Reforming the international tax system: what you need to know
Similar to the June communique from G7 finance ministers endorsing the proposals in principle, this represented another important step towards a radical overhaul of the international tax system. Following a period of understandable scepticism that – given the scale of agreement required – this project could get off the ground, it now looks a realistic possibility that the proposals may actually come into force.
Businesses should start thinking seriously about how these proposals may affect them.
Notwithstanding the current triumphant mood amongst those sponsoring these proposals, there remain technical and political obstacles that could yet derail the whole endeavour. This includes the domestic legislative changes required to pass through each signatory jurisdiction – with a critical mass needed to ensure the project is a success.
This note sets out what you need to know about what the proposals might mean in practice and what is likely to happen next.
What problem is the OECD/G20/G7 trying to solve?
Under the current international tax system, tax is generally paid in the jurisdictions where a company has a physical presence. An increasingly digitized world has meant that revenue can be generated in places where – under current rules – a business has no taxable presence. Globalisation and the attendant rise of multinational groups has meant there are more opportunities to generate profits outside of the jurisdictions in which companies’ customers are located.
The genesis of the OECD project was therefore a desire to modernise the tax system to ensure value derived by businesses through digitalisation is properly taxed where it is created and limit the reduction in effective tax rate that businesses can achieve through their group arrangements. While the original “BEPS” project made progress towards these ends, many of the difficult questions around a digitalised economy were left unanswered.
In parallel, some jurisdictions have spoken of the need to avoid a “race to the bottom” – in the absence of a new global settlement, countries face an incentive to keep reducing their tax rates to attract investment from international (often, digital) businesses which would otherwise chose to locate themselves in jurisdictions offering a lower tax environment.
What are the proposals that have now been agreed?
For two broad problems there are two broad sets of solutions – or “Pillars”, to use the OECD nomenclature.
- “Pillar One” allocates new taxing rights to market jurisdictions, including where a multinational lacks physical presence in their territory. Following the Biden administration’s intervention earlier this year, the focus is no longer on “tech” companies (which the US perceived as unfair) but is aimed instead at the “largest” companies (determined by global revenue and profitability).
- In-scope companies will be those with turnover exceeding EUR 20bn (although this will fall to EUR 10bn after seven years if implementation is successful) who will have to allocate 20—30% of their profits in excess of a 10% margin to the countries where they operate (known as “Amount A”). Their market jurisdictions will be determined using an allocation key, which under current proposals would mean countries where the group derives at least €1mn in revenue (or €250,000 for countries with GDP below €40bn).
- “Pillar Two” will set a global minimum corporation tax rate of at least 15%. This is not an obligation for jurisdictions to change their nominal rates, but rather would mean that signatory countries agree to ensure multinationals headquartered in their jurisdictions have paid this rate of tax across their foreign controlled subsidiaries (the “Income Inclusion Rule”).
- In practice this would involve comparing the effective tax rate of profits from each subsidiary jurisdiction to the agreed minimum tax rate, and topping up any shortfall as required on a country by country basis (with such tax paid in the headquarter jurisdiction, where they have signed up). This would remove any tax advantage to establishing subsidiaries in low tax jurisdictions.
- Where a parent company is not located in a signatory jurisdiction, the “Undertaxed Payment Rule” is designed to support the same end goal by allowing participating countries to disallow deductions for base eroding payments made to low tax countries.
- The final rule is the “Subject to Tax” rule which is designed to ensure source jurisdictions that have ceded taxing rights under a treaty can apply a top-up tax to the agreed minimum rate (between 7.5% - 9% on gross income, rather than 15% on net profits) on certain related party payments.
The US quid pro quo: goodbye to digital services taxes (DSTs)
In return for agreeing to proposals that would see a shift in taxing rights over its tech companies away from the US, other deal signatories have committed to the abolition of domestic DSTs (which primarily targeted American tech companies). This represents the second limb of the US success in pivoting the tax spotlight away from its tech giants (the first one being the reframing of the scope of Pillar One in terms of size rather than provision of digital services).
The technical detail has advanced, but many key questions remain
The OECD’s most recent statement (on 1 July 2021) was welcome in confirming the consensus that had been reached on several outstanding points, such as whether financial services will be excluded from the scope of Pillar One (they will, as will the extractives sector) and whether there will be any exclusions from the minimum tax rate (there will be a “substance” carve-out based on tangible assets and payroll in a jurisdiction, and a de minimis exclusion for certain jurisdictions below a set threshold).
But many questions remain unanswered and core details have yet to be worked out:
- Revenue sourcing – the end market-jurisdiction where goods or services are used or consumed is the indicator for identifying revenue in a market jurisdiction but the question of whether revenue is derived from a market is not always straightforward (consider a free-to-use social media platform or a manufacturer with an extended supply-chain). The OECD statement confirms that “detailed source rules for specific categories of transactions” will need to be developed – but doesn’t give away much about what these will look like.
- Segmentation – this is the approach of applying the Pillar One rules to particular business lines of a multinational rather than its profits in aggregate, which enables the rules to apply to sufficiently profitable streams where these would otherwise be excluded because the multinational isn’t in aggregate sufficiently profitable.
- The “Amount B” proposal – the intention of Amount B is to simplify transfer pricing rules by introducing standardised remuneration of related party distributors that perform certain marketing and distribution activities, however the details of this aspect have been delayed.
- Scope – the minimum tax proposal will principally apply to large groups with turnover in excess of EUR 750m, however countries will have the ability to apply a lower threshold to groups headquartered in their country if they wish. The threshold for the subject to tax rule has not been confirmed in the agreement therefore this could have widespread implications for smaller groups.
- Tax base - an agreed global standard tax base will need to be devised to determine the ETR that triggers the “GloBE rules” (the collective name for all three of the Income Inclusion, Undertaxed Payment and Subject to Tax Rules). The challenge is agreeing which tax adjustments are acceptable, for the purposes of ascertaining how much tax needs to be topped up. There are a wide range of possible adjustments, each with their own particular rationale (capital allowances, participation exemptions and loss relief to name a few), and political agreement will need to be reached.
- Substance-based carve-out – this seeks to carve out income that provides at least 5% return on tangible assets and payroll (at least 7.5% in the five year transition period). Discussions, or negotiations are likely to continue on this important exclusion as it will have a pivotal role in the value of certain incentive regimes like the patent box.
- Interaction with the US foreign profits regime known as GILTI – the way in which the US GILTI regime will co-exist with the global minimum tax rules is still under discussion. In particular, Pillar Two operates on a jurisdiction-by-jurisdiction basis but GILTI takes a blended approach and furthermore, the GILTI rate is currently below the proposed minimum of 15%.
Will this actually happen?
Although substantial progress has been made, significant hurdles remain to be cleared between now and a world in which Pillar One and Pillar Two are fully functional.
- Various jurisdictions remain reticent: several countries out of the OECD’s 139-strong Inclusive Framework have not yet signed up to the deal, most notably Ireland which has used domestic tax policy to support its policy of attracting foreign investment.
- Domestic politics (generally): it is one thing a country agreeing in principle to adopt these measures, but that is really just the beginning. Implementing these proposals will require updates to both domestic legislation and bilateral treaties, the success of which will depend on the political situation in each country.
- Domestic politics (the US): despite the Biden administration’s enthusiasm for the deal, uncertainty over whether the proposals will make their way through the US legislature presents one of the greatest threats to the proposals’ success. The Biden administration is pursuing domestic tax reform at the same time as this international project, and it is not clear that the one can survive without the other. The measures do not enjoy bi-partisan support, and the Senate currently divides 50:50 on party lines (with the Vice President holding a casting vote).
Is this the end of US-EU trade tensions over tax?
Probably not. Despite the progress on the OECD deal and the commitment to repeal domestic DSTs, the EU has been planning to press on with its own “digital levy” (of 0.3% tax on goods and services sold by companies operating in the EU with a turnover of EUR 50m or more), to help finance its post-Covid recovery fund. This has caused tensions with the US in particular who argue that – much like the original Pillar One proposals and DSTs generally – it would discriminate against American tech companies.
The EU recently agreed to postpone unveiling its proposals until October: if progress on global tax reform stalls, it may well be that US-EU tensions on the taxation of the digital economy quickly resurface.