U.S. tax reform bills passed by the House (the Tax Cuts and Jobs Act (H.R. 1)) on November 15 and Senate take a uniquely U.S. approach to combating base erosion and profit shifting by U.S. multinationals. The legislation proposes the most dramatic changes to U.S. international tax rules since those rules were first enacted. For the most part, the bills offer a solution that will give the United States — rather than the many other countries that thought they would profit from BEPS — the first cut at taxing the profits of both U.S.-headquartered companies, and foreign companies operating in the country.
If the OECD’s BEPS project was about ensuring that profits are reported where the economic activities that generate them are carried out and where value is created, the House and Senate bills indicate that U.S. legislators believe that the proper location for that is the United States. A review of the BEPS action items illustrates how the bills propose to address each of the identified problems, providing Treasury with the ability to capture revenue associated with profit-shifting activities. The House and the Senate appear to have taken a page from the U.K. corporate tax playbook, adopting a mantra often repeated by the previous Conservative government: Enact the most competitive system possible to attract businesses, but protect the tax base by ensuring that companies that do business in the country pay all the tax that is owed.
Action 1: The Digital Economy
The problem of taxing corporate profits generated by the digital economy was a primary impetus for the BEPS project. However, the OECD was unable to come up with recommendations within the BEPS action plan time frame, and two years later — as demonstrated at the most recent public consultation on the topic — appears no closer to doing so. (Prior coverage: Tax Notes Int’l, Nov. 6, 2017, p. 531.) It now expects to issue a draft report to the G-20 in April.
Much of the driving force behind action 1 came from European and other countries’ attempts to make sure U.S. tech behemoths — such as Apple, Google, Facebook, and Amazon — pay more tax within their jurisdictions. As a result of the failure of BEPS to produce a solution, some European countries, led by France, have been pushing for a gross receipts tax on tech firm profits. European leaders’ frustration at their inability to collect more taxes from U.S. tech firms is also reflected in the state aid cases brought by the European Commission against member states’ issuance of tax rulings to multinationals.
The U.S. reform proposals — especially the Senate bill — have turned the tables on this effort. Both the Senate and House bills include variations on a foreign minimum tax, which would ensure that U.S. tech firms’ foreign earnings are taxed at a minimum rate. The Senate bill includes a provision that can be viewed as the U.S. version of a patent box — a lower U.S. tax rate on intangible income earned from foreign sources. European efforts may have backfired: If U.S. tax reform works as intended, U.S. companies may retrench by moving not just their profits to the United States, but their intellectual property as well.
Action 2: Hybrids
The BEPS action 2 recommendations are designed to “neutralize” the tax effects of hybrid mismatch arrangements that “exploit differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to achieve double nontaxation.” Few countries have adopted the hybrid recommendations, the U.K. being one notable exception. The EU has also proposed anti-hybrid recommendations in its anti-tax-avoidance directives. While the House bill contains no specific hybrid proposals, the Senate bill contains two separate anti-hybrid rules. The first would disallow a U.S. shareholder the benefits of the participation exemption for any “hybrid” dividend, defined as an amount for which the dividends received deduction would otherwise be allowed if the payer receives a deduction (or other tax benefit) from taxes imposed in the foreign country.
The second would deny a deduction for related-party payments of interest or royalties paid or accrued in accordance with a hybrid transaction or by, or to, a hybrid entity. It defines a hybrid transaction as a payment for which there is no corresponding inclusion to the related party, or the related party is allowed a deduction for that amount under the country’s tax law. This rule essentially adopts the primary rule of BEPS action 2.
While the Senate bill is designed to prevent the use of hybrid instruments or entities that could reduce the U.S. tax base, it has less of an impact on foreign-to-foreign hybrid planning, the type of U.S. multinational planning that many countries blame on the U.S. check-the-box rule. Both the House and Senate bills would leave check-the-box rules in place.
Action 3: CFC Rules
The United States pushed hard for the OECD to recommend stronger controlled foreign corporation rules in action 3, an effort mostly rejected by other countries (although the EU anti-tax-avoidance directive includes a requirement for EU member countries to adopt CFC rules). The House and Senate bills leave intact the subpart F regime, but strengthen it through adoption of a foreign minimum tax, albeit in different ways. The bills would in some cases tighten the definition of a U.S. shareholder and eliminate the requirement that corporations qualify as a CFC for a 30-day period during a tax year in order for the U.S. shareholder to have a subpart F inclusion.
Action 4: Interest Expense
Action 4 attempted to develop recommendations to prevent base erosion through the use of interest expense. The action 4 report recommended a fixed ratio rule that would limit to a percentage of its earnings before interest, taxes, depreciation, and amortization, an entity’s net deductions for interest and payments economically equivalent to interest. It also recommended a group ratio rule that would allow an entity with net interest expense above the fixed ratio to deduct interest up to the level of the net interest/EBITDA ratio of its worldwide group. Both the House and the Senate go beyond this, adopting a limitation on interest expense that would essentially allow interest expense deductions only when both requirements have been met: a fixed ratio of interest to taxable income for the entity claiming the deduction, and another limitation that would disallow interest expense in excess of a proportionate share of the group’s worldwide interest expense ratio to EBITDA (or debt to equity, in the Senate version). This could increase the tax bills of large European multinationals that have reduced their U.S. taxable income through leverage.
Action 5: Harmful Tax Practices
Action 5 represented a continuation of the OECD’s prior work on shutting down harmful tax regimes, and was mostly limited to developing new substance rules for patent boxes. These special regimes impose a beneficial tax rate on income derived from intellectual property, but are generally described by economists and policymakers as a poor means of incentivizing the research and development that they are supposedly designed to encourage.
The Senate bill offers a variation on the patent box. It includes a provision that would allow U.S. companies to deduct a percentage of the sum of their foreign-derived intangible income plus the amount of global intangible low-taxed includable income. Foreign-derived intangible income is income above a fixed return on tangible assets, derived from the sale of products or the provision of services to a foreign person. The U.S. variation on the patent box doesn’t specifically incorporate the BEPS action 5 substantial nexus requirement.
Action 6: Treaty Abuse
Action 6 recommends that as a BEPS minimum standard, all countries include language in their treaties ensuring that the treaties are not used for tax avoidance. Most countries plan to adopt this minimum standard by including a principal purpose test in their treaties. The U.S. has rejected that approach, instead preferring to rely on its more technical limitation on benefits provisions to prevent treaty shopping.
The tax bills for the most part do not contain any specific measures related to tax treaties. But by adopting strict computational anti-base-erosion provisions, including the foreign minimum tax, both the House and the Senate indicate the United States’ continued preference for bright-line rather than intent-based antiabuse rules to combat multinationals’ cross-border planning.
Action 7: PE Definition
Many countries participating in the BEPS project insisted on broader permanent establishment rules that could provide them greater leeway to find that nonresidents had a taxable presence in their jurisdictions. They complained that multinationals operating within their jurisdictions had taken advantage of PE definitions to generate large sales without giving rise to large profits, while establishing contractual arrangements that artificially avoided triggering PE status. Broader rules for PEs are therefore included as part of action 7.
The United States has refused to commit to the looser standard, which has also received only limited acceptance among countries signing the multilateral instrument. (Prior analysis: Tax Notes Int’l, June 19, 2017, p. 1029.) The House and Senate bills don’t attempt to broaden the definition of a U.S. trade or business, instead focusing on making sure that the U.S. Treasury can capture sufficient tax on nonresidents’ U.S. business activity.
Actions 8-10: Transfer Pricing
The attempt to fix transfer pricing rules was a large part of the BEPS project. However, no one has been satisfied with either the final BEPS report’s arm’s-length standard, or the vague rules adopted in the revised guidelines that essentially provide tax administrations the leeway to recharacterize transactions they don’t like. Work in this area continues, particularly in attempts to determine PE profit attribution and the right way to use the profit-split method. The recent Paris public consultation demonstrates just how contentious these issues remain. (Prior coverage: Tax Notes Int’l, Nov. 13, 2017, p. 652.)
The U.S. Treasury has also been a victim of its inability to draft coherent transfer pricing rules, with the IRS in recent years consistently losing high-profile and costly transfer pricing cases.
The House and Senate bills don’t propose amendments to section 482, the statutory basis for the U.S. transfer pricing rules. But the Senate bill contains a proposal that is intended to address what it calls “recurring definitional and methodological issues that have arisen in controversies in transfers of intangible property for purposes of sections 367(d) and 482.” This rule would codify a controversial regulation (T.D. 9803) issued in 2016 that is intended to help the IRS claim a larger taxable base upon the outbound transfer of intangibles. It also gives the IRS commissioner the authority to specify the method used to determine the value of intangible property, both for outbound restructurings of U.S. operations and for intercompany pricing allocations.
More broadly, both the House and Senate bills contain a mechanism to address systemic transfer pricing base erosion from deductible payments made by U.S. companies. The House uses the blunt tool of a 20 percent gross basis excise tax on all deductible payments. The Senate has a more targeted approach, with a special tax intended to ensure that U.S. companies with relatively large amounts of deductible payments to foreign related parties pay a minimum tax on their U.S. profits derived from U.S. sales. Both the House and the Senate proposals depart from the OECD approach that requires tax administrators to perform complex analyses of control of risk allocated among affiliated group members. In fact, other countries may prefer the U.S. approach over the OECD’s administratively burdensome recommendations in the revised transfer pricing guidelines. (For an explanation of the administrative advantages of the Senate proposal, see Itai Grinberg, “The BEAT Is a Pragmatic and Geopolitically Savvy Inbound Base Erosion Rule” (Nov. 2017).)
Both proposals have stirred controversy, and it may be that final legislation includes neither version. But the proposals still provide an indication of where U.S. legislators’ would like to head in addressing these concerns.
Action 11: Quantifying BEPS
In the BEPS action 11 final report, the OECD suggested that multinationals were avoiding between $100 billion and $240 billion in taxes through BEPS activities. The Joint Committee on Taxation’s scoring of the various measures proposed by the House and the Senate provide a point of comparison. The original scoring of the House proposal (JCX-54-17) for a gross basis excise tax on base-eroding payments alone was approximately $174 billion over the 10-year revenue window (later reduced when the provision was modified by amendment), while the Senate’s initial version of the base erosion minimum tax was scored at approximately $123 billion for the 10 year period. The total net revenue from the international tax reforms proposed by the Senate in the JCT’s November 9 scoring of the Chairman’s Mark (JCX-52-17) is $104 billion over 10 years, and that includes offsets from taxpayer-favorable provisions such as reduction of the corporate tax rate and the participation exemption.
Action 12: Mandatory Disclosure Rules
Action 12 outlined rules countries have adopted to require taxpayers to disclose certain types of tax planning structures, without recommending any specific approach. The EU has moved forward aggressively on action 12, proposing a directive (COM(2017) 335 final) that would require countries to mandate disclosure early and often. The United States has had disclosure regimes since the 1980s, and the House and Senate bills do little to change them.
Action 13: Transfer Pricing Documentation
In action 13, BEPS project participants agreed to a global template for multinationals to report country-specific information about income, employment, and taxes paid, and to exchange that information with other countries.
The Senate base erosion minimum tax would provide Treasury with the authority to impose new information reporting requirements on companies. Treasury could require taxpayers to provide the name, principal place of business, and country or countries in which a party related to the reporting corporation is organized or resident, including information on base erosion payments the taxpayer paid or that accrued to a related foreign entity during the tax year.
Action 14: Dispute Resolution
In action 14, the OECD was attempting to improve cross-border dispute resolution for a system widely acknowledged as broken. Despite a bill that proposes strong anti-base-erosion measures and aggressively asserts U.S. taxing rights over income associated with U.S. sales, Congress can do little on its own to improve the problems with the failed cross-border tax dispute resolution system. The treaty framework that provides the dispute mechanism relies on the good faith of countries’ competent authorities, or an enforcement mechanism such as mandatory binding arbitration (which many countries have rejected). Other countries’ tax administrations may continue to launch aggressive audits against U.S. multinationals, while the heavy-handed U.S. approach to taxing multinationals’ profits could make things worse.
But if the combination of carrots and sticks in the congressional tax bills works as intended — minimizing the incentives for U.S. multinationals to engage in aggressive tax planning abroad — there soon could be fewer reasons for other countries to try and assess additional taxes on U.S. company profits.
Action 15: Multilateral Instrument
A signing ceremony of the multilateral instrument hosted by the OECD in June demonstrated the willingness of BEPS-participating countries to revise their bilateral tax treaties to incorporate BEPS measures. (Prior coverage: Tax Notes Int’l, June 12, 2017, p. 933.) The multilateral instrument modifies, but does not amend, existing tax treaties. All signatories are required to commit to the BEPS mandatory standards. The multilateral instrument also includes optional treaty recommendations. In general, changes to a bilateral treaty are made only if both parties make the same choice for any particular clause and there are various ways to opt in and later make changes to ensure matching.
The United States has not signed the multilateral instrument, generally arguing that its treaties already meet BEPS minimum standards, especially when combined with U.S. anti-conduit rules. In 2016 the United States released a new version of its model treaty, confirming its long-standing position as a leader in ensuring that its treaties won’t be used for tax avoidance. Some of the newest changes to the U.S. model treaty include restricted withholding benefits on payments made to entities that benefit from special tax regimes, and denying some benefits for payments made from inverted companies.
The House and Senate bills incorporate some of the principles behind the changes to the U.S. model treaty. For example, they deny the availability of the participation exemption for payments made from inverted companies. If the bills are passed in largely their current forms, one can expect U.S. and OECD treaty policy to shift even more over time.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law and director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu
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