Paul L. Caron

Friday, September 2, 2022

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Harpaz's International Tax Reform — Challenges To Multilateral Cooperation

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews Assaf Harpaz (Drexel; Google Scholar), International Tax Reform: Challenges to Multilateral Cooperation, 44 U. Penn. J. Int’l L. __ (2022).

Mirit-eyal-cohenWith the digitalization transformation of the economy where commerce has been occurring mainly online, and most functions become automated, concerns for cross-border taxation of multinational corporations became the focus of international tax discussions. The digital platform allows greater mobility of large multinational enterprises (MNEs) to shift profits more easily to low-tax jurisdictions or avoid paying tax altogether in market jurisdictions. It is estimated that corporate tax avoidance amounts to between $100 to $240 billion in annual costs, equal to 4% to 10% of global corporate income tax revenues. The OECD has had a central role in designing international tax norms. In mid-2021, while implementing the BEPS agreements, the OECD began working with an Inclusive Framework of over 140 countries that includes non-OECD members on a major reform to profit-shifting rules governing cross-border taxation of multinationals. Indeed, this reform marks a crucial juncture in international tax history and cross-border taxation.

The OECD solution has two pillars: Pillar One addresses the tax challenges of digitalization, detailing new nexus and profit allocation rules. For example, the proposed rules redistribute taxing rights from residence (where most digitalized MNEs are incorporated) to source jurisdictions (where most MNEs ultimately have sales). The manner to achieve this principle will be via a new taxing right for market jurisdictions termed “Amount A”. Amount A will apply on top of the pre-existing Permanent Establishment principle and will apply to companies subject to MNEs with global revenues exceeding €20 billion and profitability (before tax) exceeding 10% of revenues. This new nexus indicates that a market jurisdiction qualifies for the Amount A allocation when the MNE derives at least €1 million of revenue from that jurisdiction. For smaller jurisdictions with GDPs lower than €40 billion the nexus threshold is €250,000. In order to accurately distinguish the appropriate market jurisdiction and associated revenue while limiting compliance burdens, Amount A will be allocated to market jurisdictions based on a transaction-by-transaction basis including location-specific services, advertising services, and online intermediation services. Pillar One also incorporates a mandatory conflict resolution mechanism to prevent and resolve disputes over Amount A and avoid double taxation. In addition, it sets forth a transfer pricing rule relating to an additional tax – Amount B – which would apply the arm’s length pricing standard in a simplified manner for in-country baseline marketing and distribution functions to cover distributors that buy from related parties and resell to unrelated parties and have a routine distributor functionality profile. It is anticipated that this rule will tax at least 100 MNEs, half are headquartered in the U.S. representing the majority of the share of global profits and market value of in-scope companies.

Pillar Two of the OECD proposal consists of a rule called the “Global anti-Base Erosion Rules” as a floor for tax competition. It sets forth a 15% global minimum corporate income tax rate for foreign-earned income for MNEs and their subsidiaries with annual revenues exceeding €750 million in at least two of the four preceding fiscal years. An Undertaxed Payment Rule denies deductions to a parent entity when the low-tax income of the constituent entity is not subject to the minimum tax. Such rule denies the deduction by assigning the top-up, minimum tax of up to 15% on a parent in a high-tax jurisdiction making a payment to a low-taxed subsidiary in hope of preventing base erosion through intra-group payments. In addition, Pillar Two creates a treaty-based Subject to Tax Rule that permits source jurisdictions to levy limited source taxation of 9% on certain related- party payments below the minimum rate. 

This OECD solution has been described as the most extensive reform to international tax rules in the past several decades. It is estimated that Pillar one will generate $125 billion and Pillar Two at least $150 billion in new global tax revenues every year. Yet, there are many obstacles in the way to implementing such cross-border tax reform. In this Article, the Author points to such challenges that will need to be addressed when implementing the OECD reform proposal.

First, the OECD’s outputs will need to be adopted into the domestic laws of approximately 140 Inclusive Framework jurisdictions that have committed to the agreements, which embodies inherent political and administrative challenges. Accordingly, there will be immense multilateral cooperation necessary to reallocate taxing rights and limit profit shifting, which the Author doubts may be accomplished. For example, the Author points out that adopting the OECD’s outputs into domestic laws will conflict with some existing regimes that already address the tax challenges of digitalization such as the Digital Services Taxes (currently in effect in France, the U.K., and Austria and 40 other jurisdictions), which are flat taxes levied on gross revenues from taxable digital services earned by large MNEs in rates usually ranging from 2% to 7%.

Moreover, the Author focuses on the fact that the entity that negotiated the OECD proposal (“soft law”) is not the legislative branch that is the ultimate authority to domestically incorporate those concessions (“hard law”). To approve a treaty, the U.S. Senate vote needs a two-thirds affirmative vote of Senators present. Thus, political shifts and transitions in domestic administrations could contest soft law commitments. For example, the Trump administration strongly opposed increasing tax burdens on MNEs or upholding carbon reduction and climate change agreements thus such measures were put on hold during his administration. Nevertheless, these challenges exist in international law or any polity by which the administrative agencies execute policies and negotiate on behalf of the legislative body. The latter, a collection of representatives, has inevitable disagreements in implanting domestic policies. These challenges are not unique to the OECD agreement, the international tax environment, or the legislative process at large.

Likewise, the Author claims that the OECD proposal is a political compromise rather than a principled approach to tax policy, which lowers the reform’s likelihood of achieving long term compliance. He points out that the non-binding status of the OECD’s outputs can lead to a phenomenon of “mock compliance” by which countries adopt the form but not the substance of the OECD’s agreements to avoid incurring heavy costs by full compliance. In trying to deal with this, the OECD require countries to advance tax transparency in tax affairs. Indeed, Pillar One entails that all parties withdraw unilateral digital services taxes (DSTs) from their domestic legislation and commit to refraining from imposing such measures in the future.

But such requirement, the Author argues, infringes on tax sovereignty (the right to tax or not to tax), limits tax competition, and undermine the economic interests of developing countries, which create even larger obstacles to the reform’s success. For instance, the benefits and interests of the U.S. as a residence country where MNEs have sales are quite different from other lower-tax jurisdictions. Infringement on sovereignty exist also because refusing to commit to the OECD’s outputs leaves administrations in diplomatic isolation and their tax administrations in legislative disarray. Political pressures have urged countries to join the Inclusive Framework commitment – requiring tax sovereignty concessions – without meaningful economic benefit. These circumstances were evident for investment hubs such as Ireland, Hungary, Barbados, and Saint Vincent and the Grenadines who did not immediately join the OECD agreement. But having investment hubs on-board the new international tax framework, even at the expense of their economic interests, is vital for the success of the reform. Concessions driven from a fear of exclusion and political retaliation, rather than genuine acceptance of the new rules, the Author contests, are not an indication for international tax reform success.

Lastly, the Author scrutinizes the lack of meaningful involvement of developing countries in the negotiations and policymaking process and calls for the Inclusive Framework to genuinely be inclusive. Developing countries should be involved not only in the diplomatic endorsement stage of the policymaking process, but in the critical areas of negotiation and idea development. Equal participation ought to enable all participants, including poorer countries, to effectively promote the interests of their citizens in negotiations on matters that impact them. He argues that the reform creates winners and losers and developing countries may not be content to cooperate against their economic interests as developing countries have considerably lower per-capita national incomes than developed countries.

The Author concludes (without any normative suggestion) with an observation that these challenges are difficult to resolve because many are inherent to the OECD’s structure and wider international policymaking practices. The OECD is not designed to promote inter-nation equity or secure the tax sovereignty of all countries. Nevertheless, one way to achieving better international cooperation—not only in the diplomatic endorsement phase, but also in policy design—could be allowing countries in the Inclusive Framework voting rights during early stages of the discussion. These voting opportunities will allow Inclusive Framework members more active participation and to not be bound to weigh the interest of economic gain and public popularity against the benefits of multilateral cooperation and political compromise within the OECD’s framework. 

Here's the rest of this week's SSRN Tax Roundup:

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