Tax Substance Abuse

Like a lot of tax policy folks, I’ve often used the phrase “rough justice,” normally to mean an imperfect but acceptable solution. But I’m pretty sure the first time I heard the term was during the sentencing of an Ohio capital murder trial, in my days as a local newspaper reporter. There, it meant something starker.

The contrast between the two different meanings is striking–but both imply that true, absolute justice is hard to get in this world.

This is something I think about as the international tax world trends towards more blunt, hard-and-fast rules that work by formulaic proxies, in lieu of more subjective principles. Formulas can be unfair–they can’t possibly account for every possible situation a taxpayer may fall into–but at least they won’t always favor the taxpayer who can summon the most brilliant lawyers to argue a principle to death in the courtroom. Rougher, but also juster, in theory.

One of the most prominent examples is the Organization for Economic Cooperation and Development’s 15% global minimum tax–”Pillar Two” of the Two-Pillar solution, also known as the Global Anti-Base Erosion rules (GloBE). The policy ensures that companies pay at least 15% on their income, no matter where it is.

But their definition of “income” is much narrower than what is commonly used by most tax authorities. The calculation includes the “Substance-Based Income Exclusion,” based on the taxpayer’s amount of tangible assets and payroll. This is because those factors indicate economic substance, and “are generally expected to be less mobile and less likely to lead to tax-induced distortions.”

“Are generally expected to be” isn’t something you normally expect to see in law. Isn’t the law supposed to concern what is, not what could likely be? But this comes after decades of difficulty in pricing and taxing intangible assets, such as IP or branding, that can be worth billions to tech or pharmaceutical companies. When you can’t even define something, let alone measure it, then identifying it by ruling out what it isn’t–tangible, physical property or flesh-and-blood employees–gets close enough to the target. Unusually high returns on small amounts of real stuff seems to be a good sign that something fishy is going on.

This approach dates at least as far back as 2014 and the revised tax reform draft released by then-Rep. Dave Camp, a Michigan Republican and chairman of the House Ways & Means Committee. That included a tax on “intangible income,” as defined as a profit return of at least 10% on “qualified business asset investment,” or depreciable tangible property. With only a few tweaks, QBAI survived into the 2017 Tax Cuts and Jobs Act’s tax on global intangible low-taxed income, using the same overall concept. The GILTI tax applies to the foreign income of U.S. companies, but only after 10% of the company’s depreciable tangible property is taken out. Again, this is supposed to focus the tax on intangible income, instead of real economic activity. We’re willing to leave that to the foreign country to tax–in a sense, they earned it.

The 2014 Camp discussion draft was supposed to be for, well, discussing. But in the mad dash to construct and pass the TCJA, there wasn’t a ton of debate about whether the QBAI concept made sense. Democrats claimed that it could encourage companies to move facilities and jobs offshore–which implies that QBAI actually is a decent approximation of economic substance. But in the days since, taxpayer after taxpayer has complained that GILTI catches a much wide swath of companies than pure tax haven entities. Many service companies run high profits on low staff, and in the eyes of GILTI are engaging in profit-shifting even if they aren’t.

But it’s not just the results that are the potential problem with this approach. Even hard-and-fast rules will produce uncertainties and subjectivities on the margins.

In comments to the OECD on the Pillar Two implementation package, released earlier this year, commenters identified several situations where the SBIE may encounter difficulties in calculation, or lead to results too unusual to be ignored. The German Federal Chamber of Tax Advisers and the International Chamber of Commerce noted that many industries, such as construction or aviation, use “mobile assets” which will be moved through several jurisdictions within a year. Accounting firm RSM UK noted that share-based compensation–notoriously difficult to calculate–could skew the payroll cost factor. And the Silicon Valley Tax Directors Group noted that mixed-used assets, those used for both rental income/value appreciation as well as production, could be a problem for the OECD as the latter are supposed to be exempt from the SBIE.

The OECD may well have worked these issues in the time since then, but they are doubtless many more that could potentially pop up. The substance-based carveout is arguably one of the biggest sleeper issues in the package, not yet receiving tons of attention but about to become a systemic, pervasive part of the global tax system.

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.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

The potential conflict between the U.S. and the European Union over the Inflation Reduction Act’s green tax-based incentives is continuing to smolder, and could hinder not only the IRA’s goals but the OECD multilateral project as well. But in a joint appearance last week at the White House, U.S. President Joe Biden and French President Emmanuel Macron pledged to work together, citing the shared goals of reduced carbon emissions. Stay tuned.

Value-added taxes were created during World War I, but they continue to be seen as a cutting-edge revenue tool. The EU on Thursday announced a series of measures to update the Union’s VAT “to work better for businesses and more resilient to fraud by embracing and promoting digitalisation.” The new items include beefing up the EU’s “one stop shop” for VAT registration, and new real-time digital reporting.

Who remembers Amount B? The OECD released a consultation document on the proposal, the lesser-discussed aspect of Pillar One that’s meant to simplify transfer pricing on “routine baseline marketing and distribution activities.” Officials hope that Amount B will be a major help for developing countries, who’ve been rumbling about jumping from the OECD’s tax forum altogether–so responses to this should be interesting.

Miss Masque, who firsted appeared in Exciting Comics #51 in September 1946. The "Scourge of the Underworld," she is a socialite who fights crime and injustice in disguise, relying on "her wit and a pair of pistols."