By Scott Wilkie
Thinking Beyond the Limits of Immediate Perception
It is sometimes revealing to step back from the assumptions and presumptions of any discussion to appreciate its essence – and its historical context.
The international tax conversation flowing from BEPS and the two Pillars, now amplified by the rather opaque announcement on June 5 by the G7 Finance Ministers endorsing global minimum tax, invite this kind of reflection.
The essence of the Pillar 1 Blueprint is to replace long-standing notions of tax jurisdiction and taxable presence, notably for so-called “customer facing” and “automated digital services” businesses, with something else that preserves an appropriate degree of source country taxation for local “value created”. Fundamentally, it embraces some kind of global fractional apportionment of income particularly for free-standing or embedded “intangibles”.
Pillar 2 and Minimum Tax
The essence of the Pillar 2 Blueprint, anticipated now by the United States’ Administration’s Made in America Tax Plan and the enthusiastic embrace by the G7 of minimum tax, is for the parent jurisdictions of establishments and entities through which business is conducted in other countries to “occupy” the tax room left untaxed to an internationally acceptable degree by low tax countries, i.e., “tax havens. This will be orchestrated in a way that essentially prevents the circumstances of benign high tax and problematic low tax income being meshed in a way that would effectively elevate income out of its otherwise low tax condition. This is a familiar constraint, to a greater or lesser extent, in countries’ foreign tax credit rules that, like Canada, silo income country-by-country or according to relevant quantitative features to avoid sheltering low tax income with unused high tax country tax credit.
We have seen all of this before, in at least two ways.
CFC Rules By Another Path? Irresistible Parallels?
The Pillar 2 Blueprint acknowledges the influence of “controlled foreign corporation” rules, in Canadian tax language the “foreign affiliate” rules. Effectively, what Pillar 2 does is to apply the logic and to a certain degree the engineering of CFC rules to foreign undertaxed business income, otherwise untaxed or tax-deferred, as those rules commonly would apply to non-business income.
But the application of such a dramatic step for business income is selective; it only applies to income associated with countries considered to have undertaxed it according to an evolving international standard. It is as if a Canadian “FAPI” or US Subpart F” regime applied generally to business income for “designated” countries on a “black” contrasted with a “white” list. But, this kind of parsing of “bad” and “good” tax jurisdictions has not enjoyed favour historically; the effects of the Pillars are similar but more elliptical. This resort to the tendencies of CFC rules is bolstered by the proposed Subject to Tax Rule, which essentially impairs the utility of transfer pricing and payment deduction strategies to shift otherwise taxable business income from its commercial source to somewhere else relying on private law’s range of organizational and transactional forms the fiscal significance of which we might doubt.
A well-known example in Canadian tax law is the business income character preservation rule in subparagraph 95(2)(a)(ii). Income of one “foreign affiliate” that originally is exempt “active business income” of one foreign affiliate enjoys the same exempt active business income treatment when transmitted (“shifted”) to another by a payment otherwise in the nature of income from property, like interest, if deductible in computing the payer’s active business income under applicable tax laws.
But there is a catch; the Canadian shareholder(s) must have substantial though short of controlling interests in the payer and the recipient, and both of them must conduct business and reside in countries with which Canada has a tax agreement – a “designated treaty county”, which essentially is an ambulatory list by description rather than by name though the effect is the same. Speaking colloquially, these are “good” or “whitelisted” countries” although not as such in the law. For other non-“white listed” countries, active business income is not reclassified and taxation still deferred until incomed is distributed, but when distributed it is taxed to the extent it has not been taxed where it was earned.
This looks a lot, directionally and even in terms, like Pillar 2. The effects are similar. And the devices to police the intended allocation of income, split ownership, and general undistorted continuity, is similar.
Something Else: “Harmful Tax Competition” – The Way Back to Away Back?
Some may remember the OECD’s most recent attempt to counter “tax competition”. It published a report in 1998 entitled Harmful Tax Competition An Emerging Global Issue.
The 1998 Report recommended the adoption by countries of CFC regimes that distinguished between haven and non-haven jurisdictions to ensure that income associated with or directed to haven jurisdictions would not enjoy preferential taxation. In effect it recommended the application of the imputation aspect of CFC and like rules and regimes to business income as they would have applied to investment or property type income. It also recommended that related discipline be applied to transfer pricing to mitigate the shifting of income from high source countries to low or haven tax jurisdictions. It was prepared to identify the “good” and “bad” jurisdictions at least by description.
Pillar 2 is in many respects Harmful Tax Competition, risen from the ashes, not merely as an idea but also directionally and methodologically.
A Fiscal Riddle: When is a DST Not a DST, CFC Rules Not CFC Rules, Selective Trade Practices Not Selective Trade Practices?
The G7 went out of its way to contemplate the replacement of problematic digital services taxes (DSTs) by initiatives associated with Pillar 1 or 2, possibly in combination. The focus is in one way or another to enforce a globally acceptable degree of taxation associated with market connections even if the countries whose markets they are do not tax relatable income meaningfully. Indeed, the effect of the minimum tax, at this early juncture and without any real elaboration yet, can be perceived to be very similar to a DST. But it is not and not to be called a DST. I mentioned this in an earlier blog.
And seemingly Pillar 2 and the consequential minimum tax bear a striking resemblance to CFC rules applied generally to business and not merely non-business or investment income. The influence of CFC rules is acknowledged by the OECD, but the Pillar 2 prescription is not framed or presented as CFC rules. Why not? Hard to say. There may be concerns that not all countries have (robust) CFC rules or have embraced the OECD’s encouragement in the BEPS Reports to adopt robust CFC rules. There may also be concerns about whether CFC rules as such are sufficiently easily administrable even assuming that all countries would have or adopt them. So, it may be that that mimicking the effects of CFC rules, with an inbuilt base erosion / transfer pricing rule that is not uncommon in CFC rules as such, is an artful and reasonable substitute – a “new” take on an “old” play.
In some ways then, Pillar 2 and the anticipated minimum tax could be seen as chameleons for DSTs and / or CFC rules.
It may also be that it reflects sensitivity to trade law concerns that may be presented by seeming to target or selectively marginalize low tax jurisdictions directly. In her book, the published version of her PhD thesis (Jennifer E. Farrell, The Interface of International Trade Law and Taxation Defining the Role of the WTO, International Bureau of Fiscal Documentation, IBFD Doctoral Series Volume 26, Ch. 8, quoted below at section 8.8 pp 202-203), Professor Jennifer Farrell notes this possibility as a potential though at the time unseen and still not widely imagined impediment to the progress of the last harmful tax competition initiative. She wrote:
“… [T]he OECD threatened the use of economic measures against “harmful jurisdictions” to remedy harmful tax competition. These measures included, inter alia: disallowing deductions, exemptions, credits and other allowances related to transactions; the denial of foreign tax credit; and the imposition of withholding tax on certain payments to residents. As the defensive measures only applied to targeted non-OECD countries and did not extend to the “preferential” tax regimes of OECD countries, this difference in treatment possibly breached the MFN [the WTO “Most Favoured Nation”] obligation. With ten of the blacklisted jurisdictions being WTO members, the opportunity to launch a WTO complaint against any OECD member utilizing the economic measures would have been available. By 2004, the OECD had changed its approach to harmful tax competition, moving away from recommendations and sanctions, and instead focusing on exchange of information and transparency. In part, this can be viewed as a result of the incompatibility problems with the WTO rules.
…One can speculate that the OECD felt the WTO would not interfere with any action against harmful tax competition, or more worryingly, the OECD drafted its policy without consideration for trade law implications. As one tax expert noted: “the OECD has a habit of not looking at possible trade law consequences of its actions until after the fact. [reference to C. Scott, OECD Harmful Tax Competition Move May Violate WTO Obligations, Expert Says, 22 Tax Notes International (30 Apr. 2001) 2146, at 2147 (reporting comments made by Mark Warner, former legal counsel with the OECD)]””
Could it be that by adopting the Pillar 2 approach that is agnostic with respect to any particular jurisdiction other than with a generally applicable reference to degrees of taxation, the OECD is being careful about not colliding with the non-discrimination tenets of trade law? That said, the trade law connection of any of this is undeservedly understated in the present debate about the Pillars and minimum tax.
Where Are We?
Is the result a “DST” with an anti-avoidance transfer pricing rule, that is not a DST or transfer pricing, “CFC rules” that are not CFC rules, and a “blacklist” that is not a blacklist taking account of trade law imperatives, but in concept, fact, and application is all of those things?
There is a lot to take in… and a lot that should be considered and remembered.