While the US has not adopted BEPS wholeheartedly, it has adopted several unilateral measures that would reduce base erosion and profit shifting.
The OECD’s Base Erosion and Profit Shifting (BEPS) project is aimed at reducing the ability of multinationals to shift profits out of high-tax countries to low-tax ones and to avoid double non-taxation. It does so by tying reported profits more closely to ‘economic substance’, meaning that companies can only claim profits where real economic activity — such as jobs, assets and sales — is actually located. When the OECD first announced its 15 step action plan to go after tax planning and double non-taxation by multinationals, I wrote about why the BEPS Project should be a source of concern for the US. At that time, the US had the highest statutory corporate tax rate in the OECD and there was a real risk that the country would lose economic activity — jobs, research activity and actual production — to other low-tax jurisdictions.
Since that time, much has changed. In December 2017, the US passed an historic corporate tax rate cut as part of the Tax Cuts and Jobs Act (TCJA), lowering its headline corporate rate from 35 per cent to 21 per cent, less than the OECD average. It also made significant changes to the international taxation of US multinationals.
The US Response to BEPS: What do These Changes Signify?
A big takeaway is that, post-tax reform, the US has unilaterally taken steps to address profit shifting, base erosion and non-taxation of multinational income. In addition, it has created strong incentives for companies to relocate investment, economic activity and profits in the US through a more competitive tax code. If I were to rewrite my op-ed referenced earlier, I would title it ‘The OECD is right to worry about the US BEPS project’, instead of the reverse.
A prominent agenda item of the OECD BEPS project is the taxation of digital companies. Many countries in the European Union have expressed frustration with the fact that tech companies, such as Apple, Google, Facebook and Amazon, are able to operate and sell within their jurisdictions, but pay little or no corporate income tax. Some countries have tried to unilaterally implement measures such as a diverted profits tax, or equalization levies to tax digital activities. The US tax reform effort has put in place a provision that would provide US multinationals a lower tax rate on ‘intangible income’ – in reality, high profits not tied to tangible forms of capital – earned from foreign sources. Broadly speaking, the Foreign-Derived Intangible Income (FDII) rule provides a deduction of 37.5 per cent to intangible income derived by domestic companies from their overseas operations, lowering a domestic corporation’s effective tax rate to 13.125 per cent. If this works effectively, digital companies should find it in their interest to move, not just their profits to the US, but their intellectual property as well. In addition, the TCJA now imposes a minimum tax on excess foreign earnings of US multinationals. Hence, if the aim of the BEPS project was to capture more of this intangible income in the European Union, the new US tax law will likely interfere with their efforts.
FDII is also a reaction to BEPS Action 5, which is aimed at developing new substance rules for patent boxes. Patent boxes are essentially means by which companies can get preferential tax treatment for certain intellectual property such as patents. The BEPS project tries to tie these kinds of preferential tax treatments to real activity, so as to discourage companies from merely shifting profits to low tax jurisdictions that offer such benefits. While FDII does provide a deduction on this kind of intangible activity, it does not take into account the substantial nexus (economic activity) requirement. However, given that substance requirements are becoming more important under BEPS, non-US companies should still have an incentive to meet substance requirements for any excess income claimed in the US.
BEPS Action 2 aims to neutralize the effects of hybrid mismatch arrangements. In effect, the aim of this action item is to prevent companies from being able to get multiple deductions for a single expense, deductions in one country without corresponding taxation in another, or the generation of multiple foreign tax credits for one foreign tax payment. Similar to BEPS Action 2, the TCJA also adopts an anti-hybrid rule. Under it, a US company is no longer allowed a deduction for an interest or royalty payment to a non-US related entity if the local tax rules in the jurisdiction of that entity exempt such a royalty or interest payment from tax. This new rule would reduce the ability of firms to lower their tax bill by showing higher interest or debt payments for US tax purposes when such payments would otherwise go untaxed on the other side. In addition, US shareholders will not be allowed to avail of tax-free repatriations of ‘hybrid dividends’. A hybrid dividend is an amount otherwise eligible for the dividends-received deduction for which the distributing controlled foreign corporation (CFC) received a deduction with respect to income taxes imposed by a foreign country.
The BEPS CFC recommendations are designed to ensure that tax jurisdictions have rules that prevent taxpayers from shifting certain kinds of passive income into foreign low-taxed subsidiaries in which they have a controlling interest. This is something that the US had pushed for, but which did not receive much support from other countries. As a result, these are not adopted as minimum standards in BEPS, but are recommendations for best practices gathered from other countries’ experiences. Accordingly, the TCJA has broadened the scope of CFC rules to include the case where a non-US parent owns both US and non-US subsidiaries. In this case, non-US subsidiaries, which are sister companies to the US subsidiaries are now going to be treated as CFCs. These CFCs will be required to make detailed annual filings with the IRS regarding the activities of non-US subsidiaries. In addition, if a US subsidiary owns 10 per cent or more of the shares of a non-US sister company, then the US subsidiary must generally include in income its share of passive-type income, such as dividends, interest and royalties and certain other income received by the non-US sister company.
Action 4 of the BEPS project is an attempt to reduce base erosion through limitations on interest deductibility and other financial payments. The problem here is that since interest payments are tax deductible, intra-group financing within a company can lead to high levels of debt and total interest deductions that could exceed their unrelated third party interest expense. Along the same lines, the TCJA limits interest deductions for a US company to the sum of a US company’s business interest income for the taxable year plus 30 per cent of the company’s adjusted taxable income for the year.
Another BEPS recommendation that has been adopted by the US includes country-by-country reporting standards. The BEPS project requires participants to report country-specific information on a common template about income, employment, and taxes paid, and to exchange that information with other countries. In the TCJA, the base erosion and anti-abuse tax (BEAT) would further allow the Treasury to obtain information on reporting companies such as the name, place of business, countries in which related parties are resident and any base erosion payments made. The BEAT is a 10 per cent minimum tax on the amount of any base-erosion tax benefits that US companies derive from transactions with non-US affiliates. It relates to any deduction that results from a payment by a US company to a related party, such as interest or royalty payments.
Finally, in order to reduce multinationals’ ability to avoid US taxes, the TCJA has put forward mandatory repatriation and GILTI (global intangible low-taxed income) provisions. As the US has now moved to a territorial system, it is possible, in practice, for companies to pay dividends to their US parent without facing any taxes. This could potentially result in a loss in revenues since companies have built up more than US$2 trillion in untaxed offshore earnings over the last several decades. Instead, the TCJA imposes a one-time tax on such foreign held earnings. The tax rate is 15.5 per cent for earnings held as cash or cash equivalents, and 8 per cent for reinvested earnings. A second provision, termed GILTI, imposes a tax of 10.5 per cent on certain amounts of profits (in excess of 10 per cent of depreciable tangible property) earned by non-US subsidiaries, irrespective of whether those profits are repatriated, unless the non-US subsidiaries have paid a significant amount of taxes on these profits already.
One contentious area where the US has co-operated with the OECD, but as yet has refused to sign on to, is in the area of multilateral treaties under BEPS. The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) provides ways by which governments can close the gaps in international tax rules so as to avoid double taxation, battle tax treaty abuse and improve dispute resolution mechanisms. BEPS participants have generally agreed to revise their bilateral tax treaties to incorporate BEPS measures to go after tax avoidance and treaty abuse. All signatories are required to commit to BEPS mandatory standards. The US has not signed on to this and insists that its own treaty framework already meets BEPS minimum standards. The new treaty model that it released in 2016 includes provisions that further reduce companies’ ability to use the treaty for tax avoidance. Some of these new provisions have been adopted in the TCJA as well, such as the denial of the participation exemption for payments made from inverted companies.
As is clear from the review above, the TCJA has dramatically changed the landscape for US multinational firms. It has pushed the US forward in terms of tackling profit-shifting, non-taxation and base erosion. While the US has not adopted BEPS wholeheartedly, it has adopted several unilateral measures that would reduce base erosion and profit shifting. At the same time, with a more competitive corporate tax code, the hope is that there are now strong incentives for firms to locate real economic activity in the US, as well as profits and intangible incomes. In effect, the US has now beaten the OECD BEPS Project to the punch.
Aparna Mathur is a former Senior Fellow at Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government where she is researching the US social safety net. She is a Visiting Fellow at FREOPP and a Senior Research Manager in Economics at Amazon. Aparna spent a year as a Senior Economist at the Council of Economic Advisers during the pandemic. She joined the Council as part of the COVID-19 response task force at the peak of the crisis in April 2020 and worked with epidemiologists on the health aspects of the crisis, while also tracking the economic downturn that came with the lockdowns. Prior to joining CEA, she was a resident scholar in economic policy studies at the American Enterprise Institute. At AEI, she directed the AEI-Brookings Project on Paid Family and Medical Leave, building bipartisan momentum on paid leave, for which she was recognized in the Politico 50 list for 2017. Her academic research has focused on income inequality and mobility, tax policy, labor markets and small businesses. She has published in several top scholarly journals including the Journal of Public Economics, the National Tax Journal and the Journal of Health Economics, testified several times before Congress and published numerous articles in the popular press on issues of policy relevance. Her work has been cited in leading news magazines such as the Economist, the New York Times, the Wall Street Journal and the Washington Post. She has regularly provided commentary on prominent radio and television shows such as NPR’s Marketplace and the Diane Rehm Show, as well as CNBC and C-SPAN. She has been an adjunct professor at Georgetown University’s McCourt School of Public Policy. She received her Ph.D. in economics from the University of Maryland, College Park in 2005, and is currently serving on the University of Maryland Economics Leadership Council. She is also on the Board of the National Academy of Social Insurance, Simply Green and the National Economists Club.