More State Aid Thoughts

Probably more than a decade ago, a tax policy expert (I don’t even remember who) told me something intriguing:

“It’s not possible to break transfer pricing law.”

What he meant is that while there are lots of laws out there that forbid things, some laws only enable–they don’t say “thou shalt not,” but “the government shall.” Or, in the case of Section 482, the U.S. transfer pricing statute, “the [Treasury] Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances” between related parties, if he decides it is necessary “in order to prevent evasion of taxes or clearly to reflect the [taxpayers’] income.”

Indeed, much of the international tax code, when it comes to corporations, comprises this type of law. The taxpayer is allowed to do almost anything, but the government can make adjustments after-the-fact. Sometimes the government may recharacterize the contract entirely, but more often it looks at the prices set by the company in a transaction, and sees if they can be changed.

Of course, a taxpayer may just be cooking the books–but in that case, you’re dealing with the federal laws that ban fraud or misrepresentation.

The implications of this are probably mostly rhetorical. When tech CEOs come before Congress and testify that their companies are paying all the taxes they legally owe, they’re probably not lying, at least in this frame. But the statement doesn’t mean as much as it might sound like to most people. The laws allow companies a lot of discretion to form whatever structures they want.

If a corporation decides to charge an offshore subsidiary $1 to use a valuable piece of intellectual property, that’s probably legal. (Well, with some caveats.) It’s, of course, going to catch the Internal Revenue Service’s eye and will probably result in a quick adjustment. But the initial structure isn’t illegal per se, if maybe very unwise.

And even if the result of the audit, adjustment and potential litigation is not only an income adjustment but penalties and interest for prior years, the company can legitimately say it was paying the correct amount of taxes the whole time. Legally, the tax wasn’t owed until the end of the process–probably, a court making a final ruling.

No wonder regular people get exasperated and cynical about international corporate taxes. The rest of us live in a tax world that’s pretty black-and-white, with taxpayers either being in or out of compliance. (It’s definitely possible to break individual tax law, even to go to prison for it. Although it’s surprisingly difficult–the onus is on the government to prove a deliberate mispayment. Absent that, it’s just a mistake, not a crime.)

Corporations, on the other hand, get to live in a tax world of ranges, margins and adjustments, where the taxpayer and government often find a way to meet each other halfway. Try doing that on your next W-2.

I bring this up because I’m still mulling over the Court of Justice of the European Union's recent final decision in the European Commission’s state aid case against Apple Inc. and Ireland. A lot has already been said about the disagreements that tax experts (and the U.S. government) have with the Commission’s reasoning and use of the arm’s-length principle.

But it occurs to me that this is another area where the EC and the CJEU departed from how international taxes are typically done according to standards set by the Organization for Economic Cooperation and Development.

The EC and CJEU didn’t readjust Apple’s Irish intercompany payments, they threw them out entirely and assigned new income to the Irish subsidiary. Even if the U.S. or Irish tax authorities had agreed with the Commission’s logic, they probably would have enforced the point by changing the prices for the IP payments and readjusting the income earned in the relevant jurisdictions.

In many ways, the Commission's approach seems closer to an economic substance analysis than a transfer pricing one. In the U.S., the economic substance doctrine is one way that the government can invalidate a structure outright if they can prove it’s illegitimate and lacking in any real business purpose. But the doctrine has a whole different series of thresholds and tests than transfer pricing, refined through decades of court decisions. The bar is quite high–especially when an entity has legal ownership of IP.

Not that there isn’t a lot of overlap, though. The OECD’s transfer pricing guidelines, updated through the 2015 Base Erosion and Profit-Shifting project, advise close examination of an entity’s true purposes and functions when high-value intangible assets are involved. It definitely sounds like an economic substance analysis. And a 2022 Internal Revenue Service memo allowing more use of the economic substance doctrine noted that a lack of arm’s-length pricing is one indication that a case may be warranted. That's a direct overlap.

One reason tax authorities may tend to shy away from this type of enforcement is that if you’re going to invalidate some structures as being wrong, you have to say what would be right–and that can be a whole new series of headaches. It’s one that the CJEU and EC may have run into, assigning all of this allegedly misappropriated income to Ireland, the very country they claim lacked enough economic substance to justify it.

Things may be changing, though. As noted above, the IRS and U.S. Treasury Department have signaled they’re more open to bringing economic substance doctrine cases than they may have been in the past. The U.S. District Court may have opened the floodgates with the Liberty Global decision.

And then there’s the recent state aid ruling.

All of this coincides with a new focus on formulaic determinations of substance at the OECD–moving away from the close factual analysis to easy and blunt approximations.

Formulas may not always be fair, but at least they leave less to argue about.

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

• Did I mention the substance-based formulas used at the OECD? It seems like it's been a while since we've talked about the formulaic substance carveout to Pillar Two, the OECD's 15% global minimum tax. But there's been activity under the surface. The National Foreign Trade Council and the Cruise Lines International Association wrote an open letter to the OECD on Tuesday urging them to hurry up with guidance the organization promised on how the SBIE will apply for mobile assets. Since tangible assets are one of the factors for the carveout, there are a lot of questions about how it will work for industries with assets that move from jurisdiction to jurisdiction--which don't just include obvious sectors like airlines or shipping, but many more who participate in the global economy. I continue to believe that the substance carveout could end up being much more important to Pillar Two that folks realize at the time, so this could be an issue to watch. (Note: CLIA was a client I worked with while at Capitol Counsel.)
• The OECD released a study Monday on "tax arbitrage," especially for owners of closely-hold and unincorporated businesses. The report looks at different ways that individuals and companies could be finding ways to profit through entity form selection, including to create corporations for what would otherwise labor income. Curiously, it doesn't seem to touch on the prior work the OECD has done on hybrid mismatch arrangements, another example of arbitrage. It also doesn't mention the U.S. pass-through deduction, meant to benefit small businesses but with complex rules to keep out labor income. (One of many things up for renewal next year.) Definitely an interesting read.
• It's been a while since I've written about the OECD's interesting work on climate change and carbon pricing. The organization is hoping to become a kind of clearinghouse and forum for countries to explore standardizing and comparing different policies to reduce emissions, including carbon taxes. To that end, the OECD today released "mapping methodology" to connect a given climate policy to its "greenhouse gas emissions base." I still think this could be the future for international taxes, so we all may want to start brushing up on the terminology.

NOTE: This newsletter will be off next week for travel.

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The Super-American, appearing first in Fight Comics #15 in 1941. An American soldier from the year 2350, when everyone has superpowers, he was summoned by a present-day scientist fearing the looming Nazi threat. Maybe we could use him today?

Contact the author at amparkerdc@gmail.com.