On 8 October 2021, the Organisation for Economic Co-operation and Development (“OECD”) announced that world leaders of 136 countries had formally agreed to an overhaul of international tax rules, intended to reflect the realities of the digital economy. The OECD has spent years advocating for a tax reform targeting the shifting of business profits of certain multinational enterprises (“MNEs”).
Concretely, 136 countries have agreed to the OECD’s eight-page statement that updates its 1 July blueprint and includes an annex that provides important details regarding the implementation of the agreement.
The plan was endorsed by the G20 Leaders on 30 October during the Summit.
The reform represents an effort to “send back” tax revenues that have scattered away with the evolution of the digital economy (Pillar 1) and at the same time to eliminate the possibility to shift profits to tax havens (Pillar 2)
It is intended that Pillar One will achieve a fairer distribution of profits and thus, reallocating some taxing rights from an MNE’s home jurisdiction to market jurisdictions where it has business activities and profits, regardless of whether the firm has a physical presence in those jurisdictions.
Under the scope of Pillar One fall MNEs with global turnover above EUR 20 billion and profitability above 10%. Based on the current global understanding, said threshold may be reduced to EUR 10 billion upon review seven years after the agreement enters into force.
► The nexus rule
The allocation of a share of the residual profit to market jurisdictions will be based on a new special-purpose nexus rule. The test will be met in market jurisdictions where an in-scope MNE derives at least EUR 1 million in revenue. In the case of smaller jurisdictions with a GDP lower than EUR 40 billion, the nexus threshold will be set at EUR 250,000.
Under the October statement, it is clarified that 25% of residual profit of in-scope businesses will be reallocated and thus, subject to the new reallocation rule.
► Dispute resolution
In case of double taxation or issues of interpretation, businesses falling within the scope of Pillar 1 will be able to rely on mandatory and binding dispute prevention and resolution mechanisms designed to avoid double taxation for Amount A, including all issues related to Amount A (e.g., transfer pricing and business profits disputes).
► Existing digital services taxes
The statement released in October provides that a multilateral convention (MLC) will require all signatories to remove all digital services taxes (“DSTs”) on all companies and to commit not to introduce such measures in the future.
Noteworthy is the fact that currently, there are five European countries that have introduced domestically DSTs - Austria, France, Italy, Spain and the UK.
The aim is to implement the new rule of Amount A through an MLC. The current agreement is that such MLC should become effective as of 2023, which leaves room for negotiation of the said Convention throughout 2022.
The goal pursued by the implementation of Pillar Two is to introduce a global minimum tax rate of 15%.
Concretely, under Pillar Two governments could still set their own local corporate income tax rate but if companies pay lower rates through a subsidiary operating in another jurisdiction overseas, their home jurisdiction could “top up” the parent company’s tax liability to the set 15% global minimum tax in order to deter shifting profits to lower jurisdictions.
Unlike Pillar 1, Pillar 2 has no profitability threshold. The global minimum tax rules will apply to MNEs that meet the threshold of EUR 750 million combined financial revenues as determined under the country-by-country reporting rules.
Pillar 2 excludes from the scope: government entities, international organizations, nonprofits, pension funds and investment funds that are ultimate parent entities of an MNE group.
The October statement provides for a carve-out excluding an amount of income that is 5% of the carrying value of tangible assets and payroll. During the transitional period of 10 years upon signing the MLC, the amount of income excluded is intended to be set at 8% of the carrying value of tangible assets and 10% of payroll, declining annually by 0.2 percentage points for the first five years, and by 0.4 percentage points for tangible assets and by 0.8 percentage points for payroll for the last five years.
The new taxing rules also provide for a de minimis exclusion for those jurisdictions where the MNE has revenues of less than EUR 10 million and profits of less than EUR 1 million.
The October statement provides a rather ambitious schedule for implementation of Pillar Two, with a plan for a model treaty provision to be negotiated by the end of November 2021 along with an MLC similar to Pillar 1 (by 2023).
Following the agreement in October, the European Commission published a press release, according to which the international tax reform at OECD-level is complementary to the EU's tax agenda by offering solutions that Europe needs to support its Single Market and accelerate the post-COVID-19 recovery.
Earlier in May 2021, the European Commission published the Communication on Business Taxation for the 21st Century. The Communication set out a long-term vision to provide a fair and sustainable business environment and EU tax system, building on the progress made and the principles agreed in the global discussions. It also sets out a tax agenda for the next two years, with targeted measures that promote productive investment and entrepreneurship and ensure effective taxation.
Notwithstanding the objectives and the aims pursued by the EU in a post pandemic single market, it is essential that the implementation of Pillar 1 and Pillar 2 is compatible with the Treaties and existing EU legislation.
Ever since the OECD published its blueprint, the intended tax reform has been subject to a heated debate. Although a prima facie agreement has been reached there are certain challenges along the process of implementation.
► Time frame
Firstly, the time frame for negotiation and implementation is rather optimistic. As indicated hereby, the deadline for the new reform to become effective is 2023. Of course, this tight deadline might be driven by strained state budgets due to the COVID-19 pandemic and the need to generate more revenue in order to sustain economies but nonetheless, the reform concerns a very sovereign question – taxing rights.
To that end, a period of one year of negotiations will most likely not be enough in order to perform a major transformation and shift of the international tax arena.
► Is there a benefit for developing countries
When a given reform concerns the design of a tax system that intends to discourage harmful tax practices of profit shifting, impact assessments must be conducted in order to assess the cost-benefit outcome for developing countries. In July 2021, Michael Devereux and Martin Simmler (Oxford University Centre for Business Taxation) performed such an impact assessment based on the scope of the initial statement as of 1st July 2021(1). Based on their analysis, the assessment indicated that the tax reform will affect only 78 of the world’s largest 500 companies and only about 37 European companies.
Concretely, around 64% of this total will be generated by US-headquartered companies, meaning that this would be revenue gathered by the US tax administration. Next, around 45% of this total would be generated by technology companies, and around USD 28 billion would be generated from the largest five technology US companies.
Given that the overall idea is to capture-in these MNEs, the majority of which is currently headquartered in rather developed economies, it is rather questionable what would be the gain for developing economies which will hardly be benefiting from the global minimum tax. This indicates that the global agreement has clear biases in favour of the countries where MNEs are headquartered.
Noteworthy is the statement made by the head of the OECD - Pascal Saint-Amans, in which he indicates that the global agreement is “conceived in such a manner as you need the big countries; and if they agree, they have the big countries with 94% of the world economy, we have the critical mass.”(2)
Although many technical details remain to be ironed out before talks in November 2021, it is indisputable that the agreement for a global tax reform is perceived as one that will restore stability within the international tax system.
Companies that currently fall within the scope of Pillar 1 and Pillar 2 should determine whether their tax strategies require changes in light of the upcoming reforms.