EU Struggles to Reply to the U.S. Weaponizing Tax

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Richard Asquith

Richard Asquith Avalara

Richard Asquith, VP Global Indirect Tax, Avalara

We are going to war—global tax war sparked by the recent U.S. Federal Tax reforms—and Europe is struggling. Many countries that feel harmed by the reforms are likely to seek redress.

This month, the European Union (“EU”) is expected to publish details of its proposed 5 percent gross revenues tax on U.S. digital multinationals such as Google, Facebook, Amazon and Apple. Apple immediately seized on the reforms to shift to the U.S. over $200 billion in foreign earning previously held offshore. This has been partially spurred by President Trumps' slashing of corporate taxes on U.S. multinationals' foreign earnings to encourage a massive repatriation of $3 trillion in U.S. foreign profits currently sheltered from U.S. tax offshore. But the EU's proposals, launched by France and Germany, are already facing internal opposition from member states, and may also flout bilateral agreements against double taxation with the rest of the world.

Globally, countries such as China, Israel, and Australia have also launched plans to reduce their tax burdens to remain competitive with the new U.S. regime. A number of countries have also threatened to make a referral to the World Trade Organization (“WTO”) court, presaging a U.S. retreat on international trade cooperation and an attack on the global tax consensus and the balance of global investment.

U.S. Joins Tax “Race to the Bottom”

For more than 30 years, the U.S. stayed out of the “race to the bottom” on corporate tax rates, leading to significant international investments by U.S. companies that have helped underpin the economies of many trade rivals. For example, many U.S. companies hire a high percentage of foreign employees, including Johnson & Johnson (72.6 percent), Proctor & Gamble (73.3 percent), and Oracle (62.9 percent) (December 2016). However, the new U.S. reforms make the U.S. far more attractive to multinationals that are able to shop around the world for the most favorable tax environments.

The U.S. reforms are designed to spur future investment in the U.S. and bring back trillions of dollars in offshore U.S. profits, but they are viewed by some countries as a grab for tax income.

Threatening Reforms?

Which are the specific reforms deemed threatening to U.S. trade rivals? These include:

  •  cutting the U.S. federal tax rate from 35 percent to 21 percent. This compares to the average rate of 23 percent in other major developed countries. For example, the average statutory corporate tax rate in Asia is 20.05 percent, in the EU 21.82 percent, and in South America 28.73 percent;
  •  a one-off tax charge of 15.5 percent on historic earnings sheltered offshore and now repatriated to the U.S. The prohibitively high 35 percent tax rate that has been in effect for years led U.S. corporations to accumulate an estimated reserve of more than $2.5 trillion in tax havens around the world. This particular reform is part of a shift from taxing all global income to taxing only income earned in the U.S.—a move that all of the largest U.S. competitors made years ago to attract redomiciling multinationals;
  •  imposition of a minimum tax on earnings held offshore from technologies and related intellectual property. The levy on global intangible low-taxed income (“GILTI”) could initially be around 10.5 percent, but will rise to over 13 percent. Again, this is to discourage investment in technologies and patents outside the U.S., and to spur U.S. corporations to bring their research activities home.

These measures will transform the U.S. corporate tax system from arguably the most uncompetitive among the major economies into a hugely attractive location in which to base investment, research and jobs. However, for every dollar retained or repatriated to the U.S., another country loses a dollar of taxable income. And the numbers are big—the U.S. is the world's largest foreign investor, sending around $26 trillion offshore in 2016.

The World Strikes Back

In anticipation of losing much of this benefit to their economies, many global trade rivals have been quick to react. The EU, China and Russia have already launched retaliatory actions or plans, while Israel and others have alerted the U.S. of their intent to shield their fiscal sovereignty. Here are the specific actions to date:

  • The EU will this month will publish details of its proposed Digital Tax on the gross sales of digital multinationals. This will seek to wrestle back profits destined for the U.S. under the Trump reforms. The tax rate proposed is believed to be between 2 percent and 5 percent of gross revenues. The majority of the 28 members of the single trading bloc believe U.S. tech companies are abusing the right to sell across borders without paying local corporate income taxes. The digital giants stand accused of deliberately locating themselves locally in low-tax EU states such as Ireland, Luxembourg and the Netherlands. The EU's single market rules mean this enables them to avoid high business taxes in the major markets of Germany, France, Spain and Italy. The sales tax will seek to impose “fair” tax on the U.S. multinationals by creating a new tax status of “digital permanent establishment,” subject to the new tax.What is not clear is whether all of the EU member states support the draft: Ireland has threated to wield its veto over the measure. The EU does not have the right to breach international tax law, so the measure may fail on this test alone.

  • China, which already faced slowing foreign direct investment in 2017 due to rising inflation, has brought forward its own new tax breaks to tackle likely U.S. outflows. For example, on December 28, 2017 in an effort to stop U.S. firms from repatriating earnings, the Finance Ministry announced temporary plans to exempt foreign companies from corporate tax on reinvested profits. This will be retroactive, meaning many U.S. companies will be able to make reclaims on taxes paid in 2017 if they step up investment in strategic sectors. Further, China's 25 percent corporate tax rate offers many deductions.
  • Russia, in an effort to sustain recent inflow levels, proposed at the end of December 2017 to eliminate fully its already low tax on capital repatriated from abroad.
  • Israel, which is highly dependent on U.S. R&D investment, is feeling particularly exposed. It had already cut its corporate tax rate to 21 percent, but declared in December 2017 that it will drop the level again, given the new competitive environment.
  • The EU warned the U.S. Treasury in December 2017 that the reforms gave unfair fiscal advantages to U.S. companies. Ministers from the U.K., Germany, Italy, France and Spain warned Washington that it should adhere to “international obligations to which it has signed up.” The warning continued, “…certain less conventional international tax provisions could contravene” tax treaties and could have “a major distortive impact on international trade.”
  • Ireland and other onshore, low-tax EU member states, such as the Netherlands and Luxembourg, have built their modern economies around acting as conduits to U.S. investment around the world. They will seek to leverage the EU's mighty negotiating powers – the EU's 28 states comprise the largest international market for the U.S.—to pressure the U.S. not to further penalize foreign investment.
  • Australia announced shortly after the passage of the U.S. reform that it will cut its corporate tax rate from 30 percent to 25 percent.
  • Argentina, in December 2017, quickly reformed its pension scheme to help fund a cut to its business tax rate from 35 percent to 25 percent in two years' time.

The Conflagration may be Settled in Court

Many of the countries that feel harmed by the U.S. tax reforms will seek international redress, typically through the WTO court, which oversees global trade and tax rules and resolves disputes arising among the more than 160 member countries. The petitioners will likely claim that the U.S. reforms lead to double taxation and problems with transfer pricing issues.

Since President Trump has already publicly expressed his disdain for the WTO and the constraints it puts on the U.S., such a referral could simply initiate a U.S. exit from the organization as another demonstration of the current administration's America-first policy. This would be a major setback to the progress of globalization and fair trade.

If this trend continues, the “race to the bottom” will accelerate, pitting various countries against each other as tax becomes a powerful weapon in trade competition.

Richard Asquith is VP Global Indirect Tax at Avalara.

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