Building on the Base Erosion and Profit Shifting (BEPS) initiative that culminated in the Multilateral Instrument (MLI), which has achieved fundamental changes to treaties, the Organisation for Economic Cooperation and Development’s (OECD) Secretariat continues to pursue an in-depth and comprehensive international tax reform.
In the fall of 2019, the OECD’s Secretariat issued a consultation document on digital taxation (“Pillar 1”). This document proposed new taxation rules to ensure that digital businesses pay tax in the jurisdictions in which they operate even if they do not have a traditional physical presence (nexus or a permanent establishment).
In November2019, the OECD Secretariat issued the Global Anti-Base Erosion Proposal (GloBe”) – Pillar 2 document in which it outlined its proposals to further reform international taxation. As discussed below, the proposals are far-reaching, and the OECD has received over 3,000 pages of feedback from various stakeholders.
Pillar Two’s objective is to implement a worldwide minimum income tax system and to ensure that there is also a minimum amount of cash tax is paid by multinationals (MNEs). At this time, the Secretariat has not indicated an income threshold; hence, it could apply to larger MNEs (for example those that are subject to transfer pricing country-by-country (CbC) rules because their sales are greater than €750 million) and to smaller entities. Also, the Pillar Two proposal has not specified what the minimum target income tax rate should be.
Components of Pillar Two – GloBE
The four components of the GloBE are:
- An income inclusion rule to allow a jurisdiction to tax the income of a foreign branch or a controlled foreign corporation (CFC) if that income is taxed at an effective rate that is below the minimum rate;
- An undertaxed payments rule to deny a deduction or impose a withholding tax on payments to a related party if that payment is taxed at an effective rate that is below the minimum rate;
- A switch-over rule to support the income inclusion rule that would introduce a treaty provision that would allow a switch from an exemption to a credit method if income of a permanent establishment (PE) is taxed at an effective rate that is below the minimum rate. This rule could also apply to immoveable properties that are not part of a PE;
- A subject to tax rule to support the undertaxed payment rule by subjecting payments that are taxed at a rate below the minimum rate subject to withholding tax and/or by denying the tax treaties’ benefits.
There is a significant overlap between the four components of GloBE and it is far from clear how they will interact with each other or whether countries will be provided a choice as to the means to be used to achieve the Pillar Two objective of establishing a minimum effective tax rate.
Tax base and consolidated financial statements
The GloBE suggests that consolidated financial statements should be used to determine the tax base. The use of consolidated financial statement raises a number of issues, such as:
- The choice of Generally Accepted Accounting Principles (GAAP) to be used (US, Japanese, International Financial Reporting Standards or local GAAP);
- The impact of items denominated in foreign currencies on the Currency Translation Account (CTA);
- The taxation of foreign exchange operations and the choice of currency for the payment of taxes;
- The impact of permanent and temporary differences;
- The appropriateness of changes to the tax base as a result of accounting principle changes;
- The ability to audit consolidated financial statements by local taxation authorities;
- The ability to standardize tax rules – for example to take into account the diversity of tax treatment for the deductibility of stock-based compensation, the deductibility of interest expense, etc.
Interaction between Pillar One and Pillar Two
The interaction between Pillar One and Pillar Two proposals is unclear. Presumably, Pillar One on digital taxation would apply to a MNE before Pillar Two applies. Therefore, it would seem logical that any taxes paid as a result of the application of Pillar One would be taken into account in computing the minimum taxes paid on income. However, the interaction and the interdependency of the two Pillars need clarification.
Another critical element that has not been addressed is to determine how and where the tax would be collected according to the organisational structure of the company. We believe that the GloBE proposal should be applied at the ultimate parent level. For example, A owns B and B owns C. A would apply the GloBE provisions to the income generated by B and by C. And, as long as A applies the GloBE proposal to the income generated by B and by C, B would not apply the provisions to the income generated by C. However, the proposal could also be interpreted as being applicable at each level in the organisational structure where a branch or a subsidiary is controlled by a member of the group. The determination of which legal entity or entities in the group are within the scope of the proposal is another critical issue that needs to be addressed. A bottoms-up approach toward taxation at each level in the organisational structure would be immensely complex and time consuming for taxpayers.
Lastly, the interaction with a particular jurisdiction’s CFC rules must be taken into account, otherwise, double or triple taxation could arise.
Too soon for GloBE?
As noted above, BEPS has introduced important changes to tax systems within the OECD. As a result, significant measures to protect countries’ tax base have recently been introduced in various countries including the following:
- Interest deductibility rules (generally based on a percentage of EBITDA – earnings before interest, taxes, depreciation and amortization);
- CFC legislation that should contribute to achieve a minimum taxation rate if it is properly implemented;
- Anti-hybrid legislation that eliminates tax arbitrage obtained from exploiting various tax classifications by the countries;
- Tightening of rules to limit tax benefits that may be obtained with regard to intellectual property;
- The introduction of a principal purpose test in tax treaties which will greatly limit the ability to obtain lower withholding tax rates in the source jurisdiction if taxpayers do not have substantive economic presence in the country of residence via the MLI;
- Modifications to transfer pricing guidelines (BEPS action items 8-10);
- Tax treaty provisions regarding PE status (BEPS action 7).
We believe that the OECD should continue to monitor the effectiveness and efficiency of these recently introduced changes and should continue to study measures that reform international taxation with approaches similar to GloBE or Pillar One proposals.
If the enacted measures outlined above do not achieve the tax policy objectives of protecting national taxation bases and of having MNEs paying a minimum tax due to meaningful CFC legislation, the introduction of GloBE type measures should then be seen as a means to this end.
Torn world – is there sufficient consensus to implement international tax changes?
The Pillar One and the Pillar Two proposals can only be achieved if there is a consensus among jurisdictions – otherwise double taxation will result.
In early December, the US Treasury Secretary indicated that the US has “serious concerns” with respect to certain aspects of Pillar One (digital taxation) proposals that could constitute a mandatory departure from the arm’s length principle and from the related nexus rules. The Secretary also announced that the US fully supports a GILTI-like Pillar Two proposal (“Global Intangible Low-Taxed Income” ) – perhaps by restricting the type of changes that the US is likely to accept in order to reach a consensus on reforming international taxation.
International taxation and digital taxation will continue to fuel discussions within the international community, including G20. For example, the Office of the US Trade Representatives (USTR) outlined a proposal on December 2 to impose additional duties of US$2.4 billion on French products (including champagne, cheese, cast-iron cookware) in response to the recently introduced French digital service tax.
For a more in-depth discussion of the issues raised by the GloBE proposals, please consult our detailed comments to the OECD.