LOST IN TRANSLATION: EXCESS RETURNS AND THE SEARCH FOR SUBSTANTIAL ACTIVITIES.

Date22 March 2022
AuthorFaulhaber, Lilian V.

INTRODUCTION 547 I. HOW THE OBAMA ADMINISTRATION'S EXCESSIVE RETURNS PROPOSAL BECAME THE TRUMP ADMINISTRATION'S GILTI AND THE OECD'S PILLAR TWO 550 A. The Evolution of Excess Returns Proposals in the United States from 2010 to 2017 551 B. Action 3 of the OECD's BEPS Project 558 C. GILTI 560 D. Pillar Two of the OECD's Digital Economy Project 563 E. Map of the Changing Definitions and Explanations of Excess Returns 568 II. WHAT DO EXCESS RETURNS REPRESENT? 575 A. The Theory of Excess Returns 576 B. Excess Profits Taxes 580 C. Residual Profits in Transfer Pricing 583 D. Summary of the Theories of Excess Returns, Excess Profits and Residual Profits 584 III. PRACTICE VERSUS THEORY: HOW DO MINIMUM TAXES ON FOREIGN EXCESS RETURNS COMPARE TO THE THEORIES OF EXCESS RETURNS,E XCESS PROFITS AND RESIDUAL PROFITS? 585 A. Differences Between the Various Proposals 587 B. Are These Taxing Excess Returns? 589 C. Are These Taxing Excess Profits? 590 D. Are These Taxing Residual Profits? 590 E. What Are These Taxing? 591 IV. THE DIFFICULTIES OF DEFINING SUBSTANTIAL ACTIVITIES 592 A. The Search for Substantial Activities 593 B. Criticisms of Efforts to Define Substantial Activities 599 C. Normal Returns as a Proxy for Substantial Activities 600 V. EXCESS RETURNS, THE SEARCH FOR SUBSTANCE AND PROBLEMS OF TRANSLATION 602 A. The Problems with Using Normal Returns as a Proxy for Substantial Activities 602 1. Unacknowledged Discretion 602 2. Unacknowledged Differences 603 3. Unacknowledged Inconsistencies 604 B. Problems of Translation 605 VI. CONCLUSION 606 INTRODUCTION

This Article charts the evolution of one tax reform proposal across administrations, political parties and jurisdictions. Starting in 2010. one international tax reform proposal moved from being a one-page idea in the Obama Treasury's proposed budget to being one of the Organisation for Economic Co-operation and Development's (OECD) options for controlled foreign company (CFC) reform to becoming the basis for one of the major international tax reform provisions in the 2017 tax reform to being in Pillar Two of the OECD's current digital tax project. With every iteration, this proposal changed shape in terms of how it was described, how its elements were calculated and how its proponents justified it. At each stage of its development, it was understood to mean something very different from what it meant at the previous stage.

The proposal in question is one for a minimum tax on foreign excess returns. The general concept of such a tax is that it separates excess returns from so-called normal returns and then imposes a minimum rate of taxation on the excess returns while excluding the normal returns from taxation. This minimum rate may be the same rate as the domestic rate in the country applying the tax or a lower rate. This Article highlights that this description can apply to several different Obama Treasury proposals, Camp Option A, the international tax provisions in the Tax Cuts and Jobs Act (1) that was passed under the Trump Administration, Action 3 of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project and Pillar Two of the OECD/G20 project on digital taxation.

At the same time that it points out the common thread that links all these rules, this Article also shows how differently the drafters of each rule have understood the purpose and design of a minimum tax on foreign excess returns. This Article argues that there is not one shared understanding about how to design taxes on excess returns or why to impose taxes on excess returns. Instead, although policymakers are all using the same terminology and referring to the concepts of excess returns and normal returns, they all mean different things, and they are all using these terms for the purpose of addressing seemingly different problems.

This Article therefore considers possible explanations for the different ways that these different provisions define normal returns and excess returns. It turns to economic theory to consider whether the theory of exempting normal returns from taxation explains the different definitions. Are these proposals for minimum taxes on excess returns trying to target economic rents as understood by economists? Or are they trying to target excess profits of the sort targeted by previous wartime taxes on windfalls? Or, alternatively, are they trying to target residual profits as defined by transfer pricing analyses? This Article finds that these proposals differ in important ways from any economic theory of excess returns, economic rents, excess profits or residual profits.

On investigation, it turns out that these proposals are all trying to impose taxation on shifted income, particularly shifted income from intangible assets. In other words, they are all designed to address the concern that a taxpayer earned income in one jurisdiction but was able to shift it to a second jurisdiction, thereby avoiding paying taxes in the first jurisdiction and paying taxes in the second jurisdiction. Implicit in this concern is the assumption that the second jurisdiction imposes lower tax rates than the first jurisdiction.

This Article argues that these minimum taxes on foreign excess returns therefore represent a new phase in the search for substantial activities. For many years, policymakers have been searching for a solution to the problem of how to tax income that has been shifted to a low-tax jurisdiction from the jurisdiction that contributed to the creation of that income. This problem has many guises, but the general concept is that policymakers want to impose taxation on income that does not arise from so-called "substantial activities" (or "economic substance") in the low-tax jurisdiction. How to identify substantial activities and economic substance, however, has vexed policymakers for decades. These minimum taxes on foreign excess returns represent a new phase in the search for substantial activities. After many efforts to define substantial activities for themselves, policymakers turned to economic theory for a solution. And they found the theory of excess returns, under which normal returns should be exempted from taxation and the remaining excess returns should be taxed. But, when they translated this theory into practice, policymakers did so in a variety of ways, creating measures that differed both from each other and from the theory that inspired the measures.

To illustrate this interplay between theory and policy in the context of minimum taxes on foreign excess returns, this Article proceeds in five parts. Part I tells the story of the many proposals for such taxes over the last decade, following the Obama Administration's excess returns proposal from its first brief appearance in 2010 through its evolution into much more detailed proposals in subsequent budgets. This proposal then made an appearance in the OECD's Action 3 Report as one of the options for reforming CFC rules, and it ended up being enacted into U.S. law as the Global Intangible Low-Taxed Income (GILTI) provision in the 2017 tax reform bill. This proposal has also been included in Pillar Two of the OECD's digital tax project.

Part II discusses the economic literature on taxing excess returns, focusing on discussions of cash flow taxes and allowances for corporate equity. Part II does not intend to be a rich discussion of the debates over these tax reforms but instead aims to provide a general overview of how excess returns have traditionally appeared in the economic literature. Part II also briefly discusses excess profits (or windfall) taxes and the taxation of residual profits in the transfer pricing context.

Part III discusses the many differences between all of the provisions outlined in Part I that consider themselves to be focused on excess returns. These differences exist in terms of the rates used to define normal returns, the costs or assets used to define normal returns, and the scope of the excess returns calculation. Part III then considers what these differences tell us about what these measures are targeting. Part III concludes that these taxes are not targeting excess returns as envisioned by economic theory, nor are they targeting the excess profits traditionally targeted by windfall taxes or the residual profits associated with transfer pricing. Further, Part III concludes by pointing out that the provisions all overlap in the sense that they are all trying to impose some degree of taxation on income that policymakers consider to have been shifted away from the jurisdiction that contributed to the earning of that income.

This insight about shifted income brings readers to Part IV. which considers how the recent excess returns provisions all contribute to an ongoing debate in the international tax policy space about how to identify "substantial activities" or "economic substance." For some policymakers, tax preferences should only be granted to income arising from substantial activities in a jurisdiction and taxes should focus on income that does not arise from those same substantial activities. How to determine whether or not income arises from substantial activities, however, is an ongoing challenge for policymakers. For decades, they have designed tax rules that define substantial activities in a variety of ways, and these minimum taxes on foreign excess returns are a new phase in the search for substantial activities. In effect, policymakers have been searching for a solution to the problem of substantial activities, and they turned to excess returns taxation to solve this problem. In translating the theory of excess returns into practice, however, policymakers transformed it into rules that defined normal and excess returns in ways consistent with policymakers' visions of substantial activities and not with the theory of excess returns.

Part V discusses three concerns raised by the translation of the theory of excess returns into widely diverging definitions of...

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