Substance Requirements in the International Taxation of Intangible Capital: A Double-edged Sword?

Abstract

The Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting project has focused on income attributed to intangibles with an objective of curtailing perceived artificial profit shifting by multinational firms. A key part of this effort is a renewed emphasis on the concept of “economic substance.” Economic substance standards require companies to have people functions (i.e., employees) in jurisdictions for companies to be able to report profits related to intangibles in such jurisdictions. Our analysis suggests that an emphasis on economic substance tied to people functions can have a significant impact on the scale as well as the location of economic activity (i.e., employees dedicated to the creation and use of intangibles). Furthermore, the likely implications on economic activity can be highly unfavorable for high-tax jurisdictions. Viewed from a US perspective, this new international environment provides an explanation for the international provisions adopted as part of the US tax reform of 2017.