We're witnessing an increased convergence of tax and trade in corporate risk management.

• Author: Davis, J. Brian
• Position: New Frontiers of Dispute Settlement in a Pillar One World, part 1

Over the past several decades, the seemingly discrete disciplines of international tax and trade have become increasingly aligned as the globalization of corporate supply chains and the proliferation of online sales have accelerated. With this development, relations between the general counsel's office and corporate tax departments have expanded. Corporate counsel have become more familiar with transfer pricing and tax operating models, and now tax directors better appreciate customs duties and tariffs, bilateral investment treaties, and the role of the World Trade Organization (WTO).

More recently, the digital transformation of corporate operations and offerings that has taken hold across the private sector has elicited from legislatures new and novel tax measures--many arguably seeking to extract some measure of tax from nonlocal enterprises able to access local markets without triggering tax liabilities under traditional tax laws, often due to the digitization of corporate products and services. These novel tax measures have in turn provoked aggressive countermeasures, threatened large-scale trade wars, and accelerated multilateral efforts at the Organisation for Economic Co-operation and Development (OECD) to discipline the chaos of uncharted waters. In our view, the digital era presents new opportunities for general counsel offices and tax departments to collaborate on managing and resolving international tax disputes as well as strategic opportunities for in-house professionals who can capably traverse the increasingly unified world of global tax and trade.

We focus on the evolution of global tax and trade that is being driven by the digitization of multinational enterprises (MNEs) and offer our thoughts on how US MNEs might consider dispute settlement (DS) matters in this new era. We also offer a primer on recent tax and trade events and challenges as well as a brief overview of potential tools and venues for DS. Our aim is to bridge gaps in cross-disciplinary knowledge and help corporate counsel and tax directors better navigate modern global tax and trade. Digitization has spurred transformations in global tax, finance, trade, and market operations, and change in this space can be frenetic. Our hope is to lay a foundation for more robust and strategic discussions between general counsel and tax departments focusing on corporate risk management and DS in the digital era.

A Brief Perspective on an Evolving World

To better understand the impact of digitization on global tax and trade, and the corresponding implications for multinational risk management and DS, the best place to start is the work being advanced by the OECD/G-20 Inclusive Framework on Base Erosion and Profit Shifting (hereafter the Inclusive Framework).1 For the past five years, the Inclusive Framework has worked to find global solutions to address the tax challenges arising from the digitization of business, and since January 2019 that work has been laser-focused on creating "new nexus and profit allocation rules" in an effort known as "Pillar One."2 As tax departments are well aware, the Pillar One proposals are nothing short of transformative in terms of the impact on the global allocation of taxing rights or, stated differently, how governments justify their claim to tax a portion of your company's income.

Like other legal frameworks for international affairs, the laws governing international taxation are not established by one legislative body but are instead determined by a collection of individual countries' tax laws. Nevertheless, to achieve some level of consistency within this patchwork of laws, fiscal representatives from individual countries routinely gather in working parties assembled under the aegis of intergovernmental organizations like the United Nations or the OECD to agree on policies and best practices for the international taxation of income.3 If these policies and best practices are acceptable to the governing bodies of an individual member country, then that country will adopt the policies and best practices (in part or in full) by embedding them into the country's tax laws and by treating them as the foundation for negotiating international income tax treaties. However, if a country considers the policies and practices unacceptable, then it will simply construct its own tax laws and policies as it deems appropriate. Either way, each country retains its sovereign right to levy taxes as it sees fit.

Although this pattern of rule-making preserves the sovereignty of individual countries, the mobility of capital, the globalization of trade, and a desire for "foreign direct investment" (that is, the investment of capital in an economy by nonresidents) are strong forces that tend to drive international consensus. Over time the policies and best practices promoted due to OECD and UN work begin to form a global framework for how international tax laws are generally understood to operate. Though the OECD and the UN may promote different policies and best practices (after all, the two have separate constituencies), in many respects there is convergence.4

THE ROAD TO PILLAR ONE

The original international tax rules were crafted in an era when global trade was defined by transactions in tangible goods and robust international communication networks were nonexistent. Thus, the right to tax the income of nonlocal businesses typically was based on notions of physical presence. Indeed, the tax laws and treaties of many countries today adhere to notions that 1) taxing rights are allocated on the basis of whether a company has a "permanent establishment" (PE), meaning some physical presence, in a country, and 2) once a taxing right exists, the income associated with the PE (or associated with transactions between affiliates) is determined using transfer pricing principles that rely on the "arm's-length principle," which dictates that tax results are to be based on the economics that would be observed if the PE were independent or if related transacting parties were unrelated. For MNEs, the obvious consequence of allocating taxing rights to countries based on the PE standard is that the standard can also operate as a shield to avoid taxes where there is no PE.

Pillar One originated from the work of the Inclusive Framework, which as noted earlier was tasked with finding global solutions to address the tax challenges arising from the digitization of business. But these "challenges" pertain to the current tax framework, which keeps multinational profits out of national treasuries. In other words, Pillar One is about expanding each country's right to tax the profits of MNEs, and the "tax challenges" that animate this effort are those encountered by tax authorities without a legal right under existing law to collect taxes from nonresidents that transact business in that country via the cloud. The Pillar One effort, in short, aims to break cleanly from the past by lowering legal barriers to taxation and, in essence, granting each country additional income taxing rights mainly because its residents buy, use, consume, or access your company's products or services--essentially a market-is-the-measure approach.5

Countries have in fact sought to expand their taxing rights over MNEs using a market-is-the-measure approach for most of the twenty-first century.6 Moreover, resentment at how the current system allocates taxing rights became more acute in the wake of the Great Recession as countries looked for new sources of revenue. And full-scale disenchantment with the present system settled in around 2012, with courts (most notably those in Spain) aggressively pushing back on the technical operation of international tax laws and the French government commissioning a report, released in January 2013, to assess how it might acquire better taxing rights over global internet companies.7 Around the same time, G-20 world leaders called on the OECD to study how the international tax system might be reformed with a view to addressing concerns about "base erosion and profit shifting" by MNEs, an effort that became the BEPS Project.8

The BEPS Project was arguably a once-in-a-generation effort aimed at determining how the existing international tax system could be comprehensively reformed and, as corporate tax departments know all too well, it was ambitious. However, to the disappointment of many countries (including several European Union member states), the conclusion reached in the 2015 final report relating to the impact of digitization on tax laws was that "the whole economy was digitalizing and, as a result, it would be difficult, if not impossible, to ring-fence the digital economy" and write special rules for it.9 It did, however, commit a working group to continue to monitor the digitization of the economy with a goal of producing an updated report in 2020.10 That timing proved too long to wait, and in March 2017 the G-20 finance ministers mandated a new report on the topic; that new report was delivered in March 2018 and formed the foundation for Pillar One.11

In addition, beginning in early 2015--despite the ongoing BEPS Project, or perhaps in some cases in anticipation of a potential lack of action regarding digitization--some Western nations began to enact "alternative tax measures" designed to combat the perceived failure of the international tax system to properly allocate taxing rights to market jurisdictions. The United Kingdom's "diverted profits tax" was the first such significant measure, followed shortly by Australia's "multinational anti-avoidance law."12 These measures--discrete and local, perhaps motivated by politics and an impatient public--arguably served only as stopgap solutions.

By early 2018, the EU, the United Kingdom, and other countries embarked on a new course of action designed to target the revenue of digital MNEs: enacting so-called digital services taxes (DSTs) to tax revenue derived from the local...