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An agreement on global tax reform was announced at the recent G7 meeting. On July 1, 2021, the G20 issued a statement on proposed solutions and provided additional details (the “July Proposals”).
The Organization for Economic Co-operation and Development (“OECD”) has been leading discussions on international tax reform under the Base Erosion and Profit Shifting initiative, better known as BEPS, for many years. The July Proposals provide details on how to implement Pillar 1 which relates to taxing the digital economy and Pilar 2 which relates to a minimum global tax rate.
Pilar One – Taxing rights transfer
The Pilar One proposals apply to multinational enterprises (“MNEs”) with a turnover of more than €20 billion and a profit margin of more than 10%. These thresholds will be determined based on the accounting results of MNEs, with some adjustments. MNEs subject to Pillar One will not be limited to companies operating in the digital economy. However, extractive industries and regulated financial services will be excluded.
The objective of Pillar One is to shift the taxation rights from the home countries to the market jurisdictions (where the customers are located). The exact portion of profits that will be shifted has not yet been confirmed. The July Proposals indicate that between 20% and 30% of profitability in excess of 10% will be allocated to jurisdictions in which an MNE is deemed to have a sufficient presence, a concept known as “nexus”. The allocation will use a turnover-based distribution formula.
Profits will be allocated to a market jurisdiction if revenues in that jurisdiction exceed a certain threshold that depends on its GDP, i.e.:
- GDP lower than €40 billion: €250,000
- GDP equal to or greater than €40 billion: €1 million
Revenue will be sourced to the end market jurisdictions where goods or services are used or consumed. To facilitate the application of this principle, detailed source rules for specific categories of transactions will be developed.
In many cases, because of its current structure, the residual profits of an in-scope MNE are already taxed in a market jurisdiction. In this case, a marketing and distribution profits safe harbour will cap the residual profits allocated to the market jurisdiction. Further work on the design of the safe harbour will be undertaken.
The application of the arm’s length principle to in-country baseline marketing and distribution activities will be simplified and streamlined. This work will be completed by the end of 2022.
The Pilar One proposal will result in a significant transfer of profits between jurisdictions and will require the use of exemptions or credits to avoid double taxation of MNEs. One reason for the risk of double taxation is that different jurisdictions will not necessarily impose the rules in the same way.
Pilar One will be implemented through the use of a multilateral instrument, the same recently used to implement changes to tax treaties. The OECD expects that the multilateral instrument will be opened for signature in 2022 and come into effect in 2023.
The turnover threshold of €20 billion is expected to be reduced to €10 billion seven years after the implementation of the agreement.
Pilar Two – Global Minimum Tax
Pilar Two establishes a minimum tax on a country-by-country basis. It introduces Global anti-Base Erosion Rules (“GloBE”). These proposals will apply to MNEs that meet the €750 million threshold as determined for the country-by-country reporting of transfer pricing declaration.
The July Proposals state that countries are free to tax MNEs that do not meet the €750 million threshold. The Proposals could potentially apply the small and medium-sized enterprises (“SMEs”). Government entities, international organizations, non-profit organizations, pension funds or investment funds that are Ultimate Parent Entities (“UPE”) are not subject to the GloBE Rules. Only the international shipping industry is excluded from these proposals.
The minimum tax will be 15%, using on a common definition of covered taxes and a tax base determined by reference to financial accounting income (with agreed adjustments consistent with the tax policies of Pilar One).
Some types of income (for example, interest and royalties) could be subject to a lower rate (between 7.5% and 9%).
The July Proposals reiterate the range of mechanisms that can be used to achieve a global minimum tax. These mechanisms are:
- Income Inclusion Rule (“IIR”): which imposes top-up tax on a parent entity in respect of low income of a constituent entity.
- Undertaxed Payment Rule (“UTPR”): which denies deductions or requires an equivalent adjustment to the extent the low tax income of a constituent entity is not subject to tax under an IIR. This is a measure similar to the U.S. base erosion and anti-abuse tax (BEAT).
- Subject to Tax Rule (“STTR”): a treaty-based rule that allows source jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate. The STTR will be creditable as a covered tax under the GloBE rules.
It is agreed that Pillar Two will apply a country-by-country minimum rate. In this context, the July Proposals will take into account the conditions under which the U.S. GILTI regime will coexist with the GloBE rules. This concession is important to ensure U.S. participation in the Pillar Two proposals.
According to the OECD, the July Proposals will establish a robust minimum tax with limited impact on MNEs that engage in real economic activities with substance. A plan to implement Pillar Two is expected by 2022 and it will take effect by 2023.
The next steps
The July Proposals provide the tax community with additional information on Pillars One and Two. However, several details remain to be worked out. The OECD is expected to finalize a detailed implementation plan by October 2021.