The Case Against BEPS: Lessons for Tax Coordination.

• Author: Herzfeld, Mindy
• Position: Base erosion and profit shifting

Introduction 3 I. BEPS in Perspective 8 A. What Is BEPS? 8 B. Origin of Current System 13 1. Colonialism and the Development of International Tax Rules 13 2. A More Benign View 17 C. Why BEPS Now? 18 1. Inequity and the Financial Crisis 18 2. Digital Economy 21 3. Cover for Politicians 22 4. Global Power Shifts 23 5. The OECD's Role 28 II. Weak Foundations 29 A. Global Politics 29 1. No Agreement on Allocation 29 2. Global Politics--Shifts in Balance of Power 35 B. Domestic Politics 37 1. Power to Tax Means Political Power 37 2. The Need to Encourage Investment (E.g., Patent Box) 38 C. Value Creation 42 III. Poor Outcomes 43 A. Minimum Standards and Lack Thereof 43 B. U.S. Nonparticipation 45 C. Digital Economy 50 D. Vague Rules 52 1. Transfer Pricing Guidelines--Deliberate Incoherence? 52 2. The Permanent Establishment Standard 56 IV. Conclusion 59 Introduction

International tax rules have a number of goals. They allocate taxing rights between two jurisdictions when goods or services are transferred across borders. They set out guiding principles for when a resident of one country may be taxed by another country on income associated with that country. They may encourage or discourage cross-border trade based on the degree to which countries attempt to assess tax on cross-border transactions, such as the extent to which countries give relief for taxes paid in another jurisdiction. Finally, they aim to protect individual countries' tax bases by preventing taxable income from escaping national borders. (1)

The rules accomplish these goals through a number of mechanisms. Countries can set their own domestic laws governing crossborder transactions or their residents' foreign earnings. Withholding taxes allow countries to assess taxes earned by foreign residents from cross-border sources. Bilateral tax treaties set out agreements between two countries over how to allocate taxing rights for income that could be taxed in one or the other jurisdiction in order to prevent double taxation. Multilateral agreements such as model treaties or transfer pricing guidelines represent commitments from a larger group of countries to a more widely accepted set of principles.

The international tax laws and agreements in existence today are, with few major modifications, built upon rules that were put in place in the early twentieth century. (2) The belief that they no longer function well in today's global and digital age is widespread. (3) In the United States, cries for the need to update domestic international tax rules to reflect a different global financial and political order have been getting progressively louder over the past several decades. More recently, this need has been recognized on a global scale. (4) Macro-economic developments, growth in cross-border trade, shifts in global political power, and the increasing sophistication of the world's financial system, have all put increasing pressure on the rules and how they are enforced. At the same time, individual countries' incentives to change their rules to protect their own corporate tax bases are under pressure due to fears over the loss of investment that could result from a tax system being viewed as uncompetitive in a world of mobile capital.

The global financial crisis of the late 2000s provided both an incentive and a means of addressing these concerns. With employment and social services suffering and government budgets under strain, the ability to attract more revenues from corporations presented itself as a useful fix to some of society's most highly visible problems. Countries could avoid the beggar-thyself problem by acting in a coordinated fashion. Corporate tax planning, facilitated by global accounting firms, served as a useful point of attack for pursuing the goal of shoring up domestic revenues. Multinational companies, whose own ties to any particular country were exceedingly attenuated as revenue sources and manufacturing locations shifted from historical locales, provided a particularly promising scapegoat for attacks rooted in fears of economic decline and inequality. (5)

Out of this environment was born the base erosion and profit shifting project, or BEPS, mandated by the G20, and managed and implemented by the Organisation for Economic Co-operation and Development (OECD). (6) Under the guise of cracking down on multinationals' tax planning techniques that enabled them to lower their global tax burdens, in part by moving their profit-generating assets and activities to low-tax jurisdictions, the project was intended to facilitate the coordination of international tax rules to ensure higher effective corporate tax rates (an objective implicit but never directly stated in the project's action plan). The coordinated nature of the project was key to making sure that rogue countries did not attract additional corporate investment at the expense of other countries looking to plug the leaks in their own domestic revenue bases. (7)

Over the course of two years, the OECD pushed through reports, recommendations, and changes in 15 identified areas of international tax rules. (8) But the volume of paper published by the OECD glosses over its poor results. Claims of success in the BEPS project pay lip service to agreements on paper but mask real underlying differences that will cause significant problems going forward. In the area of transfer pricing rules, for example, the OECD introduced a set of rules that lacks the economic coherence necessary to produce the meaningful analysis needed to support cross-border pricing. On the crucial area of determination of when a resident of one country has a permanent establishment (PE) in another country, perhaps the fundamental basis for determining the allocation of taxing rights among countries, the project produced a vaguely worded standard with little interpretive guidance. The rules for how to allocate profits to newly found PEs remain unresolved. In the area of treaty abuse, a broadly worded anti-abuse test, the adoption of which is essentially a requirement for all countries signing up to the project, will serve as the basis for litigation and uncertainty for many years to come. Rather than coordinated rules, the project resulted in vague standards that everyone could agree on because they meant all things to all people.

Most importantly, the project failed in one of its most crucial tasks: to force the United States to change its rules to prevent its multinationals from engaging in income-shifting activities among other countries. Not only did the United States not change its rules to benefit other countries, discussions of U.S. tax reform under a new administration opened up the possibility of even more radical tax reforms that potentially benefit U.S. companies to the detriment of other countries. Finally, the project resulted in no meaningful consensus for improvement on the mechanism for resolution of cross-border disputes.

The BEPS project may be able to declare success in one of its declared aims: that of ensuring greater tax payments by multinational companies (only time will tell). But proclaiming success for a project that weakens an already fragile international tax system is to no one's benefit, other than those who hope for collapse in order to start from scratch. (9) Vague guidelines that don't lend themselves to clear interpretation and application don't necessarily benefit tax authorities in the long run. (10)

The poor outcomes of the BEPS project could largely have been predicted because of the nature of the project's undertaking and its underlying premises. Amidst the rhetoric and the declared focus on stopping multinationals' tax avoidance activities, the opportunity for a rigorous examination of the underlying causes of the identified issues was missed. Also hidden behind the rhetoric was any meaningful discussion of real and significant concerns going to the merit and validity of the endeavor. There was no acknowledgement of the various reasons why local politicians offer tax incentives or other (less explicit) tax planning opportunities to multinationals, or of the role played by governments in facilitating tax planning opportunities for both domestic and foreign companies. Tensions between emerging economies and OECD member countries, which lay (unacknowledged) at the root of the project, remained unaddressed.

The project also failed to address another set of broader, more philosophical questions, rooted in economics but also in concerns over fairness in the context of global economic development. The tools that public finance economists have developed for analyzing what constitutes sound policy in a domestic setting are not easily transportable when the questions morph from those having to do with maximizing economic welfare within a particular set of borders to maximizing welfare globally. No country has signed on to such a concept as the basis for international tax rules that may lead to the diminishing of its own revenue intake. (11) In a coordination setting, larger countries can and likely will act to negotiate and implement rules that may work to their best advantage, potentially to the disadvantage of smaller and less powerful countries, and the BEPS project largely failed to assuage such concerns. (12)

These concerns provide lessons for international tax coordination efforts more broadly and prompt the question as to whether there are alternative mechanisms for improving the existing system. Greater scrutiny of the systemic issues that prompted the BEPS project, rather than a narrow focus on corporate tax avoidance, could have resulted in a more substantive project, rather than the flawed endeavor that BEPS became.

This Article proceeds as follows. Part I provides a background on the BEPS project. It begins with a brief outline of the project and then steps back in time to review the historical framework of international tax rules, followed by an analysis of the...