Proposed Foreign Tax Rule Raises Blacklist Fears

A proposal from the White House to stem tax avoidance by foreign corporations would give the U.S. Treasury Department wide leeway to determine when it applies — a potential source of conflict, both in the U.S. and abroad, should the policy be enacted into law.

The administration hopes to pass the rule, the Stopping Harmful Inversions and Ending Low-tax Developments, or SHIELD, provision, as part of an agreement with other nations over a global minimum tax, which could smooth over international disputes. But negotiations at the Organization for Economic Cooperation and Development remain uncertain, and Treasury's recent analysis makes clear that President Joe Biden wants to enact it with or without an agreement.

The provision would reduce or eliminate deductions for outbound related-party transactions if they are not taxed above a certain level — either the rate agreed to in OECD negotiations or 21% if there is no agreement — in foreign jurisdictions. Treasury would determine when, "to the satisfaction of the secretary," the minimum level of taxation has been met. In most cases, the calculation would likely not be difficult. But given the complexity of defining a tax base and measuring tax levels, tricky cases will certainly arise.

The policy recalls the "blacklists" and "whitelists" that other countries and the European Union have used to designate when a country is considered a tax haven, which have been fraught with political controversy and which the U.S. has traditionally avoided.

"The secretary may choose to avoid edge cases, but when you start denying deductions — particularly to a company based in a country with whom we have a double tax treaty — then that other country will have reason to respond in some way," said Daniel Bunn, vice president of global projects for the Tax Foundation, a conservative-leaning think tank.

If enacted, the SHIELD rule would replace the base erosion and anti-abuse tax, a provision of the 2017 Tax Cuts and Jobs Act that also targets deductions of both U.S.-parented or foreign-parented companies. But the BEAT applies formulaically, based on a calculation of the U.S. entity's domestic minimum tax rate, and doesn't take into account other jurisdictions involved in the transaction.

Treasury officials have said SHIELD will serve as a backstop to the global minimum tax they hope to enact, negating the incentive for companies to leave the U.S. through inversions and to ensure U.S. companies are not disadvantaged against foreign ones.

"The president's plan would repeal and replace the BEAT to more effectively target profit shifting to low-taxed jurisdictions by multinational corporations while simultaneously providing a strong incentive to bring nations to the bargaining table and end the race to the bottom," Treasury said in an outline of Biden's plan released in April.

SHIELD also resembles the undertaxed payment rule, a provision in the OECD's proposal for a global minimum tax, known as Pillar Two of a two-part plan. That rule would also reduce deductions on related-party payments to low-tax jurisdictions that do not follow the OECD guidelines. In April, Pascal Saint-Amans, the OECD's director of tax policy, said the undertaxed payment rule would ensure that the global minimum tax agreement is enforced, even if not all countries agree to it.

The OECD's most recent draft of the proposal, released in October, said that under its plan "a taxpayer would be offered the possibility to certify" that it had paid above the minimum in tax or that the other jurisdiction involved in the transaction had enacted its own global minimum tax rule compliant with the OECD's standards. But the OECD does not lay out how that certification would be granted.

Lilian Faulhaber, a professor of tax at Georgetown University Law Center, said that in practice the provision would likely only give Treasury the power to issue regulations carrying out the OECD standards.

"I don't see it as giving complete flexibility, although it's written broadly enough that it could do that," she said. "It's an interesting change, but it's not completely unprecedented."

Outside the U.S., many other countries designate certain jurisdictions as havens or noncompliant, subjecting them to harsher reporting or taxation rules. The EU's so-called tax blacklist is a perennial source of political controversy.

Germany also has long had a "royalty barrier" rule, which reduces deductions on royalty payments to jurisdictions found to have preferential regimes at a 25% rate or lower. Germany's law takes into account the OECD's Forum on Harmful Tax Practices, which determines whether countries are following OECD guidelines on patent boxes and other special tax incentives.

Germany has investigated whether the U.S. deduction on foreign-derived intangible income, which only applies on foreign sales, qualifies under the rules. So far, it has put off making a final decision.

The White House has momentarily put its international tax proposals to the side, as Biden now hopes to reach an agreement with Republicans to pay for infrastructure plans with a corporate alternative minimum tax, as well as increased Internal Revenue Service enforcement.

In the meantime, OECD officials say they hope to reach a preliminary agreement by July, with a finalized deal in place by October.

Treasury and the OECD did not respond to a request for comment. 

--Editing by Tim Ruel and Neil Cohen.

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