Developments Towards Global Agreement On Corporate Taxation For Multinationals

The push for global tax reform received a significant boost over summer 2021, with broad international consensus reached on the principles of a “two-pillar solution” to address the tax challenges of digitalisation. Adoption and implementation of the two pillars is likely to fundamentally change the international tax landscape for multinational enterprises (“MNEs”). This summer’s breakthrough was the result of substantial work by the US and other members of the G20 and the OECD, building on groundwork laid in October 2020, when the so-called OECD/G20 Inclusive Framework (a group of (now) 140 jurisdictions) proposed its “blueprints” for the two pillars.

What did the blueprints propose?

Pillar 1 deals with the situation where an MNE earns profits in a market country, without sufficient physical presence to create a taxable nexus in that country under current rules. The essence is to reallocate taxing rights over a proportion of the MNE’s residual profits to that market country. The original proposal was extremely complex both in scope (i.e., in identifying the automated digital services businesses and, possibly, consumer facing businesses to which the rules would apply) and in computation (e.g., how to determine residual profits and the methodology for allocating them to market jurisdictions).

Pillar 2 is about ensuring that large MNEs pay a minimum level of tax, wherever they are headquartered or have their business operations. Three main tools would achieve this.

The first two, an “income inclusion rule” (or “IIR”) and an “undertaxed payments rule” (or “UTPR”), are global anti-base erosion tools.

The IIR (rather like a classic CFC rule) would trigger an inclusion of income at the level of the shareholder where the income of a controlled foreign entity is taxed at below an agreed effective minimum tax rate.

The UTPR would act as a backstop to that, and address inversion risks, by allocating a top-up tax to a company in certain circumstances, for example where deductible intra-group payments are taxed on receipt at below the agreed effective minimum rate.

The third, a “subject to tax rule” (or “STTR”), would deny treaty benefits for certain deductible intra‑group payments made to jurisdictions where those payments are subject to no or low rates of taxation.

How did the US then react?

US enthusiasm for global tax reform was ignited with the election of President Biden at the end of 2020. The domestic tax agenda from the new administration included components that align broadly with the IIR and UTPR aspects of Pillar Two. The US became a vocal supporter of ending the “race to the bottom” in global taxation, hoping for widespread buy-in from the international community so as not to lose competitiveness by going it alone.

That increased enthusiasm did not extend to the Pillar One blueprint. The US remained mindful of the disproportionate impact the proposals would likely have on US headquartered MNEs, especially if the new reallocation rules were to be limited to digital services businesses.

These sentiments were highlighted in a presentation given by the US Treasury to the Inclusive Framework in April 2021. Along with a robust commitment to complete Pillar Two, a challenge and counterproposal was made in relation to Pillar One. The alternative envisaged by the US is that Pillar One should apply only to the largest and most profitable (up to 100) MNE groups, and that revenue and profit margin thresholds be used to identify businesses within scope rather than business sectors. The US also required that unilateral digital services taxes (such as that in the UK) be withdrawn.

What happened next, and where do things now stand?

A flurry of activity followed at all levels, from individual countries, the EU, the G7, the G20 and the OECD. This culminated in a statement published by 130 members of the Inclusive Framework on 1 July 2021, announcing an “agreed two-pillar solution”. In broad terms, some key components announced were these:

MNEs within scope of the new taxing right are those with turnover above EUR20 billion and profitability (profit before tax/revenue) above 10%. The turnover threshold may be reduced, depending on a review to begin after seven years.

Regulated financial services and extractives (both undefined) are to be excluded.

Segmentation can occur “in exceptional circumstances” where, based on segments disclosed in financial accounts, a segment meets the scope rules. This is potentially a route to capture a profitable division of a group, even though the group as a whole has an overall low profit margin.

For in-scope MNEs, between 20-30% of residual profit (defined as profit in excess of 10% of revenue) will be allocated to market jurisdictions with nexus using a revenue-based allocation key. However, there will be no allocation to a market jurisdiction unless the MNE derives at least EUR1 million in revenue from that jurisdiction. A reduced threshold of EUR250,000 will apply to jurisdictions with GDP lower than EUR40 billion.

Revenue will be sourced to the end market jurisdictions where goods or services are used or consumed, with detailed source rules for specific categories of transactions.

Regulated financial services and extractives (both undefined) are to be excluded.

Segmentation can occur “in exceptional circumstances” where, based on segments disclosed in financial accounts, a segment meets the scope rules. This is potentially a route to capture a profitable division of a group, even though the group as a whole has an overall low profit margin.

For in-scope MNEs, between 20-30% of residual profit (defined as profit in excess of 10% of revenue) will be allocated to market jurisdictions with nexus using a revenue-based allocation key. However, there will be no allocation to a market jurisdiction unless the MNE derives at least EUR1 million in revenue from that jurisdiction. A reduced threshold of EUR250,000 will apply to jurisdictions with GDP lower than EUR40 billion.

Revenue will be sourced to the end market jurisdictions where goods or services are used or consumed, with detailed source rules for specific categories of transactions.

The proposal is to move forward with each of the IIR, UTPR and STTR.

The rules will apply to MNEs that meet the EUR750 million threshold for country by country reporting, but individual countries are free to apply the IIR to MNEs headquartered in their country even if they do not meet the threshold. Government entities, international organisations, non-profit organisations, pension funds and investment funds that are parents of an MNE will be excluded, as will holding vehicles used by them.

There will be a de minimis exclusion, although the amount has not been specified. There will also be a formulaic substance carve-out to exclude an amount of income that is at least 7.5% (falling to 5% after a five-year transition period) of the carrying value of tangible assets and payroll.

The agreed minimum tax rate for the purposes of the IIR and UTPR is “at least 15%”. The STTR will apply by reference to a rate between 7.5% and 9%.

The proposal is to move forward with each of the IIR, UTPR and STTR.

The rules will apply to MNEs that meet the EUR750 million threshold for country by country reporting, but individual countries are free to apply the IIR to MNEs headquartered in their country even if they do not meet the threshold. Government entities, international organisations, non-profit organisations, pension funds and investment funds that are parents of an MNE will be excluded, as will holding vehicles used by them.

There will be a de minimis exclusion, although the amount has not been specified. There will also be a formulaic substance carve-out to exclude an amount of income that is at least 7.5% (falling to 5% after a five-year transition period) of the carrying value of tangible assets and payroll.

The agreed minimum tax rate for the purposes of the IIR and UTPR is “at least 15%”. The STTR will apply by reference to a rate between 7.5% and 9%.

The number of Inclusive Framework members who have now signed up has increased to 134, with Estonia, Hungary, Ireland, Kenya, Nigeria and Sri Lanka holding out.

What are the next steps?

The Inclusive Framework members hope to announce a final deal on the two Pillars in October 2021, together with an implementation plan for creating model legislation, guidance, and a multilateral convention, so that the new rules can be implemented in 2023.

Although there is clearly much political will to make this happen, it is difficult to predict the actual route to implementation. There is still work to be done in finalising the details, and there remains scope for disputes on some of the principles. One notable challenge will be convincing Ireland as a significant holdout country to accept a 15% minimum rate under Pillar Two in light of its 12.5% domestic tax rate. Another will be resolving the status of a new digital levy being considered by the EU, and an apparent plan to push forward with it regardless of whether Pillar One is introduced. There may also be protectionist disputes about further exclusions from Pillar One for certain companies and industries. Domestic politics could come into play as an obstacle even once the details have been hashed out between the participants, including in the US where the legislative process (for adopting Pillar One in particular) is not straightforward.

All eyes will be focused on the Inclusive Framework update due in October, and accompanying announcements from the individual members.