Article at Tax Notes: The TCJA’s Unilateral Provocation of DSTs

Updated: Jun 16, 2021

By Benjamin M. Willis and José Rubens Scharlack Tax Notes Federal, January 25, 2021, p. 591



Tax and trade go hand in hand. Imposing tariffs on and eliminating foreign tax credits for countries that seek to implement digital services taxes is no coincidence. But we asked for this. As the OECD was working with the world to establish fairly apportioned taxes, the Tax Cuts and Jobs Act used key base erosion and profitshifting action items to ensure America would be the first to tax the revenue it desired. Since enactment of the TCJA’s quasi-territorial tax system, the U.S. tax code has departed from generally accepted principles of international taxing rights by using nearly every possible means to tax foreign earnings.1


In questioning the constitutionality of the global intangible low-taxed income regime, Reuven S. Avi-Yonah recently reminded us that “the Supreme Court explained that jurisdiction to tax must rest on one of two bases: nationality/ residence or territoriality.”2 By taxing based on residence, the United States historically captured the worldwide income of some of the world’s largest taxpayers. If they expatriated, the United States generally continued to tax them.3 The United States taxed some deferred earnings of foreign corporations controlled by U.S. shareholders; and while this pushed the boundaries of taxing rights, the Second Circuit held that it was constitutional. But the TCJA really upped the ante with the questionable taxing policies underlying its new integrated quasiterritorial tax system that could violate WTO and EU state aid rules.4


Of course, the extraterritorial deduction for foreign-derived intangible property will first come to mind to those who have considered whether the policies underlying the TCJA were intended to create economic distortions favoring U.S. trade and whether the United States was complying with international taxing policies. But recall that the onetime repatriation taxed three decades of foreign earnings that might never have made it to the United States, an event that U.S. shareholders simply couldn’t have anticipated. This led to the new territorial dividends received deduction (DRD) that was designed to encourage the movement of foreign cash into the United States. This DRD by no means created a territorial tax system, but it served as the basis for expanding subpart F of the IRC to tax GILTI and to create the base erosion and antiabuse tax, which enlarges the taxation of foreign earnings and creates economic friction to ensure that cash is kept in the United States.


While some ideas that stem from these provisions certainly have merit, that is probably because they were derived largely from the 15 BEPS actions that the OECD presented on October 5, 2015.5 But by being enacted first by the United States, they now accomplish the exact opposite of the intended goal: fairly allocating taxes among countries. Instead, they benefit only one country and ensure U.S. corporations remain untaxed on their global operations — which continue under the GILTI regime because of its 10 percent tax-free return and global netting — showing a lack of appreciation for individual countries and complicating the OECD’s goal of a fair allocation of taxes for each country in which businesses profit.6 But the U.S. corporate tax rate was slashed by 40 percent under the TCJA. If GILTI was the cost to ensure that the United States would deny hundreds of countries — from which the United States profits — the ability to tax, it was a small price to pay. Will foreign countries view the 10 percent tax-free return under GILTI as stateless income and tax it?


GILTI is a minimum tax levied on active, foreign-sourced income of U.S.-based multinational enterprise groups, regardless of whether that income arises from assets or risks allocated to U.S. entities or is a proxy for a dividend distribution to a U.S. shareholder.7 It is clearly divorced from established international practice.8


GILTI represents the United States’ unilateral exercise of its residence-based taxing power to reach the income of its residents wherever that income is and however it arises. It also represents how the United States began to perceive U.S.- based MNE groups as U.S. residents, with little or no regard to the residence-based taxing power of the jurisdictions hosting the controlled foreign entities of those groups.


The TCJA also departed from international tax standards when it created the BEAT, which taxes foreign income9 (at a 10 percent rate, as a modified tax liability) as if it were subject to U.S. tax in the first place and therefore also disregards the arm’s length principle’s separate-entity approach by considering foreign affiliates of U.S.-based MNE groups U.S. residents (and by granting the U.S. parent the right to offset from the BEAT the respective FTC).


Because the United States unilaterally deviated from traditional international tax principles when it created GILTI and the BEAT, it doesn’t make sense, as we will see, that Treasury now expresses “concern” that the inclusive framework’s proposal for amount A of pillar 1 would depart from “longstanding pillars of the international tax system.”


This brings us to the taxation of digital services and whether the new administration will engage in meaningful collaboration with the OECD or continue the pretense of recent years.


Although we don’t disagree that the United States should speak with one voice regarding international affairs and that the executive branch has the power to do so, we cannot fail to see the incongruence of Treasury’s current stand, not against unilateral DSTs (whereby countries are creating jurisdictional ties in no broader ways than the United States) but against the likely new international consensus, given recent developments in the U.S. tax system.


After exploring the support that the TCJA’s international provisions lend to foreign countries imposing DSTs, we will now recap the facts that led to the current impasse and explore a 2018 Supreme Court case that made it clear that the United States understands the concerns underlying pillar 1 and DSTs.



Pillar 1 and the Unilateral Imposition of DSTs


Following the BEPS action 1 report, the inclusive framework has been shaping a

consensus-based solution (the unified approach) to the tax difficulties stemming from the

digitalization of the economy. Members’ proposals were grouped into two pillars: pillar 1,

which seeks to expand the taxing rights of market jurisdictions based on new business models; and pillar 2, which is designed to ensure a minimum level of taxation by providing (generally residence) jurisdictions with a right to “tax back” when other (generally source) jurisdictions fail to exercise or don’t fully use their primary taxing

rights.


Besides improving tax certainty through mechanisms that prevent and resolve disputes,

pillar 1 explores two types of taxable profit that may be allocated to a market jurisdiction: amount A and amount B. While it is a refinement designed to ease compliance and reduce disputes, amount B is still anchored in traditional profit-allocation rules and in the arm’s-length standard (it is a fixed remuneration for baseline distribution and marketing functions for goods bought from related parties and resold at the market jurisdiction). Amount A is the actual novelty.


Amount A reflects a market jurisdiction’s new taxing right: a formula-based share of an MNE group’s or business line’s (rather than a particular entity’s) residual profits arising from the active and sustained participation of a business in the economy of the market jurisdiction through activities (rather than physical presence) in, or directed at, such jurisdiction. The unified approach regards amount A as “the primary response to the tax challenges from the digitalisation of the economy.” According to the unified approach:


In a digital age, the allocation of taxing rights and taxable profits can no longer be exclusively circumscribed by reference to physical presence. Due to globalisation and the digitalisation of the economy, there are businesses that can develop an active and sustained engagement in a market jurisdiction, beyond the mere conclusion of sales, without necessarily investing in local infrastructure and operations. This means that the profits attributable to the physical operations that a business undertakes in a jurisdiction, in accordance with articles 5, 7 and 9 of the OECD and UN Model Tax Conventions, may no longer be reflective of its sustained and significant engagement in the market.10



Targeted businesses are those that generate revenue from the provision of automated and standardized digital services to a large population of users or customers across multiple jurisdictions. Examples include online search engines, social media platforms, online marketplaces, digital content streaming, online gaming, cloud computing services, and online advertising services. Also targeted are businesses that generate revenue from the sale of goods and services to consumers, either directly or through third-party resellers or intermediaries such as direct resellers or multilevel marketing operators.


Since the inclusive framework began discussing the tax impacts of the digital economy

and developing the unified approach on amount A of pillar 1, countries progressively decided to “go rogue” and create their own version of digital taxes, just in case the resistance of residence countries is formidable enough to prevent the inclusive framework from reaching a consensus that would enable a taxing power shift from residence to source jurisdictions.


About half of all European OECD countries have either announced, proposed, or

implemented DSTs.11 The U.S.’s alterations of the OECD’s BEPS proposals to expand its own claims on taxing rights are well understood. The new wave of DSTs is no surprise and will certainly continue absent a change in the U.S.’s nationalistic tax and trade policies.


The proliferation of unilateral DSTs, “and the political pressure that led to them in the first place, have been among the key driving forces behind Pillar 1 of the OECD’s approach.”12

International consensus on amount A of pillar 1 is needed to replace unilateral DSTs and to end the tax maze that source jurisdictions are forming.


Whose Stand Is This?


The United States is a strong force within the OECD and historically a collaborative one that benefits greatly from the global economy and reduced trade frictions. Regarding the inclusive framework’s unified approach, Treasury, on one hand, participates in the discussions and works closely with fellow members. On the other hand, it is concerned that amount A of pillar 1 (or its substitutes, the unilateral DSTs) might hurt its digital champions and ultimately decrease residence taxation of U.S.-based MNE groups.


On January 29, 2019, a Treasury official said, during a meeting of the District of Columbia Bar, that the United States is engaged in the inclusive framework’s talks “out of the very deep concern that the longstanding international consensus around the allocation of taxing jurisdiction is breaking down.”13 On December 3, 2019, Steven Mnuchin sent a letter to the OECD expressing the United States’ “serious concerns” that pillar 1 would depart from “longstanding pillars of the international tax system upon which U.S. taxpayers rely.”14


Perhaps because Treasury’s rhetorical efforts have not produced their intended outcome,

Treasury said, in a June 12, 2020, letter to European countries, that negotiations on pillar 1

“have reached an impasse and that Washington won’t accept even interim tax changes affecting U.S. technology companies.”15 Treasury then seemed to leave the inclusive framework’s negotiation table, but it apparently came back later.


Also, U.S. Trade Representative Robert Lighthizer announced section 301 investigations

into nine countries (Austria, Brazil, the Czech Republic, India, Indonesia, Italy, Spain, Turkey, and the United Kingdom) and the European Union because of their creation of or intention to create DSTs.


The investigation initially will focus on the following concerns with DSTs: discrimination against U.S. companies; retroactivity; and possibly unreasonable tax policy. With respect to tax policy, the DSTs may diverge from norms reflected in the U.S. tax system and the international tax system in several respects. These departures may include: extraterritoriality; taxing revenue not income; and a purpose of penalizing particular technology companies for their commercial success.16


Finally, Treasury and the IRS issued REG-101657-20, on November 12, 2020, which

introduced a new jurisdiction nexus requirement for a foreign tax to be considered an income tax (or a tax in lieu thereof) and thus qualify as an FTC under sections 901 and 903.17 Under the new proposed regulations, a foreign tax meets the jurisdictional nexus requirement if it: (1) taxes income attributable to the nonresident’s activities within the foreign country under traditional principles (including the nonresident’s functions, assets, and risks located in the foreign country, but not the location of customers, users, or any other similar destination-based criterion); (2) taxes income (other than income from sales or other dispositions of property) sourced in the foreign country (but only if the foreign country’s sourcing rules are similar to those existing in the United States); or (3) taxes income from the sales or dispositions of real property situated in the foreign country or movable property that is part of the business property of a taxable presence in the foreign country.18


Explaining these provisions in the preamble, Treasury said that “in recent years, several foreign countries have adopted or are considering adopting a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction as reflected in the Internal Revenue Code.”