The letter addressed to the Secretary of the Treasury Jacob Lew, written by the leaders of the Congressional tax-writing committees, Orin G. Hatch and Paul D. Ryan on June 9, poured a healthy dose of water into the wine of the advocates of stricter international tax regulations.
By loudly voicing their concerns with respect to (some of) the fundamental changes in international tax rules under the OECD’s Base Erosion and Profit Shifting project, Mr. Hatch and Mr. Ryan shredded cliquey notions of a broad consensus on international tax reform.
In light of the harsh rhetoric of the letter, it appears conceivable that the U.S. could eventually refrain from signing the final BEPS reports. While it seems unlikely that the U.S. will abandon the BEPS project altogether, it is worthwhile to contemplate possible effects of the waning consensus.
When looking at the bigger picture, it appears questionable whether abandoning the BEPS project altogether would constitute a favorable outcome for taxpayers. While counterintuitive, a little-bit-of-BEPS may actually offer a more favorable tradeoff than no BEPS. Here is why:
As a European, one is involuntary intrigued about the blunt opposition Mr. Lew has to face. His European counterparts do not encounter similar challenges – at least publicly. It is indeed sadly amusing to imagine Mr. Schauble being addressed in similar fashion. One reason for this could be seen in the nature of current European Union tax policies that are, at least ostensibly, less focused preserving national interests than on establishing consensus and shifting policy prerogatives to Brussels.
The leaders of the Congressional tax-writing committees on the other hand provide a remarkably frank summary of U.S. interests. In this context, it is notable that, following general introductions, Mr. Hatch and Mr. Ryan commence their letter by explicitly expressing their support of the contribution of Mr. Lew to the BEPS project insofar as it serves to advocate the arm’s length principle as the leading paradigm for international taxation.
Only after emphasizing their support of the arm’s length principle do they continue by questioning whether the BEPS reform, particularly the introduction of the country-by-country reporting standard (BEPS Action 13), would result in a favorable outcome for U.S. companies.
The effects of country-by-country reporting in a nutshell; taxpayers would be obliged to disclose more detailed information on the foreign operations of MNEs (including county-specific data on assets, number of employees, revenues and profits).
While the respective concerns of Mr. Hatch and Mr. Ryan are focused on confidentiality issues, their ultimate concerns could also relate to fact the country-by-country reporting might serve as a first step towards adopting formulary apportionment on a global scale. Considering that the country-by-country reporting provides fiscal authorities with the required input to apply formulary apportionment it appears plausible that the authorities will indeed utilize such information in tax audit situationws in order to challenge profit allocations based on the arm’s length principle.
As formulary apportionment does not account for the value added by intangible assets, substituting the arm’s length principle with formulary apportionment will allocate a higher share of profits towards entities located in large markets (factor: revenues), entities utilizing manual labor (factor: employees) as well as entities operating plants and machinery (factor: tangible assets).
For U.S. MNEs such as Google or Starbucks, applying global formulary apportionment would generally result in allocating more profits to entities located abroad – i.e. India, China or even Europe. In this context, it should not be forgotten that the BEPS project was initiated to curb the low effective tax rates of (primarily U.S.-based) MNEs that were attributable in large part to profits allocated to intangibles (i.e. license payments).
The BEPS project, and specifically country-by-country reporting, are explicitly directed against the tax practices of some U.S. MNEs and it is thus understandable that Mr. Hatch and Mr. Ryan are questioning whether making concessions in implementing these measures will result in a favorable outcome for U.S. companies and the U.S. economy.
But are Mr. Hatch and Mr. Ryan to be applauded for pressuring Mr. Lew into not signing the final BEPS reports unless concessions made by the U.S. are carefully reviewed? Answer: It depends.
To be sure, emphasizing the importance of preserving the arm’s length standard as well as calling attention to the fact that some of the proposed reform measures (country-by-country reporting) are out of proportion (particularly considering the weak empirical evidence of BEPS) are most welcome. On the other hand, it is rather difficult to evaluate the tradeoff of abandoning the BEPS project altogether.
One crucial aspect to consider in this context is that European governments are fiercely committed to taking action against BEPS. In view of the public sentiment prevailing in Europe and the political efforts invested, failure of BEPS does not constitute an attractive option for European governments.
In case the U.S. would walk out on BEPS it appears more likely than not that this would immediately fuel demands for substantial European countermeasures (i.e. U.K.’s Diverted Profits Tax) and ultimately even facilitate the adoption of the CCCTB.
For taxpayers the failure of the BEPS project would thus almost certainly translate into increased double taxation and could actually erode the (remaining) consensus on the arm’s length principle as leading paradigm of international taxation. While country-by-country reporting is hardly worthy of much praise, the respective concessions should be kept in perspective – i.e. MNE Groups having a total consolidated group revenue of less than 750 million euro will be deemed as “Excluded MNE Groups” and thus would not be obliged to file country-by-country reporting.
Compared to Mr. Hatch and Mr. Ryan, the stance adopted by U.S. Treasury Deputy Assistant Secretary Robert Stack reflects a more nuanced evaluation of the tradeoff. While Mr. Stack strongly condemned the OECD’s work in context of the BEPS project, his criticism is primarily targeted at the failure to stipulate prescriptive rules rather than indicative guidelines and to prevent member countries (U.K. and Australia) from adopting unilateral countermeasures.
In the context of the OECD International Tax Conference in Washington in June, Mr. Stack touched upon a number of additional issues that could be crucial for the further course of the BEPS project. His call for more prescriptive rules are targeted at curbing the (“appalling” and “shocking”) discretion granted to tax examiners when assessing tax structures.
His comments call attention to the negative effect of governments focusing on maximizing tax national revenues by selectively introducing more restive regulations instead of improving the general framework of international tax regulations – specifically ensure the effective application of the arm’s length principle. Mr. Stack emphasized that an increase of tax revenues should not constitute the measuring-rod for success of the BEPS project:
“When will countries think that BEPS concerns have been allayed?” […] “If it’s driven by political pressure, do the concerns dissipate when the press coverage dies down? Will BEPS fears die down when effective rates of multinationals increase? Will countries be satisfied when [they can] post more tax revenues from multinationals? And if more revenues are the test, then how much revenue?”
A more sensible measure of success of the BEPS project would be whether the reforms facilitate a closer alignment between value added and tax receipts – which would ultimately reflect a more efficient application of the arm’s length principle. As pointed out by Mr. Stack this would, however, imply that “countries need to acknowledge the sometimes unpleasant reality that very often, there’s not much value added in their jurisdictions, so their desire for outsized tax receipts […] is in the end a pipe dream.”
At the top of Mr. Stack’s wish list for a post-BEPS world: “slow down the pace of BEPS work.” This actually makes a lot of sense. The BEPS project, comprising fifteen detailed Action Points, is highly complex and it could well be argued that the project suffers from an overloaded agenda. It is extremely difficult to keep score and to evaluate whether compromising on specific Actions Points is worthwhile.
What is clear, however, is that the reforms will result in fundamental changes in international taxation. It is irritating that such important reforms are implemented without a clear diagnosis of the root causes or a reliable measurement of the extent of economic damage attributable to BEPS. Mind you, Action Point 11 (published in May) is dedicated to improving the analysis of BEPS and aims to introduce a respective methodology and indicators.
The analysis contained in the respective OECD discussion draft is, however, of preliminary nature and even the OECD points out that attempting to construct indicators or undertaking an economic analysis of the scale and impact of BEPS are severely constrained and should be heavily qualified.
Slowing down the pace of the BEPS project could have many benefits. Here is my wish list (or pipe dream) for a post-BEPS world:
1) Taking the time to conduct a more accurate assessment of the nature of BEPS (see Action 11) in order to establish a basis for more accurately targeting the root causes of BEPS – avoiding excessively broad regulation;
2) in designing more targeted and pragmatic reforms, it would be vital to soften the edges of some of the more drastic reforms and scale back disproportionately strict regulations; and
3) adopting a stronger focus on the technical issues, specifically improving the efficiency of the arm’s length principle.
This could further lessen political pressures and thus facilitate a consensus on a more focused (limited) reform agenda – less could very well be more in this case.