Withhold Your Horses!

After months of negotiations, the Organization for Economic Cooperation and Development finally released the text of a 200-page multilateral convention to implement Amount A of Pillar One–essentially a treaty for countries to enact a new global taxing system which aims at capturing more income from online, digital transactions. The release marked a significant achievement, finalizing language on a project that began more than six years ago.

Well….almost.

The release notes that the document reflects the “current consensus achieved so far” (emphasis mine) among the 140-odd nations participating in the OECD’s global tax project. The OECD’s text concedes that “different views on a handful of specific items” by a “small number of jurisdictions who are constructively engaging to resolve differences.”

It is true that it’s only a few countries that are raising the most objections. But they include Brazil and India, two of the biggest emerging economies on the globe. The OECD has also stressed that the differences are largely technical–which may be true, but some seem to veer close to issues of policy. (If there really is a distinction.)

Among the biggest points of disagreement is whether Amount A will take into account withholding taxes, especially in regard to the elimination of double taxation. These are taxes that a country will take out of intercompany payments for items like royalties or interest, usually on a percentage basis. When countries negotiate tax treaties, they normally reduce or eliminate those withholding taxes–which are simple and crude anti-avoidance measures–to put into place the more complex arm’s-length income allocation rules.

While this issue is relatively minor in the grand scheme of things, it could become the next major hurdle the OECD faces as it tries to beat back the still-long odds for this project’s completion.

The Amount A project began as a reaction to the proliferation of proposed and enacted digital services taxes, which target the revenue (not income) of online activities like advertising or data collection. Lawmakers passed these responding to public outrage over the perceived non-taxation of tech companies, due to an outdated tax system that often is based on the physical presence of a taxpayer.

In theory, DSTs are only temporary patches to the global income taxes, until a permanent solution can be found. Amount A is likewise an income tax patch, although it’s supposed to be permanent. It avoids targeting online transactions specifically (which the United States strongly opposes) by instead giving market countries a new slice of income from transactions in their jurisdiction, whether or not the taxpayer is present there physically. The tax only hits large, profitable companies, with the thinking that they’re the likeliest to be using valuable intangible assets.

It’s a version of formulary apportionment, when income is allocated to different jurisdictions based on a company’s global income and certain factors, in this case sales. But it’s only supposed to be a small amount affecting a few companies, allowing the rest of the traditional arm’s-length system to continue. There’s also a system for avoiding double taxation, so jurisdictions don’t try to use transfer pricing to get at the same profit they already taxed through Amount A.

That’s where the withholding tax issue comes in–after some pressure from business groups, the OECD agreed to take it into account when ensuring that Amount A isn’t overlapping with existing taxation. This includes the “marketing and distribution safe harbor,” (MDSH) which is “a formulaic measure of excess profits deemed to be taxed under the regular tax system,” according to an analysis from Ernst & Young LLP. (Aggravatingly, the marketing and distribution safe harbor isn’t really a safe harbor, and doesn’t necessarily have to do with marketing and distribution–such is the way of words in tax policy and treaties.)

Withholding taxes are also taken into account for an additional system that Amount A uses to avoid overall double taxation.

In the case of the MDSH, the amount of excess profit used to measure the size of the carveout is increased if there are withholding tax payments, approximating the income that would be there if the withholding tax were an income tax. This “effectively equates profits associated with withholding taxes and profits associated with income taxes.” Ultimately, it means there's less Amount A taxation.

So, are withholding taxes the equivalent to income taxes? Well, it’s complicated.

Technically the answer is no–withholding taxes are usually applied on the overall amount of the payment, without taking into account potential costs. But in many cases tax authorities consider withholding taxes to be a proxy for income, or a tax “in lieu of” income tax. For instance, with a lot of caveats, companies can claim a foreign tax credit for withholding taxes, even though FTCs are only meant to apply to income taxes. Withholding taxes are a safeguard to a country’s income tax system.

Many representatives of developing countries–who are more likely to rely on withholding taxes for revenue–aren’t buying it, however.

“We do not find any merit in the claim that withholding taxes will result in double counting,” wrote the Intergovernmental Group of Twenty-Four on International Monetary Affairs and Development, also known as the G-24, in comments to an OECD July 2022 release that first floated the idea of a withholding tax adjustment.

“Withholding taxes are levied in respect of a limited set of payments only and there cannot be any presumption that they are related to residual profit only,” the G-24 said. “On the other hand, withholding taxes are mostly linked to operational activities leading to routine profits and, therefore, outside the scope of Amount A.”

A carveout for withholding taxes would render Amount A “unattractive and meaningless” for developing nations, according to the G-24.

On the other hand, many taxpayer groups warn that without an adjustment, countries would soon turn to withholding taxes for new revenue, just as they turned to digital services taxes under the current system.

“The failure to address this issue in a principled manner will result in a proliferation of withholding taxes, destabilizing the system and undermining the objectives of Pillar One,” the National Foreign Trade Council wrote in its 2022 comments.

OECD officials are pretty certain that this issue can be resolved, and it doesn't seem like the kind of thing that could hamstring an entire project of this size. Although, I wonder if the perception that the United States will never sign onto the treaty–which, based on the agreement's own implementation system, would render it non-operative–is making countries more reluctant to go out on a limb for a compromise. Why set a precedent you perceive as against your own interests, for a project that’s doomed anyways?

But mostly, I think this issue highlights the difficulty with creating a new taxing right which is supposed to complement and run parallel to the existing system. It can sound simple enough in theory, but creating rules to keep the two systems separate and prevent them from consuming each other can become exponentially complex. The OECD’s most recent release is more than 800 pages of dizzying, sometimes impenetrable language outlining scores of new terms, provisions, backstops, measures and counter-measures trying to arrive at an amount that everyone can live with.

In a recent webcast, OECD Deputy Director Tax Policy and Administration Achim Pross said that much of this complexity was “computational,” and could be simplified over time as tax authorities become more practiced at doing it. That may be true, but I dunno.

And if the two taxing paradigms do ultimately come into conflict, who will win–the complex, formulaic, market-based system or the increasingly strained, century-old system of transfer pricing?

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• As the paralyzed Congress slowly responds to the horrific crisis in the Middle East, taxes have unexpectedly been drawn into the political maneuvering. The House of Representatives on Thursday passed a military aid package to Israel, which purported to offset the $14 billion in new spending by repealing new funding for the Internal Revenue Service authorized by the 2022 Inflation Reduction Act. Democrats immediately lambasted the proposal soon after it was unveiled, claiming it would hamper the agency’s new enforcement efforts, including in areas of international tax evasion and money laundering. No one in DC thinks this provision will make it into law, but it’s significant that it was both proposed and passed by House Republicans. The $80 billion in new IRS funding, already controversial for conservatives, will be an easy target for whenever Republican lawmakers want to offset new spending, so expect to see this again. That’s even though repealing the IRS funding would actually decrease revenue, according to the Congressional Budget Office, since it would hamper enforcement.
• As I wrote a few weeks ago, it’s hard to even contemplate the fallout if the Supreme Court issues a decisive ruling for the plaintiffs in Moore v. United States, which challenges the 2017 Tax Cuts and Jobs Act deemed repatriation tax. The logic of the Moores’ complaint would fundamentally change how Congress can approach income taxation and could leave much of the current system in shambles. The Committee for Responsible Budget, a DC-based deficit watchdog, tried to put some figures on this, however. According to a Wednesday post, a narrow ruling that only affected the TCJA could reduce tax revenue by as little as $3.5 billion. But a broad ruling, that called into question not only the TCJA’s international tax framework but longstanding provisions like Subpart F could cost more than $1 trillion. This isn’t even taking into account future taxes that would no longer be possible options for Congress, like a tax on unrealized capital gains or a wealth tax.
• While it seems like most of the world has moved on from the coronavirus pandemic and resulting economic fallout, African nations have still not been able to return to pre-2020 levels of revenue, measured as a percentage of gross domestic product. That’s according to a new report from the OECD, released Tuesday, on fiscal challenges facing the continent. On the same day, the OECD announced that it would extend its memorandum of understanding with the African Tax Administration Forum, “to continue to work together towards the common objective of promoting fair and efficient tax systems and administrations in Africa.”

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Marksman, first appearing in Smash Comics #33 in 1942. In the grand tradition of Robin Hood and other noblemen-turned-heroes, Marksman uses his archery skills to fight the invading Germans during World War II. He also spies on the enemy disguised as a Nazi major.

Contact the author at amparkerdc@gmail.com.