In January French President François Hollande, attempting to deflect attention from revelations of his scandalous affair with a French actress, proposed a radical shift away from the tax policies of the leftist wing of his Socialist Party.
After pursuing a multiyear agenda of tax increases and, most recently, a special 50 percent payroll tax on salaries in excess of €1 million, Hollande on January 14 proposed a substantial reduction of French corporate taxes. (Prior coverage: Tax Notes Int'l, Jan. 27, 2014, p. 314.) Not wishing to be known as the leader of a country that is referred to as the "sick man of Europe," and hoping to remain employed, Hollande hit on corporate tax reduction as the way to jump-start the French economy.1
Hollande is certainly not the first head of state to turn to tax cuts and incentives to promote domestic fiscal growth, but the irony here is compounded when one looks at his policies to date and his election platform. His about-face serves as a lesson to the OECD as it seeks to encourage its member countries and nonmember countries in the G-20 to sign on to the base erosion and profit-shifting initiative, which could limit their ability to provide tax incentives to their own citizens and tax residents.
The push to lower corporate tax rates is often portrayed as a race to the bottom; however, for the countries that propose these initiatives, the policy rationale behind them is generally described as reaching for the top in terms of jobs, opportunity, and innovation. One country's proposals for economic growth may be another country's base erosion.
The BEPS initiative ultimately relies on its member (and nonmember) countries to join together in mutual self-interest; self-police and enact changes in their domestic tax laws and bilateral treaties; modify the rules of corporate taxation; and apportion multinational companies' global tax earnings in a more equitable manner, consistent with policies yet to be announced by the OECD. Yet why would countries that are committed to tax reductions, targeted tax incentives, and favorable tax regimes to attract and retain business sign on to a global initiative that would dictate how to account for a global company's income?
Harmful Tax Competition
A look back at the OECD's efforts to combat harmful tax competition, which began almost two decades ago, may provide a helpful guide for those wishing to wager on the BEPS program's likelihood of success.
In 1996 the OECD member countries decided to study the problem of tax competition and called on the organization "to develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases."2 This effort ultimately resulted in the OECD's release of its harmful tax competition project.
Part of the initiative's purpose was to address "[t]ax schemes aimed at attracting financial and other geographically mobile activities." As initially articulated, the purpose of the project was essentially to address tax competition that resulted in low tax rates on mobile income -- not too different from the activities being attacked by the BEPS effort today. The activities begun by the OECD in 1998 perhaps launched its reputation as global tax policeman and furthered its goal to establish "a multilateral approach under which countries could operate individually and collectively to limit the extent of these practices."3
However, in proposing to point fingers at, and ultimately blacklist, tax havens (along with harmful preferential tax regimes), the OECD first needed to come up with a definition of those terms. Its struggle to develop an objective standard for a tax haven and a harmful preferential tax regime ultimately doomed the substantive part of its effort to eliminate international tax competition regarding mobile income.4
A 1998 report, which included a lengthy list of recommendations to combat harmful tax practices, was followed by a June 2000 progress report entitled "Towards Global Tax Co-operation: Progress in Identifying and Eliminating Harmful Tax Practices." The 2000 report outlined the progress made by the OECD's Forum on Harmful Tax Practices in its work, and identified 47 potentially harmful preferential tax regimes in OECD member countries and 35 jurisdictions found to meet the tax haven criteria. It also suggested a process whereby tax havens could commit to eliminate harmful tax practices (those jurisdictions are known as "committed jurisdictions") and made proposals for associating nonmember economies with the harmful tax practices project. In addition, the 2000 report proposed the adoption of defensive measures against harmful tax regimes.
Despite the achievements touted in the 2000 report, the OECD's actual levels of success when compared with the proposals in the original initiative were decidedly mixed. Although the early proposals focused on technical tax rules and, in particular, a definition of tax haven based on whether there was sufficient substance in a relevant jurisdiction, the OECD -- under significant pressure from both the various countries that it had initially identified as tax havens and the United States -- essentially abandoned this effort and refocused its program on tax information reporting, transparency, and exchange of information. In these efforts, it had significantly more success.
In 2001 the OECD issued "The OECD's Project on Harmful Tax Practices: The 2001 Progress Report," in which it stated its intent to focus on tax havens (and not preferential regimes or harmful practices).5 In the 2001 report, in response to pressure from both the Caribbean nations and the United States, the OECD dropped the "no substantial activities" factor from its criteria for defining an uncooperative tax haven (discussed below). As a result, it was essentially left with two criteria, focusing on transparency and exchange of information.
Also in the 2001 report, the OECD shifted its focus from harmful tax competition to uncooperative jurisdictions -- that is, jurisdictions that would not commit to greater transparency and exchange of information. Only uncooperative or uncommitted jurisdictions would be identified as tax havens under the new rebranded and refocused project, and a jurisdiction would not be considered uncooperative if it committed to transparency and effective exchange of information.6
In April 2002 the OECD released its list of uncooperative tax haven jurisdictions, naming only seven countries that had not yet made commitments to improve their tax information exchange and transparency practices. In introducing the report, Gabriel Makhlouf, then-chair of the OECD's Committee on Fiscal Affairs, said: "The real success of the project so far is that we have received commitments from 31 jurisdictions to the OECD's principles of transparency and effective exchange of information."7 The United States bore no small part of the responsibility and took its share of credit for reorienting the OECD's focus away from the substantive nature of countries' tax policies and toward information exchange and transparency.8
The Initiative's Failure
The consensus, academic and political, regarding the OECD's 1998 initiative is that although it was successful in promoting a program of transparency and exchange of information, it generally failed to accomplish what it set out to do.
This failure is especially striking in one area in particular. Since the issuance of the 1998 report, which attempted to address tax competition regarding mobile income strategies, a significant percentage of OECD member countries have actually put in place programs to attract and retain mobile income. The OECD project did not lead to the elimination of targeted tax regimes that attempt to attract mobile income; instead, the world moved in the opposite direction, as many of the OECD member countries have enacted such regimes.
IP (intellectual property) and patent box regimes grant a beneficial tax rate on income generated from patents and other types of IP, with special tax incentives and rates that range from 0 percent (Malta) to approximately 15 percent (France).9 The IP box was virtually unknown at the time of the 1998 report but has since been implemented in at least 11 countries in Europe.10 As a recent academic paper concluded, "IP Boxes can be viewed as preferential tax rates on a mobile form of income."11
The BEPS Action Plan
With the history of the OECD's prior efforts to curb harmful tax competition in mind, let's take a fresh look at some of the action points proposed in the BEPS action plan.
Address Tax Challenges of the Digital Economy
In action 1, an open-ended action item, the OECD allows itself a lot of room to propose changes to current law on the taxation of digital income. The initiative is thought to be motivated in part by countries that would like to be able to tax the significant revenue associated with digital sales generated by their own resident customers. The action item has come under attack, and the OECD toned down its rhetoric in this area.
The OECD has received several complaints from high-tech consortiums and other companies with significant digital income about the proposed imposition of a separate standard on mobile income. On December 23, 2013, the Digital Economy Group, a lobbying group for high-tech companies, wrote a letter to the OECD arguing that:
enterprises that employ digital communications models operate in all sectors of the global economy. These enterprises constitute the digital economy. Accordingly, any options for addressing the digital economy should apply fairly and equally across all business lines. We believe that enterprises operating long-standing business models, subject to established international tax rules, should not become subject to altered rules on the basis that they have adopted more efficient means of operation.
In response to the strongly worded comments, the OECD has shifted tactics somewhat. It has indicated that "the findings are that there is no such thing as digital companies rather than digitalization of the economy."12
In other words, the action item on the digital economy is not likely to lead to a whole new program for the taxation of income generated by intangibles associated with the digital economy.
Neutralize Effects of Hybrid Mismatch Programs
In the second action item, the OECD addresses the development of model treaty provisions and recommendations regarding the design of domestic rules to neutralize the effects (for example, double nontaxation, double deduction, and long-term deferral) of hybrid instruments and entities. Given that the U.S. check-the-box rules -- perhaps the largest hybrid mismatch program in the world -- have withstood the test of time despite repeated questions as to their purpose and efficacy, it is unlikely that the U.S. would accept a proposal that could impose significant negative restrictions on its internal domestic law. The U.S. has much to lose, and little to gain, by eliminating a set of rules that gives its multinational companies significant benefits with minimal cost to the U.S. fisc.
Further, the U.S. already has a set of rules that target benefits received under treaties from structures involving hybrid arrangements in treaties: reg. section 1.894-(1).
Strengthen CFC Rules
The third action item requires the OECD to develop recommendations regarding the design of controlled foreign corporation rules. Since enacting section 954(c)(6) in 2005 with an original expiration date of 2009, the U.S. Congress has acted several times to extend the benefits of the provision to U.S. multinationals, which significantly diminishes the effect of its CFC rules by allowing many cross-border interest and dividend payments to fall outside the scope of its subpart F rules. Also, the IRS has contributed to the diminished effect of the subpart F rules by expanding the scope of some regulatory exceptions to the rules. At the same time, lawmakers have proposed various tax reforms, a number of which would significantly expand the scope of the CFC rules by imposing immediate U.S. income tax on a much broader category of foreign earned income.
Other countries have reduced the scope of their CFC rules. The U.K., for example, substantially modified its CFC rules, effective January 1, 2013, most significantly by introducing a partial exemption for intragroup financing income. The new rules represent a relaxation of the prior U.K. CFC rules, which generally imposed full taxation on the entirety of a CFC's financing income.
Given the trend of CFC legislation, or lack thereof, in some of the largest OECD member countries, it is questionable how successful the action item for strengthening CFC legislation is likely to be. In other words, if the U.S. (or the U.K., or France, or Germany) wishes to move from a system that allows for deferral to one that requires more immediate taxation of foreign earned income, it will do so, regardless of any OECD proposal on CFC rules.
Limit Base Erosion Via Interest Deductions
Action 4 requires the OECD to develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense (for example, via related-party and third-party debt, to achieve excessive interest deductions or to finance the production of exempt or deferred income) and other financial payments that are economically equivalent to interest payments.
Most of the OECD member countries already have rules in place to prevent the deduction of excessive interest expense that have gone through internal political, legal, and regulatory review.
Counter Harmful Tax Practices More Effectively
As described by the OECD, action 5 requires a revamping of the work on harmful tax practices with an emphasis on improving transparency, including compulsory spontaneous exchange on rulings regarding preferential regimes, and a substantial activity requirement for any preferential regime. Thus, in action 5, the OECD is reviving its attack on harmful tax practices that it dropped over a decade ago.
Prevent Treaty Abuse
Action 6 requires the OECD to develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances.
It is unclear why the OECD model treaty, on which most existing bilateral treaties are based, would not already be designed to prevent the granting of treaty benefits in inappropriate circumstances. The U.S. and many other countries already have domestic laws that do so. So the models are out there for countries that are concerned about this issue to freely adopt.
The Bottom Line
The OECD's failed attempt over a decade ago to shame countries into adopting changes to local law that would require a significant rethinking of substantive tax rules causes one to have tempered expectations for the BEPS initiative. Many of its action items have already been addressed by various jurisdictions. If, for example, a country has not yet changed its local law to restrict a resident company's ability to claim interest deductions in its home country, it is not clear why an action item from the OECD would prompt the country to do so. As already seen with the focus on rules for digital income, efforts to change substantive law that have the potential to affect large constituencies are likely to be met with resistance. The focus of the BEPS initiative may ultimately shift to transparency, information exchange, and reporting (including transfer pricing documentation) for the same reasons that scuttled much of the OECD harmful tax competition program.
Ultimately, countries lower taxes and provide special tax rates on some types of income to encourage growth and job creation, and to broaden their tax base. Taxation goes to the heart of a nation's sovereignty, and as the OECD's recent history shows, attempts to write rules that diminish that sovereignty are doomed to fail.
1See "François Hollande promises tax cuts for French business," Financial Times (Jan. 14, 2014).
2 OECD ministerial communiqué, May 22, 1996, available at http://www.g8.utoronto.ca/oecd/oecd96.htm.
3 Communiqué issued by the G-7 heads of state at their 1996 summit in Lyon, France, available at http://europa.eu/rapid/press-release_DOC-96-5_en.htm.
4 The OECD initially identified four characteristics of a tax haven, namely, a jurisdiction that has:
- no or only nominal taxes and offers itself, or is perceived to offer itself, as a place to be used by nonresidents to escape tax in their country of residence;
- laws or administrative practices that prevent the effective exchange of relevant information with other governments on taxpayers benefiting from the low or no tax jurisdiction;
- lack of transparency; and
- the absence of a requirement that the activity be substantial.
5 Belgium, Portugal, Luxembourg, and Switzerland all abstained from the report.
6 Cordia Scott, "OECD Unveils Progress Report on Harmful Tax Regimes," Tax Notes Int'l, Mar. 29, 2004, p. 1151 ("after bearing criticism -- mainly from non-OECD jurisdictions and their supporters -- and losing the U.S. government's approval of the project's original scope, the OECD modified the initiative during the summer of 2001. It dropped two of the four criteria for determining a country's status as a tax haven: low-tax rates and the availability of ring-fenced tax regimes for foreign investors, but not for local residents. The principles of effective exchange of information and fiscal transparency were supposed to be the only determining criteria remaining").
7See "Statement of OECD Fiscal Affairs Committee Chair on Uncooperative Tax Havens," Tax Notes Int'l, Apr. 29, 2002, p. 420; Robert Goulder, "OECD Updates Tax Haven Blacklist, Claims Progress in Curbing Harmful Tax Competition," Tax Notes Int'l, Apr. 29, 2002, p. 375.
8 In a press release issued at the time the 2002 report was released, then-Treasury Secretary Paul O'Neill stated, "I am glad to see that our efforts last spring to refocus the OECD project on information exchange and transparency has led to these results. I applaud these countries for coming forward to make a commitment to improve their tax information exchange and transparency policies." See "Statement by U.S. Treasury Secretary O'Neill on OECD Tax Havens Blacklist," PO-3008 (Apr 18. 2002).
9 Lisa Evers, Helen Miller, and Christoph Spengel, "Intellectual Property Box Regimes: Effective Tax Rates and Tax Policy Considerations," Discussion Paper No. 13-070 (Sept. 2013).
10 France, Ireland, Hungary, the Netherlands, Luxembourg, Belgium, Cyprus, Liechtenstein, Malta, Spain, the Swiss canton of Nidwalden, and the United Kingdom have all implemented their own versions of the IP box. These jurisdictions have different incentives and requirements for allowing the preferential rate on IP. Some require that research and development take place in that country or that the IP in question is developed there.
11 Evers et al., supra note 9.
12 Vanessa Houlder, "Special tax rules for internet companies 'not viable,'" Financial Times, Jan. 20, 2014.
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