29 Apr International Tax Reform: A Solution in Search of a Problem
Annalise Foong of Future-Moves Group discusses the progress of the negotiations towards international consensus on tax rules, including the recent proposals by the U.S., and considers the challenges ahead.
At center stage of this discussion are two major pillars that have been the focal point of discussion at the Organization for Economic Cooperation and Development (OECD) since 2019. Conceptually, the two pillars neatly address the two dimensions that drive a multinational enterprise’s (MNE’s) global tax bill—that is, where profits are taxed, and at what rate.
The first, “Pillar One,” relates to the taxation of profits derived by large MNEs engaging in Automated Digital Services (ADS) and/or Consumer Facing Businesses (CFB) in market jurisdictions. In essence, Pillar One proposes that the profits of large MNEs be (re)allocated to market jurisdictions and subject to taxation.
These proposed rules were designed to overcome a gap in the international tax system that allowed large MNEs to pay no tax due to the absence of a physical presence, despite having a business presence and activities in a local jurisdiction. Typical examples would include online advertising service providers, social media platforms and digital content service providers.
The second pillar, “Pillar Two,” recommends 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 MNE falls below a predetermined threshold.
The goal is for the Inclusive Framework (a group of 139 countries) to achieve consensus for Pillars One and Two under the OECD’s leadership by July 2021.
Taxation Reform of the Digitalized Economy: Challenges
As difficult as the mission of revolutionizing international tax rules may be, the inherent complexity has been compounded by diverging political interests and time pressures, exacerbated by Covid-19 fiscal pressures.
First, the scope of the Pillar One rules has been the subject of contention. Depending upon the composition of large corporates in each jurisdiction, there has been no agreement on how wide the scope of the rules should be. For instance, a narrow focus on automated digital services would hit U.S. technology companies without giving the U.S. the opportunity to recoup taxes from sectors.
The U.S. has therefore been advocating for a wide scope, to ensure a reciprocal opportunity to collect taxes. Meanwhile, other countries have pushed for a narrow scope which would exclude CFB from the scope of Pillar One rules. As a result, even after two years of intense discussion, the scoping rules remain a critical open item.
Second, we have already seen a proliferation of countries applying unilateral taxes on digital services, which will result in double taxation under the new proposals. In response, the U.S. Trade Representative has found such unilateral taxes to be discriminatory against U.S. companies, and the U.S. has responded in kind by imposing additional tariffs against the offending countries. With this, we have the ingredients necessary for a trade war.
In response, the OECD and the Inclusive Framework have been working at a feverish pace in a heroic bid to achieve a finely-tuned balance to bring the world back from the brink of a trade war.
The OECD-led Inclusive Framework is now racing towards the July 2021 deadline to achieve political agreement on the two-pillar solution to the tax challenges of digitalization. So far, deliberations have been fraught with complex technicalities, stakeholder management and to a large extent, political bartering. During the negotiation process, which has taken more than two years, the U.S. has been an influential actor, coming on stage and leaving with dramatic flair at various intervals to either stall discussions or more recently propel discussions forward with new proposals.
On April 5, 2021, we saw the first act of the international tax reform play in the form of U.S. Treasury Secretary Janet Yellen’s proposal for a global minimum corporate tax rate. The second act arrived less than a week later, with more substantive proposals from the U.S. relating to taxation of the digitalized economy, but now with a diminished target audience.
The latest Pillar One proposal from the U.S. suggests a simplified approach, whereby all types of MNEs, with some carve outs, will be subject to the scope of Pillar One. Instead of scoping by business activity, a revenue and profit margin threshold would apply to ensure that only the largest and most profitable corporate giants are taxed. On the face of it, this approach strips much of the complexity out of the equation and would presumably result in an outcome which the U.S. would not consider as “discriminatory against U.S. firms.”
It is no surprise that the simplified approach has received endorsement from the U.S. technology companies (Netflix, Spotify and Snap Inc.), as technology companies which have been within the scope of Pillar One would have had to grapple with the complexity of Pillar One proposals.
On the Pillar Two front, there have also been calls from the U.S. for a minimum 21% rate—aligned with its proposed Global Intangible Low Tax Income (GILTI) tax rate, incidentally—which has met with pushback from EU lawmakers and could potentially delay global negotiations. David Malpass from the World Bank recently went further, warning world leaders against setting a global minimum tax rate for companies that is so high that it hinders the ability of poor countries to attract investment.
Dangers of Simplification
Complexity was called out as an issue that needed to be resolved during the OECD Public Consultation sessions on Pillars One and Two in January 2021. Simplification was needed, a call which the OECD heeded.
However, there is a real danger that an oversimplified response to the complex challenge of the digitalized economy will produce a political agreement that fails to achieve a solution.
Pillar One Perspective
The latest U.S. Pillar One proposal relies on quantitative criteria to scope in the largest and most profitable MNE groups, regardless of industry classification or business model. The intention is to focus only on those companies that benefit most from global markets, are most intangibles-driven, and are best-equipped to handle the compliance burden that Pillar One entails.
Accordingly, if we start from the premise that the solution should be responding to a problem, this solution assumes that the original sin was a general failure to allocate profits arising from intangibles to market jurisdictions.
However, there are two key issues with such a broad-based premise.
First, the main driver behind the Pillar One proposal was to derive a harmonized and multilateral solution to address the challenges of the digitalized economy. In return, countries would be persuaded not to rescind or refrain from imposing unilateral digital services tax and similar unilateral measures.
A Pillar One solution that does not specifically address digital services within its scope is unlikely to dissuade unilateral digital services taxation from becoming the mainstream avenue for countries to capture the share of the digital tax pie.
Second, any solution that is broadly framed to address the failure to tax intangibles in the appropriate jurisdictions—such as the U.S. proposal—will require a robust mechanism to allocate revenue to the respective jurisdictions. Currently, the revenue sourcing rules specific to ADS and CFB have been developed, but developing revenue sourcing rules for other sectors, especially those which have no identifiable end users, will be challenging.
As Pillar One is based upon a formulaic allocation methodology, all aspects of the methodology that relied on predetermined thresholds, such as the profitability and reallocation percentage, will need to be considered in context of all sectors, not just ADS and CFB.
It is arguable the current U.S. proposal is for not more than the largest 100 corporate giants, hence a tailored solution could be agreed upon. However, both fluctuations and revenue and profit levels and potential changes to the threshold that is currently proposed, means that the solution will need to be more robust.
Pillar Two Perspective
From a Pillar Two perspective, on the face of it the global minimum tax rate proposal may discourage profit-shifting activities. However, there are two underlying issues, in particular when a high minimum rate is applied.
First, while harmful tax competition should clearly be addressed, a global tax rate at 21% will not only wipe out fair competition but will be punitive for many countries at a time when they are already struggling to cope with the fiscal impact of the Covid-19 pandemic.
Furthermore, since 2019 the international tax community has already made significant progress to address harmful tax practices and base erosion activities. The measures that have been put in place are sophisticated and address the underlying issues, such as increased transparency and directly addressing anti-avoidance practices.
Second, there are many factors beyond tax rates that affect tax morale and tax compliant behavior. The OECD’s report “What Drives Tax Morale?” mentions that tax-compliant behavior is influenced by satisfaction with public services and expenditure, trust in government, and perceptions of corruption. Thus, countries which have efficient public systems and high levels of compliance do not need to resort to excessive tax rates. In turn, compliant behavior is seen in countries which are open, transparent and trusted.
Investment Hub Position
The OECD’s October 2020 Impact Assessment recognized that the two-pillar solution would have differing consequences for countries depending on the income level of the country. Investment hubs were separately analyzed as a category, albeit with the unfortunate characterization of countries which impose no corporate taxation along with those which have a minimum rate of 10%.
The latest proposals potentially serve as a double hit to investment hub locations, including economies known for simulating trade and productivity such as Hong Kong, Ireland, Luxembourg, Netherlands, Singapore and Switzerland. Focus has already been building on the impact of a global minimum tax rate to the economies of countries which have traditionally had lower statutory tax rates and provided tax incentives.
The second proposal—i.e. to widen the scope of Pillar One—may further exacerbate the impact as Pillar One rules result in reallocation of profits and the associated taxes out of the investment hub locations. Lower taxes in the hub or principal location arising from the profit reallocation to market jurisdictions further reduce the effective tax rate, potentially below the minimum rate.
Investment hubs by nature need to attract investments, and lower statutory corporate tax rates and tax incentive regimes are understandably part of their policy toolkits. Each of the major investment hubs have long been committed to meeting international tax standards specifically designed to address BEPS concerns.
Such countries also have tax incentive regimes in place that are subject to rigorous peer review and have undergone reforms made to ensure that these incentives are fully compliant. This is not a sign of harmful tax competition and does not justify aggressive measures such as global minimum corporate tax rates set artificially high.
The recent return of the U.S. to the negotiating table has put the spotlight on the ongoing Pillar One and Pillar Two negotiations. On the surface, the U.S. two-pillar solution does seem neat and tidy: it would achieve simplicity, as well as a global minimum tax rate that is aligned with the U.S. GILTI effective rate.
Assuming that this is the magic formula to achieve political agreement in time for the G-20 meeting in July 2021, that would almost certainly not be the end of the story. Without a solution that directly addresses the digitalized economy, countries are unlikely to agree to retract unilateral digital services taxes, leaving the door open for inevitable trade wars as the U.S. takes action against countries which implement digital service tax measures.
Of even greater concern is the excessive global minimum tax rate of 21% that has been proposed. While there have been no impact assessments performed on the potential implication of a 21% global minimum tax rate (the OECD’s October 2020 Impact Assessment assumed a maximum of 17.5%), it would be safe to conclude that both investment hubs and developing countries will be on the losing end of this political tussle.
If we are to come out of the U.S. proposal with anything, it would be that the scope of Pillar One needs target a smaller group of companies. Calls for a higher Pillar One revenue threshold and a phased introduction are not new and are more likely to address the original challenge of the digitalized economy.
For now, all eyes will be focused on the Pillars One and Two stage. MNEs welcome simplicity in the proposals; however, it would seem incongruent for simplicity to be taken to the point that we ignore the complex and varied business environment that will be the very subject of taxation.
After more than two years of difficult negotiations by the OECD and Inclusive Framework, it would be unfortunate if political pressures lead us to win the battle but lose the war by achieving an agreement that fails to solve the problem.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Annalise Foong is the Director of Financial and Tax Advisory at the Future-Moves Group. She has extensive experience in this field, in particular with a focus on Compliance, Tax Policy and Transaction Advisory. If your organisation is grappling with a complex tax puzzle and looking for professional and practical consultancy support, do get in touch at email@example.com.