Retaliatory Strikes

Back in July, I speculated that Donald Trump’s victory in November seemed so assured, the OECD might want to think about cutting a deal with the U.S. now over the Pillar Two global minimum tax, while it still can.

Since President Joe Biden stepped out of the race and Vice President Kamala Harris surged ahead as the Democratic nominee, that’s not nearly so certain. But there’s still a good chance that Trump will be president again in 2025. And Congress may be partially or wholly controlled by Republicans, regardless of how the presidential race turns out.

So the chances are still good that at some point in the future, opponents of Pillar Two and the Organization for Economic Cooperation and Development’s overall global tax plan will have a stronger hand than they do now, and could use various levers of power to oppose it. That would mean retaliation of some kind, likely against countries which impose Pillar Two’s under-taxed profits rule on U.S. companies.

So it’s worth taking a look at how this could work, and what it would mean.

A future Republican president would have many means to push back against Pillar Two–most obviously, through the same tariffs that the Trump administration used to threaten countries which enacted digital services taxes. Trump is already vowing to further flex America’s economic muscles with harsh protectionist measures against countries which displease him–or any country at all.

But there are also more nuanced ways that the president could attempt to punish taxpayers from countries that use the UTPR. Furthermore, Republicans have proposed new legislation that would target Pillar Two specifically, in the same tit-for-tat retaliatory manner.

This could end up playing out many different ways, and it could depend on how willing Congress and the White House are to act unilaterally and outside global norms–the very thing they accuse Pillar Two of doing.

Countries enacted digital services taxes in the latter half of the 2010s as a temporary patch to a broken global income tax system that could not capture profit from the modern digital economy. That was the claim, anyways, and it’s how lawmakers justified using a gross-based tax targeted at only a few categories of transactions. The U.S. strongly opposed this concept, and that’s how it ended up triggering an imminent trade war.

In this case, Section 301 tariffs made sense as the retaliatory tool–they also apply based on transactions, and are meant to discourage discriminatory practices. The law gives the president broad authority to decide when and where these tariffs apply. (In theory, it gives the U.S. leverage in negotiations over trade bills. But it can also be used to flout free trade entirely.)

I wouldn’t be surprised if Section 301 would end up being used against the OECD as well. Both politics and bureaucracy tend towards the path of least resistance, and this has become well-trod territory in recent years as both Democrats and Republicans have rediscovered their taste for protectionism.

But there is the distinction that Pillar Two applies solely as a new form of income taxation. It’s not just a patch. Albeit, it’s applying income taxation in a way that the critics claim flouts the whole concept, but there’s still a desire to fight this back in the realm of income taxation as well.

Back in May of 2023, House Ways and Means Chairman Jason Smith (R-Mo.) unveiled legislation, supported by all Republican members of the committee, that would enact a “reciprocal tax” on the U.S. income of both corporate and individual taxpayers from countries that use the UTPR against U.S. companies. (In the case of individuals, it would apply for those with investments or effectively connected income in the United States.)

The tax would begin at 5% of income and increase by that amount for each year the tax applies, until topping out at 20%. It doesn’t target the UTPR in particular, but any jurisdiction with “extraterritorial” or “discriminatory” taxes, with the U.S. Treasury Department in charge of determining when it would apply.

When it was released, the bill was seen as more of a messaging document than a serious potential statute, too broad and simple to really be practical. Within a few months, Rep. Ron Estes (R-Kans.), released his own, similar bill that would achieve the same goal, but leans more on existing law and has a more targeted approach.

This bill, the Unfair Tax Prevention Act, would target “foreign-owned exterritorial tax regime entities,” or taxpayers based in jurisdictions which use the UTPR. Rather than enacting a new tax, the bill would tighten the existing base erosion and anti-abuse tax, which taxes intercompany transactions. As it stands now, the BEAT applies based on many factors, including a minimum tax calculation on U.S. income and whether the transactions include “base erosion payments,” such as those for interest, royalties or services. The Estes bill would skew some of these factors against those taxpayers that qualify, effectively raising their U.S. tax rate.

There’s an irony here, since the BEAT bears some ancestral connections to the UTPR, although the resemblance may now be all but invisible. Both rules are rooted in denial-of-deduction anti-abuse regimes, that many countries use to protect against base erosion on outbound payments. The UTPR was originally the under-taxed payments rule, and would have only allowed countries to reduce deductions on payments to jurisdictions which did not cooperate in Pillar Two, in cases where the taxpayer paid a tax rate lower than 15%.

For whatever reason, the UTPR was broadened to allow both reduced deductions and outright tax payments, which can apply if the corporate group pays a low tax rate anywhere--including its home territory. This change, while apparently slight, turned it into an altogether new beast, critics allege. The new UTPR allowed countries to tax foreign income it has no real connection with. That’s a real substantive difference from achieving the same result through manipulation of deductions or outbound payments, because it lacks any true limiting principle to prevent outright formulary apportionment.

There’s also some subtle needle-threading going on here by the U.S. lawmakers. It would seem hypocritical for Congress to retaliate against unprincipled extraterritorial taxation by applying extraterritorial taxation of its own. Especially in the case of the Estes bill, there’s a desire to enact revenge through existing tax norms. (Although this is complicated by protests from many countries against BEAT, claiming it violates existing tax treaties.)

Regardless, there may be a law already on the books that would accomplish these same goals, and remain in the income tax realm. Passed in the 1930s over a dispute with France as negotiations on a double tax treaty reached an impasse, Section 891 allows Treasury to double the tax rates of taxpayers from countries that subject U.S. taxpayers to “discriminatory or extraterritorial taxes.”

How this would work is a bit of a mystery, since it’s never been invoked in the 90 years since. Does the administration have any discretion to decide which citizens and corporations would see their tax rates doubled? (For that matter, does the increase really have to be fully half?) But it is another tool at a future president’s disposal, albeit one that could be clumsy and arbitrary in practice.

The goal here, aside from pure revenge, is to put pressure on non-U.S. global multinationals to convince their home countries to turn off the UTPR, or to reach some agreement so it wouldn’t hit U.S. companies as much. This would only work for those companies that have some presence in the U.S., but there are plenty of those. If they start to see that their bottom lines could be seriously hurt by these retaliatory measures, the diplomatic politics on this could change. But there's a certain degree of randomness in any of these tools--they would only apply for taxpayer with a certain degree of presence in the U.S., including other qualifications. That may create an uneven response that will affect some countries differently than others.

As in warfare both economic and real, it’s always a guess how the other party will respond to the latest attack. Rather than a compromise, these could just as easily trigger another round of retaliatory trade measures–and it would happen parallel to another trade war that’s likely to be occurring over DSTs. That’s enough to give many pause about this course of action.

Trump, however, has shown no hesitation when it comes to trade war, and neither have his fellow partisans in Congress.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

Coincidentally enough, or maybe not, the biggest news item of the week in international taxes concerns a potential trade war as well. The United States Trade Representative submitted a request to Canada on Friday for a consultation under the United States-Mexico-Canada Agreement, over Canada’s 3% digital services tax. The tax, which applies to revenue from activities such as data collection and social media, has long been under consideration by the Canadian government and recently was enacted by the Parliament, although it hasn’t yet been collected. A consultation may sound innocuous, but it’s the first step towards establishing a panel that will make a finding which the U.S. could use as a basis for a retaliatory measure. (This is the dispute resolution mechanism which the USMCA largely inherited from its precursor, NAFTA.) In its response, Canada said that the USMCA was the “appropriate forum” to hash out these concerns, but showed no signs of backing down on the tax.
As part of a joint initiative with the International Monetary Fund and other international organizations, the OECD last week released a “reference guide” on the optimal structure for a tax administration. The report comes as many countries, especially in the developing world, find administering complex tax rules to be a monumental challenge. The report emphasizes the need for flexibility and coordination with other government agencies.
The mounting costs of increased tax compliance is increasingly becoming a central worry in the corporate tax sphere, and the Tax Foundation is out today with some eye-popping statistics in a new survey, showing that companies estimate a 32% rise in tax complexity since 2017. A large portion of these new costs are due to international rules, both from Pillar Two and the Tax Cuts and Jobs Act.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Kitty Carson, the Ruff Ridin' Gal Sheriff, appearing first in Kerry Drake Detective Cases #12 in 1949. Daughter of the former county sheriff, she donned his gold star and seeks justice for her father's killers. No superpowers, but she's a "crack shot" with six-shooters who also knows how to work a lasso. Puzzlingly, this seems to take place in the 1940s, not the Wild West.

Contact the author at amparkerdc@gmail.com.

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