In October 2019, we published a summary of some of the key challenges posed to existing tax
systems by the internet.
At that time, the Organisation for Economic Co-operation and Development “OECD” had intended to build a broad consensus on the way forward by the middle of 2020.
The COVID pandemic has delayed this but July 2021 has seen major progress and the OECD hopes to finalise a detailed implementation plan by October 2021, following endorsement by the G7 and G20.
This article provides a brief summary of the key proposals which will fundamentally change the
way the international tax system has worked for the last hundred years.
It should be noted that many aspects are complex and potentially affected taxpayers are recommended to analyse them in detail.
What’s the problem?
As discussed in the previous article mentioned above, the development of the internet has enabled some multinational businesses to build revenues via a digital presence in a jurisdiction
without the need for a significant physical presence.
Without such a physical presence a permanent establishment (‘PE’) or branch to which revenues and profits are attributable may not exist under current domestic tax rules or double taxation agreements (‘DTAs’).
At the same time, there has been a growing consensus that many multinationals have been able to minimise the overall tax on their activities because the internet gives them greater flexibility to locate key profit generating activities in jurisdictions with low effective tax rates.
Moreover, some jurisdictions, alongside traditional tax havens, have sought to provide low tax environments for certain activities in order to attract foreign investment.
A two pillar solution
To tackle these twin problems, the Inclusive Framework has agreed a two-pillar approach to
adapt the international tax system to the realities of the digital economy.
For countries which adopt this approach, the pillars will requirechanges to both the domestic tax system and any DTAs to which the country is party
a) How it will work: Pillar One
Pillar One introduces a revolutionary approach to taxing multinationals.
Instead of the current approach of computing taxable amounts based on the sources of income and residence of the recipient, the new approach will allocate taxing rights to countries where goods and services are sold/consumed (‘market jurisdictions’) even where the legal entity generating the revenue is not tax resident in that jurisdiction and does not have a source of income there which is subject to tax under current rules.
This is to be achieved via the computation of ‘Amount A’ based on the overall accounting profits of the multinational group part of which will be allocated to market jurisdictions based on a pre-determined formula and taxed there.
Relief will then be given for the resulting tax in the legal entity’s residence jurisdiction via credit or
exemption to avoid double taxation.
‘Amount B’ will be a methodology to define the taxable income of an entity in a market jurisdiction that is involved in marketing and distribution and already taxable there.
This will be based on a simplified application of the arm’s length principle.
Much of the detail of how this will work, and how the inevitable disputes over allocation will be
settled, has yet to be agreed.
The important feature is that it overrides the application of the arm’s length principle to individual subsidiaries of the multinational.
It is planned to prepare a multilateral instrument to make necessary modifications to the application of DTAs before the end of 2022.
This will come into effect in 2023 at the earliest.
Changes to domestic tax laws in implementing jurisdictions will also be required. Rather than focusing on digital businesses specifically, such as Amazon and Facebook, the Pillar One is to apply to multinationals with a turnover in excess of 20 billion euros and pre-tax profits exceeding 10% of revenue.
Subject to successful implementation, it is intended todigital services taxes will be withdrawn by
countries which adopt Pillar One.
How it will work: Pillar Two
Pillar Two is intended to introduce a minimum level of taxation on the profits of multinationals
and would apply much more widely than Pillar One.
Prima facie, it will apply to the extractive industries and regulated financial services, which
are to be excluded from Pillar One.
The proposed minimum effective tax rate is 15% and this will apply to multinationals with a
turnover of at least 750 million euros (much lower than that contemplated for Pillar One).
The basis for calculating the effective rate will be the tax charge shown in the relevant financial
statements, rather than the statutory rate, as the latter can be reduced in practice by incentives,
reliefs and exemptions.
Where the subsidiary of a multinational has an effective tax rate below the minimum rate, new
tax rules will be applied to tax the parent company on the difference between the actual
effective tax rate and the 15% minimum.
Where payments are made to an affiliate which is subject to an effective tax rate below the minimum, the amounts will not be deducted in computing the payer’s profit tax.
These new rules are referred to as the Global anti-Base Erosion (‘GloBE’) rules and will require changes to domestic law.
A second regime (the ‘Subject to Tax Rule’ – ‘STTR’) will be introduced to participating jurisdictions’ DTAs via a multilateral instrument, to enable source jurisdictions to apply tax (presumably via withholding in most cases) to related party payments which are subject to tax at a rate below a specified minimum which is proposed to be in the range 7.5% - 9%.
Pillar Two is to be implemented via law and DTA changes during 2022 and to apply from 2023.
When we last wrote on this topic in 2019 a global consensus seemed far off, and in particular to
attitude of the United States of America (home of most of the largest participants in the digital
economy) was seen as obstructing progress.
It is impressive that so much has been achieved since the new US administration came to office.
As usual, however, the devil is likely to be in the detail, and the OECD’s plan for rapid implementation is certain to give rise to further uncertainty and potential conflicts.
The proposals are already being criticised by some NGOs as unduly favouring developed over
The Tax Justice Network believes that the formula proposed for computing Amount A advantages headquarter jurisdictions over market jurisdictions, particularly those in the developing world.
They also argue that raising the minimum effective tax rate under Pillar Two to 21% could raise additional tax of US$100 billion.
The proposals seem to have the international political support needed to succeed despite the
resistance of a few low tax jurisdictions, notably Ireland and Hungary.
We will provide further updates as the implementation phase progresses.
The writers are with Cristal Advocates