A&M Tax Advisor Weekly
A landmark approach to global tax reform addressing the challenges presented by the digital economy advanced this month with 136 countries agreeing to an October 8th “Statement,” which was quickly given an endorsement by the G20 Finance Ministers. The multi-year journey involving intense negotiations and compromises which began as Action 1 of the BEPS Project has culminated in a five-page statement describing (i) fundamental changes in how large multinational enterprises (MNEs) will be taxed in market jurisdictions (Pillar 1), and (ii) a global minimum corporate tax rate of 15% (Pillar 2).
The parties to the Statement have committed to an ambitious goal of implementing the reforms by 2023. This could provide impetus for the Democrats to rally around their spending and tax plans in the budget reconciliation bill that includes a revamped global minimum corporate tax regime (which is described here) to address base erosion that would align at a high level with Pillar 2.
Although many technical and implementation issues still remain unresolved, we thought discussing the salient points and looming concerns of the global tax reform system would be helpful, not only for the targeted multinational enterprises as they consider the necessary modeling, but also for unsuspecting smaller businesses that could be affected.
Reallocating Large Multinationals’ Profits
The goal of the new profit allocation and nexus rules under Pillar 1 is to provide the jurisdictions where customers are located (“market jurisdictions”) a new right to tax income of certain large MNEs (based on thresholds described below) when those MNEs do not have a significant physical presence in that country. Although this reallocation of taxing rights is aimed at the tax challenges of a digital economy, it is not limited to companies that provide digital goods and services.
Under the proposed rules, roughly 25% of an MNE’s book profits in excess of 10% of its book revenue (Amount A) is reallocated to market jurisdictions in which the MNE derives at least €250 thousand (approximately $400 thousand) in revenue, for jurisdictions with a GDP lower than €40 billion, or at least €1 million (approximately $1.16 million) in revenue for all other jurisdictions. The allocated book profit will be subject to tax in the applicable jurisdiction, or the losses will be carried forward. Therefore, tax will be based on financial accounting income, with some adjustments.
Example: A pharmaceutical company in Ireland, which is subject to Pillar 1 has book revenue of €30 billion and book profits of €20 billion, generates €100 million of revenue from sales to France. Under the proposed rules, the pharmaceutical company’s Amount A would be roughly €4.25 billion (25% * (€20 billion book profits – (10% * €30 billion book revenue))), which could be shifted to France.
As a result of shifting profits to other jurisdictions under Pillar 1’s formulary approach, there is the risk of double taxation that arises because countries currently tax the residual profits of these multinationals based on the arm’s length standard and according to bilateral income tax treaties. These countries will have to exempt the allocated profits from tax or provide a credit for tax paid in the market jurisdiction. Implementation of Pillar 1 will be accomplished by an envisioned multilateral convention, which will include a mandatory and binding dispute resolution mechanism.
A&M Insight: While the proposal is designed to help avoid double taxation, the implementation of the avoidance of double taxation may be difficult due to book-to-tax differences. Specifically, countries will need to determine to what extent the allocated book profits are actually subject to tax in their jurisdiction. Additionally, the proposed dispute resolution mechanism may override current treaty provisions. While Congress has overridden past treaties across the board, it is quite rare (e.g., treaties were overridden to implement the FIRPTA regime).
The second element of Pillar 1 provides for a fixed return (Amount B) for baseline distribution and marketing activities that occur in the market jurisdiction. The envisioned multilateral convention will provide a simplified and streamlined approach to the application of the arm’s length principle to those activities.
The multilateral convention will also require the removal of digital services taxes and similar unilateral measures for all companies. According to the Statement, governments will commit not to impose newly enacted measures on any company beginning October 8th until the earlier of December 31, 2023, or when the multilateral convention comes into force. The Statement does not address existing measures in the interim, but since its release the United States and European countries have reached an agreement on how existing digital tax measures would be rolled back.
A&M Insight: There are numerous technical issues that need to be addressed for taxpayers to truly evaluate the implications of the agreement, including how residual profits are calculated, what are the revenue sourcing rules, and the protections against double taxation. Also, reaching agreement on how to calculate Amount B may be a challenge, as most companies engage third party agencies for business-to-consumer campaigns.
Mitigating Base Erosion
The anti-base erosion rules under Pillar 2 allow countries where multinationals are headquartered to impose additional taxes on income arising outside of their jurisdiction (based on a threshold described below) using a 15% minimum tax rate. Carveouts will be based on a percentage of intangible assets and payroll costs — initially at 8% and 10% respectively, and then reduced annually over a ten-year period, ultimately to 5% for both intangible assets and payroll.
Pillar 2 also provides source countries the right to tax some base-eroding payments, such as interest and royalties, if they are taxed at a rate below 9% in the residence country. That rule, referred to as the subject-to-tax rule (STTR), is treaty-based and can be applied to MNEs even if the country opts out of the 15% minimum tax rules.
A&M Insight: Managing effective tax rates will become more complicated with implementation of Pillar 1 and Pillar 2 requiring robust country-by-country data collection and analytical tools to assess the implications. Like Pillar 1, Pillar 2 still has technical issues that need to be addressed including how to calculate the applicable effective rate on a jurisdictional basis, although the proposed GILTI country-by-country reporting in the House’s draft legislative language may provide some insights (which is described here). With that said, because the rate will be based on financial accounting income, rather than taxable income, companies will need to understand the mechanisms that will be used to address timing differences.
Thresholds Target Large MNEs
Pillar 1 targets the largest and most profitable MNEs (about 100 companies) — those with gross sales above €20 billion (approximately $23 billion) and pre-tax book profits above 10% of revenues — while excluding for certain types of businesses, such as regulated financial services and extractive industries. The OECD estimates that $125 billion of annual profits will be reallocated from jurisdictions in which MNEs are headquartered to market jurisdictions in which their customers and users reside. In-scope MNE groups are expected to be predominantly headquartered in the United States, Switzerland, Ireland, and the United Kingdom, although there is no geographic limitation on the location of the headquarters for the agreement to apply.
Pillar 2 will apply to more MNEs— those with over €750 million (approximately $870 million) in revenue with some exclusions. The anti-base erosion regime is estimated to generate around $150 billion annually in additional global tax revenues.
A&M Insight: Although the two-pillar system should combat global tax base erosion, the effects of the measures on multinationals could trickle down to their suppliers and OEMs. For example, a pharmaceutical company in Ireland selling to France, with third-party suppliers of powders, chemicals, or packaging material wouldn’t necessarily be affected by the two-pillar system but could get squeezed as multinationals reassess their supply chains. As multinationals consider restructuring, OEMs may have to realign themselves to ensure they are not left out.
Implementation in the United States
While the announcement of the agreed upon framework is momentous, it is the starting point rather than an ending point. On top of ironing out the technical issues for the multilateral convention under Pillar 1 and the model rules under Pillar 2, countries will need to implement those policies, including enacting legislation. In the United States, partisan politics may throw a monkey wrench into its ability to implement the global system, which will require modifications to the GILTI regime and tax treaties.
A&M Insight: Democrats are trying to advance their domestic agenda but haven’t been able to overcome the objections of some members, creating some uncertainty as to whether they will be able to enact some aspects of their spending and tax proposals. On top of that, the Biden Administration has committed to implementing something that will reform global tax laws, which will need to clear Congress, and may require Republican signoff.
A&M Taxand Says
Designing a harmonized set of rules to tax digital presence and ensure that locally generated value is taxed locally seems appealing, but the implementation challenges shouldn’t be overlooked. With that said, it is imperative that companies begin to think about how the rules could be interpreted and model out the potential implications. The OECD expects to have model rules for implementing the global minimum tax and a model treaty to effect the STTR by the end of November, followed by a multilateral convention to update relevant bilateral treaties by mid-2022. The implementation framework for the minimum tax rules will be completed in 2022, which will provide administrative procedures and safe harbors to ensure coordination and consistency. We think it’s important for taxpayers to assess systems capabilities and adaptable solutions for an ever-changing environment. If you would like to discuss your situation, the changes coming, and operational and strategic challenges, please feel free to contact Kevin M. Jacobs, Fabrizio Lolliri, or Marc Alms.