Formula Won?

Michael Plowgian, the deputy assistant secretary for international tax affairs at the U.S. Treasury Department, took a beating during July 19th’s tax subcommittee hearing at the House Ways & Means Committee.

“Duplicitous,” “disgusting” and “socialist” were just a few of the words used by angry Republicans to describe the 15% global minimum tax agreement struck by the Biden Administration at the Organization for Economic Cooperation and Development, along with Treasury’s conduct negotiating it and Plowgian’s own testimony defending the deal.

This wasn’t much of a surprise, given how much Republicans have railed against the agreement so far this Congress, as well as the generally partisan and rancorous nature of Washington these days.

What was a bit unexpected was how much of the hearing was genuinely substantive, even (a little bit) informative. Members of the committee, at least on the GOP side, may not like the OECD agreement, but they’ve clearly spent some time trying to understand it and how it may affect U.S. businesses.

Still, these are politicians, their knowledge only went so deep. There were still plenty of misleading factoids and misguided lines of questioning.

For instance, Rep. Drew Ferguson, R-Ga., was especially concerned about the precedent that the agreement could set by allowing foreign companies to tax U.S. companies on U.S. income.

“How can you justify France being able to tax a U.S. company?” he asked (rhetorically). “That is absolutely crazy.”

Later on, Ferguson asked Plowgian, “is it appropriate to allow one state or country to collect income tax earned on income outside its border?”

But when Plowgian replied that the U.S. regularly taxes foreign income of U.S. companies through Subpart F and the tax on global intangible low-taxed income–and that treaties allow this–Ferguson seemed a bit surprised. He ultimately dropped that line of questioning and turned over the mike.

The point that Ferguson was trying to make–I think–is an important one that’s worth discussing. It is true that extraterritorial taxation, as a concept, goes back many decades. It’s a basic part of Subpart F, enacted in 1962, which immediately taxes foreign income from royalties and interest of U.S. companies. But you could go back even further, to the dawn of the international tax system in the 1910s and 1920s as advocates for source-based taxation and residence-based taxation hashed it out at the League of Nations. The latter is also a form of worldwide taxation and therefore includes both domestic income and income earned abroad.

The distinction between that and some provisions in the OECD’s global minimum tax plan is that Subpart F, GILTI, and other currently accepted forms of extraterritorial taxation only apply to income earned by a U.S. entity. If they’re American taxpayers, the U.S. is entitled to a cut of everything they’ve earned, if it chooses to exercise that right.

But when it comes to subsidiaries of foreign parents operating in the U.S., we’re limited only to what is earned inside the U.S. We can tax that subsidiary, and if that subsidiary has its own subsidiaries (as in a regional HQ), the law doesn’t see a distinction–we can tax those subsidiaries as well. But what we can’t do is work our way up the chain and use the local subsidiary as a way to tax the overall foreign parent group.

At least, not yet.

There are other ways that a tax authority can impose taxes on a larger foreign group within current global tax norms. Many jurisdictions have withholding taxes on certain crossborder payments. And there are laws that deny deductions on outbound related-party payments in some circumstances, such as the base erosion and anti-abuse tax. In many situations that’s economically the same as a tax imposed on both the local subsidiary and other parts of the corporate group–but it can only apply when there’s an outbound payment. (Ways and Means Republicans actually did a pretty good job outlining this concept in a recent letter.) Like the requirement that extra-territorial taxes only be imposed on domestic taxpayers, tying taxes like BEAT and similar measures to inbound payments serves as a limiting principle.

The under-taxed profit rule or UTPR originally began as a denial-of-deduction regime, meant to only apply as a “backstop” against countries that refuse to participate in the OECD agreement. But its ultimate form grew broader, and included taxes imposed on a local subsidiary, but related to low-taxed income earned in another jurisdiction. The income can even be earned in the corporate group’s home jurisdiction. In the case of the U.S., this threatens tax incentives such as the research and development credit, and it’s become the central focus on Republicans’ ire.

It’s not just that this is extraterritorial taxation–it’s extraterritorial taxation that can conceivably target any subsidiary in a worldwide corporate group. How much the country is entitled to tax under the UTPR isn’t determined by its connection to the jurisdiction with the low-taxed income, but based on calculations of the global group’s attributes. Specifically, the country’s percentage of the low-taxed income is based on its percentage of the company’s global workforce and tangible assets.

This is a pretty clear example of formulary apportionment–an alternative to our current transaction-based tax system, in which taxable income is divided between nations based on factors like employees or sales. That the UTPR is formulary isn’t something that the OECD really tries to hide, referring to the “substance-based allocation key.”

Formulary apportionment is also often called unitary taxation, because it’s based on attributes of the entire parent corporate group, not one subsidiary or another. That perhaps makes clearer why a formulary system requires extraterritorial taxation, and why any kind of new extraterritorial taxation raises the specter of a formulary apportionment upending our current system.

That the UTPR is a formulary concept seems simple and obvious to me, but it also seems like it’s underappreciated in these debates–especially as the OECD explicitly rejected a formulary approach at the beginning of this project. This is one of the key reasons that tax justice groups--which have long advocated formulary apportionment as a way to overhaul our global tax system--are pushing for the United Nations to become the arbiter of tax issues.

The prospect of formulary apportionment is lurking just underneath a lot of current tax policy debates. Note the recent controversy in Australia over its proposed public country-by-country reporting, which the OECD allegedly pushed back against in negotiations. The country-by-country system was originally developed by the OECD itself as part of its first BEPS negotiations, and it includes factors like workforce, sales and income–the very attributes that would be used in a formulary system. But that system was supposed to be private. A public system, long the goal of many nonprofits, could be used to pressure corporations to allocate income based on the reports’ factors, becoming de facto formulary in practice while technically adhering to the arm’s-length principle.

Ditto for the Financial Accounting Standards Board’s own country-specific tax disclosure plan, which Republicans recently opposed in a group letter, decrying the measure as “an effort to politicize financial reporting.”

In many ways formulary is already here, and the hybridization has begun. Ironically, the U.S., which has long been one of the status quo’s most vociferous defenders, may have accidentally smuggled it in, with GILTI acting as a Trojan horse. GILTI uses a substance-based carveout, largely adopted by the OECD, and both share a formulary system’s assumption that employees and assets indicate (in part) the value creation behind taxable income. It’s not as many leaps as you’d think to get from there to the decision that factors like those should be the primary or exclusive basis for taxation.

Once you start doing formulary it’s hard to stop. That’s something the OECD has learned in its struggles to stop double taxation under its Pillar One plan. After you’ve grafted a small formulary system onto the arm’s-length system, by what principle do you determine the limits of either? How do you stop countries from using both to tax the same underlying income?

Just like it’s hard to be a little bit pregnant, it’s hard to be a little bit formulary. But the OECD may have stumbled onto a way to do it. The UTPR is limited to only the company’s low-taxed income–defined as income taxed below 15% in a jurisdiction, measured by a financial accounting standard and factoring in a substance-based exclusion.

In theory it could stop there. But will it?

And should we start debating it under those terms, and considering whether this formula is the right one to begin a formulary system. (Note that while the OECD’s substance-based carveout factors in payroll, while the UTPR allocation key uses workforce head count. And why aren’t sales included?)

I’m not saying a formulary system is necessarily bad. Formulary apportionment advocates often note that it’s used by U.S. states. But it requires a certain amount of acknowledgement and buy-in from all sides.

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 Tax Justice Network released a study Tuesday claiming that countries will lose $4.7 trillion due to tax avoidance and evasion over the next decade. The report is worth reading–and also worth giving some scrutiny, given the wide disparities in estimates for global profit-shifting. This report highlights “abnormal deposits” in low-tax jurisdictions, and attempts to impute what would have been paid in the country of origin. I think that may be disregarding all of the different reasons why companies locate income in favorable jurisdictions, as well as the potential costs for those arrangements elsewhere. Still, the study is transparent about its methodology and backed by many earlier calculations. TJN uses the results of this report to continue to push for a greater role by the United Nations in global tax debates.
• The OECD didn’t request any formal input for its new Pillar Two guidance last week–but that didn’t stop businesses from responding, anyways. Business at OECD, a coalition of corporate taxpayers (confusingly known as BIAC, because their name used to be the Business and Industry Advisory Committee to the OECD), released a statement Tuesday, praising the latest guidance for clarifying some issues but still expressing concerns about the overall complexity that remains. The subtext here is that the OECD has only held one formal public consultation on the global minimum tax since the agreement was announced back in the summer of 2021, leading some observers to wonder if the process is jumping ahead too quickly. Still, it’s not like businesses haven’t been able to make their opinions on the policy known.
• The OECD also had two new releases this week highlighting its work to deal with tax avoidance in developing countries. On Wednesday it announced that the organization, collaborating with the Economic Community of West African States and the West African Economic and Monetary Union, developed three “community legal tax instruments” to combat base erosion and promote tax transparency. These include new measures to enhance coordination as well as a directive for beneficial ownership reporting rules. The OECD also released comments it has received on new “draft toolkits” to aid developing countries deal with tax avoidance risk in mineral extraction. (A fascinating issue, BTW.)

PUBLIC DOMAIN SUPERHERO OF THE WEEK

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

Yet another WWII-era hero....The Conqueror, who debuted in Victory Comics #1 in August 1941. A pilot who crash-landed somewhere in the Rockies, Daniel Lyons was revived by a reclusive mountain-dwelling scientist with a "Cosmic Ray Lamp." The lamp gave him superpowers which he decided to use to fight the Axis in Europe. Aside from his super-strength, his belt also holds a revolver and throwing knife, because I guess sometimes the old ways are still the best.

Contact the author at amparkerdc@gmail.com.