Digitalisation and globalisation have had a profound impact not only on the world economy, but also on the lifestyles of people. Digitalisation and the advent of Artificial Intelligence have further accelerated the impact in the 21st century. These changes have brought with them challenges to the age-old taxing rules of international business income which have resulted in multinational enterprises (MNEs) not paying their fair share of tax despite their huge profits.
In 2013, the OECD ramped up efforts to address the challenges in response to growing public and political concerns about tax avoidance by large multinationals. Implementation of the 15 Action Plans of the BEPS package, agreed to 2015, is well underway, but gaps remain. Globalisation has aggravated unhealthy tax competition.
In March, 2018, the OECD released the document Tax Challenges Arising from Digitalisation — Interim Report, 2018 as a follow-up to the 2015 final report on Action 1 of the project on Base Erosion and Profit Shifting. The 2018 Interim Report did not include any specific recommendations, indicating instead that further work would be carried out to understand the various business models in existence in the digital economy.
In January, 2019, the OECD released a Policy Note for renewed international discussions to focus on two ‘pillars’: one pillar addressing the broader challenges of the digitalization of the economy and the allocation of taxing rights, and a second pillar addressing remaining BEPS concerns. Following the Policy Note in February, 2019, the OECD released a Public Consultation Document describing the two-pillar proposals at a high level. The OECD received extensive comments from stakeholders and held a public consultation in March, 2019.
At the end of January, 2020, the OECD released a Statement by the Inclusive Framework on BEPS on the Two-Pillar Approach. With respect to both pillars, the documents included new details on the proposed approaches and identified key issues under consideration and areas where more work was to be undertaken.
In October, 2020, the OECD released detailed reports on the Blueprints on Pillar One and Pillar Two; an Economic Impact Assessment of the Pillar One and Pillar Two proposals; a Cover Statement by the Inclusive Framework on the work to date; future steps and a Public Consultation Document requesting comments on the Blueprints on both pillars.
On 1st July, 2021, the OECD released a Statement on a Two-Pillar Solution to Address the Tax Challenges Arising From the Digitalisation of the Economy (July Statement), reflecting the agreement of 130 of the member jurisdictions of the Inclusive Framework on some key parameters with respect to both pillars.
On 8th October, 2021, the OECD published an updated Statement (October Statement) regarding the conceptual agreement on the Two-Pillar Solution and the framework for the implementation of the same. And 136 out of 140 jurisdictions of the Inclusive Framework have agreed to the October Statement. The four jurisdictions which did not join the October Statement are Pakistan, Kenya, Nigeria, and Sri Lanka.
The 136 jurisdictions which have joined the Two-Pillar Solution represent more than 90% of the world’s GDP. An agreement is reached on a Detailed Implementation Plan that envisages implementation of the new rules by 2023.
The Two-Pillar Solution will ensure reallocation of excess profits of the large and profitable companies based on ‘nexus approach’ and that the MNEs will pay a minimum tax rate of 15%. This solution also aims to address concerns of the developing countries of having a fair share of tax revenue from MNEs who have a large customer base in these countries.
2. ISSUES UNDER THE EXISTING INTERNATIONAL TAXATION RULES
A key part of the OECD / G20 BEPS Project is addressing the tax challenges arising from the digitalisation of the economy which has undermined the basic rules that have governed the taxation of international business profits for the last one century.
The existing international tax rules are based on agreements made in the 1920s and are enshrined in the global network of bilateral tax treaties.
There are two main issues:
(1) The old rules provide that the profits of a foreign company can only be taxed in another country where the foreign company has a physical presence. One hundred years ago, when digital technologies were non-existent and business revolved around factories, warehouses and movement of physical goods, this made perfect sense. However, in today’s digitalised world, MNEs often conduct large-scale business in a jurisdiction with little or no physical presence in that jurisdiction.
(2) Secondly, most countries only tax the domestic business income of their MNEs but not foreign income on the assumption that foreign business profits will be taxed where they are earned.
The growth of importance of intangibles like brands, copyrights and patents, and companies’ ability to shift profits to jurisdictions that impose little or no tax, means that MNE profits often escape taxation. This is further complicated by the fact that many jurisdictions are engaged in unfair tax competition by offering reduced taxation, and even zero taxation, to attract foreign direct investment and its attendant economic benefits.
OECD estimates that corporate tax avoidance costs anywhere from USD 100 to 240 billion annually, or from four to ten percent of global corporate income tax revenues. Developing countries are disproportionately affected because they tend to rely more heavily on corporate income taxes than advanced economies. Lack of global consensus on taxing MNE profits has given rise to unilateral measures at the national level, such as Digital Services Taxes (DST) and the prospect of retaliatory tariffs.
Such an outcome could cost the global economy up to 1% of its GDP. Again, this would hit developing countries harder than more advanced economies. The implementation of the Two-Pillar Solution aims to avoid trade wars, provide certainty and prevent unilateral domestic tax measures that would adversely impact trade and investment.
3. EVOLVING TWO-PILLAR SOLUTION
3.1 Pillar One
Pillar One aims to ensure a fairer distribution of profits and taxing rights among countries with respect to the largest MNEs which are the beneficiaries of globalisation. Tax certainty is a key aspect of the new rules, which include a mandatory and binding dispute resolution process for Pillar One, but with the caveat that developing countries will be able to benefit from an elective mechanism in certain cases, ensuring that the rules are not too onerous for low-capacity countries. The agreement to re-allocate profit under Pillar One includes the removal and standstill of DST and other relevant, similar measures, bringing an end to trade tensions resulting from the instability of the international tax system. It will also provide a simplified and streamlined approach to the application of the arm’s length principle in specific circumstances, with particular focus on the needs of low-capacity countries.
Pillar One would bring dated international tax rules into the 21st century, by offering market jurisdictions new taxing rights over MNEs, whether or not there is a physical presence.
a) Under Pillar One, 25% of profits of the largest and most profitable MNEs above a set profit margin (residual profits) would be reallocated to the market jurisdictions where the MNE’s users and customers are located; this is referred to as Amount A.
b) Pillar One also provides for a simplified and streamlined approach to the application of the arm’s length principle to in-country baseline marketing and distribution activities, referred to as Amount B.
c) Pillar One includes features to ensure dispute prevention and dispute resolution in order to address any risk of double taxation, but with an elective mechanism for some low-capacity countries.
d) Pillar One also entails the removal and standstill of DST and similar relevant measures to prevent harmful trade disputes.
3.2 Certain aspects of Amount A and Amount B
a) Computation of Amount A
Amount A would be computed for in-scope MNEs (i.e., ‘covered entities’ to which Pillar One applies), as 25% of residual profit (residual profit is defined as profit in excess of 10% of revenue) will be allocated to market jurisdictions with nexus using a revenue-based allocation key.
Revenue will be sourced to the end jurisdiction where the goods or services are ultimately used or consumed.
The base profit or loss of the in-scope MNE to be used for computation of Amount A will be determined by reference to the financial accounting income, with a few adjustments. (These rules are yet to be prescribed.)
b) Computation of Amount A in a case where marketing and distribution activities are undertaken in the relevant jurisdiction
In case the relevant market jurisdiction is already allocated a portion of the residual profit, a safe harbour will apply to cap the total residual profits allocated to such marketing jurisdiction under Amount A. Further work is expected to be undertaken to determine this safe harbour.
c) How would tax certainty be achieved for Amount A?
A dispute prevention and resolution mechanism will be introduced to avoid double taxation of Amount A. Such dispute resolution mechanism is expected to be mandatory and binding on jurisdictions. An elective binding dispute resolution mechanism will be made available on issues related to Amount A for developing economies which are eligible for deferral of their BEPS Action 14 review and have no or low levels of dispute. Interestingly, India has agreed to this Clause in the context of Pillar One, despite its consistent resistance to mandatory arbitration.
d) Computation of Amount B
Amount B would be based on the arm’s length return for in-country baseline marketing and distribution activities. The work on simplifying the computation of Amount B and streamlining the same is expected to be completed by the end of 2022. A safe harbour rate or other guidance may be provided for determining arm’s length return to compute Amount B. However, till such time one needs to follow the general principles enshrined in the Transfer Pricing Regulations.
e) How would Pillar One be implemented?
Amount A will be implemented through a Multilateral Convention (MLC) which will be developed and opened for signature in 2022, and Amount A is expected to come into effect in 2023. Unlike the MLI, which although multilateral, amends bilateral tax treaties, the MLC will operate multilaterally and along with the MLI.
3.3 Important elements of Pillar One
i) The scope of Amount A is restated without change as MNEs with a global turnover above €20 billion and profitability above 10% of profit before tax. These thresholds will be calculated using an average mechanism (yet to be described in detail).
ii) Amount A will allocate 25% of ‘residual profits’, which is defined as profit before tax in excess of 10% of revenue, to market jurisdictions with nexus using a revenue-based allocation key.
iii) A mandatory and binding dispute resolution mechanism will be available for all issues related to Amount A. For certain developing countries, an elective binding dispute resolution mechanism will be available. The eligibility of a jurisdiction for the elective binding dispute resolution mechanism will be regularly reviewed. If a jurisdiction is found to be ineligible, it will remain ineligible in all subsequent years.
iv) The removal of all DSTs and other relevant similar measures with respect to all companies will be required by the Multilateral Convention (MLC) through which Amount A is to be implemented. No newly-enacted DSTs or other relevant similar measures will be imposed on any company from 8th October, 2021 and until the earlier date of 31st December, 2023 or the coming into force of the MLC.
v) The October Statement reiterates that the MLC through which Amount A is implemented will be developed and opened for signature in 2022, with Amount A coming into effect in 2023.
3.4 Pillar Two
Pillar Two aims to discourage tax competition on corporate income tax through the introduction of a global minimum corporate tax rate of 15% that countries can use to protect their tax bases (the GloBE rules). Pillar Two does not eliminate tax competition, but it does set multilaterally agreed limitations on it. Tax incentives provided to spur substantial economic activity will be accommodated through a carve-out. Pillar Two also protects the right of developing countries to tax certain base-eroding payments (like interest and royalties) when they are not taxed up to the minimum rate of 9%, through a ‘subject to tax rule’ (STTR).
Governments worldwide agree to allow additional taxes on the foreign profits of MNEs headquartered in their jurisdictions at least to the agreed minimum rate. This means that tax competition will now be supported by a minimum level of taxation wherever an MNE operates.
A carve-out allows countries to continue to offer tax incentives to promote business activity with real substance, like building a hotel or investing in a factory.
3.5 Pillar Two seeks to reduce tax competition and protect tax base by introducing a minimum global corporate tax. It consists of the following:
i) An Income Inclusion Rule (IIR) which imposes a top-up tax on a parent entity in respect of the low-taxed income of a constituent entity;
ii) An Undertaxed Payment Rule (UTPR) which denies deduction or requires an adjustment to the extent the low-taxed income of a constituent entity is not subject to tax under the IIR. IIR and UTPR together are called the Global anti-Base Erosion Rules (GloBE);
iii) A treaty-based STTR that allows jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate.
The IIR is to be applied in the country in which the parent is situated, whereas the UTPR and the STTR apply in the case of the subsidiary.
3.6 Which entities are covered?
MNEs that meet the €750 million revenue threshold under BEPS Action 13 (Country-by-Country Reporting) would be subject to the GloBE rules. However, even if the above thresholds are not met, countries are free to apply the IIR to MNEs headquartered in their States.
The exclusion from the GloBE rules also includes Government entities, international organisations, pension funds or investment funds that are Ultimate Parent Entities (UPE) of an MNE Group or any holding vehicles used by such entities.
UTPR will not apply to MNEs in the initial phase of their international activity, i.e., those MNEs whose tangible assets abroad do not exceed €50 million and who do not operate in more than five jurisdictions. Such exclusion is limited for a period of five years after the MNE comes within the scope of the GloBE rules for the first time. For MNEs which are covered by the GloBE rules when they come into effect, UTPR will not apply for five years and the period of five years shall commence at the time the UTPR Rules come into effect.
3.7 Income Inclusion Rule
The IIR will operate to impose a top-up tax using an Effective Tax Rate (ETR) test that is calculated on a jurisdictional basis. The minimum tax rate specified is 15%. Accordingly, in a situation where the constituent entity has not been subjected to tax of at least 15%, the jurisdiction of the parent entity will collect top-up tax.
3.8 Undertaxed Payment Rule
The UTPR applies in a situation where the transaction is not subject to IIR. It allocates top-up tax from low-tax constituent entities. The minimum ETR for the UTPR is 15%.
3.9 Subject To Tax Rule
The members have agreed on a minimum rate of 9% for the STTR and therefore covered payments, which are subjected to tax in the residence jurisdiction at a rate lower than 9%, will be subject to STTR in the payer jurisdictions. [This is a bilateral solution applicable in case of Interest, Royalties and other specified payments. Where a treaty partner country taxes such income below the STTR rate of 9% in its jurisdiction, then the other partner may tax the differential rate so as to ensure that such payments are taxed minimum at the STTR rate.]
3.10 Implementation
As the GloBE rules relate to amendments in domestic tax laws, model rules will be developed by the end of November, 2021 defining the scope and setting out the mechanics of the rules. It is expected that Pillar Two will be brought into law in 2022, to be effective in 2023 and UTPR to apply from 2024. Implementation of the GloBE rules is not mandatory on jurisdictions. However, if such rules are implemented, a common approach is to be followed and the rules and implementation are to be undertaken in the manner provided in Pillar Two.
A model treaty provision will be developed by the end of November, 2021 incorporating the STTR.
3.11 Important Elements of Pillar Two
i) It is restated that Inclusive Framework members are not required to adopt the GloBE rules but if they choose to do so, they should implement and administer the rules in a way that is consistent with the outcomes provided for under Pillar Two, including the model rules and guidance agreed to by the Inclusive Framework. It is also restated that Inclusive Framework members accept the application of the GloBE rules applied by other Inclusive Framework members.
ii) The design of Pillar Two is restated, including the GloBE rules, consisting of the IIR and the UTPR, and the STTR. Exclusion from the UTPR will be available for MNEs in the initial phase of their international activity (i.e., MNEs with a maximum of €50 million tangible assets abroad that operate in no more than five other jurisdictions). This exclusion is limited to five years after the MNE comes into the scope of the GloBE rules for the first time. In respect of existing distribution tax systems, there will be no top-up tax liability if earnings are distributed within four years and taxed at or above the minimum level.
iii) The minimum tax rate for purposes of the IIR and UTPR will be 15%.
iv) The substance-based carve-out is modified from the July Statement, with a transition period of ten years. (Detailed guidelines are provided for the same.)
v) A de minimis exclusion is provided for those jurisdictions where the MNE has revenues of less than €10 million and profits of less than €1 million.
vi) The nominal tax rate used for the application of the STTR will be 9%.
vii) Pillar Two will apply a minimum rate on a jurisdictional basis. Consideration will be given to the conditions under which the United States Global Intangible Low-Taxed Income (GILTI) regime will co-exist with the GloBE rules, to ensure a level playing field.
viii) The October Statement reiterates that Pillar Two generally should be brought into law in 2022, to be effective in 2023. However, the entry into effect of the UTPR has been deferred to 2024.
4. LIKELY IMPACT OF TWO-PILLAR SOLUTION
Under Pillar One, taxing rights on more than USD 125 billion of profit are expected to be reallocated to market jurisdictions each year. With respect to Pillar Two, with a minimum rate of 15%, the global minimum tax is estimated to generate around USD 150 billion in additional global tax revenues per year. The precise revenue impact will depend on the extent of the implementation of Pillar One and Pillar Two, the nature and scale of reactions by MNEs and Governments and future economic developments.
In terms of the investment impact, the Two-Pillar Solution is expected to provide a favourable environment for investment and growth. The absence of an agreement may have led to a proliferation of uncoordinated and unilateral tax measures (e.g., Digital Services Taxes and Equalisation Levy) and an increase in tax and trade disputes which would have undermined tax certainty and investment and resulted in additional compliance and administration burdens. It is estimated that these disputes could reduce global GDP by more than 1%.
5. FURTHER COURSE OF ACTION
Model rules to implement Pillar Two will be developed in 2021 with an MLC to implement Pillar One finalised by February, 2022. Inclusive Framework members have set an ambitious deadline of 2023 to bring the new international tax rules into effect.
6. IMPORTANT ASPECTS OF TWO-PILLAR SOLUTION
6.1 Impact of the Two-Pillar Solution on tax payments by MNEs
Each Pillar addresses a different gap in the existing rules that allows MNEs to avoid paying taxes. First, Pillar One applies to about 100 of the biggest and most profitable MNEs and reallocates part of their profit to the countries where they sell their products and provide their services, where their consumers are located. Without this rule, these companies can earn significant profits in a market jurisdiction without paying much tax there.
Under Pillar Two, a much larger group of MNEs (any company with over €750 million of annual revenue) would now be subject to a global minimum corporate tax of 15%.
6.2 Coverage of MNEs in Two-Pillar Solution
The BEPS Project aims to ensure that all taxpayers pay their fair share of tax. While it is true that the reallocation of profit under Pillar One would apply to only about 100 companies now, these are the largest and most profitable ones.
There is also a provision to expand the scope after seven years once there is experience with implementation. Pillar One also includes a commitment to develop simplified, streamlined approaches to the application of transfer pricing rules to certain arrangements, with particular focus on the needs of low-capacity countries which are very often the subject of tax disputes.
The objective of Pillar Two is to ensure that a much broader range of MNEs (those with a turnover of at least €750 million, which will be several companies) pay a minimum level of tax, while preserving the ability of all companies to innovate and be competitive.
For other smaller companies, the existing rules continue to apply and the Inclusive Framework has a number of other international tax standards like the BEPS actions to reduce the risks of tax avoidance and ensure that they pay their fair share.
6.3 Developing Countries – Beneficial Impact
Developing countries make up a large part of the Inclusive Framework’s membership and their voices have been active and effective throughout the negotiations. The OECD estimates that on average, low-, middle- and high-income countries would all experience revenue gains as a result of Pillar One, but these gains would be expected to be larger (as a share of current corporate income tax revenues) among low-income jurisdictions. Overall, the GloBE rules will relieve pressure on developing countries to provide excessively generous tax incentives to attract foreign investment; at the same time, there will be carve-outs for activities with real substance. Specific benefits aimed at developing countries include:
i) Protecting their tax base by implementing the Subject to Tax Rule in their bilateral tax treaties ensuring minimum overall 9% tax on income from interest and royalties to MNEs (refer para 3.9 for further details).
ii) The simplified and streamlined approach to the application of the arm’s length principle to in-country baseline marketing and distribution activities, as low-capacity countries often struggle to administer transfer-pricing rules and will benefit from a formulaic approach in those cases.
iii) A lower threshold for determining the reallocation of profit under Pillar One to smaller economies.
The Two-Pillar Solution acknowledges the calls from developing countries for more mechanical, predictable rules and generally provides a redistribution of taxing rights to market jurisdictions based on where sales and users are located, often in developing countries. It also provides for a global minimum tax which will help put an end to tax havens and lessen the incentive for MNEs to shift profits out of developing countries. Developing countries can still offer effective incentives that attract genuine, substantive foreign direct investments. Importantly, this multilaterally agreed solution avoids the risk of retaliatory trade sanctions that could result from unilateral approaches such as digital services taxes.
6.4 Impact on profit-shifting by MNEs via tax havens, etc.
Harmful tax competition and aggressive tax planning have done great harm to the world economy. Tax havens have thrived over the years by offering secrecy (like bank secrecy) and shell companies (where the company doesn’t need to have any employees or activity in the jurisdiction) and no or low tax on profits booked there. The work of the G20 and the OECD-hosted Global Forum on Transparency and Exchange of Information for Tax Purposes has ended bank secrecy (including leading to the automatic exchange of bank information), and the OECD BEPS Project requires companies to have a minimum level of substance to put an end to shell companies along with important transparency rules so that tax administrations can apply their tax rules effectively. Pillar Two will now ensure that those companies pay a minimum effective tax rate of 15% on their profits booked there (subject to carve-outs for real, substantial activities). Many countries including the UAE have introduced Economic Substance Regulations and related reporting each year to avoid shell companies.
6.5 Exclusions for certain business activities
There are four exclusions from the Two-Pillar solutions; these are, mining companies, regulated financial services, shipping companies and pension funds. The OECD Document clarifies that the exclusions that are provided for ‘relate to types of profit and activities that are not part of this problem either because the profit is already tied to the place where it is earned (for example, regulated financial services and mining companies will have to have their operations in the place where they earn their income), or the activity benefits from different taxation regimes due to their specific nature (such as shipping companies and pension funds).’ In any case, these types of businesses are still subject to all the other international tax standards on transparency and BEPS to ensure that tax authorities can tax them effectively.
7. IMPLEMENTATION TIMELINES
A detailed Implementation Plan has also been agreed upon. It contains ambitious deadlines to complete work on the rules and instruments to bring the Two-Pillar Solution into effect by 2023.
PROPOSED TIMELINES
A. Pillar One
a) Early 2022 – Text of a Multilateral Convention and Explanatory Statement to implement Amount A of Pillar One;
b) Early 2022 – Model rules for domestic legislation necessary for the implementation of Pillar One;
c) Mid-2022 – High-level signing ceremony for the Multilateral Convention;
d) End 2022 – Finalisation of work on Amount B for Pillar One;
e) 2023 – Implementation of the Two-Pillar Solution.
B. Pillar Two
a) November, 2021 – Model rules to define scope and mechanics for the GloBE rules;
b) November, 2021 – Model treaty provision to give effect to the subject to tax rule;
c) Mid-2022 – Multilateral Instrument for implementation of the STTR in relevant bilateral treaties;
d) End 2022 – Implementation framework to facilitate coordinated implementation of the GloBE rules;
e) 2023 – Implementation of the Two-Pillar Solution.
The detailed Implementation Plan provides for a clear and ambitious timeline to ensure effective implementation from 2023 onwards. On Pillar One, model rules for domestic legislation will be developed by early 2022 and the new taxing right in respect of re-allocated profit (Amount A) will be implemented through a multilateral convention with a view to allowing it to come into effect in 2023. India and many other countries may see changes in their domestic tax laws to include provisions of Pillar One. Similarly, one may see the end of unilateral measures such as the Equalisation Levy once the agreement is finalised, as stated by our Finance Minister recently. Meanwhile, work will be developed on Amount B and the in-country baseline marketing and distribution activities in scope, by the end of 2022. As for Pillar Two, model rules to give effect to the minimum corporate tax will be developed by November, 2021, as well as the model treaty provision to implement the subject to tax rule. A multilateral instrument will then be released by mid-2022 to facilitate the implementation of this rule in bilateral treaties.
8. CONCLUDING REMARKS
The October Statement marks an important milestone in the BEPS 2.0 project on fundamental changes to the global tax rules, with all OECD and G20 countries (including the European Union) now supporting the agreement on key parameters. However, more work will be required to reach agreement on some key design elements of the two Pillars. In addition, there is significant work to be done to fill in the substantive and technical details in the development of the planned model rules, treaty provisions and explanatory material. That work will need to be completed quickly in order to meet the timelines reflected in the implementation plan. It should be noted that while the October Statement provides that the work will continue to progress in consultation with stakeholders, the implementation plan provides limited time to policymakers to engage with businesses and other stakeholders.
It is said that technology has made our life simple in many respects but extremely complicated when it comes to determination of source rules for taxation. The Two-Pillar Solution is anything but a simplified, zero-defect multi-prong solution. The OECD Document admits that even the minimum corporate tax rate of 15% is a compromise, as a majority of jurisdictions have a higher corporate tax rate. But then it is said that we all live in an imperfect world, striving towards perfection which is nothing but a mirage.
Acknowledgement: The authors have relied upon various OECD publications and statements, etc., in July and October 2021 for this write-up.)
