Article at Tax Notes: The TCJA’s Unilateral Provocation of DSTs
Updated: Jun 16, 2021
By Benjamin M. Willis and José Rubens Scharlack Tax Notes Federal, January 25, 2021, p. 591
Tax and trade go hand in hand. Imposing tariffs on and eliminating foreign tax credits for countries that seek to implement digital services taxes is no coincidence. But we asked for this. As the OECD was working with the world to establish fairly apportioned taxes, the Tax Cuts and Jobs Act used key base erosion and profitshifting action items to ensure America would be the first to tax the revenue it desired. Since enactment of the TCJA’s quasi-territorial tax system, the U.S. tax code has departed from generally accepted principles of international taxing rights by using nearly every possible means to tax foreign earnings.1
In questioning the constitutionality of the global intangible low-taxed income regime, Reuven S. Avi-Yonah recently reminded us that “the Supreme Court explained that jurisdiction to tax must rest on one of two bases: nationality/ residence or territoriality.”2 By taxing based on residence, the United States historically captured the worldwide income of some of the world’s largest taxpayers. If they expatriated, the United States generally continued to tax them.3 The United States taxed some deferred earnings of foreign corporations controlled by U.S. shareholders; and while this pushed the boundaries of taxing rights, the Second Circuit held that it was constitutional. But the TCJA really upped the ante with the questionable taxing policies underlying its new integrated quasiterritorial tax system that could violate WTO and EU state aid rules.4
Of course, the extraterritorial deduction for foreign-derived intangible property will first come to mind to those who have considered whether the policies underlying the TCJA were intended to create economic distortions favoring U.S. trade and whether the United States was complying with international taxing policies. But recall that the onetime repatriation taxed three decades of foreign earnings that might never have made it to the United States, an event that U.S. shareholders simply couldn’t have anticipated. This led to the new territorial dividends received deduction (DRD) that was designed to encourage the movement of foreign cash into the United States. This DRD by no means created a territorial tax system, but it served as the basis for expanding subpart F of the IRC to tax GILTI and to create the base erosion and antiabuse tax, which enlarges the taxation of foreign earnings and creates economic friction to ensure that cash is kept in the United States.
While some ideas that stem from these provisions certainly have merit, that is probably because they were derived largely from the 15 BEPS actions that the OECD presented on October 5, 2015.5 But by being enacted first by the United States, they now accomplish the exact opposite of the intended goal: fairly allocating taxes among countries. Instead, they benefit only one country and ensure U.S. corporations remain untaxed on their global operations — which continue under the GILTI regime because of its 10 percent tax-free return and global netting — showing a lack of appreciation for individual countries and complicating the OECD’s goal of a fair allocation of taxes for each country in which businesses profit.6 But the U.S. corporate tax rate was slashed by 40 percent under the TCJA. If GILTI was the cost to ensure that the United States would deny hundreds of countries — from which the United States profits — the ability to tax, it was a small price to pay. Will foreign countries view the 10 percent tax-free return under GILTI as stateless income and tax it?
GILTI is a minimum tax levied on active, foreign-sourced income of U.S.-based multinational enterprise groups, regardless of whether that income arises from assets or risks allocated to U.S. entities or is a proxy for a dividend distribution to a U.S. shareholder.7 It is clearly divorced from established international practice.8
GILTI represents the United States’ unilateral exercise of its residence-based taxing power to reach the income of its residents wherever that income is and however it arises. It also represents how the United States began to perceive U.S.- based MNE groups as U.S. residents, with little or no regard to the residence-based taxing power of the jurisdictions hosting the controlled foreign entities of those groups.
The TCJA also departed from international tax standards when it created the BEAT, which taxes foreign income9 (at a 10 percent rate, as a modified tax liability) as if it were subject to U.S. tax in the first place and therefore also disregards the arm’s length principle’s separate-entity approach by considering foreign affiliates of U.S.-based MNE groups U.S. residents (and by granting the U.S. parent the right to offset from the BEAT the respective FTC).
Because the United States unilaterally deviated from traditional international tax principles when it created GILTI and the BEAT, it doesn’t make sense, as we will see, that Treasury now expresses “concern” that the inclusive framework’s proposal for amount A of pillar 1 would depart from “longstanding pillars of the international tax system.”
This brings us to the taxation of digital services and whether the new administration will engage in meaningful collaboration with the OECD or continue the pretense of recent years.
Although we don’t disagree that the United States should speak with one voice regarding international affairs and that the executive branch has the power to do so, we cannot fail to see the incongruence of Treasury’s current stand, not against unilateral DSTs (whereby countries are creating jurisdictional ties in no broader ways than the United States) but against the likely new international consensus, given recent developments in the U.S. tax system.
After exploring the support that the TCJA’s international provisions lend to foreign countries imposing DSTs, we will now recap the facts that led to the current impasse and explore a 2018 Supreme Court case that made it clear that the United States understands the concerns underlying pillar 1 and DSTs.
Pillar 1 and the Unilateral Imposition of DSTs
Following the BEPS action 1 report, the inclusive framework has been shaping a
consensus-based solution (the unified approach) to the tax difficulties stemming from the
digitalization of the economy. Members’ proposals were grouped into two pillars: pillar 1,
which seeks to expand the taxing rights of market jurisdictions based on new business models; and pillar 2, which is designed to ensure a minimum level of taxation by providing (generally residence) jurisdictions with a right to “tax back” when other (generally source) jurisdictions fail to exercise or don’t fully use their primary taxing
Besides improving tax certainty through mechanisms that prevent and resolve disputes,
pillar 1 explores two types of taxable profit that may be allocated to a market jurisdiction: amount A and amount B. While it is a refinement designed to ease compliance and reduce disputes, amount B is still anchored in traditional profit-allocation rules and in the arm’s-length standard (it is a fixed remuneration for baseline distribution and marketing functions for goods bought from related parties and resold at the market jurisdiction). Amount A is the actual novelty.
Amount A reflects a market jurisdiction’s new taxing right: a formula-based share of an MNE group’s or business line’s (rather than a particular entity’s) residual profits arising from the active and sustained participation of a business in the economy of the market jurisdiction through activities (rather than physical presence) in, or directed at, such jurisdiction. The unified approach regards amount A as “the primary response to the tax challenges from the digitalisation of the economy.” According to the unified approach:
In a digital age, the allocation of taxing rights and taxable profits can no longer be exclusively circumscribed by reference to physical presence. Due to globalisation and the digitalisation of the economy, there are businesses that can develop an active and sustained engagement in a market jurisdiction, beyond the mere conclusion of sales, without necessarily investing in local infrastructure and operations. This means that the profits attributable to the physical operations that a business undertakes in a jurisdiction, in accordance with articles 5, 7 and 9 of the OECD and UN Model Tax Conventions, may no longer be reflective of its sustained and significant engagement in the market.10
Targeted businesses are those that generate revenue from the provision of automated and standardized digital services to a large population of users or customers across multiple jurisdictions. Examples include online search engines, social media platforms, online marketplaces, digital content streaming, online gaming, cloud computing services, and online advertising services. Also targeted are businesses that generate revenue from the sale of goods and services to consumers, either directly or through third-party resellers or intermediaries such as direct resellers or multilevel marketing operators.
Since the inclusive framework began discussing the tax impacts of the digital economy
and developing the unified approach on amount A of pillar 1, countries progressively decided to “go rogue” and create their own version of digital taxes, just in case the resistance of residence countries is formidable enough to prevent the inclusive framework from reaching a consensus that would enable a taxing power shift from residence to source jurisdictions.
About half of all European OECD countries have either announced, proposed, or
implemented DSTs.11 The U.S.’s alterations of the OECD’s BEPS proposals to expand its own claims on taxing rights are well understood. The new wave of DSTs is no surprise and will certainly continue absent a change in the U.S.’s nationalistic tax and trade policies.
The proliferation of unilateral DSTs, “and the political pressure that led to them in the first place, have been among the key driving forces behind Pillar 1 of the OECD’s approach.”12
International consensus on amount A of pillar 1 is needed to replace unilateral DSTs and to end the tax maze that source jurisdictions are forming.
Whose Stand Is This?
The United States is a strong force within the OECD and historically a collaborative one that benefits greatly from the global economy and reduced trade frictions. Regarding the inclusive framework’s unified approach, Treasury, on one hand, participates in the discussions and works closely with fellow members. On the other hand, it is concerned that amount A of pillar 1 (or its substitutes, the unilateral DSTs) might hurt its digital champions and ultimately decrease residence taxation of U.S.-based MNE groups.
On January 29, 2019, a Treasury official said, during a meeting of the District of Columbia Bar, that the United States is engaged in the inclusive framework’s talks “out of the very deep concern that the longstanding international consensus around the allocation of taxing jurisdiction is breaking down.”13 On December 3, 2019, Steven Mnuchin sent a letter to the OECD expressing the United States’ “serious concerns” that pillar 1 would depart from “longstanding pillars of the international tax system upon which U.S. taxpayers rely.”14
Perhaps because Treasury’s rhetorical efforts have not produced their intended outcome,
Treasury said, in a June 12, 2020, letter to European countries, that negotiations on pillar 1
“have reached an impasse and that Washington won’t accept even interim tax changes affecting U.S. technology companies.”15 Treasury then seemed to leave the inclusive framework’s negotiation table, but it apparently came back later.
Also, U.S. Trade Representative Robert Lighthizer announced section 301 investigations
into nine countries (Austria, Brazil, the Czech Republic, India, Indonesia, Italy, Spain, Turkey, and the United Kingdom) and the European Union because of their creation of or intention to create DSTs.
The investigation initially will focus on the following concerns with DSTs: discrimination against U.S. companies; retroactivity; and possibly unreasonable tax policy. With respect to tax policy, the DSTs may diverge from norms reflected in the U.S. tax system and the international tax system in several respects. These departures may include: extraterritoriality; taxing revenue not income; and a purpose of penalizing particular technology companies for their commercial success.16
Finally, Treasury and the IRS issued REG-101657-20, on November 12, 2020, which
introduced a new jurisdiction nexus requirement for a foreign tax to be considered an income tax (or a tax in lieu thereof) and thus qualify as an FTC under sections 901 and 903.17 Under the new proposed regulations, a foreign tax meets the jurisdictional nexus requirement if it: (1) taxes income attributable to the nonresident’s activities within the foreign country under traditional principles (including the nonresident’s functions, assets, and risks located in the foreign country, but not the location of customers, users, or any other similar destination-based criterion); (2) taxes income (other than income from sales or other dispositions of property) sourced in the foreign country (but only if the foreign country’s sourcing rules are similar to those existing in the United States); or (3) taxes income from the sales or dispositions of real property situated in the foreign country or movable property that is part of the business property of a taxable presence in the foreign country.18
Explaining these provisions in the preamble, Treasury said that “in recent years, several foreign countries have adopted or are considering adopting a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction as reflected in the Internal Revenue Code.”
Taxing sales based on source isn’t inconsistent with the IRC and support for expansive jurisdictional taxing rights is found beyond the TCJA.
Not American States
Is physical presence required to tax the source jurisdiction on sales made by digital businesses to consumers in that jurisdiction? In Wayfair,19 the Supreme Court analyzed this question under the commerce and due process clauses of the Constitution in the context of state sales and use taxes and decided it is not.
After reaffirming the Complete Auto test,20 the Supreme Court decided that “the physical
presence rule is not a necessary interpretation of the [nexus] requirement” and that it “creates rather than resolves market distortions,” as well as “imposes the sort of arbitrary, formalistic distinction that the Court’s modern Commerce Clause precedents disavow.” Instead, “the sale of goods or services ‘has a sufficient nexus to the State in which the sale is consummated to be treated as a local transaction taxable by that State’” because “a sale is attributable to its destination.”21
On the other hand, the “nexus requirement is ‘closely related’ . . . to the due process requirement that there be ‘some . . . connection, between a state and the person, property or transaction it seeks to tax’ . . . It is settled law that a business need not have a physical presence in a State to satisfy the demands of due process. . . . Although physical
presence ‘frequently will enhance’ a business’ connection with a State, ‘it is an inescapable fact of modern commercial life that a substantial amount of business is transacted [with no] need for physical presence within a State in which business
is conducted.’” Requiring the seller’s physical presence as a condition for the destination state to tax the sale “has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers — something that has become easier and more prevalent as technology has advanced.”
Once the Supreme Court has determined that a market jurisdiction (a destination state) can validly tax the whole amount of a sale made by a remote (out of state) seller to a buyer in that jurisdiction without requiring that the remote seller have a physical presence in the market jurisdiction, it has shown that the Constitution does not forbid the taxation of part of that sales amount (that is, the income taxation of the remote seller). Taxing sales based on source isn’t inconsistent with the IRC. Replicating such understanding in the international context is therefore a question of neither legality nor constitutionality, but of political will.
Treasury said countries should tax income, not sales. There is no practical difference between taxing a sale and taxing the gross revenue from a sale. Taxing sales is precisely what the states are doing after Wayfair. Even foreign sellers are subject to state and local sales taxes on remote sales made to buyers in the 50 states, regardless of whether they have a permanent establishment in that state or are in the United States at all, even
though treaties otherwise protect them against state income or franchise taxes. The TCJA can eliminate so many deductions that gross receipts are effectively taxed. Also, federal excise taxes, which operate as a sales tax on select items, make up 3 percent of federal tax receipts.22
States know the difficulties businesses can face trying to comply with different economic nexus standards and thresholds, and they have been working together to provide a common framework for sales and use taxes. The Streamlined Sales and Use Tax Agreement and the discussions so far produced by the Multistate Tax Commission’s
Wayfair Implementation and Marketplace Facilitator Work Group are examples of such
initiative. By refusing to embrace the global standard that the OECD is trying to put together, Treasury risks replicating internationally the chaos its taxpayers experience internally, because more and more unilateral DSTs shall come to be, each with its own standards and thresholds. The states already experience this chaos and want to get out of it, not by giving up sovereignty but by coordinating with each other. Treasury should learn to do the same internationally.23 Collaborating, as is being done in the Multistate Tax Commission and OECD, can minimize double taxation through apportionment or tax credits as well as minimize distortions resulting from who and how sales are taxed (for example, gross receipts, excise, income).
If the United States continues to preach internationally what it doesn’t do internally (that
is, taxing digital transactions at source jurisdictions), or push to foreign countries a
remedy it doesn’t want for itself (that is, sticking to the arm’s-length standard and to traditional PE notions), how sound is that policy and for how long is it intended to last? 24 Can it really be said that the United States isn’t inviting DSTs?
1 Benjamin M. Willis, “GILTI as Charged: FDII Regulations Prove Harmful Tax Export Subsidy,” Tax Notes, Mar. 25, 2019, p. 1481.
2 Avi-Yonah, “Is GILTI Constitutional?” Tax Notes Federal, Jan. 11, 2021, p. 283.
3 See, e.g., sections 7874 and 877A. 4 William Hoke, “EU Proposes Extending State Aid Law to Foreign Tax ‘Subsidies,’” Tax Notes Int’l, Oct. 5, 2020, p. 135.
5 BEPS Report Tracker; see also Stephanie Soong Johnston, “BEPS 5 Years Later: Action 1 and the Quest to Tax Digital Activity,” Tax Notes Int’l, Oct. 5, 2020, p. 20.
6 Willis, “GILTI’s No-Limit Standard Deduction,” Tax Notes Federal, Oct. 5, 2020, p. 85.
7 José Rubens Scharlack, “How Will Brazilian CFCs Respond to the TCJA,” Tax Notes Int’l, Dec. 16, 2019, p. 1005 (“The GILTI tax is a global tax that goes where subpart F and section 482 (transfer pricing’s arm’slength standard) cannot go.”).
8 Scharlack, supra note 7, at 1007.
9 Although section 59A’s goal is to disallow a U.S. entity’s deduction of base erosion payments to related entities, its mechanics actually represent taxing the foreign related entity’s corresponding receipts at a 10 percent rate of U.S. income tax.
10 OECD, “Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising From the Digitalisation of the Economy,” at 9 (Jan. 29-30, 2020).
11 Elke Asen, “What European OECD Countries Are Doing About Digital Services Taxes,” Tax Foundation (Oct. 14, 2020).
12 Francois Chadwick, “Addressing the Largest Hurdles to Pillar 1 Consensus,” Tax Notes Federal, Mar. 2, 2020, p. 1445.
13 EY, “US Treasury Official’s Remarks Outline Scope of US Involvement and Input Into the OECD Discussion on International Taxation Beyond Digital,” Global Tax Alert (Feb. 1, 2019). 14 Naomi Jagoda, “Mnuchin Raises Concerns Over Global Talks on Taxing Digital Economy,” The Hill, Dec. 4, 2019.
15 Hoke, “U.S. Says OECD Talks on Digital Economy Have Hit an Impasse,” Tax Notes Federal, June 22, 2020, p. 2171.
16 Office of the United States Trade Representative, “Initiation of Section 301 Investigations of Digital Services Taxes,” USTR-2020-0022 (June 2, 2020).
17 The jurisdictional nexus requirement is clearly stated in prop. reg. section 1.901-2(c), but prop. reg. section 1.903-1 makes explicit reference to it (see, e.g., prop. reg. section 1.903-1(c)(2) and (c)(2)(iii)).
18 Prop. reg. section 1.901-2(c)(1)(i), (ii), and (iii).
19 South Dakota v. Wayfair Inc., 138 S. Ct. 2080 (2018)
20 Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977) (sustaining a tax as long as it (1) applies to an activity with a substantial nexus with the taxing state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the state provides).
21 Wayfair, 138 S. Ct. 2080.
22 Urban-Brookings Tax Policy Center, “Briefing Book: Key Elements of the U.S. Tax System” (May 2020).
23 For more similarities between the inclusive framework’s amount A initiative and the post-Wayfair scenario, and on how the latter can be an example for the former, see Walter Hellerstein, Jeffrey Owens, and Christina Dimitropoulou, “Digital Taxation Lessons From Wayfair and the U.S. States’ Responses,” Tax Notes Int’l, Apr. 15, 2019, p. 241.
24 Speaking at a virtual conference sponsored by the District of Columbia Bar on January 14, Lafayette G. “Chip” Harter III, former Treasury deputy assistant secretary for international tax affairs, said the United States should express its support for pillar 1 of the OECD’s two pillar blueprint for updating the global tax rules for the digital age. Countries hope that agreement on the two pillars — especially pillar 1 — will discourage a growing patchwork of unilateral measures, such as revenue-based digital services taxes, which could heighten trade tensions. The inclusive framework is scheduled for mid-2021 for agreement after missing its original end-of-2020 deadline. See Kiarra M. Strocko and Johnston, “U.S. Must Rethink Stance on Global Tax Reform Deal, Harter Says,” Tax Notes Int’l, Jan. 18, 2021, p. 370.