Conventional wisdom tells us the OECD’s base erosion and profit-shifting initiative is the most significant development in tax policy in decades. Not so, says Reuven Avi-Yonah, a law professor at the University of Michigan and one of the leading critical thinkers in global taxation. His recent paper, coauthored with Haiyan Xu, argues that BEPS is an inadequate response to what’s ailing the corporate income tax. Their paper also questions the foundational pillars on which today’s national tax systems are built. You can read it here.
The authors contend that the root of the problem lies in the prevailing “international consensus,” which provides the conceptual basis for allocating jurisdictional tax rights among nations. The consensus dates back to a multilateral dialogue held under the auspices of the League of Nations almost 100 years ago. According to Avi-Yonah and Xu, we are overdue for a rethink.
To make a long story short, four economists sat around a table in Geneva in March 1923 and decided on the following roadmap for dealing with cross-border profits: Active business income should primarily be taxed in the source country (i.e., where the profits were earned), while passive business income should be primarily taxed in the taxpayer’s country of residence. The rest, as they say, is history. Almost every country’s corporate tax regime is premised on this core principle. Ditto for the OECD model tax convention and transfer pricing guidelines.
In fairness, the international consensus has enjoyed a remarkable run. It has survived the rise of socialism, fascism, the Great Depression, World War II, and the Cold War. But can it survive the era of globalization? Avi-Yonah thinks it cannot, and that the evidence is all around us. He’d have us believe the consensus is already functionally dead, but that policymakers are so deeply entrenched in the orthodoxy they can’t read the writing on the wall. Such is the nature of path dependency.
So what’s wrong with the consensus?
For starters, it relies on antiquated notions of corporate residence and source of income. The international consensus assumed such matters were fixed and objectively determinable – and for most of the 20th century they were, but in the 21st century they’ve proven to be malleable constructs. These days, a multinational’s country of residence is wherever the tax department wants it to be. And profits can be sourced to almost any jurisdiction that offers a favorable after-tax outcome. Think of high-value intangibles -- the jurisdictions that claim tax rights over their economic returns routinely lack any meaningful connection to where the intangibles were developed or deployed.
BEPS is an effort to more closely align the incidence of corporate taxation with economic activity and value creation. That is, it seeks to improve source-based taxation of active income (much in the same way that the Foreign Account Tax Compliance Act seeks to bolster residence-based taxation of passive income by individual taxpayers). These moves are predictable, but they also suggest a degree of desperation. Avi-Yonah and Xu see them as Band-Aids that mask deeper problems.
Note that governments outside the OECD club (e.g., Brazil, China, India) were never sold on the international consensus in the first place. They are amused by our clinginess to jurisdictional tax principles that no longer mesh with reality or adequately protect the public fisc. One has to wonder if the next great paradigm shift in global tax policy will emanate from their ranks, not ours. If so, it’s likely to bear little resemblance to BEPS.