If God exists, she's definitely on the US Treasury's side. That is the only reasonable explanation for the Pillar 2 agreement.
To understand why, we have to go fifty years back in time.
Background
It all started in 1971 when the Nixon administration passed the Domestic International Sales Corporation Act (DISC). The legislation granted certain US export-oriented companies tax breaks. The then European Community immediately argued that the DISC legislation constituted an export subsidy in breach of the GATT rules. The United States responded that the territorial tax laws of several European countries in such a case also constituted illegal tax subsidies. If "the minor" (certain tax relief on foreign source income) constituted an illegal subsidy, "the greater" (no taxation at all on foreign source income) should also amount to such a subsidy.
European countries can afford to be more generous toward their home-based MNEs because they have adopted other taxes – especially the VAT - to compensate for the loss of tax revenue from MNE activities conducted abroad
The US has since advocated that corporate domestic and foreign source income - whether active or passive - should be taxed according to the residence country's tax rate. The US has a narrow tax mix and cannot afford to completely refrain from taxing American MNE's foreign profits. Since the US imposes its domestic corporate rate on home-based MNEs global income, the US Treasury believes that European countries should do the same. Otherwise, European MNEs obtain an unfair competitive advantage.
However, EU countries (including Sweden) tax MNEs’ income derived abroad only nominally. As long as such income is considered ‘active’, European countries care little if it is low or high taxed. They can afford to be more generous toward their home-based MNEs because they have adopted other taxes – especially the VAT - to compensate for the loss of tax revenue from MNE activities conducted abroad. The United States can only blame itself if it has become too dependent on the corporate tax.
GATT never completely resolved the issue. Instead, the US and the EU continued in the 1990s to dispute, in the newly formed WTO, whether the failure to - in whole or in part - tax foreign source income could constitute an illegal export subsidy. (1)
The issue spilled over into the OECD's work during the same period. Two OECD reports, one on Member country CFC legislation (2) and the other on tax sparing treaty clauses (3) indirectly addressed the issue. The US wanted the reports to recommend increased residence taxation of corporate foreign source income, which the OECD's European countries largely opposed. The OECD Secretariat made every effort to find wording in the reports that could satisfy both parties. No one emerged victorious from that battle. The reports recommended increased residence taxation of foreign source income, but at the same time emphasized that there were legitimate reasons for some countries to act differently. (4)
The firm opposition of some European countries to increased residence taxation of MNEs’ foreign income led the US Treasury – in order to improve the competitiveness of its own industry – to de facto "allow" its MNEs to plan away the tax on foreign source income. However, the gaps left in the tax legislation were so effectively exploited by American MNEs that they ended up not paying tax on either domestic or foreign source income.
After one last unsuccessful attempt to persuade the rest of the world to agree to increased residence taxation of MNEs’ foreign source income during the BEPS work (Action Point 3), the United States abandoned the idea of a global solution. Instead, the Trump administration adopted a tax reform in 2017, which means that the US taxes currently a certain part of MNE's active foreign source income. In exchange, the corporate tax rate has been reduced from 35 to 21%.
Then the issue takes a completely unexpected turn.
France and Germany present the GLOBE proposal the following year. This proposal then provides the basis for OECD’s Pillar 2 that is adopted in October 2021.
After spending 50 years combating all American attempts to make residence taxation of MNEs’ foreign income an international tax standard, a number of European countries suddenly decide – without the US Treasury even asking for it – to meet US demands on the issue!
The Consequences of Pillar 2
Pillar 2 imposes current taxation on MNEs’ low-taxed income derived abroad. Admittedly, the rules are ultimately the result of a compromise and contain several (time-limited) exceptions. Notwithstanding, Pillar 2 - through the slippery slope effect – amounts to a first step toward making current taxation of MNEs’ foreign profits a new international standard in the tax area.
Just look at Lockheed Martin’s recent mega sale of US fighter jets to Finland. The military security guarantees that implicitly accompany the Finnish purchase of F35 fighter aircraft can never be matched by Lockheed’s primary competitor SAAB, the Swedish producer of the JAS Gripen fighter aircraft
While it remains unclear whether Pillar 1 will ever be implemented, pillar 2 is likely here to stay. My guess is that countries' willingness to cheat with both the implementation and application of Pillar 2 and MNEs’ attempts to circumvent the rules will lead to Pillar 2 eventually becoming an internationally binding convention with sanction rules. (5)
Pillar 2 means in practice that the "competitive advantage" European industry had over the American industry, by not being taxed on profits sourced abroad, will now be gradually eliminated. At first glance, this may seem only fair as foreign source income exemptions could, as the US Treasury claimed already in GATT in the 1970s, be considered an export subsidy.
It should be noted, however, that American industry often has other inherent competitive advantages over European industry. The creation of a level playing field in this tax area will therefore only reinforce US industry's competitive advantage over its European competitors.
Just look at Lockheed Martin’s recent mega sale of US fighter jets to Finland. The military security guarantees that implicitly accompany the Finnish purchase of F35 fighter aircraft can never be matched by Lockheed’s primary competitor SAAB, the Swedish producer of the JAS Gripen fighter aircraft.
In the long run, the United States will therefore be the biggest winner under Pillar 2. Only God is able to give the US Treasury such a divine gift!
[I will now take a pause from blogging. The next series of blog posts will be published starting on March 1, 2022]
(1) See “GATT Panel Tax Legislation Reports” and “WTO Foreign Sales corporation Panel Reports”.
(2) “Controlled Foreign Company Legislation. Studies in Taxation of Foreign Source Income”, OECD (1996)
(3) “Tax Sparing. A Reconsideration”, OECD (1998).
(4) For a summary of the latter report, see Owens and Fensby, "Is There a Need to Reevaluate Tax Sparing?" Tax Notes Int'l, May 4, 1998.
(5) Se further Fensby, “What the G20 Should Consider Before Adopting Pillars 1 and 2”, Tax Notes Int’l, September 21, 2020.
Comments