You can stumble across some interesting things on the internet. I recently encountered a Twitter thread related to the OECD’s pillar 1 proposal, which provided thoughtful insights that are worth sharing. The thread examined how pillar 1 would affect various nations in terms of net revenue gains or losses. That’s no trivial matter. The OECD project envisions billions of dollars in taxing rights being shifted among countries.
The OECD has produced its own estimates on the volume of global profits that would be eligible for reallocation to market jurisdictions. The objective here is to drill down further and gauge the revenue consequences for specific countries. Governments and taxpayers should know what they’re facing before political commitments are made.
French Minister of Finance Bruno Le Maire expects pillar 1 to raise between €500 million and €1 billion annually for France.1 U.S. Treasury Secretary Janet Yellen has claimed that pillar 1 will be largely revenue neutral for the United States.2 Most countries have generated their own internal projections of what to expect under pillar 1, but we typically know little about the computational methods.
The instigator behind this latest number-crunching exercise is Dan Neidle, a London-based tax attorney with Clifford Chance. Neidle describes the undertaking as a back-of-the-napkin analysis, which takes nothing away from its usefulness.3 He acknowledges that his findings should be taken with a grain of salt, because he’s forced to rely on various assumptions the most obvious of which is that the details of pillar 1 remain a work in progress.4
Given that the OECD itself doesn’t yet know what the final version of pillar 1 will look like, any studious attempt at quantitative analysis must include a bevy of caveats. So be it. The inherent imprecision of the exercise is no reason not to proceed. Ballpark estimates are better than none at all.
By way of reminder, under pillar 1 most countries will experience two opposing influences. The corporate tax base will expand to the extent the countries are positioned as market jurisdictions and acquire new taxing rights that were previously off-limits. That translates to more tax revenue coming into the national coffers.
At the same time, countries will see tax receipts decline to the extent other governments are able to claim new taxing rights over profits that were previously another country’s exclusive domain. This reduction assumes that governments will allow some kind of credit corresponding to the resulting foreign tax payments. As discussed later, the availability of those credits might not be as straightforward as we think. But let’s not get ahead of ourselves. The balance between these opposing influences will determine whether a country emerges from pillar 1 as a winner or a loser.5 Neidle addresses the effects of pillar 2 in a separate thread.
Neidle’s initial objective was to estimate how his country, the United Kingdom, would fare under pillar 1. He later expanded the analysis to other countries. His calculations suggest a modest uptick in U.K. tax revenue when pillar 1 is viewed in isolation. That gain, however, is entirely offset once we factor in the revenue not collected as result of the country’s digital services tax being repealed. This orientation correctly views the withdrawal of DSTs as an indispensable component of pillar 1 adoption.
As far as the United Kingdom’s outlook is concerned, pillar 1 results in a wash. That’s rather unsexy given our expectations of transformative change. Worry not. The thing that grabs your attention is the revenue estimate for the United States.
Data Set and Methods
The process begins with the Forbes Global 2000 index, which ranks the world’s largest publicly traded companies according to a mixture of assets, profits, sales, and market value. Forbes magazine has been producing the annual ranking since 2003. The list does not account for privately held corporations. Neidle used the available data set for 2019, which predates the economic downturn associated with the COVID-19 pandemic.
Neidle transferred the company-specific data into a spreadsheet, and then removed banks and extractive industries. The reason for omitting these firms is an assumption that they would be left outside the scope of the final version of pillar 1. Whether that proves accurate is unclear. As mentioned, making assumptions is unavoidable. Banks and financial service companies account for about half of the top 20 entries on the Forbes global ranking.6
The exclusion for extractive industries and banks does not come out of nowhere. Both sectors were outside the scope of the original OECD proposal, which was guided by subjective considerations and focused on so-called consumer-facing businesses and firms providing automated digital services. The U.S. Treasury pushed back against that aspect of the OECD blueprint — wisely in my opinion — by favoring a comprehensive scoping principle that will be guided by objective considerations.7
After the banks and extractives have been removed, the Forbes index still leaves many companies in the data set; more than the U.S. Treasury regards as optimal. Washington’s preference is that the scope of pillar 1 be limited to the 100 largest worldwide companies, with sectoral carveouts eliminated to the greatest extent possible.
The OECD blueprint limits pillar 1 through a worldwide gross revenue threshold, which could range anywhere between €750 million and €5 billion. That narrows the reach of pillar 1 to between 620 and 2,300 companies. Considering the wide disparity in the number of taxpayers that could be affected, use of the Forbes index does not seem out of bounds, at least until all scoping issues and the gross revenue threshold have been ironed out.
Next, Neidle filtered out those firms with profit margins under 10 percent, which the OECD favors as a preliminary step in determining the quantum of profits subject to reallocation. This is a loose proxy for removing routine profits from the pillar 1 allocation, leaving only residual profits. Using the Forbes data set, the profit-margin cutoff produces a figure of $835 billion, which can be viewed as an approximation of in-scope aggregate profits.
This calculation ignores segmentation of intrafirm activities, which certainly leaves out a lot of residual profits. For example, Amazon may have a companywide profit margin well under the 10 percent standard. (My colleague Marty Sullivan has estimated Amazon’s profit margin for 2017 to be in the vicinity of 2 percent.8) However, the company’s lucrative web services division is thought to have a much higher profit margin, which could easily be in scope for purposes of pillar 1 if the company were segmented into component pieces. The same observation could be made for many large multinational corporations.
While business line segmentation is more inclusive if you’re seeking the full picture of residual profits, it represents a major source of complexity that the OECD has wrestled with for some time.9 The U.S. Treasury wants segmentation eliminated, calling it the greatest source of complexity in the pillar 1 architecture.
As anticipated under the OECD blueprint, 20 percent of the in-scope profits would be up for grabs. The percentage is not set in stone. The blueprint provides a range of workable rates between 10 and 30 percent, making 20 percent a convenient median. Dividing the figure for in-scope aggregate profits ($835 billion) by 5, we get $167 billion. This corresponds to the concept of amount A, representing the quantum of profits eligible for reallocation to market jurisdictions using formulary methods.
The OECD blueprint has allocation of amount A based on a jurisdiction’s proportional share of a company’s sales, relative to worldwide sales. In lieu of making that calculation for every company in the Forbes data, Neidle chose to approximate country-level outcomes by making an assumption about each country’s share of global consumption. For that, he relied on the World Bank’s global index of private consumption expenditures.
According to the World Bank data, the United Kingdom accounts for 3.76 percent of global private consumption. We can use the 3.76 percent national consumption figure as a convenient plug-in for the sales factor apportionment ratio. Doing the math, 3.76 percent of amount A (estimated here as $167 billion) produces a profit allocation to the United Kingdom of $6.3 billion.
For any selected taxpayer, the percentage of U.K. sales relative to global sales may not be exactly 3.76 percent. However, the average percentage should converge toward the national consumption figure as more companies are drawn into the fold. For example, Apple’s U.K. sales as a percentage of its global sales might be nowhere close to 3.76 percent, but as you evaluate a larger pool of companies the percentage is likely to mirror the ratio of national consumption to global consumption.
The next step is to translate the estimated amount A allocation for the United Kingdom ($6.3 billion) into corporate tax receipts. Neidle does that by multiplying the figure by a presumptive tax rate (25 percent) and converting the product from U.S. dollars into U.K. pounds. Applying a currency conversion ratio of 0.71, that comes to about £1.12 billion.
Pillar 1 Giveth; Pillar 1 Taketh Away
That’s only half the picture. Our analysis must account for the fact that some portion of the current U.K. tax base will be shared with market jurisdictions. The fundamental principle of avoiding double taxation means that some adjustment must be made. That could take the form of the resident country allowing the taxpayer to claim a foreign tax credit. Alternately, affected taxpayers could be allowed to deduct their reallocated profit from their taxable income.
The latter approach more closely resembles an exclusion method of double-taxation relief, which is arguably more direct and more effective than the credit method.10 The rationale for excluding a company’s amount A from its taxable income (for domestic purposes) is that, by definition, it represents a slice of profits that will be devoured by other taxing jurisdictions through formulary apportionment, leaving nothing for the residence country. Where there are no overlapping jurisdictional claims over company profits — because of a harmonized system of sales factor apportionment — then the potential for double taxation of those profits is satisfactorily addressed.11
It’s not clear whether countries will allow a full credit for the resulting foreign tax payments under pillar 1. Regardless, Neidle proceeds under the assumption that U.K. tax law will allow a full credit. He concedes that it may prove to be overly generous to taxpayers and add a layer of imprecision to his calculations. To reflect full crediting, he extracts the corresponding allocable profits for U.K.-headquartered multinationals from the Forbes data set. This comes to $3.5 billion. Again, he multiplies it by a presumptive tax rate (25 percent) and converts the product from dollars to pounds. That results in an offset of £620 million.
Subtracting the costs of crediting from the preliminary revenue gain produces a net revenue enhancement of £495 million.
The final step is to deduct the revenue the United Kingdom would have collected under its DST, which is to be repealed in connection with other reforms. According to government estimates, the DST would draw in around £750 million per year.
Once the dust settles, the overall revenue impact of pillar 1 on the United Kingdom (net of DST repeal) would be a loss of £254 million. The calculations are summarized in Table 1.
I | Revenue Gain |
|
|
Total Pillar 1 Amount | $ | 167,160,900 | |
Attributable to U.K. (3.76%) | $ | 6,286,588 | |
Taxed at 25% | $ | 1,571,647 | |
Convert USD to GBP | £ | 1,115,869 | |
II | Less: Cost of Crediting |
|
|
U.K. Headquartered Pillar 1 Profit | $ | 3,493,580 | |
Taxed at 25% | $ | 873,395 | |
Convert USD to GBP | £ | 620,110 | |
Net Revenue Gain: | £ | 495,759 | |
III | Less: Repeal of DST | £ | 750,000 |
Overall Revenue Effect: | £ | (254,241) | |
Copyright 2021 Dan Neidle. All rights reserved; used with permission. | |||
Mindful of the U.S. Treasury’s comprehensive scoping proposal, Neidle repeats the analysis assuming pillar 1 is limited to the top 100 firms in the Forbes index. Predictably, the narrower scoping model resulted in lower estimates for in-scope profits, amount A allocations, and the cost of crediting. Because these figures decline by a comparable degree, the outcomes under comprehensive scoping differ only slightly when compared to the subjective scoping model. The U.K. estimates are £491 million (comprehensive scoping) compared to £495 million (subjective scoping). In the grand scheme of things, that’s a negligible difference.
The comparison underscores the idea that switching to comprehensive scoping reduces the sharing of corporate tax revenue by less than you’d expect. Accordingly, the primary reason to embrace comprehensive scoping is not that it somehow shrinks amount A and thereby short-changes market jurisdictions (which it doesn’t seem to do), but that it significantly simplifies the computational process for both taxpayers and governments.
The computations under a comprehensive scoping model are summarized in Table 2.
I | Revenue Gain |
|
|
Total Pillar 1 Amount | $ | 94,871,280 | |
Attributable to U.K. (3.76%) | $ | 3,567,919 | |
Taxed at 25% | $ | 891,980 | |
Convert USD to GBP | £ | 633,306 | |
II | Less: Cost of Crediting |
|
|
U.K. Headquartered Pillar 1 Profit | $ | 800,000 | |
Taxed at 25% | $ | 200,000 | |
Convert USD to GBP | £ | 142,000 | |
Net Revenue Gain: | £ | 491,306 | |
III | Less: Repeal of DST | £ | 750,000 |
Overall Revenue Effect: | £ | (258,694) | |
Copyright 2021 Dan Neidle. All rights reserved; used with permission. | |||
Allow me to suggest that it’s a mistake to focus on those estimates producing negative numbers. The better impression is to regard pillar 1 as a wash for the United Kingdom under either scoping approach. That makes sense given the many caveats that apply and that the numbers are small relative to the size of the U.K. economy.
Also, Neidle explains that his computational methods likely underestimate the revenue effects. As mentioned, he ignores segmentation, which tends to understate the pool of in-scope profits. He assumes full creditability, which tends to overstate the offset. He also excludes privately held corporations.12 Each of these factors could understate the revenue effect.
Even so, the implication is that pillar 1 is unlikely to result in dramatic change for the United Kingdom. Those who were expecting pillar 1 to serve as a major revenue boost might be disappointed. At a minimum, they should manage their expectations of what successful implementation would look like.
That does not mean the OECD project isn’t worth doing. At its core, the inclusive framework is about sharing taxing rights in a more equitable manner and promoting a more stable international tax regime. It’s also about discouraging unilateral countermeasures and the trade war that would almost certainly follow. Revenue swings are by no means irrelevant, but they’re not the fundamental reason why the world needs to consider global tax reform.
About Those Other Countries
Moving beyond the United Kingdom, Neidle applied the same analysis to about three dozen other countries, drawing from the same data sets and making the same assumptions about segmentation and creditability. The only difference in his methods is that he no longer adjusts for foregone DST revenue. To do otherwise would make it difficult to produce apples-to-apples comparisons, because not every country has a DST.
The results appear in the figure below, and you’ll notice that one country stands out. The United States receives a pillar 1 revenue increase of $12.6 billion, far more than any other country.13 That greatly exceeds the corresponding figures for China ($4.7 billion), Japan ($2.7 billion), India ($2.6 billion), and Germany ($2 billion). That magnitude of difference says something about the United States’ status as a dominant market economy.
However, the impressive revenue enhancement must be reduced by the cost of crediting. This is where the United States is a more remarkable outlier. The cost of crediting for the United States is estimated at $22.9 billion, resulting in a net revenue change of negative $10.3 billion.
By contrast, China’s cost of crediting is only $4.2 billion — which ranks as the next-highest figure within this category. For China, that results in pillar 1 being a moderate net revenue enhancement to the tune of just $420 million ($4.7 billion minus $4.2 billion). That’s a wash for practical purposes, as was the case with the United Kingdom. That places China in the same ballpark as most other countries in the survey, despite its massive population and hefty economic output.
If the analysis is correct, or anywhere close to it, the United States will be affected by pillar 1 to a much greater degree than other nations. That’s both as to the plus-side gains and the negative-side offsets.
The combined effect is not favorable to the public fisc. We’re looking at a net pillar 1 revenue loss of $10.3 billion per year. To review, that’s a revenue gain of $12.6 billion, coupled with an offset of $22.9 billion. Those figures are noticeably out of sync with other countries. For instance, the next biggest loser under pillar 1 is Switzerland, but it shows a net loss of only $772 million — which is a minute fraction of the corresponding U.S. figure.
Why should the U.S. estimates be so different than those of every other country, particularly the estimate for the cost of crediting? One plausible explanation is that the U.S. corporate community is disproportionately loaded with in-scope taxpayers, under both the subjective and comprehensive scoping models.14 Another explanation is that the U.S. corporate tax base is, in principle, disproportionately stuffed with the type of profits that are drawn into the pillar 1 reallocation principles.
Collectively speaking, corporate America is immersed in a sea of in-scope profits, such that any kind of sales factor apportionment scheme will result in a substantial amount of tax being payable to foreign governments. We can ponder why this might be the case. It’s likely the result of trends in business and international taxation that have been at play for generations. Perhaps it’s the lingering influence of the United States’ long-standing deferral/repatriation regime, which was only recently amended under the Tax Cuts and Jobs Act.
Decades of deferral have left a lasting influence on the corporate tax base. U.S. multinationals have, generally, been adept at escaping domestic taxation on their foreign profits. The TCJA may have made that more challenging but did not rewrite the fundamentals. That’s another reason why the estimated cost of crediting for the United States ($22.9 billion) could be overstated. The foreign profits in question might continue to avoid current taxation domestically, and thereby not factor into the foreign tax credit picture — although that outcome could change significantly if Treasury’s desired reform of the global intangible low-taxed income regime becomes a reality. In a real sense, what happens in regard to pillar 2 and the onset of global minimum taxes (including the GILTI regime) is bound to influence the revenue consequences of pillar 1.
What Yellen Said
It’s challenging to reconcile Neidle’s estimates with Yellen’s statement, noted above, that pillar 1 is largely revenue neutral from the U.S. perspective. That is, unless she has made a very different assumption about the creditability of foreign tax payments. Perhaps Yellen intended to say the envisioned OECD reforms would be revenue neutral once pillars 1 and 2 are combined. If that were the case, the pillar 2 global minimum tax will need to do some heavy lifting. According to these estimates, it would need to raise $10 billion per year just for the United States to break even.
In hindsight, this could explain former Treasury Secretary Steven Mnuchin’s preference for pillar 1 being optional for U.S. corporations. Looking at the figure below, if you had to guess which of the surveyed countries had a reason to opt out of pillar 1, there’s one obvious candidate.
My lasting impression is that number-crunching exercises of this variety are bound to raise questions about the political viability of pillar 1 when it eventually goes before Congress. If lawmakers were presented with the cost estimates shown in the figure, it’s understandable they’d want to be reminded why pillar 1 is a good idea for the United States. There might be a perfectly reasonable response, but it will require a thoughtful explanation.
FOOTNOTES
1 Stephanie Soong Johnston, “France May See Billions Under Global Tax Reform Deal, Le Maire Says,” Tax Notes Int’l, June 14, 2021, p. 1543. Le Maire’s projection of French revenue gains from pillar 1 would need to be adjusted downward by the offsetting revenue loss from repealing the country’s digital services tax, estimated at €400 million per year.
2 Johnston, “U.S. Pillar 1 Tax Pitch Is Largely Revenue Neutral, Yellen Says,” Tax Notes Int’l, June 14, 2021, p. 1559. Yellen made the claim in a June 4 letter, responding to a member of the Senate Finance Committee who had inquired about the costs associated with the OECD project.
3 The original thread can be accessed on Neidle’s Twitter account (@DanNeidle), posted on June 16, 2021, 8:40 a.m. (EST).
4 Johnston, “U.S. Offers Key to Unlock Scope Issue in Global Tax Reform Talks,” Tax Notes Int’l, Apr. 12, 2021, p. 148.
5 There’s another factor to consider when trying to label countries as winners or losers under pillar 1. As other commentators have made clear, the counter-factual to pillar 1 is not the status quo as we know it. Approximately 30 countries have either enacted DSTs or are planning to do so pending the outcome of the OECD inclusive framework process. Should the process fail, the number of countries with DSTs will increase. As a result, the realistic alternative to pillar 1 is a future that looks quite different to what we know today. For related analysis, see Michael J. Graetz, “A Major Simplification of the OECD’s Pillar 1 Proposal,” Tax Notes Int’l, Jan. 11, 2021, p. 199.
6 For 2020 the top 20 firms on the Forbes Global 2000 ranking are as follows: 1. Industrial and Commercial Bank of China (China); 2. JPMorgan Chase (United States); 3. Berkshire Hathaway (United States); 4. China Construction Bank (China); 5. Saudi Aramco (Saudi Arabia); 6. Apple (United States); 7. Bank of America (United States); 8. Ping An Insurance Group (China); 9. Agricultural Bank of China (China); 10. Amazon (United States); 11. Samsung (South Korea); 12. Toyota (Japan); 13. Alphabet (United States); 14. Bank of China (China); 15. Microsoft (United States); 16. Citigroup (United States); 17. Volkswagen (Germany); 18. Walmart (United States); 19. Wells Fargo (United States); and 20. Verizon (United States).
7 Robert Goulder, “Treasury’s Pillar 1 Reset: In Praise of Comprehensive Scoping,” Tax Notes Int’l, Apr. 26, 2021, p. 553.
8 Martin A. Sullivan, “OECD Pillar 1 ‘Amount A’ Shakes Up Worldwide Profit,” Tax Notes Int’l, Feb. 24, 2020, p. 849.
9 Johnston, “OECD Seeking to Simplify Segmentation Under Global Tax Overhaul,” Tax Notes Int’l, Nov. 9, 2020, p. 844.
10 See Graetz, supra note 5.
11 This observation about the mitigation of double taxation assumes every country is operating from the same playbook in terms of how the sales factor apportionment is coordinated globally. Sales factor apportionment would not eliminate overlapping jurisdictional tax rights in situations when governments deviate from the agreed script and develop their own apportionment rules. The inability to compel multilateral collaboration and consistency is the main reason why sales factor apportionment has proven elusive at the international level — just as it has proven problematic at the U.S. state level.
12 Privately held firms, as a category, might be more aggressive in their profit-seeking behavior than similarly situated public firms. The latter are generally more accountable to external stakeholders, such as institutional investors and nongovernmental organizations, and related notions of corporate social responsibility.
13 By way of explanation, the U.S. percentage of global private consumption is a whopping 29 percent, according to the World Bank data. That’s despite the United States accounting for only 5 percent of the global population. The calculations use a presumptive U.S. corporate tax rate of 26 percent (21 percent at the federal level and a weighted average of 5 percent reflecting subnational income taxes).
14 It should be emphasized that comprehensive scoping does not necessarily lead to fewer U.S. corporations dragged into pillar 1, proportionally speaking. Fewer U.S. firms would be affected, in raw numbers, because the pool is far narrower (that is, 100 firms under comprehensive scoping versus a number somewhere between 650 and 2,300 firms under the OECD’s preferred model of subjective scoping). According to a recent analysis by the Tax Foundation, U.S. companies would continue to account for the dominant share (72 percent) of in-scope profits under comprehensive scoping. Firms based in China account for 10 percent of in-scope profits, as would firms based in Europe. The remainder of countries (outside the United States, China, and Europe) account for just 8 percent of in-scope profits. See Daniel Bunn, “Treasury’s Latest Pillar 1 Proposal: A Strategy to Split the Riches or Give Away the Store?” Tax Foundation (Apr. 14, 2021).
END FOOTNOTES