International taxation and ISDS: how businesses can mitigate Trump-related risks

One of the executive orders has formally withdrawn the US from involvement in the Organisation for Economic Co-Operation and Development’s (OECD) international agreement to introduce a framework to address tax challenges arising from the digitalisation of the economy. The other executive order, dubbed “America First Trade Policy”, provides the US Treasury with the power to investigate potentially discriminatory tax practices by other countries that impact US companies operating in those jurisdictions, and impose retaliatory increases in tax rates for companies from the jurisdictions where such practices are found to exist.

The combined effect of the two executive orders has significant implications for international tax cooperation, potentially leading to fragmented tax policies and more trade and investment disputes. These changes reflect the Trump administration’s emphasis on policies that are framed as protecting the interests of American businesses and workers. This could increase the risks for foreign investors operating in the US. For European companies, the risk is aggravated by the limited access to the investment protection regime given the US’s narrow network of investment treaties with major European economies. For instance, the US has no investment treaty in force with any of the EU’s 15 original Member States, such as France, Germany, Ireland, Luxembourg, Netherlands, Spain and the UK.

The lack of investment treaties between the US and the EU, or the UK, limits the legal protections and remedies available to EU and UK investors, when their investments in the US have been negatively impacted by the new tax measures and policies.

A significant number of investment treaty disputes arise from tax-related measures imposed by host states. These disputes are often handled through mechanisms like investor-state dispute settlement (ISDS), which may allow investors to challenge arbitrary and disproportionate tax measures and seek compensation from host states before international arbitration panels. However, without an ISDS framework, such as a bilateral investment treaty, multilateral treaty or free trade agreement with investment provisions, investors would need to rely on the host state’s domestic legal system or other not as effective remedies.

Companies based in jurisdictions with no investment treaty in force with the US should consider investment restructuring to mitigate the potential risks. This could be achieved, subject to certain caveats, by the inclusion of a holding company into their corporate structure, with the holding company registered or operating in a country that has a favourable investment treaty in force with the US.

The implication of US’s withdrawal from the OECD’s agreed tax framework

The executive order signed on 20 January sent a formal notice to the OECD that “any commitments made by the prior administration on behalf of the United States with respect to the Global Tax Deal have no force or effect within the United States”.

The US move to withdraw from the OECD’s two-pillar global tax framework to address the challenges of the digitalisation of the economy has left the future of the deal approved by 130 countries in the OECD/G20 Inclusive Framework in 2021 in serious doubt. The US withdrawal is expected to create particular challenges in relation to the implementation of Pillar 2 of the framework, which involves the creation of a 15% minimum level of tax for large multinational enterprises. Under the agreed Global anti-Base Erosion (GloBE) Rules multinational enterprises with global revenues above €750 million are required to pay a minimum effective tax rate of 15% regardless of where they are headquartered, or the jurisdictions in which they operate.

Historically, the location of a company’s profits and the jurisdiction entitled to tax those profits were determined according to the jurisdiction where the company was physically based. As a result of the increasing digitalisation of the economy, businesses are now able to generate significant global profits in jurisdictions where they have no physical presence. Consequently, this created opportunities for businesses to shift profits to jurisdictions where low levels of tax are paid and avoid paying taxes in jurisdictions with higher levels of taxation. In certain circumstances, multinationals were able to lawfully structure their businesses to choose which jurisdiction they would pay taxes in. Ultimately this gave rise to scenarios where jurisdictions receive low levels of tax receipts from a business, notwithstanding that the business may generate significant profits from that jurisdiction.  Pillar 2 aims to level the playing field and ensure that multinational companies pay a fair level of tax on profits regardless of where they are headquartered, or where they have a physical office.

Pillar 2 is made up of two core rules. The first is the income inclusion rule (IIR), which requires that if an entity’s tax rate in any jurisdiction is below the minimum 15% rate, the ultimate parent entity is liable to pay a ‘top-up tax’ to bring the rate up to 15%.

The second rule is the undertaxed profits rule (UTPR). Essentially, this is a backstop tax that allows jurisdictions to proportionally tax any profits that otherwise have not been taxed at a rate of at least 15% by denying otherwise deductible cross-border payments. Countries that have adopted UTPR include EU member states, South Korea, Australia, Canada, and the UK. For countries that have implemented Pillar 2, the rules apply for accounting periods commencing on or after 31 December 2023.

The US global minimum tax rate is currently 10.5%. Consequently, the introduction of Pillar 2 may lead to top-up taxes being imposed on US companies by the EU, the UK and other participating countries. 

Risks for foreign investors operating in the US

The withdrawal from the OECD’s agreed tax framework, combined with the “America First Trade Policy”, means foreign companies operating in the US are potentially exposed to retaliatory increases in tax rates.

Under the “America First Trade Policy”, if the US Treasury finds any foreign country subjects US citizens or companies to discriminatory or extraterritorial taxes, the US may invoke section 891 of the Internal Revenue Code, which doubles the US federal tax rate on individuals and companies of that jurisdiction.

The 15% minimum tax rate introduced as part of the OECD’s Pillar 2 framework may lead to top-up taxes being imposed on US multinationals operating within the EU and the UK, such as consumer-facing tech businesses. If a US Treasury investigation determines that such practices are discriminatory against US tech multinationals, then the US can invoke section 891 against these jurisdictions, leading to higher US taxes becoming payable.

To avoid US retaliatory taxes, it is understood that the UK government is currently exploring whether to introduce changes to its digital services tax, that predominantly impacts large US companies.

Investment restructuring as a legitimate risk mitigation strategy

Corporate nationality planning in the form of investment restructuring is considered a legitimate due diligence or risk mitigation technique so long as it is carried out before a dispute arises or is foreseeable. Companies based in jurisdictions with no investment treaty in force with the US could consider structuring their investment through a jurisdiction that has a favourable investment treaty in force with the US.

However, acting quickly is important when implementing this strategy, because if a specific dispute with the host country becomes foreseeable, the restructuring of an investment could be considered an abuse of the investment protection regime. An abuse of process objection prevents the investor from relying on the relevant investment treaty to establish the jurisdiction of the tribunal constituted under the treaty.

Additional potential hurdles need to be taken into consideration when assessing the available investment treaties. These include, for example, tax carve-out, fork-in-the road and exhaustion of local remedies provisions. Tax carve-out refers to provisions that exclude tax-related matters from the scope of an investment treaty. This means disputes arising solely from tax measures might not be eligible for arbitration under the treaty. The fork-in-the road provisions usually require an investor to choose between pursuing its claim in the host country’s courts or through international arbitration. This prevents parallel proceedings and ensures disputes are resolved in a single forum. The exhaustion of local remedies requires investors to first use all available legal remedies in the host country before turning to international arbitration.

Tax-related investment treaty disputes

A significant number of investment disputes arise due to the tax policies and measures of the host states. These disputes occur when investors believe that tax measures, such as new tax laws or changes to existing tax policies, negatively impact their investments in ways that violate international law. There have been several high-profile tax-related investor-state arbitration cases where significant awards were granted in favour of investors. For example, US companies Occidental Petroleum Corporation and Occidental Exploration and Production Company brought an investment treaty arbitration against the Republic of Ecuador under the US-Ecuador Bilateral Investment Treaty. Part of the dispute related to tax measures introduced by Ecuador, which saw the host country withhold value added tax (VAT) refunds owed to the investors. The US companies argued that the refunds were withheld unfairly, and this violated the protections offered under the BIT. The tribunal awarded $1.77 billion to the US investors.

Similarly, UK investors Cairn Energy PLC and Cairn UK Holdings won an investment treaty arbitration against India brought under the India-UK BIT. The dispute concerned India’s retrospective tax demands imposed on Cairn Energy. The arbitration tribunal under the Permanent Court of Arbitration (PCA) ruled in favour of Cairn Energy and India was ordered to pay Cairn $1.2 billion in compensation.

Protections offered by investment treaties

The power to tax is a quintessential sovereign right. It is generally used by states for legitimate public purposes but any such right may be abused in order to interfere with or harm foreign investments. Investment treaties are designed to provide a range of protections to foreign investors to ensure a stable, predictable and fair environment for their investments. These protections typically include protection from unlawful expropriation, obligation to accord fair and equitable treatment and full protection and security, protection against discrimination, and the commitment to the observance of obligations. In a world where tax policy changes may be implemented in a discriminatory or unfair manner, the importance of investment treaties and upholding the rule of law is ever more important. 

Co-written by Penny Simmons and Juan Pablo Charris of Pinsent Masons.