Global Agreements and the Decay of Tax Treaty Law

1. Introduction

It is a tremendous privilege to be able to contribute to this volume in honour of Professor Rainer Prokisch. No one knows tax treaties better than Rainer, so I had to pause before offering this commentary on the state of these treaties at the closing of 2021. Some have celebrated a so-called global agreement during 2021, when 136 countries comprising most of the Inclusive Framework signed a statement dictated by the G7 and the OECD, a statement which purportedly included the building blocks for a new international tax regime.1 The statement adopted the two Pillar framework promoted by the OECD, which offers new taxing rights to market (source) countries over foreign taxpayers even in the absence of physical presence and a global minimum tax to residence countries.2 The agreement concludes the post-BEPS work by the OECD, which prior to the very last version of the two pillars program (the abovementioned statement) focused on finding a solution to the challenges that the rise of the digital economy had presented to the international tax regime. The statement shifted the discourse completely, refocusing the project to taxing the largest multinational enterprises more aggressively.

The tax treaty based international tax regime faced serious challenges over the turn of the millennium.3 The continuous degradation of source taxation mobilized so-called source countries (often meaning developing countries) to demand a new “deal” that would expand their taxing rights.4 Some core tax treaty concepts, notably permanent establishment and arm’s length could not be simply applied to many modern transactions. Sophisticated financial instruments quite easily navigated through antiquated tax law dogma. The ascent of the intangible and the digital economy made it easy, especially for the largest multinational enterprises, to significantly (and unfairly in the views of most) reduce their effective tax rates. The OECD dominated the regime through the OECD Model and Commentaries but had done so without universal legitimacy and without taking responsibility for the impact of the regime beyond the OECD membership.5 It resisted change yet the public outcry that eventually led to the BEPS project forced the OECD into action. The focus of the project became the preservation of power with the OECD rather than a principled reform of the international tax regime. BEPS resulted in a dramatic change in the audit environment worldwide, in an unprecedented multilateral tax treaty (the Multilateral Instrument (MLI)), and very little change in the substance of international tax law.6 The OECD punted on the core issue of the digital economy, but was forced to address it post-BEPS, eventually leading to the recent agreement over the said statement. Unlike the 2015 BEPS agreements, the recent agreement significantly alters the substance of international tax law and tax treaties.   

This short essay cannot of course comprehensively evaluate the recent agreement and in its light the future of tax treaties. Instead, it makes four observations about basic aspects of the current discourse, each of which presents a serious threat to the viability of tax treaties and the great achievements of the international tax regime to date. First, it discusses the casual treatment of treaty override, not a new phenomenon but one that has come up more bluntly in the context of the new agreement. Second, it puts recent developments in the context of the long-term discourse of multilateralism in tax law. Third, it addresses treaty dispute resolution in the new agreement, and claims that it is likely to harm rather than aid the evolution of tax treaty dispute resolution. Finally, it argues that the agreement, consistent with the BEPS project, continues to blur the boundaries between tax treaty and domestic law in an unprincipled manner, leading to an erosion of the status and impact of tax treaties.

2. Treaty Override?

The current agreement became possible only when the United States presented its proposal for the revision of the “Two Pillars” approach, and pushed it through the G7, the G20, and eventually, with the support of the OECD secretariat, through the inclusive framework.7 It still includes a new taxing right for market economies under Pillar One that would not require physical presence for taxation at source, in direct contrast to the prevailing norm of tax treaties and international tax law more generally. The implementation of this reform requires the adoption of a multilateral tax convention (MTC) to ensure the uniform implementation of this agreement across the parties to the agreement (or at least a large section of them).

This requirement was acknowledged by all parties and did not attract much attention or debate at first. The work on the MLI and its eventual success likely contributed to the calm with which this requirement was adopted. Nonetheless, commentators have quickly noticed that the proposed MTC will be very different from the MLI. The MLI had been designed to merely amend bilateral tax treaties, keeping them at the helm of the international tax regime, while the MTC will have to be, and is proposed to be, a separate multilateral tax treaty with substantive tax provisions, which norms violate, or deviate from – as one wishes, the norms of bilateral tax treaties. The MTC will likely have a 100+ parties adopting (more or less)8 the same rules, with many bilateral relationships among these parties not already being covered by bilateral tax treaties. The immensity and complexity of such endeavour quickly reveals itself even if one ignores the difficulty of the simpler MLI to come into effect with respect to its signatories.9

One cannot ignore however the low likelihood of the United States joining the MTC. The central role of the United States in the materialization of the recent agreement that continues to draw irritation and criticisms even among parties to the agreement makes its likely abstention from the MTC significantly important. The Biden Administration has yet to admit that the United States will not simply join the MTC, yet it has quickly presented alternatives that should have (according to the Administration) similar consequences.10 This stance that suggests an intent to circumvent the normal process of treaty making and the power given to the Senate to consent to ratification of  a treaty obviously irked the legislators in an already tense political climate.11 The alternatives include: (1) an adoption of the treaty as an “executive agreement,” which is an extraordinary, but not rare, avenue for adopting treaties without Congressional support, an avenue that had not before been used for substantive tax law, and (2) adoption of domestic rules that imitate the obligations that the United States would have taken on itself in the MTC. The problem with the former alternative is mainly political. It seems that it would be difficult to go ahead with a detour around Congressional power at the time when the administration is trying to pass its domestic agenda through a fragile Congress. This is particularly true when such a move would be precedential and would unquestionably force Democratic members of Congress to consider whether they would want to open this pandora’s box for future use by Republican administrations.12

The more problematic, and presumably likely in the mind of the Biden Administration is the domestic legislative route which would avoid constitutional questions but would require Congress to act, and that was the problem of the Biden Administration with the MTC in the first place.13 Not legislating (i.e., doing nothing) would be the other option, somehow accepting the violation of tax treaties by some countries (enforcing the new taxing right in violation of their treaty obligations to the United States). The problem with this option is that the tax imposed under Pillar One would probably be considered uncreditable in the United States due to its lack of sameness to the United States corporate income tax. That would be particularly difficult for United States multinational enterprises to stomach, especially when they are the primary target of Pillar One. The United States may agree to credit such taxes somehow, but it is difficult to see how it could do so without imposing an equivalent tax themselves, a tax that would, again, be in violation of bilateral tax treaties with over 60 other members of the Inclusive Framework. It is evident that promoting the current agreement that relies on a MTC without a straightforward way to join such MTC puts the United States and the agreement in a precarious position.

This essay argues that the more worrying aspect of the Pillar One debacle is the casual discussion of treaty override and the mixing of international and domestic law measures in the discussion without careful attention to the consequences. It is well known by now that the United States’ Constitution opened the door to treaty override in the form of later-in-time domestic legislation in violation of earlier treaty obligations by the United States.14 This fact as well as the fact that tax treaties are overridden more than other treaties15 are known to treaty partners of the United States that nonetheless continue to conclude new treaties and maintain treaty relationships with the United States. Such acceptance may be explained by:16 (1) the relative restraint exercised by Congress over the years, using treaty overrides primarily for anti-abuse purposes,17 (2) the limits put by the Supreme Court on treaty override,18 and (3) the fact that other countries, most notably Germany, have recently accepted treaty override as a legitimate action against inappropriate tax planning.19

This begrudging20 acceptance of treaty override may change and even help unravel the international tax regime. Some of the risk stems from politics: (1) the United States was the key player to push and even dictate the current agreement; (2) the United states promoted the current agreement knowing that its domestic politics will make it difficult to implement the agreement in the United states; (3) the agreement looks to be disappointing for developing countries; (4) countries beyond the United States increasingly accept treaty override as legitimate while other countries are prevented from using it by their own constitutions. The greater risk however relates to the authority of international law in the realm of tax. The unbearable lightness of the suggestion to use treaty override through the enactment of domestic legislation in lieu of joining the MTC demonstrates a deep disregard to the importance of international law in general, and tax treaties in particular. International law is sometimes dismissed as primarily political or diplomatic. This view misses the importance of international law for the stabilization of international relations - the core function of international law.21 One should contemplate whether they would rather live in a world with limited international law in compatibility with the latter view. Tax treaties are regularly undermined based on similar arguments,22 but also due to a narrow view of their purpose. When merely viewed as mechanisms to eliminate double taxation (or even double non-taxation) they are indeed unessential and as such also vulnerable to critique that they mainly serve the most developed countries at the expense of developing countries.23 Such critique ignores the impact of tax treaties on cross-border investment, which is the true purpose of tax treaties (elimination of double taxation and double non-taxation are merely the means to meet this end), their support of investor confidence, and their utility in bringing together a rather cohesive international tax regime. Viewed this way, tax treaties present a triumph for international law. The thought that dispersed domestic legislations could replicate it is unrealistic under the best of circumstances and specifically unlikely in the current political reality of the United States. This approach further dismisses the importance of standardization of international tax norms, which is the most prizeworthy achievement of the international tax regime to date, standardization that significantly reduces the tax-related waste and cost of cross-border investment.      

3. Multilateralism

The necessity of a MTC for the implementation of the recent agreement has gone undisputed within the Inclusive Framework. It is not evident that Pillar Two could not be implemented without it, yet as demonstrated also above, Pillar One would likely necessitate it. If the MLI signified the passing of the Rubicon for multilateralism in taxation, a MTC will be its first uncontested domain. To date the most dominant multilateral aspects of international taxation involved multi-party treaties in service of bilateral tax treaties that continued to serve as the building blocks of the international tax regime. Even the MLI, which provided a great service to multilateralism in taxation when proving that a large-scale multilateral tax treaty involving substantive tax norms is feasible, has not been independent of bilateral tax treaties. The MTC will be different.

The MTC’s membership will potentially include the entire membership of the Inclusive Framework, possibly having more signatories than the MLI’s 96 parties. Most of these possible parties have yet to conclude bilateral tax treaties among them, and the nature of the MTC makes it unlikely that parties would exclude some bilateral relationship from the application of that convention unlike the MLI which scope was decided by the signatories. The scope of the MTC will be even larger since it would not be limited to bilateral and some trilateral relationships like traditional bilateral tax treaties. The substance of the MTC (not all of which is clear at this point in time) will also sharply deviate from current treaty norms, such as the requirement for physical presence and permanent establishments for taxation of non-residents, source rules based on acceptable connections to the taxing jurisdiction, and arm’s length taxation.

Multilateralism of the sort presented by the MTC pioneeringly responds to the discord between the decentralized international tax regime and the interdependence of the world economies that translates to interdependence of tax policies. A multilateral tax treaty such as the MTC does not conceptually interfere with bilateral tax treaties. As demonstrated by multiple fields in which bilateral and multilateral treaties complement each other, the choice between the two routes for treaty relationships is not binary.24 The combination may have benefits in enforcement and dispute resolution. The multilateral treaty may provide the conceptual framework, leaving the country specific details to bilateral agreements, ensuring the continuity of the regime and a development of international law in the field. Alas, these potential benefits of multilateralism are not replicated in international taxation, at least not at the present. Nonetheless, there is hope that a multilateral tax treaty could solve the biggest problem of the regime, namely the lack of trust among its constituents, and particularly the distrust in the OECD that inflates its illegitimacy as an international standard setter. The MTC as presented by the recent agreement is unlikely to reverse this course since it presents too little change and a minimum (if at all) benefit for countries other than the richest. Furthermore, the fundamental norms of the proposed MTC under Pillar One address basic aspects of international taxation dramatically differently than bilateral tax treaties that will continue to govern the overwhelming majority of international taxation (everything stays the same except for the minor new taxing right in Pillar One). Instead of harmony, these rules will only serve as explicit evidence that things could be different and that the holy cows of international taxation are not so holy even if they persist and continue to dominate the vast grazing grass of the regime.

Now, one may argue that the MTC is just a first step in an evolutionary process to modernize the international tax regime. The narrow scope of the MTC and its lack of a principled infrastructure do not much matter at the present, so goes the argument, since its true purpose is to stabilize the international tax regime and to demonstrate without endless debate that the norms of the regime could be modernized. If successful, an incremental reform of the regime will follow, and the goal of modernization achieved. Such an argument relies on the belief that fundamental reform of the regime is impossible and on the power of the OECD and its most dominant members to eventually push through the incremental reform. This essay argues that this approach is problematic. First, the belief that genuine international negotiation of a fundamental tax reform is currently impossible is baseless since such negotiation has never been tried. The entire BEPS and post-BEPS process was hurried and dictated by the OECD without an opportunity for genuine negotiations to take place. Second, this approach ignores the harm that the incremental approach could cause to the regime that will now have two contradictory systems operating one beside the other with unclear boundaries and justifications for the differences. Third, this approach relies on and primarily aims at maintaining the coercive power of the richest countries in the world and of the OECD over the rest of the world, a paradigm that has proven to be ineffective and anachronistic beyond its moral inadequacy. A more transparent and honest approach may take a bit longer, but it bears with it the promise of stability and effectiveness. 

4. Tax Treaty Dispute Resolution

One of the fundamental building blocks of Pillar One is the inclusion of a new dispute resolution mechanism in the recent agreement. The new taxing right provided by Pillar One should require this mechanism to provide the parties certainty and provide stability to the regime. The details of the new dispute resolution mechanism are unclear at the present, but the Oct. 8 statement provides that disputes on whether issues may relate to Amount A will be solved in a mandatory and binding manner.25 Other issues, including the elimination of double taxation will be dealt with through dispute prevention and resolution. The statement is silent about the latter being mandatory and binding and therefore one should assume that there had been no agreement on that matter.

 Current tax treaties generally include non-mandatory, non-binding dispute resolution provision known as the MAP (Mutual Agreement Procedure), which calls for treaty parties to resolve disputes among them via their competent authorities. Despite the resilience and almost universality of the MAP, its typical duration and lack of finality have attracted much criticism over the years. Most commonly, mandatory arbitration has been promoted as an alternative to the MAP. The OECD and others coalesced over so-called baseball arbitration triggered after two years of fruitless MAP negotiations as the preferred alternative, and the same was adopted on an opt-in basis by the MLI.26 The early attempts to promote mandatory arbitration ended with only few such provisions but in the MLI over 20 countries committed to the solution. It is too early to assess the impact of such commitment on tax treaty dispute resolution. The MAP therefore continues to dominate the field, benefiting from some enhancement and a peer review process established by the OECD after BEPS.

One would then expect the MTC to follow the same pattern for its mandatory and non-mandatory dispute resolution mechanism, yet the Pillar One “Blueprint” published by the OECD in 2020, expanding on the two pillars solution albeit in its former version, not precisely the one adopted in the recent agreement, defied such expectation. It alternatively suggested a completely novel solution: multinational enterprises subject to the new taxing rights will submit their self-assessment to the “lead tax administration” (usually the country of residence) that will review it and exchange it with conclusions with other relevant tax authorities; unless agreement is achieved a dispute prevention panel, comprised of 6-8 representatives of diverse jurisdictions will be established to assess the disputed issues; further disagreement will lead to the convening of a determination panel, which composition is still undetermined (no agreement on the matter was achieved among the members of the inclusive framework), and which conclusions will be binding unless the MNE disagrees and decides to withdraw its request. Only domestic dispute resolution procedures will then be available to the MNE and the conclusions of the panels will still be available to all relevant jurisdictions.27

This innovative mechanism clearly has standardization as its primary aim, which is natural for a new taxing right, especially when essentially the entire legal construct leading to such right is new and in many ways contradictory to the established regime. The mechanism is designed to help the new regime develop new law, and it is quite sensible in its evolutionary approach to the development of such law. Although dramatically novel, this new dispute resolution mechanism attracted little of the criticism directed at the recent agreement to date, perhaps due to the many other challenges presented by the agreement. Nonetheless, the proposed mechanism is highly complex, lacks many important details, both of which are good reasons for questioning its viability. In this short essay, however, I wish to question the fundamental idea of a representative panel coordinated by the OECD for dispute resolution. The current agreement requires countries to concede tremendous power to a competing tax jurisdiction – the so-called lead tax authority, which almost always will be a most developed country, and in most cases the United States. This authority sets the stage and writes the script for the dispute. Disagreement leads to further conceding of the dispute to a panel of several other countries through a complex process. Finally, the process does not guarantee finality. Once compared to the most discussed alternative to the MAP, namely mandatory tax treaty arbitration the proposed mechanism falls short on almost all accounts. It does not provide certainty, or finality; It seems that it will be very lengthy and costly; but, most importantly, it envisions countries conceding control over their taxing rights to other countries rather than a judicial or even pseudo-judicial process.28 The choice here is clear: the OECD prefers politics and power assertion to the law and legal solutions. Even the one area in which the prosed solution seemingly excels: standardization and the development of (common) international law is questionable, since the proposed solution does not explain the precise legal authority, the source of international law created by this solution. Moreover, the seeming advantage in terms of law development that the proposed solution has over arbitration may prove illusory since nothing prevents arbitration from providing incremental contributions to the development of such. Again, it seems that the architects of the recent agreement focused on power preservation rather than a long-term viable solution to treaty dispute resolution. 

5. Treaties and Domestic Law

The softness of the international tax regime partly stems from the different constitutional statuses awarded to treaties in different jurisdictions. The relationships between domestic laws and tax treaties are therefore not always straightforward, as already discussed above in the context of treaty override. Nonetheless, some aspects of these relationships should be clear, most importantly that tax treaties do not impose taxation and traditionally their role has been to limit domestic tax law’s reach in cross-border situations. Professor Klaus Vogel aptly equated their role to a stencil imposed on domestic law, setting boundaries, and preventing the latter’s reach beyond the surface of the stencil.29

This role of tax treaties corresponds with their key function of limiting double taxation. With the turn of the millennium, stakeholders began to promote the desire to limit double non-taxation as an equivalent key function of tax treaties. Prior to that movement the improper use of tax treaties to reduce one’s taxation had been dealt with by domestic anti abuse mechanisms and by treaty dictates to contracting tax authorities to exchange information and assist each other to prevent the inherent lack of coordination embedded in tax treaties from being abused by taxpayers. These mechanisms have proven insufficient in the modern global economy, so stakeholders decided to both fortify such traditional mechanisms and introduce the new term “double non-taxation” and make it a seemingly parallel function of tax treaties to the elimination of double taxation. A new catchphrase “single tax principle, coined by Professor Avi-Yonah, was adopted by the OECD to promote this idea and this new “purpose” was inserted to the OECD Model’s preamble as well as to the preamble included in the MLI. Finally, new and quite aggressive provisions, including a controversial principal purpose test (PPT) were introduced via the MLI. This whirlwind of anti-abuse mechanisms invaded international tax law with little attention to the harm that its lack of coherence may cause: the narrative was of evil taxpayers taking advantage of vulnerable tax authorities with defective weapons in their arsenal dominated the discourse, leaving little space for principled analyses. Many jurisdictions were effectively pressed to toe the line and adopt rules such as the PPT and the Hybrid Mismatches rules that blur the line between domestic tax law and tax treaty law as a secondary means of limiting the reach of the former.

The complexity of these recent development has yet to hit the reality of implementation and the handling of disputes arising from it in the courts, yet it promises to be a long and complicated journey before the dust settles on these changes in the international tax regime.30 Nonetheless, the OECD has already taken what I view as the next step in the recent agreement, providing that it will supply the parties with model domestic laws for the implementation of the new Pillar One taxing right. As mentioned, treaties cannot impose taxation but with the recent agreement the OECD wishes to circumvent such obstacle by an agreement to adopt unified domestic legislation. The goal of this strategy of the OECD is clear and understandable: since this is a new taxing right it will be too risky to leave legislation of domestic law to the various countries, a process that would be lengthy and unreliable so far as standardization is concerned. It is also true that tax treaty concepts and rules have over the years been adopted by domestic legislations with the effect of standardizing international tax law. The permanent establishment rules serve as a good example for successful transplantation of treaty concept into domestic tax laws.

What is proposed in the recent agreement however is different. We are used to the OECD dominating international tax law with the OECD Model Convention and Commentaries being accepted in many jurisdictions as powerful means for the interpretation of tax treaties due to the lack of alternatives for judges when they come to decide a treaty case. Now the OECD is trying to do the same thing with domestic law. Not only it intends to provide model domestic laws, but it also complements these model laws with “commentary that describes the purpose and operation of the rules,” pushing a parallel to the adoption of the Model Convention and Commentaries in many countries as the primary sources for interpretation of tax treaties. Naturally, domestic legislators do not have to accept the model laws and domestic courts do not have to use the model commentaries on such laws, yet realistically there is a good chance that many will do. The pressure applied by the OECD and the most dominant economies on the rest of the inclusive framework countries, the abundance of developments and new rules that countries need to contemplate, and the neck breaking speed of these developments leave many countries with no practical means to halt and seriously evaluate the desirability of the entire package delivered to them by the OECD (and the United States in the case of the recent agreement). There are good reasons to believe that this has been the state of affairs throughout the existence of the inclusive framework,31 and it very clearly is the case with the recent agreement. In effect, the OECD has adopted the role of an international tax government in a world that is yet to agree to having one. One may of course argue that an international tax organization would be a good thing to have, but having the OECD, a legitimacy challenged organization to assume leadership of one without debate and consent over the precise implications of such a step, and without a clear understanding of the responsibilities that such a role for the OECD entail seem to me unacceptable. Again, it seems that the OECD rushed to put the cart before the horse in a move that promises to weaken rather than bolster the international tax regime.

 6. Conclusion

The breadth and complexity of the recent global discussions of the future of the international tax regime have made it difficult for all to seriously assess the desirability or even the implications of many of the component of the various agreements. The most recent agreement however goes further than all other agreements in both country and substantive scope. The neck breaking speed of events camouflages the problematic implications of some of the provisions of the recent agreement to international tax law. This essay discusses four examples for the disregard of the architects of the agreement to international law and to the rule of law more generally. This is sufficiently worrisome by itself. The essay further explains that this approach is also unlikely to be effective since a too casual attitude towards the meeting of international obligations can only result in violations by everybody, and a deterioration of the system to the detriment of cross-border investment.