Now that countries agree to explore several proposals to adapt global tax rules to the digital age, it just might be possible to achieve some kind of consensus, a top U.S Treasury official said.
Speaking January 29, Lafayette G. “Chip” Harter III, U.S. Treasury deputy assistant secretary for international tax affairs, discussed the publication of a new policy document, also released January 29, from the OECD inclusive framework on base erosion and profit shifting. The document, which set out a strategy to guide the focus of discussion in the hope of reaching consensus by 2020, comes shortly after the group met January 23-24.
Among the major countries involved in the discussions, “there is a desire for this to succeed,” Harter said, “I was encouraged by the pragmatism that I was seeing around the room.”
Harter, who appeared at a conference sponsored by the District of Columbia Bar Taxation Community and the Georgetown University Law Center, acknowledged that the process won’t be easy. “But I don’t see any other way forward,” Harter said. “There simply is no mechanism that offers the capabilities of the OECD to try to broker a new multilateral agreement on allocating taxing jurisdiction. I think there is some hope that we can push this through successfully.”
The 127 countries in the framework, which comprises OECD member and nonmember countries committed to implementing the BEPS project, agreed to evaluate proposals “without prejudice” under two broad pillars, one covering the allocation of taxing rights through changes to profit allocation and nexus rules and the other on anti-BEPS measures, according to the note.
The strategy is in line with the OECD action 1 report of the BEPS project and the interim report on tax challenges arising from digitalization, in which inclusive framework countries agreed to conduct a coherent and concurrent review of existing profit allocation rules and nexus.
On the table under the first pillar are proposals that would give market or user jurisdictions more taxing rights in cases when a business activity creates value via participation in those jurisdictions that doesn’t fit into existing allocation of profit rules, the note says.
The inclusive framework is aware of the implications that these proposals “may reach into fundamental aspects of the current international tax architecture,” with some of them calling for a reevaluation of transfer pricing rules related to non-routine returns, and others requiring changes that could extend beyond non-routine returns.
“In all cases, these proposals would lead to solutions that go beyond the arm’s-length principle,” the note says. “They also go beyond the limitations on taxing rights determined by reference to a physical presence generally accepted as another cornerstone of the current rules.”
Countries are rethinking nexus concepts, including amending the permanent establishment threshold, and are looking more closely at such concepts as “significant digital presence,” special treaty rules, and “significant economic presence,” an idea that was included in the BEPS action 1 report but was not recommended at the time.
The group acknowledged that the proposals may have ripple effects that will not just hit a handful of highly digital businesses but also companies involved with cross-border transactions, such as “those with marketing intangible profits but limited risk distribution structures in market jurisdictions.”
With the second pillar, inclusive framework members will consider taxing rights that would “strengthen the ability of jurisdictions to tax profits where the other jurisdiction with taxing rights applies a low effective rate of tax to those profits,” the document says. The options under discussion reflect such international tax developments as the U.S. Tax Cuts and Jobs Act, the note says.
“The proposal under this pillar would be designed to address the continued risk of profit shifting to entities subject to no or very low taxation through the development of two interrelated rules, i.e. an income inclusion rule and a tax on base-eroding payments,” the note says.
The second pillar echoed elements of an approach that Germany and France recently proposed, which calls for the adoption of an income inclusion rule that has been described as being similar to the global intangible low-taxed income provision in the TCJA, as well as an anti-base-erosion measure.
Both pillars aren’t mutually exclusive and appear to show convergence, according to Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration. Most notably, there seems to be a convergence between countries under pillar 1, he said. The fact that countries are open to considering proposals that go beyond the arm’s-length principle “is something which is quite strong and meaningful,” Saint-Amans told Tax Notes. That openness shows how serious countries are about changes to international tax rules, which may not be so surprising after the adoption of the TCJA, he added.
However, while some proposals may question the existing wisdom of the allocation of taxing rights, they may result in a kind of profit split or another method that may be considered a formulary method, but that only applies to residual profits, Saint-Amans said. “So it’s not trashing the arm’s-length principle — we need to be careful.”
Harter also expressed doubt that the arm’s-length standard would be abandoned. “At the end of the day, to the extent you get consensus, it will be around something that leaves the arm’s-length standard in place for the vast majority of circumstances, but you have certain guardrails,” he told reporters on the sidelines of the conference, adding he was quite confident that it “will not be a wholesale repudiation of the arm’s-length standard.”
The first pillar must be a “fairly narrow, simple formulaic result,” Harter said. Certainly, under the second pillar, the OECD hasn’t likely realized how complicated creating a minimum tax regime can be, he added.
“A minimum tax regime is a fairly discrete concept that I think people can understand a whole lot of technical work will have to go into figuring out how we do that on a multilateral basis . . . but as a political concept, it perhaps is something that can be sold in part of a consensus package,” Harter said at the conference.
The OECD will publish a consultation document with a more detailed description of the proposals in the coming weeks and hold a public consultation March 13-14 to help the inclusive framework develop a detailed program of work and pave the way for greater convergence among countries, according to Saint-Amans.
Harter offered a few hints about what the discussion materials will include, saying there was a “whole range of options on the table for discussion, from A to Z.”
“It’s pretty clear to me that as we work towards consensus, there is probably a very narrow range of options that have any hope of gaining a consensus,” Harter said. He also said that two proposals, one based on user contribution, favored by the United Kingdom, and a proposal involving unitary taxation with three-factor apportionment, put forward by India and other developing countries, were not likely to get broad agreement.
The inclusive framework’s steering group will present a detailed work program at the next inclusive framework meeting in May. The group will then report its progress to G-20 finance ministers when they meet in June in Fukuoka, Japan, further setting the stage to present a consensus-based solution in 2020, the note says.
A Unique Opportunity
Commentators spanning the international tax spectrum consider this a pivotal opportunity to reform the international tax system in a way that’s beneficial to a variety of stakeholders and economies. While a positive reception by nongovernmental organizations sometimes contrasts with the reactions from business, that divide doesn’t seem as obvious in this case.
The note represents progress and indicates that the inclusive framework is willing to have a constructive discussion to try to find a consensus solution, though “it obviously leaves us a long way from actually reaching consensus,” Jesse Eggert of KPMG LLP told Tax Notes. It does what it’s supposed to do, which is to reflect a political agreement among the inclusive framework that further work is going to be done and that in that future work, countries are going to be willing to consider options that go beyond the arm’s-length principle, according to Eggert.
The note’s comment under the first pillar that the proposals will lead to solutions going beyond the arm’s-length principle is striking, though it’s prefaced with the point that the discussions are conducted without prejudice, meaning countries aren’t committing to particular options upfront, Eggert said. He added that the comment is potentially concerning because the arm’s-length standard is the best way that’s been identified so far to allocate taxing rights in a way that doesn’t create double taxation, or at least too much double taxation. “It’s going to be a hard bit of work to find a comprehensive solution that eliminates double taxation in a new way,” he said.
Allison Christians, professor at McGill University in Montreal, said she didn’t agree with the OECD’s assumption that incorporating user value or other undervalued items into current pricing methods would “all” go beyond arm’s length. “The arm’s-length principle has evolved and it can evolve further,” she said, adding that she thinks the principle can accommodate more than some of the OECD membership may be prepared to accept.
“I interpret the framing of possible changes as if they overturn rather than interpret or evolve the standard as a means to forestall rather than foster the development of a serious proposal,” Christians said.
The policy note hints at potentially radical changes to the existing international standards regarding jurisdiction to tax and allocation of profits to a permanent establishment, or to an affiliate, under the transfer pricing guidelines, but makes clear the proposals will be explored on a “without prejudice” basis, “meaning that it could all come to nothing if the countries are unable to reach agreement,” said Jefferson VanderWolk at Squire Patton Boggs.
Asked whether the “without prejudice” qualifier is concerning, Eggert said the inclusive framework is facing an increasing number of countries enacting unilateral measures that tax gross income and aren’t coordinated terribly well with each other, leading to the potential for multiple taxation. The hope must be that if they have a constructive discussion and arrive at a solution that a large majority can live with, “they’ll be able to persuade the holdouts to go along for the sake of effectively preventing chaos,” he said.
Moving away from an arm’s-length standard and toward increasing allocation to market countries are things that NGOs have been advocating, but if the framework arrives at a solution that taxes net income, doesn’t result in double taxation, and is administrable and accompanied by effective dispute resolution, that’s about as good an outcome as businesses can expect, said Eggert. “The particular allocation among countries is not something that I would have thought was a big deal as long as there’s no double taxation,” he added.
The second pillar of the work, to stop the shifting of profits to low-tax jurisdictions, seems to be expanding the scope of the original BEPS project, which dealt with tax planning involving arbitrage of tax rules regarding character of both instruments and entities and timing, but explicitly did not deal with rate arbitrage, said VanderWolk. Now it appears that the countries do care about rate arbitrage, at least in certain circumstances, he said.
“What seems to have advanced the project since the interim report almost a year ago are the contributions made to the debate in the digital taxation policy paper from U.K. Treasury, the more recent Franco-German minimum tax proposal, and, of course, some of the international provisions of TCJA,” Rick Minor of Womble Bond Dickinson (U.S.) LLP told Tax Notes. He said that he was pleased to see references to those concepts in the note. The tax community might be concerned that the publication date for the consultation document hasn’t been fixed, considering that the date for the consultation has been set for March 13-14, he added.
“Finally there have been realignments, which open the way to the kind of reform we have consistently advocated, away from the arm’s-length principle and towards a more balanced and simplified system of allocation of income and taxes” of multinationals, Sol Picciotto of the BEPS Monitoring Group said in a message to that group’s members. In the past when the group has argued for a similar approach, “the response on the side of business and tax advisers was that we were being utopian,” Picciotto told Tax Notes.
There is now an opportunity to redesign international tax rules for the 21st century, and all international tax specialists have a responsibility to contribute constructively, Picciotto said. “We hope that business representatives will now give their full support to the new approach,” he said. Above all, the rules need to be clear and simple to apply, “to reduce the administrative costs for even the poorest countries,” Picciotto added.
The discussion of allocating taxing rights shouldn’t be limited to the digital economy, Tommaso Faccio of the Independent Commission for the Reform of International Corporate Taxation (ICRICT) said. “There is pressure from some developing countries, who have tabled a separate proposal, for a broader approach to shift taxing rights to market countries,” Faccio said. In a report released earlier in January, ICRICT advocated for formulary apportionment and said the BEPS project has failed to adequately address transfer pricing abuses.
Faccio said ICRICT is hoping for an agreement on a minimum tax on profits, which would deter developing countries from giving away tax incentives, mitigate tax competition, and “make current avoidance structures no longer cost effective.”
The inclusive framework and the OECD certainly have their work cut out for it, according to Saint-Amans. One major conundrum they face is how to strike a balance between the ongoing debate on long-term answers, which requires some deep thinking and reflection, and the political urgency of finding a solution, which can lead to unilateral action. “That’s one of our big challenges,” he added. “There are many questions and a lot of work ahead of us.”
Jennifer McLoughlin contributed to this article.