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The Coming Corporate Tax Revolution

Matthew DeMello: Welcome back, everyone. We’re here once again with CrossBorder Solutions Chief Economist Mimi Song, now out with a new article in Bloomberg: “The Corporate Tax Revolution is Coming: Are We Ready?”  

This is a fantastic articleMimi. We hear phrases like digital economy and digital companies not paying their fair share of taxes in the media. Mimi, what is the fundamental reason for a tax revolution, so to speak? 

Mimi Song: So the tax system, as we know it, it’s antiquated. It was developed back in the 1920s, at least in the US, [with] the concepts of taxation based on brickandmortar businesses. If you think about it, a company who is producing and manufacturing a product in order to sell that product to customers in Korea, I’ll use that as an example, they would have had to establish an operation in Korea in order to be able to reach that customer and actually make sales locally. 

So this concept of taxation was created when businesses had to have a physical presence in order to market to the global economy, to the global markets, to other jurisdictions. Now, the problem is the digital economy. What has this done to the world? It’s allowed companies to have a much broader reach without having a physical presence. 

You can buy a product directly from Korea, manufactured in Korea, with a Korean company. Even if you’re in the US, if you’re in Saudi Arabia, you can be in France, you could be anywhere. And you can now buy products and acquire services from companies all over the world. These companies that are locally based in one jurisdiction have a much more farreaching capability than they would have had before the digital revolution. And now the problem is, governments are thinking, “Wow, how do we tax this fairly? Is this fair? [and] “You’re able to sell products and goods into my market now. Am I getting my fair share of taxable profit? 

Matthew DeMello: The OECD has boiled a quotetaxation of the digital economy plan, down to two proposals. We know them as Pillar One and Pillar Two. Let’s start with Pillar One. If passed, how would that work? 

Mimi Song: The Pillar One and Pillar Two initiatives were initiated to help address this idea of the digital tax revolution. And they are designed to raise approximately a hundred billion dollars in corporate tax dollars on a global basis. That’s pretty significant amount. 

Pillar One specifically is a redistribution of profits. The intention here is, Hey, is everybody getting their fair share of the pie? I think that there’s some questions about, okay, a US multinational company, are they paying their fair share of taxes in other jurisdictions where value might be created? 

And Pillar One actually has two specific amounts. And they’re referred to as Amount A, which is the actual split of all these residual digital profits. And then Amount B, which is considered to be this fixed return for certain routine activities like a marketing distribution or those activities that physically occur in a particular jurisdiction. 

Now, there’s still a lot of questions on the table in terms of how to apply Amount A and Amount B. The blueprint on Pillar One actually came out in October of 2020, and lots of public commentary has been received. When I was listening to the inclusive framework discussion, they explained [that] over 200 public comments were actually received. So they now have to go through that and figure out exactly how this is going to work in practice. 

Matthew DeMello: And Pillar One has particular significance for transfer pricing, as you mentioned in your article. Can you tell us about that? 

Mimi Song: It definitely is an allocation of the residual profits. And so it challenges this concept of the arm’s length principle, which is every entity that is involved in an intercompany transaction is earning a return in line with their functions and assets and risks, in line with their activities. 

Now, the arm’s length principle is the foundation of transfer pricing. So when we start talking about this Pillar One Amount A and the allocation of residual profits, the problem is it’s very formulaic. And so at least based on the blueprint as it exists today, because it’s so formulaic, what this does is it creates a divergence perhaps from the arm’s length principle and creates an environment of complexity. Now companies that are appropriately applying the arm’s length principle and ensuring that the prices charged between related parties are based on third-party market conditions could now, potentially, be subject to double taxation under this Amount A calculation. 

Matthew DeMello: So tell me, Mimi, how has that been received? 

Mimi Song: Well, it depends on who you ask [Matt and Mimi both laugh]. I think even transfer pricing economists and multinationals, clearly, I think they all believe in the arm’s length principle. And so the arm’s length principle has a lot of support. And I think the fact that the Pillar One blueprint currently challenges the arm’s length principles outcome is a problem. It’s not necessarily being as well received as anticipated. 

The US specifically had basically commented to say they want to see Pillar One applied on more of a safe harbor basis – a more elective, as opposed to a mandated, sort of allocation of residual profits.  

Like I said, it depends on which jurisdiction you’re talking about. Other countries, as you can imagine, the countries who perhaps feel as if theyre not getting their fair share of taxable income today, because of the way that the rules are set up and situated, they’re very much for Pillar OneAmount A allocation. 

And they perhaps are not as concerned about the deviation and the interplay with the application of the arm’s length principle. Now, everyone acknowledges though, that in order for Pillar One to work, there needs to be a new definition of what constitutes a nexus. What constitutes taxable income or tax liabilities in certain jurisdictions when you don’t have to have a physical presence anymore? 

I think that’s going to be the real key factor here. Because what gives a country a right to tax that particular revenue? I will give you an example of this because I was thinking about the reallocation of profits. And in particular, I remember a business trip I made where I landed at Copenhagen in Denmark, and at the airport, I called an Uber. 

So, I’m a US citizen. I called Uber, which is a US company. I landed in Denmark, but that Uber then took me to Sweden. How does that get taxed from Uber’s perspective? And I think it just creates some complexity. As you can see, there are a lot of different components to that particular fact pattern that I gave you that clearly need to be worked out. 

Matthew DeMello: Now what about Amount B, how will that work? 

Mimi Song: Amount B, as it relates to Pillar One, is specifically related to establishing a fixed return for certain routine activities like marketing and distribution activities. And in order for Amount B to apply, once again, all of these guidelines that the OECD is going to come out with have to be adopted into law first and foremost. 

The calculation of the Amount B, as the blueprint lays out, is that the return for marketing and distribution activities would be based on the transactional net margin method, unless a different method proves more appropriate. So already there’s a formulaic approach to establishing, Hey, you know, the OECD or different jurisdictions. 

There’s already a problem I can see, which is, does each country have a different understanding of what an appropriate fixed return should be? Is it the same in all countries? Is it different in all countries? Who’s going to be able to determine that? Who’s going to make the rules on that?  

And then I think it’s also unclear as to how this fixed return impacts the calculation of Amount A. So once again, let’s go back to my Uber example for a second. In that example, the US multinational company could, or should, retain a certain percentage of the profit for marketing and distribution activities, which probably undertakes some of those activities in Denmark, as well as Sweden. 

And so each of those different countries earns a routine return for those functions. And then the question is, does Amount A apply, which the residual then gets allocated and distributed across those three jurisdictions based on some other formulaic approach? It’s still .. very unclear. 

Matthew DeMello: And what about Pillar Two? Tell us how that works. 

Mimi Song: Pillar Two [is] basically the global minimum tax. It’s referred to as the Global anti-Base Erosion Proposal. Everyone loves acronyms! So this is GLOBE.  

When I first looked at it, I thought it should be like GLABE [both laugh], but GLOBE is probably a little more catchy 

Pillar Two proposes a minimum level of tax, where all these jurisdictions around the world would have to agree to tax at least 12½ percent of the profits generated by companies headquartered inside their borders. And what this does is it levels the playing field. 

Matthew DeMello: I think in politics, we need a sort of scapegoat of absurdity in the procedure process whereby, it doesn’t matter what you name a law, only that the abbreviation sounds nice. [Mimi laughs.] I think that that’s a palpable amount of absurdity that could really help the whole process just move forward little bit better. 

Mimi Song: Well, in this case, we have GLOBE [Matt laughs.] 

Matthew DeMello: … Who cares what the actual abbreviation means in terms of the words, we’ll just accept that globe is what it should be. What are the issues that Pillar Two represents? 

Mimi Song: First and foremost, you have to get all these different countries to agree to a minimum tax of 12.5 percent. And then you have different jurisdictions with unilateral tax measures in place, for example, the US. And by the way, going back to the whole acronym issue, we got US as GILTI [Matt laughs], the “GILTI tax, the Global Intangible Low Taxed Income. Now that currently is a 10.5 percent minimum tax on IP held abroad by US multinational companies. 

And so the question will become, “How does Pillar Two interact with the US’ existing tax regime? Would GILTI need to be changed or modified? Is it a duplication? Is it a replacement? What’s going to happen?” I think it creates some concerns, especially if I’m a US multinational enterprise. 

And I think one of the challenges right now that we see, especially from a US perspective, is that Pillar One and Pillar Two, addressing this concept of the digital economy, they are targeting certain very large US-headquartered multinationals. Or, that’s the perception. And let’s be fair. The reality is probably in line with the perception. 

And so I think right now [with] the Pillar Two initiatives, the US would have to perhaps reconsider tax reform, and we’ve already been through tax reform once. And we anticipate that they’d have to implement new tax reform legislation in response to Pillar Two. But it’s even more complicated than that. The tax rules are so complex that when we think about MNEs, who are paying taxes on certain CrossBorder transactions, because of certain CFC rules versus withholding tax rules and the way that they treat foreign tax credits. 

All of a sudden you’re creating this really complex web, which then could potentially continue to incentivize base erosion. Creating this level of complexityI don’t know if it necessarily prevents multinationals from looking for the loopholes, if you will. I think it just means that they have to do it a little bit smarter.  

Matthew DeMello: In which case, it just turns into a burden of greater bureaucracy. Your article also talks about new Treasury Secretary Janet Yellen and her role in all of this. What do you think her take on all of this will be? 

Mimi Song: Well, Janet Yellen actually has much more of a teamplaying attitude. She has been quoted as saying she would work with the OECD immediately and vigorously, versus the former administration where former Treasury Secretary Steve Mnuchin withdrew from the OECD talks last summer. He actually didn’t want to work with the OECD because he was pretty adamant that this would impact America’s digital companies. 

It went so far as to be the US actually threatened retaliatory tariffs for European countries. And there was an investigation into whether or not certain countries were involved in unfair trade practices related to these digital tax initiatives. 

Once again, I think there is a little bit of a concern that US multinationals are really targeted when it comes to this digital economy taxation project. And the US wants to make sure that the application of this new global minimum tax is not just targeted towards these US multinationals. But that if it’s going to work, it’s going to apply to all types of different digital companies, because almost every company out there is really focusing on how to digitalize its processes, its business model. 

This tax is going to have to apply to some of those European luxury companies. Not just Google and Facebook and Apple, but it’s got to apply to some of the other Europeanheadquartered multinationals in order for everyone to cooperate and make it work. 

Matthew DeMello: Speaking of EU countries, a number have launched individual digital services taxes. In your article, you mention that poses problems as well. Can you elaborate? 

Mimi Song: The whole idea here of the inclusive framework and the OECD’s work on Pillar One and Pillar Two is to get to global collaboration, to understand how we’re going to get to a multilateral solution that countries are all going to get behind and support. 

What’s been happening is that the initial information being presented by the OECD has created a lot of awareness. So all of these different foreign jurisdictions understand that there’s an opportunity here. And they feel as if getting to a global solution, perhaps they’re not as confident that we’re going to get there. Or that the OECD is going to get there. 

And so they’ve been launching their own unilateral digital services taxes. Countries like Austria, France, Hungary, UKItalyPolandSpainThere’s just a few countries that have already launched taxes related to digital companies, taxing digital companies. And there’s only more on the horizon as well. 

When each of these different jurisdictions takes an individual approach to how they want to apply these digital taxes, it creates challenges. It just exacerbates the situation. And to be honest, I think it creates an environment that shows that all of these different jurisdictions are perhaps not invested in actually coming to a global solution. We know that at the end of the day, a simpler tax system is absolutely required. 

Matthew DeMello: That’s the conclusion that we are drawing today, both from your article and from this podcast. Mimi, thank you so much for being with us today. 

Mimi Song: Absolutely. Thank you, Matthew. You know, I heard a really good story about this digital services tax really quickly. I don’t know if it was on LinkedIn or Facebook, to be honest. But on social media, I saw someone post a receipt to demonstrate the impact of these unilateral tax measures as well as, by the way, the impact of Brexit. 

This is a UK citizen, and they made an online purchase of … some sort of luxury good, I don’t know exactlyThey indicated that their purchase was about 300 euros and then the tax on that was equivalent to 120 pounds. Significant. And it was exacerbated clearly because of Brexit. But it’s also as a result of some of these digital service tax initiatives. 

Matthew DeMello: Are multinationals getting concerned about these digital services taxes? 

Mimi Song: Absolutely. I think this changes everything. And ultimately, they’re going to be paying very close attention to this in terms of the logistics alone. That’s going to be complicated. And you’re already talking about a very complex tax systemand don’t forget the digital services tax and all the implications. 

This could also have implications with respect to aligning it with the transfer pricing policies. And [whether] this is actually a consumer tax? Is it a corporate tax? Does it go above the line, below the line? How does this impact the underlying prices? 

I have to tell you at the end of the day, the people who are going to be paying this tax [are] not necessarily the multinationals, but [is] really the consumer. I think that’s going to be a huge challenge. 

You know, I was thinking about this and this brings up a good point. Because when we think about the application of Pillar One and Pillar Two on a global basis, this concept of creating a global consensus framework for the tax system it’s the prisoner’s dilemma! 

Because if just one jurisdiction decides to deviate from the plan, they could make out like a bandit [Matt laughs]. I was just thinking about it and I was like, wow, it’s the prisoner’s dilemma. And that’s the challenge we’re facing right now. So hopefully we can all agree to not say anything [Mimi laughs]. 

Matthew DeMello: And so, to salute Mr. Nash, the founder of game th “Time for some game theory!” 

Mimi Song: That’s right. So nobody plead guilty. 

Matthew DeMello: GILTI, no one plead guilty! 

Mimi Song: No one plead guilty. That’s right. 

Matthew DeMello: I was almost tempted when you had mentioned before about whether or not this tends to get labeled as home countries, just being US-based tech companies. And of course, that’s a majority 

For a very nuanced answer that I really thought was illuminatingon the Dr. Lorraine Eden episode we just had not too long ago, when I asked her about that directly. I was pretty frank about it. I was like, I hear this colloquially, it’s just code for the United States. [Mimi laughs.] 

And for the purposes of this podcast and keeping things short, that makes a lot of sense to summarize it there. But if I can point everybody to a very, very nuanced answer that I think is very illuminating on that point, [it’s in] that episode.