Tax & Digitalization: Do We Really Need To Do Absolutely Everything, All At The Same Time, Right Now?

(Disclaimer: The views in this piece are my own and not necessarily those of PwC.)

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It is with infinite caution that any person [man] ought to venture upon pulling down an edifice which has answered in any tolerable degree for ages the common purposes of society, or on building it up again. 

- Edmund Burke, Reflections on the Revolution in France (1790)

In the tax world, we are currently engaged in a project of unparalleled scope to remake the international income tax rules. And the G20, which finds itself in charge of this project, has allowed the Paris-based Organization for Economic Cooperation and Development (OECD) only until “the end of 2020” to reach a “consensus-based solution with a final report”.  The solutions that are being discussed are, individually and collectively, a radical change to the rules that have operated for nearly one hundred years. The politics of many countries seem to require some changes to the rules, and the instability of the current system seems to require it.  

But the scope of the project, the shortness of the timeline, and the (current) lack of deep agreement on either principles or practicalities among countries highlight the challenges.  Moreover, reaching an agreement in name only would do little to reduce the current instability that threatens cross border trade and investment, and to economic growth. Trying to remake the rules to cover (almost literally) the whole world in one go, and at one time, seems incredibly ambitions – but perhaps also unnecessary.  While not a name that gets mentioned overly often in tax policy discussions, I think the Anglo-Irish philosopher and politician Edmund Burke, writing over two hundred years ago, might offer us a solution.

Burke, wrote his seminal book on conservatism, Reflections on the Revolution in France, towards the end of 1790, just as the outlines of the French Revolution were becoming clear.  The optimism of 1789 was already beginning to slowly curdle into what would eventually become the Reign of Terror three years later.  Burke, from almost the beginning, opposed the revolutionary changes in France as destined to lead to chaos. 

Based on the ideas of idealistic French philosophers from Descartes to Rousseau, France’s new rulers were seeking to destroy the ancien regime and replace it with something totally new and untested.  This was, in Burke’s view, complete madness; it was contrary to both common sense, as well as to the very obvious defects of human nature.  If something works, preserve it, he thought; and if something ceases to work, change it incrementally, and to the smallest degree necessary.  While to some eyes this now seems unimaginative, excessively cautious, and unresponsive to pressing needs, in fact, it expresses a deep truth about humility in the face of experience, while also accepting change in the face of necessity.

Following Burke’s principles, my suggestion is that we lean into this change, but in a careful and empirical way.  In relation to international tax policy today, governments want the revenue they believe is earned in their jurisdictions; businesses want the certainty and stability that allows them to plan (and grow) in a global environment.  So change is clearly coming – but why not test new approaches out in a couple of stages, starting small, learning from mistakes, until (on a set timetable, to be sure) we are ready to cover the whole world? That would allow us to build something that works, but also to much better understand the impacts on national economies.  Given the size, scope, and potentially substantial, but unintended, impacts of this project, it is much more important to get this right, than it is to do it under an unreasonable timeframe, and get it wrong.  

How might that work? Well, there are two basic ways to progress incrementally: either by phasing in some of the provisions at different times, or by phasing in each of the provisions by starting small and slowly increasing the coverage.  Below are some suggestions on how to build up incrementally on Pillar 1, but equally one might ask whether we could start with just Amount A, or just Amount B, at least as an initial matter? While they exist within the “Unified Approach” one is not reliant on the other, so why not try one first?  That way, we would be able to establish not just what works, but also could see what might relieve the pressure that is currently making the international tax system unstable.  

But if it is decided to implement the entire “Unified Approach”  at the same time, we could consider the following incremental steps:

• On Amount A (the reallocation of profits to market jurisdictions) one might start with a very high threshold – relating to revenue, or profitability, or some other measure, and bring it down over time to include more businesses, once the unintended consequences have been worked out.  For example, there has been much talk of reallocating 10% of income over a 10% Operating Margin threshold. So in the first stage of this, Amount A could be applied only to 10% of OM over 30%. After a suitable period (including observation and changes in administrative and compliance provisions, etc.) governments could lower the threshold to 20%, resulting in a larger sample size.  And still later, if warranted, reduce the threshold to 10% (or whatever number is decided).
• On Amount B (the fixed margin for routine distribution and sales) there are a number of ways of starting small and building up.  One would be to restrict the numbers, by again applying either a profitability threshold or a size threshold (e.g. based on revenue) so that only a handful of large businesses were involved at first, although in this case, only ones with physical presence.  Alternatively, if it were decided that the final fixed return would be, just for example, 2.5% of sales, then set the bar lower for the first and second periods before eventually hitting 2.5%. 
• On Pillar 1 generally, a number of potential dispute prevention and dispute resolution provisions could be trialed on a smaller sample size, including (sorry, I’m going to use the words) mandatory binding arbitration, but in a smaller, controlled and well-observed setting.  This would give businesses the certainty they want without raising for countries the full range of sovereignty issues and other concerns that have bedeviled this project.

Pillar 2, which deals with income inclusion rules and undertaxed payments rules, obviously raises different issues than Pillar 1.  However, the radical nature of those proposed Pillar 2 rules and their potential complexity is no less.  

So, given the complexity of both the Pillar 1 and Pillar 2 rules (not to mention the current uncertainty as to their form, and the potential for overlap), at the highest level an incremental approach might include postponing the implementation of Pillar 2, while Pillar 1 is refined and tested in the ways suggested above. In the same way that Amounts A and B do not (logically) have to be implemented at the same time, nor do Pillar 1 and Pillar 2 necessarily have to be introduced contemporaneously.  The Pillar 2 design issues – look at GILTI with its imperfections and 100’s of pages of regulations – mean that Pillar 2 may well require more time.  

If the decision is made to implement both Pillars at the same time, then another form of incrementalism would be to apply Pillar 2 only to harmful preferential regimes in the first instance, with a period of time to test out the new rules, and see if there are BEPS “gaps” still remaining that need to be filled.

And other ways of reducing the initial impact to give time for improvement might be considered.  For example, there could be size thresholds, or it could start with lower rates of minimum tax. If, for example, the eventual aim were to have a minimum effective tax rate of, say, 15%, then start at 5% for an initial period, then move to 10%, and later, if warranted, move to 15%.  In that way, again, with a smaller set of businesses (and countries) in the sample size it will be easier to test and modify the rules over a sufficient period of time.

If it is decided to bring in a broader version of Pillar 2 immediately, then crucial to this part of the project will be appropriately shaping the rules (global blending, listing of already-compliant regimes, proper attention to the accounting issues, etc.) from the very beginning.  

Of course, any incremental proposal raises a fundamental question for those businesses that are in scope in the first (or second) phase of this project under either Pillar 1 or 2.  Why me? What’s in it for me? Here’s my answer. I think that many businesses would pay a little more tax for certainty and stability. But, increasingly, I hear businesses worry that under a hastily constructed, project, without broad, deep agreement, they’ll likely pay more tax with no more certainty (perhaps even less).  

The benefit for those businesses in scope in the first phase would need to be a genuine increase in certainty.  I believe businesses that may be in this group want several key things: the repeal of unilateral measures such as Digital Services Taxes (and others, such as equalization levies); rock-solid dispute resolution procedures; administrative simplification on compliance (e.g. filing with one country; coordinated audits, etc.); and relatively clear and simple rules for calculation (e.g., regarding the use and possible modifications to financial accounts).  All of these measures would be very difficult to achieve – probably impossible – with a “big bang” approach to this project involving thousands of MNE groups, and billions of revenue in play. But with a small sample size and less revenue initially at stake, countries should feel more comfortable taking these incremental steps on dispute resolution. 

Of course, there are still the significant issues about how to coordinate the necessary changes across a broad range of countries for even for an initially limited number of businesses, but this again will be easier to achieve  if the sample size starts small.

Burke, too was a supporter of change.  “ A state without the means of some change is without the means of its conservation,” he wrote.  But the prism through which he viewed change was “prudence”. And prudence should also be our guide in this tax project.  We shouldn’t be driven solely by the passions of the moment, or get drunk on theoretical logic. The changes we are discussing are, to be sure, not quite in the same category as the French Revolution.  But they are, nevertheless, revolutionary. We should approach them prudently, and try to, empirically, understand what works best as we adopt the change that many countries want, while at the same time preserving the ability of businesses across the world to create the inclusive growth, jobs and prosperity that the world so badly needs.  Change is coming; let’s act prudently to make sure it works.