#TheDress and International Taxes

Yesterday was the five-year anniversary of #TheDress, one of the most fascinating and confounding Internet memes of the past decade. At the time, I saw a remarkable parallel to an international tax policy issue , and considered writing a blog post comparing the two. I wrote it out, but decided not to submit it to my editors—and I’ve regretted it ever since. Here it is, with minimal edits and an update at the end.

March 1, 2015

Unless you spent this weekend away from your computer, your TV, and your phone, you probably heard about “The Dress”—or as it became known on social media, #TheDress. The garment, pictured above, seemed ordinary enough, until people started to describe it. Some people said it was gold and white, others said it was black and blue, and neither group could figure out what in the world the other was talking about. Tens of millions of people on every continent spent Thursday night arguing about it, and it lasted throughout the weekend.

(I can’t see anything other than gold and white. Believe me, I tried.)

The answer, it turns out, wasn’t some social delusion, sorcery, or a mass outbreak of color-blindness. It didn’t even really have to do with eyesight or color. Experts suspect it is due to slight variations in neurology creating differences in how people interpreted the images, color, and light in the picture lead to very different conclusions about what was being depicted.

There’s a similar dynamic which sometimes occurs when governments look at complex corporate tax structures. Due to differences in laws and customs—often slight—tax authorities can come to quite different conclusions about what a structure is, and how it should be taxed. And while #TheDress just resulted in a few moments of amusing online diversion, when it comes to international taxation this phenomenon can cause a serious problem.

Background

The Organization for Economic Cooperation and Development sets universal but non-binding taxing standards to promote a stable, uniform system that encourages global commerce. However, this is still a world of nations, and they have the prerogative to apply their own tax regimes. And much of the international tax system is a product of hundreds of bilateral tax treaties, all produced through rounds and rounds of negotiations and all a little bit different.

Companies sometimes figure out ways to use the differences to their advantage.

One famous (or infamous) example is Apple Inc.’s so-called stateless income. As highlighted in Senate hearings headed by then-Sen. Carl Levin D-Mich., the computer behemoth created a subsidiary which was incorporated in Ireland, but controlled by executives in the U.S. Because the U.S. bases tax residency on the place of incorporation, and Ireland on the place of management and control, neither country saw a taxable entity within their borders. Thus, the subsidiary’s earnings were effectively tax-free.

Or there’s the Double Irish tax design, which is enabled by quirks in the U.S.’s “check-the-box” rules.  You can read more about this here—in short, a U.S. company can create a structure which the Internal Revenue Service views as a single subsidiary operating abroad, but foreign countries view as two separate subsidiaries. That discrepancy allows the company to engage in transactions between those entities designed to lower its effective foreign tax rate, while shielding those transactions from U.S. laws meant to prevent such practices.

Companies have also found ways to manipulate how countries reward tax deductions. In theory, an inter-company transaction which creates a deductible payment in one country ought to create taxable income in another country. But due to differences in laws, that doesn’t always happen.

For instance—an investment in a company can either be a loan, which earns interest, or equity (such as stock), which earns a dividend payment. There are subtle and sometimes fuzzy differences between the two types of payments, and countries use various criteria to determine which is which. This creates situations where a company pays interest to a related party, which is a deductible payment. But the company receiving the payment is in a country which doesn’t recognize it as an interest payment, but rather as a dividend—which may also be tax deductible.

Thus, the larger organization earns two deductions on the same income.

Solutions

These so-called hybrid mismatch arrangements have been identified as a problem by the OECD, which has included them in their Base Erosion and Profit Shifting project.

But why, precisely, are they a problem? If Country A thinks that a certain payment should be deductible why should they care if another country sees it differently once the money has left their borders? Why is it any of their business?

That’s sort of the tax accountant’s version of pondering how many angels can fit on the head of a pin. But the OECD—while acknowledging that it’s often difficult to tell who, precisely, is being harmed by some of these instruments—clearly feels they are a problem.

The organization’s first draft on the issue, released in March 2012, noted that these instruments reduce the overall amount of taxes collected. They reduce economic efficiency by promoting some transactions over others, as they reduce basic fairness by promoting some taxpayers over others. And they reduce the general public’s faith in the tax system.

But what can be done? Rather than try to get everyone’s tax system in perfect alignment—that’d be a bit like fixing everyone’s brain so we all see the same colors on the dress—the OECD has opted to write new rules which identify hybrid mismatch arrangements, and try to prohibit or tax them.

One thing to keep in mind--#TheDress was an argument about a photograph, not physical clothing. If we were looking at the actual dress, (which is black and blue, by the way), I doubt anyone would be confused. But we were all looking at a photo—an incomplete collection of pixels with an awkward perspective, a confusing background, and a disorienting flash of light in the upper right-hand corner. Our brains immediately wanted to interpret and understand the image, but at least some of them came up short.

Likewise, these countries aren’t confused about the actual structure of these corporations—which may be confusing, but not this way. Rather, this is about the companies’ structures as represented by the global tax system. The international tax system is a mirror of global commerce, but often it is an incomplete funhouse mirror filled with optical illusions and distortions. Like our brains, governments often come up short trying to understand it.

Update: Later that year, the OECD released its BEPS report on hybrid mismatches, with recommended legislation to eliminate tax advantages from hybrids. Similar language was included in the 2017 Tax Cuts and Jobs Act. Ireland eliminated the Double Irish so-called loophole at the beginning of this year, although its branch allocation rules remain controversial and subject to European Union state aid investigations. “Check-the-box” remains an aspect of U.S. tax law, but its importance was reduced by other international provisions of the TCJA such as the tax on global intangible low-taxed income, which targets earnings that could be shielded by the check-the-box maneuver.

If anything, I’d say that the international tax discussion has moved away from debates about how to properly define tax entities and transactions, and towards more targeted measures—digital service taxes, global minimum taxes—that aim to block gains made from tax system arbitrage. Who knows—maybe we can learn to live with differing perceptions, after all.