The end of international tax?

“In watching the flow of events over the past decade or so, it is hard to avoid the feeling that something very fundamental has happened in….” international tax.

Thirty years after Francis Fukuyama's landmark essay the words in italic were borrowed from the opening of that bold essay that was not about marking the "end of history" from a scientific perspective, something indeed impossible, but to declare the triumph of liberal democracy against other competing ideologies.

In the same way as history, international tax cannot be ended, if we mean the need for an international tax system or coordination. But we all may have Fukuyama moments and perhaps mine is asking if today we are not looking towards the end of international tax?

In my early presentations on the BEPS project back in 2013, I started with a picture of Frank Lloyd Wright Fallingwater. For those less keen on architecture, Fallingwater is an iconic house designed in 1935 and considered Wright's most beautiful work. 

But 1935 also marked the emergence of a new field of work called international tax law focused on elimination of double taxation with the most visible effort being the 1935 Draft Convention for the Allocation of Business Income between States for the Purposes of Taxation, developed under the auspices of the League of Nations.

Fallingwater and the architecture of the tax system share more communalities than the period when they were developed. Commissioned as a country residence for Edgar J Kaufmann Sr, the owner ended up calling it the 'seven-buckets building', referring to the leaky roof and other deficiencies. The house underwent structural reinforcements and revamps several times and was later converted into a museum. Those insufficiencies were not sufficient to place it as a representation of modern architecture due to underlying marvel that was the integration with the landscape. 

The 1935 Draft itself was also a precursor of the tax treaties as we knew them for more than 50 years post-emergence of the 1963 OECD Model Double Taxation Convention on Income and Capital. That early Draft contained a definition of business income taxable on the basis of the accounts of a permanent establishment and determined that an enterprise with permanent establishments in more than one country that one should attribute:

“to each permanent establishment the net business income which it might be expected to derive if it were independent enterprise engaged in the same or similar activities under the same or similar conditions”.

The permanent establishment concept as we know it was born deeply interlocked to the arm’s length principle in attributing profits. A linkage that was never considered flawless and fueled a “Quest for the Holy Grail” as the world got more industrialized first and later globalized. The first “Holy Grail” was the symmetry on principles of elimination of double taxation that inspired many of the early OECD updates to its model. The knights of King Arthur were the key OECD countries pushing for the completion of the tax treaty network which soon become widespread between developed and developing countries.

Long time ago on the benches of Leiden ITC, I learned with Prof Kees Van Raad one of the fundamental rules on the interaction of tax treaties and domestic law through a figurative presentation where a blank piece of paper would represent the domestic law and the tax treaty would be a smaller piece of paper put on top of the first paper – giving the real impression that such tax treaty merely restricts the ability of a country to tax. Naturally as tax treaties were given their primary object (and objective) of eliminating double taxation the precedence was critical.

But the interplay between tax treaties and domestic law proved to be considerably more complex than any founding architect anticipated and it was perhaps here in this very fine point that the castle of cards also became unstable.

Who does not recall the emergence of technical issues such as treaty override, triangular cases, extra-territorial taxation and last but not least the murky relationship between domestic anti-abuse rules and treaties. The OECD partnership report of 1999 was a good example of walking a thin line. At that time, there was a push towards internationalism and even talk of international tax language as a cure to difficult interpretation cases.

In the backdrop of the emergence of the importance of tax treaties in the decades of 90s and 2000s there were in my opinion several critical issues that further contributing to “leakages” in the international tax architecture. Let’s name a few:

1.     The growth and possibility of MNE to use transfer prices to reduce tax made transfer pricing one of the least understood but important international tax issues pushing the boundaries of tax law towards economics. The problem was that there was no limit on the complexification that transfer pricing could take over and like the mythological the serpent started eating its own tail.

2.     Countries and organizations soon understood that additional pillars should be added to reinforce the structure of the system and the first focus was on saliently accelerating access to tax information and breaking information asymmetries. From slaying bank secrecy to augmenting exchange of information leading to CRS and country-by-country it was in the blink of an eye. Conversely the dispute resolution framework was not a walk in the park and much still remains to be completed.

3.     Finally another factor which I considered affected the international tax stability was the development of regional solutions. The EU Law became a clear case of catch-22 within the wider international tax architecture. The EU internal debate of level playing field, harmonization, harmful tax competition, state aid all concepts raised under an apparent promise or need of protecting the European social model lead to a multiplication of unknown unknowns in the coordination between EU tax law and international tax law. Ultimately, those unknowns ended up with time weakening the overall balance of the architecture and raising the need for new answers. 

Other points could be raised but one should not forget the economic underpinnings which brought the full force of capitalism on the 90s and 2000s – the flattening of the world in Thomas Freidman words. That flattening was also made with the help of the asymmetries of the international tax system that rewarded the bold.

 Just like the Titanic’s eight-member band that keeps on playing whilst the boat is sinking, there was a sense of immobilism on the international tax sphere at that time as regards perceived problems, which ultimately sheltered sovereignty-preserving positions under a delusion of boundless economic growth. Tax arbitrage or avoidance was largely underestimated but the solutions put forward were also incomplete.

 Then came the 2008 financial crisis in the form of the worst economic crisis since the Great Depression of 1929 and “oops” there was no pre-installed controls in the international tax system to salvage the deluge. 

That crisis brought a newfound state interventionism that spread like fire to international tax.

It was a rather peculiar alignment of the stars in the form of the context and public-outcry resulting out of the financial crisis that could and would work as a narrative to counterbalance national austerity measures. New words on the dictionary were added such as tax morale or tax gap and the road for the BEPS project paved.

 The task was monumental and also deeply embedded in political discourse. The narrative the  BEPS Project and its Action Plan was fundamental reform was necessary to fix the international corporate tax system and such actions could [end up] “redefining the architecture of international taxation, rules, tax treaties, guiding principles, recommendations, and decisions within the OECD”.

What resulted from the enormous BEPS 1.0. technical work in my view was a sense of calm confusion. 

The first reason for confusion is the prevalence of domestic law recommendations seeking some sort of harmonization and level playing fields in highly complex areas with different adherence levels. Principle setting in cross-border tax issues either inbound (such as interest deductibility systems) or outbound (such as CFC rules) should go beyond the overarching approach. It should go from principle to law, from law to regulation and from regulation to case resolution.

 The second reason for confusion is the apparent lack of opportunity to tackle more ambitious tax treaty outcomes rather than weakening further the status of tax treaties. Time will tell but the reading of the action points of BEPS will likely shift the prevalence back to domestic law. The multilateral instrument could be understood as a limited instrument that if not enlarged of new scope and purpose may pass in history as a semi-quick fix to a sub-set of technical issues.

The calmness comes from the uncertainty created from the various defensive measures countries build to defend unilaterally their perceived interests being that market or technologically oriented.  

The dust is taking some time to settle on BEPS 1.0 outcome and you already see in the horizon the next sandstorm approaching. One could say we are today in the calm before the storm.

The question then is if we in fact are reaching the end of international tax? Are there, in other words, any fundamental issues that can be resolved in the context of modern cross-border taxation that would be resolvable by the old architecture or we are moving from the first time past the “patchwork” to a new international system.

The early part of the year saw the release of the Policy Note Addressing the Tax Challenges of the Digitalisation of the Economy followed by the consultation documents to collect stakeholder views on both proposals - Pillar 1 and Pillar 2 - the first called “nexus and profit allocation” and the second given the suggestive name of “remaining BEPS issues”.

From Pillar 1 even if three initial proposals were put forward by key market jurisdictions, the consensus building effort seems to be focused around the OECD led “Unified Approach” which would give countries the right to tax profits of an enterprise (regardless of whether they have a base in the country or not) based on calculating up to three separate baskets of profit – using a part-formulary based allocation based on sales. This represents the first explicit move away from the 1935 principle of the “net profit” linked with physical presence and arm’s length approach.

Pillar Two proposals on the other hand ran under the radar of most persons but are equally disruptive for a series of reasons. Under the vests of a BEPS concern of profit shifting, the Franco-German proposal could be read as European style social model protection type of measure (even if incorporating principles adopted by US tax reform) with basically two angles of attack.

The first angle is an “income inclusion rule” one like expanding CFC rules was not sufficient we will have further complex anti-base eroding rules to tax the income of foreign branches or CFCs if that income was subject to a low effective rate of tax in its primary jurisdiction, with the aim of reducing the incentives for multinational companies to allocate returns for tax reasons to low-taxed entities. The second angle is base-erosion induced through a non-deduction rule that will deny deductions for payments to related parties not subject to tax at an agreed minimum rate and/or deny certain treaty benefits where income has not been sufficiently taxed in the other state.

The timeline of the end of 2020 for agreeing consensus on this topics is highly ambitious especially because we are talking of addressing this through the Inclusive Framework of over 120 countries rather than the OECD core membership. If you put in the same pot low tax jurisdictions, intermediary jurisdictions, large market producing jurisdictions and developing jurisdictions all with their own concerns and interests we may imagine the puzzle that this new global tax governance has become.

What is interesting in both Pillars is the reliance on new domestic law criteria as a fix for international tax problems and the apparent demise of tax treaties as bilateral instrument to allocate taxable profits and eliminate double taxation. If and when the consensus comes, the OECD will have to deal with complex implementation issues such as framing both pillars potentially on new standalone multilateral-type treaties (similar to the BEPS MLI). 

Under this new approach (if it is implemented in similar fashion as proposed) the next question is if we may be moving away from the old architecture and embracing a multilateral norm-producing organization. Not yet but there is no U turn possible. Hence our position that if adopted on worldwide scale this move would represent more than a rewrite of the international tax architecture but the lay down of a new system altogether.

One could argue that the foundations of the current system will always be there, being the bilateral tax treaty or the exchange of information mechanisms. But on other hand one may argue that truly we are in a pivotal moment where past and future principles clash. Here are five reasons for such claim:

1.     There is recognition by international tax experts that flaws of the old architecture may only be resolved with domestic harmonization and multilateralism solutions that impose self-abiding level playing fields. Those solutions are definitely no longer bilateral and coordinated within wider-arching organization such as OECD but require other level of cornerstones to tackle certainty, simplicity, administrability and enforcement on a global basis.

2.     The ongoing reform attempts demonstrated an unprecedented politicization of the global tax governance debate ranging from the tax avoidance debate as a by-product of the austerity debate to the emergence of digital taxes as a by-product of the perceived depletion of government budgets by the new digital economy. This politicization is reflective of the importance of such new standards to the division of the “tax cake” between nations. We also cannot forget that the future of taxation within large regional platforms such as EU hang also on the line with this debate. 

3.     There remains a somewhat silent “great divide” within the world when it comes to sustainability, social models, tax mix, neutrality, allocation and accountability on tax revenues and predictability. Under the old model designed for the age of manufacturing the cross-border tax revenues were a fraction of the domestically related tax revenues. In an interconnected machine-learning society this tendency is inverted and we are not prepared for that. Ideology is contaminating the international tax norms. The narrative of increasing unilateralism is a demonstration of our lack of preparation to this next chapter. The balance of powers between west and east or America and China is still shifting and remains as fundamental to the outcome of this debate.

4.     The increased complexity and dual-standards (for large and smaller enterprises) are a bad policy when it comes to international taxes because it ultimately will work as a barrier of entry (on top of other technological ones). We are facing an innovation explosion in the society and responding to that with more tax rules and regulations is not in my view the right approach. The level of complexity is so high that most stakeholders feel alienated from that debate (me included) and fall under the circle of the half empty or half full glass.

5.     The international tax data (and hence revenues) is the new oil under which the foundations of a new system should be framed (and shared) and tax concepts are not the same anymore or at least do not mean the same – see the example with digital or diverted profits taxes. Origin-based taxes, like the current corporate income tax, have their days counted and further work should be done on the shifting to consumption or destination-based taxes and what type of institutions are necessary for this measures to endure and substitute the flawed transfer pricing system.

I finish in the same way as I started by borrowing and tweaking slightly the words of Fukuyama when he stated 30 years ago that “I can feel in myself, and see in others around me, a powerful nostalgia for the time when [international tax] existed. Such nostalgia, in fact, will continue to fuel [tax] competition and conflict even in the post-[international tax] world for some time to come”. The end of international tax is definitely near but its replacement not. 

Tiago Cassiano Neves

18 January 2020

 "Opinions expressed are solely my own and do not express the views of any law firm or organization to whom I am affiliated"