The following is a guest post by Maximilian Frank, intern for International Institutions and Global Governance at the Council on Foreign Relations.
Global capitalism presents plenty of paradoxes, and the geographic disconnect between digital earnings and taxation on those earnings is one of the most glaring. Companies that provide digital services operate on a global basis, yet the country that hosts their headquarters holds the lion’s share of the authority to tax those operations. Because they lack a physical footprint in many jurisdictions where they ply their online wares, digital service providers complicate traditional customs duty, value-added tax, and sales tax regimes. This has made them a prime target for reformers seeking to align tax policy—traditionally the prerogative of individual states and localities—with the realities of contemporary global commerce.
The Organization for Economic Cooperation and Development (OECD), a group of advanced economies, recently took up this issue. Under its Inclusive Framework on Base Erosion and Profit Shifting (BEPS), the OECD has tried to advance multilateral efforts to ensure large multinational enterprises, including digital companies, “pay tax wherever they have significant consumer-facing activities and generate their profits.” In an effort to increase the universality and effectiveness of the reforms, the negotiations have also included non-OECD/Group of Twenty (G20) states who have committed to adopting the resulting policy program, the total number of which currently stands at 135. The pragmatic proposal is the culmination of these states’ efforts to come to grips with global tax avoidance. It promises to make headway on a major challenge of globalization, in an era when considerations of national sovereignty too often derail multilateralism before it has had a chance to take effect.
Tax and regulatory arbitrage, the problems the agreement is designed to address, are nothing new, of course. Multinational enterprises have long sought to base themselves in countries with low corporate tax rates and, where possible, relaxed regulatory regimes. U.S. multinationals, for example, took advantage of favorable tax rates in Ireland to avoid paying U.S. taxes on an estimated $100 billion of overseas profit per year, until a 2014 lawsuit from the European Union (EU) forced the island nation to suspend the arrangement. The mismatch between commercial activity, which often occurs in global markets, and taxation and regulatory regimes, which often govern activity on a national basis, discourages countries from adopting stringent regimes that threaten to erode their tax bases and can put smaller firms that operate domestically at a competitive disadvantage.
Digital service providers are among the companies eager to take advantage of such patchwork legislation. In 2018, the European Commission found that digital companies pay an average effective tax rate of 9.5 percent within the EU—less than half of the 23 percent paid by traditional businesses with a physical footprint in the same countries—in part because they can allocate intellectual property flexibly among subsidiaries in low-tax jurisdictions. For example, the U.S. Internal Revenue Service filed a lawsuit earlier this year alleging that Facebook avoided paying $9 billion in U.S. taxes by selling intellectual property to its Irish subsidiary at a discounted rate. Similarly, Google paid French regulators over $1 billion in 2019 to compensate for unpaid taxes, due again to the firm’s incorporation in Ireland.
The OECD’s proposed solution to these problematic trends rests on two pillars. The first comprises rules on where tax should be paid and what profits should be taxed, and the second attempts to set a global minimum corporate tax rate in order to limit the appeal of tax havens. Under this broad framework, the OECD has negotiated fifteen action items, the first of which deals with the unique taxation challenges of the digital economy. This action item’s pillar one proposals define the concept of a “significant economic presence” for digital companies and determine “what portion of profits could or should be taxed in the jurisdictions where customers and/or users are located.” The pillar two action items seek to help “stop the shifting of profits to low or no tax jurisdiction facilitated by new technologies” and define the concept of a global minimum tax for digital multinational enterprises.
Together, these pillars allow states and the OECD to thread the sovereignty needle, preserving national authority and augmenting government revenue while offering a degree of global harmonization through a minimum corporate tax rate. What is more, these negotiations have broad international support, a remarkable development given the state of global governance writ large. Even before COVID-19 shattered illusions of a functional multilateral system, U.S. President Donald J. Trump and like-minded world leaders had skewered many international institutions to the point of powerlessness or irrelevance, the World Trade Organization’s defanged Appellate Body being a case in point. This raises an important question for proponents of international cooperation: what makes global governance of digital service taxation different?
The answer has to do in part with the growing role of online commerce in the global economy. The U.S. Department of Commerce reports, for example, that the share of American retail transactions conducted online has risen by ten percent in the last ten years, a trend sure to be amplified in the months ahead as the COVID-19 pandemic continues to limit in-person commercial activity. The UN Conference on Trade and Development, meanwhile, estimates that global cross-border business-to-consumer sales reached $412 billion in 2017 and that a quarter of the world’s population now shops online.
States have responded to these trends with increased calls for both domestic and international tax reform. In 2019, for instance, France implemented a three percent digital services tax (DST), a measure predicted to generate over $560 million in revenue per year, and more than half of EU member states have implemented or are considering some form of a DST. European interest in digital taxation stems not only from a desire to fill government coffers, but also from a desire for more indigenous e-innovation. “We must have mastery and ownership of key technologies in Europe,” declared European Commission President Ursula von der Leyen in a speech in a recent European Parliament Plenary Session. India also recently announced a two percent increase to its existing six percent tariff on non-resident digital advertising services for many of the same reasons.
In sum, these efforts indicate a growing awareness of and political will to address the unique taxation challenges posed by the global digital economy. The potential for increased revenue serves as a powerful motivator for states to participate in a unified taxation framework, even as they continue to jealously guard their fiscal policy prerogatives.
And yet, the ongoing OECD negotiations must overcome significant obstacles if they are to bear fruit. Chief among these obstacles are the reservations of the Trump administration. In December 2019, U.S. Secretary of the Treasury Steve Mnuchin sent a letter to OECD Secretary-General José Ángel Gurría expressing concerns about changes to longstanding tax practices. Secretary Mnuchin also proposed a “safe harbor” exemption to the proposed framework, which would effectively allow signatory states to opt out of some of the framework’s requirements and thereby advantage firms based in those jurisdictions.
President Trump has been more emphatic in his opposition to the proposed plan and to foreign taxation of American firms in general. In a December 2019 press conference, he was unequivocal: “If anyone is going to take advantage of the American companies, it’s going to be us. It’s not going to be France.” The Trump administration has suggested that unilateral DSTs amount to an unfair trade practice, threatening retaliatory tariffs last year against France for its DST. For now, the United States remains something of a wildcard in the OECD negotiations, as it would gain tax revenue from regulation of BEPS behavior but is simultaneously concerned with protecting the global dominance of its technology sector. This latter concern looms in the penumbra of the Trump administration’s critique of DSTs as uncompetitive practices. Indeed, it is consistent with other administration priorities, such as confronting China in the global race to implement 5G telecommunications technology.
Despite these obstacles, the OECD has made significant progress of late, and the possibility of realizing a successful convention on digital taxation is not beyond hope. After the Trump administration’s outbursts in December, a trade truce emerged in January when the U.S. president and his French counterpart, Emmanuel Macron, agreed to refrain from tariff escalation to avoid further jeopardizing the OECD negotiations. Moreover, despite the fiscal and logistical challenges posed by COVID-19, the OECD Secretariat released a statement on March 17 indicating that negotiations were proceeding “full steam,” and that it was still working toward a “political decision on the key components of a multilateral consensus-based solution,” with the aim of reaching a tentative agreement by the time of the G20/OECD Inclusive Framework on BEPS plenary meeting in July. Though the economic devastation wrought by COVID-19 will dominate the global economic agenda for months to come, if these negotiations do succeed, they could set the stage for a final agreement by the end of the year. The road ahead is treacherous, but the accomplishments to date represent a rare step forward for global governance in a world political environment skeptical, if not outright hostile, toward multilateral cooperation.