The OECD’s “no Plan B” approach on digital taxation backfires

Oliver Treidler

By Oliver Treidler, CEO, TP&C GmbH, Berlin

As reported by major newspapers last week, the US has announced its withdrawal from the global digital tax talks.

In a letter written by US Treasury Secretary Steven Mnuchin to the European finance ministers, Mnuchin explained that from the perspective of the US, the negotiations are at an “impasse” and should be put on hold while the countries focus on coping with COVID-19.

Looking at the immediate consequences, the New York Times suggests that: “[t]he collapse of negotiations could set off an escalating trade war and saddle multinational corporations with vast new uncertainty over their future tax bills, at a time when the coronavirus has upended supply chains and business models worldwide”.

The suggestion offered by the New York Times seems to be a rather safe bet at this time. It is, however, also quite unspecific, only scratching the surface of possible implications for the realm of international taxation.

The OECD hits the wall

While the news of the US withdrawal is a bit stunning, it is not surprising, in principle.

For those observing the global digital tax talks in the last couple of months, the trajectory of the discussions did not seem promising. In January, the OECD declared the technical discussion on Pillar 1 to be over – despite a plethora of vital conceptual issues remaining unresolved. The head of the OECD’s tax policy centre, Pascal Saint-Amans, declared that the train had left the station.

Instead of engaging in an admittedly complex (but more principled) discussion on how to define fundamental concepts underlying the overhaul of taxing the digital economy (e.g., defining value generation and nexus thresholds), the OECD committed itself to broker a consensus by the end of 2020.

Instead of engaging in an admittedly complex (but more principled) discussion on how to define fundamental concepts underlying the overhaul of taxing the digital economy (e.g., defining value generation and nexus thresholds), the OECD committed itself to broker a consensus by the end of 2020.

It seemed evident that brokering a consensus would hinge on offering the non-market countries (mostly the US) an increase of tax certainty that is sufficient to make them feel comfortable with surrendering a (“reasonable”) slice of their tax base to the market-countries.

Considering that these negotiations are largely a zero sum game, involving comparatively high stakes (e.g. a quasi-permanent re-allocation of taxing rights), reaching a consensus is a tall order even under ideal circumstances. As it turned out, however, the conditions in 2020 would be far from ideal.

As the dramatic effects of COVID-19 started to become clear, there seemed to emerge a situation in which the OECD could have opted to relent the end-of-2020 deadline without losing face. Instead of pursuing a more long-term approach, however, the OECD re-committed to its original goal.

Following-through with these, arguably most complex and far-reaching reforms of the international tax structure in decades, reflected a distinctly short-term oriented (politics-driven) approach that due to the zero-sum nature of the negotiations seemed to exacerbate a more confrontational mind-set.

As an outsider, it is naturally hard to imagine and comprehend the specific course of the negotiations. In case the quote of Robert E. Lighthizer, the United States trade representative, offered the New York Times, however, one can imagine that tempers must have flared from time to time: “The reality was, they all came together and agreed that they’d screw America, and that’s just not something that we’re ever going to be a part of,” he said. “I don’t want tax systems that unfairly treat American companies”.

Obviously, there are (at least) two sides to the story. Still, the fact that the OECD rushed into these difficulties without having established a somewhat robust conceptual framework did likely not help to “anchor” the expectations of the stakeholders.

 After all, it seems rather elusive to negotiate a “fair” allocation of taxing rights (income allocation) when even the most basic concepts (see above) remain undefined.

While the new nexus rule arguably enjoys a reasonable consensus among stakeholders, it is not clear (and does not conceptually follow) that market countries should be entitled to a substantial share of residual profits (calculation of Amount A and Amount B based on formulary apportionment favoring market countries).

To anchor the expectations of the stakeholders and create the conditions for an agreement, the OECD would have to facilitate the technical discussion on how to appropriately capture the value-added contribution of market jurisdiction. A shortcut will not work, as statements such as those by Mr. Lighthizer cannot be addressed without a clear frame of reference. The statement of Mr. Lighthizer might conceivably be justified, but at this point, any argument is futile.

One may identify three distinct shortcomings of the OECD in the context of the discussion on digital taxation.

First, the OECD succumbed to political pressure and myopically focused on end-of 2020 to finalize these complex and ambitious reforms. Being ignorant of the actual political pressures exerted on the OECD, it is admittedly hard to judge whether the blame is deserved in full.

The second, perhaps most important shortcoming, can be seen in the unprincipled stance of the OECD when it comes to contextualizing the Pillar 1 discussion with BEPS. The OECD did not appropriately emphasize that Pillar 1 is conceptually unrelated to the previous reforms aimed at curtailing tax avoidance. This lack of conceptual clarity was coupled by a somewhat awkward anti-MNE rhetoric as well as misplaced notions to notorious weasel words such as “fairness”.

This unprincipled stance facilitated an “over-politicization” of the reforms, with the OECD becoming more a political stakeholder than an impartial arbitrator focused on safeguarding the conceptual consistency of the international tax framework and ensuring a pragmatic implementation of the rules (e.g., as previously reflected in its role in updating the OECD guidelines).

The third shortcoming was a (mind-bogglingly) ambiguous stance on the status of the arm’s length principle.

Previously, the OECD made a commitment to the arm’s length principle. This held true during the evolutionary modifications to the arm’s length principle during BEPS.

While there has always been “noise” on the arm’s length principle, the OECD commitment to the arm’s length principle served as the bedrock of international taxation. Calls for modifications and reforms, such as BEPS, as well as addressing the (justified) concerns of BRICs in applying the arm’s length principle in developing economies (e.g., accounting for location-specific advantages) could be resolved without jeopardizing the consensus on the arm’s length principle.

While it is legitimate to deliberate about pragmatic solutions (including “elements” of formulary apportionment) for coping with digital taxation, one could not help but wonder during the Pillar 1 discussions, whether the OECD is still committed to the arm’s length principle as the ruling paradigm of transfer pricing.

The problem in tinkering with formulary apportionment, as perhaps best illustrated by the quote of Mr. Lighthizer, is that suddenly stakeholders, especially politicians, feel free to invoke their perceptions of “fairness” when commenting on an appropriate allocation of taxing rights.

The problem in tinkering with formulary apportionment, as perhaps best illustrated by the quote of Mr. Lighthizer, is that suddenly stakeholders, especially politicians, feel free to invoke their perceptions of “fairness” when commenting on an appropriate allocation of taxing rights.

Needless to emphasize that such perceptions are opposed to a transaction-based interpretation of the arm’s length principle and are more susceptible to nationalistic and populist interpretations.

Are trade wars imminent – is a global solution for digital taxation dead?

The short answer here is: no, but we are close to the brink. Still, in case “reason” prevails, there is still room to strike an agreement – but not by the end of 2020.

On April 19 I outlined three possible scenarios for Pillar 1 here on MNE Tax.

In my view, the US withdrawal from the current talks serves to dramatically emphasize the negative implications of scenario one described in that article: “Pillar 1 adopted by the end of 2020 (short-term orientation)”.

It seems that the US has decided to draw a line in the sand at this point. But looking beyond the emotional comments of Mr. Lighthizer, there still seems to be room for engaging in constructive discussions. As quoted by the New York Times, Monica Crowley, a Treasury spokeswoman, states that “The United States has suggested a pause in the OECD. talks on international taxation while governments around the world focus on responding to the Covid-19 pandemic and safely reopening their economies.”

Now, that seems to be a sensible statement. The OECD, as well as some of the (European) countries eager to implement national digital taxes, would be well advised to take this to heart. They would also be well advised to take a deep breath before further escalating the situation.

As of today, nothing much has changed. It will matter, however, how the further discussion is framed. As I pointed out in April, taxing MNEs (digital commerce) might be viewed as an extremely appealing source of additional tax revenue (“sitting duck”) from the perspective of national politicians. But, as the US has now made clear, there will be consequences in going after these specific ducks.

The question the national politicians need to confront is whether, when assessing the tax revenue actually at stake, accounting for the detrimental consequences of retaliatory action is worthwhile.

It seems unlikely that an unemotional look of the tradeoff would support attacking the sitting ducks at this point. Also, it seems quite relevant to consider that deferring to tax the sitting ducks for a couple of years does neither imply a loss of face nor forfeiting a (principled) claim to additional taxing rights.

Also, at least for some stakeholders, it would not hurt to remember that the digital MNEs in question are not engaging in tax evasion (or avoidance for that matter) when considering the core issue at stake (the new nexus!).

In other words, there is no ongoing erosion of the tax base that would demand imminent counter-measures.

That being said, French finance minister Bruno Le Maire has been widely quoted as stating that “Whatever happens we will impose a tax [on digital giants] because it is a question of justice.” Mr. Le Maire might be well advised to think a bit more carefully about what constitutes a “question of justice.”

The EU officials’ comments are hardly helpful. They reflect a disturbing willingness to stoke the international conflict to foster the unfortunate EU agenda of tax harmonization and centralization that (luckily) had been stalled during the OECD negotiations. 

The best option is to pause the negotiations, as suggested by Mrs. Crowley.

The pause should not be squandered, however. Instead, stakeholders should resume their work on establishing a sound conceptual framework for taxing the digital economy.

The pause should not be squandered, however. Instead, stakeholders should resume their work on establishing a sound conceptual framework for taxing the digital economy.

The US will likely be willing to participate in this work, provided the increasingly ridiculous and non-sensical end-of-2020 deadline is abolished.

Naturally, the US will push for solutions that grant a smaller slice of the tax base to market jurisdictions – but then again, such arguments are not entirely without merit.

The market jurisdictions have not advanced arguments that legitimize their taxation of a substantial share of residual profits of Facebook & co.

There is certainly room for advancing more conclusive arguments; merely alluding to “fair” taxation is not going to be sufficient. As illustrated by Mr. Lighthizer, fairness is a rather subjective concept that brutally exposes the weakness of formulary apportionment – assigning “value-added contributions” to individual MNEs may also be somewhat subjective, but arguably not to the same extent.

Yes, it will take time to reach a solution. But what is the rush? The US will likely consent to a more moderate and conceptually sound Pillar 1 reform.

Also, US MNEs should not be gleeful about the current difficulties in reaching a consensus, but rather show public determination to bring the US back to the table – i.e., the sitting ducks are still sitting ducks.

While the market jurisdictions would have to exercise patience and be content with a more moderate share so retaliatory measures are avoided, they would certainly not be the “losers” of the process.

Quite the opposite. The new nexus rules would be a watershed moment in international taxation and would ensure a quasi-permanent increase of the tax base for market jurisdictions.

Unlike national politicians, the OECD will inevitably lose face. It has failed, and it should acknowledge its failure.

Early statements from OECD Secretary-General Angel Gurría, however, seem to suggest that the OECD is not ready to face reality and remains committed to the end-of-2020 deadline. This is bordering on being delusional, as without the US at the table, the result will never be the kind of global consensus that was the original aim.

While it was sad that the OECD did not receive the praise it deserved for bringing BEPS to a (more or less) successful conclusion, it needs to be held accountable for the shortcomings in handling Pillar 1.

Brokering a consensus involves keeping the stakeholders at the table. While the broker may hold sympathies with the position of a particular party, he should maintain a level of neutrality and objectivity that allows the discussions to proceed without bias. The OECD should take a close look into the mirror and ask whether it is still acting with the required impartiality.

There still seems the possibility to salvage the digital tax project. In a first step, the OECD should answer to the justified comments by Mrs. Crowley and aim to channel the communications back to a cooperative setting.

When the OECD remains stuck in the bunker mentality, we need to brace ourselves for witnessing senseless shouting matches between Mr. Lighthizer and Mr. Le Maire. Nobody will be a winner, including the OECD, which could possibly lose its relevance as an international institution in the quagmire of the nationalization (regionalization) of tax policies.

We do not need an OECD that is engaging in political grandstanding. Instead of the OECD contributing to political brinkmanship, we need it to focus more on its traditional (perhaps technocratic) functions of safeguarding and continuously improving the conceptual framework of international taxation – maybe that is something Mr. Saint-Amans should think about.