For an international tax junkie, the last six weeks have been a perplexing time: The U.S. Treasury Department threw a major wrench into the OECD’s most recent multilateral tax coordination project.
The project is the latest incarnation of the base erosion and profit-shifting initiative, known as BEPS version 2.0. BEPS 2.0 consists of two conceptual pillars that, if widely adopted, would fundamentally alter how the foreign profits of multinational enterprises are taxed. Pillar 1 — the more radical of the two — would give market jurisdictions a new and unique taxing right. Pillar 2 is a less controversial minimum tax on foreign profits.
The latest bombshell came in early December when Treasury announced its preference that pillar 1 be discretionary — that is, it would apply only if taxpayers opted in. It seems clear that very few firms would do that. Why permit your host countries to seize new taxing rights, even if it’s implied that any additional foreign taxes paid might be creditable against your existing tax bill at home? In substance, Treasury effectively nullified the bite of pillar 1 by pushing for an elective approach.
That was no accident. Treasury heard from its stakeholders and wanted pillar 1 to go away, even though that would likely encourage more countries to adopt unilateral digital service taxes targeting U.S. firms. The list of countries considering DSTs is steadily growing. France has enacted one, although it promised to repeal the measure (and return any DST payments) if the OECD reaches a global consensus under BEPS 2.0. Policymakers in Washington appear to be less scared of DSTs —which they believe can be adequately dealt with through assertive trade policy — than the bold new taxing rights in pillar 1.
Here’s a suggestion for our friends at the OECD: Roll with the punches. When fate hands you lemons, make lemonade.
Pragmatism suggests the OECD acquiesce: The United States (both the government and the business lobby) isn’t ready yet for Pillar 1. Perhaps that will change in a generation or two. For now, Treasury views it as too much too soon. And without the world’s largest economy on board, you can’t claim a genuine consensus.
But that doesn’t mean BEPS was all for naught. Consider the virtues of partial victory. The glass-half-empty crowd might assert that BEPS 2.0 failed to reach its full potential if the prevailing nexus and profit attribution concepts survive the battle. I say nonsense. And besides, those standards might not win the war. Aside from BEPS, the permanent establishment doctrine and arm’s-length transfer pricing rules continue to face pressure from within. All over the world we see resistance to the orthodoxy these concepts represent.
Call me an optimist for suggesting the glass is half full. The global proliferation of minimum taxes modeled after pillar 2 would be no small thing. If I could whisper in the OECD’s ear, I’d encourage it to place pillar 1 on indefinite hold and charge ahead on pillar 2 as a stand-alone endeavor. There’s no shame in incremental progress.
Pillar 1 was always a hard sell. Notably, the proposed changes to the nexus and profit allocation rules would not have applied to all corporations – only “consumer-facing businesses.” That’s a bizarre orientation few can grasp. It isn’t the same as business-to-consumer and business-to-business distinction. And pillar 1 wouldn’t reach the financial sector, the trade-in-commodities, or the extractive industries. That’s a lot of activity to exclude from what is ostensibly a new global norm, especially when it’s been clear from the start that ring-fencing an isolated segment of the global economy (namely, digital services) is frowned upon. Treasury has warned against ring-fencing the digital economy for the better part of a decade. If European governments can’t accept that as a ground rule, it only proves that a meeting of the minds was never in the cards.
One of the trends in international taxation over the last quarter-century has been the spread of territorial corporate regimes, which generally exclude foreign profits from the domestic tax base by virtue of a participation exemption. Few territorial regimes include a minimum tax as a backstop against outbound base erosion — but that could soon change. Minimum taxes are on the verge of going mainstream, and the OECD should be driving that bandwagon.
Businesses will need to adjust to the concept of a top-up tax, which would apply when the foreign profits (now sheltered by the participation exemption) are insufficiently taxed elsewhere. Minimum taxes make parking foreign earnings in low-tax jurisdictions less attractive. The top-up should guarantee some level of taxation determined by the chosen threshold rate. The last step of pillar 2’s build-out process will be settling on a recommended rate. The hesitation is strategic; the threshold rate will largely determine whether some countries are for or against pillar 2. Save that decision for the tail end of the project. Rumor has it that the threshold will be in the vicinity of Ireland’s corporate rate: 12.5 percent. Luck of the Irish, indeed.
Adding in a top-up doesn’t mean foreign income will be taxed at the same rate as domestic income. Expect each country’s threshold rate to be a fraction of its domestic corporate rate. The bias favoring foreign investment relative to domestic investment will not be eliminated by a minimum tax — it will just be less pronounced.
There’s a lot to like about the concept of a minimum tax. And even though it was very late to the game in adopting a territorial regime, the United States has been a trendsetter here. Not only did the Tax Cut and Jobs Act bring a participation exemption to the U.S. code, it also included a global minimum tax in the form of the global intangible low-taxed income regime.
The OECD still has plenty of work to do coordinating the minimum tax regimes popping up across its member states (and the 100-plus other countries that make up the inclusive framework on BEPS). For instance, should the minimum tax be calculated using a per-country or aggregate approach? The TCJA took the latter route, which is administratively easier but allows tax havens to remain relevant in cross-border tax planning. Aggregation means that MNEs could — and most certainly would — park income in tax havens to counterbalance the income generated in high-tax countries. Coordinating this critical detail of pillar 2 will be key for the OECD in the months ahead.
As for pillar 1, creating new taxing rights for market jurisdictions will probably need to wait a while. Give the concept another 10 years to percolate. Perhaps there’s a BEPS version 3.0 still to come. Changing the international consensus on taxing rights is a process, and it’s not a quick one. And so long as unilateral DSTs hang around — and they might remain part of the fiscal landscape for a long time — the pressure for additional reforms will only grow.
History loves grand political bargains, so here’s one to consider: Let Treasury have its way on pillar 1 and, in return, let the OECD proceed with pillar 2 premised on a per-country approach. Taxpayer-friendly jurisdictions like Ireland might go along with the deal as long as the OECD’s recommended minimum tax threshold rate doesn’t exceed 12.5 percent. Internationally, competitive pressures might lead countries to coalesce around that rate. That would be a de facto floor on the so-called race to the bottom — a race that strains countries’ fiscal well-being. Not everyone would be satisfied with that bargain, but wisdom has it that a successful negotiation occurs when each side gains something it wanted and gives up something it hoped to retain. Until then, I’ll keep praising half-victories and toasting half-full glasses.