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The emergence of the digital economy and new business models in our technology-enabled, borderless world have created a seismic disruption in the international tax framework. Typically, the profits of a Multinational Enterprise (MNE) will come under the tax net of a country if it has a Permanent Establishment (PE) in that country and the profits are directly attributable to that PE. This was the international tax principle that underpinned most Double Tax Treaties (DTT) and domestic tax legislations.
This rule was mostly suitable for traditional “brick and mortar” businesses that require the presence of production factors, such as personnel, premises and machinery in the market jurisdiction (that is, where consumers are located) where goods and services are provided. However, Globalization and the Digital economy have ensured that MNEs can earn substantial revenue from a market jurisdiction without having a PE in that country. Thus, these market jurisdictions are denied a considerable amount of tax revenue because the traditional tax rules are inadequate to cope with the new realities.
In addition, MNEs are taking advantage of the tax competition among countries, to shift their profits to low tax jurisdictions. The ease of migration of People, Capital and Intangibles, with corresponding income, to lower tax jurisdictions has encouraged aggressive tax planning by MNEs. While each jurisdiction has the right to offer generous tax incentives to attract MNEs, there is the danger that harmful tax competition will lead to a race to the bottom. The budgetary strain is potentially, exacerbated by the impact of the COVID-19 pandemic.
The OECD has championed efforts to introduce reforms to the international tax system, in response to the clamour by tax authorities for a fair tax system that can cope with the new challenges and ensure that MNEs pay their fair share of tax in the market jurisdiction where income is generated. There is also the need for a level-playing field across tax jurisdictions.
In recent times, the OECD has issued several reports, called for Public consultations, and collated stakeholder ideas in a bid to arrive at a consensus-based solution. Nonetheless, reaching a global consensus on a new international tax rule has not been an easy task. Divergent views on the subject have resulted in conflict amongst nations on what method would be best adopted to counter excessive tax planning strategies that exploit gaps and mis-matches in tax rules.
Consequently, many countries have gone ahead with imposing unilateral taxes on the gross income of MNEs from digital economy. For instance, Digital service taxes have been introduced in many countries, usually collected using the withholding tax system. This kind of unilateral application of tax rules to cross-border transactions have been said to undermine the international tax system, including double tax treaties and multilateral agreements.
There is therefore an urgent need to reach a consensus-based solution driven by political agreement between stakeholders. This week, some of the world’s richest nations under the G7 agreed to support the “Pillar one” and “Pillar two” proposals of the OECD.
The OECD introduced proposals under the “Pillar one” blueprint to address the need for new rules for allocating Taxing rights (“Nexus”) to market jurisdictions where there are no PE (in the traditional sense), and rules for attributing profits to those Nexus.
Put simply, the proposed new rule will use Revenue threshold instead of PE, as a primary indicator of sustained and significant involvement in a market jurisdiction. After establishing such nexus, the new rules will allocate a share of the MNE’s residual profits to the nexus based on a multilaterally agreed percentage allocation. This will work in tandem with normal rules for attributing profits to a traditional nexus where they exist, especially for local baseline functions.
The G7 Finance Ministers’ communique on June 05, 2021 reads:
“… We commit to reaching an equitable solution on the allocation of taxing rights, with market countries awarded taxing rights on at least 20% of profit exceeding a 10% margin for the largest and most profitable multinational enterprises. We will provide for appropriate coordination between the application of the new international tax rules and the removal of all Digital Services Taxes, and other relevant similar measures, on all companies.”
The OECD introduced proposals under the “Pillar two” blueprint which seeks to re-allocate taxing rights back to the contracting state where a jurisdiction has not exercised its primary taxing rights or has a preferentially lower tax than a minimum tax rate.
Put simply, the proposal introduces a set of interlocking rules that ensures that MNEs pay a minimum tax on their profits, irrespective of where they are reported. Where the MNE pays effective tax rate below this Minimum tax, the rules will seek to include such income that were hitherto excluded from tax, due to favorable tax regimes or DTT exemptions. It will allocate the rights to the “Top-up tax” (that is, additional tax over the minimum tax) to the other contracting state. This is to discourage tax-motivated profit shifting by MNEs and unhealthy tax competition among countries.
The proposal, however, excludes certain entities from the scope, such as Investment funds, Pension funds etc, and also excludes MNE groups with gross revenue below a threshold of EUR 750 million.
The G7 countries’ communique on June 05, 2021 reads:
“…We also commit to a global minimum tax of at least 15% on a country by country basis. We agree on the importance of progressing agreement in parallel on both Pillars and look forward to reaching an agreement at the July meeting of G20 Finance Ministers and Central Bank Governors.”
Following the support from the G7 countries, there is optimism that the agreement will mark the start of a new dawn for a fair international tax system. The potential revenue gains are projected to be in the billions of dollars.
The new rules are to be implemented by a combination of changes to domestic tax legislations, tax treaties, and multilateral conventions.
Although, It is still a long way from a final agreement, however, it seems we are edging towards a Global consensus quicker than expected. The fine details will still require wider consultation with opposing countries and other world powers.
The G20 countries, which include China, Russia, and India, will meet next month to discuss the proposals.
The detailed mechanics of the rules proposed in Pillar One and Pillar Two will be examined in future publications.
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