More than 130 countries have come to agreement on the largest overhaul of international tax rules in more than 100 years. Under the OECD/G20’s two-pillar approach, Pillar 1 will lead to a re-attribution of taxation rights to market jurisdictions in an unprecedented departure from traditional tax rules. Pillar 2 seeks to introduce a global minimum tax rate of 15 per cent to end the “race to the bottom” in terms of tax competition. Further, the EU is actively addressing the so-called debt bias, and is looking into plans that could fundamentally alter the line between debt and equity (“DEBRA”).
The tax world is changing rapidly, with major developments around the taxation of multinationals, and a growing number of initiatives around hot topics such as transparency and the environment.
In this first of our series of blogs aimed at the industrials sector, we look at how the changes to the international tax framework could impact industrial multinationals.
The OECD’s two pillars
There has been much publicity around this initiative which is the culmination of years of work through which the international community has been trying to modernise tax laws that have been around for the last 100 years to adapt to an increasingly digitalised world. This began in 2013 with the OECD BEPS (base erosion and profit shifting) project, which sought to improve various aspects of the international tax system. One of the workstreams was updating the tax system to deal with the changing economy and digitalisation of the economy. Although there have been bumps in the road the project reached a critical milestone in October 2021, with agreement from nearly 140 countries including the OECD, the G20, and all EU member states.
Pillar one was originally motivated, at least in part, by a sense that big tech were not paying their “fair share” of taxes, or not paying it in the right places. The proposed solution is for some taxing rights to be allocated to those jurisdictions where a business has its end consumers. However, crucially, under the latest agreement, this is not limited to technology companies and applies to any multinational group (i.e. including large industrial MNEs) with an annual turnover of EUR 20 billion (potentially decreasing to EUR 10 billion in the future) and a profitability of at least 10 per cent. Pillar 2 is dealing with the concern that multinationals were shifting their profits to tax havens, as a result of which they eroded the tax base (and tax revenues) of other jurisdictions. The solution to this is to ensure that all multinationals with revenues of at least EUR 750 million a year have an effective tax rate of 15 per cent in each jurisdiction in which they are active.
Pillar One – a new taxing right
Under traditional tax principles, groups pay tax according to where they have physical presence. A century ago, this would have been aligned with where they had their assets, activities and capital risks. However, shifting business models and increasing globalisation and digitalisation of the economy mean that a tax system based on physical presence alone is no longer fit for purpose. In a situation where a large multinational centralises ownership of its legal IP and intangible assets in a particular jurisdiction, taxing on the basis of where the IP is owned takes no account of the value that is created from user participation or other marketing intangibles in the places where the multinational is supplying its goods or services (the “market jurisdiction”). What Pillar 1 aims to do is allocate some of the tax pie to those market jurisdictions.
How does it work?
The new rules apply to any group that meets the Pillar 1 thresholds set out above, including any industrial MNEs that meet these thresholds. The only exceptions at present are for regulated financial services and extractives - although the precise parameters of these exclusions are still to be decided. It is anticipated that 80 to 100 multinational groups will be in scope and the amounts subject to reallocation will be very significant. The next step is determining how much profit is to be allocated to the jurisdictions where the multinational sells its goods or services, or where its users are active. This amount being reallocated is called “Amount A”, and will be set at 25 per cent of what is referred to as “residual profits”. Residual profits are all profits in excess of the 10 per cent profitability threshold. This means that for every euro in excess of 10 per cent profitability EUR 0.25 will need to be reallocated to market jurisdictions. If a multinational’s revenues are below EUR 1 million in a certain jurisdiction (or below EUR 250,000 for smaller jurisdictions) there is no reallocation to that jurisdiction.
The rules quickly get complicated when you start looking in detail at how amounts are allocated, or what is within the exceptions. In addition, they will have to be implemented into domestic law and will require changes to tax treaties (or a new multilateral treaty). The potential for double taxation and disputes is high, particularly if the rules are not implemented consistently or at the same point in time. Furthermore, all jurisdictions that participate must abolish any unilateral digital services taxes that they might have introduced. For this global agreement to take effect, it requires cooperation from the tax administrations of both the market jurisdictions and the head office jurisdictions. The US is clearly one of the biggest of these, and it is not going to be straightforward getting this through the US legislative process, even with the Biden administration on board.
Many industrials may have implemented distribution models that limit their physical presence in high tax jurisdictions, or that ensure their subsidiaries and permanent establishments in those jurisdictions have a very low risk profile to reduce the profit margin allocated to them. Accordingly, if Pillar 1 means that (at least) 25 per cent of a group’s residual profitability will be taxed in the market jurisdictions where their customers are, this may have a large impact on existing distribution structures.
A case study
Take the example of a large, highly profitable diversified industrial MNE with its ultimate customers all over the world, which is headquartered and operates through a jurisdiction with a relatively low tax rate of 10 per cent. To date, in order to deliver its products locally, it has primarily relied on direct sales from its head office or, where this is not feasible, on low-risk local distributors which only attract a minimum profit margin in the market jurisdictions, resulting in an effective global tax rate of 12 per cent. Its ultimate customers are primarily based in countries with an effective corporate tax rate of 30 per cent.
Pillar 1 will lead to these market jurisdictions attracting a piece of this MNE’s tax pie – i.e. 25 per cent of its profits in excess of a 10 per cent profit margin – and being able to tax such profits, significantly increasing the MNE’s future effective global tax rate. The position may not be straightforward for MNEs that are not directly consumer facing, such as a large automotive supplier that predominantly serves two automotive original equipment manufacturers (OEMs) in jurisdictions A and B but with customers located all over the world. In such a situation, which are the relevant market jurisdictions to which excess profits could be re-allocated for taxation: A, B or the countries in which the ultimate customers reside? And if the latter, how do you make this workable in practice….?
This overhaul of the existing tax system is likely to lead to large multinational groups reorganising structures and having to assess whether they have the systems in place to ensure they have the information needed to comply with these new rules and to handle any disputes that may arise.
Pillar Two – a global minimum rate of tax
Although Pillar 1 is revolutionary as a tax idea in terms of what it looks to do, it is relatively narrow in terms of the number of industrial groups affected. By way of contrast, Pillar 2 could impact more industrials groups, firstly because it has a much lower threshold for groups to be in scope and secondly because it uses tools that are already in the tax armoury and just notches things up another level, so will potentially be easier for tax administrations to implement. The basic idea is that you look at a multinational on a jurisdiction by jurisdiction basis and in each jurisdiction you look at the profits that are being earned there broadly by reference to what is reported in the accounts of the entities that are based there or trading there. If the effective tax paid in that jurisdiction on those profits is less than 15 per cent, then potentially you could face additional tax under these rules.
How does it work?
This works by way of two main rules. The primary ‘income inclusion rule’ is one that it is anticipated that the parent jurisdiction of the group would operate, and this is akin to a controlled foreign company or CFC type rule. The way that would then work is that the parent jurisdiction would levy a top-up tax to bring the effective rate of tax paid in that jurisdiction up to 15 per cent. There is also a secondary ‘under taxed payments rule’, which is designed to operate as a backstop where the parent jurisdiction is not (or not sufficiently) operating the primary rule. This is important because it is intended to limit the incentives for groups to migrate, moving the parent company from a jurisdiction that does apply the primary rule to one that does not. To prevent this, the secondary rule allows other jurisdictions in which the multinational operates (i.e. not the parent jurisdiction or the low tax jurisdiction) to levy the top-up tax in if payments are made from such jurisdiction to a low-tax jurisdiction. There are two broad effects of this. One is that it reduces the incentive for jurisdictions to compete on tax, in the so called “race to the bottom” by reducing corporate tax rates or narrowing the corporate tax base. This is why those jurisdictions which do compete on that basis, Ireland being a prominent example, were concerned about this. However, they have decided that it is better to apply the rules themselves rather than have those revenues go to other tax administrations instead. The second impact this will have is on those groups who might historically have used IP holding structures or financing structures. These changes could therefore potentially influence broader decisions around the location of operating businesses, although it should have little impact on the location of holding companies.
For industrials, although Pillar 2 will impact more groups due to the lower threshold, its impact is likely to be less disruptive as it essentially fills in the gaps that have not yet been closed by existing tax rules that are already in place. But again, taking a longer term view, it may lead groups to rethink their tax structuring as, for those groups with subsidiaries or permanent establishments in low tax jurisdictions, current structures may not make as much sense going forward, either because these jurisdictions will adapt to the new 15 per cent level, or there will be a top up tax elsewhere in the group.
As always, the devil will be in the detail and the application of the new rules is unlikely to be straightforward. For example, MNEs that make use of special tax deductions or "super allowances", for instance for investments into digitalisation or green investments, will need to ensure that this does not lead to their effective tax rate falling below the 15 per cent threshold in the relevant jurisdiction.
DEBRA: Debt Equity Bias Reduction Allowance
This initiative from the EU (which forms part of its Business Taxation for the 21st Century package – BT 21, as to which see our dedicated webpages) is designed to address the fact that taxpayers are currently incentivised to leverage up as much as possible to generate interest expenses which are deductible and thereby reduce the amount of tax due. The result of this, particularly in times of crisis, is that companies are over-leveraged, increasing the risk of insolvency. The EU is seeking to disincentivise this debt bias and promote stability and it is exploring two ways of achieving this (i) by restricting deductions for interest payments, and (ii) giving deductions for equity funding. The consultation on this has now ended, but the details are still unknown and the likelihood of implementation of this measure remains unclear. The key focus of the EU is currently on the OECD initiative around the two pillars, but this measure is definitely one to watch, because if it is implemented, it could have a material impact on both internal and external financing structures.
The international tax framework is changing and this could have a fundamental impact on industrial groups, both in terms of the amount of tax they pay and in terms of their structures. The potential for international tax disputes in this area (around double taxation and otherwise) is also high. We expect more details on all these initiatives in 2022 (and potentially even by the end of 2021 in the case of Pillar 2).
"Today’s agreement will make our international tax arrangements fairer and work better. It is a far-reaching agreement which ensures our international tax system is fit for purpose in a digitalised and globalised world economy." OECD Secretary-General Mathias Cormann