OECD’S ‘GloBE’ PROPOSAL – PILLAR TWO (Tax Challenges of the Digitalisation of the Economy – Part II)

The current international tax
architecture is being exploited with the help of digitalised business models by
the Multinational Enterprises (MNEs) to save / avoid tax through BEPS. To
counter this, the existing tax rules require reconsideration and updation on
the lines of the digitalised economy. Many countries have introduced unilateral
measures to tackle the challenges in taxation arising from digitalisation which
restricted global trade and economy.

Now, OECD has set the deadline of
end-2020 to come out with a consensus-based solution to taxation of
cross-border transactions driven by digitalisation. For this, OECD has
published two public consultation documents, namely (i) ‘Unified Approach under
Pillar One’ dealing with Re-allocation of profit and revised nexus rules, and
(ii) ‘Global Anti-Base Erosion Proposal (GloBE) – Pillar Two’. It is important
to understand these documents because once modified, accepted and implemented
by various jurisdictions, they will change the global landscape of international
taxation in respect of the digitalised economy.

Part I of this article on ‘Pillar
One’ appeared in the January, 2020 issue of the BCAJ. This, the second
article, offers a discussion on the document dealing with GloBE under ‘Pillar
Two’.

1.0 BACKGROUND

Thanks to advances in technology,
the way businesses were hitherto conducted is being transformed rapidly. In
this era of E-commerce, revenue authorities are facing a lot of challenges to
tax Multinational Enterprises (MNEs) who are part of the digital economy. To
address various tax challenges of the digitalisation of the economy, OECD in
its BEPS Action Plan 1 in 2015 had identified many such challenges as one of
the important areas to focus upon. Since there could not be any consensus on
the methodology for taxation, the Action Plan recommended a consensus-based
solution to counter these challenges. OECD has targeted to develop such a
solution by the end of 2020 after taking into account suggestions from the
various stakeholders. Meanwhile, on the premise of the options as examined by
the Task Force on the Digital Economy (TFDE), the BEPS Action Plan 1 suggested
three options to counter the challenges of taxation of the digitalised economy
which could be incorporated in the domestic laws of the countries. It is
provided that the measures to tackle the challenges of taxing digitalised
economy shall not be incompatible with any obligation under any tax treaty or
any bilateral treaty. They shall be complementary to the current international
legal commitments.

OECD issued an interim report in
March, 2018 which examines the new business framework as per the current
digitalised economy and its impact on the international tax system. In January,
2019 the Inclusive Framework group came up with a policy note to address the
issues of taxation of digitalised economy into two complementary ‘pillars’ as
mentioned below:

Pillar 1 – Re-allocation of
Profits and the Revised Nexus Rules

Pillar 2 – Global Anti-Base
Erosion Mechanism

The three proposals suggested under
Pillar 1 are as follows:

(i) New Nexus Rules – Allocation based on sales rather than physical
presence in market / user jurisdiction;

(ii) New Profit Allocation Rules – Attribution of profits based on
sales even in case of unrelated distributors (in other words, allocation of
profits beyond arm’s length pricing, which may continue concurrently between
two associated enterprises);

(iii) Tax certainty via a three-tier mechanism for profit allocation:

(a) Amount A: Profit allocated to market jurisdiction in absence of
physical presence.

(b) Amount B: Fixed returns varying by industry or region for certain
‘baseline’ or ‘routine’ marketing and distributing activities taking place (by
a PE or a subsidiary) in a market jurisdiction.

(c) Amount C: Profit in excess of fixed return contemplated under
Amount B, which is attributable to marketing and distribution activities taking
place in marketing jurisdiction or any other activities. Example: Expenses on
brand building or advertising, marketing and promotions (beyond routine in
nature).

Thus, it highlights potential
solutions to determine where the tax should be paid and the basis on which it
should be paid.

Let us look at the proposals
under Pillar Two in more detail.

2.0 PILLAR TWO – GLOBAL
ANTI-BASE EROSION PROPOSAL (‘GloBE’)

The public consultation document
has recognised the need to evolve new taxing rules to stop base erosion and
profit shifting into low / no tax jurisdictions through virtual business
structures in a digitalised economy. According to the document, ‘This Pillar
seeks to comprehensively address remaining BEPS challenges by ensuring that the
profits of internationally operating businesses are subject to a minimum rate
of tax. A minimum tax rate on all income reduces the incentive for taxpayers to
engage in profit shifting and establishes a floor for tax competition among
jurisdictions.’

The harmful race to the bottom on
corporate taxes and uncoordinated and unilateral efforts to protect the tax
base has led to the increased risk of BEPS, leading to a lose-lose situation
for all jurisdictions in totality. Therefore, the GloBE proposal is an attempt
to shield the tax base of jurisdictions and lessen the risk of BEPS.

Broadly, the GloBE proposal aims
to have a solution based on the following key features:

(i) Anti-Base Erosion and Profit Shifting

It not only aims to eliminate
BEPS, but also addresses peripheral issues relating to design simplicity,
minimise compliance and administration costs and avoiding the risk of double
taxation. Taxing the entities subject to a minimum tax rate globally will seek
to comprehensively address the issue of BEPS. Such a proposal under Pillar Two
will cover the downside risk of the tax revenue of the MNEs globally by
charging a minimum tax rate, which otherwise would lead to a lose-lose
situation for various jurisdictions.

(ii) New taxing rules through four component parts of the GloBE proposal

The four component parts of the
GloBE proposal, proposed to be incorporated by way of changes into the domestic
laws and tax treaties, are as follows:

(a) Income inclusion rule

Under this rule, the income of a
foreign branch or a controlled entity if that income was subject to tax at an
effective rate that is below a minimum rate, will be included and taxed in the
group’s total income.

For example, the profits of the
overseas branch in UAE of a Hong Kong¹  (HK) company will be included in the taxable
income in HK, as the UAE branch is not subjected to tax at the minimum rate,
say 15%. But for this rule, profits of the overseas branch of an HK company
would not have been taxed in HK. Of course, HK may have to amend its domestic
law to provide for such taxability.

Example 1 – Accelerated taxable
income (as given in the public consultation document). In our
opinion, this example throws light on the income inclusion rule.

Application of income inclusion
rule

(b) Undertaxed payments rule

It would operate by way of denial
of a deduction or imposition of source-based taxation (including withholding tax)
for a payment to a related party, if that payment was not subject to tax at or
above a minimum rate.

(c) Switch-over rule

It is to be introduced into tax
treaties such that it would permit a residence jurisdiction to switch from an
exemption to a credit method where the profits attributable to a Permanent
Establishment (PE) or derived from immovable property (which is not part of a
PE) are subject to an effective rate below the minimum rate.

(d) Subject to tax rule

It would complement the
under-taxed payment rule by subjecting a payment to withholding or other taxes
at source and adjusting eligibility for treaty benefits on certain items of
income where the payment is not subject to tax at a minimum rate.

The GloBE proposal recognises the
need for amendment of the domestic tax laws and tax treaties to implement the
above four rules. However, it also cautions for coordinated efforts amongst
countries to avoid double taxation.

3.0  DETERMINATION OF TAX
BASE

The first step towards applying a
minimum tax rate on MNEs is to determine the tax base on which it can be
applied. It emphasises the use of financial accounts as a starting point for
the tax base determination, as well as different mechanisms to address timing
differences.

3.1 Importance of consistent tax base

One of the simple methods to
start determining the tax base is to start with the financial accounting rules
of the MNE subject to certain agreed adjustments as necessary. The choice of
accounting standards to be applied will be subject to the GloBe proposal. The
first choice to be made is between the accounting standards applicable to the
parent entity or the subsidiary’s local GAAP. The next choice is which of the
accounting standards will be acceptable for the purposes of the GloBE proposal.

As per the public document, it is
suggested to determine the tax base as per the CFC Rules or, in absence of CFC
rules, as per the Corporate Income Tax Rules of the MNE’s jurisdiction. Such an
approach will overcome the limitation of the inclusion of only certain narrow
types of passive income. However, it would mean that all entities of an MNE
will need to recalculate their income and tax base each year in accordance with
the rules and regulations of the ultimate parent entity’s jurisdiction. There
can be differences in accounting standards between the subsidiary’s
jurisdiction and the ultimate parent entity’s jurisdiction, and to address the
same the public document recommends that the MNE groups shall prepare the
consolidated financial statements and compute the income of their subsidiaries
using the financial accounting standards applicable to the ultimate parent
entity of the group as part of the consolidation process.

Accounting standards which are
accepted globally can serve as a starting point for determining the GloBE tax
base.

3.2 Adjustments

Financial accounting takes into
account all the income and expenses of an enterprise, whereas accounting for
tax purposes can be different. Relying on the unadjusted figures in accounts
could mean that an entity’s net profits may be overstated or understated when
compared to the amount reported for tax purposes. Most of the differences among
the accounting standards will be timing differences and some of the differences
may be permanent differences or temporary differences that require further
consideration, and some of the timing differences may be so significant that
they warrant the same consideration as permanent differences.

3.2.1  Permanent differences

Permanent differences are
differences in the annual income computation under financial accounting and tax
rules that will not reverse in the future. Permanent differences arise for a
variety of reasons. The need to adjust the tax base may depend upon the level
of blending ultimately adopted in the GloBE proposal. Inclusions and exclusions
of certain types of income and expenses in domestic tax policy may lead to
permanent differences. Thus, consideration for such differences is of utmost
importance while determining the tax base.

Examples of permanent differences

Dividends received from foreign
corporations and gains on sale of corporate stocks may be excluded from income
to eliminate potential double taxation. Under the worldwide blending approach,
the consolidated financial statements should eliminate dividends and stock
gains in respect of entities of the consolidated group. However, under a
jurisdictional or entity blending approach, the financial accounts of the group
entities in different jurisdictions would be prepared on a separate company
basis and dividends received from a ‘separate’ corporation would be included in
the shareholder’s financial accounting income.

Permanent difference also arises
due to disallowance of certain deductions under the domestic tax laws of a
particular jurisdiction, such as entertainment expenses, payment of bribes and
fines, etc.

3.2.2  Temporary differences

Temporary differences are
differences in the time for taking into account income and expenses that are
expected to reverse in the future. It can lead to a low cash effective tax rate
at the beginning of a period and high cash effective tax rate at the end of a
period, or vice versa. A separate blending approach may lead to
difference volatility in the ETR from one period to another. Temporary
differences are very important in determination of the tax base and also affect
the choice of blending.

Approaches to addressing
temporary differences

The public consultation document
on Pillar Two lists three basic approaches to addressing the problem of
temporary differences, namely,

(i) carry-forward of excess taxes and tax attributes,

(ii) deferred tax accounting, and

(iii) a multi-year average effective tax rate.

It also provides that these basic
approaches could be tailored and elements of the different approaches could be
combined to better or more efficiently address specific problems.

4.0 BLENDING OF HIGH-TAX
AND LOW-TAX INCOME FROM ALL SOURCES

According to the public
consultation document, ‘Because the GloBE proposal is based on an effective
tax rate (“ETR”) test it must include rules that stipulate the extent to which
the taxpayer can mix low-tax and high-tax income within the same entity or
across different entities within the same group. The Programme of Work refers
to this mixing of income from different sources as “blending.”’

Blending means the process of mixing
of the high-tax and low-tax income of an MNE from all the sources of all the
entities in the group. Blending will help to calculate the ETR on which the
GloBE proposal is based. It can be done on a limited basis or a comprehensive
basis, from a complete prohibition on blending to all-inclusive blending.
Limited basis will lead to no or less blending (mixing) of income and taxes of
all different entities and jurisdictions. This would restrict the ability of an
MNE to reduce charge of tax applied on all entities across all jurisdictions
through mixing the high-tax and low-tax income.

It is suggested to apply the
GloBE proposal (minimum tax rate rule) in the following manner:

First Step: Determine
the tax base of an MNE and then calculate the Effective (blended) Tax Rate
[ETR] of the MNE on the basis of tax paid.

Second Step: Compare
the ETR with the Minimum Tax Rate prescribed according to the relevant blending
approach.

Third and the final Step: Use any
of the four components as specified in the GloBE proposal to the income which
is taxed below the minimum tax rate prescribed. [The four components as
discussed above are: (i) Income inclusion rule, (ii) Under-taxed payments rule,
(iii) Switch-over rule and (iv) Subject to tax rule].

Determining the Effective
(blended) Tax Rate [ETR] of the MNEs forms the second step in applying a
minimum tax rate rule. It throws light on the level of blending under the GloBE
proposal, i.e., the extent to which an MNE can combine high-tax and low-tax
income from different sources taking into account the relevant taxes on such
income in determining the ETR on such income.

There are three approaches to
blending:

4.1   Worldwide blending approach

4.2   Jurisdictional blending approach

4.3   Entity blending approach.

The above three different
blending approaches are explained in brief below:

4.1 Worldwide blending approach

In this case, total foreign
income from all jurisdictions and tax charged on it are mixed. An MNE will be
taxed under such an approach if the total tax charged on such foreign income of
an MNE is below a prescribed minimum rate. The additional tax charged on such
income will be the liability of an MNE to bring the total tax charged to the
prescribed minimum rate of tax.

4.2 Jurisdictional blending approach

In this case, blending of foreign
income and tax charged on such income will be done jurisdiction-wise. The
liability of additional tax would arise when the income earned from all the
entities in a particular jurisdiction is below the minimum rate, i.e., if an
MNE has been charged lower tax on the income from a particular jurisdiction
than the minimum rate of tax. The sum of the additional taxes of all the
jurisdictions will be the tax liability of an MNE.

4.3 Entity blending approach

Under this approach blending is
done of income from all sources and tax charged on such income in respect of
each entity in the group. Additional tax will be levied on an MNE whenever any
foreign entity in a group is charged with tax below the minimum tax rate
prescribed for that foreign entity.

All three approaches have the
goal congruence of charging MNEs a minimum rate of tax globally with different
policy choices.

In addition, in respect of
blending, the public consultation document on Pillar Two also explains in
detail the following:

(1)   Effect of blending on volatility

(2)   Use of consolidated financial accounting information

(3)   Allocating income between branch and head office

(4)   Allocating income of a tax-transparent entity

(5)   Crediting taxes that arise in another jurisdiction

(6)   Treatment of dividends and other distributions.

5.0 CARVE-OUTS

Implementation of the GloBE
proposal is fraught with many challenges and therefore, to reduce the
complexity and restrict the application, the Programme of Work²,
through its public consultation document, calls for the exploration of possible
carve-outs as well as thresholds and exclusions. These carve-outs / thresholds
/ exclusions will ensure that small MNEs are not burdened with global
compliances. They would also provide relief to specific sectors / industries.

The Programme of Work calls for
the exploration of carve-outs, including for:

(a) Regimes compliant with the standards of BEPS Action 5 on harmful tax
practices and other substance-based carve-outs, noting, however, that such
carve-outs would undermine the policy intent and effectiveness of the proposal.

(b) A return on tangible assets.

(c) Controlled corporations with related party transactions below a
certain threshold.

The Programme of Work also calls
for the exploration of options and issues in connection with the design of
thresholds and carve-outs to restrict application of the rules under the GloBE
proposal, including:

(i)   Thresholds based on the turnover or other indications of the size
of the group.

(ii) De minimis thresholds to exclude transactions or entities
with small amounts of profit or related party transactions.

(iii) The appropriateness of carve-outs for specific sectors or industries.

6.0 OPEN ISSUES

There are several open issues in
the proposed document, some of which are listed below:

6.1 Appropriate Accounting Standards

Determination of tax base is the
starting point to apply measures given in the GloBE proposal. Thus, the use of
financial accounting is the basis to determine the tax base. Hence, the issue
could be, which of the accounting standards would be appropriate and
recommended for determining the tax base across various jurisdictions?

6.2 Non-preparation of consolidated accounts by smaller MNEs

There can be some instances when
smaller MNEs are not required to prepare consolidated accounts by the statute
for any purpose. In such a case where the information is not consolidated, how
will the tax base be determined?

6.3 Compliance cost and economic effects

The blending process,
irrespective of the policy approach, will have a lot of compliance costs which
may even exceed the economic benefit out of the process. How does the GloBE
proposal deal with this?

6.4 Changes in ETR due to tax assessments in subsequent years

MNEs operate in different
jurisdictions and each jurisdiction may have different tax years, assessment
procedures and so on. It is very likely that tax determined for a particular
year based on self-assessment may undergo significant change post-assessment or
audit by tax authorities. This may change the very basis for benchmarking of
ETR with a minimum tax rate. There should be a mechanism to make adjustments
beyond a tolerable limit of variance.

7.0 CONCLUSION

OECD had asked for public
comments on its document on GloBE not later than 2^nd December, 2020.
However, there are several areas yet to be addressed which are ambiguous and to
find solutions to them within a short span of time till December, 2020 is
indeed a daunting task. However, it is also a fact that in the absence of
consensus and delay in a universally acceptable solution, more and more
countries are resorting to unilateral measures to tax MNEs sourcing income from
their jurisdictions.

In this context, it is important
to note that vide Finance Act, 2016 India introduced a unilateral
measure of taxing certain specified digitalised transactions by way of
Equalisation Levy (EL) @ 6%. The scope of EL is expanded significantly by the
Finance Act, 2020 by providing that E-commerce operators, including
facilitators, shall be liable to pay EL @ 2% on the consideration received
towards supply of goods and services.

Determination
of a tax base globally on the basis of consolidated profits is a very complex
process. To give effect to all the permanent and temporary differences while
determining the tax base along with blending of income from different sources
from all jurisdictions will be a challenging task for the MNEs. It is to be seen
how effectively the four components of the GloBE proposal, individually and in
totality, will be practically implemented. The success of the GloBE proposal
also depends upon the required changes in the domestic tax laws by the
countries concerned. The cost of compliance and uncertainty may also need to be
addressed. A higher threshold of revenue could take care of affordability of
cost of compliance by MNEs, whereas clear and objective rules may take care of
uncertainty.