This article originally appeared in the May 17, 2021, issue of Tax Notes International.
]We’re not in the midst of a global war — traditionally one of the greatest drivers of tax innovation — but some recent rhetoric surrounding international tax reform has adopted a bit of that flavor.
In the heady, early days of the OECD’s base erosion and profit-shifting 2.0 project, the constant message streaming from the OECD’s Paris headquarters was that the world needs tax certainty and tax stability. That is still true, but as we march closer to the OECD’s anticipated October deadline, the tone has shifted. Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, has his mind on something a bit more intangible. “People need peace — tax peace,” he recently said at a University of Oxford Saïd Business School virtual tax conference. Similarly, IMF Managing Director Kristalina Georgieva believes the international corporate tax system has become “dark and distorted.”
“But we have a special opportunity this year to bring the light of simplicity and fairness to it,” Georgieva said at the beginning of May. “We must rise to the occasion.”
So how do we emerge from these seemingly darker ages of tax? In the absence of war, are the stresses of the COVID-19 pandemic and climate change enough to drive innovative tax policymaking? The IMF thinks so, and it has a book full of ideas on how that can be done, with a special emphasis on policymaking for low-income countries.
The book, Corporate Income Taxes Under Pressure, is a follow-up to the IMF’s 2019 policy paper “Corporate Taxation in the Global Economy” and goes into far greater detail than that paper’s 90 pages allowed.
The book was prepared before the COVID-19 pandemic, so its recommendations cannot be closely examined through that lens. But the IMF sought to present a broad assessment of the international tax landscape and offer some alternative frameworks.
Where does the IMF see things heading? Increasingly toward destination-based taxation, although it believes it’s too early for a destination-based cash flow tax or formulary apportionment with a sales factor. In the meantime, the institution believes that we will continue to see greater adoption of consumption taxes at the expense of corporate and labor taxes, because they achieve similar effects and are already well used.
Getting a Handle on Harmful Tax Competition
The million-dollar question: When is one jurisdiction’s tax competition another’s tax burden? The OECD sought to address the harmful aspects of tax competition through its first BEPS project and now its second. But the IMF believes tax competition is likely to grow based on three recent trends. It’s worth noting here that the IMF refers to tax competition generally; it doesn’t draw a line separating “harmful” from “normal” competition.
Technology is a key driver because goods and services can increasingly be produced in jurisdictions distinct from those in which target consumers reside. “As a result, the tax base that is internationally mobile will increase and, with it, governments’ returns to offering preferential terms,” the book says.
On the other hand, the IMF thinks that some of the multilateral efforts addressing harmful tax regimes and the corresponding shrinking of tailored tax incentives could cause governments to lower their general tax rates in a bid to draw investment. The IMF doesn’t go into specifics here, and it’s a bit too early to assess how the COVID-19 pandemic will play into this.
The IMF also believes that multinational investment decisions will become more sensitive to taxation as multilateral antiavoidance measures reduce business’ abilities to shift profits without making corresponding adjustments in their real production decisions.
The book’s answers to these three challenges are strengthening source-based taxation by expanding the definition of source income, strengthening profit allocation, and harnessing minimum taxes and regional cooperation to reduce tax competition.
Over the past few years, taxing authorities have been focusing more attention on the permanent establishment concept as governments grapple with the challenges of taxing multinationals in the increasingly digitalized economy. Diverted profits taxes come to mind. The IMF says there are more ways to broaden the scope — it writes that a broader PE concept could strengthen source-based taxation and could be achieved in both simple and ambitious ways. On the more incremental side of the scale, countries could reduce the number of PE exclusions they grant, or they could shorten the time period for recognizing construction- or project-based PEs. Relying on service PEs, which are included in the U.N. model tax convention, is another option.
Deploying monetary thresholds as a backstop is another possibility. This involves subjecting nonresidents to taxation if their annual turnover in the source country exceeds a specific amount, according to the book. Another option is employing the “force of attraction” principle under article 7.1 of the U.N. model convention, which dictates that when a foreign entity establishes a PE in a source country, the country can tax all profits earned there by the entity, regardless of whether those profits are tied to the PE.
The book’s set of solutions leads with source-based issues because tax competition is inherently tied to source-based taxation. Therefore, efforts to blunt it must target the interdependency of domestic tax rules. Residence-based tax rules are to be considered, particularly minimum taxes on outbound investments like the U.S. global intangible low-taxed income provision. The IMF notes outbound minimum taxes could be the most effective solution to strengthen residence-based taxation, particularly if they are coordinated multilaterally. Regional cooperation is floated as another solution.
On the profit allocation side, the IMF notes that mechanical or formulaic approaches, including safe harbors or residual profit allocation mechanisms, might be better suited to fit the needs of developing countries. Additionally, restrictions on the deductibility of expenses can strengthen the allocation of profits.
To Arm’s Length or Not to Arm’s Length . . .
We already know that if BEPS 2.0 is successful, the arm’s-length principle is not disappearing any time soon because the project partially relies on it. While the IMF’s book is critical of the arm’s-length principle and its usefulness for low-income countries, it proposes some workarounds for countries that have difficulty accessing data needed for transfer pricing evaluations. For example, instead of attempting to estimate arm’s-length prices, taxing authorities could allocate profits via formulary apportionment methods — an issue the book explores in depth — although a full move to formulary methods is not the only option. Relying on transaction-level profit splits, which could include remuneration of routine functions with some split of residual profits, are another option, according to the book.
The Legal Perspective
Although we are in an era of creative international tax policymaking, these ideas can only go so far if they’re not legally feasible. The IMF rated the feasibility of five different policy options, most of which have a moderate chance of adoption. Those options are as follows:
a strengthened nexus requirement to include a significant economic presence without the need for a physical presence or PE (as currently defined);
a residence-based minimum tax on outbound investment (like GILTI), combined with a residence-based minimum tax on inbound investment (modified base erosion and antiabuse tax) (essentially the OECD’s pillar 2);
unitary taxation with formulary apportionment (combined formula);
residual profit split, with sales factor (essentially the OECD’s pillar 1); and
a destination-based cash flow tax, with an exclusion for location-specific rents.
Feasibility is ultimately based on how well the proposal could coexist with international tax norms. The IMF thinks there’s a medium likelihood that countries will continue to expand their significant economic presence concepts, which we are already seeing in countries like Nigeria and India as they introduce ways to tax the digital economy. As for a pillar-2-style proposal, the IMF sees a high-medium likelihood of adoption, particularly because countries can adopt residence-based minimum taxes unilaterally. Unitary taxation with formulary apportionment received a medium-low rating based on the reality that it would create new norms that countries would be slow to adopt. On the other hand, pillar 1 received a medium rating given that the proposal exists within tax norms. At the bottom of the group is a destination-based cash flow tax, which has a low chance of adoption based on potential trade concerns, according to the book.
Looking Beyond BEPS
Parallel to the BEPS 2.0 process, the EU has been reevaluating its code of conduct on business taxation and its standards for transparency, preferential tax regimes, and noncooperative third-party jurisdictions. The IMF believes BEPS and the EU process are important, but not critical for developing countries because those countries first need to address foundational tax issues and strengthen their domestic legal frameworks. Additional measures they may contemplate should be rules-based and focus on distortions and double taxation risks. Essentially, inbound minimum taxes should get priority, according to the book.
“Low-income countries have a sovereign right to implement a well-designed inbound minimum tax measure and should be cautious about agreeing — whether bilaterally or multilaterally — to constrain their ability to enforce that right, including by agreeing to allow another country’s outbound measure to apply in priority to their own inbound measure,” the book says.
But there are a few design principles that low-income countries should keep in mind. The first is that measures should be residence-based, in keeping with existing treaties. The second is that any assessment should be on amounts that are already subject to minimum effective taxation in the hands of the recipient, and any taxpayer seeking an exemption should bear the burden of proving that it has already paid an adequate amount of tax.
“This design feature will better mitigate against the risk of double taxation and more specifically target asymmetric related-party arrangements (deduction for payment in the low-income country, without corresponding taxation of the payment in the hands of the related recipient),” the book notes. Lastly, they should be nondiscriminatory.
Another issue the book flags is the taxation of location-specific rents. Although low-income countries are well versed in designing taxes for the extractives sector, the IMF suggests they should target location-specific rents more broadly to cover income from rents linked to other national assets, including licenses to exploit public goods like electricity, gas, or other utilities, and telecommunications and broadcast spectrum and networks. Given the reality that low-income countries typically are not home to large multinational companies, they need to ensure that they keep “substantial” taxing rights over their natural resources, especially because there’s quite a bit at stake. Location-specific rents are an attractive tax base because in principle they can be taxed without distorting investor behavior.
The Pandemic Effect
In its April 2021 Fiscal Monitor, the IMF was clear that if governments are serious about using the pandemic to expand their public services and strengthen their redistributive policies, those efforts will require “substantial” increases in tax capacity and more efficient public spending.
What is at stake? A lot, according to the IMF’s calculations. Strong post-pandemic economic growth could cumulatively yield more than $1 trillion in additional tax revenues in advanced economies by 2025.
The IMF’s potential path to get there is both sensible and ambitious. It focuses heavily on revenue collection and intertwining that collection with well-coordinated tax policy goals. Some examples include:
pairing well-designed VAT with timely refunds;
increasing property tax capacity;
gradually expanding corporate and personal income tax bases chiefly by eliminating tax exemptions; and
efficiently taxing extractive industries.
On the more ambitious side, the IMF suggests developed countries closely consider increasing their reliance on inheritance and gift taxes and increase the progressivity of their income tax regimes. Hearkening back to wartime rhetoric, the COVID-19 pandemic recovery contributions and “excess” corporate profits taxes are also options. At the bottom of the list are wealth taxes, which the IMF says should be considered if the above measures are insufficient.
All told, the IMF offers numerous recommendations that envisage a world in which taxing authorities incrementally push the needle toward larger reforms. The hope is to create a sustainable international tax overhaul in the coming decades.