“It became necessary to destroy the town to save it:” The US and the OECD’s Unified Approach

By Professor William Byrnes (Texas A&M University School of Law)

Since 2013, the OECD has worked on forging a grand coalition (now 136 countries) it calls the “Inclusive Framework” around adopting the outcomes of the OECD’s base erosion and profit shifting (BEPS) project of 15 Action Items. The OECD has promoted BEPS as the ‘be-all and end-all’ to resolve double non-taxation and double taxation through calibration of the current international tax system built on arm’s length, tax treaties, and transparency.

But less than four years after adopting its 15 substantial reports of amendments to the current rules, the OECD appears to have had an ‘about face’ in late 2019 to pivot toward in a new world order. 

The new world order, the OECD titles the Unified Approach Pillar 1 (although it is merely a proposal conceived by the OECD’s staff without any member countries yet agreeing), allocates a percentage of US MNEs’ corporate earnings, say 10 percent, to be divvied up among the rest of the world based on a formulary apportionment methodology. The apportionment step of a US MNEs’ allocated earnings (called “Amount A” in the OECD proposal), cannot work within the context of the current global tax system.

The new world order, if it is to avoid substantial risk of multiple taxation of a US MNE’s income, requires that the US Treasury agree to let the US MNE allocate the OECD’s established ‘slice off the top’ portion of group earnings to a global mechanism, perhaps the OECD, perhaps the US Treasury itself.

The global arbitrator will then collect from the rest of the world their claims of new tax rights over the income, then divide the income through apportionment among the countries that filed a claim for a piece of the US’ pie.  The full amount is distributed to the countries but not more than the full amount.

US Treasury Secretary Steven Mnuchin, realizing the ‘bait and switch,’ has declined to pay the rest of the world an access fee for US multinational to do business, expressing politely in a December 3, 2019 letter: “…we have serious concerns…” The OECD’s 2013 Action Plan Report on BEPS states: “No or low taxation is not per se a cause of concern, but it becomes so when it is associated with practices that artificially segregate taxable income from the activities that generate it.”

The Unified Approach is a deviation from this well-established tax principle (and genesis of the BEPS project) that income be taxed in the countries wherein value is created.

Treasury Secretary Mnuchin’s letter intimates, without specifically stating, that the BEPS reforms such as the BEPS revisions to the OECD Transfer Pricing Guidelines and the current tax treaty system built on the arm’s length standard present the best framework to robustly manage base erosion and profit shifting risks for both developed and developing economies from emerging digital business models and e-commerce.

In 1923, the League of Nations already set the groundwork for BEPS’ incremental modifications to the application of the arm’s length standard that will re-align it to where value is generated within the modern global digital economy. The League of Nations’ Economists Report posited that taxation should be based on a doctrine of economic allegiance.

While the economists in 1923 were thinking about labor, this value statement applies just as well today to allocating value to the local market wherein the sales occur. The value can be connected to the local country by expanding its taxing right in the tax agreement to levy tax on business that has a “substantial economic presence”. The US state of Wisconsin’s win at the US Supreme Court offers the nexus solution in this regard.

But the amount of the global value chain that is allocated to the taxable presence in the local country should remain in the context of the arm’s length standard and the OECD Transfer Pricing Guidelines. If the OECD or US’ trading partners want to have a negotiation about formulary apportionment then the US should include the full set of factors relevant for value creation such as size of GDP, national expenditure on R&D (including all the companies that burned through billions of investors’ funds and failed), and national defense spending. Why national defense spending? It is a big figure in favor of the US that will lead to the US receiving a large allocation of European business’ net earnings.

If a market access fee is what Europe requires, then a global defense-spending fee is what the US requires.

The OECD has done an excellent job building a global tax system of treaties and transfer pricing rules that in general work and will work much better because of BEPS. Unfortunately, the Unified Approach sounds like that infamous Peter Arnett Vietnam War quote (NYT, February 8, 1968): “It became necessary to destroy the town to save it.”