More on "Minimum Tax", BEPS, the Pillars, CFC Rules and Trade Law


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.  This is sometimes called "thinking outside the box".  There are other euphemisms directed to blinkered thinking, for example, not seeing the forest for the trees.  I had a spirited conversation yesterday about the OECD Pillars and minimum tax with a close friend elsewhere in the world.  As our conversations always make me do, it made me think even harder about some of the issues in this arena.

The international tax conversation, consumed as it is by conflicting currents of debate and analysis flowing from BEPS and its Pillars progeny most recently amplified by the rather opaque announcement on June 5 by the G7 Finance Ministers endorsing some kind of global minimum tax into which the ongoing OECD Pillar 1 and Pillar 1 initiatives would factor, may be a case in point for this kind of reflection.  It may be that we are so dominated by the present narrative that we have forgotten what we are solving for and why - and, importantly, that we have been there before.  There may be some lessons to learn from other lines of sight.


Pillar 1

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 "value created" in source countries.   Fundamentally, as with most questions about the allocation of international income, this can be and in fact is seen through a transfer pricing lens.  The villains are jurisdictional norms considered to be outmoded in the "new" modern tax era - the last modern tax era was in the 1920s and 1930s when guided by the League of Nations and to a lesser degree the International Chamber of Commerce what we commonly and casually refer to as the "international tax system" originated in a form that is essentially intact today.  Stripped of its density and heft, the Pillar 1 proposal is to accept, or possibly more accurately to reflect, some kind of global fractional apportionment of income particularly in so far as the "intangibles" aspect of commercial transfers and services deliveries are concerned, though possibly not by name.  The aversion to "formulary" in the international tax community is legendary, mythological, and largely unwarranted.


Pillar 2 and Minimum Tax

The essence of the Pillar 2 Blueprint even before its recent embroidery by the United States'  Administration's Made in America Tax Plan and the enthusiasm recently expressed by the G7, broadly is for the parent  jurisdictions of establishments and entities conducting business in other countries to occupy the tax room left by low tax countries, i.e., "tax havens" to adopt for the convenience of this discussion a much used international tax epithet, by taxing income allocated to them that they have not taxed to an internationally acceptable degree.  This would be accomplished through the companion notions, the "Income Inclusion Rule", the "Undertaxed Payments Rule”, and in treaty contexts, the "Switchover" and "Subject to Tax" Rules.  Again, stripped of its density and heft of the Blueprint, the effects of these rules, applied together even if not  necessarily entirely conditionally in relation to each other amount to something like this:  "undertaxed income" - income commonly attributed to "low tax" or "haven" jurisdictions effectively will be imputed, not as such but this is the effect, to the superior member of the corporate family and taxed up to the minimum rate as if it has been earned directly or distributed timely by the entity or presence whose income it is.  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 some 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.  The “Subject to Tax" rule essentially targets tax planning that "shifts" source country income to a low tax destination, effectively by returning that income to its source to be taxed according to what is considered an appropriate degree.

From the vista of the forest rather than the internal matrix of its trees, Pillar 2 seems to accomplish two things, to impute or levitate undertaxed foreign income to its ultimate "home", the superior group member’s jurisdiction, and to reverse the kind of  effects closely associated with transfer pricing planning and its reliance on deductible charges to "resource income". Its primary aspect is the former.


CFC Rules By Another Path?  Irresistible Parallels?

Now a first step outside the box.

The Pillar 2 Blueprint acknowledges the influence of "controlled foreign corporation" rules, in Canadian tax language the "foreign affiliate" rules.    The "participation exemption" regimes of other countries are similarly directed.   Effectively, what Pillar 2 does is to apply the logic and to a certain degree the science and methodology of CFC rules to foreign undertaxed business income, as if it were the same kind of income to which imputation would apply under tax regimes that do not prefer or defer the taxation of income from investments or property contrasted with business income.

In Canada, for example, the kind of income imputed to controlling shareholders is "foreign accrual property income", taxed under Canadian rules as if it had been earned directly by the controlling shareholder(s) whether or not actually distributed.  In the United States, this kind of income is commonly known as "Subpart F" income.

But the application of such a dramatic step for business income is selective; it only applies to income of those countries considered to have undertaxed it according to an evolving international standard, namely the minimum tax rate or degree.  In other words, only the taxable connections in certain designated, or to use a "bad" international tax reference "blacklisted" jurisdictions, are affected.  It is as if a "FAPI" or Subpart F" regime applied generally to business income for "designated" countries on the "black" contrasted with the "white" list.  But, it will be known, this kind of parsing of "bad" and "good" tax jurisdictions has not enjoyed favour; the effects in Pillar 2 are similar but more elliptical, just as the "digital services tax" overtones of the minimum tax, also a term of checkered international tax repute these days, are not expressed this way.

The CFC or FAPI system implications of Pillar 2 are bolstered by the Subject to Tax Rule, which essentially impairs the utility of transfer pricing and payment deduction strategies, common BEPS catalysts, 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 in any event doubt.  Countries' CFC regimes reflect devices to facilitate this kind of shifting, quite deliberately in the design of their tax codes.

Canada is no exception.  A famous and enduring example in Canadian tax law is the business income character preservation rule in subparagraph 95(2)(a)(ii) of the Canadian Income Tax Act.  Income of one "foreign affiliate" that qualitatively according to how it was earned is "active business income" and therefore exempt from Canadian taxation even when distributed to its Canadian corporate shareholders of  which it is a foreign affiliate,  enjoys the same exempt active business income treatment when received by another foreign affiliate in the form of a payment otherwise in the nature of income from property, like interest, provided that the payment was deductible by the paying affiliate in computing its active business income under the tax laws applicable to it.  It matters not whether the recipient is taxable at all on the receipt; and the method of transfer, or displacement, or to be provocative "shifting" of the original source affiliate's income is usually the kind of payment which on its own would not qualify as active business income.

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”, and protected or exempt active business income is associated with them.  Canada has very many tax treaties and tax information exchange agreements, all of which count for this purpose.  In the case of other countries, countries with which Canada does not have tax agreements, active business income is not reclassified, and it still is taxed on a deferred basis, but when distributed it is taxed to the extent it has not been taxed where it was earned.  This kind of income, again to be slightly provocative associated with "bad" or "blacklisted" countries though certainly not by name but nevertheless countries that may not have robust tax systems in the Canadian image, is called "taxable surplus".   And, in this regime, there are various and many rules to prevent the unintended conversion of taxable to exempt surplus and to track credit for appropriate allocations of underlying foreign tax.

This looks a lot, sympathetically and directionally, and even in terms, like Pillar 2. The effects are similar.  And the kind of complexity to police the intended allocation of income, split ownership, and general undistorted continuity, is similar.


"Harmful Tax Competition" - The Way Back to Away Back?

Now, another step outside the box.  Some, though because it was twenty years ago maybe fewer than might be expected, will remember the OECD's prior most recent attempt to counter "tax competition”.  It published a report in 1998 entitled Harmful Tax Competition An Emerging Global Issue.

Aside from being much briefer, there is a remarkable similarity between that 1998 Report and its recommendations,  and the Pillars, but particularly Pillar 2.  The 1998 Report, notably, 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 recommended that 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.  It also recommended other changes, concerning withholding tax, transparency, and residence that are or have been addressed elsewhere in the BEPS firmament.

The point of this observation, though, is that Pillar 2 is in many respects Harmful Tax Competition, risen from the ashes, not merely as an idea but both directionally and methodologically even though the grandchild is much more consumed with and by technique.  The simple may have been made complex, but the simple in its essence is still the simple.

For those trying to make sense of the Pillars even without reaching back to the 1920s and 1930s, a read or re-read of Harmful Tax Competition is worth the time.  It is refreshing, bracing.  It is also only about sixty-five pages long, not including a few brief annexes that are not essential for the purpose and to fully appreciate sense of the Report.


A Fiscal Riddle:  When Is a DST Not a DST, CFC Rules Not CFC Rules, Selective Trade Practices Not Selective Trade Practices?

There are some other interesting observations to reflect on, particularly in light of last weekend's G7 announcement.

The G7 went out of its way to contemplate the minimum tax as a replacement for problematic digital services taxes, or DSTs.  Yet, 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 my last post on this 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 is sensitivity to trade law concerns 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 jurisdictions or any countries other than with generally applicable reference to degrees of taxation for commonly determined tax bases, 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.


- Professor Scott Wilkie (Distinguished Professor of Practice, Osgoode Hall Law School)



Comment on “More on "Minimum Tax", BEPS, the Pillars, CFC Rules and Trade Law

  1. Scott, you offer sage and important observations. In particular, I agree that the OECD has been mindful to frame Pillar Two as non-discriminatory to avoid the potential trade rule pitfalls that beset the 1998 Report. Ultimately, I cannot see how countries will be on board with BEPS 2.0 without at least someone WTO complaints arising.

    To build on your observations regarding sensitivity towards trade rules: it seems to me as economies sit at a crisis point arguably not seen since the post-War period, an opportunity presents itself for greater reflection, and perhaps the G20/OECD should hit the pause button to investigate more deeply the impact of cross-border taxation and how tax strategies raised in BEPS impact upon international trade and international investment behaviour (an issue you've raised in previous writings). To date, G20/OECD have focused on base erosion without looking at the other inextricably linked impacts on trade and investment behaviour.

    As we now live, or we are at the very least rapidly moving towards, a data-driven tax world, there are fewer reasons why we cannot begin to extract ourselves from the fuzzy and often outdated parameters of international taxation and international trade concepts (e.g., concepts of ‘harmful tax competition’ and ‘aggressive international tax planning’ in the tax world, and related concepts of ‘unfair trade practices’, ‘discrimination’, ‘subsidies’ or ‘state aid’ in the trade world), and to start looking at and measuring a whole spectrum of tax rules/behaviours with a more quantitative, evidence-based lens. And, on this basis, we may begin to distinguish and measure offending tax rules/ behaviours that erode public finances, but also distort fundamental international taxation and international trade law principles (i.e., the removal of barriers to trade and investment, and notions of fairness and a level playing field).

    This will offer a basis to then question how offending "tax-trade distortions" should be regulated (where and if at all) by the tax and trade worlds, when legitimate policy exceptions should be observed (e.g., on issues such as the environment and fiscal recovery especially for developing country), and when distortions are simply inherent background disparities that are baked into a world where multiple and differing national tax systems and private laws operate.

    It seems without the G20/OECD taking an interim pause (at some point) to address and investigate the above, we will continue to have a rinse and repeat situation, where tax advantages offered by countries or tax strategies employed by MNEs (as seen with EU state aid rulings) may constitute unfair trade practices, but such distortions are largely overlooked in an international regulatory setting. And paradoxically, when international tax policy counters offending tax behaviours (e.g., G20/OECD Pillars One and Two), or countries enact unilateral measures (e.g., DSTs), we see the WTO rules weaponized (sometimes legitimately and sometimes not) to dilute or prevent such measures.