Taxes: The Rules Continue to Change and Tax Authorities Focus on Enforcement
January 11, 2021
In recent years, the international tax system has experienced significant change as tax authorities across the globe have adopted and implemented new rules and procedures to respond to the new economy and perceptions of taxpayers arbitraging differences among jurisdictions.
While this process has been partially delayed by special temporary tax measures enacted by governments in response to COVID-19, once these measures expire, tax authorities and policymakers can be expected to rapidly resume forceful enforcement initiatives and the introduction of further substantive law changes. We expect to see, in particular, an increased focus on how to tax companies engaging in digital transactions. While many of the rules enacted so far are intended to prevent deductions from being claimed in more than one jurisdiction and income from escaping taxation entirely, they may inadvertently result in taxpayers being subject to double taxation or whipsaw, particularly as the new rules are being adopted and implemented simultaneously and without coordination. Taxpayers will need to be vigilant, thorough and proactive to minimize their risks.
Increased Enforcement Efforts
Around the world, taxpayers are faced with new disclosure obligations, enhanced information sharing and increasingly aggressive enforcement strategies. The EU and the UK have introduced a new mandatory disclosure regime, known as DAC6, requiring intermediaries (including tax advisers, accountants, lawyers and banks) that establish or advise on certain kinds of “cross-border arrangements” to provide extensive information about those arrangements to local tax authorities. Following Brexit, the UK rules now only apply to a limited extent, with a focus on arrangements that undermine financial account information reporting obligations and arrangements that obscure beneficial ownership.
While the first reports are not due until early 2021 in most jurisdictions (other than Germany, Austria and Finland, where reporting obligations commenced in July 2020), the period covered looks back all the way to June 2018. As intermediaries start to make reports, taxpayers can expect enhanced information sharing among tax authorities and wide-ranging follow-up information requests.
We expect DAC6 to result in a significant increase in audits (including multijurisdictional joint audits) and in assertions of tax underpayments by tax authorities. Additionally, several jurisdictions, particularly in Europe, are increasingly resorting to criminal investigations, prosecution and/or “dawn raids” of companies perceived as not paying their fair share of taxes. Many companies are establishing dawn-raid crisis management plans, even if they have no reason to believe they have underpaid their taxes or are otherwise at risk.
Reshaping the Global Tax System for the Digital Economy
Various jurisdictions have recently introduced unilateral rules targeting digital transactions and structures.
In the UK, a digital services tax (DST) took effect in April 2020. It applies at a rate of 2% on revenues derived by certain businesses from social media platforms, search engines or online marketplaces. To fall within scope, the taxpayer does not have to be a UK tax resident, but the relevant revenue must be linked to the participation of UK users. In July 2019, France adopted a DST levied at a rate of 3% on the turnover derived on or after January 1, 2019, from certain digital services provided in France, including online intermediation and advertising services. A similar tax was introduced in Italy, effective as of January 1, 2020.
Looking to the future, the October 2020 Organization for Economic Co-operation and Development (OECD) program includes new proposed nexus and profit allocation rules to ensure that multinational companies (including digital companies) pay tax wherever they have significant profit-making consumer-facing activities. This program may result in governments enacting additional new rules.
Companies offering digital services should be prepared for drastic changes to their worldwide tax exposure and filing obligations as these and other measures take effect in the coming years.
Other Significant Changes to Tax Systems
Recent years have also witnessed an unusual increase in other significant changes to tax systems, and we expect this trend to continue in the near future.
The EU anti-tax avoidance directive (referred to as ATAD) took effect in 2019 and includes extensive anti-hybrid rules modelled after the OECD’s base erosion and profit-shifting (BEPS) recommendations. ATAD also includes changes to Controlled Foreign Corporation (CFC) rules and a harmonization of the rules across the EU. The EU, the United States and the OECD have also enacted or proposed various measures intended to ensure that multinational companies pay a minimum rate of tax on global income.
In connection with the transposition of ATAD into EU Member States’ national laws, as well as the drive to raise revenues to cover pandemic-related aid packages and to address recent tax-related scandals (such as German cum/ex schemes), we expect increased significant legislative activity (for example, Germany has recently started to overhaul its substance requirements and withholding tax system). The EU has also established a “blacklist” of non-cooperative jurisdictions for tax purposes and regularly publishes updates of the commitments taken by tax haven jurisdictions to implement tax governance principles, such as transparency and fair taxation. New economic substance rules have been introduced by several jurisdictions (e.g., Bermuda, Cayman Islands) that were under EU scrutiny for facilitating offshore structures or arrangements without real economic activity.
Multinational companies should be prepared for similar reforms across the globe in the coming months and years, and they should evaluate their current tax strategies and intercompany transactions and structures accordingly.
Changing Priorities and Increased Tax Litigation Expected in the United States
Over the past few years, the U.S. Department of the Treasury and the IRS have been focused on providing administrative guidance implementing the tax reform law enacted in 2017 (referred to as the “TCJA” and the “2017 Tax Reform”). This guidance (in the form of Treasury Regulations, FAQs, new IRS forms and information publications, and other substantive and procedural releases) has been voluminous, complex and often controversial. While Treasury finalized an enormous amount of this guidance before the end of 2020, there are some regulatory projects that were only recently released in proposed form and could not be finalized before year-end.
Whether we will see any significant tax legislation in 2021 is unclear at this point and will depend in large part on the politics in the U.S. Congress. Whether we will see any significant tax legislation in 2021 is unclear at this point and will depend in large part on the politics in the U.S. Congress and what the Biden administration wants to focus on, particularly given what now appears to be a very narrow Democratic control of the Senate. The Biden administration could, however, take significant actions in the tax area without involving Congress, including by adopting new regulatory rules and establishing new enforcement priorities and policies.
Indeed, tax litigation is an area of increasing focus in the United States. There has been a significant increase in the number of court cases challenging the legal validity of Treasury regulations and other forms of IRS guidance, as well as IRS enforcement actions, and we expect this will continue for at least the next few years, if not decades. The challenges have included assertions that the guidance or actions are invalid because they are substantively contrary to the underlying statutory rules and because Treasury and the IRS procedurally did not comply with the U.S. Administrative Procedures Act (APA) or other applicable rules. Taxpayers have had some significant and sometimes surprising success, while the IRS has also had its share of successes. One result of this litigation is that Treasury and the IRS are focusing significant attention and efforts on shoring up the substantive and procedural support for all of their rule-making and enforcement actions.
One particularly significant tax case was argued in the U.S. Supreme Court in early December 2020, and we expect to see a decision in the first half of 2021. CIC Services LLC v. IRS involves the ability of a taxpayer to challenge whether an IRS Notice establishing an information-reporting requirement (enforced through a tax penalty due in the event of non-compliance) is valid before the IRS has sought to impose the non-compliance penalty. The U.S. Anti-Injunction Act and the Declaratory Judgment Act generally prohibit courts from enjoining the collection of any tax before the IRS has attempted to collect the tax (referred to as a “pre-enforcement challenge”). But the scope of these prohibitions and how they interrelate with taxpayers’ rights under the APA are being tested through numerous lawsuits. In CIC Services, the plaintiff is asserting a violation of the APA’s procedural requirement that rules go through a public “notice and comment” process before being finalized; other cases are asserting that various Treasury regulations are inconsistent with the underlying Internal Revenue Code provision or are substantively “arbitrary and capricious” in violation of the APA.
This case is distinguishable from many of the other cases because it involves a rule requiring only the reporting of information to the IRS – not a rule that requires the payment of taxes. Nevertheless, the Supreme Court’s decision may have an impact on the questions raised in the other cases, particularly whether taxpayers have any ability to challenge substantive tax regulations or IRS notices pre-enforcement. This is a very important issue to taxpayers for whom a decision as to whether to undertake a particular transaction is entirely dependent upon whether a substantive tax regulation will or will not apply. It is an equally important issue to Treasury and the IRS, which do not want to be inundated with pre-enforcement challenges.
- Taxpayers operating in Europe and the UK should be aware of increased information reporting and sharing in relation to their cross-border activity. There is likely to be a consequential increase in audit and enforcement activity, including criminal investigations.
- Companies offering digital services should prepare for the possibility of new nexus and profit allocation rules that require them to pay taxes where they have significant profit-making, consumer-facing activities. All multinational companies should be prepared for further tax reforms focusing on measures such as substance and minimum levels of taxation.
- In the United States, it remains uncertain whether we will see any significant tax legislation in 2021 and whether the Biden-led Treasury Department and IRS will pursue significant changes through administrative guidance and enforcement actions. Tax litigation will also be an area of focus and interest in 2021, as we await the Supreme Court’s decision in the CIC Services case challenging the validity of an IRS rule and observe its impact on the many similar cases pending in the lower courts.