A consideration of the future of the OECD Pillar One and Pillar Two initiatives.
This article was written by Jerome Tse, Stuart Broadfoot and Amanda Kazacos.
In June 2020, the United States pressed “pause” on its participation in the OECD’s Pillar One and Pillar Two initiatives, which are designed as “phase 2” of the OECD’s base erosion and profit shifting (BEPS) project. Despite this, the OECD emphasised its view that the United States has neither walked away from negotiations nor pulled out of discussions. This serves as a timely reminder that there are a range of hurdles to the implementation of the OECD’s Pillar One and Pillar Two initiatives. This article provides an overview of the relevant initiatives and considers alternative methods of moving forward with these initiatives where there is no consensus between countries.
Pillar One – Unified Approach
Pillar One is designed to address the perceived issue of digital services companies and other participants in the digital economy not being subject to tax in the jurisdiction in which they offer their services. The OECD’s concern that the traditional methods of capturing taxes through the use of permanent establishment and transfer pricing rules are no longer “fit-for-purpose” in determining where tax should be imposed – on the basis that value is being created in the “market jurisdiction” (being the location where the end user is located).
The OECD released its unified approach in October 2019, which targeted multinational:
- automatic digital services businesses (e.g. online search engines, digital content streaming and social media platforms); and
- consumer-facing businesses (e.g. businesses that sell products through third-party resale, franchise businesses).
It proposed to fundamentally alter the taxing rights that each country has in relation to the profits of multinational companies, to give the “market jurisdiction” new taxing rights.
Under the proposal, the profits that may be allocated to the “market jurisdiction” include:
- Amount “A” – this is designed to be a share of the “residual profits” of the business (i.e. that profit in excess of a defined base level of profits), which would be allocated based on a formula to each market jurisdiction (irrespective of whether the business had a permanent establishment in that jurisdiction).
- Amount “B” - a fixed base level return based on a standard set of routine marketing and distribution activities, which take place in the market jurisdiction, and which is only allocated if the business has a permanent establishment in the jurisdiction;
- Amount “C” Amount - an additional level of return applicable where activities in the market jurisdiction are over and above the consideration reflected in Amount “B”, to be determined on the basis of arm’s length principles and applicable only where the business has a permanent establishment in the market jurisdiction.
The base level of profits would continue to be allocated to the “home” jurisdiction.
A range of elements vital to the application and implementation of Pillar One remain unresolved including the gross revenue threshold (currently EUR 750 million is being contemplated) and the de minimis threshold for an entity to be within the scope of Pillar One and the profitability thresholds for determining what profits are “residual profits”.
Pillar Two - GloBE
Pillar Two is the global anti-base erosion (GloBE) initiative and is designed to address perceived concerns about the shifting of profits to low or no tax jurisdictions. In essence, it is designed to allow jurisdictions to “tax back” amounts where amounts have not been subject to a global minimum income tax rate.
However, the fundamental element of this initiative, the minimum rate, is yet to be determined and will have significant influence on the scope of the measure. By way of example, the minimum rate will determine whether this measure only captures jurisdictions with no/nominal tax rates, or whether it also captures a range of other jurisdictions who have adopted low tax rates to encourage international business (e.g. Ireland, especially when compared to Australia’s current corporate tax rates). Significantly, it suggests that jurisdictions that choose to impose a low or no income tax are a problem per se (which does not seem to be the position under the original BEPS measures).
Within this initiative there are a range of rules that could apply to ensure amounts are subject to the minimum tax rate:
Home jurisdiction collects additional tax
- inclusion rule - where income is not subject to an effective rate of tax above the minimum rate, an amount would be additionally taxed on the parent entity (based on consolidated global accounting profit) in its home jurisdiction.
- switch off exemption rule – this extends the inclusion rule to switch off the traditional exemption from tax for profits attributable to a foreign branch under double tax treaties, and would subject those branch profits to tax in the home jurisdiction.
Market/source jurisdiction collects the tax
- undertaxed payment rule - denying a deduction (or making an equivalent adjustment) in respect of intra-group payments in the market/source jurisdiction, where the payment would not be subject to the minimum tax in the recipient jurisdiction.
- subject to tax rule – this involves subjecting a payment to withholding or other taxes imposed by the source/market jurisdiction (and denying treaty benefits that may otherwise exempt / reduce those withholding taxes), where the payment is not subject to minimum tax in the recipient jurisdiction.
The order of priority of the above rules has not yet been determined and will be significant as it will determine which jurisdiction collects any additional tax raised. There is also a suggestion that there may be limitations to the application of the Pillar Two initiative, including a group turnover threshold (currently a threshold of EUR 750 million is being contemplated, akin to the Pillar One initiative) and exemption for regimes compliance with BEPS Action 5 on harmful tax practices (which the United States has advocated for, and which would result in this being a much more limited, anti-avoidance style measure).
Roadblocks to implementing (and a roadmap for) the Pillar One and Pillar Two Initiatives
There are considerable roadblocks to the successful implementation of the Pillar One and Pillar Two initiatives.
Most critically, as already noted, the United States has “paused” its involvement in the Pillar One and Pillar Two initiatives. Given the preponderance of multinational digital services business are located in the United States, this poses a significant hurdle to progressing these measures. However, the actions of the United States are perhaps not surprising given that the United States has the most to lose from this measure, which may see its taxing rights allocated to other jurisdictions.
More broadly, there is a significant level of complexity to resolve in respect of the Pillar One and Pillar Two initiatives. Pillar One would allocate taxing rights to a range of new jurisdictions, and likely involve allocations amongst numerous jurisdictions. Accordingly, there is a need to resolve how disputes over that allocation would be settled. There is also likely to be significant disagreements surrounding the quantum of and formula to determine the amount of profits to be allocated to the market jurisdictions, given they are effectively about allocating additional tax revenues.
In respect of Pillar 2, there are key features still to be resolved, including the relevant minimum tax rate and the order of application of measures. On the minimum rate, as already noted above, this will make a considerable difference to the scope of the measures, and it remains to be seen whether key jurisdictions with lower tax rates (as opposed to only those jurisdictions will nominal tax rates) would be caught. On the order of measures, this will determine which countries collect the additional tax revenue – and whether it will flow to generally Western headquartered / parent company jurisdictions, or whether smaller and developing countries (where payments are made) get the revenue.
Both proposals also make extensive use of global accounting standards to try and “simplify” and make more consistent the application of the rules (rather than relying on the varying tax bases of each relevant jurisdiction). However, accounting standards are not designed to be a basis for imposing taxation, and there are a range of adjustments that would be necessary to be made to allow them to fulfil this purpose (potentially creating what is, in essence, a global taxable income standard). Equally, there is the prospect for significant cross-border disputes over the way accounts are prepared and the way the accounting standards are to be interpreted.
The OECD and most jurisdictions are still working on developing the Pillar One and Pillar Two proposals. The hope is likely to be to be able to pressure jurisdictions into adopting the rules if a consensus can be reached. However, the unilateral actions of certain countries indicates that there may need to be roadmaps to allow progress to be made in circumstances where consensus cannot be reached.
Pillar One is, in essence, a digital services tax. It is understood that any implementation of Pillar One would include a commitment by members to withdraw any unilateral digital services taxes. However, a failure to institute Pillar One may encourage countries to implement unilateral digital services taxes, which have already been considered and implemented in various countries. Relevantly, the United Kingdom, France, Austria, Italy and Turkey have proposed or implemented a digital services tax. However, this runs the risk of creating significant trade disputes. By way of example, the United States is proposing tariffs of roughly USD 2.4 billion in French products in response to the introduction by France of a digital services tax that “discriminates against US companies” and in addition has cautioned the United Kingdom that unless the “punitive” digital services tax is reconsidered, any post-Brexit trade deal may be derailed or alternatively that the US may impose trade tariffs.
Against this background of United States retaliation, it may be that countries move to a hybrid model of broadening the goods and services tax base (or VAT) to encompass a greater level of digital services (although this raises significant problems of revenue collection). Whilst it may result in additional revenue collection and may address disparities between local and multinational businesses, it is not going to address popular media and NGO concern that accompanies the release of the levels of tax paid in jurisdictions by the global multinational digital service companies (the so-called FAANGS).
If consensus is not achieved in respect of Pillar Two, it is possible that this initiative could be introduced on an opt-in basis by way of multilateral instrument (similar to the original BEPS measures). This would involve amending various double taxation agreements on a jurisdictional basis and if history is an indication (with the significant number of signatories to the multilateral instrument by jurisdictions with respect to the original BEPS measures) this may be a workable option.
The US has also already implemented rules that are in many respects similar, in the form of their global intangible low-taxed income (GILTI) and base erosion and anti-abuse tax (BEAT) measures. Those measures effectively result in additional tax being paid in the US by multi-national corporations. Accordingly, there may be some compromise possible where those aspects of Pillar Two are implemented (although this is likely to initially leave small and developing countries without any additional tax revenue).
Whatever the outcome, there is likely to be a bumpy road ahead for international taxation.