From “BEPS Inaction 1” to “BEPS 2.0”
Monica Gianna’s new paper, OECD BEPS (In)Action 1: Factor Presence as a Solution to Tax Issues of the Digital Economy, does a great job identifying the deficiencies in the current physical-presence permanent-establishment (PE) standard. Citing the 2018 OECD interim digital tax report, she thoroughly catalogs the many unilateral actions countries are taking in response to those deficiencies.
Her suggestion for reform is simple and elegant: Do what the U.S. states do!
Ten U.S. states use a common factor-based nexus rule, under which a nonresident has a taxable presence for income tax purposes if they have a certain amount of payroll, property, or sales in the jurisdiction.
Gianni points out that this kind of nexus rule doesn’t ring-fence. It doesn’t favor or disfavor any particular sector, and, once nexus is established, Gianni’s proposed apportioned income tax could apply to all income, regardless of industry. This lack of ring-fencing and sectoral discrimination is important, not only because it makes good sense, but also because EU law restrains such discrimination.
Gianni’s proposal is one in a long line suggesting exportation of U.S. approaches. While I have advocated caution in this area, Gianni is correct that the U.S. nexus rules have much to recommend them compared to the old, fixed-place PE rule.
When considering Gianni’s proposal it is important to remember how the U.S. states arrived at this happy and low threshold for tax nexus, and whether it’s realistic to think other countries could follow. The Supreme Court provided the nexus requirement in cases like International Shoe and Burger King, which held that purposeful availment — without more — satisfied due process fairness requirements.
So, in the United States, standardization derives from (1) the Supreme Court, which sets the nexus threshold for every state, and (2) a common tax base (the common tax base results from state incorporation of the federal tax base). Both of these elements are absent from the international scene.
With nexus and the base established federally, all that’s left for the U.S. states to determine is allocation.
But there’s the rub.
Gianni notes that the Multistate Tax Compact recommends three-factor formula apportionment, but only about half the states use it. The rest use whatever factors they want in whatever combinations they want.
The virtue of this system is that if Virginia thinks that the market state should get a larger share, while New York thinks the labor state should get a larger share, each can — independently, without consulting each other and without modifying a treaty or being accused of disobeying the law — adopt apportionment rules that reflect those views.
The only limit to this independence is what the Supreme Court calls internal consistency. Under internal consistency, each state’s rule must be such that, if adopted by all the states, it would not lead to double tax. So Virginia could use sales-only apportionment, and New York could use payroll-only apportionment, and neither would violate the Constitution or be expected to ask the other’s permission.
The problem is obvious — uncoordinated apportionment rules lead to double tax and tax gaps. Congress could force the states to use the same formula, but it doesn’t. (The Canadian provinces all use a common formula; fine, we can add that to the long list of things Canada does better.)
But if you don’t have a central authority that has the power to impose a common formula, how do you get agreement on the formula if each state has a different view about what its share should be?
Well, you don’t. That’s probably why Avi-Yonah and Clausing say the United States should switch unilaterally to formulary apportionment as a first mover, without waiting to secure commitments from other states to do the same. They argue that if the United States went to single-factors-sales apportionment, then the United States would be a haven for all other factors of production. Competition with the United States would encourage other states to follow suit by also adopting single-factor-sales. Because it would be difficult to abuse, single-factor sales apportionment would be an efficient — though not necessarily fair — way to allocate revenue from cross-border activities.
Simple, non-physical nexus rules like the ones Gianni suggests would be an improvement over our current system, and so might be formulary apportionment, but the real question is: How can we get there when countries simply do not agree about nexus or allocation? Gianni has worked on the normative side of this issue, but there are persistent and difficult political obstacles to moving forward with her plan, or any of the many others described in the interim OECD report. Fortunately, many states appear committed to working cooperatively through the OECD, at least for a little while longer. So there may be hope in BEPS 2.0 for progress on BEPS Action 1.