Last week, Australia released guidance on its Multinational Anti-Avoidance Law (MAAL), a proposal that introduces a new special taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. aimed at deterring multinational corporation from shifting income to low-tax jurisdictions. The underlying structure of the tax proposal is notable because it has important implications for international tax treaty conventions and possibly interferes with parts of the OECD's Base Erosion and Profit ShiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. (BEPS) project.
Following in the UK's Footsteps
Australia's MAAL proposal is very similar in aim and structure to the United Kingdom's diverted profits tax (DPT), and both have been called the "Google tax." The Australia MAAL proposal and the UK DPT law receive such a name because they target large multinational corporation like Google that are able to sell goods and services to customers in Australia or the UK while barely paying any corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. relative to their Australian or UK earnings.
So what exactly is this Google tax, and how is it supposed to deter tax avoidance? Broadly speaking, the Google tax imposes a penalty on large companies that shift income abroad through certain transactions and corporate structures. Under the UK DPT law, a 25% tax is imposed on profits that should have been reported and taxed in the UK, but were instead shifted to foreign entities. Under the Australian MAAL proposal, a penalty of up to 120% of relevant taxes is imposed on profits that should have been reported in Australia but were shifted abroad.
As I describe the UK and Australian Google taxes in these broad terms, the fundamental difficulty of these policies becomes uncomfortably apparent. How is the government supposed to identify when profits "should have" been reported domestically, rather than abroad?
Underlying Issues: Permanent Establishment (PE) Status
These thorny issues hit at the important concept of permanent establishment (PE) status in international tax policy. When companies are based in one location but earn income in another, countries apply PE status rules established under bilateral tax treaties in order to determine when a foreign-based company has "PE status", and subsequently, when a country can tax the profits of that company.
Traditionally, the great majority of PE status rules have required that a country can only tax a foreign-based company if the company maintains a physical, tangible presence domestically. For example, an Irish company would have PE status in the U.S. if it set up a U.S. retail store. Any profits from the store on sales of goods and services would be subject to U.S. corporate income taxes (CIT).
However, with the Google tax policies, the UK and Australia will be able to tax companies even if they do not technically have PE status under existing tax treaties and treaty conventions. Instead, the Google tax examines the intent and tax savings of transactions and corporate structures. Under the UK DPT, a company is subject to the Google tax if 1) the "primary" intent of an income shifting transaction is to achieve tax benefits, and 2) if the company's UK tax liability decreases more than the company's foreign tax liability increases. Similarly, under the Australian MAAL, a company is subject to Google tax if the primary intent of the income shifting transaction is to achieve Australian tax benefits or foreign tax benefits.
For example, suppose a simplified situation where company A shifts $100 of profits from the UK to Ireland, with the primary intent of lowering its tax liability. In the UK, company A saves $20 in corporate taxes (20% rate), but pays only $12.50 in corporate taxes (12.5% rate) in Ireland on those same profits. Because company A's UK tax liability decreases more than its Irish tax liability increases, the diverted profits of $100 would be subject to the UK DPT at a rate of 25%.
Once the Google tax is determined to apply, the government then begins to identify relevant profits by introducing a theoretical "notional permanent establishment." In other words, the government attempts to use transfer pricing rules to determine how much profit the foreign company would have reported domestically if it had established a PE in the first place. While this task is an interesting intellectual challenge, it is potentially a nightmare for tax administrators.
Implications for Tax Treaty Conventions and the OECD BEPS Project
The Google tax's impact on international tax treaties can be seen from two perspectives. On the one hand, the Google tax is disruptive of tax treaty conventions because it is fundamentally against the physical presence standard of PE status outlined in the OECD Model Tax Convention. If countries continue to adopt Google tax policies, then the traditional concept of PE status will be eroded and may even become obsolete.
On the other hand, it may be argued counterintuitively that the Google tax may instead protect the concept of PE status. By specifically targeting income shifting by multinational corporations, the Google tax eliminates the necessity to modify and dilute the current concept of PE status to address income shifting.
While both arguments have some truth, the former is stronger because even if the Google tax does not directly alter PE status rules (and in this sense preserves them), the Google tax attacks the fundamental principles of PE status and in doing so effectively weakens PE status as an international standard. If countries flock to Google tax policies over PE status rules, then the preservation of existing PE status rules would turn out to not be of much use.
Moreover, the Google tax encourages countries to take unilateral actions that are antithetical to progress in international tax policy. The Google tax emerges as the OECD releases its final reports for the internationally-coordinated BEPS project, with BEPS Action Plan 7 tightening exclusions to PE status and expanding the definition of PE status to include commissionaire agreements. By encouraging unilateral action, the Google tax may help countries collect additional tax revenues in the short term, but it ultimately hinders international cooperation and will likely result in incongruous tax policy across jurisdictions.
Learning from Experience
To understand the potential difficulties of a widespread adoption of the Google tax, it is useful to look at the physical presence rules in the U.S. states. Each state is highly interconnected, has open borders with other states, and shares a common currency. Consequently, U.S. states face the same problems of income shifting when corporations are based in one state and sell goods in another. Furthermore, states have had decades of experience with tax policies similar to the Google tax that are currently emerging on the international stage.
These states’ experiences provide a wealth of information for developing international tax policy. To name a few places to start, Tax Foundation's Joe Henchman authored a thorough piece on the devolution of the physical presence rule in personal jurisdiction and physical presence nexus. Tax Analysts also compiled a set of articles on U.S. state lessons for international tax reform, addressing issues highly relevant to PE status.
Conclusion
Overall, although it is frustrating for countries like Australia and the UK to deal with corporate tax avoidance among multiple other revenue issues, the Google tax causes more problems than it remedies. It is a short-sighted policy that erodes international tax treaty conventions and disrupts international coordination on tax issues. It is ultimately important for policymakers to keep in mind that tax policy should not be legislated in a vacuum, just as a country does not exist in one.
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