Debates over whether the right to tax residual profits of multinationals belongs to source or residence countries have traditionally pitted developing countries, or those characterized as benefiting from an international tax system that gave greater weight to source, against developed countries, generally described as residence countries. Developing countries have been arguing for greater source-based taxation for years, and the U.N. model treaty — developed to cater to the needs of those countries — in theory favors source-based taxation for the benefit of their revenue goals. Developed countries, meanwhile, have generally resisted big changes to the international tax system, holding firm to historical principles that give residence countries strong claims of tax, including the existing transfer pricing system.
That broad alignment appeared to hold during the OECD’s base erosion and profit-shifting project. Countries such as China and India, commenting on the BEPS transfer pricing work (action items 8-10), argued for greater allocation of tax rights to the market to define value for source-based taxation, but the OECD rejected that radical concept in favor of an approach that adheres to well-accepted transfer pricing principles.
However, attributing a greater share of taxing rights to the jurisdiction where the sale takes place may no longer be just a developing country cause — to the contrary, the United States and many EU countries are arguing the loudest for basing source taxation on the market. Rather than a tug-of-war between developing and developed countries, the fight for greater source-based taxing rights, and for defining source as attributable to market share, is pitting the EU against the United States.
The Trump administration’s April statement that the destination-based cash flow tax — which looked to the location where sales takes place as the key determinant for asserting taxing rights — is no longer under immediate consideration has generally been interpreted to mean the proposal is dead. But that doesn’t mean that attempts to use the destination (market) to allocate multinationals’ profits have ended. Both the EU and the United States are debating proposals that would result in their asserting greater taxation rights over profits attributable to sales occurring in their jurisdictions. While the EU calls for greater source-based taxation are derived mainly from the perceived need for improved taxation of tech company profits, the U.S. arguments are broader.
OECD and Digital
Action item 1 on how to tax the digital economy remained an open item from the OECD’s BEPS project, and the organization has committed to providing a report on the topic to the G-20 by next spring. On September 22 it requested comments in preparation for a discussion draft it intends to release before a November 1 consultation to be held at the University of California, Berkeley.
The potential solutions outlined in the consultation document all appeared — but were not recommended — in the final BEPS report, which seems to indicate that the OECD has made little progress on the topic since the release of that report two years ago. They include an expanded definition of permanent establishment that would eliminate the requirement for a physical presence, an equalization tax, and a withholding tax on digital services. The United States resisted those options during negotiations, which is largely why the report was issued without any concrete recommendations. There’s no reason to think current U.S. Treasury representatives participating in the project will support those proposals more than their predecessors did.
Estonia, which holds the EU presidency, has prioritized taxation of the digital economy. It hosted an international conference on taxing the digital economy on September 7 and led a meeting of the EU finance ministers the following week on the same topic. While the Estonian presidency previously said it isn’t opposed to innovative ideas such as an online advertisement tax, an additional levy on digital services, or a virtual PE, after those meetings it emphasized its opposition to radical and immediate solutions. It has said it prefers a coordinated approach to amending international tax rules and wants the EU to provide the OECD with combined comments that press the case for a global solution.
Other EU members are less sanguine about that type of measured approach. EU Tax Commissioner Pierre Moscovici has expressed skepticism about the likelihood of OECD success because of U.S. resistance. He has suggested that the EU move on its own, saying, “We have to go further and faster.” France is leading the charge, pushing for greater rights to tax the profits of tech companies selling into its market, with both the finance minister and president singling out and criticizing the domination of U.S. tech companies as part of a campaign for improved taxation of the digital economy. The country wants an approach that would abandon the traditional income tax system in favor of a turnover tax on tech companies’ profits. At the September 7 meeting of EU finance ministers, France appeared to have secured the support of at least nine other EU members, but details on the proposal are scant.
On September 21 the EU released COM(2017) 547, announcing a new EU agenda to ensure the digital economy is taxed fairly and in a way that would aid growth. Although the EU isn’t unified on a single proposed solution, it said that in the absence of adequate global progress, it should implement its own solutions to taxing the profits of digital economy companies. It emphasized that alongside coordinated international work on a long-term strategy for taxing the digital economy, it will also consider more immediate, short-term measures to protect member states’ tax bases. Those measures are the same ones described by the OECD: an equalization tax on turnover of digital companies, a withholding tax on digital transactions, and a levy on revenues from the provision of digital services or advertising.
The initiative’s success isn’t guaranteed: Any direct tax proposal needs unanimous agreement from EU members, and it’s a safe bet that small countries that profit from income shifting into their jurisdictions won’t support those kinds of proposals. Dmitri Jegorov, Estonia’s state secretary for financial affairs, has suggested that perhaps a smaller group of EU countries could adopt a solution. But the EU tried a similar approach for its proposal for a financial transaction tax and has been mired in disagreement for years.
Even if they fail in changing EU law, the proposals are likely to pressure the OECD to advance a concrete proposal for taxing tech company profits in the market jurisdiction. To remain relevant and avoid having its role undermined, the OECD must continue to propose tax law changes in line with the wishes of its members.
U.S. tech companies can be expected to oppose any changes that would result in increased taxation of their profits (including those suggested by the OECD or EU). Many U.S. companies sell into the European market through tax-advantaged distributorship structures that limit their nexus to high-tax countries, so they would also oppose any expanded PE definition in EU member countries. But the U.S. government might be unable to take the high-minded route in opposing the EU proposals (as it did when the EU competition office determined that tax rulings granted to U.S. companies by EU members violated EU state aid principles) because proposals being considered by the U.S. Senate Finance Committee — and perhaps the White House as well — could also greatly expand U.S. taxing rights over profits derived from sales into the U.S. market.
The Gross Basis Surtax
Bret Wells of the University of Houston Law Center, who testified at the October 3 Senate Finance Committee hearing on international tax reform, has long advocated a gross basis surtax as a backstop to transfer pricing rules. He has argued that the surtax is needed to address excessive base-eroding payments made by companies doing business in the United States and for the U.S. fisc to properly capture the profits earned by multinationals from sales made into the United States.
Wells also testified before the committee in 2011 regarding his proposal for a base-protecting surtax, which he described as a tax on any base-eroding payment made by a U.S. payer to a foreign affiliate. That testimony drew on an article Wells wrote with Cym Lowell of McDermott Will & Emery LLP that detailed the proposal and the concerns it was developed to address (“International Tax Reform: Source and Collection Are the Linchpins,” 65 Tax Law. Rev. 535 (2011)). Wells and Lowell wrote that U.S. transfer pricing rules have been unable to ensure that residual profits created by activities in the United States are taxed there. Few would disagree with that claim, which has been confirmed by a string of IRS losses on transfer pricing cases, including Medtronic Inc. v. Commissioner, T.C. Memo. 2016-112, Amazon.com Inc. v. Commissioner, 148 T.C. No. 8 (2017), and Altera Corp. v. Commissioner, 145 T.C. 91 (2015). Wells and Lowell argued for replacing existing law that relies on the government to assess a transfer pricing adjustment with a presumption that any base-eroding payments be subject to a gross basis withholding tax. In his 2011 testimony, Wells suggested that a 10 percent surtax on the gross amount of any base-eroding payment would be a reasonable approximation of a 35 percent net basis tax on the residual profits associated with those payments. (The idea of applying withholding tax unless the nexus with the U.S. tax base is disproven isn’t unprecedented. Dispositions of U.S. real property interests are similarly subject to a gross basis withholding obligation, unless the transferor can prove that the tax imposed by the Foreign Investment in Real Property Tax Act doesn’t apply.)
Wells and Lowell proposed letting companies apply for certification that the IRS had correctly allocated the amount of residual profits attributable to the companies’ U.S. business operations under a residual profit or formulary apportionment method in accordance with a process like that used for advance pricing agreements. A taxpayer that proved its case could also request from the IRS a refund of the excess portion of the surtax withheld. Wells and Lowell suggested that companies be required to perform a functional analysis to determine which country should be entitled to tax the residual income, and that until proven otherwise, the U.S. presumption should be that the residual profits should be taxed in the United States because that’s where they arose.
According to Wells’s 2011 testimony, the proposal shouldn’t conflict with U.S. treaty obligations, because it relies on existing transfer pricing concepts of profit split or formulary apportionment to calculate the final tax. Thus, the United States would still be collecting tax only on profits attributable to it under generally accepted accounting principles. Implementing a gross basis surtax on cross-border base-eroding payments would merely change presumptions regarding the amount and timing of tax.
Wells had extensive experience in the private sector before turning to academia, and his proposals can’t be dismissed as coming from left field. Conclusions are based on his experiences both as an in-house tax director at an oil and gas services company and as a law professor. Further, the idea is in line with proposals being developed by academics and tax practitioners who are also focused on the importance of more aggressively taxing the profits attributable to the U.S. tax base, meaning profits derived from sales into the U.S. market.
Oxford Residual Profit Allocation
A group led by Michael Devereaux of Oxford University, which also developed the destination-based cash flow tax proposal, has been working on an alternative proposal for a residual profit allocation system. In the existing system, the taxable return to any specific jurisdiction is based on an “entrepreneurial” transfer pricing model in which the intellectual property owner in a tax-favored jurisdiction is considered the developer of the intangible and earns residual profits associated with it. All other group affiliates are compensated based on routine returns, whether associated with contract manufacturing, research and development, distribution, or marketing. The groups’ proposed residual profit allocation would flip that calculation and allocate residual profits to the country where the sale to the third-party customer takes place; other group affiliates would still be compensated based on routine returns. In effect, the residual profit allocation model adopts the destination-based system without many of the complications that led to that system’s demise. (Further details about the proposal are expected in an upcoming book.)
Graetz and Doud Proposal
Michael Graetz and Rachel Doud have also argued that U.S. international tax rules should hinge on U.S. sales in determining the U.S. tax base of multinationals, suggesting that U.S. efforts to limit income-shifting focus on times when the U.S. share of a company’s sales is a multiple of the U.S. share of its profits. They have questioned whether the way the United States measures income from domestic sales should be changed if a group’s U.S. taxable profit is far less than its U.S. sales relative to total sales. They have proposed requiring that a company’s ratio of U.S. to worldwide income be not less than its ratio of U.S. to worldwide sales to ensure that the United States is capturing the appropriate tax revenue from its market.
An Inbound Minimum Tax?
There has been a lot of focus on a minimum tax on the foreign profits of U.S. multinationals — an idea that appeared in both Obama administration budgets and the GOP’s recent unified framework on tax reform. In his October 3 testimony before the Senate Finance Committee, Itai Grinberg of Georgetown University Law Center flipped the idea of a minimum tax on its head, calling for an inbound corporate minimum tax. Like Wells, Grinberg argued that a priority for U.S. tax reform is to act on reforming inbound rules to help level the playing field between U.S. and foreign multinationals. Focusing on inbound companies helps address concerns raised by U.S. multinationals over reforms included in a bill proposed by former House Ways and Means Chair Dave Camp that would address “roundtripping” of intangibles by U.S. companies without providing similar treatment for foreign companies.
Republican congressional leaders have been touting the party’s recent unified framework on tax reform, which includes a large reduction in the top corporate rate and a commitment to exempt U.S. companies’ foreign earnings from tax, as a way to spur the economy. Democrats, meanwhile, have characterized the plan as a giveaway to the highest earners and to corporations, potentially harming middle-income taxpayers and increasing the deficit.
The rhetoric from both sides ignores (perhaps deliberately) serious proposals to expand the U.S. corporate tax base by ensuring that it more closely matches the profits attributable to U.S. sales. Depending on the size of their proposed rate reductions, the proposals could result in increased effective rates on foreign companies with U.S. operations and U.S. multinational companies that own IP overseas. Further, any U.S. law change to allocate taxable income based on sales into the United States would make it harder for the United States to oppose OECD and EU proposals that might accomplish the same thing.