Correlation is not causation

I listened to a very good podcast episode today from the if/then podcast from Stanford Graduate School of Business. The podcast discusses how to confirm whether a correlation reflects a causation or not. Figuring that out is not easy because it is often hard to get data that allows one to disentangle different effects. For that reason, we often don't make the efforts necessary to get a clear answer. Often easier to just rely on our priors - if a correlation fits our priors, we tend to view it as causation.

Gabriel ZUCMAN , the French economist and leading researcher on BEPS, just "x'd" (or whatever the new word for "tweeting" is ...) that the latest BEA stats on multinationals show a drop in the percentage of profits booked in low-tax jurisdictions. This is after years of rising share of profits in these jurisdictions. Zucman suggests four potential reasons for this reversal:

1. Delayed effect of the TCJA
2. Anticipation effect of Pillar 2
3. Industry composition effects
4. CAMT

I am fairly certain it's not 2-4. Companies tax planning doesn't move that fast that 2 & 4 can be a reason. And the change is too big to be explained by 3. It definitely is 1 (ok, that's my prior ... but prove me wrong). I would also add the impact of BEPS 1.0.

For those of us involved in global tax planning for US multi-nationals, this change comes as no surprise. What has gone underreported, unfortunately, is that BEPS 1.0 was already impacting how multi-nationals approached global tax planning. The DEMPE requirements and CbC reporting made many companies rethink principal and IP structures that lacked sufficient substance. The TCJA then significantly lowered the differential between the US and these low-tax jurisdictions significantly reducing the incentive to keep profits off-shore.

So why is that only showing up in the data now? The answer is simple ... despite what many believe, these operations in low-tax jurisdictions have real business substance associated with them. Unwinding or re-shoring these structures in the US isn't simple and certainly isn't something that can be done overnight. Also, tax departments have been overworked with the constant onslaught of new regulatory changes limiting their ability to work on significant changes like this. Nonetheless, that change has started and I would bet that this percentage will drop further in the coming years.

All of this is happening even before Pillar 2 is in effect, or even anticipated. Recall that in 2022 there were still a lot of questions whether Pillar 2 would actually happen.

So, why do we need Pillar 2? The short answer is, we don't. Recall, Pillar 2 was originally part of larger project to address the concern the digital age would make income even more mobile and harder to tax. BEPS 2.0 was supposed to save us all from the scary and very complicated DSTs. That effort morphed over time and ultimately a global minimum tax became the main aim. Ironically, that was inspired by the TCJA and the GILTI regime it introduced.

Now, instead of getting scary and complicated DSTs, we still get scary and complicated DSTs, but we also get even scarier and more complicated Pillar 2 compliance! Business at OECD (BIAC) , in its recent comment letter to the OECD, warned that "neither MNEs nor tax audit teams will be able to cope with this [Pillar 2 filing] complexity beyond the first three years of the transitional Safe Harbor."

The reference to tax audit teams (ie tax authorities) is important here - the complexity of these filings will only increase the complexity of tax disputes. Pillar 2 will not deliver Tax Disputes 2, but squared.

The OECD and the key parties driving this effort still have a chance to stop the full insanity of Pillar 2 - make the CbC safe-harbors permanent; and without changing the required information in the CbC reports (i.e., don't shift the complexity from the GIR to the CbC report).

When asked about this at a recent conference in Munich, Félicie Bonnet , acting head of the global minimum tax unit, declined to explain why this was not doable pointing to on-going negotiations. Certain parties appear to be against that - but we are not allowed to know who or why. Tax transparency is seemingly only required for taxpayers, not tax regulators.

Instead of hitting the brakes on this effort, making the CbC safe-harbor permanent and declaring victory, it seems the OECD is working hard to discover new sources of low-taxed income. In a recent research paper, they've identified low-tax income hidden in high-tax jurisdiction. In their view, this, of course, only validates that this effort is necessary: the guidance & research will continue until all ETRs improve!

I am sure, as the share of profit in low-tax jurisdictions drop, the OECD will say "look, Pillar 2!" But remember, correlation is not causation, and the drop started well before Pillar 2 is fully implemented.