion (GLOBE) proposal, should U.S. multinationals have anything to fear? Treasury Secretary Steven Mnuchin has already demonstrated his willingness to protect U.S. interests regarding pillar 1 of the OECD’s second multiyear push to reduce base erosion and profit shifting.

The secretary’s December 3 letter informed the OECD secretary-general that the United States would not support any mandatory new nexus rules from market countries. Having pretty much put the kibosh on pillar 1 if that effort ventured anything more than a hair’s breadth away from the arm’s-length standard, making the case for insulating U.S. business from the GLOBE proposals under pillar 2 is an easy and natural next step. Perhaps another letter is in the works. (For a brief description of pillar 2 proposals, see the box.)

After all, since the passage of the Tax Cuts and Jobs Act, U.S. multinationals have been subject to U.S. tax on global intangible low-taxed income. In effect, GILTI rules impose tax on a U.S. multinational’s foreign-source income to the extent the minimum tax rate exceeds the multinational’s effective foreign tax rate. The first part of the OECD’s two-part GLOBE proposal is an income inclusion rule — that is, resident taxation on foreign-source income to the extent a minimum tax rate exceeds some measure of the multinational’s effective foreign tax rate.

Having invested two years of blood and sweat in the development of GILTI, why should Treasury and U.S. taxpayers adopt a new approach when, with GILTI, they already have a minimum tax that addresses the OECD objective of reducing the “risk of profit shifting to entities subject to no or very low taxation”? With their hands already full with the staggeringly complex GILTI rules, any additional requirements from the OECD would squarely contradict the one goal on which all parties seem to agree: simplification.

Not that Treasury needs any backup, but Congress provides a second line of defense for U.S. multinationals. Legislation would be required to reform and transform GILTI if any OECD-proposed minimum tax guidelines drifted away from current U.S. law. The inherent inertia of Congress, galvanized by gridlock, makes any change in tax law a heavy lift. Even a feel-good extenders bill is a big deal. The circumstances under which this Congress would be willing and able to upend the barely-settled new U.S. international tax system are hard to imagine. “The U.S. GILTI regime must be considered a GLOBE-compliant income inclusion rule,” insists the Business Roundtable. Good luck trying to get Congress to take its direction from technocrats in Paris over the objections of U.S. multinationals.

GLOBE Proposals as Described in the OECD’s May 2019 ‘Programme of Work for Addressing the Tax Challenges of the Digitalization of the Economy

“The [pillar 2 GLOBE proposal] seeks to address the remaining BEPS challenges through the development of two interrelated rules:

1. an income inclusion rule that would tax income of a foreign branch or a controlled entity if that income was subject to an effective rate [of source country tax] that is below the minimum rate; and

2. a tax on base eroding payments that would operate by way of a denial of a deduction or imposition of a source-based taxation (including withholding tax), together with any necessary changes to double tax treaties, for certain payments unless that payment was subject to tax [imposed by the recipient country] at or above the minimum rate.”

“Blending refers to the ability of taxpayers to mix high-tax and low-tax income to arrive at a blended rate of tax on income that is above the minimum rate.”

“Options and issues are expected to include . . . different options of blending . . . with particular focus on blending at the jurisdiction versus global level.”

Warning!

For the time being, with these hurdles in the way of any OECD-inspired modifications to GILTI, monitoring OECD developments on pillar 2 probably shouldn’t be a priority for hardworking U.S. practitioners. But keeping an eye on the horizon would be prudent. Here is one scenario that would command attention: With the threat of uncoordinated multiple layers of taxation hanging over their heads (that is, tax chaos), the U.S. government and U.S. multinationals might feel compelled to obtain an agreement that includes the elimination of all current, proposed, and future digital taxes.

To that end, concessions might be required. One concession could be (and yes, it is a long shot) agreeing to replace worldwide blending with jurisdictional blending. (Under U.S. GILTI rules, this would require compartmentalizing the GILTI foreign tax credit limitations into separate country-by-country subcategories.) Jurisdictional blending of any income inclusion rule has been a priority for Germany and France as well as developing countries.

A far simpler concession could be to raise the effective foreign tax rate that triggers U.S. tax on GILTI. As pointed out by the African Tax Administration Forum, developing countries tend to have high corporate tax rates, so to prevent significant profit shifting, a minimum tax should have as high a rate as possible. In the United States, that rate is already scheduled to rise from 13.125 percent to 16.4 percent in 2026. Perhaps that date could be moved up. And such a tax increase could be made more palatable by pairing it with statutory fixes to the expense allocation rules and other shortcomings in the 2017 drafting, such as the disregard of foreign taxes paid by loss corporations and the absence of foreign tax credit carryovers.

A second scenario that would make OECD developments more relevant to U.S. practitioners would be a reshuffling in the makeup of political power in the United States. All Democratic candidates for president have ambitious spending plans. Raising taxes on multinational corporations is a popular method of offsetting the cost of those plans, even with moderates, including front-runner former Vice President Joe Biden. To follow through on these plans would require not only one of them winning the White House but also Democrats taking control of the Senate. Far from likely, but not impossible.

Blending

The case for global blending is based almost entirely on the assertion that the most likely alternative, jurisdictional blending, would require the annual computation of taxes and income on a per-country basis. This quagmire of calculations would pose crushing burdens on tax departments and tax authorities. There is near unanimity on this point by the dozens upon dozens of commentators on the GLOBE proposal. (One exception worth noting, however, is that the German Federal Chamber of Tax Advisers — an organization that should be particularly sensitive to compliance — favors jurisdictional blending.)

The case for global blending is based on practicality, not principle. The problem with global blending that is too often swept under the rug is that, unlike jurisdictional blending, it allows businesses with average foreign tax rates that exceed the minimum tax rate to invest and to shift profit into zero- and low-tax jurisdictions with no tax penalty.

Example 1.1: Multinational XYZ has two foreign subsidiaries. One has $100 of profit taxed at 25 percent in Country A. The other has $100 of profit taxed at 15 percent in Country B. The home country of X imposes a minimum tax of 10 percent. Now suppose X considers shifting $100 of profit in Country A to Country C, a tax haven with no corporate tax. If the minimum tax has global blending, the $100 of shifted profit will incur no minimum tax. (The new average foreign rate of 10 percent is not below the minimum rate.) With jurisdictional blending, the $100 of shifted profit would incur home country minimum tax of $10.

Moreover, global blending can add distortions when none would otherwise exist.

Example 1.2: Multinational enterprises MNE1 and MNE2 reside in the same home country, have a large number of foreign subsidiaries, and are considering entering into the same line of business in Country D, which has a 5 percent tax rate. MNE1 has an average foreign tax rate of 15 percent, and MNE2 has an average foreign rate of 7.5 percent. If the home country has a pure territorial system, both companies would be subject to only the 5 percent Country D tax. If the home country has a 10 percent minimum tax with jurisdictional blending, both companies would be subject to a combined 10 percent rate (5 percent to Country D and 5 percent to the home country’s minimum tax). But if the home country’s minimum tax has global blending, MNE1 would have an unfair (and economically inefficient) tax advantage because it would not be subject to minimum tax, unlike its competitor MNE2.

Without keeping numerical examples like these in mind, it is easy to gloss over the important differences between jurisdictional and worldwide blending. Consider the following two sentences from a May 31 OECD press release:

The second pillar will explore the design of a system to ensure that multinational enterprises — in the digital economy and beyond — pay a minimum level of tax. This pillar would provide countries with a new tool to protect their tax base from profit shifting to low/no-tax jurisdictions.

The first sentence reflects the policy goal that no multinational should pay tax below a specific rate — a relatively modest goal achievable with global blending. The second sentence implies a more ambitious policy goal that no profits are shifted to havens for tax reasons. There is a big difference between the two. Economic efficiency is promoted when, as much as possible, taxes play no role in decisions about the location of real investment. This requires reducing the dispersion of tax rates. This is clearly achieved with jurisdictional blending because it puts a floor on marginal tax rates that matter in location decisions. Global blending also puts a floor on marginal tax rates but provides a major carveout. The size of the carveout depends on the extent the multinational’s average tax rate exceeds whatever minimum tax rate is set. A lower minimum tax rate means more multinationals can shift profit into tax havens.

Global blending creates distortions not only when a high-tax multinational invests in a low-tax country but also when a low-tax multinational invests in a high-tax country.

Example 1.3: Multinational MNC has foreign subsidiaries that generate $400 of profit and pays $30 of foreign taxes. Its average foreign tax rate is 7.5 percent. Its home country imposes a 10 percent minimum tax with global blending. MNC locates new operations in Country E that generate $50 of profit and pays 12.5 percent tax due on Country E’s 25 percent corporate tax. Before investing in Country E, MNC’s minimum tax was $10 (= (10% * $400) - $30). After investing in E, MNC’s minimum tax is zero (= (10% * $450) - $45). The combined marginal effect on foreign and domestic minimum tax on $50 of profit in Country E is $5 (a $15 increase in Country E tax and a $10 reduction in home country minimum tax). The marginal effective tax rate on investment is 10 percent (equal to the minimum tax rate). The 10 percent rate is a competitive advantage for MNC over businesses in Country E paying a 25 percent rate. (Note that in this situation, the host country collects full tax and the home country subsidizes foreign investment with a reduction in minimum tax.)

Compromise Is Efficient

If U.S. political muscle has not already slammed the door shut on jurisdictional blending, it seems more than a little worthwhile to see if there is some middle ground between global and jurisdictional blending. Can we achieve at least some of the economic benefits of the jurisdictional approach without the onerous complexity it would entail?

The answer seems to be yes. In his comment letter to the OECD, Joachim Englisch, professor of tax law at the University of Munster, included this gem of an idea:

The Inclusive Framework should consider . . . the creation of white lists of jurisdictions with respect to which no [effective tax rate] test is needed, because they do not normally accord a tax treatment leading to effective tax burdens below the minimum rate. . . . Especially if the minimum tax rate is set relatively low . . . not too many jurisdictions should be left with respect to which the minimum tax could still apply.

It isn’t too difficult to identify the jurisdictions that are tax havens. Just those relatively few countries would be included in minimum tax calculations. Of course, the outrage from them will be enormous. But with the international tax community nearly out of ideas, perhaps it’s time to ruffle some diplomatic feathers.

The OECD’s 1998 Ottawa Taxation Framework includes the principles (a) “taxpayers in similar situations carrying out similar transactions should be subject to similar levels of taxation,” and (b) “compliance costs for taxpayers and administrative costs for the tax authorities should be minimized as far as possible.” Unfortunately, in the case of income inclusion rules, there is a larger than normal trade-off between neutrality and simplicity. This implies a larger than normal benefit for seeking some middle ground. The compromise suggested by Englisch seems to strike a good balance.

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