As the OECD continues its efforts to find agreement on an international digital tax framework, Annalise Foong of Future-Moves Group provides a view on the challenges which lie ahead.
On October 12, 2020, the widely anticipated formal blueprints to the Organization for Economic Co-operation and Development (OECD) Pillars 1 and 2 were released to the public, marking the start of the public consultation exercise that will run through to December 14, 2020. The initial timeline for an agreement by the end of 2020 has shifted to a goal to “bring the process to a successful conclusion by mid-2021.”
Large global multinationals will have a chance to be part of the final rule design through the public consultation exercise. The need to achieve a balance between fundamental tax principles and simplification, if possible devoid of any political considerations, will be on the minds of many: and, more pragmatically, an awareness of the potential practical consequences of the changes that are coming in the foreseeable future.
Pillar 1 establishes new nexus rules permitting taxation in a foreign country even in absence of a physical presence, as long as there is sustained engagement via digital economies and consumer-facing businesses. Pillar 2 provides a global minimum tax regime through a complex web of rules that are intended to trigger a top-up tax when the effective tax rate of a large multinational falls below a predetermined threshold.
The lead-up to the blueprints has not been easy. Each milestone of the Pillars 1 and 2 blueprints has been accompanied by rewriting long-established principles of international tax and transfer pricing rules. Major economies have asserted their rights and made their positions known in the debate on the complex web of international mechanisms that could apply under both Pillars. In particular, in the case of Pillar 2, there is an implicit bargain, an agreement seemingly to forgo a country’s tax sovereignty through a consensus-based global minimum tax rate in return for a bigger share of the tax pie.
The Global Response
The OECD’s Director of the Centre for Tax Policy and Administration, Pascal Saint-Amans, has explained the conflict between the way Pillars 1 and 2 rules work and tax sovereignty, which he referred to as the “tax paradox.” This “tax paradox” represents the desire for countries to protect their sovereignty (with tax at the core), yet at the same time, in absence of coordination and multilateralism, tax sovereignty is undermined.
Bartering has been a mainstay throughout the Pillar 1 journey: the most prominent being the U.S. conceding taxation of automated digital services under Pillar 1 in exchange for consumer-facing businesses to be in scope as well. On the other side, the EU has advocated that the focus of Pillar 1 should be on automated digital services. In each case, the respective member country’s share of the tax pie was a driving theme.
The responses from countries have been mixed. An attitude of quiet acquiescence has featured in the response to each development that has eroded established international tax and transfer pricing principles. As the U.S. and France have held a fragile truce in the impending trade war, it seems that those who wish to dwell on principles are seeking a luxury that would threaten the real imperative of finding a solution.
Even though the 137 Inclusive Framework members have continued to negotiate on an equal footing, the cost of compromise will not be equally borne. The OECD’s impact assessment that was released on October 12 concluded that under Pillar 1, it is expected that low-, middle- and high-income economies would benefit from revenue gains, while investment hubs would lose tax revenues.
Under Pillar 2, significant increases in corporate income tax revenues would occur across low-, middle- and high-income economies. The report goes on to acknowledge that there is a high degree of uncertainty on the impact of Pillar 2 on investment hubs due to its being a relatively heterogenous group of countries.
However, even if investment hubs derived a loss in tax revenues, the adverse impact of the measures would have been perceived to be justified, based upon preliminary findings in the OECD’s Corporate Tax Statistics released in July 2020. The report concluded that there is a misalignment between where profits are reported and the location where economic activities occur, with multinationals in investment hubs reporting a relatively higher share of profits compared to their number of employees and tangible assets, thereby suggesting the presence of base erosion and profit shifting (BEPS) behavior.
However, on a closer look, things may not be what they seem. The way in which the statistics were arrived at, including the approach of placing investment hubs and tax haven jurisdictions in the same category for analysis, dismisses a few key facts. Firstly, the majority of the investment hubs had met the BEPS Action 5 minimum standards and were found through the OECD’s peer review program to have legitimate preferential tax regimes that do not contravene BEPS principles. Secondly, the majority of the investment hubs under review were high-income jurisdictions, and, like other high-income jurisdictions, would have a relatively high share of profits as compared to their share of tangible assets.
The bias towards Pillar 1 and 2 outcomes that will favor the bigger players was revealed as Pascal Saint-Amans commented as follows:
“in a global economy if a government wants to stick to its local sovereignty without any interaction with the others, this sovereignty will remain nominal but not real because it will be undermined by the tax offer of investment hubs and smaller economies. Large countries understand that it was their interest to cooperate and have multilateralism to protect their sovereignty.” (emphasis added)
The fallacy in this statement is the implication that the offer of tax incentives by investment hubs in itself undermines the sovereignty of larger countries. However, this is not the case when tax incentives are properly designed to avoid artificial profit shifting, as has been the case of investment hubs which have passed the peer review process under BEPS Action 5.
Challenges Ahead
We are now at the start of the public consultation period after the release of the Pillars 1 and 2 blueprints, ready for fundamental shifts in the way how tax is managed globally. The blueprints will represent the outcome of a remarkable process, especially the OECD’s ability to pave the way for 137 members to connect through the BEPS process. The magnitude of this task cannot be understated but the question remains—whether a better outcome that respects established tax principles could be achieved instead of the aftermath of a political tussle for tax revenue?
On a pragmatic level, the complexity required to administer both Pillars will require intense investment in organizational resources.
Pillar 1 relies on multiple steps to determine whether specific thresholds are met before the allocation of residual profits to the market jurisdiction based upon a formulaic approach. Thus, whilst formulas are used to drive a “simple” solution, the components of how the formula works remain open for interpretation. Risks of multinationals will potentially be heightened in applying the formulaic rules to financial information that could be subject to challenge. This needs to be managed with extreme care.
Pillar 2, which has been subject to less controversy, has greater technical complexity. Pillar 2 rules require conceptualization of new domestic and international tax rules. First, to determine whether the minimum tax threshold is met, multinationals need to be able to ascertain their existing effective tax rate. Subject to the outcome of final negotiations, a strong preference from Inclusive Framework members is currently to apply the test on a jurisdictional basis. The resulting process of dissecting consolidated financials in order to attribute adjustments to tax base and covered taxes to underlying jurisdictions will leave tax functions grappling with both accounting and tax technicalities.
Where existing (likely jurisdictional) effective tax rates are identified as falling below the minimum tax rates, the technical rules required to ascertain how the top up tax is to be administered will require complex interactions between tax treaties, domestic and international tax rules.
The tax principles that practitioners once knew will never be the same. Practitioners will move from an international tax system with the logical sequence of applying domestic rules first, followed by international tax rules and tax treaties, to a world where the domestic rules are contingent upon the rules and treaties of an international counterpart.
For instance, Pillar 2 feature four components that are to be applied based upon a predetermined priority. The applicability of the “undertaxed payment rule” in a source country will depend on a hierarchy of rules starting with the source country’s tax treaty adoption of the “subject to tax rule” and whether entities further up the chain adopt the “income inclusion rule.” In turn, the application of the rules and the resulting tax credits will have iterative impacts on the initial question of whether the minimum tax has been paid.
Going Forward
Two important things cannot be understated as we are approaching the finishing line.
First, large multinationals by now need to be fully aware that, with Pillar 2 in particular, this is not an issue that is isolated to the tax function but also has a wider organizational ramification.
Second, large multinationals cannot lightly forgo this opportunity to have their voices heard, so that the remnants of established tax and transfer pricing principles could prevail, especially those who have an interest in ensuring that smaller countries receive fair consideration.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
This article originally appeared in Bloomberg Tax.