Tax Competition of a Different Flavor at the OECD

Tax Competition of a Different Flavor at the OECD

Tax Policy – Tax Competition of a Different Flavor at the OECD

Last week the Organisation for Economic Co-operation and Development (OECD) hosted a public consultation on several proposals to rearrange international tax rules. The policies up for discussion include three separate approaches to reallocate taxing rights among countries and two proposals to institute a minimum level of taxation for multinational corporations. In the context of the Base Erosion and Profit Shifting (BEPS) Project Action 1, the OECD has categorized the separate proposals as Pillar 1 (rearranging of taxing rights) and Pillar 2 (minimum tax approach) policies.

The Pillar 1 proposals include a rearranging of taxing rights based on:

  • Profits derived from user contributions in a market country
  • Profits attributable to marketing intangibles investments
  • Allocation of taxing rights using a formula including sales, assets, employees, and potentially users

The Pillar 2 proposals include stronger base erosion protections including:

  • A global minimum tax approach like the U.S. Global Intangible Low Tax Income (GILTI)
  • A tax on base eroding payments like the U.S. Base Erosion Anti-Abuse Tax (BEAT)

The public consultation provided a forum for stakeholders to provide their views on these proposals. Respondents included tax professionals, business leaders, and civil society organizations. The Tax Foundation participated in the consultation and had previously submitted a written response to the OECD consultation.

Several key themes arose during the discussion including concerns over the potential complexity of implementing the proposals, a desire for evaluation of recent changes to international tax rules prior to adoption of new approaches, a warning to avoid creating double taxation scenarios, and a willingness to work toward a pragmatic solution.

Complexity Concerns

The potential complexity could arise from several standpoints. The reallocation of taxing rights would create new tax liabilities for businesses in jurisdictions where they currently do not pay tax for one reason or another. When those liabilities arise, businesses may face challenges in filing tax returns or understanding why a withholding tax applies in a particular jurisdiction.

Respondents noted that complexity could also come from new rules being layered on top of current international tax rules without reconciling differences between the two. Conflicts over the application of current transfer pricing rules (which guide the taxation of cross-border transactions within companies) could be exacerbated if the uncertainties of transfer pricing valuations are relied upon in calculating which country taxes what share of a business’s profits.

Current international tax rules and their intersection with double tax treaties are by no means simple. Any proposal to change international tax rights should take this complexity into account.

One respondent specifically identified ways that current rules create challenges for customs authorities and that shifting to a new set of rules could create challenges not only in tax administration, but also for customs and trade authorities.

There was also discussion of how the OECD might create safe harbors either for countries or for businesses to allow them alternatives for simpler compliance or administration of the new rules. Those simplifications could, potentially, provide businesses with more tax certainty than they currently have.

Several respondents also pointed out that the U.S. GILTI and BEAT policies have created significant compliance and tax burdens and may not be the best models for the OECD to follow. Concerns were raised that these policies may not fit well with current tax rules and could create very complex tax outcomes for some industries.

Evaluation Before Implementation

Several respondents noted that countries have only recently been implementing proposals resulting from the BEPS project. These include tougher transfer pricing regulations, patent box nexus rules, controlled foreign corporation rules, and country-by-country reporting. Respondents at the consultation noted that the effectiveness of these recently adopted policies should be evaluated prior to the OECD work on new policies to minimize base erosion.

This is an important issue for the OECD to consider. The current push for rearranging international tax rules has loosely defined objectives, and it is possible that the current policies on the books meet those objectives. However, it is still too early to measure the effectiveness of these policies on profit shifting.

Respondents including the Tax Foundation noted the importance of not only understanding the state of policy as it stands right now, but also the importance for the OECD to be measuring how various Pillar 1 and Pillar 2 policies could impact revenues and business activity.

Don’t Tax Us Twice

Another key theme from the consultation was the potential for double taxation of the same income under various scenarios. Multiple respondents focused on how Pillar 2 options could create likely scenarios for several layers of tax on the same income.

One respondent walked the audience through a scenario where a company with offices in four countries could face five different layers of tax due to the interaction of various BEPS and Pillar 2 policies. Multiple layers of tax on the same income create both administrative and economic burdens as the tax paid may not align with profits generated in one jurisdiction over another.

The OECD was encouraged to study the potential for double taxation and to allow for dispute prevention between taxing jurisdictions so that companies could avoid having income taxed by more than one tax authority at a time.

Pragmatic Approaches

Some respondents provided comments admitting that they were willing to be pragmatic in working toward a solution. However, as one respondent noted, a pragmatic solution without principle might result in an unstable agreement. The OECD should therefore focus on adopting new proposals that align with shared principles and an agreed-upon rationale.

The pragmatism was also evidenced in the suggestion of a formulaic approach to rearranging taxing rights. A formula approach based on some measurable metric like sales in a jurisdiction could simplify both tax compliance and tax administration. Unfortunately, at this stage there is not enough detail in either the OECD approaches or the suggested formulas to determine the effects of any of the approaches.

Conclusion

The public consultation resulted in general agreement that something needs to change in the international tax rules, but also that there could be significant challenges to implementing that change. As Tax Foundation reminded the audience during the consultation, it is important to recognize that businesses are central to tax collection systems and the importance of having a discussion that is informed by the facts.

The OECD will continue to review the comments that have been received and is expected to publish a work plan in early summer. The OECD has a goal of reaching an agreement on a new policy in 2020. Tax Foundation will continue to monitor the OECD’s work on these proposals and will follow up with further analysis.

Daniel Bunn discusses the need to look at how each policy impacts the cost of capital and incentives to invest as well as overall tax complexity. Click the image above to watch.

Scott Hodge emphasizes that corporate income taxes impact workers and consumers as well as businesses. Click the image above to watch.


Source: Tax Policy – Tax Competition of a Different Flavor at the OECD

Increasing Individual Income Tax Rates Would Impact a Majority of U.S. Businesses

Increasing Individual Income Tax Rates Would Impact a Majority of U.S. Businesses

Tax Policy – Increasing Individual Income Tax Rates Would Impact a Majority of U.S. Businesses

Most U.S. businesses are not subject to the corporate income tax. Instead, most U.S. businesses are pass-through businesses, such as partnerships, S corporations, LLCs, and sole proprietorships. These businesses “pass” their income “through” to their owners, which is reported on the owners’ individual income tax returns. Overall, pass-through businesses account for more net income than corporations, meaning an increase in individual income tax rates will impact a majority of U.S. businesses.

Pass-through businesses represent the ideal tax treatment of a business form. Unlike C corporations, pass-throughs are only subject to one layer of tax, the proper tax structure. Over time, the size of the pass-through sector has increased. Since the 1980s, the number of corporations has decreased from a high of almost 2.6 million in 1986 to about 1.6 million in 2013. On the other hand, the number of sole proprietorships has increased from about 9 million in 1980 to more than 24 million in 2013. The number of S corporations and partnerships increased from 2 million to almost 8 million over the same period.

The U.S. now has fewer corporations and more individually owned businesses, increasing individual income tax rates

This growth in pass-through businesses relative to C corporations means more net business income is reported on individual income tax returns than on traditional C corporation returns. Aside from a brief period in the mid-2000s when corporate income spiked at the top of a business cycle, noncorporate business income has consistently exceeded corporate income since 1997.

More business income is reported on individual tax returns than corporate returns, increasing individual income tax rates

Pass-through business income is concentrated among high-income taxpayers. In 2016, more than 45 percent of pass-through business income was earned by taxpayers making more than $500,000 annually. Specifically, taxpayers making more than $1 million accounted for nearly a third of pass-through income.

high-income taxpayers earn the majority of all pass-through business income, increasing individual income tax rates

This data shows that a large amount of business income is hit by the high marginal individual income tax rates. As a pass-through business earns more income, higher marginal rates gradually take more out of each dollar. Under the Tax Cuts and Jobs Act, individual income tax rates take 37 cents of every dollar of income earned in the top tax bracket, though this rate is reduced for some qualifying pass-through businesses by the TCJA’s Section 199A provisions which allow qualifying taxpayers to deduct 20 percent of their pass-through business income from federal income tax.

Progressive marginal rates can discourage pass-through business owners from conducting business activities that would increase their income—such as investing in new capital, hiring workers, and producing goods for consumers.

When we think about who is subject to the individual income tax, this data shows us that a significant burden is borne by businesses. Changes to the individual income tax, especially to top marginal rates, can affect a business’s incentives to invest, hire, and produce.


Source: Tax Policy – Increasing Individual Income Tax Rates Would Impact a Majority of U.S. Businesses

Easing the Kentucky Combined Reporting Transition

Easing the Kentucky Combined Reporting Transition

Tax Policy – Easing the Kentucky Combined Reporting Transition

Last year, Kentucky adopted a major tax overhaul: it dropped its income and corporate taxes by a point, removed numerous credits and carveouts from the income and sales taxes, reduced the archaic inventory tax, and adopted single-sales factor apportionment and combined reporting for business taxes. Altogether, the package (enacted over Governor Bevin’s veto) raised some $395 million in annual revenue, to address the state’s crushing public employee pension shortfall.

Combined reporting, effective in Kentucky as of January 1, 2019, requires all corporations within one business group file a consolidated return for their activities in the state. It is distinct from separate reporting, a filing method where each subsidiary files its taxes as a distinct entity. Proponents of combined reporting say without it, multistate corporations will artificially move income between subsidiaries in different states to reduce tax liability. Opponents say defining the unitary group and calculating income is more complex than it’s worth, that subsidiaries exist for legitimate business reasons and punishing every company for a few bad actors harms the economy as a whole, and that combined reporting results in arbitrary assignment of income to different states (the thing it supposedly combats).

Counting Kentucky, 26 states and D.C. currently use combined reporting as the default filing method, and it is a hot topic in state corporate tax policy. This isn’t Kentucky’s first foray into changing business filing defaults, with the General Assembly permitting voluntary combined reporting from the 1990s until 2005, then prohibiting combined reporting from 2005 until this new law requiring it. (Confusingly, Kentucky’s Court of Appeals ruled on January 4 that this was the case even though the Department of Revenue was directing corporations to file on a combined basis at the time.) Everyone’s playing catch-up to the new default, and many in the business community want to repeal combined reporting outright or make it voluntary only.

Setting the merits of combined reporting aside, there is something Kentucky could consider to ease the one-time transition costs. A sudden switch of tax regimes benefits some companies and negatively impacts others. A third category is businesses that are not negatively harmed on an ongoing basis, but must revalue their assets as a result of either a reduced value of tax loss carryforwards or other change in assets or liabilities. Under current accounting rules, those “asset” write-downs must be taken quickly and reported on financial statements, harming a company’s valuation even if the tax change boosts profits going forward.

Other states like Connecticut, Massachusetts, and New Jersey have turned to the ASC 740 deduction as a clever fix for this problem. The state creates a narrow and limited deduction in the amount of any asset write-down as a result of the tax regime change, with only publicly traded companies that have to produce public financial statements eligible. Companies have to apply for the deduction by a given date not long after combined reporting is adopted, although the state need not pay out the deduction for years. (Connecticut in 2015 passed a law to pay out the ASC 740 deduction for seven years beginning in 2018 but later amended it to pay it out over 30 years beginning in 2021; Massachusetts was originally seven years starting in 2012 but is now 30 years starting in 2021; D.C. has put theirs off until 2020; and New Jersey until 2023.) In fact, the state can choose to keep extending when it will pay out the deduction, since what matters to the company is not the money but the deferred tax asset it can put on its books to offset the liability. The date and eligibility restrictions prevent it from being abused for unintended purposes.

Hopefully one day accounting and tax can be harmonized to the point where profitable companies aren’t punished because of the decline in value of their tax “assets” because of lower and simpler taxes. A big step was the 2017 federal tax law allowing companies to expense purchases of new equipment immediately rather than depreciating them for tax purposes over many years, removing a tax accounting rule that was disconnected from real-world cash flows, punished investment, and artificially rewarded borrowing. In the meantime, states adopting combined reporting can reduce the shock to balance sheets of that change with tools like the ASC 740 deduction.


Source: Tax Policy – Easing the Kentucky Combined Reporting Transition

Facts and Figures 2019: How Does Your State Compare?

Facts and Figures 2019: How Does Your State Compare?

Tax Policy – Facts and Figures 2019: How Does Your State Compare?

Download the 2019 Facts and Figures App

How do taxes in your state compare nationally? Facts and Figures, a resource we’ve provided to U.S. taxpayers and legislators since 1941, compares the 50 states on over 40 measures of taxing and spending.

Browse the PDF below or download the Facts and Figures app to explore data on state individual and corporate income taxes, sales taxes, excise taxes, property taxes, business tax climates, and more.

For visualizations and further analysis of this data, explore our weekly tax maps.


Source: Tax Policy – Facts and Figures 2019: How Does Your State Compare?