The G7 and reforms of the international tax system
The Political Context
The announcement that the G7 has reached agreement on reform of the international rules governing corporation tax was met with much fanfare. The Chancellor of the Exchequer, Rishi Sunak described the agreement as “historic” while the US Treasury Secretary, Janet Yellen, described it as a "significant unprecedented commitment".
Others have argued that the implications of what has been announced may be somewhat limited, suggesting that some major multinational companies may be unaffected and that the additional revenue raised will be limited. Gordon Brown, for example, has said that the G7 “needs to do better on taxing multinational companies than it did with this weekend’s deal”.
This suggests that even if the G7 package is agreed by the G20 in Venice in July, accepted by the Organisation for Economic Co-operation and Development (OECD) governments as a whole and ratified by national legislatures (with particular attention focused on the US Congress and Senate), the debate about corporation tax and multinationals will not be over.
At present, we have just one paragraph from the G7 Finance Ministers Communiqué (the Communiqué) setting out the terms of the agreement. My colleague Rhiannon Kinghall Were, sets out below an analysis of the G7 proposals and what this may mean. Before turning to the details, it may be helpful to set out the context to the agreement.
The G7 agreement is the culmination of eight years of work led by the OECD. The Base Erosion Profit Shifting (BEPS) project began in 2013, with the UK Government having been instrumental in focusing the G8 and G20 on the issue of multinational companies and corporation tax, an agenda with which, as then Exchequer Secretary to the Treasury, I was closely involved.
In the years running up to the BEPS project launch, there had been growing disquiet about the tax affairs of large multinational companies, particularly US-based technology companies. The House of Commons Public Accounts Committee held a number of prominent enquiries, initially into the effectiveness of HMRC in collecting tax but increasingly the focus was on behaviour by the multinational companies.
HMRC were placed in a difficult position. Taxpayer confidentiality meant that it was not in a position to give detailed assurances that it had been effective in collecting the tax due but, as the hearings continued, it was clear that the real criticism was that amount of tax due under the law appeared to be disproportionately small for large businesses with significant revenues from UK customers.
HMRC, of course, could only collect the tax that was due under the law. If businesses operated a strategy of maximising market share at the expense of realising profits, corporation tax liability could be legitimately very small or non-existent. It is also the case that the international tax system operates on the basis of profits being attributed to where the value was added which, in this context, placed much more weight on where technology was developed than the location of the customers. In other words, the activities that occurred in the UK, such as fulfilment, were low margin activities for which low levels of profit could be attributed.
If the profits from UK activities did not belong in the UK, where did they belong? This is where critics of the international tax system had a very good case. Rather than paying corporation tax on profits made from sales in the UK to the UK tax-collectors, tech companies appeared to be able to avoid paying profits anywhere, at least until such profits were repatriated to the US. The US tax system essentially operated as an export subsidy as US firms paid tax on domestic profits but not overseas profits. UK-based competitors to US tech companies (including newspaper groups who were rapidly losing advertising revenue to the tech giants) understandably felt aggrieved and made their views very clear.
The public outrage left the UK Government with a political problem. At a time of tight public spending constraint and rising taxes, there was a strong sense of injustice that large tech companies were not paying their “fair share”. The Government was left with a choice. It could take unilateral action or seek to change the international rules. The former risked undermining an international system that provided certainty and facilitated cross-border activity. The latter would take several years to deliver with a substantial risk that nothing would be done, given the difficulties involved in reforming the US corporate tax system in particular.
In the event, the UK Government attempted both – legislating for the Digital Services Tax and initiating the BEPS process. The Digital Services Tax was set to raise relatively modest sums of revenue but indicated a willingness to take action (it also polled extraordinarily well) and increased pressure on the US Government. Similar taxes were announced for France, Italy and Canada.
The objective of most countries, including the UK, in the BEPS process was to ensure that greater weight was placed on the location of the customer as opposed to the location of where the technology was developed. Despite several years’ worth of work and 15 focus areas for action to fix base erosion and profit shifting (the avoidance bits) the question of how the international tax system should evolve to address the digitalised economy was initially unanswered. Fast forward 5 years and the OECD continued to work in this field and produced two blueprints (Pillar 1 and Pillar 2) reporting on the tax challenges arising from digitalisation. Pillar 1 focused on the very question of how a business can generate profit in a country but have very little presence. But the difficulty here was that the US – the jurisdiction in which tech companies were based and where most of their research and development was undertaken – would lose out if overseas profits were taxed on that basis.
As a consequence, there was little optimism about international agreement until the Biden administration came forward with a “grand bargain”. In exchange for making concessions on Pillar 1, the US was now pushing for minimum tax rate under Pillar 2 of BEPS. This would make it harder for overseas profits to be sheltered in tax havens and help protect the US (which is increasing its corporation tax rate from 21% to 28% ) from tax competition. The calculation the US has made is that it will gain more from the Pillar 2 reforms than it will lose from Pillar 1. The calculation made by the other members of the G7 is that they will gain from Pillar 1 and, given that none of them have a rate below 15% (the proposed minimum rate), the loss of tax sovereignty is theoretical and a price worth paying. They will also be required to drop any proposed Digital Services Taxes but this will maintain a multilateral international tax system.
The losers from the agreement, it is assumed, will be the tech companies (although at least they gain greater certainty) and tax havens.
As stated above, there remains scope for the agreement to flounder. It is assumed that all Republican senators will oppose this, so it will require just one Democrat senator to rebel for there to be no Senate majority to pass the necessary legislation. Nor is it guaranteed that all G20 countries will be supportive. Nonetheless, the weekend’s agreement does appear to be a significant breakthrough.
Does this mean that the controversies about the tax paid by multinational tech companies will be behind us? Almost certainly not. The G7 agreement on Pillar 1 only applies to 20% of profit exceeding a 10% margin. Given the frequent confusion in this debate between revenues and profits, companies with very large revenues but low levels of profit will find themselves excluded. It is also the case that, notwithstanding Pillar 1, the reforms as a whole will mean that much of the additional tax that will be paid will not go to where the customers are based. All of this suggests that, at the point at which the Office for Budget Responsibility forecasts the additional UK tax revenue to be raised as a consequence of this agreement, the likelihood is that the numbers involved will be relatively, and controversially, small.
What has been agreed
What can we take from the 150 words in the Communiqué? As David says, the agreement is based on two pillars. It has been agreed that both pillars need to progress in tandem otherwise there is no deal. This has been an important part of the negotiating process, with the interests of certain countries tied to a particular pillar based on the relative tax revenue that might perceivably be available. Without Pillar 1, the UK was not interested in a deal. And without Pillar 2, the US was willing to walk away.
The Communiqué tells us little about how the rules work, however, a lot can be inferred from the work that the OECD has undertaken that has led to this announcement.
Taking Pillar 1 first. Here there is a commitment to designing a new allocation of taxing rights to market jurisdictions. The century old rules based around notions of physical presence of things and people can no longer accommodate the fact that value can be created (or harnessed) in jurisdictions where both those things are absent. Many modern businesses can operate in their market jurisdictions without any physical presence therein (of people or things), resulting in value-creation without corresponding taxation. This new taxing right will overlay existing rules and give a share, the top slice of profits if you will, to the jurisdiction where customers or users are based rather than where the IP or headquarters sit.
Only the largest and most profitable companies will be caught by Pillar 1. This is a departure from the original OECD proposals that sought to target digital services and consumer facing businesses, potentially casting its net to some 2,300 businesses. In recent correspondence with the OECD, the US set out some modelling to demonstrate that by having a non-sectoral approach but targeting only 100 of the largest and most profitable global companies the rules could be vastly simplified and still bring in the same revenue as the original blueprint. The G7 agreement signals that this is the direction of travel which means digital services and consumer facing businesses will no longer be singled out and the rules will apply irrespective of sector and business model. This approach will antagonise some countries in the G20/OECD Inclusive Framework as the solution may not be seen as targeting digital companies, and some countries may now lose revenue to market jurisdictions that they had not anticipated. It remains to be seen whether the rules will apply to 100 companies or if in negotiation this expands. Furthermore, a number of exemptions were trailed, including for financial services, in the initial blueprint and it remains to be seen if the principles around these exemptions withstand negotiations.
The new regime targets companies that have a profit margin of at least 10%. This will raise another point for wider negotiation if companies, like Amazon with low profit margins, slip through the net. Amazon typically makes heavy investments in its business to grow its market share and at the heart of the business it is ultimately low-margin retail. The US Treasury secretary, Janet Yellen, did signal that Amazon would be caught by the rules and so the next layer of detail is needed to understand if some form of segmentation will be added which could mean the more profitable part of a business, for example Amazon Web Services in the case of Amazon, would be caught.
Market countries will be awarded taxing rights on at least 20% of profit exceeding the 10% profit margin threshold. There are no details on how that profit will be allocated. It will be necessary to determine which market jurisdictions are eligible to receive a proportion of profits. The OECD blueprint wanted to identify which businesses had an “active and sustained” participation in a jurisdiction beyond the mere conclusion of sales. The main indicator was revenue but even this was acknowledged as a blunt tool and its use as an indicator could vary sector to sector. A number of additional indicators “plus factors” were also proposed including activity or personnel linked to supporting those sales and / or advertising and promotion.
The final part of negotiations for Pillar 1 will be to determine how to calculate the profit. The definition of accounting and taxable profits differs from country to country and so it will be necessary to have a standardised measure to determine the amount that can be allocated to the market jurisdiction. The rules will also need to take into account losses on a carried forward basis – and again countries have varying rules around this which will no doubt be a point for negotiation.
Moving to the second pillar. Pillar 2 seeks to put a floor on the race to the bottom by introducing a new global minimum tax rate. As David has highlighted, the US wants to shelter its higher corporate tax rate from being undercut by low tax countries. A rate of least 15% has been agreed by the G7. The Communiqué does not expand on this, but the rules are designed to provide parent company jurisdictions that have signed up to the protocol with the right to tax income where it is taxed below an agreed minimum rate. These rules are expected to apply to large groups with consolidated revenue in excess of €750m and to a wide range of businesses except for certain excluded sectors (such as investment funds and shipping).
The key point lost in a lot of the coverage is that the global minimum rate will compare the effective tax rate to the globally agreed amount (of at least 15%). This is different to the headline rate. This is due to a number of adjustments that are made in the calculation of profit subject to corporation tax. This can vary from disallowing fines and client entertainment to allowing (or incentivising) certain expenditure such as R&D. The effective tax rate will also take into account certain regimes like the Patent Box (where a favourable rate of tax (10%) is offered in the UK) or other incentives associated with the Freeports. The detail associated with a workable global minimum tax and various countries tax incentives will be subject to discussion. The G20/OECD Inclusive Framework will need to agree a standardised approach to calculating taxable profits but in reaching a consensus countries may feel they lose an element of their sovereignty over their tax base to attract foreign investment. This means a very political part of the negotiations is still to take place.
The global minimum tax rate will operate on a country by country basis. This means that a group with subsidiaries in a mixture of low and high tax countries will not be able to take a blended approach. In effect this means it will be necessary to test the effective tax rate in each jurisdiction.
The headlines have focused on whether a global rate of 15% is ambitious enough. The first thing to point out is that the Communiqué states “at least 15%”. This suggests there is room for manoeuvre with further negotiations (the French Finance Minister, Bruno Le Maire has said this is a “starting point”). Indeed, the rules may allow countries to impose a higher rate on their own accord but of course, by doing so, countries would reduce the attractiveness as a location for headquarters so this may not be a universally popular strategy.
Although the G7 have snatched the headlines, much is left to be decided and it is anticipated that the G20/OECD Inclusive Framework will play an active part in the final discussions to ensure the rules benefit as many countries as possible, irrespective of how developed the economy is or the size of the country. Given the detail still to be published on these rules, you could say that the most political questions are yet to be answered.
Rhiannon Kinghall Were