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Notes

The COGS Exception Should BEAT It: A Policy Analysis of the Base Erosion and Anti-Abuse ’s COGS Exception

Conflicting theories of have led countries to adopt differing approaches to taxing mul- tinational corporations (“MNCs”). MNCs, seizing upon resulting mismatches in countries’ tax rules, em- ploy base erosion and profit shifting (“BEPS”) strate- gies that shift profit to low tax jurisdictions and mini- mize global tax liability. Amid a global struggle to combat BEPS, the United States introduced the Base Erosion and Anti-Abuse Tax (“BEAT”). The United States’ most recent effort, while promising, provides a significant exception for BEPS strategies that manipu- late cost of goods sold (“COGS”). This Note argues that the BEAT would better serve considera- tions if the United States removed its COGS exception. This Note begins by describing countries’ competing approaches to international taxation, the BEPS prob- lem that results, and difficulties in combating BEPS. Next, this Note discusses the BEAT, specifically explor- ing the United States’ new territorial tax regime of which the BEAT is a part, the BEAT’s calculation, and the BEAT’s COGS exception. Finally, this Note argues that the BEAT would better serve tax policy considera- tions if the United States removed its COGS exception because the COGS exception: (1) undermines the United States’ territorial tax regime and capital import neutrality, (2) violates tax policy considerations of neu- trality and fairness, and (3) hinders the BEAT’s effec- tiveness in combating BEPS.

INTRODUCTION ...... 678 I. INTERNATIONAL TAXATION AND THE BEPS PROBLEM ...... 679 (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

678 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3

A. Approaches to Taxing MNCs ...... 680 1. Bases for Taxing MNCs ...... 680 2. Worldwide Versus Territorial Tax Regimes ...... 682 3. Choosing a Tax Regime: Theories of International Taxation ...... 683 4. Other Tax Policy Considerations ...... 685 B. The BEPS Problem ...... 686 1. An Illustration: The Double Irish ...... 687 2. BEPS Strategies ...... 690 3. The BEPS Problem Gets Worse ...... 692 C. Difficulties in Combating BEPS ...... 695 II. THE BEAT ...... 697

A. The United States Moves to a Territorial Tax Regime ...... 698 B. The BEAT and Its Calculation ...... 700 1. Who Pays the BEAT? ...... 701 2. “Modified ” ...... 702 3. “Regular Tax Liability” ...... 704 C. The BEAT’s COGS Exception ...... 705 III. THE COGS EXCEPTION SHOULD BEAT IT ...... 707 A. The United States’ Territorial Tax Regime and Capital Import Neutrality ...... 707 B. Neutrality and Fairness ...... 709 C. The BEAT’s Effectiveness in Combating BEPS .... 711 CONCLUSION ...... 712

INTRODUCTION

Driven by competing theories of international taxation and tax policy considerations, countries take varying approaches to taxing multinational corporations (“MNCs”). MNCs seize on resulting mis- matches in countries’ tax rules to minimize their global tax liability. In particular, MNCs employ aggressive tax planning strategies that, through transactions between an MNC’s affiliates, shift profit to coun- tries with low corporate rates. This practice, known as base erosion and profit shifting (“BEPS”), results in over $100 billion in lost corporate income each year, a number that may grow with further developments in technology and the rise of the digital (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 679 economy.1 Amid a global struggle to combat BEPS, the United States in- troduced the Base Erosion and Anti-Abuse Tax (“BEAT”). The BEAT, a provision of the Tax Cuts and Jobs Act of 2017 (“TCJA”), takes an innovative approach to combating BEPS. Rather than polic- ing MNCs’ transactions for fairness, each year, the BEAT requires MNCs to calculate their taxable income categorically excluding trans- actions that could be used for BEPS.2 Despite its promise, the BEAT provides for a significant exception to the transactions that MNCs must exclude from their taxable income: cost of goods sold (“COGS”).3 This Note argues that the BEAT would better serve tax policy consid- erations if the United States removed its COGS exception. This Note breaks down into three parts. Part I describes coun- tries’ competing approaches to international taxation, the resulting BEPS problem, and difficulties in combating BEPS. Part II discusses the BEAT. Specifically, it explores the United States’ new territorial tax regime of which the BEAT is a part, demonstrates the BEAT’s cal- culation, and explores the BEAT’s COGS exception. Finally, Part III argues that the BEAT would better serve tax policy considerations if the United States removed its COGS exception because the COGS ex- ception: (1) undermines the United States’ territorial tax regime and capital import neutrality, (2) violates tax policy considerations of neu- trality and fairness, and (3) hinders the BEAT’s effectiveness in com- bating BEPS.

I. INTERNATIONAL TAXATION AND THE BEPS PROBLEM

Before discussing the BEAT and the shortcomings of its COGS exception, this Note provides background information on countries’ varying approaches to taxing MNCs, the BEPS problem, and difficul- ties in combating BEPS. Specifically, Section A discusses countries’ bases for taxing MNCs, worldwide versus territorial tax regimes, tra- ditional theories of international taxation, and other tax policy consid- erations. Section B introduces BEPS, using the infamous Double Irish

1. ORG. FOR ECON. CO-OPERATION & DEV. [OECD], INCLUSIVE FRAMEWORK ON BEPS: A GLOBAL ANSWER TO A GLOBAL ISSUE 1 (2018), http://www.oecd.org/tax/flyer-inclusive- framework-on-beps.pdf [https://perma.cc/SC5Q-XZ89] [hereinafter OECD, INCLUSIVE FRAMEWORK ON BEPS]; see also David Bradbury, Tibor Hanappi & Anne Moore, Estimating the Fiscal Effects of Base Erosion and Profit Shifting: Data Availability and Analytical Issues, 2 TRANSNAT’L CORP. 91, 101 (2018) (providing more estimates on the fiscal effects of BEPS). 2. See infra Part II. 3. Id. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

680 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 with a (“Double Irish”) as an illustration, before de- scribing common BEPS strategies and how the digital economy has exacerbated their use. Finally, Section C discusses traditional efforts for combating BEPS and the difficulty in doing so.

A. Approaches to Taxing MNCs

Countries have dealt with questions of when and how to impose income on MNCs. In 1960, the United States recorded imports and each in excess of $20 billion, and twenty years ago, substantial shares of U.S. corporations’ profits were already earned abroad.4 Both countries and international organizations, most notably the Organisation for Economic Co-Operation and Develop- ment (“OECD”), have developed strategies for taxing MNCs.5 This section explores these strategies. It begins by describing countries’ bases for taxing MNCs and contrasting worldwide and territorial tax regimes. Then, it discusses the traditional theories of international tax- ation that guide a country’s adoption of a particular tax regime. Fi- nally, this section explores tax policy considerations.

1. Bases for Taxing MNCs

Before levying income taxes on MNCs, countries must have some basis for doing so. In general, countries may exercise jurisdic- tion over MNCs for tax purposes based upon two principles: (1) the residence principle and (2) the source principle.6 The residence prin- ciple states that countries can tax MNCs that are residents of their

4. MINDY HERZFELD & RICHARD L. DOERNBERG, INTERNATIONAL TAXATION IN A NUTSHELL 1 (11th ed. 2018); see also CHRISTOPHER H. HANNA, TAX POLICY IN A NUTSHELL 231–33 (2018). International has, however, skyrocketed. In February 2018 alone, the United States exported more than $204 billion and imported more than $262 billion in goods and services. See HERZFELD & DOERNBERG, supra, at 1. 5. The mission of the OECD is to “promote policies that will improve the economic and social well-being of people around the world.” About the OECD, OECD, http://www.oecd.org/about/ [https://perma.cc/76GU-5P3L] (last visited Mar. 26, 2020); see also JEFFREY L. DUNOFF, STEVEN R. RATNER & DAVID WIPPMAN, INTERNATIONAL LAW NORMS, ACTORS, PROCESS: A PROBLEM-ORIENTED APPROACH 17 (4th ed. 2015) (describing OECD as “an international organization promoting dialogue and open markets among wealthy states”). For the OECD’s guidance on tax, see Tax, OECD, http://www.oecd.org/tax/ [https://perma.cc/SGB7-RPED] (last visited Mar. 26, 2020). 6. U.N. Dep’t of Econ. & Soc. Affairs, Manual for the Negotiation of Bilateral Tax Treaties Between Developed and Developing Countries, at 9, U.N. Doc. ST/ESA/PAD/SER.E/37 (2003) [hereinafter U.N. Manual for Bilateral Tax Treaties]. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 681 country.7 In practice, the definition of residency varies. Some coun- tries rely upon formal criteria, such as an MNC’s place of incorpora- tion, while others apply more fact-intensive criteria, such as the loca- tion of an MNC’s central management and control.8 On the other hand, the source principle holds that countries can tax income earned within the country, even if an MNC is not located there.9 Rules dic- tating when a country is the source of an MNC’s income typically mir- ror “ rules,” agreed upon by countries in bi- lateral tax treaties.10 The OECD Model Tax Convention, the basis for nearly all countries’ bilateral tax treaties, designates permanent establishments in three situations.11 First, an MNC has a permanent establishment in a country if there is a “fixed place of business through which business of [the MNC] is wholly or partly carried on.”12 This requires an MNC to have threshold degrees of permanence, physical presence, and con- ducted-business.13 The OECD Model Tax Convention provides exam- ples of permanent establishments, such as places of management, branches, offices, factories, and workshops.14 Second, an MNC has a permanent establishment in a country where “a person is acting . . . on behalf of [the MNC] and, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of con- tracts that are routinely concluded without material modification by

7. Id. 8. Id. at 9–10; see OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, ACTION 1: 2015 FINAL REPORT 23 (2015) [hereinafter OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY]. 9. U.N. Manual for Bilateral Tax Treaties, supra note 6, at 9. 10. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 24, 26. When a permanent establishment exists, countries generally levy taxes by means of withholding taxes. Id. at 23. 11. More accurately, the OECD Model Tax Convention and the United Nations (“U.N.”) Model Tax Convention provide the basis for nearly all bilateral tax treaties. BRIAN J. ARNOLD, AN INTRODUCTION ON TAX TREATIES 4–5 (2015), http://www.un.org/esa/ffd/wp- content/uploads/2015/10/TT_Introduction_Eng.pdf [https://perma.cc/J24N-UKNJ]. See generally OECD, MODEL TAX CONVENTION ON INCOME AND ON CAPITAL: CONDENSED VERSION (2017) [hereinafter OECD MODEL TAX CONVENTION]; U.N. DEP’T OF INT’L ECON. & SOC. AFFAIRS, U.N. MODEL CONVENTION BETWEEN DEVELOPED AND DEVELOPING COUNTRIES (2011) [hereinafter U.N. MODEL TAX CONVENTION]. However, the U.N. Model Tax Convention draws heavily on the OECD Model Tax Convention, and the treaties’ permanent establishment rules are comparable. ARNOLD, supra, at 4; see also OECD MODEL TAX CONVENTION, supra, at 31–33; U.N. MODEL TAX CONVENTION, supra, at 11–14. 12. OECD MODEL TAX CONVENTION, supra note 11, at 31. 13. Id. at 117. 14. Id. at 31. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

682 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 the [MNC.]”15 However, such a person does not create a permanent establishment if he or she is an independent agent.16 Third, building sites or construction or installation projects that last more than twelve months constitute a permanent establishment.17 If an MNC satisfies any of these situations in a country, the OECD Model Tax Convention permits the country to tax the MNC under the source principle.

2. Worldwide Versus Territorial Tax Regimes

The residency and source principles have led to the develop- ment of two competing tax regimes. Grounded in the residency prin- ciple, a worldwide tax regime taxes all income earned by resident MNCs, even income earned in other countries.18 To avoid double tax- ation, a worldwide tax regime offers tax for taxes paid to other countries on income earned within those countries.19 However, if the MNC’s domestic tax liability is greater than its foreign tax credits, it has residual domestic tax liability.20 For example, assume that a U.S. MNC has an Irish subsidiary that qualifies as a permanent establish- ment. If the MNC is subject to a of 21% in the United States and a rate of only 12.5% in Ireland, income earned by the Irish subsid- iary would be subject to a residual tax rate of 8.5% in the United States.21 Countries impose this residual tax upon income repatriation, usually achieved through dividends paid by an MNC’s foreign subsid- iaries to their domestic parent.22 Very few developed countries employ a pure worldwide tax regime today.23 Rather, most worldwide tax

15. Id. at 32. 16. Id. 17. Id. at 31. Similarly, due to the rise of the services sector, some bilateral tax treaties, though not the OECD Model Tax Convention, allow for permanent establishments when an MNC provides services for a threshold period of time. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 27; see also OECD MODEL TAX CONVENTION, supra note 11, at 31–33. 18. HANNA, supra note 4, at 259–60. 19. Id. 20. Id. 21. Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13001, 131 Stat. 2054 (2017) [hereinafter TCJA]. The TCJA reduced the United States’ corporate income tax rate to 21%. Id. As of January 7, 2019, Ireland’s corporate income tax rate is 12.5%. PricewaterhouseCoopers, Ireland: Corporate—Taxes on Corporate Income, WORLDWIDE TAX SUMMARIES, http://taxsummaries.pwc.com/ID/Ireland-Corporate-Taxes-on-corporate- income [https://perma.cc/835S-S5B6] (last visited Apr. 25, 2020). 22. HANNA, supra note 4, at 244–60. 23. Id. at 256–60 (indicating Brazil to be only country with pure worldwide tax regime). (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 683 regimes allow MNCs to defer dividends repatriating income.24 Relying on the source principle, a territorial tax regime only taxes income for which the country is the source.25 In practice, terri- torial tax regimes achieve this by exempting dividends that repatriate income from tax liability.26 To illustrate a territorial tax regime, as- sume again that a U.S. MNC has an Irish subsidiary. The Irish subsid- iary earns income in Ireland and pays a dividend to its U.S. parent. Under a pure dividend exception system, the United States would not tax the dividend. Thus, the Irish subsidiary’s income would only be subject to tax liability in Ireland.27 Today, at least among developed countries, territorial tax regimes are much more common than world- wide tax regimes.28 However, like worldwide tax regimes, pure terri- torial tax regimes seldom exist as countries offset them with provisions seeking to protect their tax bases.29

3. Choosing a Tax Regime: Theories of International Taxation

When choosing a tax regime, three theories of international taxation have traditionally guided countries. Each approach seeks neu- trality in relation to tax’s effect on the global allocation of capital.30 For instance, “capital neutrality” seeks to neutralize tax’s effect on an MNC’s decision on where (i.e., in what countries) to invest cap- ital.31 Theoretically, with tax removed from consideration, capital will be invested in the country that would be most efficient.32 Countries favoring capital export neutrality generally adopt a worldwide tax

24. Id. 25. Id. at 245. 26. Id. at 246. 27. Expense allocation presents significant challenges to MNCs based in territorial tax regimes. Id. at 247. Because MNCs cannot claim tax deductions on tax exempt income, MNCs must allocate sufficient expenses to their foreign subsidiaries to avoid deducting expenses associated with tax exempt income. Id. 28. KYLE POMERLEAU & KARI JOHNSON, TAX FOUND., NO. 554, DESIGNING A TERRITORIAL TAX SYSTEM: A REVIEW OF OECD SYSTEMS 4 (2017), https://files.taxfoundation.org/20170822101918/Tax-Foundation-FF554-8-22.pdf [https://perma.cc/4675-43VY0]. 29. Id. at 3 (“[C]ountries need to trade off among three key goals: eliminating taxes on foreign profits, protecting their tax bases, and making their tax codes as simple as possible.”). 30. GARY CLYDE HUFBAUER & ARIEL ASSA, US TAXATION OF FOREIGN INCOME 53, 72 (2007). 31. Id. at 54. 32. Id. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

684 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 regime that offers tax credits for income earned in foreign countries.33 For example, assume that a U.S. MNC faces a decision on whether to invest in the United States or a foreign country. If the MNC invests in the United States, income earned on its investment is subject to the United States’ 21% tax rate.34 If the MNC invests in a foreign country, the capital export neutrality approach directs the United States to cap the MNC’s tax liability at 21%, typically by means of a tax , for any income earned on its investment in the foreign country.35 Thus, tax will not factor into the U.S. MNC’s decision on whether to invest its capital in the United States or the foreign country.36 Like capital export neutrality, “capital import neutrality” fo- cuses on the global allocation of capital; however, the latter theory ar- gues that countries should be neutral as to the source of invested capi- tal. Countries should not burden MNCs by requiring that they pay residual taxes to their home countries when MNCs choose to invest abroad.37 Capital import neutrality advocates for territorial tax re- gimes where an MNC only pays tax to the country where the MNC earned its income.38 Unlike capital export neutrality, capital import neutrality increases tax’s influence on an MNC’s decision on where to invest capital. Assume again that a U.S. MNC faces the decision on whether to invest in the United States or a foreign country. If the U.S. MNC will not owe residual income tax to the United States, it will choose the foreign country if the foreign country offers a materially lower tax rate. Finally, national neutrality seeks to maximize national well- being.39 To do so, the theory advocates for worldwide tax regimes where taxes paid to foreign countries are treated as deductions to

33. Id. Tax credits directly reduce an MNC’s tax liability. JOSEPH BANKMAN, DANIEL N. SHAVIRO, KIRK J. STARK & EDWARD D. KLEINBARD, FEDERAL INCOME TAXATION 23 (18th ed. 2019) (“[A] is like a voucher or gift certificate: You can use it instead of to pay your taxes.”). In contrast, tax deductions reduce taxable income. Id. 34. See supra note 21 and accompanying text. 35. HANNA, supra note 4, at 233. 36. To completely remove tax considerations from an MNC’s decisions on where to invest its capital, countries should offer tax refunds if foreign tax liability exceeds domestic tax liability. HUFBAUER & ASSA, supra note 30, at 56. Otherwise, countries will discourage MNCs from investing in high tax jurisdictions. Id. However, in practice, this does not necessarily occur. See id. (describing United States’ past practice of not offering such a credit). 37. Id. at 65–66. 38. HANNA, supra note 4, at 234. 39. HUFBAUER & ASSA, supra note 30, at 63–64. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 685 taxable income rather than tax credits.40 While similar to capital ex- port neutrality, treating foreign taxes as tax deductions rather than tax credits results in MNCs’ inability to capture the dollar-for-dollar tax advantages that they capture with capital export neutrality.41 Consider a U.S. MNC with income of $100 dollars in the United States and tax liability of $10 in Ireland. If the MNC treats the $10 as a tax credit, it would have tax liability of $11 in the United States (i.e., $100 multi- plied by 21% minus $10). However, if the MNC treats the $10 as a deduction, it would have tax liability of $18.90 in the United States (i.e., $100 minus $10 multiplied by 21%). Therefore, national neutral- ity incentivizes MNCs to invest in their resident countries even if a foreign country offers an identical tax rate.42

4. Other Tax Policy Considerations

Countries weigh tax policy considerations in addition to the aforementioned theories of international taxation when fashioning tax rules. In particular, five considerations traditionally guide countries.43 First, tax rules should be neutral.44 Countries should ensure that tax rules treat all businesses and business activities the same and do not

40. Id. at 64. For the difference between tax deductions and tax credits, see supra note 33. 41. HUFBAUER & ASSA, supra note 30, at 64. 42. In the early 2000s, Dr. Mihir Desai and Dr. Jim Hines, two tax scholars, supplemented the traditional approaches to international taxation described above by adding capital ownership neutrality and national ownership neutrality. HANNA, supra note 4, at 237; HUFBAUER & ASSA, supra note 30, at 72. Both approaches focus on neutralizing tax’s effect on the control of global assets, specifically by seeking to make resident MNCs as competitive as foreign MNCs when bidding for ownership of foreign assets. HUFBAUER & ASSA, supra note 30, at 72. Theoretically, tax considerations might otherwise prevent the most adept MNCs from controlling them. Id. Capital ownership neutrality calls for all countries to adopt territorial tax regimes; thus, no MNCs need to account for residual taxation from their resident countries when bidding on foreign assets. Id. National ownership neutrality advocates for countries to adopt territorial tax regimes even if others do not, the theory being that domestic investment by foreign MNCs will offset any decreases in investment by resident MNCs. HANNA, supra note 4, at 239; see also HUFBAUER & ASSA, supra note 30, at 72–73. 43. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 20–21; cf. ASS’N OF INT’L CERTIFIED PROF’L ACCOUNTANTS, TAX POLICY CONCEPT STATEMENT NO. 1, GUIDING PRINCIPLES OF GOOD TAX POLICY: A FRAMEWORK FOR EVALUATING TAX PROPOSALS 3 (2017), https://www.aicpa.org/ADVOCACY/TAX/ downloadabledocuments/tax-policy-concept-statement-no-1-global.pdf [https://perma.cc/ Q74A-D8XZ] [hereinafter AICPA, GUIDING PRINCIPLES OF GOOD TAX POLICY]; STEPHANIE MCMAHON, PRINCIPLES OF TAX POLICY (2d ed. 2018). 44. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 20. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

686 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 distort decision making.45 Second, tax rules should be efficient.46 Ef- ficiency calls for tax rules that minimize MNCs’ compliance costs and governments’ administrative costs.47 Additionally, efficient taxation does not unnecessarily restrict a country’s economy.48 Third, countries should strive to create clear tax rules that provide certainty and sim- plicity to taxpayers.49 Such rules allow MNCs to more easily comply with tax requirements, and additionally, they minimize the existence of loopholes that MNCs can exploit with aggressive tax planning strat- egies.50 Fourth, tax rules should be fair and effective.51 Fairness sug- gests that taxpayers in better economic situations pay a greater amount in taxes (vertical equity) while similarly situated taxpayers pay similar amounts (horizontal equity).52 To that end, double taxation and unin- tentional nontaxation should be avoided.53 Fifth, tax rules should be flexible.54 Flexibility refers to the ability of tax laws to continue to satisfy their purpose despite technological and commercial develop- ments.55 Based upon traditional theories of international taxation and these tax policy considerations, countries adopt various approaches to taxing MNCs.

B. The BEPS Problem

Ultimately, countries adopt differing tax schemes, and MNCs capitalize on resulting mismatches in tax rules with BEPS. BEPS re- fers to tax planning strategies employed by MNCs that shift profits from high to low tax jurisdictions.56 With subsequently higher taxable

45. Id. 46. Id. 47. Id. 48. AICPA, GUIDING PRINCIPLES OF GOOD TAX POLICY, supra note 43, at 3. 49. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 20. 50. Id. 51. Id. 52. AICPA, GUIDING PRINCIPLES OF GOOD TAX POLICY, supra note 43, at 7; see also OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 20–21 (listing vertical and horizontal separately from fairness). 53. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 20. 54. Id. at 21. 55. Id. 56. About the Inclusive Framework on BEPS, OECD, http://www.oecd.org/tax/ beps/beps-about.htm [https://perma.cc/KFF9-Q9KK] (last visited Nov. 11, 2019). (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 687 income in low tax jurisdictions and lower taxable income in high tax jurisdictions, an MNC minimizes its global tax liability.57 BEPS strat- egies are not typically illegal, but rather merely a is- sue.58 This section discusses the Double Irish—a prominent illustra- tion of a BEPS strategy—other BEPS strategies, and how the digital economy has exacerbated the BEPS problem.

1. An Illustration: The Double Irish

The Double Irish is perhaps the most infamous BEPS strategy. Google, employing the Double Irish, previously achieved an effective tax rate of 2.4% on non-U.S. income.59 Apple accomplished a rate of 1.8% using a similar device.60 Although all but dead today, the Double Irish provides a prominent example of how MNCs have capitalized on mismatches in countries’ tax rules with BEPS.61 The paragraphs be- low indicate the system of subsidiary companies required for the Dou- ble Irish before discussing how such a system allowed MNCs to min- imize global tax liability. The name “Double Irish with a Dutch Sandwich” indicates the three companies that MNCs created to accomplish the Double Irish: two Irish companies sandwiching a Dutch company.62 The first Irish company was an (“IP”) holding company that owned an MNC’s IP assets (“Irish Holding Company”).63

57. Id. 58. Id. 59. Michael V. Sala, Breaking Down BEPS: Strategies, Reforms, and Planning Responses, 47 CONN. L. REV. 573, 582 (2014) (citing Jesse Drucker, Google 2.4% Rate Shows How $60 Billion is Lost to Tax Loopholes, BLOOMBERG (Oct. 21, 2010), https://www.bloomberg.com/news/articles/2010-10-21/google-2-4-rate-shows-how-60- billion-u-s-revenue-lost-to-tax-loopholes [https://perma.cc/Q92W-3GK2]). 60. Id. 61. In 2015, faced with international pressure, Ireland closed loopholes necessary for the use of the Double Irish. Robert W. Wood, Ireland Corks Double Irish Tax Deal, Closing Time for Apple, Google, Twitter, Facebook, FORBES (Oct. 14, 2014), https://www.forbes.com/ sites/robertwood/2014/10/14/ireland-corks-double-irish-tax-deal-closing-time-for-apple- google-twitter-facebook/#1870d59a6c7c [https://perma.cc/55LY-XKTP]; Louise Kelly, Looking to the Future: Life After the ‘Double Irish’, INT’L TAX REV. (Feb. 24, 2015), http://www.internationaltaxreview.com/Article/3430276/Looking-to-the-future-Life-after- the-Double-Irish.html [https://perma.cc/HB64-2YDX]. MNCs that employed the device prior to the amendments to Irish tax rules had until 2020 to cease use of the Double Irish. Wood, supra; Kelly, supra. 62. Sala, supra note 59, at 587. 63. Id. at 581–88; Mark Holtzblatt, Eva K. Jermakowicz & Barry J. Epstein, Tax

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688 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3

Importantly, while incorporated in Ireland, the MNC located the Irish Holding Company’s central management and control in , a with a 0% corporate income tax rate.64 The second Irish company was a sales company that distributed products or services, thus generating revenue, in Europe (“Irish Sales Company”).65 Fi- nally, the Dutch company (“Dutch Intermediary Company”) existed to facilitate payments between the two Irish companies.66 This system of companies allowed a U.S. MNC, for example, to avoid paying taxes on non-U.S. income in Europe and in the United States. In Europe, the MNC avoided paying tax by having the Irish Sales Company pay royalties to the Irish Holding Company to com- pensate the Irish Holding Company for use of its IP in selling products and services.67 These added expenses decreased the Irish Sales Com- pany’s taxable income while the taxable income of the Irish Holding Company, the receiver of the royalties, increased.68 In other words, the MNC shifted profit from the Irish Sales Company to the Irish Hold- ing Company.69

Heavens: Methods and Tactics for Corporate Profit Shifting, 41 INT’L TAX J. 33, 39 (2015). 64. Sala, supra note 59, at 587–88; Holtzblatt, Jermakowicz & Epstein, supra note 63, at 39. 65. Sala, supra note 59, at 587; Holtzblatt, Jermakowicz & Epstein, supra note 63, at 39. 66. Sala, supra note 59, at 587; Holtzblatt, Jermakowicz & Epstein, supra note 63, at 39. 67. Sala, supra note 59, at 587–88. A royalty is “[a] payment . . . made to an author or inventor for each copy of a work or article sold under a copyright or patent.” Royalty, BLACK’S LAW DICTIONARY (10th ed. 2014). 68. Sala, supra note 59, at 587–88. 69. As described below, MNCs could manipulate royalty prices to shift increasingly more profit to Irish Holding Company. See infra Section I.B.2. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 689

Graphic 1: The Double Irish with a Dutch Sandwich70

With profit shifted, the MNC avoided paying tax based upon both the residency and source principles. Under Irish law, corpora- tions were not residents unless their central management and control was in Ireland.71 Therefore, because the MNC located the Irish Hold- ing Company’s central management and control in Bermuda, a tax ha- ven, the Irish Holding Company was not subject to tax based upon the residency principle.72 The Dutch Company was the key to avoiding tax based upon the source principle.73 If the Irish Sales Company paid royalties directly to the Irish Holding Company, which, once again, Ireland viewed as a Bermudian company, Ireland would have levied a withholding tax on the royalties to tax income for which Ireland was the source.74 However, Irish law did not impose such a withholding tax on royalties paid to corporations of certain European Union (“EU”) countries, the Netherlands included.75 Furthermore, the Netherlands

70. Illustrated for this Note by Jordan Bavis. 71. Sala, supra note 59, at 585, 588. 72. Id. at 587–88. 73. Id. 74. Id.; see also supra note 10. 75. Sala, supra note 59, at 587–88. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

690 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 did not levy a withholding tax on the royalties paid by the Dutch Com- pany to the Irish Holding Company.76 Given that the United States operated a worldwide tax regime until recently, a U.S. MNC also had to avoid U.S. tax on non-U.S. in- come for the Double Irish to be effective.77 Generally, the United States did not impose taxes on an MNC’s foreign subsidiary’s income until such income was repatriated through dividends.78 However, U.S. law provided for an exception if the foreign subsidiary constituted a controlled foreign company (“CFC”).79 U.S. CFC rules allow the United States to tax U.S. MNCs on income earned by their foreign subsidiaries if the United States determines that the foreign subsidiar- ies are sufficiently under the U.S. MNC’s control.80 Under the Double Irish, the United States would have considered the Irish Holding Com- pany a CFC and taxed its royalty income.81 However, U.S. MNCs were able to avoid taxation under the United States’ CFC rules using the United States’ check-the-box regulations, which required the United States to treat the Double Irish’s system of three companies as a single entity and recognize the royalties as intercompany payments rather than income.82 As a result, U.S. MNCs employing the Double Irish were able to avoid paying taxes on non-U.S. income in Europe as well as in the United States.

2. BEPS Strategies

While the Double Irish may be most well-known, several strat- egies exist for shifting profits to low tax jurisdictions. In fact, invest- ment by an MNC in a subsidiary located in a foreign, low tax jurisdic- tion is a BEPS strategy.83 Theoretically, the MNC, absent the investment, would have realized return on the invested capital in its resident country.84 Thus, the return on investment in the foreign, low

76. Id. 77. See infra Section II.A. 78. See supra note 22 and accompanying text. 79. Sala, supra note 59, at 590. 80. See OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 23 (describing controlled foreign company rules generally). 81. See Sala, supra note 59, at 590. 82. Id. 83. Holtzblatt, Jermakowicz & Epstein, supra note 63, at 36. 84. Id. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 691 tax jurisdiction is profit that has been “shifted”.85 Second, an MNC may shift profit by borrowing with a parent or subsidiary (collectively “affiliates”) located in a high tax jurisdiction to affiliates lo- cated in low tax jurisdictions.86 Many countries, including the United States, allow interest payments to be deducted from taxable income.87 Thus, borrowing with affiliates in comparably higher tax jurisdictions allows an MNC to maximize the effect of interest payment deductions and minimize global tax liability.88 Similarly, an affiliate in a high tax jurisdiction can borrow directly from an affiliate in a low tax jurisdic- tion to capitalize on interest payment deductions.89 This practice is known as “earnings stripping.”90 Third, and employed prominently in the United States while it operated a worldwide tax regime, an MNC may perform a tax inversion.91 A tax inversion involves an MNC re- locating its parent, and the profit generated by the parent, from a coun- try with a worldwide tax regime to one with a territorial tax regime.92 The MNC thereby avoids paying residual taxes to its resident coun- try.93 Fourth, and finally, an MNC can shift profit by manipulating transfer prices. refers to the pricing of goods and ser- vices in transactions between affiliates.94 When non-affiliated compa- nies transact, the companies’ competing self-interests theoretically produce a fair price for goods and services.95 However, when compa- nies are affiliated and have aligned interests, they may manipulate transfer prices to shift profit to low tax jurisdictions and minimize global tax liability.96 For example, an MNC employing the Double Irish had incentive to increase the price of the royalty paid by the Irish Sales Company to the Irish Holding Company because increasing the

85. Id. 86. Id. 87. See, e.g., BANKMAN, SHAVIRO, STARK & KLEINBARD, supra note 33, at 603 (“[In the U.S., b]usiness or investment interest . . . is generally deductible.”). 88. Holtzblatt, Jermakowicz & Epstein, supra note 63, at 36. 89. Id. 90. Id. 91. Id. at 36–37. 92. Id. 93. Id. 94. Id. at 39. 95. OECD, OECD TRANSFER PRICING GUIDELINES FOR MULTINATIONAL ENTERPRISES AND TAX ADMINISTRATIONS 33 (2017) [hereinafter OECD TRANSFER PRICING GUIDELINES 2017]. 96. Id. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

692 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 price would result in greater profit shifted to the Irish Holding Com- pany. Indeed, if the MNC increased the royalty price enough, royalties could completely offset revenue earned by the Irish Sales Company, meaning the MNC could earn revenue tax-free. MNCs may manipulate transfer prices in other contexts as well. For instance, the United States argued that Amazon manipulated the price of various intangible assets and illegally shifted profits from the United States to Luxembourg, a low tax jurisdiction.97 Specifically, in 2005, Amazon’s U.S. parent transferred intangible assets to its Lux- embourg subsidiary.98 The transfer required the Luxembourg subsid- iary to make an initial buy-in payment to the U.S. parent followed by annual cost sharing payments to compensate the U.S. parent for its fur- ther development of the intangible assets.99 The United States claimed that the prices of buy-in and cost sharing payments were too low, thus shifting profit from the United States to Luxembourg.100 Similarly, the European Commission determined that Starbucks manipulated coffee bean prices in transactions between its Swiss and Dutch subsidiar- ies.101 The Commission found no justification for mark-ups charged on coffee beans sold from the Swiss subsidiary to the Dutch subsidiary, claiming the mark-ups resulted in shifted profit to Switzerland, a more favorable tax jurisdiction.102 Each of these BEPS strategies may allow MNCs to shift profits to low tax jurisdictions.

3. The BEPS Problem Gets Worse

The rise of the digital economy has exacerbated BEPS.103 The digital economy, already valued at almost $3 trillion, continues to

97. Amazon.com, Inc. v. Comm’r of Internal Revenue, 148 T.C. 108, 111–12 (2017). Amazon challenged the illegality of their transfer prices and ultimately prevailed. Id. at 108– 09. 98. Id. at 112. 99. Id. at 111. 100. Id. at 111–13. 101. Vidya Kauri, Starbucks’ Transfer Pricing Behind EU’s $34M Tax Ruling, LAW360 (June 28, 2016), https://www.law360.com/articles/811753/starbucks-transfer-pricing-behind- eu-s-34m-tax-ruling [https://perma.cc/Y4GK-9EL5]. 102. Id. 103. See OECD, OECD/G20 BASE EROSION AND PROFIT SHIFTING PROJECT: EXPLANATORY STATEMENT 4 (2015) [hereinafter, OECD, BEPS EXPLANATORY STATEMENT] (identifying “Address the Tax Challenges of the Digital Economy” as Action 1 of OECD’s Base Erosion and Profit Shifting Project). (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 693 grow due to the development and commoditization of technology.104 As a result, new industries and business models have emerged. For example, e-commerce, already accounting for more than $500 billion of revenue in 2018, continues to outgrow other retail channels.105 Dig- ital marketplaces for software and online content are now abundant, and digital marketing is by far advertising’s leading medium.106 Fur- thermore, cloud-based processes have affected MNCs’ business mod- els, allowing them to centralize resources and operations and to create, for example, massive worldwide data centers.107 Nevertheless, not all industries have been affected equally. A McKinsey Global Institute report notes “[digitization] is happening unevenly . . . with some

104. Kevin Barefoot et al., Defining and Measuring the Digital Economy 2 (U.S. Dep’t of Commerce Bureau of Econ. Analysis, Working Paper, Mar. 15, 2008), https://www.bea.gov/system/files/papers/WP2018-4.pdf [https://perma.cc/3NHT-RL85]; Kosha Gada, The Digital Economy in 5 Minutes, FORBES (June 16, 2016), https:// www.forbes.com/sites/koshagada/2016/06/16/what-is-the-digital-economy/#1702e8ef7628 [https://perma.cc/826D-3TCE]. Specifically, information and communication technology (“ICT”)—technology that creates widespread access to information and interconnectivity between people and organizations—fuels the digital economy. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 36. The internet is ICT’s nucleus, and as such, ICT that facilitates internet access has been particularly important. Id. For example, the advancement of personal computing devices has reduced their price, making them more obtainable throughout the world. Id. at 37. Tablets and smartphones now supplement laptops, giving households multiple internet access points. Id. An entire industry has emerged that develops the necessary infrastructure for the expansion of telecommunications networks. Id. at 38–39. As a result, the percentage of the global population accessing the internet has risen steadily over the last decade, increasing from below 10% in 2005 to approximately 50% today. STATISTA, INTERNET USAGE WORLDWIDE 11 (2019). Additionally, ICT development has broadened the internet’s purpose. Software remains on the front-line, continually pushing the boundaries of what the internet can achieve. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 39. However, more recently, the rise of online content has given the internet an altogether new purpose as an online marketplace. Id. at 40. Finally, cloud-based processes have emerged, such as the centralized hosting of software and data, that allow individuals and businesses remote use. Id. at 41. The development of these ICTs as well as the emergence of others, such as the Internet of Things, virtual currencies, advanced robotics, and 3D printing, continue to propel the digital economy. Id. at 42–45. 105. STATISTA, E-COMMERCE IN THE UNITED STATES 3, 5 (2019) (indicating share of e- commerce sales of total U.S. retail sales has more than doubled since 2010). 106. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 58; see also Dana Feldman, U.S. TV Ad Spend Drops as Digital Ad Spend Climbs to $107B in 2018, FORBES (Mar. 28, 2018), https://www.forbes.com/sites/danafeldman/2018/03/28/u-s- tv-ad-spend-drops-as-digital-ad-spend-climbs-to-107b-in-2018/#5307e7d47aa6 [https://perma.cc/TQ9B-5ZED]. 107. See OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 41. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

694 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 companies and some sectors pulling far ahead of the pack.”108 Tech- nology, media, finance, and insurance companies have best imple- mented technology to date and are over four times as digitized as low- digitization industries such as health care, construction, and hospital- ity.109 The report classifies advanced manufacturing, wholesale trade, and retail trade as medium-digitized industries.110 These disruptions have turned international taxation on its head. Highly-digitized companies have a reduced need for extensive physical presence, complicating countries’ efforts to levy taxes on them.111 Consumers can often access the products and services of highly-digitized MNCs irrespective of the consumers’ location, and generally, the assets and business functions of highly-digitized MNCs are highly mobile.112 As a result, these MNCs can centralize resources and operations in one or a few countries.113 Additionally, highly-dig- itized MNCs’ characteristic reliance on data raises international taxa- tion questions.114 The world generates a massive amount of data each day, and MNCs leverage this data to add value to their company.115

108. JAMES MANYIKA ET AL., MCKINSEY GLOB. INST., DIGITAL AMERICA: A TALE OF THE HAVES AND HAVE-MORES 4 (2015). 109. In Brief, in DIGITAL AMERICA: A TALE OF THE HAVES AND HAVE-MORES, supra note 108. 110. Id. 111. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 99. 112. Id. at 65–68. 113. See id. 114. Id. at 99. 115. Bernard Marr, How Much Data Do We Create Every Day? The Mind-Blowing Stats Everyone Should Read, FORBES (Mar. 21, 2018), https://www.forbes.com/sites/ bernardmarr/2018/05/21/how-much-data-do-we-create-every-day-the-mind-blowing-stats- everyone-should-read/#7b0c4fe360ba [https://perma.cc/69ZS-J8MT] (noting that the world creates 2.5 quintillion bytes of data each day and ninety percent of world’s data was from previous two years alone); see also OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 69 (noting 2013 study of U.S. economy found data added combined $156 billion of revenue in 2012). Business can derive value from data in five ways: i. Creating transparency by making data more easily accessible in a timely man- ner to stakeholders with the capacity to use the data. ii. Managing performance by enabling experimentation to [analyze] variability in performance and understand its root causes. iii. Segmenting populations to [customize] products and services. iv. Improve decision making by replacing or supporting human decision making with automated algorithms. v. Improve the development of new business models, products, and services. Id. at 70. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 695

Countries disagree as to whether data should be freely shared among affiliates, and if so, how MNCs should attribute value to data.116 Fi- nally, as technology continues to develop and MNCs provide new goods and services, uncertainty surrounds the characterization of pay- ments for these goods and service for tax purposes.117 The rise of the digital economy has particularly exacerbated BEPS opportunities. With less of a need for a physical presence in countries, highly-digitized MNCs can evade high tax jurisdictions, even if these MNCs provide goods or services to those countries.118 For example, highly-digitized MNCs can centralize assets and re- sources in a low tax jurisdiction, thus avoiding permanent establish- ments in high tax jurisdictions and taxation based upon the source prin- ciple.119 Even if MNCs are unable to completely avoid high tax jurisdictions, such centralization increases the number of transactions between affiliates and the opportunity for MNCs to manipulate trans- fer prices. Moreover, MNCs can capitalize on ambiguity in attributing value to data and characterizing payments for new products and ser- vices to set transfer prices to minimize worldwide tax liability.120 Fi- nally, as countries inevitably adopt varying approaches to tackling these problems, new and unprecedented mismatches in tax rules may emerge, perhaps even leading to the next Double Irish.

C. Difficulties in Combating BEPS

Combating BEPS is difficult. Countries are free to define their own tax codes, and accordingly, they can resist closing loopholes sup- porting BEPS.121 The OECD has attempted to unify countries in the fight against BEPS, publishing a framework with “15 Actions to tackle , improve the coherence of international tax rules and ensure a more transparent tax environment.”122 Over sixty countries collaborated in creating the framework and over 115 countries are now members.123 Nonetheless, the OECD, while persuasive, merely makes

116. OECD, ADDRESSING THE TAX CHALLENGES OF THE DIGITAL ECONOMY, supra note 8, at 99. 117. Id. at 99, 104. 118. Id. at 79. 119. Id.; see supra Section I.A.1. 120. See Holtzblatt, Jermakowicz & Epstein, supra note 63, at 39. 121. OECD, ACTION PLAN ON BASE EROSION AND PROFIT SHIFTING 9 (2013). 122. OECD, INCLUSIVE FRAMEWORK ON BEPS, supra note 1, at 1. 123. Id. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

696 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 recommendations that countries can choose to adopt or reject.124 Therefore, international rebuke, catalyzed by OECD membership, may be the more effective mechanism for combating BEPS.125 Moreover, some BEPS strategies are necessary evils, thus countries are limited in what they can do to prevent them. For exam- ple, the manipulation of transfer pricing results from transfers of goods and services between affiliates. However, prohibiting such transfers would be absurd. Furthermore, countries and MNCs may legitimately disagree about the pricing of goods and services transferred between affiliates, thus undermining countries’ capacity to prescribe a strict, formulaic transfer pricing method. Consequently, most countries have settled on requiring affiliates to transact as if they were unaffiliated— the so-called “arm’s length principle.”126

124. What We Do—The OECD Initiative on Global Value Chains, Production Transformation and Development, OECD, https://www.oecd.org/dev/abouttheinitiative.htm [https://perma.cc/5RWE-CF62] (last visited Apr. 26, 2020). 125. See, e.g., supra note 61 and accompanying text. 126. OECD TRANSFER PRICING GUIDELINES 2017, supra note 95, at 33; see also Transfer Pricing Country Profiles, OECD, http://www.oecd.org/tax/transfer-pricing/transfer-pricing- country-profiles.htm [https://perma.cc/4Q32-BJJM] (last visited Apr. 17, 2020) (indicating tax rules of fifty-four of fifty-five counties reference the arm’s length principle). The OECD recommends—and many countries have adopted—five general methods for determining if transfer prices are consistent with the arm’s length principle. OECD TRANSFER PRICING GUIDELINES 2017, supra note 95, at 97; see, e.g., 26 C.F.R. § 1.482-3 (listing U.S. transfer pricing methods). First, the comparable uncontrolled price (“CUP”) method compares the transfer price of a good or service to the price of the same good or service in transactions between unaffiliated companies. OECD TRANSFER PRICING GUIDELINES 2017, supra note 95, at 101. Second, the resale price method evaluates the transfer price in relation to the price at which the good or service is ultimately sold by the transferee to an unaffiliated buyer (“resale price”). Id. at 105–06. Specifically, the resale price method determines an appropriate margin on the resale price based upon transactions between unaffiliated companies and compares the transfer price to the resale price minus the determined margin. Id. Third, the OECD recommends the cost plus method. Id. at 111. This method determines the cost of a good or service to the transferor and then marks up the cost based upon transactions between unaffiliated companies. Id. The cost plus mark-up amount is then compared to the transfer price. Id. Fourth, the transactional net margin method (“TNMM”) calculates a net profit indicator—for example, net profit over resale price—for a transaction and then compares the transaction to those between unaffiliated entities. Id. at 117–18. Fifth, the transactional profit split method identifies the total profit from transactions and then splits the profit among the affiliates. Id. at 133. The OECD is currently revising its guidelines on the transactional profit split method. Id. In addition to the transfer pricing methods recommended by the OECD, the United States allows MNCs to price goods or services transferred between affiliates using the Services Cost Method. 26 C.F.R. §§ 1.482-3, 1.482-4, 1.482-9. The Services Cost Method does not follow the arm’s length principle, but rather, allows MNCs to price certain services

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2020] THE COGS EXCEPTION SHOULD BEAT IT 697

In sum, countries take differing approaches to taxing MNCs. Countries, weighing traditional theories of international taxation and other tax policy considerations, employ tax regimes that can generally be classified as worldwide or territorial tax regimes, though most re- gimes have characteristics of both. Inevitable mismatches in tax rules give rise to BEPS opportunities. While the Double Irish remains the most well-known example, many strategies exist for MNCs to shift profit to low tax jurisdictions and minimize their global tax liability. The opportunity to employ these strategies has increased with the rise of the digital economy as efforts to combat BEPS are challenged by countries’ sovereignty and certain necessary evils.

II. THE BEAT

President Trump signed the TCJA, the largest revision to the U.S. tax code in decades, into law on December 22, 2017.127 Among other things, the TCJA reduced the United States’ corporate income tax rate from 35% to 21% and revolutionized international taxation rules.128 The BEAT, dubbed the TCJA’s most innovative provision, at-cost. 26 C.F.R. § 1.482-9(b)(1). To be eligible to use the Services Cost Method, an MNC must meet four requirements. 26 C.F.R. § 1.482-9(b)(2). First, the transferred service must either be a “covered service,” generally support services common among taxpayers that are expressly specified by the United States, or the mark-up on the transferred service must be less than or equal to 7%. 26 C.F.R. § 1.482-9(b)(3). Second, the service must not be an excluded activity. 26 C.F.R. § 1.482-9(b)(4). Such activities include: (1) “Manufacturing;” (2) “Production;” (3) “Extraction, exploration, or processing of natural resources;” (4) “Con- struction;” (5) “Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement;” (6) “Research, development, or experimentation;” (7) “Engineering or scientific;” (8) “Financial transactions, including guarantees;” and (9) “In- surance or reinsurance.” Id. Third, the use of the Services Cost Method must not violate the business judgment rule. 26 C.F.R. § 1.482-9(b)(5). Fourth, an MNC must maintain adequate books and records. 26 C.F.R. § 1.482-9(b)(6). 127. Louise Radnofsky, Trump Signs Sweeping Tax Overhaul into Law, WALL ST. J. (Dec. 22, 2017), https://www.wsj.com/articles/trump-signs-sweeping-tax-overhaul-into-law- 1513959753 [https://perma.cc/FM8Z-9XHU]; John Wagner, Trump Signs Sweeping Tax Bill into Law, WASH. POST (Dec. 22, 2017), https://www.washingtonpost.com/news/post- politics/wp/2017/12/22/trump-signs-sweeping-tax-bill-into-law/ [https://perma.cc/WEQ4- EPT8]. 128. 26 U.S.C. § 11(b); see also Philip Wagman et al., Implications for U.S. Businesses and Foreign Investments, HARV. L. SCH. F. CORP. GOVERNANCE & FIN. REG. (Jan. 5, 2018), https://corpgov.law.harvard.edu/2018/01/05/tax-reform-implications-for-u-s- businesses-and-foreign-investments/ [https://perma.cc/HD56-8U43]. Prior to the TCJA, the United States had one of the highest corporate income tax rates in the world. Holtzblatt, Jermakowicz & Epstein, supra note 63, at 34. The United States’ rate is now lower than many

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698 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 represents the United States’ most recent effort to combat BEPS.129 Before discussing the policy shortcomings of the BEAT’s COGS ex- ception, this part discusses the United States’ transition from a world- wide to a territorial tax regime, the BEAT’s calculation; and the BEAT’s COGS exception. Section A specifically explores the U.S. territorial tax regime and the limitations that the TCJA places on the new regime. Section B describes the BEAT, indicating to which tax- payers the BEAT applies and breaking down two components of the BEAT’s calculation. Finally, Section C discusses the BEAT’s COGS exception, the definition of COGS under U.S. tax rules, and the capi- talization of costs under 26 U.S.C. § 263A.

A. The United States Moves to a Territorial Tax Regime

With the TCJA, the United States embraced capital import neu- trality and moved from a worldwide to a territorial tax regime.130 Like most territorial tax regimes, the United States effectuates its regime by offering tax exemptions on dividends paid from foreign subsidiaries to U.S. parents.131 However, this general rule has some exceptions. First, the United States continues to have—and, in fact, the TCJA signifi- cantly expanded—CFC rules.132 As noted above, CFC rules allow the United States to tax U.S. MNCs on income earned by their foreign subsidiaries if the United States determines that the foreign subsidiar- ies are sufficiently under the U.S. MNC’s control.133 The TCJA broad- ened the United States’ definition of CFC, meaning more foreign

other countries including France (33%), Japan (31%), Germany (30%), China (25%), and Spain (25%). Wagman et al., supra. 129. N.Y. STATE BAR ASS’N, REPORT NO. 1397 ON BASE EROSION AND ANTI-ABUSE TAX 1 (2018) (“Among the many changes effectuated by [the TCJA], one of the most novel is the [BEAT].”); see also Reuven S. Avi-Yonah, The International Provisions of the TCJA: A Preliminary Summary and Assessment 3 (U. Mich. L. Sch. Public L. & Legal Theory Res. Paper Series, Paper No. 605, 2017), https://ssrn.com/abstract=3193278 [https://perma.cc/ QTJ6-MWNQ] (“The most important innovation in [the] TCJA is the BEAT.”). 130. Wagman et al., supra note 128; see also supra note 38 and accompanying text. 131. Wagman et al., supra note 128; see also supra note 26 and accompanying text. With the transition to a territorial tax regime, the TCJA required mandatory repatriation of income that U.S. MNCs deferred while the United States employed a worldwide tax regime. Wagman et al., supra note 128. Without such a requirement, U.S. MNCs would have been able to completely avoid paying taxes on this deferred income. Id. The United States levied tax on the repatriated income at a rate much lower than the United States’ pre-TJCA rates. Id. 132. Wagman et al., supra note 128. 133. See supra note 80 and accompanying text. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 699 subsidiaries and foreign-earned income are subject to U.S. tax liabil- ity.134 Second, the TCJA imposes tax on global intangible low-taxed income (“GILTI”).135 The GILTI provision levies a 10.5% tax on the share of a U.S. MNC’s foreign income that is attributable to foreign intangible assets.136 While foreign tax credits may reduce GILTI tax liability, the United States only allows credits for 80% of tax paid to foreign countries on GILTI income.137 To illustrate the mechanics of the GILTI tax, assume a U.S. MNC has an Irish subsidiary that earns $25 on Irish intangible assets. The Irish subsidiary’s tax liability in Ireland is $3.13 (i.e., $25 multiplied by 12.5%) and, under the TJCA’s GILTI provision, $2.63 in the United States (i.e., $25 multiplied by 10.5%). Because only 80% of the tax paid to Ireland can be credited against U.S. tax liability, the MNC owes $0.13 in residual tax to the United States (i.e., $3.13 multiplied by 80% equals $2.50; $2.63 minus $2.50 equals $0.13). To complement the GILTI tax, though itself not a limitation on the United States’ territorial tax regime, the TCJA allows a reduced tax rate on foreign-derived intangible income tax (“FDII”).138 FDII includes the portion of a U.S. MNC’s foreign income that is derived from intangible assets located in the United States.139 Because the United States offers an 80% tax credit on its 10.5% GILTI tax, U.S. MNCs are unaffected by GILTI if a foreign country’s tax rate is greater than 13.125%, as the 80% tax credit will prevent GILTI tax liability (i.e., 10.5% divided by 80% equals 13.125%). Thus, to incentivize MNCs to keep their intangible assets in the United States, the United States created the FDII provision, which offers a reduced tax rate of 13.125% on FDII.140 To illustrate the FDII reduced tax, assume a U.S. MNC has a British subsidiary that earns $25 of income on British intangible assets. The British subsidiary’s U.K. tax liability is $4.75 (i.e., $25 multiplied by 19%).141 GILTI tax liability is $2.63 on the income (i.e., $25

134. Wagman et al., supra note 128. 135. 26 U.S.C. §§ 250, 951A. 136. 26 U.S.C. § 951A. 137. Id. 138. 26 U.S.C. § 250. 139. Id. 140. Id.; Reuven S. Avi-Yonah & Martin G. Vallespinos, The Elephant Always Forgets: US Tax Reform and the WTO 5–6 (U. Mich. L. Sch. L. & Econ. Working Papers, Paper No. 151, 2018), https://repository.law.umich.edu/law_econ_current/151 [https://perma.cc/VBX4- ESW5]. 141. The U.K. rate is 19%. Rates and Allowances: Corporate Tax,

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700 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 multiplied by 10.5%). Because the GILTI tax credit completely offsets GILTI tax liability (i.e., $4.75 multiplied by 80% equals $3.80; $3.80 is greater than $2.63), the U.S. parent does not owe GILTI tax. Con- sequently, without the TCJA’s FDII provision, U.S. parents would have no incentive to keep their intangible assets in the United States. However, with the FDII provision, the same U.S. parent would only owe $3.28 in taxes if the intangible assets were in the United States (i.e., $25 multiplied by 13.125%). Because this is less than the U.S. MNC’s liability with its intangible assets located in the U.K, the U.S. MNC is incentivized to locate its intangible assets in the United States. Thus, the FDII complements GILTI, which, with the United States’ broadened CFC rules, provide limitations on the United States’ terri- torial tax regime.

Table 1: GILTI Tax in Low and High Tax Jurisdictions Foreign tax jurisdiction Ireland (12.5% tax rate) U.K. (19% tax rate) Income derived from $25 $25 intangible assets in foreign jurisdiction Foreign tax liability $3.13 $4.75 U.S. GILTI tax liability $2.63 $2.63 Tax credit available $2.50 $3.80 for U.S. GILTI tax liability Residual U.S. GILTI $0.13 $0.00 tax liability U.S. FDII reduced tax $3.28 $3.28 liability if intangible asset would have been located in United States

B. The BEAT and Its Calculation

As noted above, the BEAT is the Unites States’ most recent effort to combat BEPS.142 It is one of the TCJA’s most innovative provisions, having “no predecessor in prior law, prior proposals by Congress, or in the deliberations of the [OECD].”143 Rather than

GOV.UK, https://www.gov.uk/government/publications/rates-and-allowances-corporation- tax/rates-and-allowances-corporation-tax [https://perma.cc/WVX6-HB68] (last visited May 29, 2020). 142. See supra note 129 and accompanying text. 143. N.Y. STATE BAR ASS’N, supra note 129, at 2. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 701 evaluating transactions to foreign affiliates to identify if they are inap- propriately shifting profit, the BEAT requires MNCs to calculate tax- able income as if such transactions were never made, regardless of whether they were “fair.” Specifically, the BEAT requires a U.S. af- filiate to: (1) calculate its taxable income as if certain payments to foreign affiliates were never made (“modified taxable income”); (2) determine tax liability on its modified taxable income, typically based upon a 10% rate; and (3) compare this tax liability to the U.S. affiliate’s “regular tax liability,” and if its modified taxable income’s tax liability exceeds regular tax liability, the U.S. affiliate must pay the differ- ence.144 The BEAT calculation is represented formulaically below:145

Table 2: The BEAT Calculation BEAT = (modified taxable income * 10% tax rate) – regular tax liability

The following paragraphs provide detail on the BEAT calcula- tion. They first discuss the U.S. affiliates to which the BEAT applies. Then, they break down “modified taxable income” and “regular tax liability.”

1. Who Pays the BEAT?

An MNC’s U.S. affiliate, whether the affiliate is the MNC’s parent or subsidiary, is subject to the BEAT if that affiliate meets three requirements for a given tax year.146 First, the affiliate must be a —regulated investment companies, real estate investment trusts, and S corporations are exempt.147 Second, the affiliate must have at least $500 million in gross receipts on average for the three prior taxable years.148 Legislative history indicates that all gross

144. 26 U.S.C. § 59A(a). Once again, “affiliate” refers to an MNC’s parent or subsidiary. See supra Section I.B.2. The BEAT applies to U.S. affiliates whether the affiliate is the MNC’s parent or subsidiary. See infra Section II.B.1. 145. 26 U.S.C. § 59A(a). 146. See 26 U.S.C. § 59A(e). 147. 26 U.S.C. § 59A(e)(1). Regulated investment companies, real estate investment trusts, and S corporations differ from C corporations in that they may avoid income taxation at the entity level. See C-Corporation, THOMSON PRACTICAL LAW GLOSSARY (2020), Westlaw 1-383-9868; Regulated Investment Company (RIC), THOMSON REUTERS PRACTICAL LAW GLOSSARY (2020), Westlaw 1-503-6263; Real Estate Investment Trust (REIT), THOMSON REUTERS PRACTICAL LAW GLOSSARY (2020), Westlaw 5-501-5112; S-Corporation, THOMPSON REUTERS PRACTICAL LAW GLOSSARY (2020), Westlaw 2-382-3782. 148. 26 U.S.C. § 59A(e)(1). (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

702 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 receipts “effectively connected” to United States conduct must be con- sidered.149 Third, the U.S. affiliate’s base erosion percentage, as de- fined below, must be greater than or equal to 3% for the current taxable year.150 The BEAT lowers this threshold to 2% if the affiliate is a bank or securities dealer.151 If a U.S. affiliate meets all three requirements, it must calculate the BEAT and pay any determined liability.

2. “Modified Taxable Income”

As noted above, a U.S. affiliate determines modified taxable income by calculating its taxable income as if certain payments to for- eign affiliates were never made. In particular, when calculating mod- ified taxable income, the affiliate must exclude: (1) benefits from “base erosion payments” and (2) the base erosion percentage of any operating loss deductions.152 Importantly, the BEAT defines base ero- sion payments as “any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable under this chapter.”153 In other words, a base erosion payment is a payment that a U.S. affiliate makes to a foreign affiliate that results in a deduction to the U.S. affiliate’s taxable income. The benefit from the resulting deductions must be excluded when calculating modified taxable income.154

149. H.R. REP. NO. 115-466, at 655 (2017) (Conf. Rep.) [hereinafter TCJA Joint Explanatory Statement]. 150. 26 U.S.C. § 59A(e)(1); see also infra Section II.B.2. 151. 26 U.S.C. § 59A(e)(1). 152. 26 U.S.C. § 59A(c)(1). 153. 26 U.S.C. § 59A(d)(1). The BEAT provides definitions for some terms used in its definition of base erosion payment. The BEAT indicates that “foreign person” is defined consistently with other provisions of the U.S. tax code. 26 U.S.C. § 59A(f). A “related party,” on the other hand, includes: (1) “any 25-percent owner of the taxpayer;” (2) “any person who is related (within the meaning of section 267(b) or 707(b)(1)) to the taxpayer or any 25-percent owner of the taxpayer;” and (3) “any other person who is related (within the meaning of section 482) to the taxpayer.” 26 U.S.C. § 59A(g)(1). 154. 26 U.S.C. § 59A(c)(2)(A)(i). The BEAT provides several exceptions—which can generally be divided into two groups—to its exclusion of benefits from base erosion payments. The first group requires that certain benefits potentially not covered by the base erosion payment’s definition be excluded from modified taxable income as well. First, a U.S. affiliate must exclude deductions for payments made or accrued to a foreign affiliate in connection with the U.S. affiliate’s acquisition of depreciable or amortizable property. 26 U.S.C. §§ (c)(2)(A)(ii), (d)(2). Second, if the U.S. affiliate paid or accrued premiums or other consideration to a foreign affiliate for reinsurance payments, the U.S. affiliate must exclude corresponding reductions and deductions allowed under other provisions of the U.S. tax code.

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2020] THE COGS EXCEPTION SHOULD BEAT IT 703

A U.S. affiliate must also ignore the base erosion percentage of any operating loss deduction when calculating modified taxable in- come.155 In certain circumstances, the United States allows taxpayers to deduct net operating losses (“NOL”) from taxable income.156 How- ever, under the BEAT, a U.S. affiliate may not deduct the portion of NOLs attributable to base erosion payments.157 The affiliate deter- mines a NOL’s base erosion percentage by dividing its total benefits from base erosion payments in the year in which the NOL occurred by its total deductions.158 The base erosion percentage is then multiplied by the NOL to determine the portion of the NOL attributable to base erosion payments.159 This benefit as well as those from base erosion payments are excluded from modified taxable income. Once calcu- lated, modified taxable income is subject to a 10%—or, if the affiliate is a bank or securities dealer, 11%—rate.160 To illustrate, assume that a U.S. parent’s taxable income before deductions is $100, and the U.S. parent has deductions totaling $50. Of these deductions, $30 are benefits from base erosion payments, and another $10 is a NOL deduction for a tax year where the parent’s base

26 U.S.C. §§ (c)(2)(A)(iii), (d)(3). Third, the U.S. affiliate must exclude reductions to gross receipts from payments made to certain expatriated entities, specifically surrogate foreign corporations created after November 9, 2017 and foreign entities that are part of the same expanded affiliated group as a surrogate foreign corporation. 26 U.S.C. §§ (c)(2)(A)(iv), (d)(4). The second group of exceptions requires that certain benefits covered by the BEAT’s definition of base erosion payment be included in modified taxable income. First, benefits from base erosion payments should be included if the United States already imposed withholding taxes on the payment. 26 U.S.C. § 59A(c)(2)(B). Second, benefits from payments for services should be included if a U.S. affiliate prices the services using the Services Cost Method. 26 U.S.C. § 59A(d)(5); see also supra note 126. Third, benefits from certain qualified payments should be included in modified taxable income. 26 U.S.C. § 59A(h). 155. 26 U.S.C. § 59A(c)(1). 156. 26 U.S.C. § 172. Net operating losses occur when a taxpayer’s deductions exceed its taxable income in a given year; this lost tax savings can be applied to a different tax year in certain circumstances. John Owsley & John McKinley, Carry Your Losses (Further) Forward, J. ACCT., (May 1, 2018), https://www.journalofaccountancy.com/issues/2018/may/ carry-forward-net-operating-losses.html [https://perma.cc/6624-QKVQ]. 157. 26 U.S.C. § 59A(c)(4)(B). 158. 26 U.S.C. § 59A(c)(4)(A). Once again, the BEAT provides some exceptions. Specifically, three deductions must be excluded from the denominator when calculating base erosion percentage: (1) deductions allowed under 26 U.S.C. §§ 172, 245A, and 250; (2) deductions for services that a U.S. affiliate prices using the Services Cost Method; and (3) deductions for certain qualified derivative payments. 26 U.S.C. § 59A(c)(4)(b). 159. 26 U.S.C. § 59A(c)(4)(a). 160. 26 U.S.C. §§ 59A(b)(1), (b)(3). Beginning in 2026, both the 10% and 11% rates will increase by 1%. 26 U.S.C. § 59A(b)(2). (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

704 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 erosion percentage was 50%. Under the BEAT, the parent’s modified taxable income is $85 (i.e., $100 minus $10, or the deductions that are neither benefits from base erosion payments nor NOLs; then, $90 mi- nus $5, or the percentage of NOL deductions not attributable to base erosion payments). Assuming the parent is not a bank or securities dealers, its tax liability would be $8.50 (i.e., $85 multiplied by 10%).

Table 3: Modified Taxable Income Calculation Taxable income before deductions $100 Total deductions $50 Deductions from base erosion $30 payments NOL deduction from prior tax year $10 where base erosion percentage was 50% Other deductions $10 Modified taxable income $85

3. “Regular Tax Liability”

Once a U.S. affiliate calculates its modified taxable income’s tax liability, the affiliate must subtract its regular tax liability to deter- mine its liability under the BEAT.161 An affiliate’s regular tax liabil- ity, for the BEAT’s purposes, must include most of the affiliate’s tax credits.162 Including tax credits is unfavorable from the affiliate’s point-of-view because tax credits lower the affiliate’s regular tax lia- bility, thus increasing the possibility that it will have tax liability under the BEAT. The tax credits that affiliates may exclude are (1) research credits and a portion of tax credits for (2) low-income housing, (3) re- newable energy production, and (4) investments allocable to energy.163 Continuing with the hypothetical above, assume that a U.S. parent has regular tax liability before tax credits of $17.50. The parent has avail- able tax credits totaling $15, $5 of which are research credits. For cal- culating the BEAT, the parent’s regular tax liability is $7.50 (e.g., $17.50 minus $10). Thus, the parent’s ultimate tax liability under the

161. 26 U.S.C. § 59A(b)(1). 162. 26 U.S.C. § 59A(b)(4). 163. Id. Beginning in 2026, all tax credits must be included in an MNC’s regular tax liability. 26 U.S.C. § 59A(b)(2). For a complete list of business tax credits, see 26 U.S.C. § 38. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 705

BEAT, given the calculations above, is $1 (i.e., $8.50 minus $7.50).164

Table 4: Hypothetical BEAT Tax Liability Calculation Modified taxable income $85 Tax liability on modified taxable $8.50 income Regular tax liability before tax credits $17.50 Research tax credits $5 Other tax credits $10 Regular tax liability $7.50 Tax liability under the BEAT $1

C. The BEAT’s COGS Exception

The BEAT provides U.S. affiliates with a significant exception to base erosion payments: COGS. Congress did not expressly indicate that COGS do not constitute base erosion payments. Rather, the ex- ception turns on a distinction between “deductions to taxable income” and “reductions in gross receipts.”165 Once again, the BEAT defines base erosion payments as “any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable under this chapter.”166 The United States considers COGS a reduction of gross receipts rather than a deduction to taxable income, and thus the BEAT’s definition of base erosion payments do not capture COGS.167 The COGS exception is favorable to U.S. affiliates in two ways. First, the ability to include COGS in modified taxable income allows for lower modified taxable income, thus decreasing the possibility that affiliates will have liability under the BEAT. Second, the COGS exception allows for a lower base erosion percentage. A lower base erosion percentage allows for greater NOL deductions and, because the BEAT requires affiliates to meet a threshold base erosion percentage for the BEAT to apply, a higher probability that affiliates will be able to avoid applicability of

164. See supra Section II.B.2 (determining affiliate’s tax liability on modified taxable income to be $8.50). 165. TCJA Joint Explanatory Statement, supra note 149, at 653. 166. 26 U.S.C. § 59A(d)(1) (emphasis added); see supra Section II.B.2. 167. TCJA Joint Explanatory Statement, supra note 149, at 653; see also N.Y. STATE BAR ASS’N, supra note 129, at 14. Reductions and deductions are similar in that they both decrease a U.S. affiliate’s ultimate tax liability. However, if conceptualized linearly, reductions to gross receipts occur prior to deductions to taxable income, or in other words, reductions to gross receipts are necessary to calculate taxable income, from which deductions are then made. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

706 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 the BEAT altogether.168 The definition of COGS under U.S. tax rules controls the use- fulness of the COGS exception. Generally, COGS refers to the cost of an affiliate’s inventory and any costs sufficiently related to the inven- tory.169 The United States provides a six-part formula for identifying these costs: COGS equals the sum of (1) inventory at the beginning of the year, (2) purchases, (3) labor costs, (4) 26 U.S.C. § 263A costs (defined below), and (5) other costs associated with inventory; from this sum, the taxpayer must subtract (6) inventory at the end of the year.170 26 U.S.C. § 263A costs are of particular interest to the BEAT’s COGS exception. 26 U.S.C. § 263A allows an affiliate to capitalize certain direct or indirect costs allocable to its inventory.171 For example, affiliates may include certain sales-based royalties and management fees, costs otherwise not recognized as COGS, under 26 U.S.C. § 263A.172 Because the United States provides leeway in cal- culating 26 U.S.C. § 263A costs, affiliates looking to avoid the BEAT may be more aggressive in capitalizing costs under 26 U.S.C. § 263A.173 In sum, the TCJA revolutionized the United States’ interna- tional taxation rules. It decreased the U.S. corporate income tax rate and transformed the United States from a worldwide to a territorial tax regime. Additionally, the TCJA created the BEAT, the United States’ most recent effort to combat BEPS. In , the BEAT requires U.S. affiliates to calculate taxable income as if certain payments to foreign affiliates were never made. If tax liability on this modified taxable

168. See supra Sections II.B.1 & II.B.2. 169. PRICEWATERHOUSECOOPERS, TAXPAYERS MAY BE ABLE TO REDUCE BEAT LIABILITY BY INCREASING COST OF GOODS SOLD 2 (2018), https://www.pwc.com/us/en/tax- services/publications/insights/assets/pwc-reduce-beat-liability-by-increasing-cost-of-goods- sold.pdf [https://perma.cc/YT3B-ZVNH]. 170. U.S. INTERNAL REVENUE SERV., OMB NO. 1545-0123, FORM 1125-A, COST OF GOODS SOLD (2018). 171. 26 U.S.C. § 263A (allowing for some general exceptions). The theory behind 26 U.S.C. § 263A is that taxpayers should recognize costs that are sufficiently related to inventory when the taxpayer sells the inventory and generates revenue rather than when the taxpayer otherwise incurred the costs. Tony Nitti, Tax Geek Tuesday: Daring to Take On The Section 263A Adjustment, FORBES (Oct. 13, 2015), https://www.forbes.com/sites/anthonynitti/ 2015/10/13/tax-geek-tuesday-daring-to-take-on-the-section-263a-adjustment/#44f2e0791ad0 [https://perma.cc/R9ZM-YPK4]. 172. Michelle Johnson, Midori Nakamura, Jesal Patel & Salim Vagh, INSIGHT: Unbundling Your Way out of BEAT—Can Cost Allocations Make a Difference?, BLOOMBERG TAX (Oct. 30, 2019), https://news.bloombergtax.com/transfer-pricing/insight-unbundling- your-way-out-of-beatcan-cost-allocations-make-a-difference [https://perma.cc/6Y2Z-2LDL]. 173. See id. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 707 income is greater than the affiliate’s regular tax liability, the affiliate must pay the difference. Significantly, the BEAT allows affiliates to exclude COGS from base erosion payments. This exception provides MNCs with avenues to avoid liability under the BEAT.

III. THE COGS EXCEPTION SHOULD BEAT IT

This Part contends that the BEAT would better serve tax policy considerations if the United States removed its COGS exception.174 Three interconnected arguments support this contention: (1) the COGS exception undermines the United States’ territorial tax regime and capital import neutrality; (2) the COGS exception violates tax pol- icy considerations of neutrality and fairness; and (3) the COGS excep- tion hinders the BEAT’s effectiveness in combating BEPS. This Part discusses each argument in turn.

A. The United States’ Territorial Tax Regime and Capital Import Neutrality

The COGS exception undermines the United States’ territorial tax regime and capital import neutrality. The United States embraced capital import neutrality—which argues that tax rules should be neu- tral as to the source of invested capital—with its transition to a territo- rial tax regime.175 Like any tax regime, the United States’ territorial tax regime and the theory of international taxation which it effectuates are subject to abuse.176 For instance, assume a U.S. affiliate employs

174. Because of the BEAT’s language and legislative history, the U.S. Treasury does not have the authority to promulgate regulations to remove the COGS exception. See Chevron, U.S.A. v. NRDC, 467 U.S. 837, 842–43 (1987) (affording administrative authority only when “Congress has [not] directly spoken to the precise question at issue”); INS v. Cardoza- Fonseca, 480 U.S. 421 (1987) (relying on legislative history in determining Chevron deference). The BEAT’s language itself distinguishes between deductions and reductions, indicating that the former are generally base erosion payments while the latter are only base erosion payments in a few circumstances. 26 U.S.C. § 59A(c)(2)(A); see supra note 166 and accompanying text. Additionally, legislative history confirms the COGS exception. TCJA Joint Explanatory Statement, supra note 149, at 653 (“Base erosion payments do not include payments for cost of goods sold (which is not a deduction but rather a reduction to income).”). 175. See supra Section II.A; see also supra note 37 and accompanying text. 176. In fact, the United States may suffer more abuse under its territorial tax regime than it did while employing a worldwide tax regime. INST. TAX’N & ECON. POL’Y, THE CONSEQUENCES OF ADOPTING A TERRITORIAL TAX SYSTEM: MORE TAX AVOIDANCE, LESS INVESTMENT IN THE U.S. 1 (2017), https://itep.org/wp-content/uploads/Territorial-Fact-Sheet-

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708 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3

BEPS strategies to shift profit to foreign, low tax jurisdictions. This undermines the United States’ territorial tax regime by preventing the United States from taxing profit earned domestically, and it under- mines capital import neutrality by allowing U.S. affiliates to be treated differently based upon the source of their capital. To illustrate the lat- ter, assume the U.S. affiliate is the subsidiary of a parent located in a foreign, low tax jurisdiction. The subsidiary may employ BEPS strat- egies to shift profit to its parent’s country, thus avoiding U.S. tax lia- bility. Simultaneously, U.S. subsidiaries with parents in high tax ju- risdictions or U.S. MNCs are unable to employ the same BEPS strategies and are subjected to the full force of U.S. tax rules. Thus, international taxation is not neutral as to the source of U.S. affiliates’ capital. To address potential abuse, the United States placed limitations on its territorial tax regime.177 The United States’ broader CFC rules complicate U.S. MNCs’ efforts to shift profit to foreign subsidiaries by considering more foreign subsidiaries to be under the control of U.S. MNCs, thus subjecting them to U.S. tax liability.178 Additionally, the United States’ GILTI and FDII provisions ensure that U.S. MNCs will not relocate their intangible assets to foreign, low tax jurisdictions to capitalize on BEPS opportunities exacerbated by the digital econ- omy.179 Finally, the BEAT itself prevents U.S. affiliates from under- mining the United States’ territorial tax regime and capital import neu- trality by requiring U.S. affiliates to recalculate their taxable income to exclude certain payments that could be used for BEPS.180 However, with the COGS exception, the BEAT’s protection of the United States’ territorial tax regime and capital import neutrality falters. The COGS exception allows U.S. affiliates, in spite of the

Final.pdf [https://perma.cc/VQP6-C4TK]. For example, without the threat of residual tax liability, U.S. MNCs may employ BEPS strategies to shift profits out of the United States and completely avoid U.S. tax liability. Id. Under the United States’ worldwide tax regime, U.S. MNCs’ foreign income would have still been subject to residual tax liability based upon U.S. residency. See supra Section I.A.2. 177. See supra Section II.A. 178. See supra note 134 and accompanying text. CFC rules are arguably inapposite to territorial tax regimes and capital import neutrality because they tax foreign income. However, without CFC rules, aggressive MNCs may completely undermine the integrity of territorial tax regimes. Thus, even for proponents of capital import neutrality, CFC rules may be a necessary evil. 179. See supra Section II.A; see also supra Section I.B.3. 180. See supra Section II.B. Notably, the tax rates of all of the TCJA’s limitations on the United States’ territorial tax regime are lower than the United States’ regular corporate income tax rate. See supra Section II.A. This supports their purpose as protective measures rather than reincarnations of the United States’ worldwide tax regime. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 709

BEAT, to employ BEPS strategies using COGS. These strategies pre- vent the United States from taxing profit earned domestically, and they allow MNCs to be treated differently based upon the source of their capital. Moreover, U.S. affiliates can capitalize on the leeway afforded to them in calculating 26 U.S.C. § 263A costs, maximizing the damage of the COGS exception.181 Thus, because the COGS exception dimin- ishes the BEAT’s protection of the United States’ territorial tax regime and capital import neutrality, the BEAT would better serve tax policy considerations if the United States removed its COGS exception.

B. Neutrality and Fairness

In addition to diminishing the BEAT’s protection of the United States’ territorial tax regime and capital import neutrality, the COGS exception more generally violates the tax policy considerations of neu- trality and fairness. As noted above, countries weigh neutrality and fairness when fashioning tax rules.182 The former requires that tax rules treat all businesses and business activities neutrally and not dis- tort decision making.183 The COGS exception violates neutrality in two ways. First, it disproportionately benefits high-COGS industries. The COGS exception lessens the BEAT’s effect on MNCs in high- COGS industries, such as retail and manufacturing, while MNCs in low-COGS industries, such as the services industry, do not receive the same level of benefit.184 In fact, MNCs that do not carry an inventory are likely unable to benefit from the COGS exception at all.185 Thus, MNCs in high-COGS industries may take advantage of BEPS oppor- tunities while their low-COGS counterparts largely cannot. Second, the COGS exception violates neutrality by distorting the decision mak- ing of MNCs in high-COGS industries. Absent the COGS exception,

181. See PRICEWATERHOUSECOOPERS, supra note 169; see also NICOLAUS MCBEE, ALBERT LIGUORI, MARC ALMS & REBECCA LARA, BASE EROSION AND ANTI-ABUSE TAX FOR SERVICES COMPANIES: COST OF SERVICES ARE OUT, SERVICES COST METHOD IS IN 2 (2018), https://www.alvarezandmarsal.com/insights/base-erosion-and-anti-abuse-tax-services- companies [https://perma.cc/D5WW-Y3D6]. 182. See supra Section I.A.4. 183. See supra note 45 and accompanying text. 184. See N.Y. STATE BAR ASS’N, supra note 129, at 14 (“The COGS [exception] from Base Erosion Payments was clearly meant to provide relief for a taxpayer that either buys raw materials or partially manufactured components and inputs for manufacture and assembly in the U.S. or imports manufactured goods for resale in the U.S.”). 185. See PRICEWATERHOUSECOOPERS, supra note 169, at 2 (“COGS is the means by which a taxpayer that maintains inventories recovers the costs allocated to inventory that has been sold.”) (emphasis added). (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

710 COLUMBIA JOURNAL OF TRANSNATIONAL LAW [58:3 the BEAT diminishes tax considerations by making BEPS unworka- ble, giving them no weight in MNCs’ decision making. For MNCs in low-COGS industries, largely unaffected by the COGS exception, the BEAT indeed serves this purpose. However, in high-COGS industries, the COGS exception negates the BEAT’s effect, thus reintroducing tax’s distorting effect on MNCs’ decision making. The COGS exception also violates fairness. Fairness suggests that taxpayers in better economic situations should pay a greater amount in taxes (vertical equity) while similarly situated taxpayers should pay similar amounts in taxes (horizontal equity).186 By exempt- ing MNCs in high-COGS industries from the BEAT, the COGS ex- ception allows MNCs in low-COGS industries to shoulder a relatively higher tax burden. That is, even if an MNC in a high-COGS industry and an MNC in a low-COGS industry are otherwise identical, the MNC in the low-COGS industry could pay more in taxes. Two arguments can be made, albeit unsuccessfully, to rebut the COGS exception’s un-neutral and unfair treatment. First, an MNC’s ability to capitalize costs under 26 U.S.C. § 263A lessens the disparate treatment of the COGS exception. 26 U.S.C. § 263A provides MNCs in low-COGS industries an opportunity to share in the benefits of the COGS exception. Specifically, MNCs can capitalize costs they have historically considered expenses.187 However, 26 U.S.C. § 263A is limited. An MNC can only capitalize costs that are allocable to its inventory, making 26 U.S.C. § 263A irrelevant to much of the costs of MNCs in low-COGS industries.188 Furthermore, if an MNC does not carry an inventory, the MNC cannot capitalize costs under 26 U.S.C. § 263A at all.189 Second, one can argue that demand for efficiency counterbal- ances any biased or unfair effect of the COGS exception. Once again, efficiency requires that tax rules minimize MNCs’ compliance costs and governments’ administrative costs. Additionally, countries must ensure that tax rules do not unnecessarily restrict their economies.190 To that end, imposing the BEAT on high-COGS industries is arguably

186. See supra note 52 and accompanying text. 187. See supra note 172 and accompanying text. 188. See supra notes 171 and accompanying text; see also Johnson, Nakamura, Patel & Vagh, supra note 172. 189. See PRICEWATERHOUSECOOPERS, supra note 169, at 2. In addition to 26 U.S.C. § 263A, MNCs in low-COGS industries may be able to lessen the disparate treatment of the COGS exception if they price services using the Services Cost Method. See supra note 126. Services valued using the Service Cost Method, like COGS, are not considered base erosion payments for purposes of calculating the BEAT. See supra note 154. 190. See supra notes 47–48 and accompanying text. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

2020] THE COGS EXCEPTION SHOULD BEAT IT 711 inefficient because low-COGS industries are more likely to employ BEPS strategies. MNCs in low-COGS industries, of course, created the Double Irish, perhaps the most infamous BEPS strategy.191 Fur- thermore, as the McKinsey Global Institute notes, low-COGS indus- tries are much more digitized than their counterparts in high-COGS industries, and consequently, they are better positioned to capitalize on the digital economy’s exacerbation of BEPS.192 Nevertheless, this argument may overstate the COGS excep- tion’s efficiency. The COGS exception does not relieve MNCs in high-COGS industries of the task of calculating the BEAT each year. Rather, the COGS exception merely makes it more likely that these MNCs will not ultimately face tax liability under the BEAT. Thus, any efficiency achieved by the COGS exception appears minimal. Moreover, the COGS exception may create inefficiency in low-COGS industries. Given the usefulness of 26 U.S.C. § 263A in avoiding lia- bility under the BEAT, MNCs in low-COGS industries are likely to devote significant resources to maximizing the amount of costs capi- talized under 26 U.S.C. § 263A. Without the COGS exception and the usefulness of 26 U.S.C. § 263A, MNCs could reallocate resources to more productive tasks, unrelated to tax avoidance. Thus, arguments rebutting the COGS exception’s violation of neutrality and fairness are insufficient. As such, the BEAT would better serve tax policy consid- erations if the United States removed its COGS exception.

C. The BEAT’s Effectiveness in Combating BEPS

Finally, the COGS exception hinders the BEAT’s effectiveness in combating BEPS. As its name suggests, the United States created the BEAT (Base Erosion and Anti-Abuse Tax) to combat BEPS (base erosion and profit shifting) strategies, and as the two preceding argu- ments indicate, the COGS exception undermines the effectiveness of the BEAT in performing its task.193 The COGS exception allows MNCs to employ BEPS strategies as long as they use COGS in doing so. MNCs in high-COGS industries may effectively be exempt from the BEAT, and with the availability of 26 U.S.C. § 263A, MNCs in low-COGS industries may benefit as well. Therefore, because the COGS exception (1) undermines the United States’ territorial tax re- gime and capital import neutrality, (2) violates neutrality and fairness, and (3) hinders the BEAT’s effectiveness in combating BEPS, the

191. See supra Section I.B.1. 192. See supra Section I.B.3. 193. See supra Section II.B; see also Sections III.A & III.B. (h) Bavis (58-3) (Do Not Delete) 6/18/2020 5:19 PM

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BEAT would better serve tax policy considerations if the United States removed its COGS exception.194

CONCLUSION

Countries adopt differing approaches to international taxation, creating mismatches in countries’ tax rules and BEPS opportunities. The rise of the digital economy has exacerbated the BEPS problem, and because of countries’ sovereignty and certain necessary evils like transfer pricing, countries have struggled to combat BEPS. With the BEAT, the United States takes an innovative approach to solving the BEPS problem. Unfortunately, despite its promise, the BEAT is un- dermined by its COGS exception. The COGS exception: (1) under- mines the United States’ territorial tax regime and capital import neu- trality; (2) violates neutrality and fairness; and (3) hinders the BEAT’s effectiveness in combating BEPS. Therefore, the COGS exception should BEAT it. Alexander C. Bavis*

194. While not discussed in this Note, there is some concern that the BEAT violates international law. For an overview of these concerns and an argument for why the United States is unlikely to face any repercussions even if the BEAT does violate international law, see Alexander Bavis, Does the BEAT Violate International Law?, COLUM J. TRANSNAT’L L. BULL., http://blogs2.law.columbia.edu/jtl/does-the-beat-violate-international-law/ [https:// perma.cc/E3VM-7TFF] (last visited Mar. 24, 2020). * 2020 Juris Doctor Graduate, . Huge thanks to Rob Wentland for introducing me to the complexities of international taxation, Stuart Rosow for his topic suggestion and guidance, and Abby Bavis for her time, intelligence, and enthusiasm throughout my lengthy and often monotonous writing process. Thanks also to the editors of the Columbia Journal of Transnational Law for their invaluable feedback and Jordan Bavis for his illustrative hamburger sketch. Most of all, thank you Dad—your love and support were always limitless, whether that meant visiting a homesick basketball camper, reminding a near college graduate to be true to himself with his career choice, or journeying to the East Coast to support your son’s ambition to become a lawyer or see him marry his best friend. You are missed, but your love and support endure.