The OECD’s digital tax proposal: untangling the impact of ‘Pillar One’ on developing countries

Last week the OECD secretariat published its proposed ‘unified approach’ to update corporate tax rules for the digital era, or at least for one of the project’s two pillars. The proposal is designed to be “the basis for a negotiation that could result in a political agreement by mid-2020.” This agreement is to be made via the G20/OECD Inclusive Framework, which has 134 country members, including 24 from Africa (at the last count – it’s hard to keep up). I previously wrote about Africa’s response to this project, based on my participation at a conference organized by the African Tax Administration Forum. So, now that the OECD’s proposal is out, what can we say about its potential impacts on developing countries?

The new OECD proposal

The explicit purpose of Pillar 1 is to reallocate a share of multinational companies’ taxable profits to ‘market jurisdictions’. It includes three ‘amounts’:

  • Amount A’ gets all the attention. The top line of the whole project is often reduced to a point about how digitalization allows companies to have a significant participation in the economic life of a country without being physically present there. Amount A overcomes this by means of a ‘new taxing right’ that does not require a physical presence. It also gets tax nerds very excited because it allocates profits by means of a formula, which until recently was anathema to the OECD. But as I discuss below, it may not be where the biggest impact on developing countries is to be found.
  • The Pillar 1 proposal would also allocate some profits (‘Amount B’) to companies’ marketing and distribution functions, and says that “the possibility of using fixed remunerations would be explored.” This only applies where there is a physical presence, so it might not seem as radical as Amount A. However, it is interesting for developing countries, for a couple reasons. First, they often complain that multinationals manipulate the profits of their distribution companies downwards as a tax planning technique, and that existing tax rules do not capture the value creation of localized marketing functions. Second, the use of a simplified approach here – something that ICTD research has pointed towards – also sets an interesting precedent.
  • Let’s not forget ‘Amount C’. This allows a country to challenge the amount that it has received via amounts A and B, adjusting the total upwards by using traditional transfer pricing methods if it considers that appropriate. Even so, the language of Amount C in the secretariat proposal actually shifts the focus onto something else. It opens as follows: “Any dispute between the market jurisdiction and the taxpayer over any element of the proposal should be subject to legally binding and effective dispute prevention and resolution mechanisms,” something of a vexed topic for developing countries.

Here are some further questions, concerns and observations about the proposal:

We do not know how much, if anything, low-income countries will gain from the different permutations

There are a lot of reasons for this: many moving parts that might affect the proposal significantly; the lack of good quality data for developing countries; the need to model the dynamic effects of the proposals, that is how companies’ behavior might change. The OECD’s report to the G20 states its preliminary finding that “Overall, on average, low and middle-income economies would gain from Pillar One, experiencing a higher rate of increase in revenues than high-income economies even though, larger market jurisdictions will benefit more in absolute.”

It will be important to look at the winners and losers producing that average result when the OECD work is published. There’s a variety of ongoing work to model the impact of formulary approaches to allocating the tax base, but the reported findings – including those published by Alex Cobham, Tommaso Faccio, and Valpy FitzGerald this week –  suggest that a sales-only approach, as proposed under Pillar 1, produces more losers among developing countries than one that incorporates sales and labour. By the key decision point of January 2020, we may still not be able to say with any confidence how low-income countries will be affected.

Carve-outs and thresholds could reduce the utility of Pillar 1 for low-income countries

While the scope of Pillar 1 is now greater than just the highly-digitalised companies whose tax affairs triggered discussions, it is likely to be limited in a number of important ways:

  • The company threshold. In discussions at the International Fiscal Association (IFA) conference last month, it was suggested that the turnover threshold at which Amount A would apply could be more than €750m. Only the world’s largest companies will be affected. To take one example, Jumia, which is perhaps Africa’s best known e-commerce firm, turned over just €130m last year.
  • The revenue threshold. Amount A will only kick in once sales and/or users exceed a certain amount. This can work against less wealthy countries, where sales are naturally lower in absolute terms. The proposal helpfully leaves open the possibility of adapting this threshold to the size of the market, as well as somehow including non-paying users.
  • The residual profit threshold. Amount A only applies to a company’s ‘residual’ profits, which cannot be easily tied to specific parts of the business and are particularly high for digital companies. The residual profit would essentially be any profit above a fixed rate deemed to be the ‘routine’ profit rate, which will be negotiated within the Inclusive Framework. The higher that rate, the smaller the amount of profits that will be redistributed under Amount A. Chip Hartner, the US representative speaking at IFA, said his country’s position was that the residual profit threshold should be set high enough to isolate only the most important cases.
  • Carve-outs. As expected, the proposal states clearly that the new approach is not suitable for oil, gas and mining companies, but it suggests that it may exclude commodities and financial services, and that it will apply to consumer-facing businesses. What does this mean for developing countries? They may benefit from the exclusion of sectors where their position is primarily within value chains, and where they do not have large consumer markets, but sectoral carve-outs could also limit the application of the ‘new taxing right’ significantly.

Put this all together, and under Amount A we have a redistribution of the tax base that low-income countries may gain from. Their gains will be limited to companies larger than a certain overall threshold, which have a presence in their market above a certain threshold, only in certain sectors, and only to their profits above a certain amount. And all of those ‘certain’ elements are still under negotiation!

What difference will segmentation make?

The proposal suggests at various points that each of its elements might not apply uniformly, but might apply differently between and within companies, according to different segments, business lines, sectors and/or regions. What will this mean for low-income countries? If any fixed return under Amount B were to vary by sector, the value of the return in sectors of relevance to developing countries would be a critical matter for negotiation. Meanwhile, the possibility of a regional segmentation under Amount A needs careful consideration, given that Africa is commonly described as the continent with the highest return on investment.

The potential costs of participation

In addition to the potential gains for lower-income countries, there are a few costs from participation that merit consideration. For example, some larger developing countries currently tweak international tax rules to give themselves a larger share of the tax base.  Wilson Prichard and I have written about how China adds to international tax rules to give itself a ‘market premium’, which is now covered by Amount B. Others have implemented, or are considering, unilateral measures to help them tax digital companies, such as India’s equalization levy. The eventual package proposal from the Inclusive Framework is likely to include a moratorium on these kinds of measures, which may limit lower-income countries’ ability to innovate or to emulate. The text of the secretariat proposal makes clear that they will also be subject to mandatory and binding dispute settlement procedures. This could mean that, regardless of how well the eventual settlement works for them, lower-income countries that join may be unable to deviate from it.  A final point is that, while this is a simplification, it is also a whole new set of tax rules that will need to be applied domestically, creating an opportunity cost for countries that are often still getting the legislative and administrative basics in place.

The OECD secretariat responded robustly to the Tax Justice Network’s claims that developing countries would not gain from its proposal, by pointing out that developing countries are now at the table. As the head of the BEPS project Pascal Saint-Amans said “We now serve all these countries and a compromise will have to be found among all of them.” We may gain some indications of the politics of negotiations between developed and developing countries inside the Inclusive Framework as we see how the issues outlined above are worked through in the months ahead.

First published by ICTD.

The new politics of global tax governance: taking stock a decade after the financial crisis

Rasmus Corlin Christensen & Martin Hearson (2019). The new politics of global tax governance: taking stock a decade after the financial crisis, Review of International Political Economy, 26:5, 1068-1088

As the new academic year gets underway, it’s time for me to promote a review piece that Rasmus Christensen and I published over the summer. We provide a framing of current developments in global tax governance from a political economy perspective. The piece is written at introductory level and fills the gap for an overview reading in university courses. It is framed as a review of four interdisciplinary books, all of which we recommend. Oh and it’s open access, thanks to EU funding!

Here’s the abstract:

The financial crisis of 2007–2009 is now broadly recognised as a once-in-a-generation inflection point in the history of global economic governance. It has also prompted a reconsideration of established paradigms in international political economy (IPE) scholarship. Developments in global tax governance open a window onto these ongoing changes, and in this essay we discuss four recent volumes on the topic drawn from IPE and beyond, arguing against an emphasis on institutional stability and analyses that consider taxation in isolation. In contrast, we identify unprecedented changes in tax cooperation that reflect a significant contemporary reconfiguration of the politics of global economic governance writ large. To develop these arguments, we discuss the links between global tax governance and four fundamental changes underway in IPE: the return of the state through more activist policies; the global power shift towards large emerging markets; the politics of austerity and populism; and the digitalisation of the economy.

This table sets out the trends we identify, and our explanation of how they are affecting tax politics.

And here are the books we discuss:

Dietsch, P., & Rixen, T. (Eds). (2016). Global Tax Governance: What is wrong with it and how to fix it. Colchester: ECPR Press.

Fairfield, T. (2015). Private wealth and public revenue in Latin America: Business power and tax politics. Cambridge: Cambridge University Press.

Harrington, B. (2016). Capital without borders: Wealth managers and the one percent. Cambridge, MA: Harvard University Press.

Jogarajan, S. (2018). Double taxation and the league of nations. Cambridge: Cambridge University Press.

Unprecedented: Kenya-Mauritius tax treaty ratification struck down in court

Back in 2014 I was in touch with Nairobi-based Tax Justice Network Africa, as they prepared to take the Kenyan government to court over its tax treaty with Mauritius, signed in 2012. The treaty seemed a pretty poor deal for Kenya, lacking adequate anti-abuse protection, preventing Kenya from imposing withholding tax on technical fees, and restricting its ability to impose capital gains tax, which it was in the process of introducing. It has taken more than four years, but on Friday the High Court ruled, and it has declared the ratification of the treaty in Kenya to be invalid.

This is a landmark case, because tax treaties are usually technical instruments that undergo only cursory parliamentary scrutiny, if any at all. For a civil society organisation to challenge one in court, let alone win, is quite astonishing. Kenyans I know were excited by the possibilities of the country’s new constitution, and this shows their optimism was not misplaced!

TJN-A argued that the treaty was unconstitutional for two reasons: in content terms, the treaty would lead to an unacceptable loss of revenue; in process terms, it should have been subject to public consultation and approval by parliament. The court actually sided against TJN-A on both counts, stating among other things that it should have provided figures for the revenue lost (which should make it untenable for governments to refuse to do the same) and that consultation with Kenya Revenue Authority constituted adequate public participation. The ruling is that the statutory instrument giving effect to the treaty should have been laid before parliament, and was not. I disagree with a lot if what is in this judgement, but its political impact is nonetheless huge and welcome, as this message from TJN-A’s Alvin Mosioma illustrates:

Here are a few documents for reference:

TJN-A’s press release summarising their argument

My expert opinion submitted to the court by TJN-A (pdf)

The court ruling (pdf)

TJN-A’s press release on the judgement

Response to the OECD consultation on taxation of the digital economy: taking the politics seriously

Yesterday I was part of a group of political scientists who made a submission to the OECD’s consultation on taxation of the digital economy. The text of our submission, also available as a PDF document, is below, first published on Rasmus Christensen’s website.

The undersigned are a group of political science academics working on issues of international taxation. Such a coalition has rarely involved itself in the OECD’s technical consultations. This submission reflects two compelling factors. First, the global tax system and its governance stand at a critical junction. The current debate on solutions to the tax challenges of digitalisation has the potential to shape global tax policy and its outcomes for countries and citizens across the world for decades to come – and this has motivated us to prepare this submission. Second, our research offers important insights that can help the global tax policy community pursue sustainable reforms. Below, we offer some general comments before moving to specific responses to the consultation questions.

Vincent Arel-Bundock, Université de Montréal; Rasmus Corlin Christensen, Copenhagen Business School; Lukas Hakelberg, University of Bamberg; Martin Hearson, London School of Economics and Political Science; Wouter Lips, Ghent University; Thomas Rixen, University of Bamberg; Indra Römgens, Roskilde University and Radboud University; Leonard Seabrooke, Copenhagen Business School; Laura Seelkopf, Ludwig-Maximilians-Universität München; Saila Stausholm, Copenhagen Business School; Duncan Wigan, Copenhagen Business School

General comments

We wish to highlight three key considerations for effective and sustainable action on the tax challenges of digitalisation.

  1. The objectives of the consultation and the taxation of the digital economy policy discussion more broadly are as much political as they are technical. By ‘political’ we mean that the drivers of this consultation are rooted in the popular politics of taxation, and that the political implications of policy solutions are not incidental or secondary considerations. This includes the consequences for inter- and intra-national (re)distribution, for citizens’ experiences of fiscal systems, for the viability of global tax governance, and for the wider economic transformations occurring as a result of digitalisation, where tax policy will help determine winners and losers. Historically, the relative isolation of international tax policy-making from popular politics helped produce a remarkably stable cross-border tax system. However, isolation challenges responsiveness to political demands for change. In today’s context, international tax politics has become both more mainstream and highly politicized. The risks of not engaging proactively with diverse political stakeholder interests – including ordinary citizens, civil society, business groups (large and small), academia, etc. – are significant. For instance, one reason for the recent struggles of multilateral trade cooperation is that the trade agenda extended into areas where social and environmental concerns implicated new political actors. Yet, the multilateral regime continued to treat these issues through a narrow trade lens. Technical approaches to taxing the digital economy are unlikely to be sustainable unless their substance and the process by which they were produced are perceived as fair by a broad range of stakeholders.
  • The recent expansion of the OECD’s tax policy-making institutions to include non-OECD members brings important dilemmas. While this expansion represents an important step towards global inclusiveness and accountability, it also calls into question the balance between inclusiveness and the coherence of the global tax system itself. Global economic shifts are raising the profile and influence of historically marginalised countries in global economic governance. In some cases, incrementalism has been enough to satisfy ‘rising powers’; in others, dissatisfaction with the status quo has led to the pursuit of outside options or to stalemate over wholesale reforms. The balance between building on the work undertaken over decades and responding to these new challenges is critical for achieving effective and coherent global action on the tax challenges of digitalisation. Institutional expansion at the OECD challenges the historical division of labour between the OECD and other bodies for international tax cooperation (such as the United Nations), which allowed one group of like-minded countries to move quickly while the process of global consensus-building could take place at a necessarily slower pace. We believe that the success of institutional expansion is contingent on a serious reconsideration of policies and processes that were not historically designed to accommodate the interests of emerging and developing countries. To turn again to the example of international trade cooperation, developed countries’ unwillingness to respond to developing countries’ longstanding concerns about agricultural protectionism was a major contributor to the breakdown of the talks.
  • The move towards binding, global cooperation on taxation creates costs as well as benefits. The reluctance of governments to enter into binding cooperation has shaped the global tax system for a century, at times hindering effective action and enabling harmful tax competition. Commitments to strong cooperation on international taxation are a key prerequisite for governments’ abilities to make and enforce fiscal policies in their own interests. Moreover, given the significance of the tax challenges of digitalisation, and the increasing willingness of states to act unilaterally, the risks of furthering cross-national mismatches and unintended externalities (in the form of double taxation or double non-taxation) in the international corporate tax system are high. Nonetheless, setting the bar too high creates a risk of short-term failure, as the OECD experienced in the past with the Multilateral Investment Agreement, or long-term instability as countries defect from binding agreements. In this context, the sustainability of any policy option depends on managing effective cooperation that prevents harmful tax competition while recognising that it is contingent on meeting the interests and expectations of all its members, and limiting incursions into the design of national tax systems when such a balance is not feasible. Moreover, it is important that each government is open and transparent with its domestic stakeholders about the likely costs and benefits of entering such cooperation

Specific comments

What is your general view on the proposals? In answering this question please consider   the   objectives,   policy   rationale,   and   economic   and   behavioural implications.

  • Distributional considerations should be foregrounded. Discussing the three suggestions on revised profit allocation and nexus rules, the consultation document usefully acknowledges that while they all have the objective of recognising value created in market jurisdictions, their implications for shifts of taxing rights are different. These differences, which we take to be highly significant, have implications for the considerations on effective action outlined above. Of the three proposals, the ‘significant economic presence’ idea, given its greater sectoral scope, seems to offer the potential to shift taxing rights covering most profit, although this would naturally be contingent on the final design of the mechanics.
  • The emerging differences between taxation on the basis of source and residence vs. market/destination merit further consideration. The Inclusive Framework is committed to considering solutions that reallocate the tax base. In today’s economy, the distinction between source and residence taxation is indeed increasingly unhelpful; yet, there is a risk that a singular emphasis on ‘market jurisdictions’ may unduly disadvantage traditional source jurisdictions without sizeable markets and limited purchasing power. The interests of these jurisdictions – often less powerful and underrepresented at the OECD – should receive significant attention.

How would you suggest that the rules should best be co-ordinated?

  • Coordination design is contingent on meeting stakeholder expectations. A number of implementation measures are available to the Inclusive Framework, including standard-setting, peer review, blacklisting and sanctioning, which have proven effective to varying degrees. These measures differ in their balancing of binding ‘lock-in’, national flexibility to pursue government policy choices (especially as regards raising effective capital taxation), and international redistribution. All of these critical considerations are interrelated and must be taken into account together in coordination design. For instance, the reopening of the distributional debate on allocation issues has become necessary because of the challenges faced by the current international tax system in enforcing effective capital taxation. Thus, on the one hand, should a workable and commonly agreeable solution that matches all members’ distributional interests and national policy choices be found, strong and binding cooperation is preferable. If, however, and we see a real risk of this, the envisaged solution is unfavourable to emerging/developing countries (see previous paragraph), then strong and binding cooperation is undesirable.

What could be the best approaches to reduce complexity, ensure early tax certainty and to avoid or resolve multi-jurisdictional disputes?

  • The consultation should seek to refocus public debate away from ex post criticism of the outcomes of tax rules once they are implemented, and towards ex ante debate over rules as they develop. A core component of tax certainty is political stability – the certainty of a tax position given the likelihood of future political action affecting that position. Such action may be in the form of legislative initiatives that change tax results, changed administrative practice, or public pressure on companies to alter approaches to tax planning. The stability of any policy solution(s) on the tax challenge of digitalisation developed by the Inclusive Framework depends critically on engaging with the voices and objectives of a broad range of stakeholders, and on a reconsideration of entrenched interests. In this context, the limitations of the consultation to primarily consider ostensibly technical questions on ‘aligning value creation’ may hinder positive engagement with a broader range of stakeholders. Such consultation design erects barriers of language and expertise that limit diverse engagement, closing off stakeholder engagement. In turn, this may negatively affect the likelihood that its policy outcomes will be broadly seen as fair.
  • Deeper and broader stakeholder engagement. In this context, we encourage the OECD and the Inclusive Framework to pursue more proactive engagement with non-traditional and diverse stakeholders in relation to the tax challenges of digitalisation. At the national level, this should mean an active approach to education and consultation with stakeholders around national negotiating positions, and parliamentary debate over the adoption of new rules that moves beyond the rubber-stamping that has thus far characterised the adoption of BEPS outcomes by most countries. At the multilateral level, this would go beyond the currently institutionalised TUAC and BIAC partnerships and the few substantive consultation letters received from non-expert interests, and would include sustained interactions on questions of the political implications of the tax challenges of digitalisation, including the inter- and intra-national distributional implications. Inspiration could, for instance, be drawn from other policy domains of the OECD where non-state actors have been successfully integrated through increased voice and access channels, implementation partnerships, institutionalised reviews, etc. More generally, we suggest the Inclusive Framework could – at a minimum – set out its formal ambitions for the involvement and diversity of stakeholders in global tax policy-making, and specific initiatives to achieve these ambitions.

Transnational expertise and the expansion of the international tax regime

Hearson, M, 2018. Transnational expertise and the expansion of the international tax regime: imposing ‘acceptable’ standards. Review of International Political Economy 25(5):647-671.

We are living through a period of instability and change in the international tax regime, perhaps unprecedented in its depth and duration. It’s driven by economic and political changes, such as austerity politics, the digitisation of the economy, and the rise of China and other emerging powers. To understand the impact of these pressures on the institutions of tax cooperation, we need to know how the politics at international level works, and we have two complementary lenses to do so. One focuses on conflicts and alliances between states with different preferences: developed versus developing, offshore versus onshore, US versus Europe, and so on. The other takes a sociological approach, studying the transnational policy community that makes international tax rules and its interactions with other actors such as politicians and campaigners. To explain why the OECD, G20, EU or UN have reached a particular conclusion, we probably need to use both of these lenses.

But how do states arrive at their national positions? Those positions set the parameters for subsequent transnational discussions, but they also determine if and how states will implement international agreements. For example, with whom will they negotiate bilateral tax treaties, and on what terms? The same sociological lens is important here, because national tax policy is made by a community of people, many of whom are also involved in tax standard-setting at the OECD and elsewhere. At both national and international levels, international tax has historically been an obscure topic, the preserve of this small community of experts. Every so often – as in recent years – the community faces a conflict with others who aren’t steeped in the principles underlying the tax system, nor its technical details. Such conflicts can play out at the national level, as well as in the transnational sphere.

In an article published over the Christmas break, I explore this using archival documents that show how the UK formed its policy towards bilateral tax treaty negotiations with developing countries. I reach two important conclusions:

  1. Often it was the UK, rather than its developing country negotiating partner, that initiated and drove forward negotiations. The UK’s aim was to reduce the tax paid by British businesses abroad, making them more competitive in comparison to firms from other countries. So we can’t explain the expansion of the international tax regime into developing countries solely through a focus on developing countries’ actions.
  2. Tax experts, from the Inland Revenue and the business community, dominated policy formulation. They saw tax treaties as a means to lock developing countries into ‘acceptable’ OECD tax standards, a long game designed to protect British businesses from anything unconventional. Meanwhile, their non-expert counterparts in other government departments and businesses had different priorities derived from a focus on short-term tax gains. They were mostly unable to influence policy, however, indicating that business power over tax policy depends a lot on expertise.

I’ve uploaded all my photographs from the archive files that I cited into a zip file (warning: it’s very large: 660 pages and 273MB). Below is a selection to illustrate the argument.

First, Alan Lord, Deputy Chairman of the Board of Inland Revenue, sets out the tax expert view in 1976:

Here is an extract from the minutes of a typical meeting between the Inland Revenue and tax professionals from British businesses. As can be seen, businesses are being consulted not just about which countries to negotiate with, but also about the sticking points in individual negotiations – in this case Malaysia.

Below is one of my favourite exchanges, from a few months later. In contrast to the open attitude to the CBI tax committee, the same Inland Revenue civil servant (Ann McNicol, now Ann Smallwood) refuses to share even a list of current negotiations with other departments.

Extract from a letter from Smallwood, Inland Revenue, to Harris, Foreign and Commonwealth Office, 1973. Click to see the whole document.

Smallwood’s letter provokes a round of very angry memos within those departments, of which this is a good example.

Extract from a memo by Kerr, Foreign and Commonwealth Office, 1973. Click to see the whole document.

A particular bone of contention between the two groups (Inland Revenue and the CBI tax committee on the one hand, Foreign Office, Departments of Trade and Industry, and their business interlocutors on the other) was the stalemate in negotiations with Brazil. In the paper I show how the tax experts in business and the Inland Revenue did not want to set what they saw as a bad precedent by caving in to Brazilian demands to sign a treaty that contravened OECD standards. They came under strong pressure to sign a treaty “at any price” from business lobbyists who thought UK firms were losing out to German and Japanese competitors that did benefit from treaties with Brazil. The consequence, as Smallwood put it in 1975, was that business “spoke with two voices”.

Extract from a memo by Smallwood, Inland Revenue, 1975. Click to see the whole document.

Ultimately, as the absence of a UK-Brazil treaty today underlines, it was the tax experts who won the day. This illustrates that, while businesses have certainly helped shape the design of the international tax regime, the corporate lobby is far from monolithic in its preferences and its ability to influence. A lobbying position stands more chance of success if it is coherent with the underlying design principles of the international tax regime, and articulated by members of the community of tax professionals at its heart. Whether this conclusion still holds in an era of politicisation and rapid change perhaps merits some further investigation…

China’s challenge to international tax rules and the implications for global economic governance

Hearson, M & W Prichard, 2018. China’s challenge to international tax rules and the implications for global economic governance, International Affairs 94(6): 1287–1307.

In scholarship on international economic governance – areas such as trade, the monetary system and development assistance – a lot of attention is now devoted to the rise of China. This literature appears to be settling on a consensus that China is a cautious reformist rather than a supporter of more dramatic change, and that it pursues outside options where existing institutions do not serve its interests. Meanwhile, work on the politics of the international tax regime is still largely preoccupied with the power that the US, as a ‘great power’, wields on the international tax regime. Our view is that this underestimates the influence a rising power can wield, and so we try to link the two literatures up. We focus on the Arm’s Length Principle, which underpins OECD-led international agreement on the distribution of multinational companies’ tax bases through transfer pricing. This international regime differs from areas such as trade and aid, which have fragmented in recent years, because it is a cooperation regime characterised by strong incentives for states to find and follow multilateral agreement.

Interests: Chinese exceptionalism

We begin with China’s interests. They align neither with developing countries, despite official rhetoric to that effect, nor with OECD countries. This is partly because China is undergoing an economic transition, summarised in table 1: its past, present and future interests differ from each other. In bilateral tax treaties, China has been able to manage this situation by adopting different negotiating stances with developing countries compared to developed countries. It faces more of a challenge in multilateral negotiations.


China’s interests are also different because of what it calls its location specific advantages (LSAs). As a tax administration document states:

China has a huge population and a fast-growing middle class that form a great market capacity and huge consumer groups. This factor is unique in the world and inimitable by other small and medium-sized developing countries.

By arguing that the LSAs firms obtain from operating in the Chinese market (roughly divided into location savings for manufacturing, and market premiums for retail) are unique to it, China avoids the need to choose between its old and new interests. It has simply begun to claim a larger share of multinational firms’ taxable profits. We quote from an article written by some staff of the law firm Baker Mackenzie:

Most multinationals do not realize that their strategy of allocating ‘routine profits’ to China is under severe attack. To quote a Chinese tax director who has negotiated extensively with the Chinese tax authorities, ‘[i]t became clear that the State Administration of Taxation believes China has unique factors, including location savings and market premiums, that are not addressed by the OECD Transfer Pricing Guidelines […]’.

Capabilities: often underestimated

China has a particularly strong position in international tax negotiations because the same economic transition that is changing its preferences is also strengthening demand from multinationals to access its markets. Previous work by Lukas Hakelberg and Wouter Lips has focused on absolute market size, where China lags behind the US and EU, but we think three other variables also matter:

  1. Growth. China is undergoing huge economic and social shifts that make it a uniquely attractive place to do business, whether measured by the exploding size of its middle class, or its ascendency towards the top of the patent registration league tables. China’s attraction to investors is thus about future potential as well as present performance.
  2. Profitability. Its fairly new and rapidly growing consumer market is relatively untapped in many areas, has a taste for foreign goods and services, and is more willing to pay a premium for higher-quality products.
  3. Value-chain positioning. Chinese manufacturing has become indispensable to the production of a huge proportion of products consumed in the West, most iconically the iPhone, and this position is becoming increasingly institutionalized.

For these reasons, China can afford not to take too seriously any threats from multinational companies and foreign governments if it differs from international tax norms, giving it the kind of autonomy that only the US was thought to possess.

Strategies: Janus-faced

LSAs allow us to analyse how China has interacted with the established institutions of global tax governance. We conclude that its approach is neither conciliatory nor confrontational, but both, simultaneously. China adopts a rhetoric of common cause with developing countries, but pursues an agenda that is designed to maximize only its own share of the tax ‘pie’. It flirts with outside options such as the United Nations, while enjoying a privileged position within the G20-OECD complex at the heart of international tax rulemaking, and diverging from existing rules when it finds this to be in its interest. “China needs to strike a balance between conforming to international conventions and acknowledging its unique situation in transfer pricing legislation and practice,” wrote Chinese officials in a United Nations document in 2017. In practice, however, its actions have been more aggressive than this might imply.

In particular, China’s implementation of LSAs chips away at a core norm of the international tax regime, the Arm’ Length Principle (ALP). OECD rules require that the ALP be applied to each subsidiary of a multinational in isolation, in comparison to a locally owned independent enterprise. By contrast, the Chinese position is that:

With more and more companies poised to conduct business as groups, economic activities are more and more likely to take place in the inner circle of MNE groups. It is nearly impossible to take out one piece of a value chain of an MNE group and try to match it to comparable transactions/companies

This has ruffled some feathers, as can be seen in this quote from the United States’ former international tax negotiator, Robert Stack:

The OECD countries all ascribe [sic] to the arm’s-length standard and to what they call the basic OECD principles. Other countries have not signed on to the full implementation of the arm’s-length standard and the OECD guidelines, even countries that are in the G-20. And the reason this is very important is the question of market premium and intangibles that relate to markets and things like location-specific advantages that are specifically talked about in the OECD guidelines … [China should] not pick a rifle-shot issue that favors a large-market country and try to gerrymander the debate from that narrow issue.

The destabilising effect of China’s actions could lead to one of two outcomes, we suggest. In the first scenario, China would behave very much like the United States, throwing its lot in with the G20-OECD complex. Its growing influence would allow it to use a combination of incremental changes at global level and selective unilateralism to adapt as its place in the global economy evolves. In the second, by design or by accident, China’s approach could destabilise the core norms of the international tax regime. By opening cracks in the existing system, LSAs may induce other countries—perhaps led by other large emerging markets—to seek their own accommodations, thus placing increasing strain on the multilateral foundations of the international tax system. It remains to be seen whether China’s successful challenge to the ALP will similarly prompt subsequent challenges from elsewhere.