Taxing Times: The USA Proposes a New Global Corporate Tax

[Curtley Bale]

This thread is for the general discussion of the Article Taxing Times: The USA Proposes a New Global Corporate Tax. Please add to the discussion here.

 

[Dheepa]

So my end of the discussion this week won’t be commercially focused per se, but more so a short background into the legal issues with international corporate tax and why Biden’s proposals are so radical. No law firm will ever expect you to have an in depth knowledge on any of this, but if you’re interested anyway I hope you find this helpful.

Disclaimer: A lot of this is knowledge I have from studying corporate tax last year. That being said, I’m not an expert so if I’ve gotten anything about the law or anything else wrong, please let me know!

Background: The Legal Position

Corporations are taxed on profits or income. So when headlines talk about Google/Amazon etc making sales of X but only paying tax on the smaller amount of Y, it can be very misleading as the basis for corporate taxation is profits not sales. If a corporation operates by way of producing and selling in one country, that country will have a right to tax the company. Conversely, if a company produces and sells across different countries, it would be rather unfair to allow every country to tax one set of profits. This is the double taxation problem and the current set of rules that exist in international tax law has predominantly been built around dealing with this problem. The compromise that was made at the international level in the 1920s is essentially that

• source countries (where the profits actually arise) are allocated taxing rights over the active income of the business
• and residence countries (where the company is resident) are allocated taxing rights over passive income, such as dividends and interest

All of the double tax treaties that are signed between countries rely on the criteria set out above. So why is this an issue? Because now more than ever, especially with the rise of tech companies, governments have to deal with more double non-taxation rather than double taxation.

Looking at the infamous Irish Apple case, Apple essentially set up its subsidiaries in Ireland to benefit from the low tax rate of 12.5%. Profits from the selling of Apple products across all of Europe will be taxable in Ireland as the source country. Those taxable profits can then be reduced by allocating for tax-deductible expenses. For example, the expenditure in R&D of Apple products. So there is an agreement between all subsidiaries to reduce the share of profits on account of the research expense incurred in making the profits (this falls under transfer pricing rules, this Amazon case is a good example of why this is an issue). Add to that the fact that 1) according to Irish law, the subsidiaries are non taxable in Ireland because despite being registered in Ireland they are not controlled and managed there and 2) according to US law, since the companies are registered in Ireland they are non-taxable in the US. Technically speaking (not what actually happens but thought it’d be interesting to point out anyway), the mismatch in local tax principles across different countries results in Apple paying no taxes at all. The mismatch also incentives a race to the bottom. Countries with the lowest corporate tax rates benefit from collecting at least some taxes from multinationals, incentivising countries to progressively lower their tax rates to attract these companies to their jurisdictions. The ultimate loser here always being governments.

Companies also exploit the distinction between source and residence countries through intra-group transactions. Let’s say you have two subsidiaries, A1 and A2. A1 makes a loan to A2 who then pays interest on that loan to A1. If A1 is set up as being resident in a tax haven, then it effectively avoids paying high taxes on a substantial amount of profits being transferred to it via those interest payments. These are profits that would otherwise have been taxable in A2’s jurisdiction. This is known as profit stripping. There have been a lot of cases brought by the Commission in recent years (all based on state aid principles). The more famous ones are the Apple case I discussed, this Starbucks case and another one involving Amazon.

Obviously there have been rules introduced to circumvent these kinds of issues. The OECD recommended the introduction of base erosion (as in tax base erosion) and profit shifting rules which many countries have gone on to actually implement. So while the fundamental principles of international taxation very much helps companies pay far less tax, there have been a patchwork of rules overlaying it on things like limiting interest deductions, the introduction of controlled foreign company rules that ensures companies are taxed where its business is actually conducted and much more. Clearly it hasn’t worked very well though, because otherwise there would not be a push for a digital services tax.

Biden’s Proposals

So now that I’ve explained (very briefly) the legal position, why are Biden’s proposals so revolutionary?

1. It is finally a proposal aimed at tackling the fundamental source-residence issue. Pillar one of the proposals as the article explains allows all countries to tax companies that are making final sales in that jurisdiction regardless of the existence of a physical presence. The reason for focusing on sales is that whilst company residences are mobile, customers and the final sales made to them are not. It is a huge political compromise because for so long the US has maintained that targeting digital companies (the biggest of which all have parent companies in the US) would negatively affect its interests. In fact negotiations with Trump’s administration had been stalled because Trump wanted compliance by US tech giants to remain voluntary (which then defeats the entire purpose of any reform). Biden’s alternative is that the world’s Top 100 most profitable companies (regardless of industry) would be subject to the tax. While some push back has been expected from low tax countries like Ireland and Netherlands, the overall sentiment towards the proposals so far have been positive.
2. As I hope my explanation made clear, a huge problem with the current international tax system is the mismatch. The push in the EU to introduce a digital services/sales tax would have only exacerbated the problem by introducing more complex rules that apply in some countries but don’t in others. The minimum tax rate being introduced under pillar two is a big step because it is asking for an agreement on exactly how much money every country can expect to make from these companies. Even within the EU, direct taxation and tax rates is not something political consensus has ever been reached on. So if an agreement on a figure is reached, the symbolic significance alone would be huge.

Some negatives of the proposals:

1. It only benefits countries where sales are made. In the case of Big Tech this is predominantly in developed countries with developing countries losing out. This is not surprising in and of itself. The OECD (which is the main source of these proposals) is a think tank for rich countries after all.
2. The final impact of this tax is likely to be on consumers. If final sales are being taxed, companies are likely to pass on the cost of the tax to consumers through increased prices.

 

[Jacob Miller]

So my end of the discussion this week won’t be commercially focused per se, but more so a short background into the legal issues with international corporate tax and why Biden’s proposals are so radical. No law firm will ever expect you to have an in depth knowledge on any of this, but if you’re interested anyway I hope you find this helpful.

Disclaimer: A lot of this is knowledge I have from studying corporate tax last year. That being said, I’m not an expert so if I’ve gotten anything about the law or anything else wrong, please let me know!

Background: The Legal Position

Corporations are taxed on profits or income. So when headlines talk about Google/Amazon etc making sales of X but only paying tax on the smaller amount of Y, it can be very misleading as the basis for corporate taxation is profits not sales. If a corporation operates by way of producing and selling in one country, that country will have a right to tax the company. Conversely, if a company produces and sells across different countries, it would be rather unfair to allow every country to tax one set of profits. This is the double taxation problem and the current set of rules that exist in international tax law has predominantly been built around dealing with this problem. The compromise that was made at the international level in the 1920s is essentially that

• source countries (where the profits actually arise) are allocated taxing rights over the active income of the business
• and residence countries (where the company is resident) are allocated taxing rights over passive income, such as dividends and interest

All of the double tax treaties that are signed between countries rely on the criteria set out above. So why is this an issue? Because now more than ever, especially with the rise of tech companies, governments have to deal with more double non-taxation rather than double taxation.

Looking at the infamous Irish Apple case, Apple essentially set up its subsidiaries in Ireland to benefit from the low tax rate of 12.5%. Profits from the selling of Apple products across all of Europe will be taxable in Ireland as the source country. Those taxable profits can then be reduced by allocating for tax-deductible expenses. For example, the expenditure in R&D of Apple products. So there is an agreement between all subsidiaries to reduce the share of profits on account of the research expense incurred in making the profits (this falls under transfer pricing rules, this Amazon case is a good example of why this is an issue). Add to that the fact that 1) according to Irish law, the subsidiaries are non taxable in Ireland because despite being registered in Ireland they are not controlled and managed there and 2) according to US law, since the companies are registered in Ireland they are non-taxable in the US. Technically speaking (not what actually happens but thought it’d be interesting to point out anyway), the mismatch in local tax principles across different countries results in Apple paying no taxes at all. The mismatch also incentives a race to the bottom. Countries with the lowest corporate tax rates benefit from collecting at least some taxes from multinationals, incentivising countries to progressively lower their tax rates to attract these companies to their jurisdictions. The ultimate loser here always being governments.

Companies also exploit the distinction between source and residence countries through intra-group transactions. Let’s say you have two subsidiaries, A1 and A2. A1 makes a loan to A2 who then pays interest on that loan to A1. If A1 is set up as being resident in a tax haven, then it effectively avoids paying high taxes on a substantial amount of profits being transferred to it via those interest payments. These are profits that would otherwise have been taxable in A2’s jurisdiction. This is known as profit stripping. There have been a lot of cases brought by the Commission in recent years (all based on state aid principles). The more famous ones are the Apple case I discussed, this Starbucks case and another one involving Amazon.

Obviously there have been rules introduced to circumvent these kinds of issues. The OECD recommended the introduction of base erosion (as in tax base erosion) and profit shifting rules which many countries have gone on to actually implement. So while the fundamental principles of international taxation very much helps companies pay far less tax, there have been a patchwork of rules overlaying it on things like limiting interest deductions, the introduction of controlled foreign company rules that ensures companies are taxed where its business is actually conducted and much more. Clearly it hasn’t worked very well though, because otherwise there would not be a push for a digital services tax.

Biden’s Proposals

So now that I’ve explained (very briefly) the legal position, why are Biden’s proposals so revolutionary?

1. It is finally a proposal aimed at tackling the fundamental source-residence issue. Pillar one of the proposals as the article explains allows all countries to tax companies that are making final sales in that jurisdiction regardless of the existence of a physical presence. The reason for focusing on sales is that whilst company residences are mobile, customers and the final sales made to them are not. It is a huge political compromise because for so long the US has maintained that targeting digital companies (the biggest of which all have parent companies in the US) would negatively affect its interests. In fact negotiations with Trump’s administration had been stalled because Trump wanted compliance by US tech giants to remain voluntary (which then defeats the entire purpose of any reform). Biden’s alternative is that the world’s Top 100 most profitable companies (regardless of industry) would be subject to the tax. While some push back has been expected from low tax countries like Ireland and Netherlands, the overall sentiment towards the proposals so far have been positive.
2. As I hope my explanation made clear, a huge problem with the current international tax system is the mismatch. The push in the EU to introduce a digital services/sales tax would have only exacerbated the problem by introducing more complex rules that apply in some countries but don’t in others. The minimum tax rate being introduced under pillar two is a big step because it is asking for an agreement on exactly how much money every country can expect to make from these companies. Even within the EU, direct taxation and tax rates is not something political consensus has ever been reached on. So if an agreement on a figure is reached, the symbolic significance alone would be huge.

Some negatives of the proposals:

1. It only benefits countries where sales are made. In the case of Big Tech this is predominantly in developed countries with developing countries losing out. This is not surprising in and of itself. The OECD (which is the main source of these proposals) is a think tank for rich countries after all.
2. The final impact of this tax is likely to be on consumers. If final sales are being taxed, companies are likely to pass on the cost of the tax to consumers through increased prices.

As someone who really doesn't know much about tax law at all, this is really interesting and definitely shares a number of parallels with other areas of law. As someone who's really interested in company/ entity law, this discussion shares a lot of parallels with that area. Dheepa has already mentioned a. huge amount of substantive content, so I'm not going to take a deep dive into that side of things. I want to take a little look at some broader discussions surrounding company law which remain highly relevant in this setting, as well as considering how this sort of discussion may arise in the application process.

Judgement Proofing
I wanted to briefly touch on judgement proofing as I think the problems involved in the transnational tax regime are a prime example of it. Judgement proofing, essentially, boils down to the use of the corporate form and some of the 'loopholes', or consequences, of company and entity law to avoid incurring liability in any given setting. In this particular discussion, we're obviously seeing judgement proofing techniques used to avoid incurring tax liability, but it is also common to structure corporate groups to minimise the impact of tort claims and/ or creditor claims on insolvency.
By using the general rules of company law (i.e. that companies are separate legal persons) which are generally accepted in almost every jurisdiction in some form or another, and combining that with the fact that certain jurisdictions come from very different corporate law 'traditions*' which also impacts on things like tax, it is very obvious how the largest corporates can exploit the current system to run in as tax-efficient a manner as possible. It is also clear that Joe Biden's suggestions are a direct fight-back against anti-tax judgement proofing.

How does it come into applications?
Well, discussions surrounding major overhauls such as those proposed in this instance have a substantial impact on commercial law firms across a wide range of practice areas. Most obviously, tax lawyers in transactional, advisory and contentious roles will be very keen to monitor developments in this regard:

• Transactional impact: tax and tax efficiency have a huge part to play in any corporate transaction: buyers want to buy businesses which are structured in a tax-efficient way, sellers want the transaction itself to be tax-efficient so they themselves are subject to the minimum possible taxes on profits from the sale. As such, any 'attack' on the ability to restructure to minimise taxability will likely impact heavily on how deals are conducted and structured.
• Advisory impact: as with any regulatory overhaul, clients anxious to ensure compliance - or to find legal work-arounds - will generate a substantial amount of advisory work for firms.
• Litigious impact: another frequent side-effect of most major regulatory changes is the slew of complex litigation which follows it as corporates, tax authorities and the courts decide on more specific elements of how the new regime is to be applied in practice. This, in turn, could generate work for litigious teams - especially firms who have well-established and respected investigations/ corporate crime teams.

On the point of corporate law traditions, the first couple of pages of this article explains the two conflicting traditions well.